Gradual Fed path is aid to EM rally, not hindrance
Emerging markets are under siege from many threats but the Federal Reserve isn’t one of them. Even as the US central bank continues on its ratehike path, the risk of capital flight from developing-nation assets has diminished, money managers from Bank of America Merrill Lynch to JPMorgan Chase & Co say. That view is backed by history, which shows emerging markets remain resilient to Fed tightening as long as it’s orderly and well-communicated.
Riskier assets including emerging markets remain vulnerable to global fund outflows during times of Fed tightening as investors seek safer instruments such as US Treasuries. That was the reason Ben Bernanke’s 2013 comments on withdrawal of Fed stimulus sparked panic selling that came to be known as the “taper tantrum.”
Yet, investors who stuck to that view lost out on emerging-market rallies repeatedly - like in 2006 and 2016, when developing-nation assets advanced in the wake of rising US interest rates.
History suggests that a robust US economy is more important to emergingmarket fortunes than fluctuations in fund allocations. That relationship was evident when the MSCI Emerging Markets Index, which was rallying on trade optimism, maintained its gains even as the official jobs data showed US employers hired more than forecast in October. A strong economy should support Fed tightening, a threat to riskier assets, but last week’s news was taken as a comforting factor amid a global growth slowdown.
And that’s not just stocks. Emergingmarket bonds also defy the conventional wisdom that they must fall, sending yields higher, in times of US yield increases to maintain the extra return they offer to attract investments. There have been more than 15 occasions since 2005 when that did not happen.
For instance, in June 2007, investors accepted a risk premium of as low as 161 basis points when the 10-year Treasury yield was 5.29%. Contrast that with now when the spread is about 365 basis points and the US rate is 3.11%, and developingnation bonds begin to look cheap.
A recovery in emerging markets remains fragile as US-China trade tensions, recessions in a growing number of emerging economies and political uncertainty undermine the case for riskier assets. But investors give at least four reasons why a gradual Fed policy tightening is not one of the risks:
Risks priced in: Emerging-market stocks have already endured a $5.5tn rout this year, and dollar-denominated bonds have seen their risk premiums jump by about 30%. Market prices already reflect the worst-case scenario arising not only from Fed hikes, but also from the USChina trade war and the dollar’s strength, says Kathryn Rooney Vera, head of global research at Bulltick Capital Markets.
“I’m not worried about it unless the Fed were to jack up rates more than four times (in the next 12 months)”, she says.
Developing economies are also on a much more predictable path of growth than in the past, and can adjust to a more normal monetary-policy environment in the US. “If you’re in an environment of decent global growth, markets can withstand rate hikes,” says Rashmi Gupta, a portfolio manager at JPMorgan. “The fear is if the Fed raises rates too quickly in an environment when growth is weak.”
US growth support: With every rate hike, the Fed reiterates its faith in the ro- bustness of the US economy, which is good news for emerging economies. Developing nations send as much as 17% of this exports to America, gaining a $1.3tn growth boost.
“Activity in the US is strong, rates are still low by historical standards, and the demand for goods and services is very strong,” says Morgan Harting, senior portfolio manager at AllianceBernstein Holding LP. That means “demand for goods produced in EM countries is also strong and that’s good for company earnings and revenues of those governments.”
Case for gradualism: The US economy may be strong but not so strong as to encourage the Fed to speed up the path of normalisation.
Data releases including a worse-thanexpected dip in hiring during September and a third-quarter gross domestic product growth that was heavily dependent on inventories have spurred expectations the Fed will stick to its policy of gradual rate increases.
“When we look at this question through the lens of inflation and the labor market, there is little case that the Fed is behind the curve on its macro forecasts.” IIF chief economist Robin Brooks said.
The knee-jerk reaction of markets to Bernanke’s comments five years ago has made the Fed more circumspect in winding down stimulus, according to Merill Lynch global economist Aditya Bhave.
“They want everyone to understand that rate hikes are the primary tool by which they’re going to tighten policy because markets understand how rate hikes work through the economy much better than quantitative easing,” he says. “They want to unwind QE in a manner that’s not jarring to the markets if possible, and they’ve been pretty successful so far.”
Cheap valuations: Value hunters have plenty to pick in emerging markets - from stocks that trade at the same valuations as 4 1/2-years ago to bonds that offer 1.5 percentage points of extra return compared to the start of the year and many currencies near record lows.
“EM is getting crushed,” said Rooney Vera of Bulltick. “There’s a lot of mispricing right now and I’m honestly excited about it because we can make money for our clients.”
The US Federal Reserve building in Washington, DC. Even as the US central bank continues on its rate-hike path, the risk of capital flight from developing-nation assets has diminished, according to money managers.