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Emerging markets miss out on 2021 stock rally in developed economies

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Emerging market stocks are lagging behind those in developed economies by the most since 2013’s “taper tantrum”, as investors fret that global tightening in monetary policy will trigger a flight away from the asset class.

MSCI’s EM benchmark is essentially flat for 2021 in US dollar terms, including dividend payments. The lacklustre performance starkly contrasts with the index provider’s global gauge of DM stocks that has delivered returns of more than 20 per cent so far this year, bolstered by gains in US and European equities.

EM bonds have also fared poorly, with a fall in prices more than offsetting the relatively juicy interest payments investors earn from holding the debt. JPMorgan’s index tracking debt issued in local currency is down 8.1 per cent for the year to date in US dollar terms. A similar gauge of bonds issued in major developed market currencies is off 1.5 per cent.

Analysts warn that market conditions could deteriorate further after the Federal Reserve announced plans this week to begin reining in its coronavirus crisis stimulus measures. In 2013, the US central bank’s decision to begin easing its economic support measures prompted a heavy sell-off in emerging market assets, part of a broad shake-up in financial markets dubbed the taper tantrum.

“We are heading into a scenario of slowing global growth and rising inflation, with central banks being forced to act. That should be super negative for emerging markets in general,” said Minna Kuusisto, head of global macro research at Danske Bank in Helsinki.

Other risks include a sharper than expected slowdown in the Chinese economy — a key driver of growth across emerging markets for the past two decades — and, for many poor countries, severe delays in vaccination against coronavirus, putting recoveries from the pandemic in jeopardy.

Despite this year’s poor returns and the risks ahead, investors have continued to put money into emerging market assets.

After a bout of panic selling at the onset of the pandemic in March last year, in which foreign investors took $90bn out from emerging market debt and equities, net portfolio flows to EM assets have been positive in all but one of the 19 months since. Almost $790bn has flooded back in, including $25bn in October, according to the Institute of International Finance, an industry association.

One reason is the trillions of dollars pumped into global financial markets by the Fed and other advanced economy central banks during the pandemic. Many governments in emerging markets have seized the opportunity to issue new debt at lower interest rates than those usually on offer. Starved of yield elsewhere, and with attractive valuations compared with assets in advanced economies, foreign investors have piled in.

Column chart of Non-resident cross-border portfolio flows to emerging markets, $bn showing Investors have bought EM assets through most of the pandemic

But that has not been enough to drive prices up. One factor weighing them down, analysts say, has been the threat of rising inflation around the world, something that has pushed bond yields higher across developed markets.

“Prices reflect expectations for the future,” said David Hauner, emerging market strategist and economist at Bank of America. “Global rates have spiked and that has weakened prices, even though investors time and again have tried to buy the dip.”

Policymakers in many emerging markets began tightening earlier this year. Some have been aggressively raising interest rates in the face of accelerating consumer price inflation.

This in itself will put a brake on growth. But emerging economies are in a particular bind because one of the factors driving inflation is rising energy prices, caused partly by pandemic-related disruptions. Some countries such as Russia stand to benefit, but many emerging markets will be hurt by higher fuel prices in a world of slower growth.

Kuusisto singled out India, Turkey and Egypt as particularly vulnerable. But most emerging countries in Europe, Asia and Latin America will suffer over the coming months, she warned, as energy puts an additional drag on growth.

“Markets are focusing on inflation but not on growth stagnating,” she said. “I’m not sure if they have really paid attention [to rising energy prices] and the implications for emerging markets.”

This leaves EM stocks and bonds particularly exposed to the threat of rising interest rates in the US and other advanced economies, which will reduce the appeal of risky assets.

Many analysts say a carbon copy of the taper tantrum is unlikely because, this time, investors will not be taken by surprise. They also note that many emerging economies have built up powerful buffers in the form of foreign exchange reserves and more resilient debt profiles, with less reliance on foreign currency debt or short-term borrowing.

But the pandemic has challenged some of those defences. Trade balances have been hit by rising commodity prices, while debt has piled up, often of short duration and with an increasing share held by foreign investors, leaving many countries vulnerable to withdrawals.

Kuusisto at Danske Bank fears flows to emerging market assets may not hold up for long: “There are just so many risks,” she said.

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