US interest rates are going up. The Federal Reserve has said that if the economy pans out as expected it will raise the fed funds rate by a quarter point next month and by a further three-quarters of a point next year.
In theory, this should not affect share prices. The rises have been signalled so far in advance that they should be in the price already. History, however, warns us that this is not the case and that rate rises might well be bad for emerging markets.
Granted, this doesn’t seem to be the case if we look at simple correlations: since the early 1990s, rate rises have been associated with rising share prices. Correlation, however, is not causality. This link exists simply because the Fed tends to raise rates only in good times, which of course is when share prices rise.
If we control for changes in the S&P 500 and in 10-year US Treasury yields, there has been a strong and statistically significant link between the fed funds rate and MSCI’s emerging markets index since 1991. It runs through two channels.
One is that a low level of the fed funds rate (given US bond yields) leads to good returns on emerging markets in the following 12 months. Upward-sloping yield curves in 2003 and 2009 led to big rises in emerging markets, while inverted yield curves (when the funds rate was below 10-year yields) in 2000 and 2007-08 led to big falls.
One reason for this is that low interest rates encourage a 'reach for yield'. They compel investors to buy riskier assets in the search for decent returns. Also, the yield curve is an economic forecaster – in fact, pretty much the only decent one. An inverted curve leads to recessions, which reduce investors’ appetite for risk thus causing a slump in emerging markets. An upward-sloping curve, on the other hand, leads to economic growth and increased appetite for risk.
The second channel is that rises in the fed funds rate over 12-month periods are associated with falls in emerging markets, assuming that US share prices and bond yields don’t change. This occurred most spectacularly in 1994-95 when long-awaited rises in US rates triggered steep falls in emerging markets. But we’ve also seen it recently. Emerging markets have underperformed the S&P 500 in the last 12 months as the fed funds rate has risen.
One reason for this is that rising US rates can lead to a reversal of the 'reach for yield': if you can get adequate returns on cash, why bother investing in risky and unfamiliar assets? In addition, rising US interest rates can strengthen the US dollar, which is terrible for those countries and companies that have dollar-denominated debt.
You might object here that investors should by now have wised up to all this. They should have learned that high and rising US rates are bad for emerging markets, so this fact should already be discounted.
Certainly, the 17 per cent drop in emerging markets (in sterling terms) so far this year means that a lot of bad news is in the price now. But there’s a risk here. It’s that investors will worry that others will worry about rising interest rates. This could unsettle markets. As Maynard Keynes famously said, equity investing is about anticipating what others will believe (or what others will believe others will believe, and so on).
Instead, I suspect there’s a better hope for investors. A lot depends upon what happens to US bond yields. Historically, rises in 10-year yields have been strongly associated with rises in emerging markets. My chart shows the raw correlation between the two: it’s evident that most decent gains in emerging markets in the last 20 years have been accompanied by rising bond yields, and most sell-offs by falling yields. This shouldn’t be surprising: rising yields are a sign of increasing appetite for risk, which boosts the prices of risky assets such as emerging markets.
This has an obvious implication – that government bonds are decent insurance against a big drop in emerging markets.
It also implies that if rises in the fed funds' rate trigger rising bond yields, it’ll be good for emerging markets. In such a scenario, investors would regard such rises as compatible with ongoing growth in the US economy and hence with continued rises in appetite for risk. On the other hand, what would be would be really nasty for emerging markets would be if bond yields fell: this would happen if fears for US growth were to increase.
Many investors have for years been worried about a possible sell-off in bond markets. For emerging markets investors, however, such a prospect is not to be feared but hoped for.
