Five Keys to Emerging Market Outlook

John Lynch Chief Investment Strategist, LPL Financial

Written by 
 Boone Wealth Advisors

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We continue to prefer emerging market (EM) equities in tactical asset allocations. EM equities have given back strong early-year gains, pushing the MSCI EM Index into negative territory year to date on a total return basis. Many headwinds have weighed on EM stocks, including rising interest rates, U.S. dollar strength (and related weakness in EM currencies), and trade war fears. Here we highlight five keys to our EM outlook.


1. Interest rates and monetary policy. EM’s latest bout of underperformance began on April 1, when the latest move higher in the 10-year Treasury began [Figure 1]. Since April 2, the 10-year yield has gone from 2.73% to 3.07%, while the S&P 500 Index has returned 5.4% and the MSCI EM has lost 2.5%. Expectations priced into the bond market for Federal Reserve (Fed) rate hikes in 2018 (based on fed funds futures market prices) have also shifted over to four total hikes in 2018 (>50%) rather than three, with the higher inflation expectations and higher short-term rates putting some upward pressure on intermediate- and longer-term bond yields.

For shorter time periods, rising interest rates can cause higher volatility for EM stocks. During the so-called “taper tantrum” in the middle of 2013, EM stocks lagged the S&P 500 by about 10 percentage points (5/3/13–9/6/13). However, over intermediate and longer periods, EM stocks have tended to do well as rates rise. One-year rolling correlations between EM stocks and the 10-year yield have been positive over most of the past 30 years as economic growth and profits have won out.

Note that EM stocks performed relatively well during the most recent Fed rate hike cycle in the mid-2000s (June 2004 to June 2006), outpacing the S&P 500 when the fed funds rate rose from 1% to 5%; EM also performed well from January 1999 through July 2000, when the fed funds rate rose from 4.3% to 6.9%. EM certainly enjoyed a strong run in 2017, as the Fed hiked rates.

The EM crisis periods of the mid- to late-1990s were an exception as the Fed hiked rates and EM stocks underperformed. Beyond glaring exceptions of Venezuela and Argentina, EM economies are in stronger financial positions today. We do not see broad spillover from today’s trouble spots that the Thai bhat and Russian debt crises sparked in the mid-1990s.

Also worth noting is that, based on our expectations for a modest pickup in growth and inflation, we have maintained our year-end 10- year Treasury yield forecast range of 2.75–3.25%, suggesting limited upside potential to yields from here. We expect low interest rates overseas and contained inflation in the U.S. to prevent a significant move higher in interest rates.

2. The U.S. dollar. The U.S. Dollar (USD) Index has rallied about 5% since mid-April. At the same time, EM currencies have struggled mightily, particularly in crisis-riddled Argentina and Turkey, driving EM stock weakness. History tells us that EM has tended to struggle during strong dollar periods such as May 2014 through March 2015 (USD up 22% and EM underperformed the S&P 500 by 15%). EM struggled during the Asian currency crisis period in the mid- to late-1990s, but the asset class performed well during the dollar rally in 2005 (the dollar rallied 13% as the Fed was hiking rates). So the relationship is not entirely clear cut.

Beyond the obvious negative currency translation effects of a strong dollar for U.S.-based investors in EM stocks, we do not think the strong dollar should be particularly worrisome for broad EM investors for several reasons. First, further gains may be limited due to structural downward pressures. Second, EM exporters benefit from cheaper exports when their currencies are weak. Third, generally better current account balances (essentially the value of a country’s exports less imports) put the biggest EM countries in a good position to weather dollar gains. Last, fewer pegs to the dollar help give EM countries currency flexibility.

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