One frequently speculated outcome of the long-anticipated Federal Reserve rate hike is the ratcheting up of pressure on already embattled emerging markets.
This speculation stems from the fact emerging market currencies have fallen as the dollar has risen; while the dollar has risen 20% higher on a trade-weighted basis since July 2014, emerging market currencies have fallen roughly 40% since May 2013, the beginning of the infamous “taper tantrum” which marked the beginning of rate hike speculation.
However, could the hike in fact make emerging markets a more attractive investment prospect? James Barrineau, co-head of emerging markets debt at Schroders, thinks so.
“It is difficult to argue that the Fed has been the sole factor in emerging market debt weakness – China hard landing fears, plummeting commodity prices, Brazilian political disarray, Russian policy concerns and general weakening of growth across all regions created a near perfect-storm for emerging market debt investors,” he says.
“A more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite. If developed market bond yields remain very low - as seems likely with a very slow hiking path, set out with some confidence - emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come.”
The Fed move comes at a time when emerging market dollar debt seems “particularly attractive”, Barrineau says. Yields in the primary sovereign dollar index are at highs unseen since 2010, when Treasury yields were much higher than today.
Yield spreads over US treasuries for investment grade sovereign debt are just under 300 basis points and remain at elevated levels last seen during the European crisis of 2011. High yield sovereign debt currently has a yield to maturity of 8.5%.
“With the European Central Bank now charting a path towards a steady dose of quantitative easing as growth in Europe stabilises, Fed predictability should help curb that dollar appreciation,” he says.
“Emerging market currencies should then likely steady at attractive levels, boosting sentiment towards the asset class. Even a modest virtuous cycle led by these factors could make emerging markets one of the strongest global fixed income performers next year, given today’s generous yield levels."
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