#95 – What about Emerging Markets during a recessionary period?

Stay updated in real time

Emerging Markets – In this article you’ll find:

Emerging Markets – Where we are in terms of business cycle and how this may be critical investing decision making
Emerging Markets – Why EMs are important, and which are the five propositions for keeping them in mind
How International Finance Corporation emerging market indices (IFCG) performed during the two major Federal Reserve tightening cycles, in 1988 and 1994
What is the relationship between US federal funds rate and emerging stocks

Here you can find other articles:

Emerging Markets – Fidelity Institutional Insights

The business cycle approach to asset allocation

The business cycle reflects the aggregate fluctuations of economic activity, which can be a critical determinant of asset performance over the intermediate term.

Changes in key economic indicators have historically provided a reliable guide to recognizing the business cycle’s four distinct phases—early, mid, late, and recession.

For example, the early cycle phase is typically characterized by a sharp economic recovery and the outperformance of equities and other economically sensitive assets.

This approach may be incorporated into an asset allocation framework to take advantage of cyclical performance that may deviate from longer-term asset returns.

Asset class performance patterns

The U.S. has the longest history of economic and market data and is thus a good use case to illustrate asset class return patterns across the business cycle.

Looking at the performance of U.S. stocks, bonds, and cash from 1950 to 2020, we can see that shifts between business cycle phases create differentiation in asset price performance.

In general, the performance of economically sensitive assets such as stocks tends to be the strongest when growth is rising at an accelerating rate during the early cycle, then moderates through the other phases until returns generally decline during recessions.

By contrast, defensive assets such as investment-grade bonds and cash-like short-term debt have experienced the opposite pattern, with their highest returns during a recession and the weakest relative performance during the early cycle.

Recession phase

The recession phase has historically been the shortest, lasting nine months on average from 1950 to 2020. As economic growth stalls and contracts, assets that are more economically sensitive fall out of favor, and those that are defensively oriented move to the front of the performance line.

The stock market has performed poorly during this phase. Performance patterns relative to the strategic allocation have been significantly different in recessions than in the other three phases, most notably in the high frequency of outperformance for bonds, and the opposite for stocks.

Cash positions also enjoy their best performance relative to the balanced benchmark, albeit with only moderate hit rates. This phase of the business cycle tends to favor a high conviction in more defensive allocations.

Emerging Markets – Oaktree

EMs amid a Global Slowdown

Emerging markets have become too large and too important for global equity and credit investors to ignore.

EM economies accounted for 71% of global GDP growth in 2019, and their stocks represent about a quarter of global equity market capitalization.

EM corporate debt outstanding has reached record levels, amounting to about double the size of the U.S. high yield bond market.

Emerging Markets – American Express Bank

Emerging Markets in the 80s

In the 1980s and first part of the 1990s emerging markets were widely seen as the most exciting and promising area for investment. Individual country markets were recognised as volatile and risky but nevertheless, (or even partly because of this volatility), were expected to generate strong investment returns.

This expectation was based both on a theoretical view that emerging markets ought to outperform since they were the dynamic economies and the welcome fact that they did outperform for much of the late1980s and early 1990s.

The rise in investment in emerging markets

Private capital flows to emerging markets surged in the 1990’s compared with the 1980s and the fastest growing area was portfolio investment.

Total net capital flows rose from an annual average of $15.2 billion in 1984-9 to nearly ten times that level in the 1990s.

Portfolio investment grew rapidly in the early 1990’s, peaking (net) at $113.6 billion in 1993, but has since been very volatile.

Foreign direct investment rose steadily until 1998, when investment flows to Asia (in particular) fell back, albeit to a limited extent.

Private Flows

Direct investment rose steadily through the 1980s and 1990s, with average annual flows of $12.9bn in 1984-89 rising fourfold to $54.5bn in 1990-95 and by 20% a year in 1996 and 1997.

Portfolio investment was more volatile. In 1984-9 net portfolio flows amounted to $4.7 billion annually, only one-third of average annual direct investment flows.

In 1990-95, average net portfolio investment had risen to equal direct investment and in fact dwarfed FDI flows in 1990-93, the years before the Mexican crisis. The Mexican crisis of 1995 resulted in a sharp drop in portfolio flows to only 42% of FDI flows in 1995.

The case for investing in emerging markets rests on five key propositions

Emerging countries can grow faster than developed markets, provided that they adopt market-oriented policies.
Countries will increasingly adopt market-oriented policies in the current world environment.
Companies in fast growing emerging markets will be able to generate matching profit growth.
Emerging markets have acceptable risks.
Emerging markets have relatively low correlations with major countries.

Market capitalisation vs developed markets

The capitalisation of emerging stockmarkets rose from $614bn at the end of 1990 to $2272bn at the end of 1996, a 270% rise in the six-year period.

The previous six years had seen a fourfold increase. This compares with an increase in developed market capitalisation of 106% between end-1990 and end-1996.

Nevertheless, emerging market capitalisation was only some 12.5% of developed market capitalisation at end-1996.

Emerging markets and US monetary policy

There appears to be no simple relationship between emerging market performance and US money supply growth. Real money supply growth fell dramatically after 1986, yet emerging markets performed well.

And, after 1995, real money supply growth accelerated sharply but the S&P composite index, rather than emerging markets enjoyed the benefit.

And with the funds rate…

There does not appear to be a simple relationship between the US federal funds rate and emerging stocks, either.

The two major Federal Reserve tightening cycles, in 1988 and 1994, saw buoyant emerging markets.

However the period of very low Federal funds rate in 1992-3 does seem to have been a big stimulus, particularly in Asia.

The US Federal funds rate does of course have a very close impact on Hong Kong (not included in the IFC indices) because of the Hong Kong dollar link to the US currency.

However a recession in the US or other industrial countries is not necessarily a major negative for emerging markets. Asian stocks did extremely well in the early 1990’s despite Japan and Europe being in recession.

Emerging Markets – My Conclusions

Only if we master the business cycles, we can have a clear overview of the economy and understand where we are going on.

You’re with me if I tell you that when you have the knowledge to facilitate your work in the investing process that you’ll get a simplification about it.

Sure, it won’t be easy to do it, but you’ll get more statistics to your side.

We also have to know that in the world an important part of the world economy regards the Emerging Markets, so is important to understand these markets and how we could take the best opportunities there.

We’re witnessing a tightening cycle nowadays, so I’ve made a research how EMs have performed during the most bigger tightening cycles by the FED, in 1988 and 1994.

And if there is each relationship between US federal funds rate and emerging stocks.

Emerging Markets – Institutional Considerations

The business cycle reflects the aggregate fluctuations of economic activity, which can be a critical determinant of asset performance over the intermediate term.
The performance of economically sensitive assets such as stocks tends to be the strongest when growth is rising at an accelerating rate during the early cycle, then moderates through the other phases until returns generally decline during recessions.
Defensive assets such as investment-grade bonds and cash-like short-term debt have experienced the opposite pattern, with their highest returns during a recession and the weakest relative performance during the early cycle.
Emerging markets have become too large and too important for global equity and credit investors to ignore.
The case for investing in emerging markets rests on five key propositions

Emerging countries can grow faster than developed markets, provided that they adopt market-oriented policies.
Countries will increasingly adopt market-oriented policies in the current world environment.
Companies in fast growing emerging markets will be able to generate matching profit growth.
Emerging markets have acceptable risks.
Emerging markets have relatively low correlations with major countries.

There appears to be no simple relationship between emerging market performance and US money supply growth. Real money supply growth fell dramatically after 1986, yet emerging markets performed well.
There does not appear to be a simple relationship between the US federal funds rate and emerging stocks, either.
The two major Federal Reserve tightening cycles, in 1988 and 1994, saw buoyant emerging markets.
However, a recession in the US or other industrial countries is not necessarily a major negative for emerging markets. Asian stocks did extremely well in the early 1990’s despite Japan and Europe being in recession.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.