‘Reformed’ emerging markets more resilient to Fed action
Emerging market economies have rebalanced significantly since the global financial crisis, as well as the ‘taper tantrum’ in the summer of 2013.
There are concerns about central bank action in the developed world, but emerging markets should not be negatively impacted by Fed rate hikes/balance sheet contraction. We must assume the Fed will only act if it sees acceleration in the economic growth outlook, which will be good for EMs. From a capital flow perspective, we see current account balances, equity valuations, EPS growth differentials between EMs and DMs and the interest yield differential being at such levels that there should not be major pressure on EMs when the Fed takes action.
Furthermore, the US dollar debt funding situation in emerging markets is very different today in comparison to 2013. However, we do acknowledge that investors may seek to reduce emerging market exposures as the Fed tightens policy. This will likely be a short term dynamic, as investors recognise they are betting against fundamentals.
In recent months, dollar weakness has come to a pause and the Federal Reserve is becoming somewhat more hawkish – so where does this leave emerging markets? Emerging market debt is the asset class that comes to mind as highly vulnerable in such an environment. However, fears about another ‘fragile five’ and EM tantrum, as seen in 2013 and 2014, are probably overdone.
Many – not all – of the more exposed emerging economies have undertaken meaningful reforms to reduce external vulnerabilities. Moreover, relative valuations among fixed income markets are much more tilted in favour of EM assets than in the past. Given the frothiness in global high yield valuations, one could even see emerging market debt as a relative safe haven, regardless of what the Federal Reserve is going to do.
When it comes to emerging equities, it is probably not the rising rate trajectory of the Fed that has the power to bring the gravy train to a halt. There have been instances in the past, such as the period from 2004 to 2006, where the Federal Reserve raised interest rates substantially yet EMs continued to steam on.
Nordea’s Jorry Rask Nøddekær and SYZ’s Hartwig Kos