Why emerging markets aren’t plunging as the Fed hikes interest rates

Emerging markets have developed stronger immune systems. U.S. debt dynamics are deteriorating and the Federal Reserve has started hiking interest rates, yet EM appears under no pressure to follow suit. The U.S. has sneezed, but EM isn’t catching the proverbial cold.

Historically, when the Fed starts tightening policy, emerging economies are forced to hike as well, even if their domestic economies aren’t strong enough to warrant it, due to currency concerns and debt dynamics. This has given rise to another market cliche: the Fed is central banker to the world.

But surprisingly resilient economic growth across emerging economies this year, sturdier fiscal fundamentals, and relatively high interest rates and bond yields are offering EM central banks a degree of flexibility. That could allow them to start cutting rates in the next year, or, at the very least, enable them not to follow the Fed in lockstep as it tightens.

Rate buffer

Emerging markets – like their developed peers – are currently beset by a host of risks stemming from geopolitical strife, trade frictions, the energy price shock, and AI bubble fears. But even though some EM countries are particularly vulnerable, either to persistently high energy prices or a sudden, disorderly unwind of the AI trade, the threat of rapidly tightening monetary policy is mostly absent.

This is largely because policy rates are already elevated across much of EM. The weighted average 10-year emerging bond yield at the end of September was around its highest point in five years at nearly 6.45 per cent, according to State Street. Average inflation-adjusted EM yields, meanwhile, are also historically high, close to 3 per cent.

Lofty policy rates have helped restore EM central bank credibility, support exchange rates, and create a real rate buffer. Bank of America strategists say EM rates at the front end of the curve have “materially” overshot to such an extent that implied policy rates next year will be in restrictive territory in all major emerging economies except China.

“Widespread tightening seems unlikely,” State Street strategists wrote earlier this month.

While EMs look surprisingly calm, robust, and attractive – with some notable exceptions like Indonesia – the same cannot be said of their developed-market peers.

While many emerging countries appear to be strengthening their economic fundamentals, investors’ concern over the fiscal trajectory in the U.S., Japan, much of the euro zone, and the U.K. has sent yields across the industrialized world to the highest in decades.

Pique interest

Investors are positioning accordingly. A JPMorgan survey of investors at the International Monetary Fund/World Bank meetings in Bangkok last week showed that 33 per cent favour EM stocks, compared with 26 per cent who prefer developed market equities. Bank of America’s latest fund manager survey shows that a net 34 per cent of those polled are overweight in EM stocks, down slightly from 38 per cent in September, but hardly bearish.

Could investors be too optimistic about EM? Perhaps. The long EM equities position is one of the most crowded trades in BofA’s survey, suggesting there is still plenty of room for it to be trimmed further.

Of course, EM bond yields are higher because EM debt is still a riskier proposition than developed market offerings, especially traditionally “risk-free” US Treasuries. But it is notable that realized volatility in EM bonds has been lower than that of Treasuries for a few years, according to iShares benchmark EM bond and Treasuries ETFs.

To be sure, emerging economies’ debt burden is rising, narrowing the gap with highly indebted advanced economies. But the average EM debt-to-GDP ratio still appears manageable. The IMF projects an overall EM debt-to-GDP ratio this year of 77.2 per cent, rising to 86.2 per cent in five years, compared with forecasts for advanced economies of 108.2 per cent this year, rising to 114.8 per cent.

While the debt-to-GDP risk threshold in EM countries is lower because these economies are typically less resilient, few alarm bells are being rung. Indeed, the rise in EM debt has been quite gradual, suggesting policymakers are determined to keep it under control.

Not a monolith

Rising Fed rates and U.S. market turbulence will always affect EM economies, especially those carrying more dollar-denominated debt. And there will always be idiosyncratic EM distress stories, like we’re currently seeing in Indonesia. But events like this typically bear little relation to the broader emerging market narrative. Removing Indonesia could actually make EM equity indices more attractive to investors.

It’s also important to remember that the EM universe is wide, and the differences between economies are vast. Policymakers in some EM countries where core inflation is relatively low and expectations are anchored, like Brazil and Mexico, are cutting rates, and some, like South Africa and South Korea, are raising them to offset currency weakness or inflation. Others may prefer to keep their options open.

But the Fed doesn’t appear to be calling the EM tune like it used to, and if the record attendance at Barclays’ EM Conference in Bangkok last week is any guide, that’s music to investors’ ears.

The opinions expressed here are those of the author, a columnist for Reuters