Fed Shock to Emerging Markets May Not Be as Bad as Feared

  • Measure is near seven-year high after adjusting for inflation
  • Narrower current-account gaps show improving fundamentals

Emerging-market bond investors can stop the hand wringing.

For all the angst about the potential for higher U.S. interest rates to hammer developing-nation assets, in fact prices show the increase is mostly priced in, according to money managers including Aberdeen Asset Management Plc and UBS Wealth Management. The extra yield investors get to hold local emerging-market debt instead of bonds from developed countries is already near the highest in at least seven years after adjusting for inflation.

That provides a cushion if the Federal Reserve surprises observers with a hawkish statement Wednesday, instead of toning down expectations for further tightening when policy makers announce their rate decision. The outlook for faster growth in emerging markets, narrower current-account deficits and fairly stable political backdrops are also supporting developing-nation bonds even after the increase in U.S. and European rates over the past year.

“Our base case calls for credit spreads being supported around current levels by improving emerging-market fundamentals, gradually recovering energy prices and a benign external backdrop,” said Alejo Czerwonko, an emerging-market strategist at UBS Wealth Management.

The market-implied probability that the Fed will raise rates by year-end is about 45 percent, using the current effective fed funds rate and the forward overnight index swap rate.

The improvement in emerging-market fundamentals can most easily be seen in the current-account deficits among Morgan Stanley’s so-called “fragile five,” a group of nations the bank identified in 2013 as being particularly vulnerable to higher global rates. The gap reached 4.6 percent of gross domestic product four years ago, but has since narrowed to just 1.8 percent.

“We are in much better shape,” said Edwin Gutierrez, the London-based head of emerging-market sovereign debt at Aberdeen, which has about $385 billion under management.

The risk premium on sovereign emerging-market dollar bonds dropped four basis points to 300 basis points on Wednesday, according to JPMorgan indexes.

— With assistance by Ye Xie

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