Peter Szopo of Erste Asset Management -
The threat of rising interest rates in the US is again looming over emerging markets (EM). While the market and US Federal Reserve watchers (eg. here and here) are still uncertain, how patient Fed President Janet Yellen will be – ie. whether we will get higher rates before or after the summer – the international blogosphere has already decided that EM stocks (among other risky assets) will suffer. Higher US rates will further strengthen the dollar, the story goes, and will trigger capital outflows from emerging countries. With refinancing of dollar-debt getting more expensive, adverse balance-sheet effects will hit the corporate sector in the emerging world, due to its surging dollar-denominated debt in recent years. The ‘original sin’ is back.
These fears are not unfounded. Investors clearly remember the second quarter of 2013 when EM currencies collapsed after then Fed chief Ben Bernanke announced the phasing-out of the central bank’s quantitative easing. Particular currencies of countries with massive current account deficits and near-term refinancing needs came under pressure. Lists of ‘fragile economies’ made the round, most famously the list of the ‘Fragile Five’ comprising Brazil, Turkey, South Africa, India and Indonesia (but note that the Indian and South African stock indices in dollar terms are again above their level before May 2013).
One of the most telegraphed rate hikes ever
However, there are two problems related to the perceived threat of higher US interest rates to Emerging Markets. First: the coming interest rate hike will be “one of the most telegraphed moves in the history of the Fed”, as Gavyn Davies recently pointed out. Second, the empirical evidence is not conclusive.
One thing is obvious: A rate hike in the course of this year will not come unexpected. For about a year now, the scenario of the Fed raising rates in 2015 has been contemplated, and the strong US data flow in the second half of 2014 has largely removed any doubts. One does not need to have unlimited trust in market efficiency to assume that a rate hike later this year will surprise nobody – not even Larry Summers plus followers who have been arguing for a while that the US economy has entered a period of long-term stagnation and interest rates should stay low. In other words, it is fair to assume that a rate hike sometime in 2015 is an event that is mostly priced in by investors.
The other reason for not being overly afraid: empirical evidence does not suggest that rising US policy rates necessarily hurt stock markets in emerging markets. Yes, everybody remembers (or, if not old enough, can look up) the experience of 1994, when the Fed funds rate was raised seven times within a time span of only 12 months and emerging market indices collapsed.
A more systematic analysis though does not point to a general pattern. After updating and refining an earlier analysis of this issue we still do not find convincing evidence that higher US rates on average are hurting EM equities. The charts below portray the relation between changes in the Fed funds rate and the subsequent six-month performance of the MSCI Emerging Markets (MXEF) over the period from January 2000 to February 2015, with the first chart showing the absolute performance and the second chart showing the relative performance to the MSCI index for developed markets (MXWO).
According to the first chart, the performance of emerging equity markets is positively (!) related to changes in the Fed funds target rate over the six months following the rate change, while the second chart suggests a mild inverse relation in terms of the performance of EM markets relative to developed stock markets. In plain words: EM stocks, on average, move in line with US rates, but seem to under(out)perform their developed peers, when US rates are going up (down).
However, two caveats apply: first, in statistical terms, the relation between rates and EM performance is insignificant, and second even the inverse relation between relative performance and rates is not so obvious. In fact, since 2000 there were 20 rate hikes, and in the majority of cases (15 exactly) EM stocks still outperformed their developed markets peers.
Maybe turning points matter?
One noteworthy objection against the analysis above is that, perhaps, it is not incremental rate changes in line with already established policy trends that count, but rather turning points, when a rate hike started a new tightening cycle. Unfortunately, there were only three such turning points in the course of the past two decades: February 1994, June 1999 and June 2004, with the Fed funds target rate raised by 25 basis points in each case following an extended period of monetary easing. The experiences in all three cases, however, were quite diverse, which also Duncan Weldon recently observed in a different context.
As mentioned before, in 1994 investors were shocked by the speed and degree of the Fed’s tightening. All asset classes came under pressure, but EM stocks suffered in particular, losing nearly 20% and not much less in relative terms over the 12 months following the first rate increase. In sharp contrast, following the rate hike in 1999, EM equities gained 7% over the next 12 months and underperformed only slightly against developed markets. Over six months, they even gained both in absolute and relative terms. In 2004, finally, the Fed’s tightening had no visible impact on EM stocks at all. They gained 32% over 12 months and more than 20% in relative terms subsequent to the Fed action.
Considering this evidence, it seems that all is possible in 2015. Given the circumstances, however, a repeat of 1994 is less likely than a more benign outcome along the lines of what happened in 1999 or 2004. First, the surprise factor will be low this time around. Second, neither inflation expectations nor the growth outlook justify a quick return to pre-crisis rate levels. And third, part of the adjustment driven by the growth divergence between the US and the rest of the world has already taken place as the dollar spot index has strengthened by 20% over the past 12 months. In addition, all other main central banks globally are still determined to continue (BoJ) or re-start (ECB, PBoC) monetary easing.
Fed actions always need to be taken seriously, but this time their feared detrimental impact on EM equities could fail to materialize.
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