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When the punchbowl disappears

Created:

5 March 2010

Updated:

8 March 2010

Written by:

Chris Dillow

Sooner or later, the Federal Reserve will take the punchbowl away from the stock market party and raise interest rates. What would this imply for emerging market shares? History suggests: not much at first, but perhaps a lot of damage eventually.

To see this, I checked the statistical links between annual changes in emerging market stock prices, as measured in sterling terms by MSCI, and changes in the US yield curve and US share prices. These show - surprisingly - that the level of the yield curve, and changes in its shape, are more important for emerging market shares than are moves in the US stock market.

I say this because since January 1991, annual changes in emerging market shares have been only lightly related to the US market. Moves in the latter explain less than one-sixth of the variation in emerging market returns, with - on average - each percentage point rise or fall in the US market being associated with a 0.64 percentage point rise or fall in emerging markets. If you find this surprising, just remember that for most of the mid-90s, emerging markets struggled as the US boomed, whilst in 2007 emerging markets rose nicely even as the US wobbled.

Instead, what matters more for emerging markets are US interest rates. These account for a further quarter of the variation in emerging market returns. They matter in three ways:

1. The shape of the yield curve predicts returns. The higher 10-year Treasury yields are relative to the fed funds rate, the better emerging markets do in the following 12 months. This is probably because a steep US yield curve predicts an economic upswing, which in turn encourages investors to buy riskier assets such as emerging market shares.

2. Rises in the fed funds rate, other things equal, are bad for emerging markets. On average, each percentage point rise in the funds rate over a 12-month period is associated with a 6.2 per cent drop in emerging markets. The effect would be even greater if such rises prompted a fall in US share prices, as this would give a further knock down to emerging markets. With futures markets pricing in a half-point rise in the funds rate over the next 12 months, this tempers the bullish message of the yield curve.

3. Rises in US bond yields are enormously positive for emerging markets. A one percentage point rise in the 10 year Treasury yield is associated, on average and controlling for other things, with a 15.3 per cent rise in emerging markets. This is because bond yields are traditionally a measure of investors' appetite for risk and economic activity; bond yields rise when these rise, but these are the circumstances in which emerging markets do well.

If we put all these factors together, then the outlook for emerging markets is good. On roughly consensus forecasts - a 5 per cent rise in the US market, no change in 10 year yields and a half-point rise in the fed funds rate - emerging markets will rise 30 per cent in the next 12 months, with a less than 10 per cent chance of them falling.

If this sounds good, there are - of course! - some caveats.

First, this assumes only a small rise in the fed funds rate. Bigger rises would greatly increase the odds of a fall. This means that if you think the Fed will have to take big steps to curb the danger of inflation, you should be less bullish on emerging markets.

Secondly, these inferences are drawn form the experience of the last 20 years. During this time, investors haven't worried about high US government debt, so rises in bond yields have occurred in good economic times. If, however, bond yields were to rise because of concerns about government borrowing, emerging market shares probably would not do well.

Thirdly, there'll come a time when the US yield curve is back to a more normal, flatter, shape. After this has happened, returns on emerging markets will be much less good. In this sense, if the emerging markets party does continue, it'll only mean that the hangover is postponed.

The numbers

This table shows the regression equation I'm using. The intercept needs explaining. It shows that, if all the variables were zero, emerging markets would rise by 18.2 per cent a year. This seems high, but remember that a fed funds rate of zero is a hugely easy money policy. In more "normal" times - a funds rate of 4 per cent and 10 year yield of 5 per cent and no change in anything else, this intercept implies that emerging markets would rise 5.6 per cent a year. You can think of this as the long-term average "secular" out-performance of these markets.

Explaining annual changes in emerging markets

Note that this equation explains only two-fifths of the (very large) variation in emerging market returns. My chart gives a picture of what this means. Note that the equation doesn't capture the full extent of emerging market losses in 1998 and 2008, but it does perfectly explain their boom in the last 12 months.