The Federal Reserve’s decision in January to continue reducing the pace of asset purchases has put emerging markets in a bind.
At the end of January, the Federal Reserve decided to further reduce the pace of its monthly asset purchases by another $10 billion, down to $65 billion. This followed its December decision to initiate “tapering” and reinforced the market expectation of future reductions over the course of 2014. Leading up to the meeting, emerging market currencies had dived, with the Turkish lira and South African rand hit hard.
The prospect of a less accommodating US monetary policy seemed to prompt investment flow reverses away from emerging economies. But those economies still offer solid investments.
Tide turns on emerging markets
In response to large currency movements, the central banks of developing countries have reacted with force — raising rates in the hopes of bolstering demand for their currency and taming inflation. Following a 10% slide in the lira, the Turkish central bank raised two benchmark rates, bumping the overnight lending rate from 7.75% to 12% and the one week repo from 4.5% to 10%. The Indian central bank made a similar move, surprising investors by hiking its benchmark up 0.25% to 8%.
Reacting to these worldwide developments, the South African finance minister commented that it was “regrettable” that the Fed had not taken emerging market volatility into account in its deliberations. Instead, the Fed’s January statement gave little indication that the plunges in various currencies had affected its decision.
While US interest rate hikes remain a distant prospect, this step-by-step reduction in asset purchases will slowly bring the US back into a more normal interest rate environment. An improving US economy coupled with rising rates could make investments in emerging economies less desirable, prompting large corrections in cash flows back to the developed world.
To prevent this, emerging economy central banks have to decide whether giving immediate support to the economy is worth the potential hindrance to growth of higher interest rates. The bond giant Pimco sees these central bank responses to currency depreciation as “further postponing EM growth recovery.” Yet, while the global growth balance has shifted back to developed countries over the past year, there still remains opportunities for investors to make a solid return on emerging markets.
Persistent low US rates, not emerging market crisis
For one thing, the current low rate environment will be in place for at least another year in the US. In December, the Fed changed its forward guidance to indicate that “it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent.” This reaffirms that 6.5% remains a threshold upon which the Fed might begin to consider rate increase. In addition, the low inflation readings in the US make it harder to justify rate hikes. The personal consumption expenditure price index rose just 1.2% over the past year, well short of the Fed’s two percent target.
In addition, the Fed believes it has the tools to properly manage a gradual raising of interest rates. Currently, US banks hold just over $2.4 trillion in excess reserves at the Fed. This has raised inflation concerns over what may happen when banks decide to lend that money out. But the Fed believes its ability to pay interest rates on reserves as well as its reverse repo tool will allow it to adeptly manage both inflation and rates. This confidence will make it less likely for interest rates to shoot up quickly, thereby prolonging low returns on US bonds as well as fostering a more stable global market. Both of these make emerging markets a still promising bet.
Furthermore, the recent run on those economies is not necessarily like emerging country crises of the past. Flexible exchange rate regimes are more common now than in the past, which will help dampen external shocks. As GRI has noted in the past, currency depreciation has been shown to help GDP growth after capital outflows.
But, while the economic situation might be more conducive to stability, emerging markets are still vulnerable to political crises that shake investor confidence. For example, Turkey has struggled with protests and scandals in Prime Minister Recep Erdoğan’s cabinet. Brazil too has seen widespread unrest accompanied by slower growth. Emerging markets can still be a good investment as the developed world normalizes but it will remain important to evaluate the susceptibility of a country to self-inflicted wounds.