Investors in emerging markets always keep a close eye on the Fed. Right now, it is making them nervous.
Jay Powell, the Federal Reserve chair, has insisted that the US central bank regards the recent surge in consumer price inflation as temporary and will not risk stifling the economic recovery by tightening monetary policy too soon.
But the signals are mixed. Hawkish officials on the bank’s Federal Open Market Committee have suggested the Fed should reduce its support to the economy through asset purchases as soon as September and raise interest rates as early as next year.
For emerging market investors, this is a game changer.
“The Fed has very much accelerated the conversation, from just thinking about inflation, right into rate hikes,” said Phoenix Kalen, emerging market strategist at Société Générale in London. “That creates a very difficult few months while the market recalibrates . . . Before that first hike materialises, the dollar will move much higher.”
A resurgent US dollar spells trouble for fund managers investing in developing countries’ local-currency stocks or bonds, as it eats into the dollar value of those bets.
For much of the pandemic, the dollar weakened against the currencies of the US’s main trading partners. But since a recovery came into view late last year, the picture has changed. After steep fluctuations between January and May, the benchmark DXY dollar index is up more than 3 per cent so far this year.
Meanwhile, EM stocks have stalled. They started the year well but the benchmark MSCI EM index is now more than 7 per cent below its peak in mid-February.
The fear is of more to come. If the Fed raises interest rates to fight inflation, that not only strengthens the dollar; it also enhances the appeal of “safe” assets such as US government bonds, making investors less willing to go in search of higher-yielding, riskier assets elsewhere. This means that even EM assets denominated in dollars or other foreign currencies, such as sovereign and- corporate eurobonds, also suffer.
To add to investors’ difficulties, China’s economic recovery has begun to lose steam. As the world’s second-biggest economy after the US, and for many years a significant driver of developing economies because of its voracious demand for their commodities and other exports, China has as much influence on the performance of EM assets as the US — some analysts would say more.
“That is certainly generating a lot of fears about how fast global growth can recover in a context where China is slowing,” Kalen said.
One indicator of global prospects can be seen in commodity markets. Prices have been on a roll for the past year, with oil recently breaking back above pre-pandemic levels and copper reaching an all-time high. But they are now easing back.
Simon Quijano-Evans, an economist at Gemcorp Capital and a…
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