Over the past 12 years, the U.S. stock market has outperformed emerging markets by a large margin for many reasons, including a strong dollar and the country’s shift from reliance on imported energy to self-sufficiency. The U.S. economy also benefited from technological innovation, especially in terms of the first-mover advantage enjoyed by internet companies that have scaled and expanded their global market share.
But there’s a good chance that emerging markets will redeem themselves and outperform the U.S. this year. Long-term and short-term factors driving stock market performance are different, in this article, we will focus on the short-term factors why emerging market may come to shine.
In the MSCI Emerging Markets Index, China has the largest weighting of roughly 33%, followed by Taiwan at 14% (nearly half of which comprises of TSMC), India at 13%, and South Korea and Brazil collectively accounting for 17% of the index’s composition. The rest of the component countries are mostly raw-material or energy exporters. Excluding TSMC, China and India play the biggest roles among emerging markets. If economic conditions improve in these two countries, boosting demand for raw materials and energy, other emerging economies will benefit as well.
From a macro point of view, the possibility of a recession in the U.S. economy is fairly high this year, with many leading indicators already pointing to potential economic contraction in the States. The U.S. stock market’s decline last year was mainly due to compressed valuation. That is, the market has yet priced in the impact an economic downturn can have on corporate profits. That said, a sudden pivot where the Fed shifts to a dovish stance and begins cutting rates mid-year may help offset the impact U.S. stocks would suffer in a recession, but such a policy shift seems unlikely at this point.
Turning to China, economic recovery can be expected as the pandemic has likely peaked and the government’s grip on the real estate sector and internet platform companies seems to be loosening. The resolution to the China-U.S. ADR audit dispute also helps.
The other major emerging market, India, is also showing brighter economic outlook. During the 2008 global financial crisis, the Indian government resorted to excessive borrowing to revive the economy, which led to persistently high bankruptcy rates among Indian companies after 2008. The situation has been improving over the past few years, as companies have slowly recovered from insolvency troubles. Banks have seen growth in lending and improvement with the problem of non-performing loans. The corporate debt-to-GDP ratio is also falling. Although valuation of the Indian stock market is slightly elevated, overall India is expected to enjoy more bullish factors than the U.S. this year.
While economic recovery will provide upside potential for earnings, capital inflow is also necessary to drive the stock market upward. On this front, China’s credit impulse shows that domestic funding conditions have improved from tight to neutral over the past year. In contrast, the federal funds rate continued to rise in the U.S. The U.S. futures market currently projects the federal funds rate to reach around 5% by mid-year and estimates that there won’t be room for a rate cut until the end of the year. Given different capital conditions, the Chinese stock market is likely to perform better than the U.S. stock market. Foreign capital flows can also improve for China as the dollar peaks. Historically, economies and stock markets of emerging markets would stand to benefit from a depreciating dollar.
To sum up, there’s a good chance that emerging markets will turn the tables this year and beat the U.S. stock market.
Disclaimer
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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