The Emerging Markets Best Positioned to Withstand a Fed Hike

Over the last decade, amid historically low U.S. interest rates, investors searching for yield and growth have flocked to emerging market stocks.

Though emerging market equities have recently lost some ground thanks to volatility in China, they’re still up over the longer term compared to their own history. Since January 2005, the MSCI EM Index has gained roughly 150 percent, according to Bloomberg data as of 7/27/15.

But now, as the Federal Reserve (Fed) is poised to raise rates for the first time in nine years, many investors fear that higher interest rates could hurt the performance of emerging market stocks.

This fear is understandable, given that a rate hike could lead to higher yielding U.S. Treasuries, which would attract yield seekers away from riskier emerging market assets. For instance, during the so-called Taper Tantrum of 2013, when the Fed announced it would phase out its bond tapering program but still keep interest rates low, Treasury yields increased and EM equities fell. Indeed, history has shown that when prices for risk-free assets (like Treasuries) fall to attractive levels, investors often sell their risky assets and purchase Treasuries. However, that effect is likely to be somewhat mitigated this cycle as rates will be rising from an unusually low level. Finally, the recent correction in emerging markets has left many of these countries cheap relative to developed markets.

But even if we see a similar pattern this time around, it’s important to remember that not all emerging markets are created equal. Emerging markets have become an increasingly heterogeneous asset class, and I believe those emerging economies with the following characteristics are better positioned than others to withstand capital withdrawal from financial investments.

Current account surpluses

Economies with a current account surplus, i.e. a positive trade balance or more exports than imports, aren’t so reliant on foreign capital funding, so they may not be as impacted by capital outflows. This can provide investors with confidence about the economic sustainability of those countries.

Ample foreign exchange reserves

Countries with this characteristic (which often goes hand-in-hand with a current account surplus) have a cushion to help keep their currency stable.

Commodity importers

Rising rates may lead to a further strengthening of the dollar and a corresponding drop in commodity prices. While this will hurt commodity exporters such as Brazil and Russia, it will actually support several emerging markets in Asia.

So which emerging market countries display these fundamentals?

One example of a market better positioned to withstand capital withdrawals is Malaysia, which has amassed a current account surplus and significant foreign exchange reserves thanks to export-driven economic growth. International Monetary Fund and World Bank data show that since 2005, Malaysian current account-to-gross domestic product (GDP) and foreign exchange-to-GDP measures have consistently beaten an average of 21 large emerging market economies on a quarterly basis.

These fundamentals have allowed Malaysia to enjoy relative stability in the emerging market asset class, with the MSCI Malaysia Index exhibiting generally steady gains since a 2008 trough, according to Bloomberg data.

Malaysia is not the only country in Asia exhibiting such fundamentals. Korea and Taiwan, for example, also have significant foreign currency reserves, and such characteristics are just one of the reasons why I prefer emerging Asia over other emerging markets. In addition to increasingly competitive currencies, countries in emerging Asia have recently demonstrated greater willingness to consider and implement market reforms, and they’ll likely experience better growth than their emerging market counterparts. Korea and Taiwan, along with countries like Mexico, are also levered to U.S. growth and are likely to enjoy a bounce if the U.S. economy accelerates in the back half of the year.

On the other hand, both Poland and Turkey are more at risk than other emerging economies. Though Poland’s economy is in relatively good shape, the country has consistently run a current account deficit since 2005, according to the World Bank, and its foreign reserves are relatively depleted compared to those of other emerging market economies.

These characteristics have diminished Poland’s attractiveness to investors in the past–according to Bloomberg data, the MSCI Poland Index has consistently underperformed the broader MSCI EM benchmark over the last 10 years. This underperformance could continue should a Fed rate hike lead to capital outflows. Meanwhile, Turkey’s economic imbalance similarly puts it in a position of vulnerability.

To be sure, it’s hard to predict exactly what will happen to emerging markets when the Fed raises rates. However, the fundamentals above are worth considering when focusing on emerging market exposure in a rising interest rate environment.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

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