The reason is that the USD has already strengthened fundamentally; it was in the 1.20-1.40 range in the 2012-14 period and 1.30-1.50 in 2011. We believe the lift-off is largely priced in and, perhaps more importantly, believe the Fed will hike rates very slowly and gradually.
The US will become more and more preoccupied with the presidential elections in November 2016 and Europe will gradually become more anxious about the UK referendum on the EU, tentatively scheduled for 2017 but it could happen earlier. These are major issues that most likely will shape policies for years, but we do not think it will have a dramatic impact on the economy in the short run. We do not necessarily believe in the adage “no policy is good policy” but we do not believe any major economic decisions will be taken as Obama will become a lame duck and Brussels is unlikely to take any drastic steps ahead of the UK referendum. The economy always tends to be in the limelight but there are more topical foreign policy (i.e. Iran, Middle East and China for the US while Europe will remain preoccupied with Greece, Russia and Ukraine) and migration issues. To this end, we are concerned about rising nationalism in both Europe and the US but doubt it will have any major market impact.
Implications for emerging markets
The forthcoming rate hike in the US is obviously not good news for emerging markets as capital and the USD will become more expensive. However, we do not necessarily agree with the consensus in the market that the lift-off will be disastrous for EM assets. As a matter of fact, we see four reasons why the US rate hike – whenever it comes – may be a different kind of turning point than the market currently expects.
First, the rate hike is broadly expected and anticipated. It is, in market jargon, already priced in with the bulk of the trade – USD strengthening and EM outflows – already done. The USD has strengthened against all larger EM currencies this year and by more than 10% in Brazil, Mexico, Chile, Colombia, Peru, Malaysia, Indonesia, South Africa, Russia and Turkey. Capital flows to EMs have been weak for the past few years and in particular the months ahead of rate hike expectations (remember the various “tantrums”). The bond/equity allocations to EMs have fallen from a peak of almost 18% in 2011 to 12% now, which is much below the post financial crisis average according to data from the IIF.
Second, the rate hike is the ultimate sign that the US economy has normalized. That the biggest economy in the world is doing well should at least partially off-set the slowdown in China, especially as the euro zone gradually is doing better as well. Third, US rates will stay exceptionally low for a long time and we believe the Fed will emphasize that they intend to raise rates very slowly and gradually. And this while the ECB and BoJ will continue to print money and the PBOC is unlikely to become hawkish any time soon. So, global monetary policy is likely to stay very accommodative. Finally, and as a consequence of these factors, it may be a relief when the Fed finally takes the step and hikes the rate. It would end years of speculation and everyone can move on. EM assets have been sold on the rumors and expectation of the rate hike but the trade may start to be reversed after the lift-off.
The euro zone matters less for emerging economies in general but remain important for some and for the neighboring markets in Central and Eastern Europe in particular. The fact that the euro zone is doing better economically, as outlined above, while the ECB continue to stimulate the economy thus gives good support to emerging Europe. The macro situation in the new member states is also arguably better than ever with buoyant growth and low inflation.