By Michael Stanes, Investment Director at Heartwood Investment Management
Developed markets appear to be taking the theme of Fed tightening in their stride. The US treasury market has not reacted significantly, although shorter-dated bond yields are moderately higher over the past week. Longer-dated treasury yields are continuing to decline, signalling that the market is still concerned about the growth trajectory, particularly given the effects of a strong US dollar. The dollar has traded within a tight range against the major currencies over the last two months, but has strengthened meaningfully against some emerging market (EM) currencies, particularly the Russian ruble and Brazilian real.
Weakness seen across some EM currencies has largely been attributed to commodity price weakness combined with country idiosyncratic risk. Over the last ten years, which also coincides with the longest period of Federal Reserve monetary policy accommodation, the number of EM credit rating upgrades has outpaced the number of downgrades. However, that trend has recently started to reverse, symbolised last month by S&P’s decision to place Brazil’s credit rating on negative outlook; it now teeters one notch above junk status.
Other EM heavyweights are also under pressure. Over recent years, Turkey had been held up as a bellwether for its success in implementing market reforms and rebuilding its public finances. However, given the challenges of financing a high current account deficit, Turkey’s sovereign credit rating remains on negative outlook by Moody’s, while S&P already assigns it a speculative rating. A decision by Moody’s to lower Turkey’s credit rating to junk would lead to Turkey exiting the global investment grade bond indices, potentially leading to forced selling which could have significant market implications.
This year dedicated EM equity funds have seen a consistent trend of investor outflows and the pace has picked up since August [Source: Barclays]. Dedicated EM bond funds (hard and local currency bonds) have also been subject to outflows since April 2015. The slowdown in EM growth has been notable this year and rising country specific risk is weighing on investor sentiment. But some of these trends also show that markets are adjusting to an environment of Fed tightening.
In previous communications, Fed policymakers have expressed caution about the impact of Fed rate rises on emerging market economies. The latest US employment report probably provides more ammunition for the Federal Reserve to raise interest rates in September, providing at least the room for manoeuvre should there be a preference among policymakers to raise rates sooner rather than later. Whether rates are lifted in September or December, Fed policymakers have a precarious balancing act between making the necessary monetary policy changes without placing undue distress on certain asset classes. Markets are beginning the process of adjustment to the ‘new normal’ environment.