Doha, Qatar: Over the past two years, emerging markets (EMs) have suffered significant volatility in capital flows. This is driven by currency instability, geopolitical uncertainty, and a general lack of risk appetite among global investors.
According to the Institute of International Finance (IIF), non-resident portfolios flowing into emerging markets, i.e. foreign investors' investments in local public assets (listed** and bonds), have experienced two negative growth in recent years. This happened from March to September 2022 and August to October 2023, when the pressure was at its highest.
During these stressful times, emerging markets face headwinds such as a stronger dollar, high and rising interest rates in major advanced economies, and a severe global manufacturing recession. As a result, outflows have created a challenging environment for emerging market assets, which continue to have lower returns than benchmark returns in advanced economies.
In fact, the MSCI Emerging Markets Index has grown by around 26% since the start of 2021, covering mid- and large-cap emerging markets across 24 major jurisdictions, including some of the most dynamic economies in Asia, Latin America, the Middle East and Africa. In contrast, the S&P 500 index of major U.S.-listed companies is up nearly 30% over the same period.
However, in our view, this underperformance will moderate or partially recover as risk appetite returns and capital flows back to emerging markets. There are two main factors that support our view that the global macroeconomic backdrop is increasingly favorable for emerging markets: a shift in relative macroeconomic performance and a gradual adjustment in interest rate differentials between the US and major emerging markets.
First, growth in the United States relative to "exceptionalism" is expected to slow. Over the past few years, economic data from most major emerging markets has been unexpectedly negative, while economic data from the United States has been unexpectedly positive, leading to several rounds of revisions in favor of relative growth expectations in the United States.
This has pulled global capital into the United States, further drying up liquidity elsewhere. But that dynamic has already begun to change.
Since the end of 2023, the large gap in favor of the U.S. in the Citi Economic Surprise Index has narrowed significantly, suggesting the end of the growth correction period in favor of the U.S. In addition, the growth gap between the U.S. and emerging markets, which was very narrow last year at 180 basis points, should return to the more standard 250 basis points this year. As a result, the growth gap is expected to widen again, benefiting emerging markets and driving capital back to this dynamic jurisdiction.
Second, interest rate differentials will also favor emerging market assets and non-USD currencies to the detriment of US assets and the US dollar. After months of overheating, the U.S. economy is finally starting to slow down.
This, combined with the normalization of the ** chain due to the pandemic and geopolitical disruptions, is already supporting a rapid return to monetary stability. Inflation will quickly converge on the central bank's 2% target.
Such a macro backdrop is favorable for the Federal Reserve's (Fed) "pivot", which is expected to cut interest rates aggressively throughout the year. The market is currently pricing in a Federal** interest rate of 3 by the end of the year75%, 175 basis points lower than the current rate. This should boost global liquidity and push capital overseas in search of higher yields and returns globally, particularly in emerging markets.
All in all, after a period characterized by volatile capital flows and poor market performance, a more modest environment should emerge in emerging markets.
With both non-resident capital flows and asset returns normalizing, relative growth and interest rates should be a more favorable proposition for emerging markets.