Emerging markets face a tough time following the Federal Reserve’s decision to increase interest rates from historic lows.
While markets breathed a sigh of relief following the news that the Federal Open Market Committee had hiked rates, investors remained cautious of the implications for emerging markets.
Woodford Investment Management head of investment Neil Woodford says: “Although an increase in US interest rates may be justified for the US economy, it is far from ideal for the rest of the world.”
The strengthening dollar has hit emerging markets, which are laden with dollar-denominated debt. The markets have already suffered as a result of the Fed tightening monetary policy in its ending of quantitative easing last year, meaning many expect more pain to come.
“The currencies of many of these emerging economies have been under significant pressure in this period and that looks set to continue,” says Woodford.
“Indeed, conditions may worsen, particularly if these economies feel that their only response to the growing pressures in their domestic economies is to intentionally depreciate their currencies even further.”
However, historically the US dollar has strengthened ahead of a tightening cycle and then fallen back once tightening is underway, says Stephanie Flanders, chief market strategist for Europe at JP Morgan Asset Management.
That said, it is expected that the dollar has further to go this time and will continue to strengthen following the rate rise.
“Some further dollar strength would be manageable. But another leap upwards could be very damaging, not just for the balance of the US recovery but for broader global economic stability,” says Flanders.
“It would ratchet up the pressure on emerging market economies. It could also hit investor confidence, for example by raising renewed concerns about US corporate profits.”
The turmoil in China this summer added to emerging market woes, and all eyes will now be on the country and its currency.
“Already, we have seen China loosening its grip on the renminbi in the face of an economic slowdown that looks like a hard-landing with almost every macroeconomic data-point,” says Woodford.
“US interest rate increases are likely to put more pressure on the renminbi and are likely to increase the Chinese authorities’ desire to share their economic pain with the rest of the world through further currency depreciation.”
Currency issues aside, emerging markets could also be hit directly by the increase in US interest rates boosting returns in America.
In a period of low rates in the US, investors have sought higher returns in the emerging markets, but Ben Brettell, senior economist at Hargreaves Lansdown, thinks some of those flows will now unwind.
“When US interest rates rise, capital flows could reverse, weakening emerging market currencies and making dollar-denominated debts harder to service,” he says.
However, a deeper look into the emerging economies is needed to sort the winners from the losers, says Nick Price, portfolio manager on the Fidelity Emerging Markets Fund.
“Appetite to reform the weaker developing economies is going to be important in determining their future destinies,” he says.
He highlights India as an example of a country that is bringing about reforms and benefitting from the low oil price.
“As a net commodity importer, both the economy and the household have benefited from the impact of lower price inflation as the prices of fuel and food have fallen.
“In particular, this has allowed India’s central bank to move interest rates lower at exactly the point where the ongoing reform agenda is raising both consumer and business confidence – and with it the appetite for business investment and loan demand.”