Fed Rate Cuts Could Be Just What Doctor Ordered for EM ETFs

Emerging markets equities and the related ETFs have long been responsive to Federal Reserve decisions on U.S. interest rates. This indicates that if the central pares rates this year, some upside could be in store for those long-lagging assets.

The MSCI Emerging Markets Index is up more than 2% year-to-date. There are inklings that developing world equities are pricing in Fed easing. That could signal to investors that it’s time to be selective with emerging markets ETFs – an objective accomplished with the KraneShares Dynamic Emerging Markets Strategy ETF (KEM).

As an actively managed fund of funds with allocations to the KraneShares MSCI All China Index ETF (KALL) and the KraneShares MSCI Emerging Markets ex China Index ETF (KEMX), KEM could be ideally positioned to benefit from lower interest rates in the U.S.

History on KEM’s Side

KEM turns a year old in August, so it hasn’t been around for a true easing cycle. Additionally, it missed most of the prior tightening cycle. However, the history of emerging markets stocks following the end of U.S. rate tightening could prove meaningful as it pertains to the KraneShares ETF.

“Since 1988, EM equities have delivered positive performance 24 months after the last Fed rate hike in four of the past five Fed rate cycles. On average, returns have been solid at 29%, representing an average outperformance over developed markets of 17 percentage points,” according to JPMorgan Asset Management.

As the asset manager points out, fundamentals matter when it comes to emerging markets equities, but U.S. interest rate policy can have an outsized impact on this asset class. While rate cuts could benefit KEM and the stocks held by its component funds, the ETF doesn’t necessarily need rate cuts to thrive. Rather, if it becomes clear that the Fed has no plans to raise rates to quash inflation, the upside could accrue to emerging markets equities.

Interestingly, KEM’s nearly 45% allocation to the aforementioned KEMX could prove especially beneficial against the backdrops of no further hikes or rate reductions because some ex-China developing world stocks prove responsive to those trends.

“It has been key to differentiate China from the rest of EM, as China has been experiencing challenges unique to its market. Since the Fed’s December meeting (when the end of the rate hiking cycle was confirmed), EM excluding China has moved up 9.7% rather than 6.8% for the broad EM index. Going forward, investors should continue to hone in on the pockets of EM where positive structural tailwinds also exist,” concluded JPMorgan.

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