Since the beginning of this year, the US Federal Reserve Bank has adopted a more dovish stance, cutting rates and taking a more accommodative approach to monetary policy. This has prompted many emerging market economies to also cut rates in order to compensate. This move is likely to result in a lower dollar in the near to medium term, while emerging market currencies may strengthen. These factors alone could create the optimum conditions for a rally in emerging markets assets over the near to medium term.

The US-China trade war is also contributing to creating good conditions for a rally in emerging markets as industries realign themselves in order to compensate for the trade tensions.  

Winds of Change after Last Year’s Rout

This is welcome news for emerging markets as many are still reeling from the deep rout that began in 2018 in these markets, as global capital flows changed with US markets performing well. Stability and bull market conditions in the US, coupled with trade tensions with China saw a souring of investor sentiment in emerging markets and a flight of capital into more secure and less risky US assets.

With US markets presently at or near all-time highs, a more accommodative Fed and trade tensions with China in play, the conditions are now ripe for capital flows to shift again towards emerging markets.

Not Just Capital Markets, “Real Economy” Benefits Too

The good news for emerging markets is not just for capital markets and stocks but for the “real economy” as a whole. This is as a result of the US – China trade war. With high tariffs on many Chinese products, emerging markets like Vietnam and others are benefitting hugely as manufacturers shift operations from China into emerging markets. Emerging markets also benefit from these conditions as locations for transhipment or minor value additions so that goods can be labelled as not having being manufactured in China, to avoid US tariffs.

The Unexpectedly Strong Dollar

Despite rate cuts from the Fed and the malaise of the trade war, the Dollar has shown great resilience and in many instances has continued to remain strong. This could be a problem for a potential emerging market rally, if it continues. A strong Dollar could act as a disincentive for investors looking to move their funds into emerging markets. However, a continued strong Dollar could result in increased demand for products and services from emerging markets as they will become even more attractive.

Investor Positioning, A Threat to the Potential Rally

Since early this year, capital flows have already begun to shift in favour of emerging markets as investors have been channelling their funds into them. These inflows are significant and, according to data published by JP Morgan, are almost twice the total inflows of the previous year. While there is plenty of room for more inflows, a sudden change in investor sentiment at this point could adversely affect the present highly conducive conditions for a potential rally.

This is one of the major risks facing a potential emerging markets rally, however, conditions remain ripe and it is reasonable to expect healthy growth and returns in these markets in the near and medium term.