Why Are Emerging Markets Struggling in 2013?

Equities Push HIgher Amid Strong Economic Data

The Dow Jones Industrial Average declined for the first time in 11 days on Friday, but ended the week higher amid record high levels for the index. The S&P 500 neared its record high of 1565, but missed the mark by just two points at Thursday’s close. For the week, the Dow rose 0.8% and the S&P 500 climbed 0.6%.

Risk assets were buoyed by better than expected economic data, particularly on the retail front. Retail sales climbed 1.1% in February, well above analysts’ estimates of a 0.5% gain. The figure was partially propped up by higher gasoline prices, but there were signs of underlying strength in the report. January data was also revised upward by a tenth of a percent.

Better consumer data is a welcomed development for financial markets, particularly in the wake of a payroll tax cut elimination that was supposed to put a damper on spending. Within the report, strength was evident in a variety of sectors, including building materials & garden equipment, food and beverage stores, and clothing & apparel, among others. Following a soft patch in mid 2012 in which retail sales contracted for three straight months, retail sales have shown positive growth in seven of the past eight months.

Small businesses also reported better than expected conditions, as measured by the NFIB’s Small Business Optimism Survey. The headline index increased 1.9 points to 90.8. This is the first reading above 90 in four months, but the index remains at recessionary levels. Eight of the 10 index components improved, with one flat and the other declining. Among the categories experiencing improvement, plans to increase inventories, capital outlays, and current job openings were the biggest gainers.

Small businesses’ primary concern remains taxes and government regulation & red tape, underscoring how the uncertainty spawned by Washington is holding back the private sector. NFIB Chief Economist Bill Dunkelberg noted the impact of these issues in a statement, “Washington is manufacturing one crisis after another—the debt ceiling, the fiscal cliff and the sequester. Spreading fear and instability are certainly not a strategy to encourage investment and entrepreneurship. Three-quarters of small-business owners think that business conditions will be the same or worse in six months.”

Industrial production data also came in above expectations, reaching 0.7% in February. This was a rebound from a disappointing January in which the indicator was flat. The manufacturing component of industrial production sparked the bounce, following a 0.8% increase during the month. The data coincides with other recent manufacturing metrics like the ISM manufacturing report and the Empire State Manufacturing Survey that suggest the sector remains fully in expansion mode.

Finally, inflation data revealed that prices at the headline level firmed in February, largely the result of rising gasoline prices. Consumer prices increased 0.7% in February, and reached 2.0% in year-over-year data. This is still below the Fed’s parameters for allowable inflation per their current quantitative easing program. Core inflation remains muted, after posting a 0.2% increase during the month.

Producer prices exhibited similar characteristics. The headline index rose 0.7% during the month as a result of higher energy costs. Core inflation at the producer level was limited to a 0.2% rise. Year-over-year, the headline PPI was up 1.8%.

Why Are Emerging Markets Struggling In 2013?

Despite one of the sharpest rallies in US equities in recent memory, emerging market equities have been left curiously behind in 2013. Through last Friday, the market segment was down 1.0%, compared to an S&P 500 index that was up 10.0%. This seems to violate the regime that investors have gotten used to over the past 10 years, whereby the emerging markets equity index served as a high beta proxy for the US equity market.

So what exactly is going on with emerging markets stocks? Amid an environment of reduced fear, and seemingly much worse structural problems in developing economies than emerging, it is reasonable to question why these markets are failing to participate.

A look at the underlying components of the index does not reveal any undue influence from a particular market segment. While the BRIC countries that dominate the index have not performed particularly well – Brazil (+1.5%), Russia (+1.6%), India (+1.0%), and China (-3.6%) – neither have most of the other 17 countries in the MSCI index. Outside of a few outliers, every country index in the benchmark has a 2013 return of less than 5%; 11 of the benchmark’s 21 member countries are in negative territory.

Currency is not a factor either, at least on the aggregate. The emerging markets index has seen a modest detraction of 69 bps from appreciation in the US dollar. Eastern Europe saw the biggest headwinds from this effect, with the Europe, Middle East, & Africa (EMEA) segment’s return reduced by more than 3.5%. On the flip side, strength in the Brazilian real and the Mexican peso has caused the Latin American sub-index to see a 3.1% tailwind. Asian currencies were mixed.

One potential explanation for the weakness in EM equities is that as investors move out on the risk curve – from investment grade bonds to high yield to equities – they have done so only incrementally. This may particularly be the case for those shell-shocked investors from 2008 who are just beginning to dip their toe into equities. US stocks are the natural starting point for that demographic.

The concerns that plagued emerging markets in 2011 may also be resurfacing – namely, inflation. With developed central banks showing increasing commitment to easing policies, many are justifiably worried that they will end up exporting this inflation to emerging markets. China is often the focal point on this front, and the country’s latest inflation print was cause for alarm. At 3.2% year-over-year, inflation is at its highest level in a year and represents a steady uptrend since last fall, when it troughed at 1.7%. Other countries including Brazil, India, and Russia have seen inflation on the rise so far in 2013.

Emerging markets central banks aren’t doing much to help the cause. They, like their developed counterparts, continue down a path of unprecedented interest rate cuts and other easing policies. In 2012, emerging markets central banks cut interest rates by a combined 1,126 bps, compared to 400 bps in developed markets (according to centralbanknews.info). The pace of rate cuts is slowing somewhat in 2013, but a fifth of the 102 policy decisions made by global central banks this year (primarily emerging market economies) have been rate cuts.

Economic growth has been okay, if unspectacular. Still, compared to Europe, which is in recession, and the US, which is middling, the region looks relatively more attractive. The IMF expects the group to grow by 5.5% in 2013, but not for it to resume the levels of growth witnessed in 2010 and 2011. The IMF’s most recent World Economic Outlook noted, “supportive policies have underpinned much of the recent acceleration in activity in many economies. But weakness in advanced economies will weigh on external demand, as well as on the terms of trade of commodity exporters, given [our] assumption of lower commodity prices in 2013.”

To the extent that emerging markets are viewed as a proxy for commodity exposure, this may be an additional reason for underperformance in 2013. Through March 15, the Dow Jones-UBS Commodity index was down 0.5%, with weakness in metals and ags driving the loss. Energy is performing somewhat better, up 5.0% on the year, but a poor February pulled all commodity sectors lower. Soft import and PMI data from China was blamed partially for the pullback. While the cyclical composition of the MSCI benchmark is lower now than at the end of 2007, when energy and materials made up one-third of the index, those two sectors still comprise 23% of the index today.

Whatever the reason, emerging markets are clearly the global laggards this year, failing to keep pace with either the US or developed international stocks. From a valuation perspective, emerging markets remain reasonable, trading at 12x price-to-earnings, according to Bloomberg data. That compares to a 15.4x average since 1994.

With recent flare-ups in developed markets, including the potential election debacle in Italy and the Cyprus situation (not to mention the US’ own structural deficit issues), it will be interesting to watch how emerging markets are treated by investors moving forward. There have long been calls for EM to decouple from developed ones as the countries’ economic infrastructure matures and their healthier fiscal status is recognized, but that has not yet come to fruition. Emerging markets appear to have decoupled this year, but not in the way that investors were hoping.

The Week Ahead

There are a handful of important economic indicators this week, primarily in the housing sector. Housing starts are released on Tuesday, followed by existing home sales data on Thursday.

The markets will be more focused on the Federal Open Market Committee meeting that begins Tuesday. The FOMC meeting announcement and Chairman Ben Bernanke’s press conference occur on Wednesday afternoon.

There will be a fair amount of coverage of the developing situation in Cyprus this week as well. Over the weekend, news broke that the Eurozone would be bailing out Cyprus’ troubled banking sector. As a result of that bailout, however, Eurozone officials are imposing a tax on depositors’ accounts in the amount of 6.75% for deposits of less than €100,000 and 9.9% for amounts thereafter. This has sparked fears of a bank run and potential precedent for other troubled nations. Global markets were roiling early Monday as a result.

On the central bank front, other rate decisions will be announced by India, South Africa, Egypt, and Colombia.

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