As US bond yields rise to multi-year highs, emerging market assets are going through a challenging period. Among investors, the current pullback in EM assets rekindled memories of a similar event back in 2013 – the ‘Taper Tantrum’. This week, we take a deep dive into the emerging market economies to assess which countries are most vulnerable to rising US yields.
What is the taper tantrum?
Since the Great Financial Crisis, central banks across the developed world have slashed interest rates and purchased trillions of dollars worth of bonds in order to stimulate the economy. While these actions mitigated the worst effects of the 2009 Global Recession, they also depressed the yields on developed market bonds, leading investors to shift their investments towards higher-yielding emerging market assets. The resulting inflow of money into emerging market economies gradually led to the build-up of macroeconomic imbalances. Over time, some emerging market economies inevitably began spending beyond their means, leading them to become overly reliant on borrowing from foreign investors.
By mid-2013, the US economy had recovered enough from the Great Recession to spur discussion within the Federal Reserve about the possibility of tapering its bond purchases. The mere hint of tapering caused US bond yields to spike as markets began to anticipate the reversal of years of easy monetary policy. Some investors re-allocated their investments away from emerging market assets back into the US, prompting a painful readjustment in the former.
During the Taper Tantrum, it quickly became clear that the countries whose markets suffered the most, were also the ones that had the largest macroeconomic imbalances. In particular, investor focus fell on a group of emerging market economies known as the ‘Fragile Five’ – comprised of Brazil, India, Indonesia, Turkey and South Africa. All five countries had larger trade deficits, were more reliant on external funding from investors, and suffered from persistently higher inflation rates (this lowers the inflation-adjusted return on those assets, thus making them less attractive to foreign investors).
The lesson wasn’t lost on emerging market policymakers, who then spent the next few years strengthening their countries’ macroeconomic foundations. Indeed, emerging market economies have gradually reduced their trade deficits, accumulated larger foreign currency reserves to better cover their external funding needs, and took a harder stance in curbing inflation. As a result, we think that emerging market economies have become less vulnerable to a 2013-style taper tantrum scenario.
Nevertheless, a select few emerging markets did sold off quite heavily, showing that not all are equally immune against rising US yields. In light of this, we used a scorecard to assess which emerging markets are most vulnerable to a renewed spike in US yields. Within this scorecard, we used a number of metrics that help quantify a broad swath of external imbalances within these countries. These include measures that gauge a country’s external funding needs and its external debt exposures. In addition, we include a number of metrics that may help mitigate the vulnerabilities mentioned above. These include the ability to attract foreign investment flows, the adequacy of foreign currency reserves, and foreign currency valuations. We then rank each major emerging market based on these metrics, and obtain a set of relative rankings based on how vulnerable these economies appear.
Based on our scorecard, countries such as Argentina, Turkey, and South Africa appear the most vulnerable to rising US yields. Given their relative vulnerability, it’s not surprising that the recent market pullback has been concentrated in these markets. On the other hand, emerging Asian economies appear the least vulnerable. This isn’t surprising to us – many of these countries have highly competitive export sectors. As such, they tend to enjoy trade surpluses rather than deficits, and have been able to accumulate more foreign currency reserves as a result of their exports.
Ironically, the Taper Tantrum turned out to be a blessing in disguise for emerging market economies. It alerted emerging market policymakers to the need to strengthen their economies, thus giving them enough headway to implement much needed adjustments before any meaningful monetary tightening actually begun. Fast forward to today, with the US embarking on a faster pace of rate hikes compared to 2013, emerging market economies have broadly increased their resilience to rising yields.
We remain broadly constructive on emerging market assets, with solid global growth and still-benign financial conditions providing a favourable backdrop for the wider asset class. Within our tactical positioning, we prefer to express over view through an overweight to emerging market equities, with a preference for Emerging Asia. The region is less exposed to volatile commodity price movements, while being better placed to benefit from the ongoing health in global demand and trade. As an added bonus, the region also appears to be less vulnerable to rising US yields, based on our scorecard.