Emerging Markets Skittish On a Fed Rate Hike? Not This Time

Looking forward to rate hikes

Emerging market ETFs (EEM) have done quite well in YTD 2017 as shown in the graph below. Despite the worries of capital outflows and subsequent impact on financial assets, emerging markets have cause for optimism. This is not to say that these markets will not be jittery when the US is about to hike rates, but it would be in their own interest to see higher interest rates in the US.

The reason is that, given the economic environment in the US, an increase would be indicative of a stronger economy. This favors emerging markets (VWO) for whom the US is a major trading partner.

In this regard, the context responsible for a rate hike becomes important. In the first article of this series, we have noted that emerging market equities (IEMG) had done well in the last rate hiking cycle in the US that lasted for the two years between 2004 to 2006.

At that time, the US economy was doing very well, with growth peaking at 4.9%. This was helpful to emerging markets (SCHE) which, in turn, increased their attractiveness as investment destinations due to increased exports on the back of higher demand from the US. This same situation seems to be in place today, and is leading to emerging market assets reacting positively to a rate hike in the US.

The other case in which rate hikes can take place is to rein-in inflation while economic growth remains subdued or is contracting. If the US was faced with this situation, it would have likely hammered emerging market assets.

Emerging markets have evolved

Another aspect which can keep emerging markets on investor radars in spite of rate hikes in the US is the evolution of emerging markets. The countries are very different from what they were a decade ago whether one looks at development of financial markets, improvement in regulation, or change in economic structure.

Investors have a wider choice of investment vehicles which invest across a broad spectrum of emerging market assets, thus reducing the risk of investing in a single geography. On the other hand, investors have options of investing in a particular market or region if they view it as a more exciting prospect than the rest of the emerging market universe.

However, an important point to note is that emerging markets are much more vulnerable to sudden and sharp changes in monetary policy in the US as opposed to planned hikes. If a rate hike is unexpected or is sharper than expected, these markets will be exposed to bouts of volatility (EEMV) and capital flight. However, if the pace of rate hikes remain on the expected path, then emerging markets can remain a good investment bet based on stock valuations and macroeconomic fundamentals.