For as long as investors have viewed emerging markets (EM) as a discrete asset class, the prospect of the U.S. Federal Reserve embarking on an interest rate hiking cycle has been a source of worry. EM countries are “condition takers” ‒ benefitting from plentiful liquidity while developed market monetary policy is easy but forced to adjust to changes in capital flows and “risk-free” rates when that policy tightens. These adjustments have sometimes proven painful, leading to “accidents” in EM, such as the Asia crisis in 1997.
Will that change?
The lead-up to the Fed’s December rate increase of 25 basis points was no different. The mere hint of tighter financial conditions back in 2013 led to the so-called Taper Tantrum, which produced a concerted decline in all EM asset classes. Now, several other developments are weighing heavily, including the rebalancing of Chinese growth, the sharp decline in commodity prices and idiosyncratic political/geopolitical issues.
We are focused on two questions: Will the rate hike cycle lead to more accidents, and how much of that risk is already reflected in EM debt prices?
From a balance sheet perspective, EM sovereigns have built in high resilience against external shocks, reducing the odds of a balance-of-payments crisis. First, they have developed deep and relatively liquid local markets and substituted external debt with local. Second, many have accumulated a stock of foreign exchange reserves, now at a comfortably high $7-trillion-plus. Last but not least, most large EM countries have adopted floating exchange rates, allowing their currencies to absorb global shocks.
From a valuation perspective, we believe EM debt has already priced in a good chunk of the risks associated with Fed tightening. External EM debt, on average an investment grade asset class, is trading not far from the much lower-rated U.S. high yield bond market. EM local debt yields are at historically wide spreads versus developed market counterparts. And EM currencies have depreciated in most countries in reaction to lower commodity prices, political/geopolitical developments and the strong U.S. dollar. Barring fresh bad news, we expect investors will look increasingly to EM for higher yield and carry, which should additionally support EM currencies.
Finally, from a technical point of view, positioning in EM debt is much cleaner compared with just three years ago: Many “tourist” dollars have left the asset class while the longer-term institutional investor base has grown, and global investors are generally underweight EM debt.
These factors should not be perceived as an all-clear for all EM. It is a very heterogeneous group, with a number of countries still dependent on the global debt markets to finance spending and current account deficits. And while sovereigns have been well-behaved, EM corporates have borrowed heavily in recent years, representing a potential call on sovereign balance sheets in a number of countries.
On balance, we believe emerging markets are well-positioned to weather the Fed tightening cycle. The caveat: Country and credit selection are paramount. Good opportunities are not easy to spot and they require patience, but we think there is opportunity for long-term investors to be well rewarded.