Friday, 14 December 2018

Can't catch a break

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Emerging market investors know a US rate hike is coming – but the uncertainty around when the Fed will act is hurting them. Yet perhaps there are bigger things in EM to fret about.

The market had already moved on by the time the US Federal Reserve came to declare its decision on interest rates on September 17. After months of expectation that September would mark the first rate rise in almost a decade, the will they/won’t they debate had reached a  consensus around holding fast.

August was ugly, as a stock market meltdown in China ricocheted around the world, wiping billions of dollars from stock exchanges globally. A delay to the start of the rate-tightening cycle is welcome for borrowers – especially US homeowners who have just seen their pension savings hammered – but the continued uncertainty is negative for all assets and means emerging markets are still getting clobbered.

Jan Dehn, head of research at Ashmore Investment Management, said that while rate hikes will have a negative impact on emerging markets it is the confusion over timing that is hurting.

“Leading up to a rate hike there is considerable uncertainty in the market and that uncertainty is unambiguously negative for emerging markets. All you have to do is say ‘boo’ and 75% of emerging-market investors suddenly freak out and run for the hills,” Dehn said.

“And when they get to the top of the hill and feel safer, they look down and say ‘what was it that said boo?’ and it was probably one of them. You have a definite tendency for the market to overreact.”

Once the first rate hikes occur, that uncertainty is removed and markets should simmer down, Dehn said.

“When the rate hike comes it’s probably going to be so well flagged and so well understood that the market is just going to say thank you very much it’s over, let’s go and have a look where we can get some value,” he said.

The pain of waiting

The waiting game has been painful with emerging market assets, always among the first to get stomped when sentiment sours, particularly wounded. While the MSCI Emerging Markets stock index fell 5% on China’s ‘Black Monday’, it had tumbled almost 30% since April.

Bond prices also hit the skids. Average yields on US dollar-denominated emerging market sovereign debt had jumped to roughly 5.2% by late August from a low of 4.44% in early April, according to a Markit index that tracks bonds maturing between one and 15 years.

The response has been accelerating fund redemptions. Through to the end of August, a net US$7.8bn had been pulled out of emerging market debt funds this year, according to Bank of America Merrill Lynch. Contagion from economic weakness in China saw some US$4.2bn withdrawn in the week ending August 28 alone – the second worst week for outflows on record.

The boom that saw emerging market countries and companies raise US$1.45trn from selling bonds in foreign currencies between 2012 and 2014 has also stalled. This year such borrowers had raised US$251.9bn by the end of August, more than US$125bn lower than at the same point in 2014, according to Thomson Reuters data.

Relative winners

The fall-out in emerging markets is unavoidable; the challenge is how to soften the blow.

Marcus Svedberg, chief economist at East Capital, says while there are no havens for investors in emerging markets, some will sting more than others.

“There’s nowhere to hide,” he said. “Relatively speaking, equities look better than bonds and currencies, but even in equities foreign investors could get hit if there is a currency correction. The bottom line is it’s going to be negative and it’s going to hit across assets, but there will be some differentiation.”

Svedberg maintains, however, that any Fed-related sell-off is likely to fizzle out quickly as long as the tempo of hiking is gentle. He also believes, like Dehn, that it could spur a shift in sentiment as any lingering uncertainty is snuffed out.

“Investors might be tempted to look at the underlying fundamentals again and not look at them through the prism of Western monetary policy,” he said.

Alex Wolf, an emerging markets economist at Standard Life Investments, reckons astute investors can find many relative-value trades. The Taiwanese dollar, for example, may fair better than the South African rand, he said.

Wolf suggests countries most vulnerable to a rise in US interest rates are those that have borrowed heavily in dollars and are running current account deficits, such as Turkey. Not only has it failed to address its current account issues, but the fact that it sells more goods to the eurozone than the US means a stronger dollar will be unlikely to boost exports – a benefit that could somewhat offset the impact of a Fed hike for countries with close US trade links, such as Mexico.

Kevin Daly, a fund manager at Aberdeen Asset Management, says countries that have issued a lot of long-dated bonds such as Brazil, Turkey and Colombia are likely to be among those that could suffer the most selling pressure amid a Fed hike as they are the most liquid markets. Countries that have issued less foreign currency-denominated debt such as those in frontier markets may, by contrast, suffer less.

Rate distraction

But is a monetary policy decision made by a foreign country really the most important issue for all emerging markets around the world?

“Emerging markets have bigger issues than the Fed raising rates,” Bhanu Baweja, a strategist at UBS, wrote in a research note in August. He said that emerging markets seemed to be wilting under their own weight rather than from any external pressures.

Andreas Kolbe, head of emerging market credit research at Barclays, points to the fall in commodity prices, weak economic growth and out-of-whack bond valuations as weighing on the asset class, just as much as the prospect of rising rates.

“I would not see a gradual rise in US rates and the start of the Fed tightening cycle as a major concern for emerging-market credit if growth dynamics were strong in emerging markets and valuations generous versus developed markets,” said Kolbe. “Unfortunately, this is not the case at present.”

Alberto Gallo, a credit strategist at Royal Bank of Scotland, believes emerging market assets are likely to get even more bruised because the private sector has continued to load up on debt while fundamentals are deteriorating. Fixed-income analysts at Societe Generale wrote in August that emerging market currencies had been sucked into a death spiral made worse by China devaluing the yuan.

Even so, the pace and path of Fed hiking are likely to determine how much uglier things get – with the “taper tantrum” still fresh in the memory. The last time emerging markets had a serious shake-out, in 2013, was during the time of the taper tantrum, when bond yields surged dramatically after then Fed chairman Ben Bernanke said the central bank would start slowing the pace of its economic stimulus programme.

Marcus Svedberg at East Capital and Kevin Daly at Aberdeen are both betting the move will be slow and gradual – which should mean the impact will be less painful than if the Fed cranked rates higher more swiftly.

“A faster rate hike would change things because that’s not priced in and then we’re talking about a surprise,” Svedberg said.

“The reason why you saw such a significant sell-off in emerging-market debt back then [in 2013] was because no one saw it coming,” said Aberdeen’s Daly. “Bernanke mentioned tapering in May and all of a sudden markets got very rattled, because markets don’t like the unexpected.”

If the Fed keeps to a gentle tightening pathway then any repricing in the expected instance is likely to be modest.

“This isn’t going to be a multi-month sell-off, get-me-out-of-here-type movement. Unless we completely get the inflation call wrong, we’re not going into a period where the Fed is going to be aggressively hiking interest rates where the markets get spooked,” he said. “It might be a take-off, but it’s not going to be a lift-off,” Daly said.

For now, the wait – and the pain from uncertainty – look set to continue.

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