Where goes the US, there goes the rest of the world has long been a truism in financial markets. But it has become less true lately.
The performance of stocks, bonds and currencies of emerging markets in places ranging from Asia to Latin America is becoming increasingly delinked from major advanced markets, in part due to improved economic governance. And it is of potential benefit to investors looking to diversify risk internationally.
But as the International Monetary Fund cautions in a January blog post, the emerging-market investment landscape is still defined by risk as well as opportunity, and fund managers need to be vigilant navigating it.
The IMF notes that interest rates in leading markets have experienced a rollercoaster ride in recent months, especially rates on longer-term government bonds. Yields on ten-year US Treasuries are climbing again after pulling back from a 16-year high of 5% last October while moves in other advanced economies have also been volatile.
But rate moves in emerging-market economies have been much gentler. While this is due in part to diverging monetary policies over the past two years, “it nonetheless challenges findings in economic literature that show large spillovers from advanced economies’ interest rates to emerging markets”, the IMF says. “In particular, major emerging markets have been more insulated from global interest rate volatility than would be expected based on historical experience, especially in Asia.”
There have been other signs of resilience in major emerging markets. Their exchange rates, stock prices and sovereign bond spreads have fluctuated in a modest range. “More remarkably, foreign investors did not leave their bond markets, in contrast to past episodes when large outflows ensued after surges in global interest rate volatility, including as recently as 2022,” the IMF says.
It wasn’t just due to luck. Policymakers in many emerging markets have spent years building their policy frameworks to mitigate external pressures. They have built additional currency reserves over the last two decades. Several of these nations have also moved towards flexible exchange rates. Consequently, market-driven foreign exchange adjustments have contributed to macroeconomic stability in many cases.
The structure of their public debt has also become more resilient, and domestic savers and investors alike have become more confident about investing in local currency assets, thus reducing reliance on foreign capital.
Perhaps most importantly, the IMF says, major emerging markets have enhanced central bank independence and gained progressively more credibility, more so since the onset of Covid-19 by tightening monetary policy in a timely manner and bringing inflation toward target.
Global financial conditions meanwhile have “remained quite benign” during the current monetary policy tightening cycle. This contrasts with previous rate hike cycles in advanced economies, which were accompanied by a much more pronounced tightening of global financial conditions.
In spite of reaping rewards from years of building buffers and pursuing proactive policies, the IMF says policymakers in major emerging markets need to “stay vigilant” with an eye on the challenges inherent in the “last mile” of disinflation and rising economic and financial fragmentation.
The blog post highlights three challenges:
- Interest rate differentials are narrowing as investors expect some emerging markets to cut rates faster than in advanced economies, which could entice capital to leave in favour of assets in advanced economies;
- Quantitative tightening by major advanced economies continues to withdraw liquidity from financial markets, which could additionally weigh on emerging-market capital flows; and
- Global interest rates remain volatile as investors, reacting to increased data dependency by central bank, have grown more attentive to surprises in economic data.
“Perilous for emerging markets are market projections that central banks in advanced economies will materially cut rates this year. Should this prove to be wrong, investors may once again reprice in higher-for-longer rates, weighing on risky asset prices, including emerging-market stocks and bonds,” the IMF says.
There are other potential clouds on the horizon. A slowdown in emerging economies, which the IMF is expecting, could spell trouble via financial channels. More borrowers globally are defaulting on loans, weakening the balance sheets of banks; emerging-market bank loans are sensitive to losses on weak economic growth.