Are Emerging Markets Equities Finally Set to Outperform, Given Expectations for Federal Reserve Rate Cuts This Year? - Cambridge Associates (2024)

No. Although emerging markets (EM) stocks typically outperform after the onset of Federal Reserve easing, we suspect this episode will be different. The growing chance of a US soft landing—coupled with sluggish growth expectations globally—suggest that cuts could be modest and that the US dollar will hold its value. These conditions do not meaningfully shift the probability that EM will outperform developed markets (DM). However, given that negative sentiment toward China has led to equity market pricing becoming increasingly disconnected from fundamentals, we do recommend investors modestly overweight Chinese equities.

EM equities have massively underperformed DM peers since the Global Financial Crisis, and that malaise has intensified recently. In the three years through January 31, EM trailed by nearly 16 percentage points (ppts) per annum, which is among the worst underperformance spells in the past two decades. China (-23.3%) is the leading detractor, but the EM ex China bloc still lagged DM by almost 7 ppts per year. There have been bright spots. India (13.7%) and Mexico (20.1%) were the leading contributors to EM performance over this period, supported by structural economic tailwinds. These markets aside, EM equities have largely been a losing game.

Recent macro dynamics suggest that a wide range of EM equity performance outcomes are possible as the Fed eases policy. Looking across previous cycles, the best time to overweight EM stocks versus DM has tended to be in the early part of the business cycle. While Fed rate cuts typically precede new business cycles, there have been cutting cycles where that hasn’t been the case. And in these instances, EM outperformance has had a mixed record. Based on a slew of recent economic data, there’s a non-negligible chance this Fed easing policy ends up being more of a mid-cycle adjustment.

These dynamics may also support the US dollar, which would reduce the probability of EM outperformance. Although the greenback is expensive, two factors may keep it that way. First, Fed rate cuts are likely to be modest this year, considering recent US economic strength. Other key central banks are also expected to ease policy (save for Japan), which means that narrowing interest rate differentials are unlikely to drive US dollar weakness. Second, economic growth outside the United States is sluggish, with many regions having recently entered technical recessions. Such a wide economic growth differential does not suggest an imminent decline for the US dollar.

The EM macroeconomic backdrop may remain challenging. Most EM central banks raised interest rates aggressively following the global inflationary surge that began in early 2022, which has slowed aggregate EM money supply growth to the lowest levels on record. As a broad indicator of economic activity—and a leading indicator of the EM profit cycle—this implies EM earnings growth will remain under pressure. Further, global trade volumes have been contracting. Although certain EM manufacturing and export data have rebounded in recent months, it may be short-lived. Globally, consumer spending tailwinds are fading and there’s a lack of fiscal and monetary policy impulse to boost growth. Notwithstanding trade in specialized semiconductors, which are seeing high demand from the emergence of artificial intelligence (AI) technologies, the outlook for broader EM exports is lacking a major catalyst.

EM equities do have redeeming qualities today, namely valuations and the consensus outlook for earnings and economic growth. But these are not without caveat. EM stocks trade just below median levels, according to our preferred normalized valuation metric, and are historically cheap vis-à-vis DM peers. However, the aggregate view masks wide dispersion among countries. Those with structural tailwinds, such as India and Taiwan, already trade at a wide premium to their 20-year average levels, suggesting their growth stories (economic reform/demographics and AI, respectively) are well priced. Valuations for Mexico and ASEAN countries are more reasonable, and these markets may benefit from ongoing US-China tensions. Still, their combined size in the EM index is less than 9%. Compared to recent experience, EM economic and earnings growth is expected to outperform this year by wider-than-normal margins. But given the above discussion, we see risks to these estimates as skewed to the downside.

Taken together, we don’t think Fed rate cuts are a panacea for EM equities. Allocators should hold this sleeve of the portfolio, except for China, in line with their benchmark weight. To us, Chinese equities offer the most value as pervasive negative sentiment has led to pricing that is increasingly disconnected from fundamentals.

Stuart Brown, Investment Director, Capital Markets Research