Is the worst over for emerging markets (EM), given that the Fed seems to have backed off from hiking rates and the U.S. dollar has potentially topped out?
The Fed halting rate hikes and even cutting interest rates will not change our bearish view on EM. Over the past several years, our EM strategists have repeatedly argued that the Fed and rising U.S. bond yields are not the dominant reason for poor EM financial and economic performance. The root cause of the EM bear market has been deteriorating EM fundamentals, specifically contracting profits and collapsing return on capital.
Historically, EM share prices and EM currencies move in tandem with major swings in EM return on equity. At the same time, typically there has been a rather strong positive correlation between EM share prices, currencies, and credit markets (sovereign and corporate bonds’ excess returns) on the one hand, and U.S. bond yields on the other. From early 2009 until the middle of 2015, there was little correlation, but since the middle of 2015 the positive correlation has been restored.
Overall, in the medium to long run, EM risk assets are primarily driven by EM growth and EM return on capital rather than Fed policy and U.S. bond yields. On the flip side, the reason why the Fed has toned down its rate hike rhetoric and why it will not raise rates much further is because of the deteriorating global growth outlook, driven by slumping EM growth.
Bottom Line: The Federal Reserve not raising rates is not a sufficient reason to buy EM risk assets.
