How Will the Fed’s Decision Impact Emerging Markets?

(October 16, 2013) — The global economy will grow slowly but steadily, while emerging markets will begin to recover next year after a bout of problems from reduction in liquidity, UBS has predicted.

From a discussion of the US Federal Reserve’s decision to defer from tapering and its impact on the intricate relationships between developed and emerging markets, UBS investment teams found asset classes are safe—for now.

“If the Fed continues its ‘lower for longer’ approach, and that becomes priced into markets, this seems like a rich environment for asset class bubbles to form,” Curt Custard, chair of the UBS Global Asset Management cyclical market forum, said. “Politicians are driving prices. Fed policy is the most important aspect for markets, not just in the US, but across the globe.”

Scott Dolan, co-head of UBS’ US multi-sector fixed income, agreed on the positive effects of not tapering: “I believe we are in the early stages of a change in the interest rate cycle. The Fed’s lack of tapering in its September meeting gives me further confidence that it will not further tightening in financial conditions and will continue to trade credibility in favor of the potential for fostering economic growth and job gains.”

The forum debated three possible economic scenarios. In the first and most likely situation, according to UBS, the US and Japan will slowly lead economic recovery, with emerging markets regaining strength in 2014. The Eurozone will also see sluggish growth due to its continual need for deleveraging, and inflation will negatively impact a few emerging markets.

Another scenario presented the most bullish view: a strong US economy—a result of increasing consumer spending and a vigorous housing market—would stir global confidence, leading investors to take more risks. These trends would help European nations with debt and hasten emerging market growth.

The least likely outcome, according to UBS, was the most bearish one, with troubles in emerging markets damaging developed markets—similar to the crises in the late 1990s.

“If one of these large [emerging] countries gets into a situation where they cannot generate growth by devaluing their currency due to a lack of long-term competitiveness, it might have an avalanche effect that pulls down other players that have no business being pulled down, other than a market flight to quality,” Michele Gambera, UBS’ head of quantitative analysis, said.

UBS said this scenario would cause significant global disturbances, particularly in emerging markets and the Eurozone. While the US could continue to grow at a moderate rate, other developed markets would become sluggish at best.

“If the most negative outcome comes to pass, equities in both developed and emerging countries would likely suffer double-digit losses, while overall total returns would also be negative,” UBS said.

However, the bearish scenario might not be too catastrophic. “The emerging countries are not nearly as dependent on the US dollar and US rates as they were during the Asian crisis in 1998,” Uta Fehm, a portfolio manager of emerging market debt at UBS, said.

“Today, there are extremely liquid local currency markets in many countries, and many countries are in much stronger fiscal shape and have higher reserves. There are only a few countries with significant problems, and overall, I see the risk of contagion as much lower than in the past.”

Forum participants agreed that regardless of these scenarios, developed markets will outperform emerging markets in both currencies and total return over the next 12 months.