Our ‘working’ base case on this matter is that neither the Fed nor the ECB will move suddenly and that current inflation pressures will likely moderate.
Nevertheless, we do see a small but growing ‘tail’ risk that the two institutions might react earlier than expected to prolonged inflation pressures. And even if this does not happen, the bond market remains sceptical that inflation pressures are simply temporary.
Emerging markets as a whole will struggle
A sudden change in direction by the Fed would lead to a change in financial conditions, especially if real interest rates were to move higher. This could be rather disruptive for a range of risky assets in both the equity and bond markets.
Emerging markets will most likely be near the front of this adjustment process.
As an asset class that tends to rely heavily on external funding and a neutral to weak US Dollar, a sudden shift can cause some distress.
Historically, emerging markets have been among the first movers when the Fed pivots. While the situation in terms of fundamentals for some emerging markets countries is stronger than in the past and many countries rely more heavily on local funding, we still expect that emerging markets as a whole will struggle.
Economies recover at different paces
An important consideration in this context is the different pace of economic recovery in emerging markets in contrast to developed countries.
The higher quality investment-grade EM sovereigns are already seeing strong signs of economic recovery. This means finance ministries are able to begin consolidating public finances and central banks are able to normalise monetary policy.
Emerging markets countries generally do not have the luxury of allowing their economy to ‘run hot’ as the Fed has signalled. Instead, they will be keen to underline their hard-earned monetary policy credibility.
Nevertheless, there are many emerging markets countries, typically from the weaker side of the credit spectrum, where recovery is elusive or very patchy and policy makers’ ability to maintain accommodative fiscal or monetary support is stretched.
For many of the weaker, so-called Frontier countries, a major advantage at present is higher oil prices, as this eases the fiscal burden and allows for a less dramatic reduction in spending.
Rising interest rates are already priced into many Central and Eastern European countries
A good deal of emerging market central banks facing higher inflation have already tightened or signalled policy tightening emerging markets.
Brazil and Russia have raised interest rates, and this is already priced into many Central and Eastern European Countries such as the Czech Republic and Hungary. The pace of hiking is unlikely to be dramatic at this stage, given the mixed and somewhat fragile recoveries.
Nevertheless, it is hard to imagine that monetary policy will be as accommodating as before. This stance suggests caution on taking active exposure to emerging markets rates or duration as a whole, even though there will be discrete attractive opportunities (i.e. South African rate flatteners). When the tightening cycle is over, there will be scope for renewed exposure.
Consequences of EM foreign exchange and credit
Higher rates in emerging markets relative to the US, especially in our base-case environment where the Fed is moving very slowly, have been and should continue to be a good catalyst for taking emerging markets foreign exchange (FX) exposure.
The asset class will benefit from higher carry, versus the US, and the gradual catch-up of the economic recovery across emerging markets relative to the US.
A note of caution is advised as emerging markets FX positioning is getting more crowded, and a large Fed pivot (under our tail risk scenario) could prompt large outflows from the EM asset class. This would have a negative impact on emerging markets FX, regardless of the fundamentals.
In terms of credit, a large inflation shock in the US that translates into unexpected Fed moves risks meaningful damage to emerging markets. Especially those countries with sizeable funding needs such as Turkey and parts of Latin America.
Sovereign credits with stronger fundamentals would be more resilient, although clearly, these are also names with little spread cushion to absorb US treasury weakness or higher yields. A modest rise in US treasury yields that does not prompt emerging markets outflows or lead to a serious tightening of funding conditions can lead to good performance of emerging markets high yield sovereign bonds, as their spread cushion is much larger.
Nick Eisinger is co-head of emerging markets active fixed income at Vanguard