It's that time of the economic cycle again when investors must worry about emerging markets. This asset class suffered during the so-called "taper tantrum" in 2013, when rising yields on U.S. Treasuries sent capital rushing out of emerging markets and other risky assets.
Now, with the bull market in U.S. equities hitting its eighth anniversary, investors are becoming more and more worried that the unloved recovery will grind to a halt once the Fed resumes its tightening cycle in earnest.
Officials in emerging markets, as well as institutional investors who specialize in this asset class, become fretful whenever there is a major change in Fed monetary policy. A recent research paper for the International Monetary Fund (IMF) written by Maria Sole Pagliari and Swarnali Ahmed Hannan shows they should be.
Emerging markets tend to receive capital flows that are large relative to their economies and overall absorption capacity, according to this paper. These economies are more vulnerable to shocks not only because they are smaller and less diversified, but also because the large capital inflows tend to amplify their business cycles. This means the booms are stronger than in developed countries, but on the flipside, the busts are more devastating.
After the global financial crisis of 2007-2009, flows of capital to emerging markets became more sensitive to global factors such as low interest rates in the West, pushing institutional investors to look for yield in riskier places.
Consequently, a lot of these funds went into emerging markets debt. The IMF research shows that volatility is higher in the case of portfolio debt in emerging markets than in the case of foreign direct investment (FDI). In other words, speculative money will take flight first and ask questions later, while longer-term funds will remain for longer.
With the dollar heading north as a Fed interest rate hike at the Federal Open Market Committee's March meeting is priced in, emerging markets are likely to find themselves under pressure again. Add to this the fall in oil prices, with crude retreating back near the psychologically important $50 level, and some of these countries, especially commodity exporters such as Brazil, could suffer.
But as usual, not all emerging markets are equal, although some investors still lump them together as one and the same.
Data on global capital flows from the Bank for International Settlements (BIS) show that while all emerging markets have seen increased inflows, some countries' reliance on dollar-denominated debt has increased more than others'.
In the second and third quarter of last year there was a moderate rise in dollar credit to non-financial corporations in emerging markets, driven almost entirely by debt securities, the BIS said in its report.
By region, countries in Africa and the Middle East accounted for more than half of the increase, or around $48 billion, led by the oil exporters in the Middle East. Around $30 billion of the increase in U.S. dollar-denominated debt, representing more than a third, went to Latin America and around 20% to Asia. So, there is a breakdown of what regions are more exposed to a rising dollar.
It seems there is one region among emerging markets where U.S. dollar-denominated credit fell -- that is in central, eastern and southeastern Europe, also known as emerging Europe. There, debt denominated in dollars shrank by $8.0 billion in the second and third quarters of 2016.
It would seem that for investors seeking shelter from a potential emerging markets storm caused by Fed rate increases, emerging Europe is the place to be. For the short term, this looks to be the case. The region also should benefit from the weakness of the euro as its economy is closely correlated with the eurozone.
The economies in the region are set to grow at a faster pace than the single currency area, as they are still converging with richer European countries. Besides, central banks in the major countries -- Poland, Hungary, the Czech Republic, Romania, Slovakia -- are likely to stand pat for now, even if inflation has bottomed, providing another short-term stimulus to these economies.
However, over the medium term there are multiple risks for the region. First of all, there is the political situation; Europe is in turmoil, with nationalist and extremist parties popping up everywhere, and emerging Europe is no exception. Poland and Hungary, most notably, must deal with more authoritarian regimes, while in Romania the government faces calls to resign after it tried to push through legislation forgiving certain corruption deeds.
Second, Brexit will have a negative effect on these countries on two fronts: there will be less money in the European Union coffers for poorer members, and immigration constraints will mean fewer eastern Europeans will be able to work in the U.K. and send money home -- if, of course, the U.K. economy remains strong enough to make that worthwhile.
Third, the EU itself is transforming, with suggestions of a "multiple-speed" Europe no longer rejected. If the EU ends up fragmented, the poorer emerging Europe countries could suffer most, as a lot of investors in these countries have assumed they will continue to catch up with richer Western members.
If the Fed's March meeting does kick off a speedier tightening cycle, investors in emerging markets would need to work harder to find the places that are best suited for every stage of this cycle. Emerging Europe seems suited for the first stage over the shorter term, but beware of the pitfalls.