By this point, everyone knows how the script unfolds. It goes like this: the Federal Reserve makes an announcement about curtailing asset purchases, talk of U.S. yields rising is renewed, and investors pull out of emerging markets in droves. That was how it played out last May after the Fed announced its plan to scale back quantitative easing. And we saw a repeat performance in January when the Fed actually began tapering. Yet both times, there was a surprise ending: U.S. yields did not rise as expected. And in both instances, emerging market currencies bounced back, defying analyst predictions that tapering – or even talk of tapering – would lead to an inevitable and prolonged period of pain for countries heavily reliant on foreign capital.
In recent weeks, markets have again reenacted the first part of pattern: the U.S. dollar strengthened significantly, yields began rising and EM currencies depreciated across the board. Since the beginning of September, the Russian ruble has fallen 15 percent against the dollar, while the Indonesian rupiah and Mexican peso have depreciated 3 percent. Equities have kept pace, too: the MSCI Emerging Markets Index has dropped 11 percent since September 5. And this time, Credit Suisse expects the script to unfold differently, and considers it unlikely that emerging markets will bounce back like they did after the last two episodes.
It’s true that U.S. yields took a sharp dive two weeks ago on fears of a global economic slowdown, and that temporarily arrested declines in EM currencies. But yields have already partially corrected and should continue to do so as the Fed moves closer to a rate hike. And Credit Suisse has stuck to its call for the first rate increase to occur next June.
That view is premised on the fact that the U.S. economy seems to be finally gaining lasting momentum, growing 4.6 percent in the second quarter, the largest expansion since the final quarter of 2011. Barring a complete surprise, then, the Fed is still likely to raise rates next year. In a global market, capital flows change direction because of changes on the margin. So even if the Fed seems likely to start tightening with a mere 25 basis point increase in rates, such a move will nonetheless constitute a major shift in policy, and the effect should be anything but marginal. There will be outflows, say Credit Suisse analysts Ray Farris and Matthias Klein. The only question is how large they will be.
There are other factors at play, too. Falling commodities prices — for everything from oil to coal, wheat, maize, copper, and fertilizers — are hurting EM countries whose export sectors depend heavily on commodities, including Russia, Venezuela, and Argentina. Current account deficits in countries such as Indonesia and South Africa have widened considerably as well. Economic slowdowns in Europe and China have also affected those EM countries that trade heavily with those regions of the world. Slowing demand in China, for instance, has especially impacted Chile, Indonesia and South Africa.
It’s not all bad news for emerging markets. India, for example, is actually benefitting from lower oil prices because the country is a significant importer of energy. Consumers there are spending less on fuel and slowing inflation may lead the central bank to lower interest rates. Countries more exposed to the U.S. than to China—such as Mexico and Israel—are also benefitting from improving U.S. demand. So while it’s easy to view emerging markets as a unified bloc of countries that only stand to lose by the dollar’s rise, the reality is much more nuanced. A stronger dollar can produce winners, too.
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