Get out of emerging markets before the U.S. Federal Reserve starts raising interest rates.
That’s the position of Danica, the pension fund unit of Danske Bank A/S, Denmark’s biggest bank. The fund, which oversees about $50 billion in assets, says the shift that comes once the Fed starts tightening monetary policy will overshadow every other moving piece in markets. High-returning but illiquid markets will be a bad place to be when that happens, according to Jacob Aarup-Andersen, Danica’s chief financial officer.
“We’re much less exposed to emerging markets now,” he said in a phone interview. “Looking at a market where we’re expecting rates to eventually rise is making emerging markets less attractive.”
At Danica, the “main concern is U.S. rates, so what the Fed does,” Aarup-Andersen said. Combined with a stronger recovery in Europe than many investors are anticipating, the risk is that monetary stimulus from the world’s two biggest central banks will stop “sooner than expected,” he said.
The likelihood the Fed will move grew after Europe managed to prevent Greece from imploding and as China’s stock market showed signs of stabilizing, according to Danica.
“If the Fed raises rates, European rates will trend along, absolutely,” Aarup-Andersen said. So far, the European Central Bank has been “keeping the lid on the pressure cooker to make sure it doesn’t blow off. The minute they start easing their grip, there’s a risk the lid will be blown away and then we’ll see rates rising fast.”
After tail risks from Greece and China were contained earlier in July, investors will “squarely” be looking out for Fed rate increases, Alberto Ades and Isidore Smart, analysts at Bank of America Corp., said in report published on July 23.
The best place to be to prepare for the jolt the Fed’s monetary policy shift will bring is in “more liquid markets to make it easier to move,” Aarup-Andersen said. “What happened in the second quarter is a very good example of how fast things can move.”
Safe, liquid assets in the current environment are U.S. Treasuries, European government bonds, covered mortgage bonds and German Pfandbriefe, he said. But even some of the world’s biggest markets are seeing declining volumes, including German bunds.
“There’s no doubt the market is growing more illiquid,” Aarup-Andersen said. “It will take time to rebuild it.”