The Fed should be cautious of the impact a rise in interest rates could have on emerging markets due to their unstable economies and heavy debt burdens, according to Royal Bank of Canada (RBC).
Frédérique Carrier, director of European equities at the bank, said that Chinese credit and Greek public debt present the highest near-term and medium term risks, and the Fed should bear in mind the risk of contagion to other areas of emerging markets and developing economies before making any significant changes to monetary policy.
If there is more than one economic flare up at a time it could risk any progress made in the global economic recovery since the financial crisis, according to economists at the RBC. Ms Carrier said, “In our view the risk of an emerging market recession has increased.”
Ms Carrier cited the possibility of an emerging market slowdown spreading to developing markets as one of the biggest risks to the bank’s investment view. Other risks mentioned included rising bond yields as a result of the world’s debt overhang, outdated monetary policy becoming ineffective, and geopolitical risks impacting market volatility in the short term.
A slowdown in China would impact the real GDP growth trajectory around the world, with Japan feeling the most adverse effect with a projected change in real GDP of minus 0.75 per cent. The US and the eurozone would be the least affected regions with a projected change of negative 0.25 per cent to real GDP.
The bank identified debt hot spots in the near term - with effects expected to be felt within two years - as Greek public debt, Chinese credit, and housing exuberance, while external, corporate and oil-oriented debt also elevated. Developed world public debt was not viewed as a concern yet, but is set to become a debt hot spot in about 10 years.
Ms Carrier said, “Because the debt burden is so high, every small increase in interest rates will have a disproportionate impact on economic activity.
“All these different risks have a variety of catalysts, but all share the trigger of rising rates.”
Guy Huntrods, managing director and head of investment counsellors at RBC, reminded investors that rates have been extraordinarily low, and that when rates do gradually rise they will remain lower for longer in order to temper the blow to emerging markets.
While Mr Huntrods sees an equal chance of the Fed raising or not raising rates in December, he believes that unemployment, inflation, and wage inflation will have to improve before a move is made.
