Emerging Market Overperformance And Interest Rates

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Posted: Jun 30, 2020 10:44 AM
Emerging Market Overperformance And Interest Rates

Source: AP Photo/Jacquelyn Martin

We've looked at how U.S. interest rate expectations relate to global growth expectations (as shown by changes in copper price and supply) and the strength of the U.S. Dollar (as shown by exchange rates between the dollar and other currencies).

How do these expectations affect the trade-off between investing in Developed Market (DM) countries' stock markets and less developed, Emerging Market (EM) countries' stock markets? In other words, how would paying attention to interest rate expectations theoretically have affected returns in a portfolio made up only of EM in relation to one made up only of DM? To avoid introducing complicating factors, we put an equal amount of money into each individual country in the EM and DM portfolios respectively. So the 'bet' is not for or against a specific country but rather for or against the world of EM and the world of DM.

What we've seen previously is that when not paying any attention at all to interest rate expectations, on average the EM portfolio outperforms the DM portfolio by an average of a bit more than 1.7% per six-month period.

But let's look at an environment in which we do not have expectations of large increases in interest rates.
 

Development

Less Than 19%

19% Or Higher

Difference

EM

0.05943

0.0584

0.00103

DM

0.02050

0.0592

-0.03867

EM Overperformance

0.03894

-0.0008

0.03970

We see that in such environments (falling rate expectations and/or small increases) are a good environment for EM, with the average overperformance of EM vs. DM at almost 4% per six-month period. At such times in the past, in general EM was the better place to invest.

If, however, we look at those times when there are fairly large expected increases in U.S. rates, the EM portfolio very slightly underperforms the DM one. The number is so small as to round to zero, but it is negative. In that environment, EM in the past has not been a reliably smart bet.

Let's take a look at two of the correlation matrices we described previously. One will look at correlations between interest rate expectations and various other factors during periods of expectations of sharp interest rate hikes and the other will look at other periods.

During large hike expectations:


Interest Rate Expectations

Adjusted Bond Yields

Dollar Strength

Copper Demand Model

Capital Gains by Country

Total Returns by Country

Interest Rate Expectations

1

0.213

0.473

-0.191

0.006

-0.29

Adjusted Bond Yields

0.213

1

0.036

0.235

0.122

-0.033

Dollar Strength

0.473

0.036

1

-0.61

-0.011

-0.578

Copper Demand Model

-0.191

0.235

-0.61

1

0.006

0.555

Capital Gains by Country

0.006

0.122

-0.011

0.006

1

0.064

Total Returns by Country

-0.29

-0.033

-0.578

0.555

0.064

1


 Not during large hike expectations:


Interest Rate Expectations

Adjusted Bond Yields

Dollar Strength

Copper Demand Model

Capital Gains by Country

Total Returns by Country

Interest Rate Expectations

1

0.412

-0.42

0.522

0.044

0.432

Adjusted Bond Yields

0.412

1

-0.321

0.494

-0.02

0.167

Dollar Strength

-0.42

-0.321

1

-0.625

-0.001

-0.618

Copper Demand Model

0.522

0.494

-0.625

1

-0.008

0.494

Capital Gains by Country

0.044

-0.02

-0.001

-0.008

1

0.002

Total Returns by Country

0.432

0.167

-0.618

0.494

0.002

1

What we see is that periods of large interest rate increase expectations are different than other periods. For example, at such times interest rate expectations negatively correlate with global average returns (at a substantial -29%). In that type of environment, the higher the expected rate hike, the lower the returns. But in more normal environments, interest rate hikes correlate positively.

Think of it this way, when interest rate expectations are normal, things tend to be normal in general. If the Fed is expected to do a small increase, that often happens when growth is high enough that the Fed is not worried about growth (as we saw above in the relationship between copper prices and expectations). 

That data we see above goes together with the idea that the markets like 'normal'. But they're not crazy about abnormal environments in which the Fed is expected to hike rates quickly – in general, markets respond negatively to that.

The question is what kind of environment are we in now? Recently the Chairman of the Fed said that not only are they not going to hike rates this year, they are not even going to think about hiking rates this year. If the pattern we've seen in the past holds true, this is an especially good environment for EM. Add to that our previous finding, that EM tends to outperform even more after a crash, and it looks like it would be unwise to write-off EM as place to allocate capital.