Currencies, countries and sectors: Taking apart the emerging markets rally

By Raman Aylur Subramanian/ Investment Week

Raman Aylur Subramanian, head of equity applied research at MSCI, analyses the opportunities different emerging market countries have offered investors in the recent rally and how a handful of sectors have been key to the region’s outperformance.

Apart from a recent swoon spurred by fears the US Federal Reserve could raise rates, it was a summer of love for investments in emerging markets. The MSCI Emerging Markets index ended August up 15% for the year, after losing 20% in 2015. Compared with other rallies of recent years, much of the latest one has skirted China. Brazil (up 62% to 31 August), Taiwan (up 18%), South Africa (up 16%) and India (8%) – to cite four countries that have contributed to the rally – have performed well, but each has done so for different reasons.

The disparity highlights the differences among the 23 countries that constitute the MSCI Emerging Markets index. To illustrate this phenomenon, we have examined the performance of each of the four countries cited above through the explanatory variables of countries, currencies and sectors.

Return differences

The country factor is historically the largest driver of return differences in emerging markets and 2016 is unfolding similarly. This factor captures political, regulatory and governance risk. Graph 1 (below) shows that, through August, investors repriced sovereign risk in most emerging market countries. The contribution of the Brazilian country factor stands out in light of that nation’s tumultuous year politically.

Second, the broad basket of emerging market currencies has appreciated against the dollar as US interest rates have remained stable. Yet, there is disparity within the group.

Two Asian currencies – the Chinese yuan and Taiwanese dollar – have fallen relative to other emerging market currencies this year. However, in Brazil and South Africa, currency appreciation has rivalled the country component of return.

Finally, style and industry effects can be substantial, based on MSCI’s risk model, which contains factors tailored for emerging markets. Country and currency factor contributions to EM returns

Sector performance

The oil sensitivity factor is one industry effect that quantifies movements of oil prices for firms inside and outside the energy sector. Positive return to this factor represents a basket of stocks that tend to do well as oil prices rise.

Graph 2 shows the effects of oil and three export-related industries in Brazil, South Africa, Taiwan and India. Brazil’s economy reflects the price of oil and has benefitted considerably from the rebound in crude prices. But financials (36%) and consumer staples (18%) each outweigh energy (13%) in MSCI’s Brazil index.

South Africa’s concentration in precious metals rewarded investors. But note the country’s sensitivity to oil prices: Sasol, an international energy firm, at 5% of the index, is the third-largest constituent. Taiwan participated in the rally through its electronics industry, which constitutes nearly 60% of the sector weighting. India, which like China can represent a proxy for emerging markets in some portfolios, has not enjoyed the currency and commodity bump that Brazil and South Africa have.

Where are the emerging market ‘sweet spots’?

Still, India had tailwinds from its automotive industry, which constitutes nearly 15% of the sector weights.   A broad-based emerging markets allocation has been effective in capturing the dramatic transformations of emerging economies over the last 20 years.

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