(Bloomberg) -- Who’s afraid of Jerome Powell? Not emerging markets.
Stocks, bonds and currencies in developing nations did tumble with global markets after the U.S. Federal Reserve chairman’s comments this week spurred bets for four interest-rate increases in 2018. Conventional wisdom holds that the quick increase in borrowing costs will diminish risk appetite and end a two-year rally in emerging-market assets.
Data says otherwise. In fact, the emerging world is less sensitive to Fed policy changes than is often believed, starting with an unexpected rally when the central bank began raising rates a little more than two years ago.
“The impact of Fed rate hikes is not that great on emerging-market assets,” said Francois Savary, chief investment officer of Prime Partners SA in Geneva. “That is true as long as we don’t have too much of a ‘situation’ with the dollar. Developing nations have more room compared to the U.S. when the rate cycle moves up.”
Yield Hunt
The notion that higher Fed rates would drain capital from emerging markets has been refuted as investors embrace greater risk to maintain higher returns. That strategy could continue even in a four-rate-hike scenario as superior economic growth in developing nations supports asset valuations.
Consider currencies: Potential carry-trade returns from borrowing in dollars and investing in emerging markets are so lucrative that even an increase of a full percentage point in funding costs leaves plenty of money on the table. The chart below shows expected gains from interest-rate arbitrage before and after such a move.
The extra room shown by the blue bars means there’s little incentive for investors to take money out of emerging markets even if the London Interbank Offered Rate for dollars traded at 2.67 percent instead of the actual 1.67 percent on Thursday.
Carry-trade gains can be even bigger if Savary’s expectation for a weaker dollar comes to pass. He says a deterioration in the U.S. fiscal position because of President Donald Trump’s tax cuts and budget deal will prevail over any boost to the dollar from interest-rate hikes.
Bring It on, Fed
As for stocks, quick and successive Fed tightening is a signal for a rally, not a slump. That was true not just in Janet Yellen’s time, but even in the era of Ben Bernanke and Alan Greenspan.
Nineteen of the past 22 U.S. rate increases were followed by gains in emerging-market equities within three months. On all but seven occasions, they rallied within a week.
Developing-nation bonds are decoupling from Fed jitters, too. The 60-day correlation between Fed Fund futures and emerging-market foreign-currency bonds is hovering near the lowest since September 2016.
It all boils down to economic fundamentals. The degree by which growth in emerging economies surpasses that of developed countries is widening. That alone should support their assets, regardless of where the Fed target rate is headed, according to Savary.
"We are seeing a solid economic recovery,” he says. “That’s going to protect emerging markets.”