Investing in EM When Interest Rates Rise

Emerging markets have seen a pickup in flows so far this year, yet a common concern remains – can they avoid taper tantrum 2.0.? Colm McDonagh, head of EM fixed income at Insight, a BNY Mellon company, gives an outlook.

According to research from the Institute for International Finance, net capital inflows to emerging markets will total $78bn in 2017, accelerating to $167bn in 2018 and reversing the trend of significant outflows that was seen in 2015 and 2016. This is causing many international investors to take a fresh look at emerging market assets.

“As we advise our clients on the best approach to investing in emerging markets, a common concern we hear is the prospect of rising developed market interest rates and how this will affect yields and volatility in emerging market assets.

In our view, in order to address this question, it is critical to consider the potential catalyst for higher developed market yields”, says Colm McDonagh.

The global growth outlook is improving, output gaps in the developed world have closed, causing labour markets to tighten and boosting global trade. Developed market inflation has moved moderately higher, fears of global deflation have now passed, but disruptive technological change and globalisation are still powerful disinflationary forces. Global energy prices, typically a factor driving inflation higher during periods of stronger global growth, are being constrained by increasing US shale oil production. In this environment, major central banks have room to normalise interest rates gradually, led by the US.

For emerging markets, this backdrop of improving global growth and constrained inflationary pressures is likely to cushion against the volatility which could be caused by rising developed market yields. Real yields in local currency emerging debt markets are historically high, as the pass-through to inflation from previous currency devaluations and the rise in global energy prices dissipates. A rise in developed market yields, where real yields are historically low, would not necessarily translate into a rise in local market yields of a similar magnitude. If emerging market yields were to move to a similar degree, then the higher level of nominal yields would provide far greater protection to investors than the yields of most developed market countries.

But why, investors ask, are emerging market assets not going to experience a more violent reaction, as was seen in recent history when the US Federal Reserve first raised the prospect of winding down its quantitative easing (QE) program. Does, for example, the recent announcement regarding balance sheet reduction in the US have the potential to cause a similar episode of volatility once this policy is enacted?

If developed market yields were to rise rapidly and in a disorderly fashion, then it would potentially be disruptive for all assets, especially where valuations are extended. Assuming an orderly adjustment in yields, there are reasons to believe that the outcome would be very different. By announcing that it would taper its QE program the Federal Reserve caused US bond yields to move higher, drawing capital back towards the US as it sought to take advantage of the higher interest rates available. Under different circumstances this change in capital flows could well have been easily absorbed with limited volatility. For years leading up to the taper tantrum, capital had been flowing towards emerging markets, driven by stronger growth dynamics at first, then in a search for yield following the global financial crisis. External vulnerabilities had steadily increased, especially in certain markets, a group consisting of Brazil, India, Indonesia, South Africa and Turkey, which would become known after the taper tantrum as the fragile five. The aggregate current account position of those five countries moved from a surplus of $17bn 2003 to a deficit of $255 in 2012.

As capital inflows waned, they were no longer sufficient to finance this large current account deficit, and currencies adjusted to reflect this new reality. A vicious cycle then developed, with central banks raising interest rates in order to attract capital back towards their asset markets, but at the same time faced with accelerating inflation due to the higher cost of imported goods.

Today, many of the vulnerabilities which faced emerging markets in 2012 and 2013 have been addressed. The aggregate current account deficit of the fragile five countries has dropped from its peak of $255bn to just over $100bn in 2016, although it is projected to rise to $133bn in 2017.

Although inflation has moderated across many emerging markets, central banks have not reduced interest rates at the same pace, allowing real yields to grow. Using consensus forecasts for inflation at the end of 2017, all of the previous Fragile Five economies are expected to have positive real yields based on their current 2 year local government yield. Turkey has the lowest buffer, its central bank constrained by domestic political factors.

Market participants now widely expect developed market central banks to normalise policy over the coming years, rather than the shock of unexpected policy change experienced during the taper tantrum. If policy were to tighten more rapidly than currently expected, then that would potentially pose a risk to capital flows into emerging markets, but even in that scenario, the most vulnerable markets have reduced their need for foreign capital. Vigilance is still required in the medium term, as capital inflows combined with strengthening domestic economies, could see these improvements reverse and current accounts return to problematic levels.

Conclusion
Rather than expecting yields to rise, our core scenario is that developed market yields will actually have limited upside, until there is greater evidence that global inflationary pressures are building. In this scenario income generation from emerging market debt should provide an attractive return relative to developed markets. Interest rate policy in developed markets is now widely understood, with market participants anticipating normalisation of policy over the medium term. This combined with reduced current account deficits and higher real yields in those markets worst affected during the taper tantrum, should minimise the risk of a similar episode for now.

For those investors who are expecting a gradual repricing of global interest rates, local currency and corporate debt both offer a high nominal yield to buffer against any price falls, but at the same time have a lower duration than US dollar sovereign bonds, making them less sensitive to interest rate changes. For local currency bonds currency risk needs to be appropriately managed in order to control volatility and avoid potential losses. Policy makers in many emerging markets have become comfortable with using currency markets as a buffer to insulate their economies from negative shocks, so a disruptive upward move in interest rates could also result in potential currency losses.

Colm McDonagh believes that stronger global growth and relatively weak inflation implies only a gradual normalisation of monetary policy by developed market central banks though, which should, broadly speaking, be a positive for corporate credit fundamentals while the expectation of historically low net issuance should provide further technical support.

A top down analysis only gives part of the investment story, however. In order to achieve the greatest value, it is important to delve deep beneath the broad headline index in each asset class and carefully consider fundamentals on a regional and country level, while undertaking rigorous corporate credit analysis. At this point in the cycle market alpha can be more important than beta.