A global recovery should ultimately benefit EM economies.
Chief Market Strategist, Asia Pacific
Some investors are concerned that the recent rise in U.S. Treasury (UST) yields could hurt emerging markets (EM), especially via the effect of a stronger U.S. dollar. The 2013 taper tantrum did see EM fixed income come under significant pressure, but the impact on equities were less profound. Some EM government bond yields have already risen in recent weeks, while equity performance has been mixed. EM currency performance has also seen significant divergence, as shown in Exhibit 1 below.
A global recovery should ultimately benefit EM economies. However, many EM countries are still suffering from the pandemic, or have yet to make much progress on vaccination. This could mean a slower path to normality and greater dependence on their governments to keep spending to support households and businesses, further lifting fiscal debt.
On a more positive note, there are factors that would mean greater resilience to a stronger U.S. dollar and higher UST yields in emerging markets. External account imbalances were a traditional weakness for some emerging markets, such as Brazil, India, Indonesia, South Africa, and Turkey. Their current account deficits have improved significantly in 2020, compared with 2013. In Brazil and India, this has turned into a surplus. Admittedly, some of this is due to the collapse in domestic demand due to the pandemic, and the sharp drop in energy prices to reduce import value. Part of this improvement could therefore be temporary, but still nonetheless provides the needed support.
Foreign investor positioning in many of these markets were lighter compared with 2013, which should also improve resilience. Alongside with still relatively high real yields compared with developed market government bonds, and most EM ex-Asia currencies being relatively cheap compared to long-term historical averages, the room for correction should be more limited.
Then there are individual domestic factors at play. The Russian ruble appreciated against the U.S. dollar since February due to the pickup in oil prices, boosting earnings and economic growth expectations. The Chilean peso was also boosted by higher copper prices, as well as decent progress in vaccinating its population relative to other EM countries.
EXHIBIT 1: DIVERGENCE IN EM CURRENCY PERFORMANCE SINCE FEBRUARY 1, 2021
% CHANGE IN VALUE FROM FEBRUARY 1, 2021 TO MARCH 15, 2021
Unfortunately, there is no one-size-fits-all answer to the question of emerging markets’ vulnerability to the rise in UST yields and a stronger U.S. dollar. Between EM equities and fixed income, fixed income assets could face greater pressure given its relationship and correlation with UST. EM equities also benefit from improvements in earnings outlook for 2021 and 2022. EM fixed income investors can stay short duration and use higher yields to counter duration risks.
The rise in UST yields should support the U.S. dollar in the near term and prompt correction in EM currencies. However, given the rising fiscal and current account deficits of the U.S. economy and global economic improvement leading to stronger risk appetite in the longer run, we still see the risk to the U.S. dollar remain on the downside, which should benefit EM assets. Another important trigger supporting emerging markets more broadly would be a better containment of the pandemic, and implementation in vaccination.
On top of the general trend for emerging markets, differentiation and active management is key. The rise in industrial metals and energy prices should boost the growth outlook of economies that export these commodities. Export-oriented economies in Asia, such as Singapore, South Korea and Taiwan should also be more resilient.