Last week saw markets once again roiled by developments at their core – the United States. The S&P 500 index is testing its February lows. But for emerging markets, where fundamentals are improving, why does this matter?

Several strands of news are competing for investors’ attention at the moment. Most of them are coming from the US: the challenge to the tech sector, which has led equity markets to their current, arguably breathless, levels; increasing noise around inflation, to the backdrop of rising interest rates; and an administration seeing high turnover in key personnel, while taking steps to challenge long-held consensus views on trade.

Emerging market investors might like to think that the many diverse geographies in which we invest can be immune from such ructions. This is incorrect – the two are interlinked.

Chart 1 shows three month dollar LIBOR expectations for the next two years versus EM sovereign high yield spreads, during 2013’s ‘taper tantrum’. As we know, the Federal Reserve didn’t actually begin to raise interest rates until December 2015, but in spring 2013, expectations around rate rises in the next two years spiked, and this change in the core had a dramatic effect on EM spreads:

Chart 1: EM sovereign HY spreads versus US rate expectations, 2013

Source: Bloomberg

However, we need to do more than say ‘be risk averse when core conditions are appearing to tighten’. If we take the same chart forward to late 2016, as in Chart 2, when President Trump was elected, we see a divergence between the two indices. Let’s add in the US dollar here, too, and we can see that it has been a newly growth-oriented US economic policy, driving higher nominal yields, translating into a weaker currency, helping move EM spreads better since then:

Chart 2: EM sovereign HY spreads versus Eurodollar future and US dollar, 2016 – 2018

Source: Bloomberg

What about going forward? We wonder if US equities could take over as an important driver of EM spreads. Here is the S&P 500 index (inverted) against the same EM spreads measure, but going much further back:

Chart 3: EM sovereign HY spreads versus S&P index (inverted), 1998 – 2018

Source: Bloomberg

Whether equities prove critical from here or not, the message to the EM investor is clear – not paying attention to the core could be a mistake.


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