The Impact of Interest Rates Can’t Be Gauged in Isolation
The direction of US and global interest rates is another significant macro driver: the relationship between relative EM and developed-market performance and the US fed funds rate has tended to be negative. Rising US rates increase EM debt burdens, trigger capital outflows to higher-yielding and safer US assets, and tighten financial conditions in EM. In extreme cases, this situation has triggered financial crises.
The Fed is still in policy-tightening mode, but the pace of tightening has slowed, given the fallout from the recent banking-sector turmoil. The central bank has signaled that only one more rate hike is left in the queue, so an end is in sight for the US tightening cycle and should remove a key headwind while supporting relative EM performance.
However, the impact of interest rates shouldn’t be judged in isolation, with the US-dollar outlook as a particularly important consideration. A stronger dollar increases the burden of EM foreign currency–denominated debt obligations, makes it harder to finance current-account deficits, and may lead policymakers to raise rates to prevent capital outflows. These factors can hurt economic growth and equities.
Since its September 2022 peak, the trade-weighted US-dollar index has fallen by more than 9%. If this weakness lasts, it could be another catalyst for EM outperformance. On the other hand, if worries about credit availability in the US remain, or if we see a bout of macro volatility, the US dollar would benefit from its status as the most liquid currency and historical reputation as a “safe haven” in times of crisis.
Many EM central banks face lower inflationary pressures, giving them latitude to do less tightening or perhaps no additional tightening, but they’re vulnerable to a sudden US-dollar liquidity shortage, which could weigh on their currencies. Depending on how financial-stability risks evolve, they could also prompt still more hikes from many of these central banks in the months to come.
Overall, we see macro risks as finely balanced. The near-term cyclical outlook is a source of downside risk but doesn’t necessarily imply a bearish outlook for EM. The monetary cycle in the US and the dollar outlook could prove supportive but have potential downside risks, too.
Where Are the Opportunities in EM?
Given wide-ranging valuations, growth outlooks, inflationary pressures and vulnerabilities to macro risks within EM, an active and selective approach is needed. We can highlight several themes we think are promising, including countries that:
- Are “ahead” of other economies in the policy-tightening cycle (Brazil, Mexico)
- Have contained or declining inflation rates (China, Indonesia)
- Have seen multiples and earnings expectations adjust enough to be well positioned for a rebound (China, Indonesia, Brazil)
- Are well positioned for the net zero transition and/or benefiting from the reconfiguration of global supply chains (Brazil, Mexico, India, Indonesia)
China Should Be Considered a Distinct Building Block Within EM
From a strategic perspective, we also believe that China should be considered a distinct building block within an investors’ EM allocation. What’s the main reason for this view? The investment approach needed to form a view on China is increasingly different fundamentally than it is for other EM markets.
To a very large extent, the China view depends on President Xi’s policy. Given the overriding influence of his ideology on China’s structural strategy and outlook, getting the correct read of his policies is paramount. Making a beta call on this market is challenging, even over a shorter investment horizon.
Another distinctive feature of China is that active management has long been a standout in alpha generation among other regions. The active industry has been under pressure and performance has suffered, but equity managers with China benchmarks continue to generate positive idiosyncratic alpha—alpha adjusted for common factor exposures—in excess of other key regions (Display).