Emerging-Market Interest Rekindled by Speculation of a Fed Pause

(Bloomberg) -- The mere hint that the Federal Reserve could pause on rate hikes next year has some money managers reexamining emerging markets -- starting with the hardest-hit assets.

Aberdeen Standard Investments, Schroders Plc, Goldman Sachs Asset Management and BlackRock Inc. are looking with renewed interest after Fed Vice Chairman Richard Clarida said last week there’s “some evidence” that the world economy is cooling down. A slower pace of rate increases would weaken the dollar and aid emerging markets, which attract investors by paying higher yields to account for their bigger risk.

"A Fed on hold is a rising tide that can lift all ships in emerging markets," said Edwin Gutierrez, a money manager at Aberdeen in London. Gutierrez said he would be looking to add exposure to the most beaten-down assets like high yield bonds, frontier-market debt and developing-nation currencies.

Emerging-Market Interest Rekindled by Speculation of a Fed Pause

Clarida said last week that the Fed is getting closer to neutral level, while citing the possibility of slower global growth, while Chairman Jerome Powell cited the prospect of cooling global demand. Then, a slump in tech stocks brought the S&P 500 Index down to some of its lowest levels in five months and economists began to speculate the economy could come under greater pressure than previously thought.

Developing-nation stocks and currencies extended last week’s gains Thursday on the back of a falling dollar and U.S. yields at their lowest in more than seven weeks.

While the FOMC consensus has yet to shift away from continued rate increases, and another hike next month is widely expected, a pause is entirely plausible next year, according to Jan Dehn, the London-based head of research at Ashmore Group, which oversees $76 billion. He favors Brazilian bonds, Chinese stocks and the Czech koruna amid the more favorable backdrop for emerging markets.

Chris Diaz, a money manager at Janus Capital Management in Denver, says with U.S. growth likely to decelerate and inflation under control, a Fed pause is reasonable and would make him favor high beta currencies like the South African rand, Brazilian real and potentially the Turkish lira.

“EM currencies are responding and the local currency index is up for the month of November,” said Jim Barrineau, the head of emerging market debt at Schroders in New York. “As we get more confirmation of slowing U.S. growth, investors will get more comfortable with non-U.S. exposure and EM currencies, as well as EM dollar debt, will definitely benefit.”

The Higher the Climb, The Harder the Fall

Some investors remain cautious.

Goldman Sachs Group Inc. and JPMorgan Chase & Co. are sticking with forecasts for the Fed to hike interest rates five more times by the end of 2019, even as financial markets weaken. In recent reports, economists at the Wall Street giants predicted the central bank will raise the benchmark rate again in December, ultimately pushing it to 3.50 percent by the end of next year.

Brendan McKenna, a New York-based currency strategist at Wells Fargo, says emerging markets are mispricing the Fed right now.

“We are of the view the Fed will continue to hike rates at least three times, maybe even four, next year,” McKenna said. “If the Fed were to tighten faster than markets anticipate, the obvious impact on EM currencies would be pretty negative.”

McKenna is especially cautious on the Turkish lira as the country hasn’t yet made adequate adjustments to policy. The Chilean peso would also be at risk, he says, as the majority of the government’s debt is held in dollars.

“It is hard to argue that Chairman Powell or the Fed as a whole is set to hit the pause button,” said Sonja Gibbs, a senior director at the Institute of International Finance in Washington. Still, “if investors become more convinced of a Fed pause, EM assets in general should do well, perhaps local currency bonds in particular as that scenario would also mean a softer dollar."

©2018 Bloomberg L.P.