2. Emerging Markets (or EMs).
Historically EMs have struggled when rates are rising. Tighter monetary conditions can hurt EM stocks in a number of ways. In particular, such conditions generally raise the cost to borrow in dollars, pulling capital back into the United States from overseas and negatively impacting investor appetite for riskier securities. Since 1988, the MSCI EM Index has underperformed the S&P 500 roughly 75 percent of the time (on a quarterly basis) when the Fed Funds rate was rising. The average underperformance was nearly 5 percent. In contrast, relative returns were flat, on average, during periods when the Fed Funds rate was steady. A Fed that stays on hold, or raises rates at a very gradual pace, should mitigate some of the pressure on EMs.
To be clear, neither asset class typically performs brilliantly simply because short-term rates are stable. But stable rates could mean a less challenging environment for both small cap and EM stocks.
Market Realist – Some emerging markets may benefit as Fed the holds off on a rate hike.
When prices of risk-free assets like Treasuries fall, investors typically sell risky assets and purchase Treasuries, which are now available at attractive levels.
A rate hike in the United States would lead to higher yields on US Treasuries (TLT)(TLH). This attracts yield seekers away from riskier emerging market assets. During the taper tantrum of 2013, when the Fed announced it would wind down the QE (quantitative easing) program, Treasury yields rose while emerging market equities (EEM) fell.
The graph above shows the returns on some emerging markets in dollar terms, between May 2013 and August 2013. Indonesia (IDX) was one of the biggest losers, falling by 35.9% in that period. India (INDA), which was one of the “fragile five,” saw a dip of 28.6% in the same period. Brazil (EWZ), Russia (RSX), and China (MCHI) saw declines of 22.3%, 7.0%, and 6.9%, respectively.
Currency movements play a big role in the total returns in emerging market funds (EEM) for an American investor. The taper tantrum saw emerging market currencies nosedive against the dollar (VTVT), which was strengthening on the back of massive inflows.
However, economies with a positive trade balance aren’t very reliant on foreign capital funding, and so they may not be as affected by capital outflows. So Chinese-centric funds didn’t see a huge cutback, as the Chinese yuan was actually flat against the dollar in that period because China has a positive current account balance.
A further delay in the Fed hike could support some emerging markets. Also, many emerging markets have built up their foreign reserves and have beefed up their current account balances, which should help them reduce the currency volatility when the Fed does hike rates.
Read Market Segments to Consider While the Fed Holds for more on which segments stand to benefit if the Fed delays the rate hike further.