Are Fed tightening cycles good or bad news for emerging markets? (Part I)

Most investors tend to agree that the Federal Reserve is in the midst of a monetary tightening cycle, which will take some time to complete. But when asked about the potential impact on emerging markets, opinions differ massively. So is Fed tightening good or bad news for emerging market stocks? And has the US dollar anything to do with that?

Two Angles

Ideally, the Federal Reserve initiates a series of rate hikes to prevent an already strong economy from overheating and inflation from overshooting its target. From this angle, monetary policy creates a positive environment for equities. At the same time, higher rates slows down growth and reduce market liquidity, something emerging markets are particularly sensitive to. Both valid views, but to what extend are they reflected in the (relative) performance of emerging markets?

The table below shows the (price) returns on the MSCI World Index (DM), the MSCI Emerging Markets Index  (EM) and the tradable U.S. Dollar Index (DXY) during the four Fed tightening cycles since 1987. Unfortunately, MSCI data for EM is only available from 1987 on, resulting in a limited number of Fed hiking cycles that can be studied.

Mixed Bag

Pushing the issue of statistical significance aside, the results are mixed in any case. Emerging markets rose in three out of the four last hiking cycles, but outperformed DM equities in only two of them. And while EM equities outperformed on average by 7.5%, this result is heavily skewed towards the cycle of 2004-2006 (+45%). The median outperformance of EM stocks over DM stocks during Fed tightening cycles is barely 1%.

The differences in performance between EM and DM become less pronounced if we look at annualized returns. Obviously, an outperformance of 45% is great, but this happened during a hiking cycle that took twice as much time as the other three cycles. When correcting for ‘cycle-duration’, the difference between the average (annualized) return also falls to a mere 1%. Admittedly, things look considerably more favorable for EM stocks if we would add the returns of the current cycle (9.8% EM outperformance on an annualized basis). However, this cycle is nowhere close to its end and extrapolation has proven an investor pitfall many, many times before.


So what about the U.S. Dollar? Here too, the opinions of investors differ. In prosperous times, higher US GDP growth will be followed by higher growth numbers in other parts of the world, reducing the demand for safe havens, causing the dollar to fall. But at the same time, higher US yields make the dollar more attractive. In addition, given the impact of the Fed on global markets, any reduction in liquidity is likely to add to the demand of safe haven currencies. Again, the ‘likeliness’ of both angles is reflected in the results. The DXY rises in two of the four cycles, and falls in the other two. Adding to the ‘mixed bag’ results is the fact that DXY both falls and rises once during the two Fed cycles in which EM stocks outperformed. Obviously, exactly the same is true for the two cycles in which EM stocks underperformed.

Hence, while EM stocks went up during three of the last four Fed tightening cycles, it would be bold to state that they also outperformed DM stocks. Also, the U.S. Dollar seems little related to the performance of EM. Based on the data presented above, it’s difficult to conclude if Fed hiking cycles are good or bad for the relative performance of EM stocks.

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