Historically, interest-rate increases from the Federal Reserve have been buy signals for emerging-market assets. This time looks different, even after a selloff that has pushed currencies to record lows and equities down to levels not seen since 2009.
Developing-nation stocks advanced 38 percent on average and currencies jumped 11 percent during the two previous Fed tightening cycles starting in 1999 and 2004. Firms including UBS AG and Citigroup Inc. say more pain is in store after the first U.S. interest rate increase in almost a decade because emerging markets haven’t fallen enough to reflect subdued growth.
In the past, developing nations benefited from stronger U.S. growth. Now, stagnating global trade, a slowdown in China and a collapse in global commodity prices continue to take their toll. While stock valuations are similar to 2004, earnings have gone from growing 29 percent to falling 21 percent, and debt levels have reached a record high. Adjusted for inflation, 17 of 21 emerging-market currencies are more expensive than they were 11 years ago on a trade-weighted basis.
“It is probably the beginning of the last phase of EM selloff, but there’s a lot more to go,” said Bhanu Baweja, UBS’s head of emerging-market cross asset strategy in London who correctly predicted this year’s rout in developing nations. He spoke in an interview before Wednesday’s announcement from the Fed. “It’s like boiling a frog: it’s slowly and but increasingly turning the heat on the EM assets.”
The Fed raised interest rates on Wednesday, setting the new target range for the federal funds rate at 0.25 percent to 0.5 percent, up from zero to 0.25 percent. Emerging-market stocks rose the most in a month while currencies strengthened after policy makers signaled that the pace of subsequent increases will be “gradual” and in line with previous projections.
The prospect for higher borrowing costs in the U.S. contributed to losses in emerging-market assets this year as lower commodity prices, weaker credit growth and a slowdown in China undermine growth in developing economies.
The MSCI Emerging Markets Index has declined 17 percent in 2015, heading for a third annual drop, the longest losing stretch for equities since 2002. A gauge of developing-nation currencies has slumped more than 14 percent this year.
While Goldman Sachs Group Inc. and Bank of America Corp. see emerging markets bottoming next year as the economic outlook improves, Baweja said they may get worse before better. A similar rebound such as the one in 2004 is unlikely, he said.
17 Increases
Back then, the 17 increases that brought the Fed funds rate from 1 percent to 5.25 percent in June 2006 coincided with a 69 percent jump in emerging-market stocks during the period and 18 percent gain in JPMorgan Chase & Co.’s ELMI+ Index for developing-nation currencies.