<!-- Swiftype Variables -->

Special report: Emerging markets

Central bank rate changes shouldn’t concern investors in emerging markets

Managers say most emerging economies now in better shape

Denise Simon said the improved fundamentals of most emerging market economies are ‘key’ to absorbing any surprises in monetary policy.

Investors shouldn't fear the impact of central bank moves on emerging markets since these economies are in a better place than in recent years to deal with changing monetary policies, money management executives said.

"I think emerging markets are in much better shape to absorb this gradual tightening of the Fed," said Denise Simon, portfolio manager of emerging markets debt at Lazard Asset Management in New York. She said emerging markets fundamentals are in much better shape than previously, which is key to absorbing developed market tightening should it move at a "surprise" pace.

Ms. Simon highlighted that some emerging markets countries such as Brazil and Russia have gone through recessions and seen growth decline, but are beginning to improve.

And with these markets in better shape, investors need not fear the Federal Reserve's move toward tightening monetary policy — with three interest rate hikes expected for 2018 and more beyond.

More than four years ago, then-Fed Chairman Ben Bernanke's first mention of tapering in May 2013 resulted in what's known as the taper tantrum, with the MSCI Emerging Markets index dropping 15.28% in the month following his comments.

"We hear a lot about the taper tantrum and that emerging markets (as an asset class) always crumbles when the Fed hikes or starts tightening," said Paul McNamara, investment director, emerging markets at GAM in London.

"That's not how we see it. There were two big emerging markets sell-offs in the last 15 years — both when emerging markets' balance of payments took a big shock," he added.

Those events were in 2008, when exports to the developed world collapsed and emerging markets struggled to finance themselves, and in 2013, when emerging markets imports ran ahead of what they could afford. Mr. McNamara said the taper tantrum was "the catalyst, rather than the cause" in that conditions already were right for an upset.

Ms. Simon also noted that, prior to 2013's taper tantrum, spreads were expensive and there were imbalances in these emerging economies. "Now it is the opposite," she said.

Always be important

What central banks do will always be "very important in emerging markets," said Jim Barrineau, co-head of emerging market debt at Schroders PLC in New York. "The one interesting thing is the Fed is almost alone in developed markets in steadily raising interest rates, which you would think would result in a stronger dollar, which would be negative for emerging markets. But in fact, the dollar has been remarkably stable I would say, as the Fed approached the December rate hike and priced it in." Mr. Barrineau said with the market expecting two further hikes — although the Fed is forecasting three — "the dollar is quite stable and that's provided a good environment for local currency investing in emerging markets."

Sources said there's another reason for the 2013 taper tantrum not to take precedent in investors' minds as the Fed moves further through its hiking cycle.

Investors do not, in general, appreciate two things, added Mr. Barrineau. "Generally, across the history of Fed hiking cycles the dollar has actually fallen instead of risen because the market is so anticipatory in terms of the hiking cycle. And the second is the yield curve as a result has aggressively flattened, which has helped the dollar remain relatively weak. So, when you think about the future impact of the Fed, I think it will really revolve on whether (it) will turn surprisingly hawkish. If it continues on the same path, then it might be a positive for the emerging markets," he said.

But while investors should not fear central bank moves in general for emerging markets, there is an exception: Mexico is potentially a hot spot in otherwise positive Latin American emerging markets since its "sensitivity to U.S. tightening creates a risk," said Asha Mehta, a senior vice president and senior portfolio manager at Acadian Asset Management, Inc. in Boston. Ms. Mehta said central bank tightening is one risk on its radar among others for emerging markets.

Still, the experiences of 2013 still haunt investors in or those considering allocations to the asset class.

Not a major headwind

"We think the Fed policy normalization shouldn't necessarily be a major headwind … in previous periods of Fed rate hike cycles or normalization, emerging markets assets continued to outperform. We saw that in 1994 to 1995, then in 1999 and again from 2004 to 2006 — (in) all three periods emerging markets continued to outperform,'' said Shoqat Bunglawala, head of the global portfolio solutions group for Europe, Middle East and Africa and Asia-Pacific at Goldman Sachs Asset Management in London.

"So worries about the effect the Fed can have on emerging markets is likely overinformed by the experience of the taper tantrum where U.S. TIPS were up 100 basis points pretty suddenly," Mr. Bunglawala said. "Our base-case view is we think this time is different to the taper tantrum because emerging markets are earlier in their cycle, have more spare capacity and continue to experience more robust growth."

He added the Fed is also taking a more systematic approach to hiking this time around.

But these reactions assume the systematic approach and signposts do their jobs. Sources said investors must still keep non-emerging market central bank policy in mind when considering their risk budgets and allocations.

"People are starting to be concerned that there are too few hikes built into the U.S. curve for the next year — markets are barely pricing a couple of hikes — and we expect three to four," said Arvind Rajan, a managing director and head of global and macro at PGIM Fixed Income, heading the fixed-income, global bond, emerging-markets debt, investment strategy and economic research teams in New York. "If we get more than the market expects … that's a source of some jitters."

Said Haidar, CEO and founder at Haidar Capital Management LLC in New York, agreed.

"If any of the central banks in the developed world start getting aggressive about raising rates," that will change an otherwise positive outlook, he said. "Three rate hikes next year of 25 basis points apiece is probably not enough," nor are moves by the European Central Bank to taper its own quantitative easing. "We need to see a sudden surge in inflation somewhere or a central bank hitting the breaks hard. But right now it looks good."

Samy Muaddi, portfolio manager in the fixed-income division at T. Rowe Price Group Inc. in Baltimore, characterized the Fed as an "exogenous driver. That is probably the No. 1 thing on our minds with respect to what if we're wrong on (our) constructive outlook. The ECB is unwinding asset purchases, Fed is tightening, China got tighter – the three most important central banks in the world have had a shift in their approach. That goes into informing how much of a risk budget you want to keep."

He said that while the importance of Fed policy on emerging markets cannot be understated, it is not directly correlated to the fundamental outlook of emerging market economies.

And any strengthening of the dollar should be taken seriously in terms of its impact on local currency debt, added Mr. McNamara.

"If the Fed does something that results in a stronger dollar, emerging market currencies always struggle." He said a 1% rise in the dollar vs. major currencies typically equates to a 1.4% rise against emerging market currencies. Mr. McNamara said he would be "more worried about the dollar than Treasuries."​