It is widely believed that the Federal Reserve has multiple interest rate hikes ahead of it this year and that it could get more aggressive with rate tightening in a bid to damp high inflation.
Conventional wisdom also holds that Fed tightening regimes can be drags on emerging markets assets, and there is some historical precedent for that, including the 2013 “taper tantrum.” However, emerging markets are in different places today, fiscally speaking, indicating that exchange traded funds such as the Emerging Markets Internet & Ecommerce ETF (NYSEArca: EMQQ) and the Next Frontier Internet & Ecommerce ETF (FMQQ) may not be as bad off against the backdrop of rising U.S. interest rates as previously believed.
“Conditions today are very different, giving EMs much more resilience. One key component is currency reserves, which gives a country a buffer to absorb any damaging impact of rising U.S. rates and a strengthening greenback,” according to Morningstar research. “A rule of thumb for adequate currency reserves, as popularized by Fed Chairman Alan Greenspan in 1999, is that a country should manage external assets and liabilities in a way to be able to live without new foreign borrowing for up to one year, which translates into 7% of GDP. In 2013, 8 of 13 developing countries were well below that threshold, but by the end of 2020, only 2 were.”
Another point in favor of emerging markets as the Fed hikes rates is lower current account deficits. During the taper tantrum of 2013, developing economies’ current account deficits averaged about 4.4% of GDP, but that percentage declined to 0.4% in mid-2021.
Of course, emerging markets won’t respond to Fed tightening in linear fashion, so it pays for investors to be selective about an ETF’s country exposures and allocations.
“Furthermore, South Korea has acceded to developed nation status while the leading EM country, China, has evolved a substantial consumer economy and a respectable technology sector,” adds Morningstar.
As of the end of March, EMQQ devotes over 62% of its weight to Chinese and South Korean equities. The aforementioned FMQQ has no China exposure, but South Korea is that ETF’s largest geographic weight at an allocation of 31.13%.
Some experts believe that in the current environment, some Asian economies are better equipped to handle Fed tightening than was the case nine years ago, and several of these economies are offering attractive valuations due in large part to coronavirus-induced declines.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.