Federal Reserve sign above door
Last year’s big Fed rate rises and a strengthening US dollar sucked money out of risky assets including EM equities and local-currency bonds © Reuters

Emerging market equities have rallied more than a fifth from their October trough as easing global inflation and hopes the US central bank will soon slow its interest rate rises prompt investors to shift in to the asset class.

The MSCI Emerging Markets index has risen more than 21 per cent from its intraday low on October 25, according to Refinitiv data. Typically a rise of 20 per cent from a recent low is considered a bull market.

The more upbeat recent run comes after a painful stretch between February 2021 and late October last year, when the MSCI EM index tumbled more than 40 per cent. Last year’s big Federal Reserve rate rises and a strengthening US dollar sucked money out of risky assets including EM equities and local-currency bonds. Investment funds that buy such assets suffered their biggest outflows on record last year before staging a recovery from November on the promise of a reversal in US rates.

David Hauner, strategist at Bank of America Securities, said a survey published last week showing a drop in activity across the dominant US services sector had raised expectations among investors that the Fed would increase interest rates this year by less than previously forecast.

“There is increasing enthusiasm to pile into what could be a secular outperformance of EM over US assets,” he said.

Line chart of MSCI indices (rebased ) showing Emerging market stocks rebound from recent lows

Emerging market assets such as stocks, currencies and local-currency bonds tend to perform well when US rates are low and the dollar is weak, as less attractive returns available in the US and other advanced economies encourage investors to buy riskier, higher-yielding assets.

External conditions such as US monetary policy often have a greater impact on EM asset performance than conditions on local markets. Disruption caused by the pandemic and Russia’s invasion of Ukraine has hit some emerging markets particularly hard.

Paul McNamara, investment director at GAM Investments, said that, like other risky assets, EM stocks and bonds were being driven by Fed policy.

“If the Fed moves beyond high interest rates and we start to see inflation rolling over, that will be a powerful combination,” he said. “There is very little that is happening in emerging markets themselves to justify this.”

Nevertheless, he said, investors have seen cause for optimism in the Chinese economy, where the worst impact of the sudden lifting of the government’s zero-Covid policy restrictions was likely to be followed by a recovery in activity later this year. An increase in Chinese output is often good for other emerging economies, which supply many of the commodities and other inputs China needs.

Chinese stocks, which are the biggest weight in the MSCI EM index, have risen sharply since the autumn: the MSCI index tracking the country’s share market has rallied more than 45 per cent since October 31 in US dollar terms, according to FactSet data. The more widely followed CSI 300 index is up 23 per cent on the same basis. Markets in Taiwan and South Korea have also posted strong gains over the period.

The recent sharp fall in natural gas prices, to less than their level before Russia’s war in Ukraine sparked a steep and sudden increase, would also be good for some emerging economies, McNamara said, especially big energy importers such as Turkey and those closest to the conflict in eastern Europe.

But Hauner at BofA said that while EM investors were right to see lower inflation and US rates as a positive signal, they would be wrong to ignore the warning signs of a slowing US economy. Weaker than expected US employment and other advance indicators, including the very low gap between short and long term Treasury yields, suggested “one of the nastier cycles of recent decades”, he warned.

“The market has become completely conditioned by the idea of central banks always supporting markets — quite a large share of participants have never seen anything different,” he said. “But we are heading into quite a sharp downturn. There will be no soft landing about it.” 

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