US interest rate hike: Are emerging markets in for a bumpy ride?

Developing economies are better prepared to withstand higher US interest rates.

 

A slowdown in global trade and investment growth, as well as a fall in commodity prices are dominating the outlook for emerging economies. Major central banks – notably China, India, Indonesia and Turkey – have focused on cutting interest rates to shore up their economies as global growth slows. But as the US Federal Reserve (Fed) prepares to raise short-term interest rates by the end of the year, this divergence could create opportunities as well as risks for investors. 

 

The Fed is laying the groundwork for its first interest rate rise in nearly a decade. But both regulators and analysts are concerned that bond yields could surge after it starts raising its benchmark rate. Central bankers are trying to avoid a repeat of the taper tantrum episode in the summer of 2013, when yields spiked after then-chairman Ben Bernanke first indicated that the central bank would begin the reduction of its bond buying programme. This was when markets turned against the so-called fragile five – Brazil, India, Indonesia, Turkey, and South Africa – which had large current account deficits.

 

There is also fear around the size of the bond market. According to Bloomberg, there is $1.3 trillion of dollar-denominated sovereign and corporate bonds in developing nations today, compared to just $444bn five years ago. Yet although there is more debt in emerging economies, there are still reasons for investors to be sanguine about the prospects for these markets.

 

Part of this is because several countries have taken measures to reduce the risk of a taper tantrum.  Emerging market policymakers, particularly in Asian economies, have sought to increase tax revenues and improve their foreign currency reserves. And they have also taken advantage of lower oil prices to reduce subsidies and improve their macroeconomic stability, says Rajeev de Mello, head of Asian fixed income at Schroders.

 

If interest rates rise in the US, capital inflows to emerging markets – spurred by a combination of low US interest rates and calmer financial markets – could be reversed. “As we get closer to September, we should expect the front-end of the bond markets to perform less well. But we’ve already seen a rally in them since the beginning of the year, and investors have not altogether ran away from them,” says de Mello. 

 

International investors have reduced their exposure to the fragile five countries since the taper tantrum. Looking at emerging markets more broadly, investors will differentiate between them, and their bond markets will perform differently, depending on the perception of how strong their economies are. 

 

For example, Latin American countries, particularly Brazil, have suffered from falling oil prices, and will be more vulnerable if there is a sell-off in emerging bonds. “Other countries are running deficits linked to the commodity price cycles, and could be more exposed to a sell-off in the event of a US rate hike,” adds de Mello. 

 

There are also some risks associated with equity markets. “We think currency will remain a headwind for some time, particularly as the Fed begins raising rates,” Henry McVey, KKR’s head of global macro and asset allocation, writes in a report. He estimates that currency depreciation alone has reduced the five-year cumulative returns for a dollar-based investor in emerging markets from 29 to 11 per cent. 

 

But this doesn’t mean that equities are not offering interesting opportunities for investors. While US interest rate increases have historically had a negative impact on emerging market equities, they haven’t necessarily derailed their long-term upward trend, according to David Stubbs, global market strategist at J.P. Morgan Asset Management. This was the case in previous Fed rate hikes from 1994, 1999, and 2004 (see chart).

 

This time around, emerging markets also have stronger reserve positions and greater exchange rate flexibility than in past cycles. Developing nations’ currency reserves stand above $7 trillion, a historic high, and countries have taken steps to avoid trouble: Brazil and Russia have raised rates to prevent capital outflows, Indonesia has sought to make it more difficult for corporations to issue overseas debt, and Turkey has curbed foreign exchange borrowing in short-term contracts. Stubbs believes all of this could help avert a currency crisis should rates rise in the US.

 

There could also be a difference this time around, in that the Fed is being extremely cautious over the timing of rate rises. This could either mean that it is some time before the first rate rise, or that any rises will be a slow, incremental process. This could be helpful for emerging markets. “The most important thing to consider for these economies is not exactly when a rate hike is coming, but how rapidly it will take place,” says Stubbs. 

 

This will be combined a sustained period of loose monetary policy in other advanced economies. While in the past, rate hikes have prompted large capital outflows from emerging markets and inflows into developed economies, this time, loose monetary policy in Europe and Japan is at odds with tightening in the US. This could mean that cyclical swings from emerging markets into developed markets seen in the past are less likely.

 

“The European Central Bank and the Bank of Japan are now offsetting the US, preserving a certain attractiveness for emerging market opportunities,” says de Mello. “I think policy rate hikes in Europe and Japan are quite far away.”