INSIGHTS

On July 24, 2023

AAM Viewpoints — Further Opportunity in Emerging Markets Should U.S. Rates Steady

While inflation remains above the Fed’s target rate, there have been recent glimpses of potential cooling. And although this is unlikely to deter them from continuing on their path higher in the near term, a potential shift to a holding pattern thereafter may present an attractive opportunity for investors within the emerging markets space. Specifically, further cooling of the U.S. dollar on expectations of lower inflation and steadying rates in the U.S. can continue to prop up emerging market economies.

Looking back over the last three years, as the 10-year yield began to move higher until its peak around October of last year, as too did the dollar, appreciating nearly 19% against other major world currencies. Similarly, as the 10-year yield came down from its October highs of over 4%, the dollar declined by 12% down to its levels today.

Comparing specifically to a basket of emerging markets currencies, the MSCI Emerging Markets Currency Index, we can see the dollar’s strong inverse correlation. During the dollar’s 12% decline, the MSCI Emerging Markets Currency Index gained 8% over the same nine-month time period. Moreover, across the past three years the index displayed a negative -0.44 correlation to the U.S dollar.

Source: FactSet | Past performance is not indicative of future results.

As a result, when comparing the dollar directly to the MSCI Emerging Markets Index, a market cap weighted index of large and mid-cap stocks across emerging markets, we can see the dynamic bleed through to equity market performance. Given many emerging market economies tend to be commodity centric as well as dependent on U.S. exports, U.S. dollar appreciation tends to promptly strain emerging market economies, as imports in dollar terms become relatively more expensive to transact in.

Going back to when the dollar appreciated 19% into its October peaks, the MSCI Emerging Markets Index declined nearly 16% on a total return basis. Conversely, alongside the dollar’s pullback, the index gained over 24% from its October lows, outpacing the S&P 500 by over 2% over the same time period. As the dollar cooled, emerging markets currencies and equities alike saw strong upside moves.

Source: FactSet | Past performance is not indicative of future results.

However, a rebound in inflation measures is still at play, potentially leading to renewed pressures on the broader emerging markets space. Given the uncertainty, investors looking to position into the space should also consider exposures across factors and styles as opposed to simply broad and general exposure.

The MSCI Emerging Markets Value Index shows the potential for more resiliency against emerging respect to currency risk. Compared to its broader counterpart, emerging markets value displayed relative outperformance throughout the sharp fluctuations in the dollar. Over the last year, the index outperformed the broad benchmark by over 4%. Over the last three years as the dollar rose by close to 8%, the value index gained over 18% compared to just a 4% gain for the broad benchmark.

Source: FactSet | Past performance is not indicative of future results.

Furthermore, the value-oriented index exhibits more attractive dividend and fundamental characteristics which can provide a sturdy foundation to build portfolios around for investors eyeing the emerging markets space. With a current yield of 4.28%, emerging markets value stocks offer a 138 basis point pickup in yield and more attractive valuations relative to broad emerging market stocks.

Source: FactSet | Past performance is not indicative of future results.

Though the U.S. has not yet met their long-term inflation goals and the Fed is likely to drive interest rates a bit higher, emerging markets stand to potentially benefit if U.S. inflation concerns continue to alleviate toward the end of the year. However, we believe investors should consider proceeding with caution and lean in toward segments that may offer more insulation from the risks that come with emerging markets investing.

CRN: 2023-0706-10975 R