Will rising bond yields sink the emerging market rally? The MSCI Emerging Markets index soared by 90% between last March and 17 February as optimistic investors bet on a strong global upswing this year. Yet higher US Treasury yields are proving a party pooper, sending the index tumbling 9% since then.
Foreign investors have begun to pull cash out of emerging markets for the first time since October 2020, says Jonathan Wheatley in the Financial Times. The higher yields on offer in emerging markets look less attractive when investors can receive a decent return from holding onto “safe-haven” US Treasuries.
Another reason emerging markets are so sensitive to US bond yields is that many businesses in emerging economies borrow in greenbacks, so higher US yields make their debt costs rise. By the same logic, emerging economies also tend to do better when the dollar is weak. Yet the US currency has so far “confounded expectations” that it would fall this year, says Paul Davies in The Wall Street Journal. It has rallied by almost 2% against other major currencies.
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The jump in Treasury yields is bringing back uncomfortable memories of the 2013 “taper tantrum”, says Craig Mellow in Barron’s. On that occasion yields spiked after Fed chair Ben Bernanke “merely” suggested that he might cut back on quantitative easing (buying bonds with printed money). Emerging market stocks went on to lose “15% in a month”. In 2018, when the Fed hiked interest rates, emerging markets fell by 8%.
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Emerging markets are less vulnerable to a US yield spike today, says Vincent Tsui of Gavekal Research. In 2013 many had large trade deficits, high inflation and overvalued currencies. That left them vulnerable when their borrowing costs suddenly spiked. Yet none of those conditions remain this time. However, says The Economist, Covid-19 has “dramatically widened another kind of deficit: the gap between government spending and revenues”. Brazil’s budget deficit ballooned to 14% of GDP last year. Today the key worry in emerging economies is worsening “fiscal sustainability”, which leaves governments vulnerable to more expensive borrowing costs. Strategists at HSBC say that Brazil, Indonesia, Mexico and South Africa look particularly vulnerable.
Don’t be discouraged by “short-term blips”, says James Crux in Shares magazine. From “under-owned and underappreciated” Latin American businesses to Mexico and Vietnam (see page 26), which should both benefit from supply-chain diversification, there is plenty of opportunity in emerging economies. Investors should keep their eyes on a “much longer-term prize”.
