Are Higher Interest Rates Bad for Emerging Markets?

As developed nations’ economies recover, interest rates are heading higher, representing a further potential headwind for emerging markets. Higher rates are typically seen as a negative for emerging markets, as they increase dollar-denominated debt burdens, trigger capital outflows and result in tighter financial conditions.

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    Are Higher Interest Rates Bad for Emerging Markets?

    Are Higher Interest Rates Bad for Emerging Markets?

    Emerging market economies have been challenged by longer wait times to receive COVID-19 vaccine supplies and by their limited ability to use fiscal stimulus to counteract the economic drag of the pandemic.

    As developed nations’ economies recover, interest rates are heading higher, representing a further potential headwind for emerging markets. Higher rates are typically seen as a negative for emerging markets, as they increase dollar-denominated debt burdens, trigger capital outflows and result in tighter financial conditions.

    According to the International Monetary Fund (IMF), the impact of higher interest rates in the U.S. on emerging markets may depend upon the reason driving rates higher. In the IMF’s view, if rates are climbing due to strong economic growth, then emerging markets may actually benefit from the increased demand for exports of commodities and other products. However, if higher rates are due primarily to more hawkish central banks, they can prove harmful to emerging markets.1

    A comparable study by the Federal Reserve (the Fed) last year came to a similar conclusion, but dove a bit deeper. It studied the impact of higher Treasury yields on local currency bond yields, equity indexes, Credit Default Swap (CDS) spreads and currencies. The Fed’s analysis found that the impact of higher rates, whether due to economic growth or monetary policy, differed substantially between “low vulnerability” markets and “high vulnerability” markets. (Vulnerability as measured by a composite of inflation, current account deficits, international reserves, government debt, external debt and private sector credit growth.)2

    The Imperative of Country, Sector and Security Selection

    Last year, the top-performing emerging market, Czech Republic (+49.3%), outpaced the biggest emerging market in the MSCI-EM index, China (-22.8%).3

    With markets as inefficient and disparate as emerging markets, and each market subject to idiosyncratic economic, political and social factors, an experienced, active manager is best positioned to navigate these markets to find opportunity or sidestep risk.

    The principal caveat with an index approach to emerging market investing is that there is little scope to respond to fluid market-moving developments. For instance, the MSCI-EM index has a China weighting of over 32%, a substantial exposure to a country that has underperformed in recent years and is grappling with reining in its biggest private sector success stories. Index investors are passively anchored to this substantial potential risk.4

    We’ve written previously on emerging markets suggesting some caution about its long-term investment value. Nevertheless, emerging markets do provide periods of outperformance that may best be tapped by an active manager.

    Sources:

    1. https://blogs.imf.org/2021/04/05/how-rising-interest-rates-could-affect-emerging-markets/
    2. https://www.federalreserve.gov/econres/notes/feds-notes/are-rising-u-s-interest-rates-destabilizing-for-emerging-market-economies-20210623.htm
    3. https://www.msci.com/end-of-day-data-regional
    4. https://www.msci.com/documents/10199/c0db0a48-01f2-4ba9-ad01-226fd5678111

    Please reference disclosures: https://blog.americanportfolios.com/disclosures/

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