Fear Not: EM Bonds Can Handle Higher Rates, Trump
Higher interest rates, a stronger dollar and Donald Trump: three reasons to avoid emerging-market (EM) debt? Not necessarily. Rising rates seem to be signaling faster growth, and that’s good news for many EM bonds and currencies.
EM debt—both US-dollar and local-currency denominated—produced solid returns in 2016. But most came in the first half of the year. Donald Trump’s victory in the November US presidential election and his fiscal stimulus plans left investors scrambling to price in higher inflation. That pushed up US Treasury yields and the dollar.
As a result, EM bonds and currencies took it on the chin. Global investors worried that higher US rates would draw money out of EM assets and into US ones, putting pressure on EM government and corporate balance sheets. Trump’s antitrade platform and his pledges to rip up trade pacts didn’t help sentiment, either.
Does this mean it’s time for investors to retreat from emerging markets altogether? We don’t think so—for several reasons. To start, let’s look at rising US rates. Yes, long-term rates are higher, and the Federal Reserve may raise short-term borrowing costs more quickly in 2017 than investors expected just a few months ago.
GROWTH IS GOOD
But here’s the thing: why rates rise matters. In this case, markets are clearly pricing in faster growth and higher inflation, and a stronger US economy should boost economic activity elsewhere, emerging markets included. It’s especially good news for EM commodity producers, who stand to benefit from any further stabilization or rise in the prices of oil, gas, metals and other natural resources.
As the following Display shows, a period of gradual Fed rate increases and improving growth can coincide with tighter EM yield spreads and rising returns. On the other hand, the past several years of extremely low growth and rates in the US and other developed economies have hurt emerging economies and EM assets.
HOW EMERGING MARKETS BUILT UP SHOCK RESISTANCE
What’s more, rising rates aren’t a big problem for emerging markets today. That’s because many countries, including South Africa, India, Indonesia and Brazil, have spent the past few years chipping away at their external imbalances and reducing large current account deficits. The adjustment was painful, but it’s paying off in the form of stronger economic fundamentals, and it leaves EM assets less vulnerable to rising rates and other external shocks.
That wasn’t so in 2013, the last time US Treasury yields spiked suddenly. Back then, most emerging markets were on a borrowing binge. When rates rose, the flow of capital into these economies quickly dried up.