In May 2013, the US Federal Reserve announced it planned to wind down its bond-buying programme. In the ensuing financial turbulence bond yields spiked, emerging markets took a hammering and the ‘taper tantrum’ entered markets folklore.
Five years on, as central banks phase out quantitative easing and tighten monetary policy, it is reasonable to assume that emerging markets will get hit by similarly capricious capital outflows.
Investors pulled almost $1bn from global emerging market bond funds for the week ending 2 May, EPFR Global data shows. Argentina has been frantically raising rates in a bid to stem the peso’s decline against the US dollar.
Until recently, investor interest in emerging markets has been sky high. Foreign investment jumped 54% last year to €191bn and the lion’s share (€138bn) was in emerging markets debt, according to the Institute of International Finance.
“The stars were in near-perfect alignment for emerging market debt investors in 2017,” says Colm McDonagh (pictured), head of emerging market fixed income at Insight Investment.
“Sovereign and corporate spreads tightened by 57 basis points and 43bp respectively, and local currency yields ended 65bp lower.”
But as US Treasury yields rise and market volatility increases, will these robust foreign inflows continue?
The Fed raised its benchmark interest rate by a quarter of a percentage point in March – the sixth hike since near-zero levels in 2015 – and new Fed chairman Jay Powell suggested the pace of future hikes could be more aggressive amid positive economic tailwinds.
The market expects a further three or four rate rises this year.
Improved fundamentals
In the past, such a sharp increase in the cost of borrowing would have spelt trouble for the developing world (take, for example, the Mexican debt crisis in the mid-’90s when a Fed rate hike left the country unable to service its dollar-denominated debts.)
However, Liam Spillane, head of emerging market debt at Aviva Investors, says the impact of rising rates on emerging markets is not the harbinger of doom it once was.
“Emerging market fundamentals are more robust than they’ve been for years,” he says.
Emerging markets on JP Morgan’s GBI-EM index have generally seen a pickup in growth, a decline in inflation and improved current account balances in recent years.
Currency valuations are fair and monetary policy measured. Corporates generally have strong balance sheets – as evidenced by low leverage levels and high cash balances – and default rates on emerging market credit are at record lows.
Part of the reason for emerging markets’ robust performance over the past year has been the synchronised global growth outlook.
The IMF forecasts global growth of 3.9% this year and next – up 0.2% on 2017.
“Emerging markets have benefited from a favourable economic backdrop characterised by good economic growth momentum, healthy inflation dynamics and solid exports,” says Gergely Majoros, a member of investment committee at Carmignac.
“The positive growth outlook and favourable US financial conditions are expected to further support capital flows into emerging markets assets.”
The weak dollar – which has fallen more than 13% against the euro since the start of 2017 – has helped stabilise commodity prices, which has boosted emerging economies.
Commodity prices have risen 30-40% on average from the lows of 2015.
The political situation, meanwhile, is improving in many countries. Indian Prime Minister Narendra Modi’s pro-business reforms and new South African President Cyril Ramaphosa’s anti-corruption agenda should boost investment opportunities.
“Structural reforms in commodity producing countries have contributed to significantly improved current account balances,” says Majoros.
Local currency shift
The majority of foreign inflows into emerging market fixed income assets over the past couple of years have gone into hard currency debt making the asset class “less attractive from a valuation perspective on a longer-term basis,” Spillane says. “As a result, we expect flows to become more balanced towards local currency,” he says.
The surge in emerging market debt issuance over the past few years has seen governments try to tap domestic capital markets by issuing bonds in local currencies.
This shift has a number of implications. A domestic buyer base means that these markets are less vulnerable to the vagaries of global capital flows.
“Fixed income markets in Colombia, Peru and Chile, for example, are being buttressed by strong demand from local pension funds that must hold domestic debt for regulatory reasons.
Local investors are also boosting liquidity in Russia, the Middle East and East Asia,” says Spillane.
“We still expect fairly attractive risk-adjusted returns in hard currency debt but nowhere near as strong as the valuation dynamics we expect in local currency.”
“Emerging market yield curves are very attractive across a number of markets such as Brazil, Colombia and Chile, which have offered a spread premium of close to, or above, 150bp,” says McDonagh.
Tapering threat
It remains to be seen how emerging market securities react to a sudden rise in US Treasury yields. Almost a decade of low interest rates in the developed world has encouraged investors to seek yield in emerging economies, but this era is coming to a close.
The European Central Bank and the Bank of Japan have followed the Fed in winding down their asset-buying programmes – monetary tightening will inevitably follow.
“It’s going to get choppier,” says Yerlan Syzdykov, deputy head of emerging markets at Amundi.
“Now tapering starts in earnest, funding will be squeezed and interest rates will rise in the developed world, which may put pressure on emerging markets. If there is significant volatility, the positive flows we have seen into local currencies may change quickly. We all have memories of the taper tantrum in 2013. It could replay again,” Syzdykov says.
“We do not expect it will be a disastrous year for emerging markets where investors take their money and run, but the rebalancing process could cause underperformance and pressure on the flows side.”
A sudden reversal of flows from emerging markets-focused exchange traded funds – which have multiplied since the taper tantrum – could fuel higher volatility.
Another possible spanner in the works is China. Growth in the world’s second-largest economy is widely expected to slow this year as Beijing cracks down on rampant public debt and imposes curbs on factory pollution.
“The elephant in the room with regards to emerging markets is always China,” says Lefteris Farmakis, global macro strategist at UBS. A Chinese slowdown could dampen demand for commodities, which would have a knock-on impact on the emerging world.
The impact of a possible trade war between China and the US is another concern and there is the ever-present spectre of political risk. Left-wing populist candidates could prevail in presidential elections in Brazil, Columbia and Mexico – three of Latin America’s largest economies – which might undermine investor confidence.
Spillane, however, remains positive. “There will be winners and losers across the emerging world as we move into a period of higher rates and more volatility but we are not expecting significant underperformance. We expect investor appetite to remain strong.”
