Rate threat to emerging markets

Back in 1994-95 rising US interest rates triggered a slump in emerging markets. Ever since then, many investors have feared that Fed tightenings are terrible for emerging market equities. With rising rates looking increasingly likely, investors can therefore be forgiven for being worried.

While that experience looms large in our minds, however, it was not typical. In fact, since 1991 there has actually been a slight positive correlation between annual changes in the fed funds rate and MSCI’s emerging markets index, which means that higher interest rates have more often than not been accompanied by decent returns on these stocks. Rising rates in 2005 and 2016-17, for example, saw them do well. And many falls in emerging markets have come without any help from the Fed, such as in 1998, 2001-02 and in 2015.

There are good reasons why emerging markets need not fear higher US rates. The Fed usually forewarns us of its intentions to raise rates long in advance, so markets should price in rising rates long before they happen. And the Fed only raises rates when it is confident that the US economy is strong enough to withstand them. But these are circumstances in which investors’ appetite for risk is rising – something which is great for emerging markets.

In fact, recent history tells us that, insofar as there is a threat from US interests to emerging markets, it comes from precisely the opposite direction. It is expectations of lower rates that are bad for them. My chart shows this. It shows a strong positive correlation between returns on emerging market shares and changes in 10-year US Treasury yields. Falling yields, such as in 2002-3, 2008-09, 2011-12 and 2020, see emerging markets fall while rising yields such as in 2006, 2009-10 and 2016-17 see them do well. It was only in 2013 and 2019 that this pattern broke down.

This is because falling yields (which usually happen when the world economy is expected to weaken) are a sign of falls in investors’ appetite for risk – and because emerging markets are especially risky assets they are very sensitive to such falls.

If a rising fed funds rate is accompanied by rising bond yields, emerging markets should therefore do well. It’s not that higher yields cause them to do so, but that the circumstances in which yields rise are good ones for the sector.

Does this mean emerging market investors can safely ignore the threat of higher rates?

Not entirely.

One danger is that rising rates could strengthen the US dollar. This would hurt emerging markets, because a strong dollar raises the costs of raw materials and of servicing dollar-denominated debts.

A second danger is that if investors fear that higher rates would seriously weaken the world economy they would dump risky assets generally.

These two threats, however, are to some extent mutually exclusive. The dollar is most likely to rise in response to higher rates if the US economy look like staying strong. In such a case, demand for risky assets would stay high.

There is, however, a third danger. Our long period of near-zero rates might have broken the historic link between rate changes and emerging markets. Investors might have bought risky assets not because of their actual merits but simply out of disillusionment with the lack of return on cash. To the extent that they have done so, rate rises would see emerging markets fall as investors shift back into cash.

Sadly, we don’t know the extent to which there has been such a reach for yield, nor whether it will be reversed if interest rates rise only slightly. It’s likely that there has been some, but perhaps more so in riskier bond markets (where yield has been on offer) than in stock markets.

So yes, a higher fed funds rate is a danger for emerging markets. But it is a secondary threat. A bigger danger would be a loss of appetite for risk triggered by the threat of recession or financial crisis. Such a loss is of course inevitable at some time, but that isn’t to say that it is imminent.