Emerging market bonds and currencies sustained serious damage in the 2013 “Taper Tantrum”, but are much better placed this time around.
We see three key positive factors for EM economies today, which weren’t there in 2013:
- Real exchange rates:this measure of currency value (comparing the cost of the same goods in different countries) is much less stretched across the asset class compared to 2013. Consequently, external accounts (value of exports minus imports) are much healthier, which means EM generally have less need for, or exposure to, foreign portfolio flows. This makes the probability of dramatic declines in currencies low.
- Real interest rates: EM central banks have already begun to tighten interest rates to respond to higher inflation, giving them a head start in moving real interest rates towards or beyond zero. The relative attractiveness of EM real interest rates versus developed markets should persist, drawing capital to the asset class.
- Limited scope for dollar strength: The dollar should rise in value as market fears about higher rates increase. That will no doubt lead to higher volatility for EM currencies until there is more clarity on the timing of tapering. Unlike 2013, however, the dollar’s rise will likely be curbed by far larger external deficits and much larger fiscal deficits.
The parallels between then and now
On 22 May 2013, Fed chair Bernanke made clear that the Fed was starting on a path towards tapering bond purchases, and ultimately tightening monetary policy: “If we see continued improvement and we have confidence that that’s going to be sustained, then we could in the next few meetings….take a step down in our pace of purchases.”
On 16 June 2021, chair Powell said that “reaching the conditions for lift-off will mainly signal that the recovery is strong and no longer requires holding rates near zero”.
The similarities in statements and starting points would suggest that there will be at least some parallels in terms of asset price reactions between the two episodes. Initial market responses, on the other hand, suggest not.
What happens next?
We think that there are indeed some parallels in the market’s reaction to the perceived change in direction towards tapering, however far away that might be. So, some pain for EM assets relative to developed market assets seems probable for some period of time, but the extent of that pain is likely to be limited given the fundamental differences in the asset class between now and then.
Today, real effective exchange rates are cheaper, external accounts are more solid and inflation is broadly lower, as shown below. Additionally (and perhaps most encouragingly), central banks in key countries like Russia, Brazil and Mexico have already hiked interest rates to deal with a rise in inflation. Early signs are that this inflation bump is likely to be short lived given still wide output gaps. If so, this will make EM real interest rates even more attractive. Importantly, foreigners’ share of local debt ownership is now much lower than it was in 2013.
For all these reasons, it seems unlikely that EM asset prices will fall to the same extent as previously. And it should be pointed out that if the Fed shows more patience in the tapering cycle or even revises their outlook due to slower US growth, EM assets would be well poised to significantly outperform.
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