Is the tide turning for emerging markets?

Investors taking a cursory glance at stock markets this year might believe a rising global equity tide has lifted all boats. However, emerging market (EM) equities have lagged more impressive developed market returns.

Liquidity over growth

A stop-start trade war between the US and China, the slowing global economy and rising geopolitical tensions have done little to stop US stocks registering returns of over 25% this year. This extends a decade-long bull market - overshadowing other asset classes - in a phenomenon many investors have come to refer to as “TINA”, or there is no alternative.

EM equities, on the other hand, have returned a somewhat pedestrian 8.5%, with many currencies continuing to weaken against the US dollar. However, with the Federal Reserve (Fed) now signalling, at the very least, an extended pause in rate cuts - rising US rates are generally bad for EM equities - the stars may finally be aligning for EM to shine in 2020.

As we look into 2020, we think the outlook for EM is finally beginning to improve, with economic data beginning to show signs of acceleration. In addition the lagged effect of looser Chinese and US policy is likely to prove beneficial.

Emerging market PMIs show faster expansion than developed markets

Source: Thomson Reuters, Schroders

Is the tide turning?

The composite PMI – a measure of economic activity - for developed (DM) and emerging markets in October were a shade over 50 and just under 52, respectively, representing an economic expansion in both regions.

However, looking at the relative ratio of EM over DM PMIs reveals that we are now in the third consecutive month of positive territory - meaning EM is expanding at a faster pace than DM. More strikingly, this ratio is at the highest level since early 2013.

Plotting this ratio alongside the relative performance of their corresponding equity markets, for example, it looks like EM stocks are at an upward inflection point after a long period of relative underperformance.

Heading into 2020 we expect the EM tide to rise

With less direct support from the Fed and other central banks next year, returns will likely be driven more by growth than liquidity, favouring markets with higher earnings’ growth rates.

Assuming a limited initial US-China trade deal, the more favourable growth outlook for emerging economies next year should therefore provide a benign backdrop for EM stocks.

…but choppiness and risks lie ahead

Going forward, should we see sustained political unrest or an unfavourable outcome in the trade war negotiations, we will likely see growth momentum in emerging economies fade.

Whilst the acceleration of EM growth and PMIs ratio leave us optimistic on EM stocks as a whole, it is critical to note the importance of selectivity within the region to avoid the potential headwinds – both political and economic – that 2020 may bring.

What is the Purchasing Managers’ Index and why does it matter?

The purchasing managers' index (PMI) is an economic indicator that surveys the intentions of businesses across a range of industries. The most common PMI surveys are the manufacturing PMI and the services PMI, which together form the composite PMI. They are used as leading indicators of economic health and are important for investors when forecasting GDP growth. A PMI above 50 representing an expansion relative to the previous month while a print below 50 indicates a contraction.