Historically, interest-rate increases from the Federal Reserve have been buy signals for emerging-market assets. This time looks different, even after a selloff that has pushed currencies to record lows and equities down to levels not seen since 2009.
Developing nation stocks advanced 38 percent on average and currencies jumped 11 percent during the two previous Fed tightening cycles starting in 1999 and 2004. Firms including UBS AG and Citigroup say more pain is in store after the first US interest rate increase in almost a decade because emerging markets haven’t fallen enough to reflect subdued growth.
In the past, developing nations benefited from stronger US growth. Now, stagnating global trade, a slowdown in China and a collapse in global commodity prices continue to take their toll. While stock valuations are similar to 2004, earnings have gone from growing 29 percent to falling 21 percent, and debt levels have reached a record high. Adjusted for inflation, 17 of 21 emerging-market currencies are more expensive than they were 11 years ago on a trade-weighted basis.
“It is probably the beginning of the last phase of EM selloff, but there’s a lot more to go,” said Bhanu Baweja, UBS’s head of emerging-market cross asset strategy in London who correctly predicted this year’s rout in developing nations. Speaking before Wednesday’s announcement from the Fed, he said: “It’s like boiling a frog: it’s slowly but increasingly turning the heat on the EM assets.”
The Fed raised interest rates on Wednesday, setting the new target range for the federal funds rate at 0.25 percent to 0.5 percent, up from zero to 0.25 percent. Emerging-market stocks rose the most in a month while currencies strengthened after policy makers signaled that the pace of subsequent increases will be “gradual” and in line with previous projections.
The prospect for higher borrowing costs in the U.S. contributed to losses in emerging-market assets this year as lower commodity prices, weaker credit growth and a slowdown in China undermine growth in developing economies.
The MSCI Emerging Markets Index has declined 17 percent in 2015, heading for a third annual drop, the longest losing stretch for equities since 2002. A gauge of developing-nation currencies has slumped more than 14 percent this year.
MSCI emerging markets gauge rose 0.6 percent at 2:05 p.m. in Hong Kong.
While Goldman Sachs Group and Bank of America see emerging markets bottoming next year as the economic outlook improves, Baweja said they may get worse before better. A similar rebound such as the one in 2004 is unlikely, he said.
Changed conditions for developing nations
Back then, the 17 increases that brought the Fed funds rate from 1 percent to 5.25 percent in June 2006 coincided with a 69 percent jump in emerging-market stocks during the period and 18 percent gain in JPMorgan Chase & Co.’s ELMI+ Index for developing-nation currencies.
That is partly because the rise of the Chinese economy boosted commodities and robust global trade lifted exports from developing nations.
Those conditions are no longer there. Not only is China growing at the slowest pace since 1990, sluggish global trade also damped any expectations for a swift export-led recovery. Exports from emerging markets are headed for their first decline since 2008, according to CPB Netherlands Bureau for Economic Policy Analysis.
“We don’t think 2004 is the right analog,” Citigroup’s strategists Dirk Willer and Kenneth Lam wrote in a note on 15 December.
While emerging market currencies may start a “counter-trend rally” after the Fed’s first rate increase, the declines may resume subsequently, “given that both China and the Fed are likely to remain significant overhangs,” the strategists wrote. With investors expecting only two more Fed rate increases in 2016, US policy makers may end up raising the borrowing costs faster as the economy picks up, they said.
Not all emerging markets will collapse. Sitting on $7.5 trillion in foreign reserves, developing nations have enough at their disposal to contain any fallout.
With yields at 6.4 percent, dollar-denominated bonds sold by developing nations stand out in a market where $7.9 trillion of government securities offer returns below zero.
Yacov Arnopolin, an emerging-market investor at Goldman Sachs Asset Management, said he’s ready to “take advantage of a potential post-Fed knee-jerk sell-off” to add emerging-market assets.
“Most of the world is still faced with low, if not negative, yields, and EM should continue to look attractive by comparison,” said Arnopolin, before the Fed decision. “Inevitably, US tightening will produce some winners and losers among EM sovereigns, even though we believe the overall sector impact should be muted.”
South Africa among countries impacted
Those losers include South Africa, Turkey, Malaysia and Colombia, which either have large current-account deficits or have accumulated too much dollar debt, according to Capital Economics.
With higher US borrowing costs, it’s more expensive for emerging markets to refinance their $3.3 trillion dollar debt, threatening to increase default rates and suppress economic growth.
Lending is starting to dry up. Issuance by emerging-market borrowers slumped 98 percent to a net $1.5 billion in the third quarter, from the second quarter, according to the BIS.
“The challenge will be higher for quasi-sovereign and corporate issuers that have to roll over debt as their funding costs will be substantially higher,” said Greg Saichin, the chief investment officer for emerging-market fixed-income at Allianz Global Investors Europe GmbH. – Bloomberg