Why a Hawkish Fed Might Not Spook Emerging Markets

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Emerging markets threw a toddler-worthy tantrum in 2013 when the Federal Reserve suggested it may taper its crisis-era asset purchases. Investors are warily watching the Federal Reserve’s policy meeting this week and bracing for another painful “taper tantrum” in emerging markets that led to painful losses . But it may not be as bad this time.

Fund managers cited a taper tantrum as the second-biggest risk after inflation in a recent survey by Bank of America. Emerging markets felt the brunt of the last taper tantrum, with the MSCI Emerging Markets index falling roughly 10% in four months as investors yanked money out as higher yields in the U.S. offered them alternatives in 2013. That added pressure to emerging market countries, exacerbating precarious fiscal positions in countries reliant on foreign funding.

Many emerging market countries have better fiscal positions and stronger reserves to deal this time to deal with the fallout from another Fed taper. Increased demand for commodities should also help insulate non-Asian markets from disruptive outflows, giving policy makers more room to maneuver, according to Gavkeal Research analysts Udith Sikand and Vincent Tsui.

The duo expects a less extreme reaction in emerging markets, writing in a note this month that the Fed may also be more attuned to the fragility of the global backdrop and careful to avoid sparking a panic.

Plus, U.S. real yields are already inching up, which could mean any further rise in yields on the back of a Fed tapering could be smaller. As a result, the analysts think several emerging markets could be less vulnerable this time around and even outperform.

Of course, if a Fed taper triggers the type of outflows seen last time from emerging markets—roughly $30 billion—there will be few places to hide. The growth outlook for emerging markets, especially outside of India and China, is also less exciting and many countries will likely be grappling with higher levels of debt post-Covid. And the most fiscally fragile could still be vulnerable (think Turkey and South Africa).

But some money managers see pockets of opportunity in emerging markets. While 2013 is still fresh in the minds of emerging market investors, not all instances of Fed tightening have created such painful periods. Between 2004 to 2006, the MSCI Emerging Markets index returned more than 80% as the Federal Reserve raised the fed-funds rate by 4.25 percentage points, analysts at RockCreek wrote in a note to clients this week. A strong economic recovery led to the tightening in 2004—a period where emerging markets also saw the benefits of a strong commodities market. The RockCreek team highlighted similarities to that period: Commodities are booming again and the U.S. is in the throes of an economic recovery.

Picking the right spots in emerging markets will be important, as some countries are better-positioned for stronger commodity demand and to withstand volatility from a Fed taper. Others, like China are still grappling with country-specific issues, like antimonopoly measures that loom over not just the e-commerce and internet sectors but also education. 

Oxford Economics strategists favor commodity-oriented beneficiaries in emerging markets in Brazil, for example, where valuations are less stretched than in “new-economy” areas of the market like Chinese technology stocks.

Some emerging markets managers are also looking to banks in countries like Brazil as a way to benefit from the commodities boom and broader recovery. Gavekal also recommends overweight emerging-market stocks with a preference for non-Asian commodity exporters, as well as countries with weaker currencies like Brazil and Mexico.

The

iShares MSCI Brazil

exchange-traded fund (EWZ) is up 26% over the last three months; the

iShares MSCI Mexico

ETF (EWW) is up nearly 13% while the China-heavy

iShares MSCI Emerging Markets

index (EEM) is up just 4% over that period.

Write to Reshma Kapadia at reshma.kapadia@barrons.com