With the prospect of a US interest rate rise this year becoming more realistic, emerging markets will throw, if not quite yet a tantrum, then a sulk.
Emerging market stocks suffered their 11th consecutive losing day Monday, the longest such streak since 1990. Reminiscent of, if less intense than, the ‘taper tantrum’ of 2013, when the prospect of slowing Fed bond purchases upset emerging markets.
While uncertainty in the wake of an upset election result in Turkey did not help, Friday’s better-than-expected US employment report and the ongoing dawning that interest rates are on the way up were the underlying cause of the sell-off.
The arc of the fall so far is not too terrible, with the MSCI emerging markets index down a bit less than 10% from its recent peak. If the Fed does next week give indications that a 2015 rate rise is in the offing, perhaps as early as September, emerging markets will face something they like very little: a tightening cycle with global monetary conditions becoming increasingly less welcoming.
That’s especially true for countries such as Brazil, India, Indonesia, South Africa and Turkey which depend on attracting global capital flows to finance themselves.
“Rising US interest rates will tend to put the most pressure on those countries with significant external imbalances and weak institutional frameworks. However, it is the pace of any tightening that will be most critical.
As long as policy accommodation is withdrawn slowly and long-term interest rates increase only gradually, the probability of a systemic crisis should remain low,” economists Jeremy Lawson and Nicolas Jaquier of Edinburgh-based fund manager Standard Life said in a recent update to institutional investors.
Market interest rates have risen pretty quickly in recent weeks, taking the benchmark 10-year U.S. Treasury note yield to 2.38% from 1.85% since mid-April. Yet financial markets may still have a ways to go to catch up to reality when it comes to discounting the pace at which the Fed will be forced, and forced is a reasonable term here, to raise rates.
Emerging market investors are clearly already starting to discount such a possibility, though thus far they are showing some sensitivity to which particular nations would suffer most as money becomes tighter.
Second-worst nightmare
Steven Englander, currency strategist at Citi, argues that the Fed’s “second-worst nightmare,” after a recession while rates are at zero, is being forced to play catch-up if both employment and inflation approach their targets more quickly than investors are now betting.
“The implication would be that they would have to get to neutral policy rates faster than they or the market now expect. That would be disruptive to asset markets, leading to much higher volatility and very likely to lower returns. It would also concern the Fed since it is much harder to calibrate an abrupt move in policy rates than the slow and gentle that they hope to achieve,” Englander wrote in a note to clients.
Should investors move to discount this we would not only see capital flow-dependent emerging markets suffer, but potentially a bit of an indiscriminate sell-off.
Given that all of this is in the air, Turkey chose a particularly poor moment to slide into political uncertainty, even if the weekend’s upset elections eventually bring positive policy developments. Turkey labors under the largest short-term foreign debt, as compared to its foreign currency reserves, of all emerging markets.
Longer term, the election, being a setback for President Tayyip Erdogan, who espouses unconventional ideas about how monetary policy works, may have positive implications for Turkish institutions and its economy. Despite high inflation, Erdogan had been badgering the central bank for a large cut in rates to boost growth. Turkey’s central bank did cut rates after the election, but only on foreign currency deposits and chiefly to stem the fall in the value of the lira.
As is so often the case with emerging markets, the real action will now happen in arenas entirely outside their control.
The Federal Reserve meets June 16-17, and while there is little chance of a hike, Fed Chair Janet Yellen’s press conference and the release of new economic forecasts carry the potential to move emerging market asset prices even more sharply than those in the US.
A bit of a recovery rally in emerging markets is quite possible, especially if the Fed hints at a 2015 rate rise but reassures about its subsequent pace of hikes.
If, however, the US employment data continues strong and inflation shows up, the sulk will rapidly turn into an emerging markets tantrum.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
