The pieces of the puzzle are slowly falling into place for emerging markets

Emerging market stocks often produce paltry returns when the US dollar strengthens. But recent developments point to a change in this trend, making emerging markets a more attractive investment prospect.

Stocks in emerging countries were already relatively cheap, especially compared with their US counterparts, but gradually the other pieces of the puzzle are falling into place as well. In our outlook for 2019, published in November, we emphasized that an end to the continued strengthening of the US dollar and a greater divergence in economic growth between emerging and developed countries are key conditions for a more positive view on emerging market stocks.

End to the strong dollar

The end to the US dollar’s seemingly endless appreciation could come sooner than expected. After a period of three years, during which the Federal Reserve has made eight rate hikes, Fed Chairman Jerome Powell sounded surprisingly dovish in his latest speeches. Despite indicating in October that interest rates had some way to go before reaching ‘neutral’ territory (the level that neither stimulates nor restrains economic growth), more recently he has said that we are now “just below” that level.

Therefore, it is much more likely that after the raise in December – which is almost certainly on the cards – the Fed will take a break from hiking rates. This means that the difference between interest rates in the US and, for example, the Eurozone will not widen further. Moreover, the ECB currently looks set to start a series of its own interest rate hikes next year.

The pace of these increases will probably be extremely slow. Although the ECB may barely be off the starting blocks by the time the next recession hits, this will prevent the interest rate difference between the US and the Eurozone from increasing. And that means the US dollar won’t necessarily strengthen, as the attractiveness of a currency largely depends on interest rate differences between two regions.

Outperformance

As this week’s graph shows, a stronger US dollar often means relatively poor emerging market performance. If the Fed raises interest rates, US growth slows, putting the brakes on imports from emerging countries. As emerging market economies are more open than the US economy, Fed tightening measures often hit harder in these countries.

After a decade of monetary expansion, the rate hikes also mean a reduction in global liquidity. Generally speaking, this is having a greater impact on asset classes at the end of the risk spectrum, such as emerging market stocks.

In addition to the Fed’s more moderated tone, we are also seeing a slow shift in economic momentum. In November, the difference between the manufacturing PMIs of developed and emerging countries fell to its lowest level since October 2016. Therefore, next year we expect the difference in GDP growth rates to increase for the first time since 2015.

Historically speaking, a bigger difference in growth rates means better returns in emerging countries compared with the rest of the world.

Not without risk

Recent developments have improved the outlook for emerging countries, but this does not mean they are without risk. In particular, the ongoing trade war between the US and China and its impact on China’s economic growth could really foul things up. However, despite the inability of the two countries to reach an agreement at this point, we don’t expect the situation to get much worse, either

Rumors that China is considering lowering its tariffs on US car imports also support this view.

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