The current period of rising interest rates and falling markets is disconcerting, but it also creates opportunity, according to Franklin Templeton’s Emerging Markets Equities team.
Key points to remember
- Developed market (DM) central banks have started raising interest rates, led by the Bank of England.
- Emerging market (EM) fundamentals are better in the current tightening cycle compared to history.
- The current and 2015 US rate hike cycles have similarities for emerging market equities, based on economic and market fundamentals. In the 12 months since the first US rate hike in December 2015, the MSCI Emerging Markets Index rose 10%.
- Over the previous five US rate hike cycles, the MSCI Emerging Markets Index has on average performed better in the 12 months leading up to the first US rate hike than in the following 12 months; nevertheless, the gains of the last period remained positive.
The current period of rising rates and falling markets is disconcerting, but it also creates opportunity. The Franklin Templeton Emerging Markets Equities team believes in the importance of a long-term view and bottom-up research; look for companies that have sustainable earnings growth, trade at a discount to their intrinsic value, and have persistent and repeatable competitive advantages over time. In the current market decline, we see many companies exhibiting these characteristics. This creates opportunities for our investment team to increase exposure to these companies in preparation for the eventual recovery.
Fundamentals of EM
According to our analysis, the main differentiator between the economic fundamentals of the United States and emerging markets in the current cycle is inflation. Over the past 20 years, inflation in emerging markets has consistently been 2.4 percentage points (ppt) higher than in the United States.1 Higher inflation implies higher interest rates and a higher cost of capital in emerging markets.
However, the current cycle is different. Based on year-end 2021 data, inflation in emerging markets is 3.4pp lower than in the US,2 driven by the unprecedented fiscal stimulus, soaring commodity prices and post-COVID-19 supply chain issues.
Additionally, the emerging market current account position looks more comfortable in the current rate-tightening cycle than historically. Over the previous five US rate-tightening cycles, the average emerging market current account deficit was -0.25% of gross domestic product (GDP). At the end of 2021, the EM current account was in surplus by 0.3% of GDP.3 As interest rates in emerging markets rise, lower inflation and a higher current account position imply that interest rates could peak at lower levels than in previous cycles.
Added to the best economic fundamentals are stock market valuations. Over the previous five US rate-tightening cycles, the 12-month forward price-to-earnings (P/E) ratio was 16x, down from 11x currently.4
Back to 2015
Of the five previous cycles of US rate tightening, the 2015 cycle bears the greatest similarity to current emerging market equities. The US federal funds rate in 2015 and at the start of the current tightening cycle was close to zero. The P/E ratio of the MSCI EM index in 2015 and at the start of the current tightening cycle is similar: 11x.5
The performance of the MSCI EM Index in the 12 months prior to the first US rate hike in December 2015 was -14%. In the current cycle, the MSCI EM index is down 22% over the past 12 months.6
In the 12 months following the first US rate hike in December 2015, the MSCI EM Index rose 10%, compared to an average gain of 8% over the previous five US rate tightening cycles.7
Impact of rising US interest rates on emerging markets
We do not believe that rising interest rates in the US imply a weakening in emerging market equity markets. Over the previous five US rate hike cycles, the performance of emerging market equities has been positive, with an average gain of 8% in the 12 months following the first rate hike by the US Federal Reserve. The breakdown into individual periods highlights three cycles with gains and two with losses.
Some emerging markets are facing inflationary pressures, and policymakers are responding to this with higher rates. The central banks of Argentina, Brazil and Poland have raised interest rates by 50 to 200 basis points8 so far this year. However, other central banks are in easing mode, including China, which cut its prime lending rate by 10 basis points in January 2022.9
It’s clearly a mixed picture on the scene, pace and direction of interest rates in DM and EM. Historical data shows that emerging equities perform better in the 12 months before the first US rate hike than in the 12 months after. Nevertheless, the gains of the last period remained positive.
Take a long-term view
Economic fundamentals and historical evidence are relevant, but each cycle has different drivers. The current bear cycle is driven by the aftermath of unprecedented fiscal stimulus, soaring commodity prices and post-COVID-19 supply chain issues impacting inflation, and the war in Ukraine which has an impact on investors’ risk appetite. An aversion to holding risky assets currently prevails among many investors; what started with investors selling Russian stocks has spread to China and other emerging stock markets. In such circumstances, we believe that having a long-term perspective is valuable.
Franklin Templeton Emerging Markets Equity opened its first office in Hong Kong in 1987. Our investment team experienced the Mexican crisis in 1984, the Asian financial crisis and Russian default in 1997/98, the SARS epidemic in 2003, the global financial crisis in 2007 and the consequences of the depreciation of the Chinese renminbi of 2015/16. What each of these crises taught us was the importance of taking a long-term view and knowing that every downturn was a buying opportunity.
Having a long-term perspective means adhering to our investment philosophy through good times and bad. Companies with sustainable earnings growth and competitive advantages that are persistent and repeatable tend to have higher valuations. The lessons we have learned from past downturns are that when companies with these characteristics lose value and trade below their intrinsic value when short-term investors sell, our clients benefit when we step in and increase exposure to these companies for the eventual takeover.
Franklin Templeton Emerging Markets Equity believes in taking a long-term view and pursuing a diversified investment approach. While the current period of rising interest rates and falling markets is disconcerting, it creates opportunities for investors who have experienced similar crises in the past and understand that markets are cyclical and take a long view. term.
What are the risks ?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investments in foreign securities involve special risks, including currency fluctuations, economic instability and political developments. Investing in emerging markets, of which frontier markets are a subset, involves increased risks associated with the same factors, in addition to those associated with the small size of these markets, their lesser liquidity and the absence of executives. legal, political, commercial and social established to support securities markets. Since these frameworks are generally even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are amplified in frontier markets. To the extent that a strategy focuses on particular countries, regions, industries, sectors or types of investments from time to time, it may be subject to greater risks of adverse developments in those areas of interest than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China can be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks specific to China, including certain legal, regulatory, political and economic risks.
1. Source: Bloomberg, as of December 31, 2021. Past performance is not an indicator or guarantee of future results. To see www.franklintempletondatasources.com for more information about the data provider.
2. Source: Bloomberg, as of December 31, 2021.
4. Source: Bloomberg, as of March 11, 2022.
6. Source: Bloomberg, as of March 11, 2022. The MSCI Emerging Markets Index reflects the representation of large and mid caps across 24 emerging countries. Indices are unmanaged and cannot be invested in directly. They do not reflect any fees, expenses or sales charges. MSCI makes no warranties and assumes no liability with respect to the MSCI data reproduced herein. No other redistribution or use is permitted. This report is neither prepared nor endorsed by MSCI. Past performance is not an indicator or guarantee of future results. Important Data Provider Notices and Terms available at www.franklintempletondatasources.com.
7. Source: MSCI, Bloomberg, as of March 11, 2022.
8. One basis point is equal to 0.01%.
9. Origin: Central Bank Newsas of March 11, 2022.