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Which emerging markets funds are most exposed to another Fed shock?

10 September 2014

Fitch has identified a number of emerging markets that would be hurt by aggressive rate rises by the Federal Reserve. FE Trustnet looks which emerging market debt funds have the most exposure to these countries.

By Gary Jackson,

News Editor, FE Trustnet

Approximately half of the funds in the IMA Global Emerging Market Bond sector have exposure to the countries most at risk from another surprise from the Federal Reserve’s monetary policy, according to a recent FE Trustnet study.

Bond and equity markets were rattled last year in the "taper tantrum" that followed then Fed chairman Ben Bernanke’s warning that the central bank would start to consider withdrawing quantitative easing, which at the time was pumping $85bn a month into the market.

Emerging market debt (EMD) was hurt more than most asset classes as investors pulled back from areas susceptible to the Fed’s tapering – the JPM GBI-EM Global Composite index dropped by close to 18.21 per cent between 22 May, the date of Bernanke’s initial comments, and 1 January this year.

Performance of indices during "taper tantrum"

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Source: FE Analytics

In an analysis of the risks surrounding the Fed's monetary normalisation plans, ratings agency Fitch has identified several developing nations whose debt markets would be most exposed to a highly negative interest rate shock scenario were US interest rates to rise higher and more rapidly than expected.

Fitch argues that emerging markets with large external financing needs, low foreign reserves, high levels of leverage, vulnerable debt structures, weak policy frameworks or political fragilities would be most at risk from a new shock.

Countries displaying these characteristics include Turkey, Mongolia, Ukraine, El Salvador, Hungary, Lebanon and Jamaica.

"Financial markets may not be fully prepared for higher US interest rates, despite the Fed's forward guidance. Current low volatility and high asset prices suggest markets have not priced in much uncertainty. Therefore, in our 'shock' scenario, the spill-over effects to the rest of the world could be substantial,” Ed Parker, head of EMEA sovereign ratings at Fitch, said.

Turkey is one of the larger EMD markets and this is reflected in the number of funds that own the country’s bonds.

Data from FE Analytics shows 16 of the 27 funds in the IMA Global Emerging Market Bond sector hold Turkish debt, 12 of which have more than 5 per cent of their portfolios in the assets.

James Barrineau and Rajeev de Mello’s $25m Schroder ISF Emerging Market Local Currency Bond fund has the most exposure to Turkey in the sector, at 9.9 per cent of AUM.


In their latest update, the managers said: “In higher yielding countries like Turkey and South Africa, we have reduced duration to mitigate volatility in rates, which tend to correlate to currencies in market sell-offs.”

“Rates in these countries remain highly attractive relative to the rest of the asset class and we expect to remain overweight in these countries for a considerable period; fundamentals remain stable and external deficits continue to modestly decline.”

Other portfolios with more than 5 per cent in Turkey include Thanasis Petronikolos' $139.4m Baring Emerging Markets Debt Local Currency, Peter Eerdmans and Werner Gey Van Pittius' £1.5bn Investec Emerging Markets Local Currency Debt and Simon Lue-Fong's $7.9bn Pictet Emerging Local Currency Debt funds.

Hungary is another country that many EMD funds have exposure to. According to FE Analytics, 10 funds in the sector hold Hungarian bonds, although only two have more than 5 per cent exposure.

A recent note by Capital Economics highlighted a number of risks facing Hungary, aside from the Fed’s policy, saying its high level of external foreign currency debt makes it vulnerable to swings in the forint and could push its central bank to lift rates from their record lows sooner than expected.

Neil Shearing, chief emerging markets economist at the consultancy, said: “It's possible that a fresh sell-off in the currency – perhaps caused by an unforeseen spike in global risk aversion – could yet force the [Magyar Nemzeti Bank] to raise rates faster than we expect. But for now our central forecast is that rates will remain at record lows for at least another year.”

Baring Emerging Markets Debt Local Currency is the fund with the most exposure to Hungary, at 6.9 per cent of AUM. The MFS Meridian Emerging Markets Debt Local Currency fund, meanwhile, has 5.2 per cent in the country's debt.

Ward Brown and FE Alpha Manager Matthew Ryan, who run the MFS fund, addressed the impact that changes to Fed policy will have on their asset class, but highlighted the support coming from other major central banks.

“If US economic activity continues to improve, and the Fed’s forward guidance takes a more hawkish tone as a result, Treasury yields are likely to rise, creating a headwind for EM debt and other bond sectors. How EM debt fares in this scenario would depend on the speed and size of the rate movement,” the managers said.

“We are inclined to expect a more muted and gradual move in Treasury yields this year than last year, when the magnitude of the rate spike prompted a wave of selling that pushed EM spreads wider.”

“Outside the United States, developed market monetary policy generally remains accommodative, helping to sustain the ‘lower for longer’ expectations of ample liquidity that have fuelled a reach for yield in EM debt.”

“While the tapering of quantitative easing and stronger US economic activity raise the prospect of Fed rate hikes, the European Central Bank and the Bank of Japan seem likely to maintain an easing bias.”

Funds in the IMA Global Emerging Market Bond sector have little exposure to the other countries highlighted by Fitch as being vulnerable to an unexpected move by the Federal Reserve.

The $6.1bn Pimco GIS Emerging Markets Bond fund, which is managed by Michael Gomez, has 2.5 per cent of its portfolio in debt issued from El Salvador, making it the only fund in the sector exposed to the country. It also has 4.9 per cent in Turkey.

Simon Lue-Fong's $5.9bn Pictet Global Emerging Debt fund is the only sector member with an allocation to Lebanon, at 4.5 per cent of its AUM. It also has 4.3 per cent invested in Turkish bonds and 4.2 per cent in Hungarian bonds.


Fitch’s analysis adds that the shock scenario of faster and higher interest rate hikes is currently not the most likely outcome, which would be beneficial to markets. Analysts expect the Fed to start to lift rates around the middle of 2015.

“Our base case is for the Fed to gradually tighten monetary policy over the next 12 months, in line with its forward guidance,” the ratings agency said.

“Raising interest rates and unwinding QE will trigger some increase in financial market volatility, but we do not expect it to fundamentally destabilise global growth or financial markets.”

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