Investors are exhibiting an extraordinary amount of complacency about the impact of rising interest rates in developed market on emerging markets, taking on a reckless amount of risk, according to some managers.
Andrew Swan, manager of the GLG Asia (ex Japan) Equity fund for Man GLG, said investors are failing to grasp how deep the potential falls across emerging markets could be. if two simultaneous factors come to the fore.
One is the slowing growth in emerging markets, while the other is the policy tightening in developed economies, particularly the US.
Swan said: “It is very unusual to find a period where inflation is higher in developed markets than emerging markets.
“Strengthening developed market currencies, particularly the US dollar, are really challenging for large parts of emerging markets,” he added, because quantitative tightening would reduce the amount of US dollar liquidity, which these markets are very sensitive to.
Sacha Chorley, portfolio manager at Quilter Investors, noted that, as a rule of thumb, emerging markets and their economies tend to perform well when the dollar is weak as this lowers the cost of borrowing.
David Rees, Schroders’ senior emerging markets economist, pointed out that the last time the US attempted to reduce its balance sheets in 2018 emerging markets suffered.
“If quantitative tightening (QT) dampens dollar liquidity it could expose emerging markets that rely on inflows of foreign capital to fund external deficits, forcing a reduction in imports and ultimately a deceleration in economic growth,” he said.
According to Rees, the main thing to look out for is higher US Treasury yields as a result of the changing financial policy because there is a “clear relationship” between these and emerging market capital flows.
“Should QT result in much higher Treasury yields, emerging market inflows and growth could suffer,” Rees said.
Signs of rising interest rates in developed economies have been growing for some time in line with rampant inflation, with the Bank of England making the first move at the end of last year, moving rates up to 0.25%.
Further rate hikes are expected and the Federal Reserve is also likely also to increase rates after a note from the latest meeting revealed its plans to cut back on its bond buying, interpreted by many that it would be raising rates in 2022. Some analysts have forecast at least three rate hikes from the US central bank this year.
This negative impact is a very real concern, not just among investors, but the leaders and policy makers of developing economies.
China’s president, Xi Jinping, warned the US and Europe of the negative impact a rapid rise in interest rates could have on the global recovery from the Covid pandemic.
In a virtual speech at the opening of the World Economic Forum’s Davos Agenda, which was held online for the second year in a row, the president called for a coordinated economic policy from global leaders to prevent the global economy backtracking on its progress.
“If major economies slam on the brakes or make major U-turns in their monetary policies there will be serious negative spill overs. They would present challenges to global and economic financial stability and developing countries would bear the brunt,” the president said.
Not everyone was as worried about the impact of rising interest rates though. When asked about the effect on his various Asia Pacific funds Baillie Gifford’s Roderick Snell, said that economies in the region are used to running at higher levels of inflation and therefore interest rates “as they’ve typically been higher in the past decade”.
“There will be some headwinds, but I actually think Asia is relatively well positioned versus the rest of the world at the moment on dealing with inflation,” he said.
Chorley added that the massive fiscal policies put in place by emerging market governments during the initial 2020 outbreak have “started to trickle into their economies”, boosting consumer spending – a major positive for the region.
For investors who were concerned though, Swan said that there were investment opportunities in the recovery trades for markets just coming out of Covid, areas such as Southeast Asia and India.
Indian telecommunications company, Bharti Airtel, was one company he was particularly excited about as it is one of three main players in the growing sector “and one of the other players is struggling”, he said.
Since there are so few companies with decent offerings for the customer and investors in this space “this is an exciting idiosyncratic opportunity that has nothing to do with the economy or what is happening with central banks around the world,” Swan added.
“Opportunities can also still be found in China, where some state-promoted industries are thriving,” he said, such as the growing electric vehicles space.
“The adoption of technology in China is always fast and we're seeing incredible acceleration in the penetration rates of electric vehicles there, helped by investment from the government, which is critical,” the manager said.