Emerging market stock portfolios experienced inflows of an estimated $16.3 billion in July, marking the largest monthly inflow in over a year.
Emerging market (EM) equities are having a standout year, despite U.S. tariff announcements. The MSCI EM index has surged 22% year-to-date, outperforming the S&P 500 by 12%, and marking the best start for EMs since 2017. Markets are focusing on five key tailwinds for EMs: China’s improving economic backdrop, the resilience of many EM economies to tariffs, EM Asia's tech leadership, India's growth wave and a weaker U.S. dollar.
With the DXY index down 8% YTD1 and potential for further weakness, understanding why a softer dollar supports EM equities is crucial:
- Improved risk appetite boosting EM capital flows: Historically, EM equities have significantly outperformed during periods of sustained USD weakness. For example, from 2002-2007, the dollar weakened while EM growth soared alongside rising commodity prices. During this period, the MSCI EM index delivered an impressive annualized return of 29%, significantly outperforming developed markets. In the past, a softer dollar has often signaled reduced global risk aversion, driving flows into higher-returning EM assets. Currently, the strong dollar trend of the past 15 years seems to be hitting a speed bump. Investors are now moderating their U.S. exceptionalism trades and rebalancing toward markets like Europe, Japan and EMs. EM stock portfolios experienced inflows of an estimated $16.3 billion in July, marking the largest monthly inflow in over a year.
- Enhanced returns in USD terms: A weaker dollar also boosts unhedged EM equity returns for U.S. investors through favorable currency effects. So far in 2025, the dollar's depreciation against several EM currencies has led to impressive USD returns for EM countries, particularly in EM excluding China. Chinese equity performance, up 33% YTD, has been driven by ex-currency factors, with the CNY appreciating only 2% against the USD, given CNY is a managed currency. In other regions, currency effects have been more pronounced: USD depreciation accounts for 7% of Korea's 45% YTD return and 12% of Latin America's 33% YTD return.
- Additional benefits: A weaker dollar eases EM debt burdens and default risks, and may create fiscal space for growth. A stronger local currency also curbs imported inflation, reducing pressure for EM central banks to keep policy restrictive. This would help markets like Latin America and South Africa that have maintained very high policy rates in recent years.
Looking ahead, the factors contributing to USD weakness, including U.S. policy uncertainty and rebalancing trends, are likely to persist. However, since July, a new narrative has emerged. Labor market worries and Chairman Powell’s Jackson hole speech have cemented market expectations for two Fed rate cuts in 2025, starting in September. As easing resumes and interest rate differentials narrow, the catalysts for dollar weakness may become more cyclical.
While sustained dollar weakness could further boost EM equities through enhanced returns and inflows, it shouldn't be the only reason for investing in EMs. Through thoughtful active management, investors can tap into companies poised to benefit from structural trends including Korea’s corporate reforms and India’s ongoing reforms, as well as the five tailwinds for EMs.