The Emerging Market Stress Test

There’s no shortage of reasons to fret about the current state of financial markets. From the prospect of a disintegrating United Kingdom to a war in Iraq to a still stagnant European economy, investors are confronted with a plethora of geopolitical risks and financial vulnerabilities.

The latest cause for concern is this week’s more hawkish statement from the U.S. Federal Reserve, whose ultra-loose monetary policy over the past several years has been inflating the prices of financial assets and desensitizing investors to risks that would otherwise be of far greater concern to them. Investors are worried about what happens once things start to tighten up.

While the Fed has pledged to keep interest rates low for a "considerable time" after it ends its program of quantitative easing (QE) next month, it has signaled that the delay in tightening monetary policy is likely to come at a price: a faster pace of rate hikes in the second-half of 2015 and in 2016.

Investors don’t quite know what to make of this. While bond markets are beginning to fret about the risk of sharper-than-expected increases in U.S. interest rates, equity markets remain sanguine. The real test of investor sentiment, however, lies in emerging markets (EMs), the asset class that is the most sensitive to sudden changes in investors’ perceptions of risk.

In May 2013, developing economies were given a taste of what could be in store once the Fed starts raising rates, which is still likely to happen sometime in the first half of next year. The mere hint of a gradual withdrawal of the Fed’s monetary stimulus led to sharp declines in the bonds and stocks of EMs.

After a five-month-long rally, developing economies are again showing signs of strain. Over the past month, EM stocks have fallen 2.3 percent (and Latin American shares 5 percent), compared with a 1.5 percent rise in the benchmark S&P 500 index. What’s more, the spread, or risk premium, of EM dollar-denominated government bonds — as measured by J.P. Morgan’s benchmark EM bond index (EMBIG) — over U.S. Treasuries has shot up some 25 basis points since early August to 315 basis points.

Some of the most vulnerable EM currencies during last year’s sell-off have fallen against the resurgent dollar over the past month, with the Brazilian real, the South African rand, and the Turkish lira dropping 5 percent, 3.3 percent, and 2.7 percent respectively.

The recent falls in EM asset prices, although worrying, need to be put into context. Beneath the less favorable sentiment towards developing economies lies a resilient EM asset class. EM equities have had a good run of late and were due for a correction at some point. Indonesian, Indian, and Turkish stocks have surged, respectively, 26 percent, 24 percent, and 13 percent in 2014 so far.

Moreover, investor sentiment towards EMs is not as bleak as the headlines suggest. Foreign investors have been increasing their holdings of EM local currency bonds this year, particularly in Asia and Latin America, but also in Turkey, which is still deemed to be one of the riskiest EMs because of the country’s large current account deficit and the loss of the central bank’s inflation-fighting credibility — due to its insistence on cutting interest rates over the past three months in the face of surging inflation.

Although the east-west standoff over Ukraine is weighing on sentiment, notably towards the "Emerging Europe" region, whose equity markets have fallen 9 percent over the past three months, investors treat the Ukrainian crisis as a localized one that’s unlikely to have severe consequences for global growth.

So potent has the soothing effect of Fed’s ultra-loose monetary policies been that investors in Russian bonds have turned bullish at the slightest hint of a de-escalation in the crisis. Russian shares have only fallen 0.3 percent this month, while the yield on the country’s 10-year domestic bonds is now slightly below where it stood at the start of September, when a cease-fire in eastern Ukraine was reached — even though the truce continues to be violated. 

With yields on the bonds of many developed economies plumbing new lows — the yield on 2-year German government debt has even turned negative — higher-yielding EM debt is still attractive to investors.

There’s also another, more important, reason behind the resilience of EMs in the face of mounting financial and geopolitical risks: Developing economies are a lot more stable and credit-worthy than they were during the 1990s, when financial crises roiled Mexico, Turkey, Southeast Asia and pretty much every developing country in between.

Most EMs now have investment-grade credit ratings thanks to significant improvements in their economic fundamentals over the past 10 to 15 years, even among the so-called "fragile five" group of Brazil, India, Indonesia, South Africa, and Turkey. Just as important, the investor base for EM debt is now a lot more secure. In the past, only hedge funds and opportunistic investors were willing to put capital into emerging markets. But since 2007 or so, more stable institutional investors have come to dominate. They are unlikely to flee when the going gets tough.

Domestic institutional investors, such as Mexican pension funds and Asian insurers which have grown in recent years, hold the bulk of developing countries’ bonds, helping shore up EMs when flighty retail investors (such as European and U.S. mutual funds) exit the market, just as they did last year. EM debt

Ever since the Fed let the "tapering" genie out of the bottle in May 2013, EMs have been facing a severe stress test. A decade ago they undoubtedly would have failed. This time around they are passing.