How will emerging markets weather Fed tightening?

The mere mention of policy tightening by the Federal Reserve brings painful memories of past Emerging Markets (EM) crises. After all, the tightening cycles of U.S. monetary policy in 1994 and 1999 helped trigger the crises in Mexico and Asia, with significant damage to both economies and asset prices.

While the start of the Fed’s “liftoff” may indeed increase market volatility and put additional pressure on emerging economies, evidence suggests that EM as a group are in a better position to adjust to diverging global rates. Going forward, underlying economic fundamentals of each EM nation will be the most important driver of the asset class.

The most recent movements in foreign exchange markets have sent EM currencies to fresh all-time lows against the US dollar. These currencies have lost almost half their value since 2011 (see graph below). Although there are some country-specific factors driving this currency weakness in EM, major global forces have also been at play, such as the lack of export growth momentum and the generalized strength of the dollar against other major currencies.

But perhaps the most important aspect of the recent correction in EM financial markets has been the absence of a major hiccup and actually the fact that volatility has remained relatively low throughout.

This has to do mostly with the improved macroeconomic policy framework and greater financial flexibility that EM economies have established over the last few years. After the turbulent period of the 1990s, many emerging economies were forced to float their currencies. This transition, in turn, helped now-autonomous central banks adopt credible inflation targeting regimes. The improved policy framework was complemented by the development of a term structure of local interest rates and the terming out of public debt.

Together, the combination of flexible exchange rates and interest rates has allowed EM financial markets to self-equilibrate more effectively. When currencies move and bond prices fluctuate, they operate as automatic stabilizers, taking pressure off real economic variables and reducing the probability of experiencing a “traditional” EM financial crisis of the sort we saw in the 1990s.

Some of this progress is already evident: EM local markets have already gone through a full Fed tightening cycle in 2004, and after initial market volatility the asset class held rather well as the Fed funds rate went from 1% to 5.25% in the course of 24 months. Local financial markets were also able to withstand the 2008-2009 crisis.

But more importantly, EM financial markets now are doing a much better job at adjusting based on fundamentals. During the “taper tantrum” episode, those countries with the weakest external positions were the ones most penalized by the markets. Since then, markets have also rewarded countries where external balances have improved, with more stable currency markets (see graphs below).

In that respect, LatAm economies that have been hit particularly hard with the deterioration in their terms of trade due to the collapse of commodity prices, have also experienced more important FX depreciation than other EM economies, as we argued recently in Concentrated Pain, Widespread Gain.

Additionally, the generalized slowdown in GDP growth in EM economies has been driving equity markets lower. In the most recent World Economic Outlook published by the IMF last April, EM GDP growth projections for 2015 were revised down for the fifth consecutive time to 4.26%. In 2010 that same forecast was 6.7% (see graphs below).

The lack of GDP growth and the collapse in commodity prices have hurt especially hard equity markets in Latin America, making it the worst performing region of EM over the past three years. In fact, during the past five years Brazilian equity markets have given investors an average annual negative return of -12.5%, making it the worst performing country of EM just behind Greece.

But depreciated currencies and depressed financial asset prices may actually prove to be a good thing for EM ahead of the Fed tightening cycle. As opposed to other episodes, the absence of any evident bubble in EM that may burst, volatility of financial markets around the Fed tightening may prove to be a good entry opportunity, especially for equity investors.

In the current context of potential Fed tightening and relatively low nominal growth, our overarching theme in EM investing is differentiation, as we argued recently in When the Fed Yields. We favor Asian fixed income due to solid credit fundamentals, attractive valuations and economic reform momentum. India and China lead the perceived progress on structural reforms (see graph above).

We also like selected Eastern European countries such as Poland. US dollar denominated EM debt looks especially attractive as a result. Average yields are twice those of US Treasuries, and most sovereign EM debt now carries an investment grade rating.

But country selection is critical. Credit ratings may drift lower on the back of slower growth and falling commodity prices. Venezuela, Russia and Brazil have been among the biggest losers, yet big falls in asset prices mean investors in these countries are now better compensated for the risks.

The World Economic Forum on Latin America 2015 takes place in Riviera Maya, Mexico, from 6-8 May.

Author: Gerardo Rodriguez, Portfolio Manager, Head of Emerging Markets Multi-Asset Strategies, BlackRock

Image: An investor stands in front of screens showing stock information at a brokerage house in Wuhan, Hubei province, China, April 28, 2015. REUTERS/Stringer