Can emerging market equities work in a rising U.S. interest-rate environment?


April 12, 2016 [Emerging Markets, Economy, MSCI EM Index]
Charles Wilson, PhD

Rising U.S. interest-rates aren't the headwind for emerging markets many expect. It depends on where you start.

As we have noted previously, the stronger dollar has created a stiff headwind for MSCI Emerging Markets Index earnings, which are calculated in dollars. The roller coaster in emerging market equities over the last year has largely been driven by shifting market expectations for U.S. interest-rate policy and the dollar. Can emerging market equities work in a rising U.S. interest-rate environment? While not a large dataset, we do have three periods since the inception of the MSCI EM Index in which the Federal funds target rate rose by 300 basis points or more. The data are mixed. In the figure below, we examine the 12-month and six-month performance of emerging markets heading into and out of the first rate hike in the last three rate-hike cycles stretching back to the early 1990s. The data show emerging market equity performance was mostly strong heading into the first rate increase. Post the rate increase, though, the outcomes were more mixed.

MSCI Emerging Market Index Returns Around U.S. interest-rate Cycles

Source: Bloomberg


The 1993 tightening cycle is the outcome that investors today fear. Just before the initial rate hike, the U.S. economy slowed sharply from growth in gross domestic product (GDP) of more than 4% in late 1992 to 2.3% the following September, just before the Fed started to raise rates. Some uncertainty about U.S. growth probably contributed to the weak performance. The bigger issue was the political and financial turmoil unfolding in Mexico. Less than 12 months after the initial rate hike, Mexico was forced to depeg the peso as the central bank ran out of the international reserves necessary to defend it. This kicked off a rapid selloff across all emerging markets. The situation in 1999 was different. As Asia began recovering from its financial crisis, triggered in part by the issues in Mexico, its financial flu had spread to Russia, which devalued its ruble and defaulted on its debt in 1998, and from there to Brazil, which devalued the real in early 1999. But U.S. GDP growth was running at close to 5% and seemed unstoppable. As a result, emerging markets saw decent returns at the time, at least until they were dragged down by the tech bubble collapse. In the 2004 rate hike cycle, short-term performance was basically flat, but the 12-month returns were very strong and remained so for several years until the global financial crisis.

I would argue that the current situation in emerging markets is a combination of case two and three. Emerging markets have been forced to rebalance after global demand trends shifted, forcing them to look for a new engine of growth. Many have turned toward domestic consumption. That rebuilding process is similar to what took place in the late 1990s and the early 2000s. Patient investors were rewarded when the markets finally turned.


The performance data quoted represents past performance; it does not guarantee future results.

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