Another Fed-Led Emerging Markets Crisis Ahead?
Since last summer’s “taper tantrum” when markets reacted negatively to Ben Bernanke’s announcement of the Federal Reserve’s plan to reduce its bond purchases, much has been written about what will happen when the Fed begins the process of normalizing interest rates. More often, emerging markets (EM) are the focus of the debate.
At Newfleet, we share the view of many leading economists and strategists who believe that rising rates in the U.S. will result in periods of volatility, but that we are not in for another major EM crisis.
Here is a summary of the key points that support this view:
- The Fed’s introduction of tapering in May 2013 was viewed as a negative surprise to the market, resulting in a period of great uncertainty. Arguably, all market participants are now laser focused on the Fed, thereby reducing the potential for a negative surprise of similar magnitude.
- The Fed is likely to be very measured with its policy normalization, giving asset prices time to adjust in an orderly fashion.
- Past periods of U.S. monetary policy tightening resulted in pressure on EM currencies that were fixed, or pegged, to the U.S. dollar. Perhaps one of the best examples of this was the collapse of the Thai baht peg in 1997, which ushered in the Asian financial crisis. Today, more EM currencies are floating (not pegged), helping to inhibit bubble formation and the depletion of reserves to defend unsustainable pegs.
- Fundamentals have improved for emerging markets. Many countries have significantly larger foreign exchange (FX) reserves, lower external debt ratios, and less short-term debt than in the past. The evolution of credit ratings for sovereign debt issued by EM countries is reflective of this fact. Take Brazil, for example, which received a Moody’s rating of B1 in 2004 versus Baa1 today. The clear improvement in the country’s external vulnerability can be seen in the following table.
|External Vulnerability Indicator*||118.2||134.1||114.3||67.0||34.0||34.3||27.5||33.7||23.1||25.4||23.5||26.1|
|Forex Reserves (US$ billions)||52.46||53.22||85.15||179.43||192.84||231.89||280.57||343.38||362.10||349.03||366.48||384.80|
Source: Moody’s. Measured by (Short-Term External Debt + Currently Maturing Long-Term External Debt + Total Nonresident Deposits Over One Year)/Official Foreign Exchange Reserves.
- Local currency EM bond markets are much more developed, reducing reliance on borrowing in the U.S. dollar, euro, or yen.
- External demand remains very important to emerging markets. Improvements in the advanced economies will flow through to emerging markets over time and is expected to provide a lift.
The term “emerging markets” is a singular way to describe a very diverse set of countries, economies, issuers, and asset classes. Not all will behave in the same way. Market volatility creates opportunities for managers who are selective and have the ability to actively alter country allocations, currency positioning, and asset class types. This type of environment favors Newfleet’s approach to emerging markets investing, which has been honed over two decades.