Emerging markets have spent more than two years in a slow-motion crisis with the threat of a US interest rate rise hanging over them.
Emerging markets have spent more than two years in a slow-motion crisis with the threat of a US interest rate rise hanging over them. The Federal Reserve’s first hike in nearly a decade, when it finally comes, might actually clear the air.
An eventual rise in borrowing costs has been anticipated since May 2013 when then-chairman Ben Bernanke sparked a global emerging market sell-off by speculating about winding down, or tapering, of the Fed’s money-printing programme
As higher US interest rates raise the global cost of capital and depress the price of their commodity exports, Fed tightening has historically spelt trouble for emerging economies that still overwhelmingly rely on overseas investment.
From the ‘taper tantrum’ onwards, US tightening — though glacially slow — has prevented a durable investor return to parts of the world deemed most at risk.
But increasingly, policymakers as well as investors are hoping the Fed will get a move on.
Years of easy money pushed investors into emerging markets. That led currencies to become overvalued, widened balance of payments deficits, hurt productivity and fuelled a surge in household and company debt — weaknesses that were highlighted by the 2013 plunge.
With a Fed hike now seen as early as next month, there’s at least some hope that a healing process can begin, including via weaker currencies, said Kamakshya Trivedi, managing director for EM research at Goldman Sachs.
“I see the Fed as a catalyst that perhaps causes some EMs to make the adjustments they need. In some places it may force the adjustment to be a bit faster than it would have been otherwise,” Trivedi said.
But “to the extent the Fed move is delayed, it delays the inevitable adjustment.”
Capital outflows from emerging equities are running at almost $30 billion this year, according to Bank of America Merrill Lynch, which noted “capitulation” selling accelerating as Fed action nears.
Currencies from the Brazilian real to the Indonesian rupiah are at their weakest in over a decade. Malaysia’s ringgit is at its lowest since the Asia crisis of 1997/1998.
Emerging equities remain some 36 percent below their peaks of 2007, with MSCI’s main measure down 17 percent over the past year and close to its lows of 2013.
“For EM, the earlier the better. It is one uncertainty factor out of the way, particularly as it is one that cannot be avoided,” said Enzo Puntillo, a fund manager at GAM.
LESSER OF TWO EVILS
Critically, developing countries may suffer more if delays to Fed action release the dormant inflation genie.
That risks a longer and bigger rate-tightening cycle and could sharply raise the so-called term premium — the additional interest investors demand for lending over longer maturities.
A steeper US curve as long-term rates go up strengthens the appeal of risk-free bonds, hurting the case for holding lower quality emerging debt. Because emerging bonds increasingly cluster in five- to 10-year maturities, they tend to be extra-sensitive to US yields in that sector.
US consumer inflation at the moment is just 0.1 percent, versus the 2 percent target that guides Fed policy. Even its favoured inflation measure — the index of personal consumption expenditures (PCE) — is running at a scanty 0.3 percent a year.
But some argue inflation is artificially depressed by last year’s energy price collapse and that once these base effects dissipate, domestically driven, “core” prices will boost headline inflation back towards target.
“In many respects a Fed rate rise now is the lesser of two evils,” UBS strategist Manik Narain said.
“If the Fed starts to move, it would nip potential inflationary pressures in the bud, which is better than waiting and having to move more aggressively in 2016.”
In fact Narain reckons a scenario in which the Fed doesn’t budge in coming months would be extremely negative for emerging markets, as it would signal growth is below expectations.
Policymakers seem to agree.
Rising US rates will add $1.2 billion to Colombia’s annual debt costs, finance minister Mauricio Cardenas has said. But he expects this to be outweighed by the higher trade and investment a faster-growing United States can bring
Indian central bank chief Raghuram Rajan also says US growth will benefit the rest of the world.
With their growth premium to richer peers at 15-year lows, weak trade, investment and company earnings, and currency weakness fanning inflation and default risks, emerging markets currently have little allure.
But things can change if, as Goldman’s Trivedi says, Fed-induced volatility forces adjustments. He cites India, which slashed its current account gap after the 2013 shakeout and is now an investor favourite.
Past Fed hiking cycles have been associated with a sharp rise in EM earnings and growth, a UBS study found, although higher company and household debt could drag this time.
Rob Drijkoningen, head of emerging debt at Neuberger Berman, says a timely Fed move and clear forward guidance are crucial.
“Typically when the Fed actually starts to hike, emerging markets’ knee-jerk reaction is on the weaker side which could be a buying opportunity,” Drijkoningen said. “If historic patterns are a guide, the first hike may well provide an entry point.”