ARE WE WRONG ABOUT THE TRUE IMPACT OF US INTEREST RATES ON EMERGING AND FRONTIER MARKETS?

In our previous Smart Chart, we explored the different performance cycles of emerging and frontier markets vs developed markets.

While we were researching this we found something that goes against the conventional instinct that reigns on global markets: When US interest rates rise, investors typically have a knee-jerk reaction to rush out of emerging and frontier markets.

The reigning rationale goes something like this: “…why should investors seek out risky markets when they can earn more interest income in US treasuries? In addition, higher US$ interest rates will make it more difficult for emerging and frontier markets to service their debt…”

It happened again in 2018. When the market was convinced that US interest rates were on the way up, it abruptly reversed the emerging and frontier markets rally in the beginning of the year.

But when you look at the data, it turns out that there is a directional correlation that goes against this common heuristic.

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So what could possibly explain this?

The truth is that we don’t entirely know the answer, but we believe that it could come as a result of the following:

When interest rates are higher, institutional investors - who are mainly invested in fixed income - receive higher income, which increases their risk budget. This in turn finds its way into more ‘risky’ asset classes such as emerging and frontier markets.

While this is not a hard conclusion, to us it seems like the most logical way to make sense of this positive correlation.

Earlier on, we mentioned the fear about emerging and frontier markets facing difficulties to service their debt burdens. We believe this is yet another myth. We will explore this in more detail in our next smart chart…

If you have an opinion about this, please feel free to post it in the comments below.