Based on the Federal Open Market Committee’s September policy statement, it seems increasingly likely that the U.S. Federal Reserve (“Fed”) will begin tapering its bond purchases later this year. Emerging Markets (EM) equities have underperformed Developed Markets this year largely due to the regulatory and market turmoil in China, but now there are questions around additional pressure from tighter U.S. monetary policy. Might the burden of lower global liquidity fall harder on developing economies, which may be more sensitive to capital flows? While EM equities have generally fared relatively well in past tightening cycles, coincident currency declines weakened returns for USD-based investors. We argue that EM currencies are generally in a more favorable position now than in previous cycles. We believe currency crises are less likely to be repeated, and EM central banks are (atypically) leading the Fed in this tightening cycle, which should relieve pressure on exchange rates.
Exhibit 1 charts the average returns of the MSCI Emerging Markets Index (“EM Index”) in the early years of the last five Fed tightening cycles and from the first day of the so-called “Taper Tantrum” in 2013. Despite the perceived vulnerability of EM equities to global tightening, USD returns (solid lines) are positive. Local returns (dotted lines) are even higher. The EM Index in local terms nearly tripled, on average, in the four years following the previous five Fed hikes. In both USD and local currency returns, the EM Index outperformed the MSCI World Index (not pictured) in these periods. While it is true that the EM Index underperformed the MSCI World Index following the “Taper Tantrum,” Fed tapering in 2021 – unlike in 2013 – has also been much better telegraphed.
Even though weakness in EM currencies has detracted from USD-denominated returns in previous cycles, there are reasons to anticipate less volatility in the current tightening cycle. When we analyze the last five Fed hikes, we are reaching back into the late 1980s and 90s. Many EM currencies were pegged to the U.S. dollar in the 1990s and faced untenable fixed rates that resulted in violent currency crises including Mexico (1994-95), Russia (1998), and the Asian Financial Crisis (1998-99) felt across Indonesia, Malaysia, the Philippines, and Thailand, among others. In the wake of these crises, many countries were forced to adopt floating exchange rates, allowing their currencies to freely adjust for changes in monetary policy and/or capital account imbalances in real time.
Though the higher prevalence of floating rates decreases the likelihood of EM currency crises, even gradual FX movements can erode USD returns. Recent history, however, suggests that exchange rates have already incorporated dollar strength. In 2020, on a real effective exchange rate basis, EM currencies depreciated the most in ten years and even more than in the “taper tantrum” year of 2013 (see Exhibit 2). Even though they have partly recovered in 2021, many EM currencies are still undervalued compared with their pre-pandemic average levels. At these discounted levels, we believe many EM currencies may not have much farther to fall. Additionally, many EM central banks have bolstered their foreign exchange reserves during the recovery from the pandemic, providing additional cushion against future exchange rate volatility.
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