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Since Federal Reserve (the “Fed”) officials embarked in one of the most aggressive rate hiking cycles in decades in March 2022 – rattling global bond and stock markets in the process – investors have been seeking evidence that a policy pivot may be at hand. Coming into the September 18 decision, the only uncertainties were whether the cut would be a quarter or half-point and about the guidance on the extent of the cycle. While history suggests that stocks perform well after the Fed starts easing (absent recession), could lower U.S. rates also set the stage for a period of emerging market (“EM”) outperformance? And with the headwind from high U.S. rates subsiding, what are the important signposts for the EM asset class going forward? Those were some of the questions that portfolio managers and analysts addressed in the latest Global Strategy Meeting.
The Fed cycle: what's next?
Critical to the outlook for the dollar, and risk sentiment more broadly, is if the U.S. can avoid a recession. Beyond the debate about the size of the first move going into the September 18 meeting, participants noted that the market reaction was always going to be more dependent on indications of the speed and extent after that. Most speakers agreed that the Fed succeeded in delivering a larger 50bps cut without triggering concerns that it was “behind the curve” and thus responding to a gloomy economic outlook. Policymakers effectively conveyed that the half-point cut was a one-off and didn’t pre-commit to any pace of future cuts – Chair Powell acknowledged that, depending on data, the Fed “can dial back policy restraint more slowly.”
Portfolio managers thought this outcome created a challenge for fixed-income markets, which had already priced-in a rapid path of easing towards neutral (the Fed signaled that there is no urgency with a data-dependent speed) (see Figure 1). For equities, the path seemed more benign since the Fed’s message reinforced the view that the economy is resilient. Accordingly, with a repricing in yields higher – even if modest – it is not clear if the dollar will keep weakening as it has since July (see Figure 2). Some speakers thought it was important to monitor if the Fed’s move will revive inflows into EM – so far there is no evidence of inflows materializing (neither to bonds nor stocks) despite well-priced expectations that rates were about to shift lower.
A couple portfolio managers stressed that the pace of cuts only matter for bets on short-term rates, whereas for stocks, it is the destination that is relevant. The yield curve is still assuming a trough in rates around 2.8%, roughly in line with the Fed’s assumption of neutral, long-term levels (2.9%). The fact that the market is not expecting rates to dip below neutral, speakers suggested, seems somewhat inconsistent with the common narrative that bond markets are signaling excessive pessimism about the economy.
EM outperformance cycles: what drives them?
To better understand the potential implications of lower U.S. rates for EM, analysts gave an overview of the common factors present during past periods of sustained EM equity outperformance versus developed markets (“DM”) (we looked at this subject in detail in our latest Macro Mosaic, The Ingredients for Emerging Market Performance). One of these factors is economic growth differentials, which tilted decisively in favor of EM since 2023, reaching their widest gap since 2013. Periods of EM outperformance, however, coincide with persistent widening in the EM-DM growth gaps, not just one-off steps. Current forecasts by the IMF point to a slightly narrowing gap going forward.
The dollar is another important driver, with periods of dollar depreciation coinciding with EM outperformance. While the dollar has been under pressure of late – mainly against other G7 currencies – the outlook for persistent depreciation hinges on the U.S. achieving a soft landing, speakers noted. The Fed already began lowering rates, but the debate about the economy’s path, and the risk of recession, remains very much alive. The close race for the presidency and associated risk of protectionism adds another layer of uncertainty. With Europe stagnant and China challenged, the U.S. is the world’s main growth engine; accordingly, any signs of U.S. weakness would exacerbate downside risks to global growth and spook markets. More broadly, participants agreed that all the pieces associated with wholesale EM stock outperformance in the past are not currently present, favoring an approach that leverages idiosyncratic stories.
EM drivers: cyclical versus structural
One analyst approached the subject of periods of prolonged EM outperformance from a different perspective that focused on cyclical and structural drivers. The macro signposts seen during the last period of EM outperformance in the first decade of the 2000s – rising commodity prices, dollar weakness, EM’s widening growth edge over DM – reflected a series of structural changes. The most important tailwind for EM at the time was China’s accession to the World Trade Organization (“WTO”) in 2001. Other emerging markets benefited from China’s surging exports and its property buildup, through higher commodity prices, supply-chain linkages and other channels.
China’s role as a growth engine, however, is well behind; indeed, the economy’s structural slowdown began over a decade ago as the contributions from property and exports inflected lower. While EM has faced weakening China demand for nearly fifteen years, the more relevant point is that the drivers of the past period of EM stock outperformance – China’s growth acceleration and its rise as the world’s factory – are not repeatable. As one speaker put it, China can “only enter the WTO once” and it is “hard to find a new China.” For example, India, the world’s fastest growing largest economy, is still relatively small and its service-centric growth model is unlikely to have the type of positive externalities for EM that China’s model did. While much of the broad EM structural story seems mixed, there are cyclical opportunities in the EM space abound. One of them is in export-focused ASEAN markets, which are outperforming this year thanks in part to the benefits from the cyclical upswing in global trade.
DISCLAIMER
The information provided herein is for educational and informational purposes only, and neither The Rohatyn Group nor any of its affiliates (together, “TRG”) is offering any product or service hereby. The information provided herein is not a recommendation, offer, or solicitation of an offer to buy or sell any security, commodity, or derivative, nor is it a recommendation to adopt any investment strategy or otherwise to be construed as investment advice. Any projections, market outlooks, investment outlooks or estimates included herein are forward-looking statements, are based upon certain assumptions, and should not be construed as an indication that certain circumstances or events will actually occur. Other circumstances or events that were not anticipated or considered may occur and may lead to materially different outcomes. The information provided herein should not be used as the basis for making any investment decision.
Unless otherwise noted, the views expressed in the content herein reflect those of the participants in the GSM as of the date published and are not necessarily the views of TRG. In fact, the views of TRG (and other asset managers) may diverge significantly from certain of the views expressed in the content herein. The views expressed in the content herein are subject to change without notice, and TRG disclaims any responsibility to furnish updated information in the event of any such change in views. Certain information contained herein has been obtained from third-party sources. While TRG deems such sources to be reliable, TRG cannot and does not warrant the information to be accurate, complete or timely, and TRG disclaims any responsibility for any loss or damage arising from reliance upon such third-party information or any other content provided herein.
Exposure to emerging markets generally entails greater risks and higher volatility than exposure to well-developed markets, including significant legal, economic and political risks. The prices of emerging market exchange rates, securities and other assets are often highly volatile and movements in such prices are influenced by, among other things, interest rates, changing market supply and demand, external market forces (particularly in relation to major trading partners), trade, fiscal and monetary programs, policies of governments and international political and economic events and policies. All investments entail risks, including possible loss of principal. Past performance is not necessarily indicative of future performance.
The information provided herein is neither tax nor legal advice. You must consult with your own tax and legal advisors regarding your particular circumstances.
