Emerging market stocks have been long on promise, but short on results in recent years. Despite possessing many investment merits, including strong demographics and low valuations, stocks in these regions have generated modest returns. The MSCI Emerging Markets Index has risen only 3.8% annualized this decade.
The sector has performed better in 2019, however, gaining 12% through Friday. So, have emerging markets finally turned the corner, or is this another false start similar to 2017? (see chart)
The answer to that question depends on two key variables: the Federal Reserve’s interest rate policy and the trade war with China.
The Fed matters because the U.S. competes with emerging markets to attract capital. When the Fed raises interest rates, money from around the world flows to the U.S. in search of higher returns. This makes it more expensive for emerging market countries to borrow and spend, which can lead to lower economic growth. As a consequence, emerging markets tend to perform better when the Federal Reserve keeps interest rates low.
China is important to emerging markets because it dominates the global economy outside the U.S., particularly in the demand for commodities. Many of the raw ingredients that China uses to build infrastructure and feed its population are found in emerging markets like Malaysia and Brazil. If the Chinese economy is strong, other emerging markets benefit.
Putting it all together, emerging markets tend to excel when the Chinese economy is strong and the Fed keeps interest rates low (chart). We appear to be headed for that situation today. China has implemented a long list of stimulus measures over the last 12 months that may finally be working. We also expect a likely U.S.-China trade deal to benefit Chinese growth. Meanwhile, Fed Chairman Jay Powell has suggested the Fed is finished raising interest rates, and investors have gone from anticipating several rate hikes in 2019 to now expecting zero hikes and perhaps a cut by year-end.
With Chinese growth and Fed policy appearing to move in a favorable direction for emerging markets, our outlook is positive on these regions over both the short-term and the long-term.