Market consensus in 2014 is for emerging market assets to underperform versus developed markets as a consequence in part or at least triggered by expectations of US monetary tightening. Emerging markets are also facing an external risk from a potential economic slowdown in China and their vulnerability is exacerbated in many cases by domestic concerns. We attempt to quantify the scale of emerging equity market reaction to these twin external risks.
Some of the external risks that could impact emerging markets such as investment outflows or expected monetary tightening in developed markets can be at least imperfectly observed. Other risks, not least investor sentiment, can only be deduced indirectly by reference to market observables also impacted by these risk factors.
We present a simple model aiming to capture firstly the potential emerging market impact from a Chinese economic slowdown and secondly the impact from a stronger dollar and expectations of US monetary tightening. As market observable proxies for these factors we use Chinese equities and emerging market local debt. We considered other potential factors including US equities, US Treasuries and emerging market credit but find that the combination of Chinese equities and EM local debt gave the best fit for any pair of factors.
EM equity and Chinese equity and EM local debt historical index level
Beta of EM equities to the combination of EM local debt and Chinese equities
The analysis uses weekly index changes over the past 6 months and chart above right presents a snapshot of the current beta of emerging market equity country indices to the global EM local debt index and the Chinese equity index. We make the following observations which in most cases appear consistent with intuition as to what should be the most significant external risks for any given emerging market.
1. Among the emerging markets considered to be relatively safe (Poland, Russia, Mexico in this sample) Mexico and Russia have responded more strongly to moves in Chinese equities than has Poland.
2. Among the fragile five India and South Africa have responded less strongly to turmoil in global emerging market local debt than have Turkey, Brazil and Indonesia.
The following table summarizes the relative emerging market equity recommendations based on the expected outcome for US tapering and Chinese growth. It is important to note, however, that the beta of the country level emerging markets to the two external factors in our model is evolving over time as is the extent to which domestic factors take precedence over external factors.
|Stronger Chinese growth vs consensus||Weaker Chinese growth vs consensus|
|Slower tapering, weaker dollar||All emerging market assets should benefit from a liquidity driven recovery although this may prove short lived if US growth remains subdued.||The hardest hit emerging market equities will be Brazil, Mexico and India. South Africa, Turkey and Russia will also suffer but may fair better on a relative basis.|
|Faster tapering, stronger dollar||The hardest hit emerging market equities will be Turkey, Indonesia and Brazil. South Africa, Mexico and India will also suffer but may fair better on a relative basis.||All emerging market equities are likely to be under pressure although lower beta markets such as Poland may suffer relatively less.|
Despite the fact that this is clearly a very simple model the results are relatively stable from week to week and the theoretical country index that can be constructed simply using the betas and weekly changes of Chinese equities and EM local debt is surprisingly accurate even over the Fed-induced structural break of May/June last year, as can been seen from the following charts.
As an extension to this analysis it would be possible to assess which emerging equity markets are more fully explained by our chosen factors versus those subject to significant domestic or other external drivers. For those markets that are highly correlated a straightforward rich/cheap analysis versus theoretical index level could provide some additional insight.
Rolling 6 month history of country equity index betas vs China equity index and EM local debt index
Comparison of actual country equity index with theoretical index constructed using the 6 month rolling betas and weekly changes in China and local debt
Data sources: MSCI, iShares.