When Interest Rates Rise, Will Emerging Markets Tank?

Interest rates are going to rise. The timing may not be certain, but the Fed hints that it will be during 2015, and many expect the first rate hike to happen in September.

But what will happen to emerging-market investments when interest rates rise?

Emerging-market currencies depend heavily on U.S. monetary policy decisions. Investors should be wary of EM investments and prepare themselves for the rate hike.

Morgan Stanley’s benchmark EM equity index has lost about 17% since April 2013, and about 8% this year. While EM investments are cheap, in my view they are not yet cheap enough to invest in. They haven’t hit bottom yet.

Remember the ‘Taper Tantrum’ of 2013?

We have seen emerging markets nose-dive after past Federal Reserve interest rate hikes. The questions is – will it happen again this year?

In the summer of 2013, when the former Fed Chairman Ben Bernanke announced that the Fed was ready to begin tapering its bond-buying program, emerging markets went into a frenzy known as the “taper tantrum.” Emerging-market equities fell over 15%, and anything with foreign currency exposure was hit the hardest.

When there is a tighter monetary policy, or higher interest rates, the market has less demand for riskier investments, like those in emerging markets.

Emerging markets have seen an influx of capital in recent years as investors seek higher yields, but that is going to change with an interest rate hike. Emerging markets are known for growing fast, but most are still not funding their own growth. They have to borrow. EMs have been benefiting from the loose monetary policy of Japan, Europe and the United States to fund their growth with low interest rates.

While the emerging markets have been able to borrow at the lower interest rates, developed markets have been especially inclined to lend to the countries. The emerging markets offered much higher yields than what could be earned in a U.S. bank account, which was nearly 0%. 

This happy relationship of borrowing and lending is about to experience a breakup.

Don’t Forget the Dollar

If your portfolio is heavy in foreign currency exposure, you might be in trouble. Now is the time for good old dollar bills.

When interest rates rise, the dollar benefits, relative to other currencies. The higher interest rates attract more foreign investments that are denominated in dollars, like notes and bonds.

If you’re holding emerging-market investments, your best bets are mutual funds and ETFs that hedge for foreign currency risk. This is especially true for the currencies that have been dubbed the “Fragile Five” – the Brazilian real, the Indonesian rupiah, the South African rand, the Indian rupee and the Turkish lira. These currencies are experiencing the most pressure against the U.S. dollar.

Not All Emerging Markets Are Created Equal

There are a few qualities to consider to determine which emerging economies will best withstand a interest rate hike. When interest rates rise, we will really see the variation among the emerging markets. It will become clear which countries can swim or sink.

If countries have a current account surplus – or in plain terms, if they export more than they import – they are less dependent on foreign currency. Likewise, those with excessive reserves of foreign currencies have a cushion and are less at risk of a taper tantrum, part two.

It is unlikely we will witness the same downward spiral that occurred in 2013 for emerging markets. Countries are preparing themselves for the interest rate increase. Countries like Brazil and Russia have already raised interest rates to prevent a capital outflow.

Despite the readiness and variation among the different emerging markets, there is not a shining star in this asset class. Interest rates hikes are going to be a bumpy ride for EMs.

In short, avoid emerging-market investments for now, especially those with foreign exchange risk. If you are going to hold EM investments, invest in funds and ETFs that hedge against currency changes.

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