Emerging Market Stocks And Bonds Are On Divergent Paths

Emerging markets (EM) started 2023 on a strong note. Both EM equities and bonds have delivered positive returns so far this year, but the paths they took have been quite different.

EM local-currency bonds have been on a steady upward trend. The JPM GBI-EM Index returned 7.8% in US dollars by mid-June, handsomely outperforming its developed market (DM) counterpart, which was up a modest 1.2%.

EM equities, on the other hand, were far more volatile. The MSCI EM Index rallied 10% in January but gave back those gains by mid-March. It managed to stage a rebound in June that brought its year-to-date return back above 7%, yet this lagged DM equities’ 14% rally.

Cheap valuations and US dollar weakness are partly behind the performance of the two main EM asset classes, but there are two distinctive factors that explain, and will continue to drive, their divergence:

• Inflation dynamics
• China’s choppy recovery

Inflation dynamics

Inflation started to weaken in most EM regions from the fourth quarter of last year. And that's mostly because the forces behind 2022’s surging prices – supply chain bottlenecks and commodities scarcity – are abating.

Easing inflationary pressures have been good news for EM bonds, because central banks can ease off on interest rate hikes. In fact, markets have moved to price in different degrees of rate cuts across EMs over the next 12 months. This easing outlook, alongside high real yield embedded in the prices of EM local bonds, make a compelling investment case.

However, falling inflation can be a challenge for EM equities that are heavily tilted towards North Asia – the manufacturing hub of the world. China, Taiwan, and Korea collectively represent nearly 60% of the MSCI EM Index. Weaker goods prices mean weaker pricing power, which will weigh on profit margins and delay earnings recovery. Year-on-year change in China’s Producer Price Index has fallen into negative territory, which helps explain why company earnings aren’t keeping up with the economic rebound this year.

China’s choppy recovery

Weakening inflation in emerging markets isn’t the only problem that China has. Its post-reopening recovery has been a rollercoaster ride that’s not for the faint of heart.

After an initial strong rebound in economic activity coming out of last year’s Covid lockdown, growth indicators moderated in the second quarter. The industrial sector is particularly weak, as the National Bureau of Statistics’ manufacturing purchasing manager index (PMI) slipped below 50 in both April and May, signaling a contraction, rather than expansion. Industrial production and exports were also lower than expected.

Even more concerning is the sharp decline in property sector activities after the impressive surge in the first quarter, fueled by pent-up demand. The level of housing transactions in the second quarter is just on par with the level during the corresponding period in 2022. This has raised concerns of a growth "double dip", given that the property sector and related activities account for nearly 30% of China’s economy.

Such a swing in growth expectations has caused significant volatility for Chinese equities. The MSCI China Index was up as much as 17% in January but ended the month of May down 8% on the year.

On the flip side, China local-government bonds have benefited from the growth uncertainty and subsequent policymakers’ liquidity support. Elsewhere, China government bond 10-year yields have fallen this year (as bond prices rose). With a foreign exchange hedged carry of more than 5% on those bonds – the yield that investors will receive after hedging the currency risk of the investment back to their base currency – US dollar-based investors are getting an interesting proposition.

Given that China accounts for about 30% of the MSCI EM equities index and about 10% of the EM local-currency bonds index, the divergence in equities and bonds on the back of the country’s unconvincing recovery, has found its way to drive broader divergence in risk-adjusted returns between EM equities and bonds.

Why should you care?

Weakening inflation and China’s troubled recovery will continue to affect the performance of EM assets during the second half of this year.

For now, the mix of declining inflation, less hawkish central banks, and a challenging outlook for growth in China, suggest that local currency sovereign bonds offer the an attractive risk-reward proposition within the EM investment universe.

It may also make sense to diversify away from China to other EM stock markets with stronger fundamentals, like India and Korea.

Looking forward, if global growth starts to fall more meaningfully so that disinflation accelerates, the outlook may become even more positive on EM bonds and more cautious on EM stocks.

On the other hand, if goods prices and demand stabilize, and China rolls out enough support to shift its economy back onto a sustainable recovery path, current valuation levels of EM stocks do offer an attractive buying opportunity.