Yield-starved American investors are turning to emerging-market assets as the Federal Reserve's continued commitment to bond-buying and low rates reduces the risk of repeating the 2013 "taper tantrum" exodus of capital from stocks and bonds in developing economies.
Until now, investors have shied away from emerging markets in 2021, despite the low returns on offer from U.S. Treasurys and corporate bonds, and the stretched valuations of U.S. stocks,
The prospect of tapering evoked memories of 2013, when the Fed's suggestion that it would begin scaling back the post-financial crisis asset-purchasing program led investors to sell off their positions and caused emerging-market asset prices to sink.
Concerns that history will repeat itself is a key reason why more nonresident dollars flowed out of emerging market portfolios than into them in three of the first four months of the year, according to the Institute of International Finance.
Yet the IIF noted a "slow recovery" in demand in March, with $29 billion of net capital inflows before a $21 billion decline in April. And with the Fed reiterating its message that it will maintain its loose policy despite higher inflation signals, investors are finally accepting the Fed's word.
"The big question is, will we have a repeat of the 2013 taper tantrum?" Jeff Grills, head of emerging markets debt at Aegon Asset Management, said in an interview. "I think the answer to that is, 'no.'"
The acceptance of the Fed's narrative is most apparent in the yield on 10-year Treasurys. Rising inflation expectations pushed up the yield on U.S. government debt to a peak of 1.74% in late March from a low of 0.52% in August 2020. Investors demand higher yields when they expect inflation will eat away returns.
Yields fell back to 1.57% as of June 16 even as the consumer price index showed inflation hitting 5% in May, the highest rate since 2008.
"The market was saying, 'Well, if the Fed doesn't hike interest rates now they will over-hike later.' What has changed now? The market is believing the Fed really means what they were saying," Claudio Irigoyen, head of Latin America economics, equities, fixed income and foreign exchange strategy at Bank of America, said in an interview.
Developing economies in better shape this time
The lack of appetite for emerging-market assets is apparent in the fortunes of the global stock markets.
The benchmark MSCI EM index — which tracks large and mid-cap stocks across emerging markets — has gained 6.1% in 2021, underperforming the 12.5% rise in the S&P 500.
Emerging-market sovereign bonds also are offering strong returns but attracting few buyers. Whereas 10-year U.S. government bonds offer yields of 1.57%, as of June 16 returns in Turkey were 18.2%, in Brazil 9.1% and in India 6%. Yields rise as bond prices fall, meaning a jump in yields reflects a drop in price for that debt.
While the scale of returns suggests investing in emerging-market assets is a no-brainer, emerging-market assets historically have carried a risk premium for a reason. Past defaults in Argentina, Brazil, Thailand and other countries weigh against the entire emerging-market sector, as does political instability not found in more developed economies.
But emerging-market economies have learned from their mistakes, with more debt held locally, reducing exposure to capital flight, and budget surpluses rather than deficits now the norm.
"Emerging markets are now much more resilient than we've seen in previous occasions of a taper tantrum," Anders Faergemann, portfolio manager, EM sovereigns, at PineBridge Investments, said in an interview. "Our analysts are telling us that we're currently seeing the strongest wave of improving fundamentals since 2009."
Where are the opportunities?
Bank of America's Irigoyen sees opportunities primarily in Asia — which has benefited from the quick economic recovery of regional superpower China — ahead of Eastern Europe and Latin America.
"Volatility is much lower in Asia than Latin America, but the question is if higher volatility in Latin America is being compensated with higher expected returns," Irigoyen said.
Metals-rich countries in Latin America have benefited from the commodity boom brought about by the surge in global manufacturing. The S&P GSCI commodity index — which tracks a basket of exchange-traded commodity futures contracts — is at its highest point since November 2014, buoyed in part by record-high prices in iron ore as steel production surges.
Latin American portfolios have been the best performing among emerging-market regions, attracting nonresident inflows of $6.2 billion for equity and $1.7 billion for debt in April, whereas emerging markets in Asia suffered net outflows of $500 million, according to the IIF.
Rising inflation in Mexico and Brazil has forced central banks to raise interest rates, meaning investments in local currencies deliver even higher returns. Inflation in Brazil hit 8.1% in May. Oxford Economics forecasts the central bank of Brazil will raise rates from 3.5% currently to 6% by year-end. Brazil already has hiked rates by 75 basis points in 2021.
"We like Mexico and Brazil both from the local currency perspective and from the sovereign side," Faergemann said.
Central banks in Russia and Turkey also have increased rates in 2021, while Hungary, the Czech Republic and South Africa are expected to follow, according to Ehsan Khoman, head of emerging markets research at MUFG.
Slow vaccine rollout concerning elsewhere
While investment returns are strong, experts highlighted the risk posed by lagging vaccination rates in emerging markets compared to developed economies.
The U.S. had fully vaccinated 43.3% of its population as of June 16, according to Our World in Data. That compares with 11.1% in Brazil, 16.4% in Turkey and 6.4% in South Korea.
Brazil and India have endured recent surges in COVID-19 infections that have killed hundreds of thousands of people and brought healthcare systems in each country to the brink of collapse.
But both countries are showing other signs of recovering economic stability, Faergemann said.
"What we're more focused on is the mobility or restrictions in economies and how fast they can recover from COVID-related economic weakness. We are seeing encouraging evidence even in countries such as Brazil or India," Faergemann said.
While all the signals suggest emerging market assets could perform well, their fate will depend on the Fed maintaining its policy approach even if inflation persists. Otherwise, taper tantrum fears will reemerge.
"U.S. inflation can have a negative impact on emerging markets if we learn in the third quarter it's not transitory," Aegon's Grills said.