Emerging market equities play an important role in many investors’ diversified portfolios due to their risk and return characteristics and relatively low correlation to other asset classes. However, with the dollar-denominated MSCI Emerging Markets index down nearly 13% year-to-date and nearly 23% over the trailing one-year period as of Aug. 31, 2015, these long-term allocations have caused some discomfort recently.
Because many investors appropriately include this asset class in their diversified portfolios, we believe it will be helpful to provide a few reasons for this underperformance. In particular, we focus on China’s slowing growth and the impact of rising U.S. interest rates.
China’s Slowing Economic Growth Rate
As China is the second largest economy in the world, it is no surprise that its slowing economic growth is weighing significantly on emerging markets. Several of China’s historical growth engines have been slowing of late. Manufacturing activity has fallen to its lowest level in six years. Slowing spending on real estate and construction, as well as reduced local government infrastructure spending, are also reducing growth. China’s slowdown is directly reducing emerging markets’ economic performance, and expectations for slower future growth put downward pressure on equities.
China’s slowdown is also being felt in emerging market economies that depend on Chinese economic activity, particularly those like Russia, Indonesia and Brazil, where commodity exports contribute significantly to economic activity. Because China accounts for more than 30% of global consumption of several commodities, its slowdown significantly impacts global demand for these exports. In addition, as China’s economy continues shifting from commodity-intensive sectors to more services and consumption, downward pressure on commodities will likely continue to afflict major commodity exporters.
Interest Rates in the United States
Rising interest rates in the United States also put pressure on emerging market equity returns. Although the Federal Reserve recently declined to raise short-term rates, most expect that U.S. interest rates will begin to rise in the next year. Partly due to these expectations, U.S. 10-year Treasury rates have increased from below 1.75% in January to the recent 2.1%-2.3% range.