Mar 14, 2022

Is It True? Emerging Markets Suffer after Fed Raises Rates

The commonly held perception is that when the Federal Reserve is tightening, emerging market equities suffer both in absolute terms as well as relative to US stocks.  It is thought that emerging markets are particularly vulnerable to higher U.S. interest rates as cash flows out of emerging markets, affecting their equity as well as fixed income markets. 

As we have stated in previous studies, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and MSCI Emerging Market Index went up 84%.  The converse can also hold. The financial crisis which started in 2007 is an extreme example of the inverse relationship between Fed Reserve policy and emerging market equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to .25%, yet the MSCI Emerging Market Index fell over 46%.  

This report explores how emerging market stocks have fared 1 month, 6 months, and 12 months after the Fed first starts raising rates and midway through the fed funds rate hiking cycle.  (One does not know the midway point at the time but only after the Fed stops hiking rates.) The analysis starts in 1988 which is when the MSCI Emerging Market Index started.

What happens after the start of each episode of fed fund hikes?

Figures 1 and 2 below show, from the start of each episode of the Fed raising rates, the absolute return of the MSCI Emerging Market Index as well as its return relative to the Russell 1000 measured. Looking 6 months out from the start of the fed hiking rates, the MSCI Emerging Market Index had positive returns and outperformed the Russell 1000 in 5 out of 6 episodes.  However, looking 12 months out from the start of Fed rate hikes, the picture is mixed. The MSCI Emerging Market Index had major downdrafts both in absolute and relative to the Russell 1000 in 1994 and 1997.  Both years had major emerging market crises, especially in markets whose currencies were tied to the US dollar (the Mexican peso in 1994 and Asia currencies in 1997).

Figure 1

Figure 2

What happens after the midpoint of each episode of fed fund hikes?

Figures 3 and 4 below show, from the midpoint of each episode of the Fed raising rates, the MSCI Emerging Market Index in absolute terms and relative to the Russell 1000 Index. Looking 6 months out, the MSCI Emerging Market Index was positive and outperformed the Russell 1000 in 3 out of the 6 episodes. However, looking 12 months out, the MSCI Emerging Market Index had major downdrafts in after the rate hikes in 1994, 1997, and additionally in 1999 – years associated with currency crises in the emerging markets tied to the US dollar.

Figure 3

Figure 4


Looking 12 months out from the beginning of the middle of Fed rate hikes, the MSCI Emerging Market Index tended to have negative returns and underperform the Russell 1000 at times associated with the currency crises of the 1990s.  It was a period when many emerging market currencies were tied to the US dollar. We would expect this pattern might not repeat during the upcoming fed fund rate hike since most emerging market currencies have become free floating and thus less vulnerable to hikes in U.S. rates. It appears that the down drafts did not occur with the rate hikes in 2004 and 2015.


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