PERSPECTIVES. Fed tightening will impact some emerging markets more than others April 2015

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1 PERSPECTIVES Fed tightening will impact some emerging markets more than others April 2015 The US Federal Reserve has recently hinted that it could begin raising US interest rates as early as June. This would represent the first step in a new rate tightening cycle, which is likely to have an impact on both emerging economies and emerging stock markets. In this article, investment professionals Guilhem Savry and Gael Combes argue that a normalisation in US policy is not all bad news for emerging markets even if the initial reaction is negative. Specific emerging markets with better fundamentals and a high sensitivity to US economic growth should outperform their peers. However, it is a period that will see greater dispersion in returns across emerging market geographies and sectors. There will be winners and losers. Investors will also need to tackle the risks currently associated with emerging markets; rising leverage, slower growth, governance and political risk. To this end, a fundamental risk-based approach to investing is essential to making the distinction between the winners and losers and helping achieve outperformance for investors. Guilhem Savry is an Investment Manager in the Cross Asset Solutions team Normalisation in US monetary policy should be seen as good news The US Federal Reserve (Fed) is likely to start normalising its monetary policy in the coming months. The good news is that the Fed has excellent reasons for doing so. Much has changed in the US economy since the Fed introduced unconventional measures in November The labour market is now tight US non-farm payrolls averaged at 268,000 over the last twelve months a historic high. In the past, the Fed raised its main monetary policy rates between six months and two years after the reversal in the payroll trend, as Chart 1 shows. In the current cycle, although the US economy started creating jobs in Q4 2010, the Fed has not normalised its monetary policy yet. Therefore, the current real Fed rate seems abnormally low compared to the strong improvement in the labour market that has occurred since the financial crisis. Chart 1: US employment and real Fed rates '000 US Non Farm Payroll Real Federal Rates (Rhs) Source: BLS, Fed, % Gael Combes is a Fundamental Analyst in the Equities team Summary 1. Emerging market equities have historically been affected by shifts in US Fed policy. 2. The US Fed has sent two signals: first that it will shift US monetary policy in 2015 and second that rate tightening will be less steep than in the past. 3. A fundamental risk-based approach can allow efficient active stock discrimination to smoothen the negative impact from rising US interest rates. Read more of our publications online: Unigestion SA I 1/8

2 2. Deflation risks in the US are diminishing The main explanation behind the Fed s currently accommodative stance is the low level of US inflation. Over the last six months, the large decline in the oil price has pushed down US inflation. However, other components of US inflation such as food, housing and medical components accelerated in In our view, the headline disinflation will quickly reverse with oil price stabilisation. Moreover, wage pressures respond with a lag and in a non-linear fashion, as Dallas Fed President Richard Fisher highlighted recently. The tightening labour market should, therefore, be supportive of higher inflation in the coming months. 3. The global context is improving Another reason for optimism regarding global growth is the upswing taking hold in the Euro area. In the minutes of the September meeting, the Fed members expressed concern that the persistent shortfall of economic growth and inflation in the euro zone could lead to a further appreciation of the dollar and have adverse effects on the US external sector. Six months later, the European economy shows several signs of recovery thanks to the ECB s actions, a lower currency and the significant decline in energy prices. US policy normalisation will impact emerging markets through multiple channels The fact that this event will impact emerging markets should not be too surprising; US monetary policy has an important role to play in relation to asset performance due to both the size of the US economy relative to the world economy and the credibility of the Fed. Monetary policy affects both the economy and asset prices through different channels. However, as the IMF highlighted in a recent working paper about the spillovers from Fed policy on emerging markets, it is important to differentiate between the conventional monetary policy environment and the unconventional monetary policy environment. 1 The channels of transmission are different for each. US monetary policy has an important role to play in relation to asset performance due to both the size of the US economy relative to the world economy and the credibility of the Fed. 1. Monetary policy channels of transmission Historically, conventional monetary policy can affect stock market valuations through different channels: The interest rates channel: A change in real interest rates affects the cost of capital, causing a change in investment spending and consumption, thereby leading to a rise or a fall in output. The exchange rates channel: A change in real interest rates affects the value of the currency through the change in the spread between domestic deposit rates and the deposit rate denominated in foreign currencies. This change in the value of the currency affects the current account and, therefore, global output. The wealth effect channel: A person s household wealth is perceived to rise if the assessed value of their home increases or the stocks they own go up in price. In aggregate this increase should raise consumption and global output. 1 IMF WP14/240: Spillovers from United States Monetary Policy on Emerging Markets: Different This Time? Jiaqian Chen, Tommaso Mancini-Griffoli, and Ratna Sahay Read more of our publications online: Unigestion SA I 2/8

3 2. QE channels of transmission The introduction of quantitative easing (QE) and other unconventional policy across the world has changed the paradigm. The result has been the modification of the monetary policy transmission mechanism. We identify three channels through which QE can affect asset prices. Fratzscher et al. (2013) 2 provides a summary of the main channels of transmission, which are as follows: The portfolio balance channel: This operates in the global economy. QE involves the purchase of longer-duration assets. This reduces the supply of such assets to private investors and affects the term premium of long-term interest rates, therefore, increasing the demand for risky assets, such as emerging market equities. Another example of this channel is the US Treasury market which has benefited the most from this trend. In a world of zero rates, investors have expanded their geographical allocation and, therefore, moved from low to higher yielding countries (without necessarily downgrading their sovereign risk). This has given way to a new conundrum as yields have remained very low in the US despite the QE exit from the Federal Reserve and its declared willingness to increase rates following the significant US economic recovery. The signalling channel: QE can also have an impact on cross-border portfolio flows and asset prices via the signalling channel. If QE is taken as a commitment by the Fed to keep future policy rates lower than previously expected, then the risk-neutral component of bond yields may decline. This also benefits risky assets. The recent competitive easing implemented by central banks across the world is evidence of this channel. The liquidity channel: QE can affect portfolio decisions and asset prices by altering the liquidity premia. This is the liquidity channel: there is a decline in the liquidity premium, which encourages banks to extend credit to investors, including cross-border lending. This channel has been the least efficient over the last three years. The introduction of quantitative easing (QE) and other unconventional policy across the world has changed the paradigm. The result has been the modification of the monetary policy transmission mechanism. History confirms the effects Fed tightening has on emerging equity markets Let s take a look at how theory has worked in practice by analysing the past impact that Fed rate hike cycles have had on emerging market equities. We will use MSCI indices both at a geographical level and at a sector level in this analysis. We will look at the performance of both in the previous Fed rate hike cycles (1994, 1999 and 2004) and in 2013 to take into account the effect of the channels that we just defined as being associated with unconventional monetary policy. Impact at a geographical level Historically, the initial reaction of emerging market equities to a tightening in the Fed s monetary policy has been negative due to the interest rates channel. However, as you can see in Table 1, while the MSCI Emerging Market index declined during 1994, 1999 and 2004 on average by -5.4% three months following the first rate hike, there was a significant dispersion in returns between emerging market countries. For instance, China, Indonesia, Mexico and Poland were the worst performers while India, South Africa and Korea outperformed. Historically, the initial reaction of emerging market equities to a tightening in the Fed s monetary policy has been negative due to the interest rate channel. 2 ECB WP 1557: On the international spillovers of US Quantitative Easing. Marcel Fratzscher, Marco Lo Duca and Roland Straub Read more of our publications online: Unigestion SA I 3/8

4 Over a longer period, with the exception of China and Indonesia, the performance of emerging market equities was on average positive one year after the first Fed rate hike. The growth effect which initially led the Fed to shift the direction of monetary policy seems to have compensated for the interest channel effect. However, the tapering period that occurred between May and June 2013 stands out from other periods of Fed normalisation. During this period, the bulk of emerging equity indices were still in negative territory one year later, exemplifying the new role of the portfolio balance channel brought about by QE. Over the longer period The growth effect which initially led the Fed to shift the direction of monetary policy seems to have compensated for the interest channel effect. Table 1: Impact of Fed monetary policy normalisation on emerging equity markets, MSCI indices in USD, % Change in Fed Funds rate (in bps) MSCI China MSCI Korea MSCI Taiwan MSCI Brazil MSCI South Africa MSCI India MSCI Russia MSCI Mexico MSCI Malaysia MSCI Indonesia MSCI Turkey MSCI Poland MSCI Emerging Markets Source: MSCI, Impact at a sector level The impact of Fed normalisation at a sector level appears to show wide dispersion across sectors. Moreover, cyclical sectors outperformed due to the positive growth outlook implied by Fed normalisation. Consumer discretionary and materials gained 10% on average over the three months following the first rate hike while financials, telecoms and IT were negative over the same period. Read more of our publications online: Unigestion SA I 4/8

5 Table 2: Impact of Fed monetary policy normalisation on emerging market equities, MSCI indices in USD. % Change in Fed Funds rate (in bps) MSCI EM Energy MSCI EM Consumer Discretionary MSCI EM Financials MSCI EM Consumer Staples MSCI EM Materials MSCI EM Healthcare MSCI EM Information Technology MSCI EM Industrials MSCI EM Utilities MSCI EM Telecoms MSCI Emerging Markets Source: MSCI, USD, Unconventional policy will reduce the pace and length of policy normalisation Unconventional policy started by the Fed in 2009 will impact the pace and length of policy normalisation this time around. Forward guidance offered by the Fed in March indicated that the next rate hike cycle could last two-and-a-half years and will likely push Fed rates from 0.25% currently, to 3.125% by the end of Furthermore, these projections differ considerably from market expectations based on the Fed Funds market rate: expectations are for an even lower terminal Fed rate of 2.25% due to the weak expected inflation outlook. Either way this time the process will be longer and less steep than in previous periods of policy normalisation, as illustrated in Table 3. Table 3: Last three rate hike cycles and pricing-in for the next one Last rate hike cycle Next rate hike cycle priced by the market Next rate hike cycle based on the Fed First Fed move date Last Fed move date Duration (in days) Starting Fed rates Ending Fed rates Cumulative move (bps) Source: Fed, Bloomberg, This will affect how emerging markets digest the first Fed rate hike. In the latest Fed statement it appears that the Fed has shifted from patience to flexibility. It sends two signals: firstly that the turn in monetary policy will take place this year and secondly that it could be less steep than in the past. In our view, the first element should moderate the negative impact on risky assets that has been historically observed after the first Fed rate hike. This includes emerging market equities. In the latest Fed statement it appears the Fed has shifted from patience to flexibility. It sends two signals: firstly that the turn in monetary policy will take place this year and secondly that it could be less steep than in the past. Read more of our publications online: Unigestion SA I 5/8

6 Empirical research supports these findings There is plenty of academic research that supports our discussion on the impact of Fed policy transmission channels on emerging markets. The major conclusions are: 1) Solid fundamentals act like protection; 2) Liquidity and size of financial markets act as an accelerator; 3) Emerging currencies tend to strengthen when US monetary conditions are eased. The winners and losers at a country level There will be winners and losers, which was demonstrated during the taper tantrum episode experienced in 2013 the last significant shift in Fed monetary policy. At the time the market s reaction was exacerbated due to expectations that US rates would not rise anytime soon. As emerging market fundamentals have changed little since then current account and budget deficits still remain in place we are likely to see a similar set of winners and losers. There will be winners and losers, which was demonstrated during the taper tantrum episode experienced in 2013 the last significant shift in Fed monetary policy. The winners Large current account surpluses: These countries will benefit from solid fundamentals such as a large current account surplus and a limited budget deficit. This combination will prevent large capital outflows and pressure on the currency. Two countries that currently stand out are Taiwan and Korea. Both countries currently have the largest current account surpluses in the emerging markets at 12% and 6% of GDP, respectively. Meanwhile, China has slipped from 10% in 2007 to 2% today. Some countries have embarked on structural reforms lately that should boost growth in the medium-term and reduce imbalances. India is the best student and can afford to push pro-growth reforms. Mexico has announced significant reforms in the energy sector, but the low oil price makes it more difficult to deliver results quickly. Indonesia is a wild card as political interferences make it challenging for the new president, but progress is being made. On the other hand, Brazil and South Africa need to push for fiscal consolidation and this will slow growth further. The Petrobras scandal is only making things harder for the government in Brazil. Strong export demand from the US Some countries naturally have higher exposure to the US economy. Mexico for instance generates more than 20% of its GDP from exports to the US. However, China is rebalancing its economy away from external demand and towards consumption. Additionally, the destination that its exports go has evolved away from the US. Therefore, it is only mildly benefitting from the US recovery as exports are now only marginally contributing to growth. In addition, its currency peg has made the yuan appreciate versus countries competing in the same export categories, such as Turkey. Thus, currency depreciation with a European recovery China s main trading partner would be necessary to move the needle on the trade side. Read more of our publications online: Unigestion SA I 6/8

7 The losers Large current account deficits These countries are very dependent on external financing to sustain their economic growth and will have to shrink this deficit or face continuous currency pressure and higher inflation. Turkey (-6%), South Africa (-5%) and Brazil (-3.9%) remain vulnerable on that front. Exposure to commodities A strong US dollar and a slowdown in China are putting pressure on commodity prices. Brazil (soft commodities and iron ore) as well as South Africa (coal, gold and platinum) are the most exposed as export volume growth remains muted and unit prices have declined sharply. A high portion of the equity and bond market held by foreigners Besides the liquidity and the size of a specific market, this indicator has to be taken into account in the process of discrimination. Effectively, compared to domestic pension funds, this money is much more likely to retreat in light of higher rates in the US. Malaysia and Indonesia stand out with large foreign ownership (more than a third of the market) of their bond market but also in some large cap equities. Chart 2 shows the country positioning of our Uni-Global Equities Emerging Market fund based on our quantitative and fundamental approach. The fund has been underweight Brazil, South Africa and Turkey since the second half of In addition, we have been completely avoiding countries like Russia (due to state intervention in large sectors and the Ukrainian crisis) and Egypt (the political system is not working) for some time now. Chart 2: Winners and losers geographic breakdown China South Korea Taiwan Mexico Malaysia India Thailand Brazil Indonesia Peru Czech Republic Chile Poland Turkey Philippines South Africa Russia Qatar Colombia UAE Greece Egypt Hungary Hong Kong 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% MSCI Emerging TR Net Winners Uni-Global - Equity Emerging Market SA-USD Losers Source: Bloomberg, Unigestion Read more of our publications online: Unigestion SA I 7/8

8 The winners and losers at a sector level Sectors in emerging markets are more difficult to assess due to their high heterogeneity (regulation, state owned enterprise monopoly, etc.). However, some global sectors such as technology and healthcare are structural beneficiaries of increasing demand in emerging markets for these products. On the other hand, most banks will see their cost of funding increase and utility and telecom stocks will have to have an attractive dividend proposition. Typically, companies with low top-line growth, low dividend growth and a high pay-out ratio will likely be under pressure (such as telecoms in Taiwan or Malaysia). At the company level, exporters sourcing domestically and located in weaker countries (subject to currency devaluation) will become more competitive versus their global peers. Investors should adopt a fundamental risk-based approach Emerging markets are offering better prospects than their developed peers in terms of demographics, urbanisation trends and credit penetration. However, risks are much higher and investors have to make sure that their investments keep the seatbelt fastened. Currently, emerging market equities are challenged by rising leverage, lower growth than in the past due to the deleveraging process in developed countries and US monetary policy changes which will occur in Emerging market equities are a very heterogeneous asset class and not a true single market at all. Given this, we believe that Fed tightening risk has been a major topic for emerging markets since mid-2013 and will continue to remain a driver in In addition, there are other long-lasting risks in emerging markets, namely politics and governance. 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