The low interest rate environment in developed markets has been a boon for global stock and bond markets. US Stocks have set numerous record highs. This is because global growth is on an upswing, but major central banks are not yet putting the brakes on growth by raising interest rates. Similarly, the low rates have brought forth a "search for yield" environment for bonds, particularly corporate bonds in developed and Emerging Markets, as well as EM government bonds.

However, investors need to keep a close eye on US interest rates. This is particularly true for investors in Emerging Markets.

To see why, look back to 2013, the year of the Taper Tantrum. Taper Tantrum refers to the sudden rise in US interest rates that was not well communicated in advance by the Federal Reserve and, thus, spooked some markets. In particular, the EM bond market was hurt during the Taper Tantrum.

When US bonds suffer, Emerging Markets bonds often follow

When interest rates rise, this means that US government (Treasury) bonds are dropping in price (yields or rates are rising). The US Treasury bond yield curve is most often upward sloping, i.e. longer-dated rates being higher than shorter-dated. Duration is often used to refer to the time-to-maturity of bonds, so longer-dated bonds have higher duration.

And, when the yield curve is upward sloping and steepening, the longer duration bonds are typically hit hardest.

So why did Emerging Markets suffer? Unlike European bonds, which are relatively independent from US rates, EM bonds trade based on more of a direct comparison to the US Treasury bond curve. This comparison is measured in basis points over the US Treasury yield curve.

And EM bond indices generally have higher duration than many other markets. So when US rates rose dramatically in 2013, US bonds dropped rapidly and EM bonds fell along with them. EM corporate bond valuations are also measured in relation to US government bonds, so they suffered also.

Will Emerging Markets equities also be hurt by rising US interest rates?

If 2018 sees another Taper Tantrum, there could be another exodus from Emerging Markets bonds as investors avoid duration and exposure to US rates. Stock investors could be nervous if they see negative headlines about EM. However, it is important to note that, while EM debt would suffer, EM equities may continue to do well in a rising US rate scenario.

Generally speaking, when US rates are rising, this typically occurs during a period of strong growth in the US and this is often correlated with strong global growth.

In recent years, emerging markets have typically contributed close to one half of the global economic growth. We see this today, with countries such as China, India, Vietnam, Philippines, and Indonesia all currently posting strong GDP growth in excess of 5%.

With global growth running at a high rate, we can expect corporate profits to also continue booming in emerging markets. This would be good for EM equities, as equity valuations are based on the growth in earnings per share.

If you're an EM stock investor and still want to look out for signs from US interest rates, it may be wise to also look at the short-dated rates and the overall shape of the yield curve. If short-dated rates, like the 2-year, are rising faster than the longer-dated rates, this would mean that the yield curve flattening or inverting, which is often the sign of a coming recession. This, of course, would be bad for global equities.
© ALL RIGHTS RESERVED