By Jamie McGeever
ORLANDO, Fla. – If the consensus view of a strong dollar and higher US bond yields in 2022 proves accurate, emerging markets are in for a rough ride, particularly in the first half of next year.
Just how bumpy will largely depend on the extent to which the Fed ending its bond buying and starting its rate-hiking cycle ultimately tightens US financial conditions via a higher dollar and Treasury yields.
Emerging markets are particularly vulnerable on three fronts to tightening US financial conditions: diminishing capital and portfolio inflows; rising inflationary pressures; and as a result of these two, higher domestic interest rates, which slow growth.
Goldman Sachs’s US financial conditions index shows that the ground for borrowing, lending, investing and spending in America has rarely been more fertile since the index was compiled more than 30 years ago.
The easing of conditions this year has been almost entirely down to the boom on Wall Street. This more than offset the tightening from a higher 10-year Treasury yield and stronger dollar, on track for their biggest annual rises since 2013 and 2015, respectively.
While it is reasonable to assume asset markets have to some extent already priced in the Fed’s expected taper and rate increases next year, it is also reasonable to assume financial conditions will still tighten from the current historical lows.
Take the 10-year Treasury yield, which is currently around 1.50 percent. That may be some 50 basis points higher from a year earlier, but is 50 basis points – or more – below where many analysts thought it would be 12 months ago.
The flattening US yield curve suggests the 10-year yield may not rise much from here.
Similarly, there might not be much room for the dollar to rise further, having already strengthened 7 percent this year.
But emerging markets are so sensitive to both right now, that small rises may yet have an outsized impact.
“A challenging year for emerging market assets is nearing an end, but the year ahead could bring even greater obstacles,” SocieteGenerale economists wrote in a recent note, adding that EM inflows will be depressed by the Fed’s less-accommodative monetary policy, stronger dollar, and higher US yields.
Stagflation is already happening, even though inflation-busting policy tightening cycles are underway in many emerging countries, notably Brazil and Russia. Bond inflows, in particular, are drying up.
Data from the International Institute of Finance in Washington show that debt portfolio net inflows into emerging countries last month totaled just $6.3 billion, the lowest since a $6.5 billion outflow in March.
IIF economists say high-frequency data show that capital flows to emerging markets not including China ground to a halt this quarter, essentially a “sudden stop.”
When US financial conditions are benign and it is cheap to borrow in dollars, investors seek the higher returns offered by riskier assets in the emerging world. But when US borrowing costs rise, that proposition is no longer so attractive. – Reuters
