Fitch ratings is taking a cue for the world's biggest emerging market fund managers in saying this week that the big emerging markets are relatively safe from interest rate increases in the U.S.
Fitch expects the Federal Reserve to start raising interest rates this year. News of raising rates, coupled with a weakening euro because of the Greece crisis, has made for a stronger dollar. A strong dollar is bad for commodity producers like Brazil and Russia. Both countries are at a risk for a credit rating downgrade. Fitch currently has Russia's sovereign credit ranked BBB-, one notch above speculative grade. Brazil is BBB. Fitch ranks Brazil credit higher than its competitors at Moody's and Standard & Poor's.
"Fed tightening will exacerbate the macroeconomic and external financing pressures on emerging markets," the company said in a statement dated July 17. "Fears about a sudden reversal of capital inflows to emerging markets may be overdone. We do not expect a systemic crisis."
The ‘traffic light’ for emerging markets has now turned to Amber from Red, but a full reversal to Green is still some way off as the market is counting on the Fed to hike sooner rather than later. For investors, positioning is now so heavily skewed in favor of developed markets -- namely the U.S. -- that the eventual unwinding of central bank sponsored long positions will be
disorderly, especially in currency markets, says Jan Dehn, head of research at Ashmore Group, a $70 billion money manager in London.
In equities, emerging markets have underperformed for the past five years. The iShares MSCI Emerging Markets Index (EEM) is up 0.3%, while the QE-fed SPDR S&P 500 (SPY) is up 99.2% and the Vanguard MSCI Europe (VGK) is up 27.75%. Over the last 12 months, EEM is down 11% while SPY is up 8% and VGK is down 5%.
For risk assessment, however, investors tend to look at the bond market.
This narrative of developed market strength and emerging market weakness has survived despite overwhelming evidence to the contrary.
For example, the first bold forecasts of U.S. exiting QE appeared as early as 2011. Four years later, exit velocity and U.S. Fed hikes remain elusive.
How many ‘hard landings’ have been predicted for China in the past 10 years? At least one a year. The current market correction has happened before in China. Its equity market is not indicative of the real economy, not by a long shot.
India has gone from HSBCs "gasping elephant" back in 2012 to a two year bull market run and now a stable, investor favorite.
Russian sovereign bonds traded 700 basis points over Treasuries in December when the ruble went from the 30s to the 70s. But that changed, and seemingly overnight. The ruble is now in the high 50 to one range and its debt to GDP ratio is still below 20%. Currency reserves have been trimmed during the last year of crises, but they still exceed $350 billion; more than enough for Russia to service its debt.
Default rates in emerging market corporate high yield markets fell to less than half their historical average by the end of 2014 when the consensus predicted then was that forex mismatches would destroy the corporate bond market there in a strong dollar environment. What has happened to all the crises predicted for emerging markets? "Looking back, each was an over-reaction," says Dehn.
Dehn thinks the dollar won't remain strong for long.
Surprise inflation and a Fed reluctance to stamp it out means that the yield curve has to steepen. This will immediately threaten a newly re-inflated housing bubble in some cities, especially around Silicon Valley. Another housing crisis is not likely to go down well in Washington, so a wave of financial repression will be required to head off a ‘blow up’ in the long end of the curve, says Dehn. "We envisage that new rules – such as
minimum duration requirements and other devices – are likely to be employed to keep term yields low in the U.S.," he says. The combination of low policy rates and depressed term yields amidst rising inflation combine to push down real yields, which can mean only one thing for the dollar: it drops. And that will be good news for the big commodity exporters like Brazil.
