Emerging market stocks look more resilient to a Fed rate hike

April 9, 2015

Members of the Legio X Fretensis (Malta) re-enactment group take part in a display of ancient Roman army life at Fort Rinella in Kalkara, outside Valletta

Expectations may have been pushed to later this year for when the U.S. Federal Reserve will hike interest rates, but a repeat of another steep sell-off in emerging market stocks appears unlikely as much has already been priced in – and because of the stronger dollar.

Back in 2013, investors dumped emerging market stocks on expectations the Fed would start to roll back on its massive stimulus – in what was dubbed the “Taper Tantrum”.

Now, emerging market stocks are up an average 5 percent so far this year, and equity strategists in the latest Reuters global stock market polls expect emerging market shares to spearhead gains over the next 12 months, even though the Fed is poised to lift off interest rates from record lows – possibly in June, or perhaps a bit later.

At a Reuters Newsmaker event on Wednesday, New York Federal Reserve President William Dudley said the Taper Tantrum made emerging-market economies “much better prepared” to withstand higher U.S. interest rates.

“Even though the Taper Tantrum was probably a bit uncomfortable when we were going through it that time, it had some value in putting emerging-market economies on notice that the Federal Reserve was probably not going to follow the zero-interest-rate policy indefinitely,” Dudley said.

“In an ideal world, when we actually do hike rates, it should not be a surprise to anybody.”

Of course, it is not that simple. In our far-from-ideal world, sell-offs are unpredictable – and sell-side equity strategists are bullish by nature.

But the fact that the majority of end-2015 forecasts for emerging market indexes – including China, India, South Korea, Mexico, Hong Kong, Russia and Mexico – point to gains from current levels is not just wishful thinking.

It also has to do with the recent dollar strengthening, which has had a major impact on share prices.

As the dollar gained against major and emerging currencies alike, shares from Asia to Latin America became more attractive for international investors – provided they hedge against potential currency losses, which can be expensive in a few countries with high interest rates such as Brazil.

This is the performance of the MSCI Emerging Markets Index since the Taper Tantrum, in dollars. It shows that despite a recent rebound shares are still far from the peaks seen mid-last year. If another sell-off were to happen, stocks would trade near the troughs seen during the global financial crisis in 2009.

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A Reuters poll on Thursday showed the dollar is set to rally further in 2015, making shares outside of the U.S. cheaper, although the pace of gains should moderate.

“We no longer feel like equity strategists. Increasingly it’s all about currency,” Credit Suisse analysts Alexander Redman and Arun Sai wrote in a research note. They also pointed that a large part of the effect from higher U.S. interest rates is already priced in: “Emerging market performance appears to have been more pre-emptive in nature”.

The dollar’s renewed strength has lowered P/E ratios, they said, repeating the same pattern  from 2013 and previously. The most notable exception seems to be China, where analysts have warned of a possible bubble.

“In our view it appears that perhaps most of the emerging market EPS downgrades leading into a tighter U.S. monetary policy environment may already have been reflected in sell-side analyst models,” noted Redman and Sai.

Debt leverage should also play a role. In such environment, Asia shares are the most likely to surprise positively, Brown Brothers Harriman strategists, led by Marc Chandler, wrote in a note:

“We still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk when feasible.”

“We still favor Asia as a region, while Latin America and (to a lesser extent) EMEA should continue to underperform.”

But be careful: lower chances of a sell-off don’t make emerging market stocks a safe bet; it’s not time to get bullish yet, according to UBS analyst Marimar Torreblanca:    

“We believe the apparent delay in the first Fed rate hike should allow EM equities to get ‘back on track’ after heavy losses in early-March. However, the ‘relief’ may not last long, as the markets are now vulnerable to new upside macro surprises in the US. For a sustained, rally in EM equities, we think it would be better if the Fed were on hold until next year.”

— With reporting by Rahul Karunakar in Bengaluru

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