Market analysis: Brexit brightens long-term lustre of emerging markets

Overall, the second quarter was positive for emerging markets, with those in Europe most affected by the United Kingdom’s decision to leave the European Union (EU), while emerging markets in Latin America and Asia fared better.

On June 23, the UK voted to leave the EU, surprising many investors. The uncertainty of the situation and what came next affected all markets after the vote – emerging markets were not exempt, with the MSCI Emerging Markets Index experiencing a post-vote decline. Most markets, however, quickly rebounded.

We believe that the longer-term effect could be positive since the centre of gravity for capital markets activity could move east away from London towards markets in the Far East, such as Shanghai.

In addition, emerging markets’ trade and investment is widely diversified; the amount of trade with the UK is relatively small for most emerging-market countries. There are some specific markets where ties to the UK are greater and the impact could be felt more acutely.

For example, some South East Asian nations with historic ties to the UK could be negatively affected. There could be a silver lining for certain emerging-market countries, however, with some manufacturing and services possibly moving from the UK to Eastern European countries in the EU where costs are low.

Generally speaking, the Brexit event actually brightens our view of emerging markets and the investment potential we see for the long term. The Brexit vote shows the world that political instability is not concentrated in emerging markets – it can be found even in developed markets. While volatility may be with us a while, in our view, the markets have already begun to readjust. Part of the volatility was related to the surprise element of the vote. The markets simply did not price the leave scenario in properly.

The big question for market observers now is the knock-on effect in the EU generally. If it is perceived that other members may decide to leave the EU, then the uncertainty will continue and that could be bad for markets in Europe and the United States. But it is our view that emerging markets should be able to differentiate themselves and individual countries should be able to bounce back based on their unique fundamentals.

Emerging markets maintained an upward trend in the second quarter as strength in Latin American equities compensated for weakness in emerging European markets.

The MSCI EM Index ended the quarter up by 0.8 per cent in US dollar terms. This brought the return for the first half of the year to 6.6 per cent, significantly higher than the 1 per cent gain for the MSCI World Index. The outperformance can generally be attributed to the dovish stance taken by several major central banks globally following the UK Brexit vote, a search for income-producing assets as well as a rebound in commodity prices.

Latin America was the best-performing region for the quarter, with Brazil and Peru ending the quarter with double-digit gains. Strong appreciation in the Brazilian real, an improvement in business sentiment and generally positive economic data drove equity prices in Brazil. The victory of business-friendly candidate Pedro Pablo Kuczynski as the country’s next president supported the Peruvian market, along with higher copper prices. At the other end of the spectrum, a tightening monetary policy and increased risks to economic activity weighed on the Mexican market.

Asian markets ended the quarter slightly higher with the Philippines, Indonesia and India among the top-performing markets.

The Philippines benefited from a positive market outlook on the recently inaugurated administration of president Rodrigo Duterte, while the passage of a tax amnesty law and easing monetary policy boosted equity prices in Indonesia.

Foreign direct investment liberalisation, the passage of bankruptcy and finance bills in parliament and a positive domestic policy environment were constructive for Indian stocks.

Chinese equities lagged on renewed concerns about the Chinese economy, while the Malaysian market declined on selling ahead of rebalancing, resulting in a reduction in the market’s weighting in the MSCI EM Index.

Emerging European markets were among the weakest emerging-market performers over the three-month period as the Brexit vote rattled investor confidence in the region. Russia bucked the trend, however, ending the quarter with gains, benefiting from better-than-expected first-quarter GDP data, a rebound in oil prices and undemanding valuations. South Africa gained as mining stocks rebounded with the rise in commodity prices.

Mark Mobius is the executive chairman of the Emerging Markets Group at Franklin Templeton Investments.

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