Emerging market equities could rally in 2024 if Wall Street's new narrative of lower U.S. interest rates comes true.
There have been the best, the worst and the mediocre times for emerging market equities. This year was modest, with the iShares Emerging Markets Index (EEM) gaining 4.3% YTD compared to 18.7% of the S&P 500.
But there were a couple of notable exceptions, like Argentina's stock market, with Global X MSCI Argentina fund gaining 45% YTD, Poland's market, up 41%, both an election play, and India's Small Cap market, up 28%.
One of the reasons for the lackluster performance of most emerging markets is rising U.S. interest rates, which narrowed the gap between emerging market interest rates and U.S. interest rates, making U.S. securities more appealing to international investors than emerging market securities.
"Historically, a higher U.S. federal funds rate (or a tightening of monetary policy) has been associated with international investors withdrawing capital from emerging markets, which can lead to lower economic activity and depreciating exchange rates in these markets — and, in turn, greater financial vulnerability," said Johannes Matschke, Alice von Ende-Becker and Sai A. Sattiraju in an article published by the Federal Reserve.
"To reduce capital outflows, central banks in emerging markets can tighten their monetary policy rates to increase yields on debt securities," they added.
For instance, Brazil's 10-year Treasury Bonds are trading with a current yield of 11.12%, India's yield of 7.27%, South Africa's 10.19% and Mexico's 9.55%, compared to 4.4% of the U.S. Treasury bonds.
High domestic interest rates, in turn, hurt investments and economic growth. "Because investments in emerging markets are perceived to be risky, investments in emerging markets tend to fall more than investments in advanced economies after an increase in U.S. interest rates (even controlling for the interest rate differential)," explained Matschke et al.
Another negative development for emerging markets is the sluggish commodity prices, which take their toll on the economic growth of emerging markets that depend heavily on commodity exports. For instance, the CRB commodity Index traded sideways in the first half of the year, while copper futures dropped from $4.28 per pound at the end of last year to below $3.78 per pound at the end of this year.
The situation could be different in 2024. The U.S. bond yields are heading lower, thanks to better inflation numbers and a slowing U.S. economy, which have raised Wall Street's expectation for an interest rate policy pivot — lower interest rates.
That could be good news for emerging market stocks and bonds. It will broaden the gap between emerging market interest rates and U.S. interest rates, fueling the emerging market carry trade — the capital flows from the U.S., where interest rates are low, to emerging markets, where interest rates are high.
"When U.S. interest rates drop, investors often look for higher returns internationally," Ian Wright, founder of Business Financing, told International Business Times. "Long-term megatrends such as technological innovation are often concentrated in rapidly developing economies. With lower interest rates in the U.S. typically weakening the U.S. dollar, assets in these markets can appear particularly affordable and therefore attractive."
The weakening U.S dollar could exacerbate the carry trade, making emerging market assets more valuable for U.S. investors when converted to dollars.
Meanwhile, commodity prices have been stabilizing, with the CRB rising from 284 last June to 312 in early November, while copper futures have rebounded since the middle of September.
Mercer recently released its 2024 Economic and Markets Outlook, which shows that emerging market economies, especially China, will drive global economic growth, though growth will be divergent.
Wright sees emerging markets as a long-term value play. "The population in emerging markets accounts for 82% of the world's total," he said. "However, it is estimated that these markets account for only just over a quarter of the aggregate value of all tradable financial assets globally. Therefore, Investment in emerging markets can seem like a relatively untapped, potentially lucrative option."
Still, Wright warns investors that higher returns come with higher risks. "There is no doubt that the potential of emerging markets is huge," he elaborated.
"Historically, fortunes have been made through investment in these zones," he explained. "However, the volatility of currency and political instabilities often seen in developing economies mean that a cautious approach is prudent. If risks are carefully considered and managed, now could be a worthwhile time to invest in emerging markets."
