On May 3, the Federal Reserve raised interest rates by 25 basis points, bringing it to 5.25% for its upper limit. More importantly, its statement gave increasingly clear signs that the current tightening cycle is ending. With signs of inflation slowing in many countries, the FED will most likely not be alone in its change of stance, and other central banks are expected to follow, thus increasing investors’ risk appetite. This turn will lead to the search for higher returns, and emerging markets are strategic within this scenario. In this column, we will examine the crucial variables to consider.
What is an emerging market?
Although there is no clear definition for “emerging markets,” we can describe them as the financial markets of developing economies that are becoming more engaged with global markets as they grow. As this occurs, these markets and their financial assets become attractive to foreign investors, making specific funds and indexes more likely to include them. Typically, these countries are transitioning from a less developed, low-income economy towards a more modern one with higher living standards, like China or South Korea.
To specify which countries fall within this category, at least in terms of their markets, we can look for hints in the MSCI Emerging Market Index, as its basket has become the global benchmark in this respect. This index shows the stock performance of emerging markets. As seen in the chart, the basket mainly comprises Asian economies. China, India, Taiwan, and South Korea form nearly 87% of the index. Only Brazil holds a significant share in the region, with 4.39%, while countries such as Mexico, Chile, Colombia, and Peru are grouped within “others.”
Chart 1 Own elaboration. Data by Bloomberg and MSCI
Comparing the MSCI Emerging Markets and MSCI World indexes, the chart shows that 2023 has been quite volatile in terms of stock markets. A sharp decline in February and mid-March of 3.8% and 2.5%, respectively, marked the first anniversary of Russia’s invasion of Ukraine. It is noteworthy how, from then on, developed countries’ stocks show a higher recovery, with 6.9%, compared to a 2.9% for emerging countries. In this regard, we must remember that China is a heavy-weight index component and that its stock market has not recovered as expected by investors.
What to expect for 2023?
The lingering question is about what lies ahead for emerging markets in the remainder of 2023. The most relevant events at the beginning of the year were China’s easing on its zero Covid policy and its economic reopening. These raised investors’ optimism regarding the global economy and boosted risk appetite, benefiting not only China but the emerging economies in general.
This generated an increase in investment flows, leading to significant currency appreciation. As seen in chart 2, Mexico and Brazil are heading the Year to Date (YTD) currency appreciation. Their exchange rates have dropped 8.7% and 5.8% respectively.
However, local politics play a crucial role in risk perception for these countries. The performance of the 5-year CDS reflects this, which is the case for Turkey and its ongoing electoral process. Elections for president and parliament will take place on May 14, and for the first time in 20 years, incumbent President Recep Tayyip Erdoğan is not the favorite, which generates a high level of uncertainty among investors.
Gráfico 2. Elaboración propia. Datos Bloomberg.
Colombia has the second place in this ranking. The country has undergone a cabinet reshuffle over the first nine months of the leftist President Gustavo Petro as the government seeks more effectiveness in Congress for the approval of structural reforms to the health, labor, and pension systems. In Chile, a notable shift also occurred since the right-wing parties achieved a solid victory and obtained a majority in the Constitutional Council. The 50 members of the Council will be tasked with drafting a new Constitution to replace the one promulgated under the military dictatorship headed by Augusto Pinochet.
Two additional factors will positively impact emerging markets for the remainder of the year. One of them, mentioned above, is the apparent end of the Federal Reserve’s tightening cycle, which remained at 5.25% after its last increase at last May’s meeting. This, along with the regional banks’ turmoil, is causing the dollar to weaken, a factor that has made emerging equities more attractive in the past.
Finally, in general terms, it can be seen how assets in emerging markets have been subject to a long period of price stress. With exchange rates still at historic highs in some of them, changes in the ongoing global macroeconomic trends pose interesting opportunities. However, it should be noted that this group is highly heterogeneous, and each country’s peculiarities should always be considered when designing an investment strategy.