Earlier this year we wrote that, with the US cooling and interest rates approaching a likely peak, a new cycle in emerging markets (EM) was drawing near. The latest comments from the US Federal Reserve suggest the next cycle may begin even sooner than we thought.
The Fed has given its strongest signal yet that it is turning dovish, with Chair Jay Powell hinting the US economy might need an ‘insurance’ interest rate cut. As he put it on June 19, “an ounce of prevention is worth more than a pound of cure”.
According to IAM’s Macro Research Group, the Federal Open Market Committee is clearly in risk management mode. The team’s central case is for two rate cuts before year end.
As the US tightening cycle ends, the headwinds for emerging markets should start to fade. By way of a reminder, this is how we see the next cycle progressing:
- We expect EM assets to outperform developed market (DM) assets over the cycle.
- Many EMs start this new period from a position of strength. Fiscal and monetary policies are generally prudent, and companies have relatively low leverage and plenty of cash.
- The US may be late in the current cycle, but EMs are at a much earlier point, with room for an acceleration in investment, credit growth and consumption.
- While not as cheap as the early 2000s, valuations look attractive relative to 2013.
Risks remain for EMs (and DMs, for that matter), notably weak global growth and continuing trade tensions. The US and China will be urged to settle their differences at the G20 summit in Osaka later this month, but the outcome of the expected subsequent talks is far from certain.
Nevertheless, we see potential for EM local currency debt — which has underperformed EM hard currency debt so far in 2019, largely due to the modest performance of emerging currencies year to date — to catch up over the summer.
The Fed’s dovish turn isn’t the only potential fillip for EM currencies. Our research suggests strong outflows from emerging market equities in the last two months. If even some of this money flows back in, EM currencies could get a further boost.
The value of investments, and any income generated from them, can fall as well as rise.
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.