After a tough three-year period where commodities steadily declined in line with China’s slowdown, 2016 would prove to be the year global growth returned as markets witnessed a general rise in all risky assets. Eyebrows were soon raised in 2017 as fundamentally driven commodity markets diverged from emerging markets as the supposed close relationship between the pair appeared to have broken down.
In fact, the disconnect began in late 2016 as new President-elect Donald Trump’s supposed imminent de-regulation and growth policies would drive the dollar’s gains as the MSCI Emerging Market index retracted slightly. It was at this point, commentators noted some commodity strength (i.e +10.4 per cent oil and +10.8 per cent copper) despite a falling index (-5.3 per cent) during that period. Energy and mining stocks would thrive till the year end even as commodity performance varied and the emerging market index declined.
This year has been testament to continued deviation in returns within commodities and yet emerging markets have delivered a strong +20.4 per cent year-to-date figure whilst the closest commodities are gold +5.6 per cent and copper +4.5 per cent. So, what has been driving emerging markets?
A quick look at the composition of what goes in the emerging market index provides us useful insight to this conundrum. Index providers will assess market size, liquidity, foreign ownership and several other inputs before determining the status of a country and adding them into one of their indices. At present the MSCI and FTSE are the leading industry benchmarks, with the former having 24 constituents whilst the latter has 23 countries within their “emerging market classification”.
A simple composition analysis shows the gradual evolution of the MSCI Emerging Markets index, from an eight-country shortlist in 1988 with Malaysia as the largest weight with 33.8 per cent, to currently having 24 countries with the largest weight being China’s 28.6 per cent (as of July 2017).
Additions vary with some included at once (7.8 per cent India in 1994 and 14.8 per cent South Africa in 1995) whilst others like Taiwan and Korea were added progressively.
China was added in 1996 with Shanghai and Shenzhen listed B shares but its influence has steadily grown and now their A shares will be included in the index by June 2018. Another winner of MSCI’s recent technical review highlighted Saudi Arabia as a potential candidate whilst Argentina remains ostracised to the frontier markets. Greece is another that has oscillated within the emerging index and developed markets.
Since 2007, sector weights have clearly moved away from cyclical energy, materials and industrials which were at one stage around 39.4 per cent of the index but are currently 19.4 per cent. What was once a market dictated by commodities has now witnessed a structural shift away from primary sectors and into the more advanced, technology sectors. There has also been an uptick in consumer related stocks (combined staples and discretionary 22 per cent from previously 9.9 per cent), whilst financials are still a large allocation with 23.7 per cent as of July 2017.
With the index’s largest weighting being Samsung Electronics, Tencent Holdings Limited, Taiwan Semiconductor Manufacturing (TSM), and Alibaba Group Holding Limited; it’s evident that emerging markets are moving up the market value chain and with the inclusion of more countries, the drivers of the index need no longer only be considered as commodity only. With a deep pool of talent to draw from and competitive labour rates that aid in exploiting global opportunities and economies of scale, it does not come as a surprise that emerging markets are providing strong businesses that feed the global structural appetite for technological change.
The growth in consumer related stocks could be further testament to the influence of China’s domestic consumer trends. If this was not only because of the large size of China within the index, then I also suspect with the continued improvement to their GDP per capita and the conscious rebalancing away from an export economy to a demand driven one will only serve to make this a more dominant sector.
How has this change in drivers to the emerging markets been reflected in fund performance this year? Well, in truth very impressively as 45 managers within the Investment Association emerging market sector have outperformed their benchmark the MSCI Emerging Markets, which has delivered year-to-date 17 per cent. With the top three performers, as of beginning of August 2017 being:
- Baille Gifford Emerging Markets (27.4 per cent)
- Baille Gifford Emerging Markets Leading Companies (27.3 per cent)
- UBS Global Emerging Markets Opportunity (24.8 per cent)
The two Baille Gifford funds have larger R-squared (>67 per cent) and correlations to the MSCI Emerging Market than the UBS (46 per cent R-squared) over the last year which shows that managers do not necessarily have to be similar in order to thrive within this environment or in fact track the index.
Looking at one-year rolling R-squared reveals fluctuating relationships between commodities and the MSCI Emerging Markets. R-squared or coefficient of determination as it is fondly known by quants is the percentage of variation in dependent Y that can be explained by independent X variable (between 0 and 1), in a regression model. Or else, the variation in commodity movements that is explained by the benchmark emerging market index. Looking at a longer rolling periods of 3 years or 5 years, reveals the same fluctuating pattern but with smoother lines.
Of the agricultural markets tested, coffee has the strongest relationship to the MSCI Emerging Market index. Mining and metals generally have stronger R-squared to the index, although as you can see, there is a slight down trend. WTI crude oil also has a consistently high R-squared but that too has been coming down. China and copper have the strongest of relationships of the indices observed. However, of all the variables looked it, it is China that has the increasing R-squared in line with our earlier observations.
Perhaps expected but nonetheless, China and global structural secular trends continue to drive emerging markets and all markets for that matter. Well documented trends of ageing populations/pharma, emergence of the emerging countries middle class consumers, infrastructure and green energy, development of technology/telecommunications and artificial intelligence are all still evolving as managers attempt to catch tailwinds whilst others like commodities wane in power.
Robert Wilson is a fund analyst at FE