How Will Rising Rates Impact Emerging Market Equities

Often, investors are not aware of the relationship between rising US interest rates and emerging market economies. That relationship is particularly important today as rates in the US remain at their highest level since 2007.

It’s not surprising that the link between rising US rates and emerging market economies is rarely discussed given how nuanced it is. Consider that the biggest influence on emerging market and developing economies (EMDEs) is not the amount US rates rise but instead the reason for the increases.

Research from The World Bank explores this unexpected phenomenon. Their work identifies three main causes of rate increases in the US: 

1. Real Shocks: Rates rise due to an anticipation of improved economic activity in the US
2. Inflation Shocks: Rates rise due to elevated expectations of inflation in the US
3. Reaction Shocks: Rates rise due to investors’ belief that the Fed is becoming hawkish

Their analysis shows that the recent rate increases are “reaction shocks” given that the Fed has become more aggressive in their attempt to bring inflation down.

Here we look at why this particular type of shock matters to EMDEs, and how investors should prepare.

Why “Reaction Shocks” Are Dangerous

Reaction shocks in the US are particularly dangerous because they lead to tightening financial conditions and a fall in investment and consumption in addition to government spending cuts made to improve budget balances.

Moreover, “reaction shocks boost 10-year EMDE local-currency bond yields, widen EMBI+ sovereign risk spreads, and dampen capital flows,” according to the same body of data. Worse still, they “depreciate currencies and depress equity prices.” This is not the case with “real shocks” which have a far less destructive effect on EMDEs. The below chart shows just how different these two kinds of shocks are:

Source: The World Bank

What makes the reaction shocks even more harmful is the fact that they are occurring at a time when many EMDEs face unprecedented levels of private and public sector debt. Meanwhile, this is all unfolding as many of these economies struggle to get back on their feet after a slower Covid-19 recovery. 

The World Bank’s final assessment is sobering; they call the situation for EMDEs “exceptionally worrisome.”
The researchers share the numbers supporting this outlook:

“Given a 25 basis-point increase in U.S. 2-year yields driven by a reaction shock, the probability of a financial crisis the following year in a given EMDE about doubles, to 6.6 percent. Considering that reaction shocks are estimated to have boosted 2-year yields by 114 basis points since the beginning of 2022, this translates to an increase of 36 percentage points in the probability of [a] financial crisis.”

How Investors Should Prepare?

The depth and breadth of the data from The World Bank which examined 36 EMDEs between 1997 and 2019 should get the attention of any long-term investor.

An investment in emerging markets today now looks much riskier than it did at any point in recent history. For this reason, many investors may want to reconsider their allocations to these markets or rethink planned investments in these areas.

That said, there is some nuance at the country level. Data from the Oxford Business Group shows that countries that finance trade deficits with dollar-denominated debt likely face a greater risk of the problems that The World Bank described. Countries in this category include Argentina, Brazil, and Colombia, all of which have seen their bond yields increase dramatically relative to other emerging markets since 2020.   

For example, Argentina increased their interest rates by two percentage points to 49% just one week after a Fed rate hike. Meanwhile, Turkey kept its rate at 14% and has since decreased it to 8.5% despite their inflation of about 43% as recently as May of this year.

The 3-year chart of the MSCI Emerging Markets Index suggests that an extended period of underperformance is beginning to occur. 

MSCI Emerging Market Index 

3-Year Chart

Source: Business Insider

At the start of 2023 J.P. Morgan warned that they forecast Emerging Market growth to reach just 2.9% which is well below the pre-pandemic trend. 

In fact, Emerging Markets excluding China are forecasted to grow at only 1.8%. This picture becomes even worse when investors consider that J.P. Morgan’s forecast cites “wide regional divergences” making it difficult to isolate a region of this part of the market that might be insulated from elevated risk factors.

The future is never clear but the data from The World Bank is. Forward-looking US investors may want to stay at home for a while.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc. or Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.