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Although persistent strength in the US dollar remains a headwind for emerging markets, countries such as India and Indonesia still promise strong growth, while Brazil and Mexico stand out due to their prudent monetary and fiscal policies.

Against a challenging global backdrop, emerging markets have had diverging fortunes during 2023. Higher nominal and real policy rates amid lingering inflation in developed economies has created an environment that broadly favours some major Latin American economies, while countries like India and Indonesia still promise strong growth despite China’s slower than expected pace of recovery.

“The Fed’s hiking cycle is closer to the end than the beginning. Absent another external shock, this would normally be a better time to invest in emerging markets,” said Steven Major, Global Head of Fixed Income Research, who was speaking at HSBC’s Global Emerging Markets Forum.

Fluctuations in the value of the USD are important for emerging markets, as the currency influences total returns for many investors.

Although the Fed has slowed its rate hikes, policy rates in the US remain high, supporting a strong USD and putting pressure on emerging market currencies. Additional headwinds come from the slowing global trade cycle, while many emerging market currencies are sensitive to the Chinese economy, where growth is slower than in the past.

The result is that most emerging market currencies have fallen against the dollar, with only a few above water – most notably, Brazil’s BRL, Mexico’s MXN, and Hungary’s HUF.

“I don’t think this headwind is going away,” said Paul Mackel, Global Head of FX Research, HSBC. “And it will be a select group of emerging market currencies that can hold up.”

He favours a bottom-up approach to uncover the currencies that will be strong against the USD, which will require singling out the countries that adopt prudent monetary policy choices, while maintaining fiscal policies that are appropriate for their situation.

One potential risk is that central banks start cutting rates earlier than the economic fundamentals would suggest, creating short-term growth before local inflation is under control.

The MSCI Emerging Markets Index gained 2.2% in the year to end-September¹, underperforming the S&P 500, which gained 11.4% over the same period. The global macro environment is part of the story, but there are additional explanations, said John Lomax, Head of Global Emerging Markets Equity Strategy, HSBC.

He highlighted two relevant factors. The first is the outsized contribution that AI-related stocks have made to the US stock market this year, with a powerful rally in a small number of technology companies lifting the entire benchmark. Emerging markets lack comparable companies to create a similar boost on local exchanges. The other factor is US companies are better at absorbing inflationary pressures than their emerging market counterparts, by widening margins.

Accounting for 30% of the MSCI Emerging Markets Index, China is the largest single part of the emerging market universe. But it is a market that has underperformed its peers, with the A-share benchmark CSI 300 down 5.2% in the first nine months of the year. Market dynamics could pick up towards the end of the year, said Steven Sun, Head of Research, Operating Committee Member, HSBC Qianhai Securities.

One issue that has weighed on Chinese market sentiment is a softer than expected post-pandemic recovery. Although government has introduced a series of supportive measures, we are not yet at a tipping point that could lift stocks. But we are close, said Mr. Sun, as suggested by pricing in the local bond market.

Furthermore, he highlighted how regulators are addressing supply and demand balances in the capital markets, with large numbers of IPOs and private placements coming to market, during a period of weak demand. A recent change to the risk adjustment rules that apply to insurance companies, will likely lead to significant demand from insurers entering the market.

“In the end, we believe EM investors will be looking for bright spots that meet at least one of the three Ss, going forward; Strong fundamentals, Structural story, and Sizable risk premium” said Murat Ulgen, Global Head of Emerging Markets Research.

One of the bright spots in emerging markets is Latin America, especially from a fixed income perspective. Having suffered from volatile inflation in the recent past, regional central banks were quick to start their tightening cycles. Upward inflationary pressure has been tempered, bolstering central bank credibility, and readying monetary policy to ease when it is appropriate.

Mexico stands out due to the trend for “nearshoring”, as more international companies move production to the country to reduce supply chain risks, while benefiting from cheaper and quicker logistics to the neighbouring US. Brazil is implementing long-awaited fiscal reform.

In Asia, the growth prospects remain strong in two of its most populous countries. In Indonesia, there has a been a soft recovery following the pandemic, as fiscal support was withdrawn quickly. Despite these short-term headwinds, the country’s structural growth story remains strong over the medium term.

Indonesia aims to transition from its current role as an exporter of ores to selling processed metals in international markets, while at the same time becoming part of the electric vehicle supply chain. These developments are attracting large amounts of foreign direct investment.

India is another country that is quickly climbing the value chain. Not only is it increasing its exports of high-tech goods – such as pharmaceuticals, specialised chemicals, auto parts – it is also broadening the services it sells internationally. Outsourcing is now more than call centres and IT services, but also human resources, audit, legal, and even R&D.

These new developments will power Indian growth over the coming years. The challenge going forward will be ensuring that wealth created by the relatively small high-tech sector brings benefits to the broader population.

Pockets of strong economic fundamentals, as well as economies with the right policy mix, show that even though emerging markets face a headwind from the strong USD, the diversity of the asset class still allows investors to find attractive opportunities.