“Emerging markets debt underperforms in rising rate environments,” appears to be a common misconception and evidence suggests otherwise. Yet investor psychology has once again overwhelmed the fundamental backdrop resulting in 5 percent sell-off in the asset class over the past several weeks as investors are fretting about rising rates. Four rules can serve as a basic blue print for how advisors can help their clients avoid psychological biases and position for strong risk-adjusted returns in emerging markets fixed income in the current rate environment.
Rule 1: Help Your Clients Understand Why The Fed Is Raising Rates
Tighter monetary policy in isolation is often harmful for risk assets, such as emerging markets debt. However, as long as the Fed is raising rates for the “right” reasons, emerging markets debt could continue to perform well in absolute terms and relative to other fixed income asset classes. The global macroeconomic backdrop remains supportive and growth is likely to prevail over rate worries as markets shift their focus back to fundamentals.
Rule 2: Point Your Clients To The Bond Market As A Strong Predictor Of Economic Cycles
The bond market tends to serve as a leading indicator of economic cycles, while the equity market tends to be a lagging indicator. This trend is most pronounced in the lead up to a recession—a flat yield curve has preceded every recession in modern U.S. history. Meanwhile, it is not uncommon for equity markets to continue to appreciate multiple quarters after the conclusion of a rate hike cycle in a misguided notion that history will not somehow repeat and that the flat yield curve will not foreshadow a recession. But be forewarned: historically the equity peak to trough move has been a painful 25-35 percent sell-off. While the yield curve is near its flattest levels in over a decade, it has not yet inverted, suggesting we are currently in the late stages of the growth cycle.
Rule 3: Know That Emerging Markets Tend To Peak Towards The End Of The Economic Cycle
Emerging markets are inextricably linked to developed markets as a levered play on global growth, but often with a lag. Although emerging market economies have evolved through the years, they remain heavily dependent on commodity exports. Commodity prices tend to rise in the later stages of the business cycle as demand for resources increases. This relationship is evidenced by the nearly 10 percent average rise in commodity prices over the second half of rate hike cycles in modern history. Emerging markets inherently benefit from rising commodity demand and there is little reason to expect a different outcome over the remainder of the current cycle. Thus, risky emerging markets assets, such as equities and currencies could benefit.
Rule 4: Recognize That If The Fed Makes A Policy Error, All Bets Are Off
A notable exception to rules 1-3 is the “great bond massacre” of 1994 when the U.S. economy was roaring, and then-Fed Chairman Alan Greenspan began to hike rates pre-emptively in February 1994, as he believed inflation would soon follow. In retrospect, this was a policy mistake as inflation remained muted and continued its three-decade move lower. This led to yields spiking and risk assets peaking well before the completion of the rate hike cycle. One of the biggest risks to emerging markets debt is a similar policy error by the Fed.
Valuations have improved dramatically with the recent sell-off in emerging markets debt, thus it is an opportune time to take stock of where we are and where we are headed. The “rules of the road” suggest that emerging markets should continue to generate strong risk-adjusted returns both on an absolute basis, as well as relative to other fixed income markets. The global macroeconomic backdrop remains supportive and bottom-up fundamentals in emerging markets continue to improve. Perhaps the biggest risk to the asset class today is not a psychological threshold on interest rates or exchange rates, but rather a policy error by the Fed. Notwithstanding this risk, emerging markets are poised to outperform as markets will invariably shift their focus back to fundamentals.
Arif Joshi is a portfolio manager/analyst on Lazard Asset Management's Emerging Markets Debt team.