After months of quantitative easing by central banks around the world since the onset of the coronavirus crisis, the inevitable has happened. The Fed has sounded the alarm, hinting at tapering monetary stimulus and increasing interest rates by the end of 2023 amid rising inflation. The hikes could come even sooner, if inflation continues to accelerate faster than expected.
Back in 2013, after years of stimulus following the 2008-09 crisis, when then Fed chair Ben Bernanke suggested that monetary support would be curbed, emerging markets found themselves caught in global market chaos.
The “Taper Tantrum”, as it became known, wreaked havoc on emerging markets and gave birth to the “Fragile Five” — an especially vulnerable group of nations consisting of Turkey, South Africa, Brazil, India and Indonesia.
EM assets bore the brunt of the panic over tightening as US Treasuries sold off, sending bond yields soaring, currencies weakening, and forcing countries across the developing world to shift their policies and approach.
But this time, despite the rise in yields and signalling of higher rates, concerns are muted. First of all, the Fed has learned some lessons about the power of its own words.
“The Fed and G7 central banks have learned from the past and they want to take the tantrum out of tapering,” said Simon Quijano-Evans, chief economist at Gemcorp Capital in London. “They are succeeding in doing so. Markets have been preparing for this for months.”
With inflation having returned, so too has volatility in fixed income markets. But having witnessed the brutal impacts on global markets of a change in rhetoric in 2013, regulators are taking a more measured and gradual approach this time.
“Tapering will likely happen some time this year, potentially in the second half,” said Nick Eisinger, co-head of emerging markets active fixed income at Vanguard in London. “The market should be on alert, although the Fed will take a more gradual approach. It realises there is more at stake and so it will be careful when pulling the plug. Tapering has been better signalled this time around.”
US Treasury yields have shot up since the start of the year, with the 10 year reaching more than 1.7% in March, from 0.93% at the start of the year. As of June 23, it stood at 1.475%.
The Fed has made it clear that it will need to “see substantial further progress” in recovery before tapering.
While the market anticipates the Fed will begin tapering at any point between the fourth quarter and early next year, emerging market countries across CEEMEA, Latin America and Asia are set to weather the storm.
Central bank strength
It is not just developed markets policymakers who have learned some lessons from 2013. Certain central banks in the developing world are also demonstrating their credibility and experience.
Some EM central banks have already started a cycle of tightening in response to the rapidly changing macro-economic environment. In recent weeks, a number have pushed up benchmark rates — including Hungary, Russia and Brazil, following similar moves earlier in the year by Ukraine, Georgia and Turkey to get ahead of domestic inflationary pressures.
“We are not going to have the same tantrum because emerging markets are better prepared than in the past in terms of monetary policy,” says Elina Ribakova, deputy chief economist at the Institute of International Finance. “We will see a boring taper tantrum — a more nuanced and less explosive set of events.”
Bank of America said in a research report in late June that central bank tightening across EEMEA was “overdue”.
Some predict a continued wave of monetary tightening in anticipation of rising US rates and a stronger dollar.
Currency volatility was one of the main features of the market chaos of 2013. That, said market watchers, will not be repeated.
“It is helpful that central banks are hiking; front-loaded hiking will support EM currencies and insulate them from the worst impacts, as many vulnerabilities do tend to come from the currency side,” said Trieu Pham, emerging market debt strategist at ING in London.
BNP Paribas has predicted the situation will be a Tantrum-less Taper, in part because of the role of regulators.
“Emerging markets will not be as badly impacted as they were in 2013 because the frameworks of central banks have improved,” said Luiz Peixoto, emerging markets economist at the French bank. “They are more objective, transparent and the focus has turned towards inflation targeting. We are likely to see the wave of monetary policy tightening across EM extending and broadening in H2 2021, adding Colombia, Chile, South Africa and Poland to the mix of rising policy rates, besides Brazil and Russia.”
Better position
Financially, emerging markets are also in a much better position today than in 2013. This will act as another buffer against potential rates volatility later in the year, said market sources.
According to fund manager Ashmore, EM countries are running an average current account surplus of more than 1% of GDP, versus a deficit of about 2% in 2013.
Developing economies have strengthened their buffers in recent years, having experienced how vulnerable the dependence on foreign capital inflows had made them.
“Emerging markets have lower non-resident capital exposures, deep local currency bond markets and more conducive real interest rate environments,” said Quijano-Evans. “Those will prevent it turning into a tantrum.
“There will be a reaction in the market the closer the Fed gets to tapering, but that reaction will not be sustained over multiple months.”
Higher commodity prices and recoveries in export levels have helped to prop up current account balances.
Importantly, unlike 2013, emerging markets are — on average — far less dependent on non-resident capital inflows, making them less susceptible to a volatility-induced sell-off. The capacity of governments to fund themselves has improved. Countries have far bigger reserves now compared with 2013.
“EM relies much less on external funding and portfolio inflows now compared with 2013,” said Peixoto at BNPP. “Local liquidity is very strong, and governments have successfully extended their maturity profiles, reducing financing pressures.”
Emerging market spreads have been particularly well behaved amid volatility in the rates market, said market watchers.
“EM spreads widened briefly in February and March, which was driven by underlying core rates,” said Pham at ING. “However, since then spreads have been well contained, in fact tightening in mid-June. Though spreads have been well behaved, it is too early to say if that will last as liquidity conditions change.”
Market access continues
That so many sovereigns across the credit spectrum have been able to access international capital despite the hawkish Fed rhetoric demonstrates investor confidence in emerging markets.
“There is little concern about major emerging markets finding sources of funding, even with tapering,” said BNPP’s Peixoto. “The pandemic is a testament to the amount of liquidity out there.”
A number of emerging market issuers across the credit spectrum have poured into markets despite the Fed’s change in outlook.
In the past few weeks, even riskier EM credits such as Turkey have managed to find strong support in international markets. In June the sovereign raised $2.5bn in a sukuk sale, which bankers on the trade quoted as pricing especially tightly, in spite of a range of idiosyncratic investor concerns around central bank credibility and monetary policy.
Not so fast
However, it is not all sunshine and rainbows for emerging markets. Though they are — on the whole — in a better position than in 2013, a number of challenges await the asset class, especially the more vulnerable countries.
According to the Institute of International Finance, EM current account deficits remain “small or inexistent”, as a result of strong global demand and the recovery in commodity prices. The IIF said that this will not serve as a permanent defence. In fact, the acceleration of economic recovery across emerging markets will probably weaken the strong recent performance of external accounts.
“Eventually emerging markets will become more challenging — the asset class will be hit by the tapering over the next year or so, though it is difficult to pinpoint the exact timing,” said Pham at ING. “Current account balances will become less favourable — eventually EM countries will recover, imports will grow, and deficits will increase. Eventually, many of the countries that this year run balanced current accounts or surpluses could face deficits.”
Additionally, any withdrawal of liquidity by the Fed will naturally increase yields in the US, making emerging markets less compelling on a comparative basis. That may, some say, pose challenges for primary market issuance, particularly for high yield issuers.
Some investors are erring on the defensive, choosing to take a wait and see approach.
“The market outlook is mixed on EM,” said Eisinger at Vanguard. “In anticipation of the gradual withdrawal of liquidity, some of the frothiness in primary markets is being looked at with a bit more care. We are, and have been, positioning ourselves defensively. If the Fed continues to be hawkish, the dollar will strengthen, which is not a good recipe for emerging markets.”
Notably, while regions such as central and eastern Europe are causing little concern for market participants, some frontier markets are erring on the riskier side.
“The Fragile Five have shifted — the concern is now around the frontier markets, including countries in sub-Saharan Africa, Asia and Latin America,” said Ribakova at the IIF.
A version of this story appeared first in GlobalMarkets, a sister publication to GlobalCapital