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3 Reasons to Stick with Emerging Markets… Regardless of the Fed’s Interest Rate Decision

Reason 1: Emerging Markets Still Offer the Highest Growth and Income Opportunities

Year-to-date the MSCI Emerging Market Index is up 8.91 percent, compared to a return of 0.09 percent, for the MSCI World Index and 2.32 percent for the S&P 500 Index.¹ These returns largely track company earnings, making it clear that emerging markets currently offer the highest growth potential for global investors. Furthermore, in today’s near-zero interest rate environment, emerging market bonds provide greater interest income, especially when compared to developed market assets. Consider that, a 10-year U.S. Treasury bond yields 1.6 percent, while a similarly-dated Brazilian or Indian sovereign bond, yields 12.0 percent or 7.1 percent, respectively.² Investors seeking high income and total return, need not look any further than emerging market debt.

The Federal Reserve’s benchmark interest rate presently sits in a range between 0.25 percent and 0.50 percent. A rate hike by the U.S. central bank, by the proposed 25 basis points, would still see interest rates hovering just above record-low levels, and is more of a move by the Fed towards rate ‘normalization’. Investors should also be cognizant of the fact that while the Fed is signaling a potential rise in interest rates, other major central banks, most notably, the European Central Bank, the Bank of Japan and the Bank of England, are all pursuing loose monetary policies. This means that global interest rates are set to remain ‘lower-for-longer’, increasing the appeal of emerging market debt. Moreover, the spread between emerging market bonds and traditional developed market bonds is wide enough to absorb any impending interest rate hikes, and would still be around 500 basis points, on average.²

 

Reason 2: Resilience to Global Macro Events and Previous Interest Rate Hikes

Emerging markets have successfully weathered the macro storms of 2016, the most notable being Great Britain’s decision to leave the EU. Across the board, emerging markets have moved higher following the ‘Brexit’, exhibiting great resilience. Nowhere has this resilience been more evident than in fund flows. Leading up to mid-August of this year, emerging market equity funds saw seven consecutive weeks of inflows, totalling around US$15 billion dollars – a 58-week high.³ While emerging market debt has already attracted close to US$30 billion of inflows as of August. This number is expected to rise to US$40 billion by year-end.⁴


When the Fed last raised interest rates in December, 2015, there was a lot of market noise surrounding a potential selloff in emerging markets. Instead, emerging market investors came out on the other end virtually unscathed. The MSCI Emerging Market Index rose sharply over the subsequent days, and has actually added 12.4 percent, from December 15, 2015 through the end of August, 2016.¹

 

Emerging markets have shown, more so in recent times, that they are capable of circumventing global macro events, including interest rate hikes by the U.S. Federal Reserve.

 

Reason 3: Emerging Market Fundamentals Remain Intact

Fed rate hike or no Fed rate hike, leading emerging market nations sport robust fundamentals and will maintain their luster, for some time.

India

The catalysts that are driving India forward are well documented at this stage:

  • An above-average monsoon, following a two-year drought;
  • A pay increase for government workers, intended to boost consumption;
  • Strong improvement in company earnings; and
  • The passage of a landmark Goods and Services Tax (GST) bill, which has significantly boosted investor sentiment.


Currently the world’s fastest-growing economy, India continues to be the darling of the emerging markets.

 

Brazil

The recent impeachment of Dilma Rousseff and permanent installment of Michel Temer as President, has set Latin America’s largest economy on a clear course to recovery. Some of this turnaround is already reflected in Brazilian stocks which, despite being among the best-performing in the world so far in 2016, up 54.4 percent, are still attractively valued.⁵ With the help of a new economic team, President Temer is expected to push through a series of deep structural reforms and policies that are intended to shore up the country’s fiscal framework and stimulate renewed growth over the medium- to long-term.

 

China

Remember those predictions for a ‘hard landing’ scenario? They haven’t materialized.

Instead, China has been quietly making the shift to a new consumption-driven model, moving away from the world’s hub of cheap exports. Third-quarter growth has been holding up well, and is likely to remain in the government’s target range of 6.5-7 percent. Most notably, the services sector continued to expand, with the purchasing managers’ index (PMI) reading for the month of August rising to 52.1, compared to 51.7 in July.⁶ Services cover a range of sectors including real estate, e-commerce as well as retail, and presently accounts for approximately half of China’s GDP.

A potential inclusion of Shanghai and Shenzhen A-shares (or mainland stocks) in the widely tracked MSCI indexes could also be a game changer for China. China is making great strides towards improving the accessibility of its mainland stocks to foreign investors. The A-shares market is the second-largest in the world by market cap, and this inclusion would solidify China’s role as a major player in the global financial market.

 


¹ Bloomberg data, total return, in CAD terms, as at August 31, 2016.
² Bloomberg data, accessed on September 6, 2016. Based on 10-year local sovereign bond yields.
³ Financial Times, Investors Pour More Money into EM Equity Funds, August 19, 2016.
⁴ Amundi Asset Management, JPMorgan data, as at August 12, 2016.
⁵ Bloomberg data, total return in CAD terms, based on Brazil Ibovespa, as at August 31, 2016.
⁶ CNBC, China economy news: Caixin services PMI above 50 in August, September 4, 2016.

 

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