Impending interest rate hikes from the Federal Reserve shouldn’t deter people from investing in emerging markets, according to UBP’s Koon Chow (pictured). 
The senior macro and foreign exchange strategist says investors often correlate an increase in interest rates with increased volatility in emerging markets, following 2013’s ‘taper tantrum’, which was caused by then-Federal Reserve chair Ben Bernanke’s announcement that quantitative easing would be brought to an end.
Since the taper tantrum to date, the MSCI Emerging Markets index has struggled to redeem its performance and has lost 10.8 per cent, significantly underperforming other indices including the S&P 500, MSCI World and FTSE All Share.
Performance of indices since taper tantrum
Source: FE Analytics
However, Chow remains relaxed about rate hikes, which are expected to be put into place by the end of this year or the start of next year, and says that fears surrounding the move are unwarranted.
“Fear itself is the biggest problem – people have seen previous rate hikes and they’ve associated this with bad things in emerging markets. That’s an assumption that I hear from a lot of people, all the time,” he said.
“Whenever there’s been a Fed rate hike it always means pain for emerging markets, according to a lot of investors. That’s amusing because, even when you show them evidence of previous Fed rate hikes that haven’t led to pain in emerging markets but have actually triggered rallies, you still get that same response and that’s denial.”
Chow and the team at UBP are also relaxed about rate hikes because they have been telegraphed well.
“Since it was telegraphed by Bernanke in 2013, the amount of money that’s gone from US portfolio investors to emerging markets in various channels has been low. Even if you do get surprise in terms of it being faster or more aggressive than expected, [the rate hike’s] ability to suck money back into the US is somewhat limited,” the strategist explained.
Another reason that Chow believes nerves are misplaced is that the vast bulk of countries and large companies borrow on five to 10-year time horizons as opposed to putting out more short-dated bonds, which are more vulnerable to the effects of a rate hike.
“In the five- to 10-year part of the curve, there are a lot of drivers at the moment – monetary policy and US inflation is only one part,” he pointed out.
“Another big part is global monetary policy and global inflation and, on those counts, you’ve got a lot of things that are anchors on yields.”
“I think that the likelihood that five to 10-year US treasury yields go up much from here in the next 12 months is limited, which means that the funding increase for emerging markets corporates and sovereigns is limited, which means that the impact of that on their economies is limited.”
Chow says the importance of the actual reason behind an interest rate hike is often over-looked: an increase in rates means that the Fed is comfortable with US growth and this is typically helpful for riskier assets.
Historically, a boost in US growth has led to a greater demand for goods and services, and a vast proportion of emerging markets’ revenue is derived from that area.
“Stronger US growth is also good for prices of US risky assets, which are an anchor for EM assets,” Chow said.
“If you look at the history of US yields and US corporates, the low-rated corporates and their spreads, you actually find that there’s a negative relationship. When US yields have gone up during the cyclical upswing, those spreads have come down and, in fact, those spreads have come down from the riskier US corporate bonds more than the yields have gone up. So net/net, the bond yields of those risky companies have actually come down.”
“That’s important because US corporate bonds are a reference point for corporate bonds around the world – developed markets as well as emerging markets. So even if you think the economic channel doesn’t exist, ie hypothetically the US does well and doesn’t actually consume anyone else’s goods and they spend on what’s made at home, you’ve still got a portfolio channel, which is important.”
However, Chow adds that there are still headwinds facing emerging markets that investors need to be wary of.
One of the significant challenges impacting the market at the moment is the narrowing gap between developed market and emerging market growth, according to the strategist.
According to FE Analytics, the MSCI Emerging Markets index has outperformed the MSCI World index by 192.31 percentage points over 15 years to provide a return of 274.1 per cent. Much of this was due to investor expectations of stronger economic growth from emerging markets.
Performance of indices over 15yrs
Source: FE Analytics
However, since the start of the year, the MSCI Emerging Markets index has lost 2.75 per cent, which is 6.61 percentage points less than the MSCI World index. As well as fears over the Fed rate rise, one factor behind this was slowing growth in key emerging economies such as China.
“The key thing that drove people into emerging markets and different markets in the first place was, in the post-financial crisis period, the expectation that they would deliver superior growth and the gap between emerging market and developed market growth at the moment is one of the lowest we’ve seen in a decade,” Chow said.
“The gap is narrow: EM growth on average is around 4.5 per cent, developed market growth on average is around 2.5 per cent, so a 2 percentage point differential. In the past it’s been significantly higher. That’s the most pressing issue – that’s more likely to hold back money going into emerging markets.”
On a country-by-country basis, the strategist points out that many of the major economies have “idiosyncratic stories” that are proving difficult to work through and create uncertainty over how these issues will affect asset prices.
“China – the combination of pro-progress reform on the one hand, and slowdown, the slow manufacturing and housing sector on the other and how that pans out. You’ve got Russia of course going through a recession, and the question mark over the geopolitical dimension – what happens from here? You’ve got Brazil and the corruption scandal, I’m not sure whether it’s over and what that means for political stability. Those are the big major themes that are going to dominate people’s attentions.”
Despite the headwinds, Chow says there is far less for investors to worry about than they think.
He adds that the strength in capital expenditure from the eurozone has given emerging markets a boost.
“If the European capex is weak, as it has been, that means the manufacturers in emerging markets have a very difficult time. That’s been why Asian exports have been terrible, whereas if European capex finally does have life, it’s helpful,” he explained.
“The European car sales numbers are meaningful. If they’re going to remain strong then the eastern European car producers are going to be in better shape and some of the Asian car producers are going to be feeling the benefits as well. Let’s not forget that Mexico is a huge car producer as well – the fourth largest in the world.”
“Don’t get me wrong, emerging markets have their challenges, but we are more relaxed about a lot of factors than other investors are.”
