Starting in late August two things happened that had not occurred in several years: The Federal Reserve started expanding its balance sheet and emerging markets began outperforming. The two are intimately related and are likely to continue.
Back in July I highlighted the importance of monetary and broader financial conditions for emerging markets. While the price and availability of money matters for all risky assets, emerging markets are particularly sensitive, even more so since the financial crisis. The pivot by the world’s central banks, not just lowering rates but reverting back to asset purchases, has proved a game-changer for this asset class.
Ironically, stress in U.S. money markets was the catalyst that provided a boost for emerging market stocks. Starting in the fall the Fed began providing additional liquidity in order to stabilize money markets. Part of this effort involved resuming their asset purchases.
As a result, after declining for several years the Fed’s balance sheet began to aggressively expand. From August 31st through the end of the year, Fed asset holdings increased by approximately $400 billion. As a percentage of gross domestic product (GDP) the Fed’s balance sheet went from 17.6% to 19.3%.
A rapidly expanding balance sheet and the accompanying liquidity coincided with strong performance from emerging market equities. The MSCI EM Index gained roughly 13% versus a bit more than 10% for developed markets. Even with the United States finishing the year in a spectacular fashion, emerging market equities outperformed their developed market cousins by over three percentage points.
Liquidity continues, while China looks cheap
While the growth in the Fed’s balance sheet is likely to moderate now that money markets have calmed down, central bank balance sheets are scheduled to keep growing in 2020. Not only will the Fed grow its balance sheet, so will the European central Bank and Bank of Japan (see Chart 1). At the same time, the Chinese central bank (PBOC) is actively engaged in providing liquidity. All of this should continue to favor emerging markets.
It is also worth highlighting that this wave of liquidity is occurring at a time when emerging market stocks remain reasonably priced. The MSCI Emerging Market Index is trading at about a 26% discount to developed markets, roughly in-line with the post-crisis average.
Within emerging markets, China stands out as particularly cheap. Onshore Chinese shares are trading at a 6% discount to the broader EM space. Since 2000 Chinese shares have typically traded at a 10% premium. For investors that favor H-Shares, Chinese shares listed on the Hong Kong exchange, valuations are even cheaper, at approximately 8.5 times FY1 earnings.
A resumption of the trade friction could certainly upset this happy scenario, even if central banks keep printing money. But with hostilities seemingly on hold until after the U.S. election, the stars are more aligned for EM than they’ve been in some time.