The Fed Hikes Rates — What Next For Emerging Markets?

In a widely expected move, the U.S. Federal Reserve (Fed) hiked its benchmark interest rate for the first time in nearly a decade on Wednesday, a decision which immediately increased borrowing costs for businesses/consumers in the U.S. and could coincidentally ripple through the world economy.

After months of deliberation, Fed policy makers increased its key interest rate for short-term borrowing by a quarter of a percentage point, pushing it up from near zero where it has been for seven years.

Within minutes on the Fed’s decision, major U.S. banks increased their prime lending rates to key business customers, which will affect homeowners who borrow against the value of their residences.

Fed Chair Janet Yellen said policy makers decided to increase the rate as the U.S. economy expands “at a moderate pace” amid a “solid expansion of domestic spending” in the U.S., where consumer purchases account for around 70 percent of the economy.

The Fed said that it could continue to boost the key rate in 2016 at a “gradual” pace as the Central Bank continues to monitor the conditions of the U.S. economy, especially whether the very low annual inflation rate in the country — at “0.4 percent” – advances closer to the two percent rate that the Central Bank considers to be optimal.

The Fed said that a “gradual” series of rate hikes could be imposed in the coming months to keep the U.S. economy from expanding too rapidly and hold inflation in check, however policy makers could also hold off if U.S. economic growth slows.

If the U.S. economy should continue to expand to the Fed’s liking, it could mean quarter-point rate hikes every three months or so over the next three years, which could lead to a 3.25 percent benchmark rate by the end of 2018.

What Next for Emerging Markets?

The move by the Fed has stirred fears that another wave of turmoil could hit emerging market (EM) economies that have already been rocked by financial storms and rising debt levels.

Yellen, however paints a different picture as she said on Wednesday following the rate hike that “the U.S. economy is a source of strength to emerging markets,” and that “there are positive spillovers from a strong U.S. economy.”

But what about the strong U.S. dollar and EM debt?

The Fed-induced appreciation of the U.S. dollar is set to bring deeper pain for EM countries like Russia, Brazil, South Africa, and Turkey, where such firms have borrowed heavily in the dollar and will find it much harder to refinance their $3.3 trillion dollar debt with their weaker local currencies.

“The challenge will be higher for quasi-sovereign and corporate issuers that have to roll over debt as their funding costs will be substantially higher,” said Greg Saichin at Allianz Global Investors Europe.

EM countries now have further challenges to deal with as they are finding it more difficult to find cash to borrow as lending has started to dry up.

Issuance by EM borrowers plunged 98 percent from the second quarter to a net $1.5 billion in the third quarter, according to a report from the Bank for International Settlements (BIS). This was the largest fall since the 2008 financial crisis and reduced global sales of securities by almost 80 percent, the BIS said.

Meanwhile, investors have been racing for the exits as they have pulled a net $500 billion from EMs in 2015, which will be the first annual outflow in decades.

NN Investment Partners has estimated that a staggering one trillion dollars has been withdrawn from EMs between July 2014 and August 2015.

The big question now is if the Fed plans to raise rates over the coming months, which could provoke another stampede of investment from emerging markets.

The combination of a slump in commodities including oil, weakening EM currencies, rising U.S. rates, and a strengthening dollar could create a “perfect storm” of conditions that will lead for some EM companies to sell their assets and for others to default in the coming year.

“You could have a perfect storm in some of these emerging markets if there’s a sudden stop in capital flows,” said Ayhan Kose, the head of the World Bank’s economic forecasting branch. “They should hope for the best, but prepare for the worst.”

Mark Mobius, an emerging market investment guru and Chairman of the Emerging Markets Group at Franklin Templeton, has a contrarian point of view:

“Many currencies in emerging markets have nose-dived and they are undervalued,” Mobius said during an interview with Bloomberg Television. “There are tremendous opportunities for a recovery in these currencies.”

Mobius said he believes that the fall in commodities including oil have reached or is near a bottom and that the small increase in U.S. rates won’t have a major impact on countries with high borrowing costs such as Indonesia, whose currency he said was undervalued along with the Indian rupee and Chinese yuan.

But what if the Fed does continue to hike rates?

What lies ahead from EMs in 2016?

It appears we could be in store for yet another volatile year as the waters are choppy and a perfect storm or storms are brewing.

To grasp just how bad emerging and frontier market equities have been rocked in 2015, see the charts below.

Be careful where you park your money.

Image courtesy of Thomson Reuters

Image courtesy of Thomson Reuters