Cheer up, emerging-market investors, Federal Reserve Board Chair Janet Yellen is about to step up the pace of rate increases! It’s hard to be upbeat when your portfolio is melting, but it really may not be that bad. The first thing to keep in mind is that US interest rates will not in isolation determine returns on emerging market assets this year -- the dollar will.
A regression of monthly data going back 15 years using the currency and stock and bond returns shows that 79 percent of the MSCI Brazil Index, 60 percent of the Russian gauge and 54 percent of the Indian benchmark are related to moves in the real, the ruble and the rupee.
Similar outcomes can be found for bonds using Bank of America Merrill Lynch’s corporate plus indexes. The good news is that even as the dollar reached the highest point since January 2003 after the Federal Reserve announcement, analysts expect it to weaken next year. A look at the three previous rate-hike cycles in the US is also comforting -- whenever the dollar behaved well, emerging stocks and bonds did too.
In 1994, when the Fed raised its rate from 3 percent to 5.5 percent in six steps, the MSCI Emerging Markets index declined 10.3 percent. It might have been worse were it not for a weak currency policy the US had in place at the time, which meant that the dollar index also dropped 7.2 percent. At the time, developing assets were much more thinly traded -- so prone to wider swings -- and markets worldwide were a lot less interconnected.
In 1994, when Ace of Base topped the charts and the Fed raised rates by 2.5 percentage points, emerging market stocks fell more than 10 percent. But a weakening dollar may have buffered the drop
The rate moves at the turn of the century are perhaps a better example of what can happen. In June 1999, Alan Greenspan began a cycle of rate increases to help stem the irrational exuberance in markets amid the dot-com bubble. By the end of May 2000, the federal funds target rate had been set at 6.5 percent, 175 basis points higher than just one year earlier.
In the final year of the decade, however, the dollar behaved, sparing emerging markets. Then in the second quarter of 2000, the currency jumped and developing stocks slumped. By December, the MSCI Emerging Markets Index had dropped 26 percent and the greenback had strengthened 3.9 percent.
Perhaps the best of the rate-increase cycles of the past 30 years started in 2004. In the two years when Greenspan raised rates to 5.25 percent from 1 percent, just before handing over to Ben Bernanke, the MSCI Emerging Markets Index gained 73.3 percent. The secret? The dollar weakened 4.2 percent in the same period.
The caveat is that the dollar index is up 3.6 percent this year and touched the highest level since January 2003 after the Fed’s 25 basis-point nudge. Meanwhile, the MSCI Emerging Markets index has risen 8.6 percent since the beginning of January, and the Bloomberg Barclays Emerging Markets Hard Currency Index has returned 8.5 percent.
One explanation is that developing-nation assets were coming from a five-year period in which they lagged the world, so there was some catching up to do, despite the strong dollar. And with analysts predicting a weaker US currency, momentum may be building -- especially because a stronger American economy will also benefit emerging markets.
By Christopher Langner
Christopher Langner Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket. -- Ed.
