21st October 2017

BNY Mellon: Investing in emerging markets when interest rates rise

According to research from the Institute for International Finance, net capital inflows to emerging markets will total $78bn in 2017, accelerating to $167bn in 2018 and reversing the trend of significant outflows that was seen in 2015 and 2016. This is causing many international investors to take a fresh look at emerging market assets.

As we advise our clients on the best approach to investing in emerging markets, a common concern we hear is the prospect of rising developed market interest rates and how this will affect yields and volatility in emerging market assets.

In our view, in order to address this question, it is critical to consider the potential catalyst for higher developed market yields. The global growth outlook is improving, output gaps in the developed world have closed, causing labour markets to tighten and boosting global trade. Developed market inflation has moved moderately higher, fears of global deflation have now passed, but disruptive technological change and globalisation are still powerful disinflationary forces. Global energy prices, typically a factor driving inflation higher during periods of stronger global growth, are being constrained by increasing US shale oil production. In this environment, major central banks have room to normalise interest rates gradually, led by the US.

For emerging markets, this backdrop of improving global growth and constrained inflationary pressures is likely to cushion against the volatility which could be caused by rising developed market yields. Real yields in local currency emerging debt markets are historically high, as the pass-through to inflation from previous currency devaluations and the rise in global energy prices dissipates. A rise in developed market yields, where real yields are historically low, would not necessarily translate into a rise in local market yields of a similar magnitude. If emerging market yields were to move to a similar degree, then the higher level of nominal yields would provide far greater protection to investors than the yields of most developed market countries.

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Investments, Investment Commentary