Fed tightening not the end for EM financial markets

The positive reaction by investors on Thursday to the FOMC minutes, which gave a heavy hint that US interest rates will be hiked next month, supports the view that emerging markets (EMs) will fare well in 2016/17. Equities generally rallied by around 1% and currencies appreciated by about 0.5% against the dollar.

 Those moves were small in magnitude, but they should at least dispel the notion that Fed tightening will automatically trigger a meltdown in EMs. And recent history shows that EM markets actually performed well during the last two Fed tightening cycles that kicked off in 1999 and 2004.

Admittedly, markets slumped in 1994 when the Fed caught investors off guard, US monetary policy suggests that they could be vulnerable to this again. Whereas the implied rates on federal funds futures were largely unchanged on Thursday.

"We expect the federal funds rate to rise much further and faster than generally anticipated (to 3.25-3.50% by end-2017). As such, we forecast the 10-year US Treasury yield to rise to 3.5% by end-2017, from 2.3% currently", says Capital Economics in a research note.

But a re-run of 1994 is unlikely. For a start, it is surely now the case that few investors will be surprised when the Fed starts raising rates. And the relatively hawkish forecast is predicated on the US economy being strong enough to warrant such a pace of tightening. That economic backdrop should be positive for riskier assets. In addition, EM financial markets have already suffered heavy losses and history may eventually show that the taper tantrum in May 2013 was the "1994 moment". While those past losses clearly do not preclude future falls, measures of valuation are not generally consistent with another EM-wide meltdown.

"The upshot is that we remain comfortable with our forecasts for 2016/17. In particular, we expect equities to rise by 15-20% on average by the end of 2017 and to outperform those in developed markets", added Capital Economics.