Opinion  

Fasten your seatbelt

Nandini Ramakrishnan

When I am flying on airplanes, I am never good with turbulence. When the captain says “Please fasten your seatbelt” in the middle of the Atlantic, I clutch the armrest (if I have won the turf war for it).

But what is even worse than that announcement is when the turbulence happens without warning. We know there is going to be turbulence in markets as the US Federal Reserve begins to raise rates. The region that could feel the shakiness the most is emerging markets, but given a proper warning, investors should feel comfortable with a safe landing at the end of this particular flight.

From taper tantrums to all-out market hysteria, nerves have been frayed in the financial world for quite some time. So last week, it was no surprise to find the eyes of the world – and not just the US – focused intently on the Fed. And emerging markets were paying particularly close attention.

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After the global financial crisis, flows into emerging market assets increased tremendously, as global investors searched for both growth and income. This led to capital flows out of emerging markets back in 2013, when the Fed first communicated a shift away from easy US monetary policy. Now, with the Fed set to begin raising rates, it is time for investors to think carefully about the effect this may have on emerging markets.

So should we be steeling ourselves for taper tantrum round two? I do not think so. The pricing of EM assets has improved over the past two years. But investors now need to focus on EM economies less reliant on dollar funding, with strong foreign exchange reserves, improving current account positioning and better growth and earnings prospects.

In the wake of the global financial crisis, investors flocked to EM equities and debt, amid abundant liquidity, low rates and low growth in developed markets. However, these inflows did not always reflect positive domestic fundamentals, and the EM outlook has become increasingly difficult and differentiated over the past four years.

Many now worry that global investors will reallocate away from riskier EM assets back toward the US, given better growth prospects, rising yields – albeit from very low levels – and greater safety.

EM equity returns have tended to be negative in the short term (one week to one month) after the first rate hike, but more positive in the long term (six months to the end of the tightening cycle). This could be attributed to an initial panic following a first rate hike, with investors refocusing on EM fundamentals over the longer term. Indeed, looking back at the taper tantrum, the initial reaction was quite negative, but over time, performance stabilised.

Dollar strength means lower returns once returns are converted from local currency. During the 1994/1995 cycle, the dollar gained 2 per cent against a broad basket of currencies, denting returns for EM equities in dollars.

From 2004 to 2006, on the other hand, the dollar depreciated 7 per cent, helping dollar returns. What is more, a stronger dollar drags down commodity prices (which are priced in dollars), hurting commodity-exporting EM countries and sectors. The chart shows how EM equities underperform developed market equities during periods of dollar strength.