Oil and water, Coke and Mentos, and drinking and driving might seem like ideal pairings in comparison with rising interest rates and emerging markets equities. We don’t need to look very far to see investor concern. Although the market interpreted the US Federal Reserve Bank’s (Fed) comments on March 18 as relatively dovish, the long-term expectation for a rise in US interest rates remains unchanged. In the “taper tantrum” period (late May through June 2013) after the Fed announced it would gradually unwind its asset purchasing program, the MSCI Emerging Markets Index (“EM Index”) declined over 9% while the S&P500 fell over 3%. Why did investors react so negatively to the announced end of quantitative easing in the United States? How has Causeway positioned its emerging markets portfolios to weather an inevitable change in the US monetary regime?
To answer these questions, we spoke to Causeway’s co-portfolio manager and quantitative research head, Arjun Jayaraman, as well as our portfolio strategist, Ryan Myers.
Causeway Funds: Impact of interest rates on emerging markets
Arjun, with the Fed signaling a 2015 increase in interest rates, what type of reaction do you expect from emerging markets?
AJ: Across emerging markets asset classes—equity, debt, and currency— we expect a pullback in response to a US interest rate increase, although markets may have already discounted some expectations of reduced monetary liquidity. Emerging markets currencies will likely suffer due to the current monetary policy divergence. While US monetary policy is expected to tighten, several emerging markets central banks have already been loosening their monetary policy, including India, China, and Russia. Under this scenario, we expect emerging markets equities to fare relatively better than emerging markets debt. As a US-dollar based investor, the strengthening dollar versus local emerging markets currencies detracts from returns on both equity and fixed income. However, equities have an advantage over debt. Specifically, domestic currency weakness typically leads to incremental earnings growth of exporting companies, and all companies generally benefit from the stimulative effect on their regional economy.
In anticipation of relative underperformance of emerging markets versus developed markets, have you made a sizable reduction to your emerging markets allocation?
AJ: In our International Opportunities portfolios that invest in both developed and emerging markets, we have moved to a modest underweight position in emerging markets versus the MSCI All Country World ex-US benchmark. But it isn’t all gloom and doom. Yes, the specter of monetary tightening in May-June of 2013 sent emerging markets reeling. However, here we are, almost two years later, and it appears as if emerging markets are becoming increasingly acclimated to the likelihood of higher US interest rates. Emerging markets are no longer “whipsawing” on the day-to-day Fed chatter, as they were in earlier periods. Meanwhile, the Eurozone and Japan have embarked on massive money creation programs, which may offset some of the monetary liquidity reduction coming from the United States.
RM: Additionally, a number of key catalysts of previous emerging markets crises are no longer present. The 1994-95 “Tequila Crisis” in Mexico, and the 1997-98 “Asian Financial Crisis,” which began in Thailand, were triggered by unsustainable fixed exchange rates versus the US dollar. Today, most emerging markets currencies are floating versus the US dollar, and that acts as a natural adjustment mechanism. Furthermore, most emerging countries have less US dollar-denominated public sector debt and higher foreign exchange reserves than they carried in prior crisis periods.
AJ: It is also important to recognize the significant variation in macroeconomic conditions across emerging markets. Political and economic characteristics, and ultimately equity market returns, differ to a much greater extent in the developing countries. In fact, over the last ten years, as illustrated below in figure 1, the standard deviation in country returns within emerging markets has averaged over 60% more than that of country returns within developed markets. And in the last two years, dispersion within emerging markets has increased to nearly twice the dispersion levels in the developed world. In general, we do not expect the entire emerging markets asset class to move in tandem.
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