EMD Relative weekly notes
Week Ending May 27, 2016
Where are we in the cycle of the impact of the Federal Reserve hiking interest rates on emerging markets? It remains too early to draw conclusions since the market seems to have taken a week off in terms of hiking anxiety, but evidence is accumulating that this cycle is more likely to be a tactical, rather than a strategic, setback for the asset class.
Despite the plethora of hawkish Fed speakers and the recently released Fed minutes which seemed designed to move markets closer to accepting a June or July rate hike, developed markets spent the week unimpressed. Up to Friday, market pricing of a June rate hike, as evidenced in two-year US Treasury bond yields, the US dollar index, and the emerging markets (EM) local currency index all remained nearly flat with their May 18th levels, even though the Fed minutes suggested a much higher probability of near-term hikes.
This result was a head-scratcher given the explicitness of the Fed message, but made even more so by stronger US economic data. The Citi surprise index of economic releases had a near-term bottom in mid-May and has risen steadily since then. The Atlanta Fed Nowcast quarterly GDP forecast has risen to 2.9% for the current quarter. It is hard for us not to conclude that the market has more work to do in terms of pricing in these factors, which would mean higher two-year US yields, a high probability of a stronger dollar and a correspondingly softer environment for EM currencies. Therefore, near-term caution is warranted in our opinion.
However, at the same time a full scale retreat seems ill-advised. Dollar credit spreads have essentially flat-lined throughout the month, meaning that the higher EM yields will have given investors a better return than nearly all of the global fixed income opportunity set. Unless this hiking episode turns into a full blown cycle, a better strategy will probably be a temporary rotation from currency risk to credit risk, not a reduction in overall exposure.
Why is this? Because the US data may be giving investors comfort that even a near-term hike will not be disruptive to either real activity or asset prices. EM growth looks set to rebound in a broad swath of large countries, regardless of Fed actions. Second, and perhaps more importantly, China fears--a feature of earlier periods when the market was Fed-focused--have moderated meaningfully. We say that with some confidence because the Chinese yuan (CNY) has depreciated steadily without any negative ramifications. The currency has fallen in value from April 1st to today by about 1.78% (see chart below). Yet this has happened with a very moderate slope and no fears about renewed capital outflows. As long as this remains the case--and there is no reason in current data to suggest it will not--then this hiking episode in our opinion is unlikely to be significantly destructive to EM assets over a meaningful investment horizon.