What rising US bond yields mean for emerging market stocks

While emerging markets are much more stable than they were during the ‘taper tantrum’ of 2013, they are dominated by internet, technology and consumer giants
Because manufacturing and financial companies will benefit more from global growth, emerging equity markets may struggle to keep up

Patrik Schowitz

Published: 5:00pm, 5 Mar 2021

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The path to recovery from the Covid-19 crisis has become increasingly clear as countries around the world are vaccinating their populations and preparing to lift restrictions on public life. This is why markets have been booming, anticipating a surge in profits from renewed economic activity.

Yet despite continued vaccination progress, markets have hit a rough patch in recent weeks, with global equities down by over 3 per cent since mid-February, and Asia-ex-Japan by around 6 per cent. What’s going on? For some time, it has been clear that there are two main risks to further rises in risk assets such as equities.

The first is any serious threat to vaccination progress or effectiveness which might endanger the global economic recovery. But while there have been vaccination delays and concerns about new Covid-19 variants, so far none of these issues have really endangered the view that by this autumn major developed economies will reopen.

The second risk is sharply rising interest rates, which might dampen the economic recovery or undermine equity markets’ lofty valuations. This risk has begun to play out and hit markets recently, as US 10-year government bond yields have risen by nearly half from just over 1 per cent at the start of February to around 1.5 per cent currently – at least partly driven by the prospects of a US fiscal spending package of US$1.9 trillion.

The rise in US government bond yields also pulled up yields in other major economies such as Europe and Japan. Only China’s relatively insulated financial system allowed it to largely escape these moves.

This brings back memories of the 2013 “taper tantrum”. Back then, after years of easy monetary policy, the US Federal Reserve surprised investors with talk of “tapering” back down their long-running government bond purchases.

This caused a fearful reaction and much volatility in markets. US government bond yields spiked from around 1.6 per cent to around 2.7 per cent over just two months. Equity markets reacted nervously, but the ensuing correction was relatively modest and short, with global equities down by around 8 per cent over a month, before resuming their upwards trend.

The lesson from this historic episode is that even though very sharp moves in bond markets can cause temporary indigestion for equities, as an overall asset class they do usually cope with rising bond yields eventually. This is especially true when the yields increase is driven by the strengthening global growth – as is the case now – rather than runaway inflation.

Then Federal Reserve chairman Ben Bernanke speaks during a news conference at the Federal Reserve in Washington on September 18, 2013. Bernanke’s suggestion in May 2013 that the Fed would begin to put the brakes on its quantitative easing programme triggered what has come to be known as a “taper tantrum” in bond markets. Photo: AP

The picture may be a little more complicated for emerging markets. Historically, emerging market assets tend not to like periods of rising interest rates in the developed economies, mostly because central banks in emerging economies can be forced to raise interest themselves to defend their own currencies from outflows.

However, these also tend to be periods of strong global growth, which historically benefited emerging economies and equity markets, given their cyclical and export-driven nature. It can be difficult to predict exactly how the two factors balance out.

But looking back at the 2013 episode, the experience was far worse for emerging market equities, which fell by around twice as much as developed equities did and continued to struggle thereafter.

Fed should remember that the bond market can still intimidate

But emerging markets today are different beasts than they used to be. The north Asian economies of China, South Korea and Taiwan now dominate emerging equities, accounting for nearly 70 per cent of the widely-followed MSCI EM index.

On the one hand, these economies are much less likely to face serious currency problems today, having seen big improvements in their macro stability since 2013. On the other, these days emerging market equity markets may benefit less from a strengthening growth environment than they had in the past. They are now dominated by structural growth companies such as Asia’s internet, technology and consumer giants.

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However, in an environment of strengthening global growth and rising interest rates, it is the cyclical old-economy manufacturing and financial companies that typically see the biggest improvement in their fortunes and share prices.

These cyclical companies now also look much cheaper compared to the high-growth technology stars, after years of being out of favour. In contrast to emerging markets, these types of cyclical companies are now quite dominant in the equity markets of Europe and Japan, which therefore may stand to benefit more over the coming year.

Putting it all together, while emerging markets these days look much more able to withstand this phase of rising bond yields economically, their equity markets may yet find themselves struggling to keep up with other regions as global growth strengthens.

Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management

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