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Volatility is coming to EMs

Emerging market assets will likely face rising volatility and capital outflows as the US Federal Reserve begins tightening interest rates, according to JP Morgan Asset Management.
Both equities and fixed income in emerging markets can be negatively impacted in the short-term, while long-term performance is dependent on a multitude of factors outside of the US monetary policy, the asset manager said. 
“Investors would be advised to consider a host of factors when making their allocation decisions within EM,” said JP Morgan, which sees more opportunities in Asia than in Latin America.
The predominantly commodity-exporting economies of Latin America are more vulnerable than Asia’s manufacturing-based economies due to the lacklustre outlook for commodity prices. 
Manufacturing and service-oriented countries are also well-positioned to benefit from rising global demand, especially if the US economy strengthens.
According to the firm, investors will take note of those emerging economies that have taken or will take measures to reduce vulnerabilities to capital outflows after the Fed begins to tighten interest rates. 
Some of these measures that include economic policy initiatives to drive economic growth, potential intervention in forex markets to ensure a more orderly depreciation of the local currency, and accumulation or stabilisation of reserves in order to respond to potential stresses.

EM capital outflows concern

Many in the market now expect the US Fed to raise the interest rate in September compared to earlier expectations of one in June. 
“The biggest concern for EMs regarding Federal Reserve tightening is that investors may reallocate portfolios away from riskier EM assets and back toward those in the US, given a perception of better growth prospects, more safety and now higher yields,” JP Morgan AM said
“Such a reallocation could increase volatility, hurt returns and damage economic growth for EMs.”
Since the global financial crisis, the capital inflows into EM countries have increased significantly and even the composition of capital flows has changed, making the countries more vulnerable. 
In pre-crisis years, foreign capital entering into emerging markets was through foreign direct investments. Post-crisis, portfolio inflows (especially into EM debt) increased dramatically as investors searched for yield and better growth prospects outside of developed markets.
 “Given the substantial inflows to EM assets post-crisis, the potential outflows in a Fed tightening cycle could also be significant.”

US dollar strength 

Historically, the behaviour of the US dollar has played a significant role with respect to performance of emerging markets, with EM equities underperforming the developed markets when the dollar is strengthening.
 “A stronger US dollar tends to hurt commodity prices (which are priced in US dollars), hurting the earnings of commodity-exporting EMs. These lower commodity prices in turn cause capital outflows from EM, at times returning to the US, which in turn fuels more dollar strength—and the vicious cycle continues.”
JP Morgan AM said the global financial crisis encouraged EM countries and especially corporations to issue debt in US dollar terms. 
“A stronger US dollar versus EMs’ local currencies makes it more difficult for EM sovereigns and corporates to service their US dollar-denominated debt.
“[However], a mitigating factor is the fact that various EM countries have significantly more foreign currency reserves now than during the late 1990s when EM currency depreciation was very much a concern for EM solvency.”

Part of the Mark Allen Group.