“Trump’s America First approach doesn’t bode well for Asia. The risk for Asian economies is that most countries depend on external demand,” notes Capecci.
“Therefore we prefer countries with different supply chains than [export-dependent] Korea and Taiwan, and favour domestically driven economies such as India and Indonesia.
“The Indian economy has in fact a very low correlation with the US. Interest rates for example have come down there this year while the Fed started hiking.”
And here we have arrived at the third threat: the Fed. Emerging markets, and particularly bonds, tend to respond badly to a hawkish Fed.
However, even though the Fed has hiked rates twice in the past six months, the 2013 Taper Tantrum hasn’t repeated itself. And there are several reasons for this.
“Asia has developed its own investor base in recent years. 90% of EM dollar issuance is done in Asia now, for Asian investors,” says Capecci.
Another reason is the larger presence of European institutional investors, who have taken long-term strategic positions in emerging market debt. This all means the asset class is now much less reliant on hot money than in 2013.
An additional factor that favours emerging market debt is the increased interest rate differential. With interest rates in Europe rock-bottom, European investors simply can’t withstand the temptation of EM that are five or six times higher than what’s on offer at home.
“EM debt is the only asset class we have added to this year,” says Frank Reisbol, managing director at Banque Carnegie in Luxembourg.
“We saw a unique opportunity in local currency debt as EM currencies were undervalued after the Trump election. The peso for example was 15% down against the dollar and has recovered all these losses since.”
Reisbol admits “most of the juice is out of this trade now”, but he isn’t selling.
“We would like to take profit, but that would mean we would be moving out of an asset class that yields 4 to 6% and move into something that gives a negative yield like as our clients base currency is euro or Swedish krona.”
But there’s one thing that hasn’t changed since 2013: emerging markets’ reliance on dollars. As EM debt stock has grown exponentially since then, one could argue that dollar reliance is bigger than ever now, and that’s hardly reassuring as the Fed is preparing to reduce its balance sheet and/or hike rates further.
Quantitative tightening will have the opposite effect of quantitative easing.
It will drive up the cost of borrowing in dollars, and the Fed can’t be expected to be deeply concerned about the problems this may create for EM companies.
“Don’t count on the Fed ensuring stability in emerging markets. Trying to do that for the US is already hard enough,” says Capecci.
Such a development would particularly hit emerging market debt prices, but if it comes in combination with a protectionist Trump move and a rising dollar, EM investors should brace for a perfect storm.
