Global asset prices have benefited from the multi-year cycle of global monetary policy stimulus, as the search for yield has encouraged investors to invest capital in all corners of the world. With the Fed continuing its path toward monetary policy normalization and the ECB edging toward tapering, some investors have expressed less confidence in the return potential of an array of assets, including emerging markets.
EMs: "Don’t worry about us so much, we’re good"
One of the defining features of emerging markets is their dynamism, and conditions today are already quite different from the challenges that punished emerging markets in 2013’s Taper Tantrum. In our view, emerging markets are significantly less vulnerable to an external shock than a few years ago, with improved current account balances, private sector deleveraging, lower inflation, and greater policy flexibility overall. Emerging markets are in a favorable position as their higher real interest rates provide a cushion to higher rates in developed markets (Figure 1).
Figure 1. Higher interest rates may help insulate EMs
Emerging Markets ex China, real rate differentials with U.S. (% pts)
Source: Morgan Stanley, “EM Economics Playbook,” EM recovery Gaining Momentum, August 2017.
Global growth and a rising tide
Global economic growth is more synchronized today versus 2013, with improving demand providing support for major EM economies. According to a recent article in The Wall Street Journal, 45 countries tracked by the OECD are all expecting positive growth this year, with 33 economies poised to accelerate from a year ago.* This shared prosperity is boosting EM export growth and, in turn, supporting a pickup in domestic demand and nominal GDP growth in these economies. The IMF forecasts GDP growth in EMs rising from 4.3% in 2016 to 4.6% this year and 4.8% in 2018.
As we have discussed in the past, the drivers of higher rates and policy normalization must be considered in tandem with the changes themselves, while the path and ending point are perhaps even more important to asset prices. Emerging markets should benefit from policy changes in response to stronger global growth as opposed to spiking inflation, which is the environment we expect to continue.
So, yes, yields will probably rise as central banks unwind monetary stimulus, but these changes are well communicated. We believe asset prices should fare better with a gradual path and low neutral rate than in past periods.
The first change can be the hardest
During the Taper Tantrum, emerging markets struggled. However, since the Fed has moved from rhetoric to action, emerging markets have adjusted to the low and gradual path of tightening. As Figure 2 shows, in the wake of the second, third and fourth Fed hikes, emerging markets consistently outperformed developed ones.
Figure 2. Equity returns by tightening event
% Total return during the 60 days following Fed tightening event
Past performance is no guarantee of future results. Source: Bloomberg. Start dates of each period are as follows: Taper Tantrum, 5/8/2013; Hike 1, 12/17/2015; Hike 2, 12/14/2016; Hike 3, 3/15/2017; Hike 4, 6/14/2017.
As we continue down the path toward normalization in global monetary policy, EMs will perhaps be evaluated more on the merits of their own fundamentals and less as a proxy for global liquidity. In our view, emerging markets are experiencing better macro conditions broadly, improving corporate fundamentals, with rising earnings and higher return on equity, and attractive valuations versus history and peer markets.