HIGHLIGHTS:
- While US stocks held stable, emerging markets rose over 20 percent and entered a bull market over the past few months.
- Emerging countries depend on US dollar-denominated borrowing to support their economies.
- At its peak, the US dollar rose over 19 percent in 2022 before declining in the fourth quarter.
- Earlier this week, China unexpectedly dropped its strict zero-COVID policy, granting open travel and ending incoming quarantine requirements.
After several successive months of negative returns in equity markets last year, the recent spate of sideways returns comes as a welcome respite to many investors. Since mid-October, the S&P 500 meandered upward and held rather stable with minimal volatility. However, not all markets act alike. Over that same period, emerging market stocks—those countries engaged in global commerce but lacking some of the liquidity, size, and accessibility of developed markets—have rallied over 20 percent, as measured by the MSCI Emerging Markets Index. This meets the commonly accepted definition of a bull market. Talking about a bull market in stocks in today's environment highlights the divergences that can and do take place, particularly near the peaks and troughs of market cycles.
This yawning performance gap between the two markets can be attributed to several factors, but one stands out: The Federal Reserve. Emerging markets are unique in several ways, including where they get their investment capital. Many of these economies rely on US dollar-denominated borrowing to build out their economy. Promising to pay back their loans in strong and secure currencies like the greenback helps these foreign governments and corporations acquire better borrowing rates. This works well in a low interest rate environment, where the dollar's strength versus other currencies is somewhat muted. However, when the Fed hikes interest rates, which strengthens the dollar, this makes those loans more and more expensive to pay back. At its peak last year, the ICE US Dollar Index rallied over 19 percent against a broad basket of foreign currencies, as markets encountered the Federal Reserve's monetary tightening cycle. It then fell in the last few months of the year.
The Fed is not the only major influence in emerging market economies. China—the largest emerging market economy—is also the largest buyer of raw goods from smaller, developing countries. The Chinese economy's health, therefore, has a tremendous influence on their fortunes, particularly those in Southeast Asia, and buyers of its goods in developed nations. After three years of lockdowns, China suddenly and unexpectedly dropped its strict zero-COVID policy earlier this week. The reversal occurs amid a rise in infections, but with the potential tradeoff that the reopening will reinvigorate the world's second-largest economy that is experiencing its slowest growth in decades.
Despite the impressive performance of emerging market stocks over the last three months, risks abound. China is still grappling with tremendous pandemic disruptions and recent turmoil in its real estate sector. While China is one of the largest consumers of raw goods, the US is its largest finished goods buyer. A significant slowdown domestically would likely throw water on the recent rally. A close eye should be kept on these various outside influences on the sector, as they tend to carry tremendous weight on performance.
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