A U.S.-China Trade Deal Won’t Rescue Emerging Market Stocks

What is happening in the slowing Chinese domestic economy matters far more for the MSCI EM index than the latest mood on tariffs

By Mike Bird

The prospect of a limited truce on trade between China and the U.S. was enough to lift global stocks in October, but even an actual deal—however likely that is—would offer little more than temporary relief for beleaguered emerging markets.

Rather, emerging-market stocks will have an opportunity to outperform only if the Chinese economy enters an unexpected upswing.

Given Beijing’s reluctance to undertake a 2016-style stimulus this year, that seems unlikely.

Emerging markets are a diverse bunch, but if there is a dominant driver of their problems in 2019 it is probably the slowing Chinese domestic economy, which is only partly related to U.S. tariffs.

The MSCI EM Index is trailing the MSCI World Index by 10 percentage points this year on a total-return basis.

Even once the U.S. is removed from the calculation, EM stock markets are lagging well behind those of the world’s other advanced economies for 2019.

The flagship EM index has seen its direct weighting to China increased in recent years, from 17.9% a decade ago to almost 32% now.

But it isn’t just Chinese stocks themselves dragging the benchmark down.

Shoppers at a Costco in Shanghai. Photo: wu hong/Shutterstock

South Korea, the second-largest component of the index, has had an even more miserable year.

In large part, that is because of its exposure to the manufacturing sector of its big neighbor. China buys around 25% of its exports, up from 10% 20 years ago.

There is a similar story for commodity exporters outside Asia, such as Brazil.

China accounts for more than a quarter of the South American country’s outward trade, up from more like 2% in 1999.

Excluding Asia makes little difference to the underperformance of EM stocks versus their developed-market counterparts this year.

When EM stocks fared badly last year, the difference was often attributed to the unwinding of Federal Reserve largess, which had helped them in previous years.

A mountain of dollar debt would become more difficult to service in a world of higher interest rates.

This year, that monetary trend has reversed, sending 10-year Treasury yields a full percentage point higher.

This may have saved them from a worse fate, but it hasn’t been enough to fuel an EM rally.

Their recent underperformance hasn’t left EM stocks on particularly cheap valuations.

The index is priced around 12 times its expected earnings for the next 12 months, not far from its highs over the past decade. In fact, their performance could have been a lot worse.

The EM index is up 9% for 2019, while more modest Chinese growth has left the CRB Raw Industrials Spot Price Index down 9%. The two usually move in tandem.

Halting additional U.S. tariffs on Chinese goods might provide a meager lift for EM equities.

But given China’s struggle to deal with its mounting debt pile while providing further stimulus to the economy, growth will very likely continue to slow.

Unless something on that front changes, EM stocks—whose wagons have become firmly hitched to China—will struggle to make major gains.

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