The Federal Reserve’s hawkish shift at its June meeting took markets by surprise. Is tighter policy a headwind for emerging markets? Alejandro Arevalo and the emerging market debt team explain why they don’t think so, and how they remain optimistic that global recovery can continue to support EMD through this year and beyond.
A hawkish pivot
Chair Jerome Powell announced last year that the Federal Reserve (Fed) was likely to wait longer before tightening policy than it used to, and earlier this year, Powell had on several occasions indicated that much of the inflation we are seeing would be transitory. Therefore, it came as a surprise to markets when the Fed took policy in a more hawkish direction at its 16 June meeting, citing upside inflation risks. While a sell-off in risk assets was short lived, a stronger dollar and weakening in longer-term interest rates and inflation have so far been sustained.
Historically, a strong dollar and tighter policy have been negatives for emerging markets, as EM issuers find themselves borrowing a stronger currency at higher interest rates. So, do tighter financial conditions present a risk for EMD?
Don’t fear the fed
While at the margin the Fed’s June move does increase the risk of further tightening, especially if we see a surprise jump in growth or inflation, we think fears are overstated and that the market reaction has already happened. We’ve seen a slightly hawkish shift in predicted long-term rates, and historically, those predictions haven’t tended to be very accurate. Long-term growth and inflation expectations haven’t changed. Instead, this is really about risk management, removing the tail risk that inflation overshoots. There is plenty of room for the Fed to be more dovish in the future.
Some commentators have also pointed to the risk of a “taper tantrum”, the likes of which we saw in the second quarter of 2013 when interest rates jumped very materially and we saw turmoil across markets, including EMD. Again, we don’t see this as likely. In 2013, there was a material disconnect between the market’s pricing of interest rates and the Fed’s expectations. That’s not the case now. Back then, there was much more uncertainty about when tapering would happen, which meant that a stray comment by Ben Bernanke could cause chaos. This time, however, the Fed has already been talking about tapering – it’s in the diary, almost.
Still optimistic about EMD
It’s also worth noting that back in 2013, emerging markets were much more vulnerable to a stronger dollar and tighter policy than they are now. EM countries have learned from past mistakes and, in general (with a few exceptions), they manage fiscal policy much better today. In addition, the proportion of owners of EM bonds that are overseas investors, who tend to cut and run at the first sign of trouble, is much lower.
There are plenty of economic tailwinds behind EMD, too: taking a step back, monetary and fiscal policy are still exceptionally loose in many areas of the world. After the trade wars of the Trump era, the political environment is benign. The post-pandemic recovery was led by the US and parts of Asia, but there is scope for EM growth to catch up as vaccination rates improve. As that recovery continues, it allows EM central banks the breathing space to reduce inflation, which will support real interest rates in EM.
The other area of concern investors often cite is China, where they are worried that growth has peaked and authorities will start to focus on tighter policy and deleveraging. We aren’t concerned, however: exports are still at a high level, and manufacturing can add more to Chinese growth. Furthermore, China has already tightened lending to housing and property-related sectors and shadow bank financing, but loans have remained robust for households and corporates. Credit policy is supportive, and there’s plenty of room to ease if growth weakens.
Selectivity is key
In conclusion, we think it’s still a good time to put risk to work in EMD. Spreads (the risk premium you get for holding EM bonds) have narrowed in recent weeks but still look much more attractive than developed market credit, where spreads are at lows we haven’t seen for years.
We remain overweight high yield across our EMD strategies, but the asset class remains very varied and diverse, with pockets we really like and areas we avoid.
We are underweight Asia, and in particular the Chinese real estate sector, where we see the risk of higher short-term volatility as authorities push companies to de-lever and comply with tighter regulations. Instead, we prefer Latin America, Africa and eastern Europe. In Latin America, for example, we have reduced our exposure to Peru, Colombia and Chile to avoid political instability there, in favour of Mexico, where the political background has improved, and Brazil, where we see growth and vaccination rates improving.
The key for us is to ensure that even when we are positive about conditions across EMD, we are still always being paid for the risk we take.
The value of active minds – independent thinking:
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