Is a tightening Fed really bad for investors outside the US, especially in emerging markets? Not according to our panel of veteran fund managers. The fear of a scarcity of dollars impacting global markets is misplaced and could actually benefit EMs, as the Fed proceeds along its current tightening path.
View from EMD expert
Luc D'Hooge, Vontobel Asset Management
Head of EM bonds
From our perspective it’s not so much the tightening, which is a given, but rather the speed and number of hikes compared to market anticipation that is relevant.
We’re not overly concerned, though, as the recent hikes have been communicated clearly by the Fed and they have been accompanied by looser financial conditions and as such have been well received by the markets.
The fear of many emerging market bond investors was that a strengthening US dollar would increase convertibility risk, and result in the cost of issuance and repayment for emerging market borrowers increasing. However, previous Fed hiking cycles have not resulted in negative effects for emerging market bonds. In fact, in the last two cycles, emerging market debt spreads have tightened during rate-hiking cycles.
Looking at emerging market bonds solely through the prism of the Fed’s interest rate policy is simplistic. Higher rates are indicative of a strengthening US economy, which is an important market for emerging economies and, therefore, a positive economic driver.
Furthermore, it is unlikely that rates in the US will rise dramatically, as there are structural impediments to future growth in the US.
These structural factors include challenges facing the growth of the labor force, due to demographics such as an aging population, lower immigration, poor productivity, elevated debt levels and digitalization.
When looking at emerging markets and the US dollar, commodities are an important factor. A rising US dollar is typically associated with lower commodity prices, which is believed to be an overall drag on emerging markets.
However, as the US has closed its output gap and could continue to increase real rates through higher infrastructure investment and capex, the US dollar is now starting to be associated with rising hard-commodity prices.
So, monetary tightening by the Fed is not something to be fearful of. Emerging markets still offer an attractive yield with hard currency bonds offering better portfolio stability than their local currency counterparts, thus removing the need for complex hedging strategies. In this environment, even after the good returns year-to-date, we expect the positive trend to continue. That’s a compelling proposition for investors.
View from a total return expert
Mihir Worah, Pimco
CIO of asset allocation and real return
We expect the Federal Reserve to proceed cautiously as it looks to reset monetary policy by keeping conditions more accommodative than would historically be warranted.
That should ultimately keep dollar strength in check. There are two reasons for this approach: one is the Fed would rather keep policy too easy than too tight given the fact that we are just moving away from near-zero levels of short-term interest rates.
Many studies suggest we are likely to be operating close to this low level even in the future.
Second, inflation has been consistently lower than the Fed’s target for the last few years.
Recent Fed research highlighting the benefits of a higher inflation target or ‘price level targeting’ tell us the Fed would like to ideally engineer an outcome where inflation is modestly above its target. It is unlikely to accomplish this in a world of dollar scarcity. Another factor keeping dollar strength in check is the Trump administration’s own view that a stronger dollar hurts the US economy.
As for its impact on emerging markets (EMs), we don’t think the current cycle of rate increases will have large negative consequences. In fact, we believe EM is one of the few attractively-priced assets available to investors even in the face of further Fed rate increases.
That said, investing in EMs is not without risk. Recent events surrounding the political scandals in Brazil and South Africa underline this point. However, we believe over the next few years an EM correction is more likely to be from idiosyncratic or geopolitical events than from a Fed-induced event.
Nevertheless, in a world of lower expected market returns, the best protection is diversification and prudent risk management. We believe portfolios diversified across different risk factors, and liquid enough to benefit from market dislocations when they occur, are most likely to outperform during what we expect to be a slow and shallow Fed rate hike cycle.
View from global bonds expert
Mark Dowding, BlueBay Asset Management
Co-head of investment grade debt
The idea that the Federal Reserve will start shrinking its $4.5 trillion balance sheet as we head into 2018 is not at all surprising to us. Notwithstanding any external events, we believe that as long as economic data remains robust and stock markets steady, the Fed will continue to hike rates but may pause in December to communicate an end to QE reinvestment.
We have been voicing that before Fed Chair Janet Yellen leaves office (likely next February) she will want her legacy to show an economy in rude health with inflation at target, the labor market at full employment, rates on the way towards neutral, and the balance sheet set on a path towards normalization.
Despite worries from some market participants, we don’t see the Fed passively reducing its balance sheet over a number of years as particularly significant in terms of market impact.
It should be stressed that the Fed itself sees this normalization going hand in hand with a further two rate hikes in 2017 and three rate hikes in 2018.
However, more significant would be a policy in which the Fed starts to normalize by directly selling bonds back into the market. This could become reality depending on the next Fed Chair – rapid rate hikes coupled with balance sheet sales would likely result in bear-steepening for the US Treasury curve. But at this juncture, we think a more passive, well-communicated approach to balance sheet reduction is the preference for most Fed members, to avert any forceful market adjustments.
Overall, we don’t think any comment regarding the balance sheet from previous Fed rhetoric should be overplayed at this juncture and there is certainly a lot of ‘noise’ floating around.
It is worth highlighting that we are currently undergoing a synchronized upswing in global growth, healthy corporate earnings and a benign environment anchored by central banks that remain biased towards monetary accommodation.
This article was originally published in the June 2017 edition of Citywire Americas magazine. To subscribe and receive the magazine click here.