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By Jeremy Glaser and Patricia Oey | 12-14-2015 03:00 PM

Fed Hike Shouldn't Cause Taper Tantrum 2.0

The prospect of higher rates is mostly baked into emerging-markets stocks and bonds, but that doesn’t mean they’re cheap or won’t be volatile, say Morningstar’s Patty Oey and Karin Anderson.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Fed poised to raise rates, many are wondering what the impact will be on emerging markets. I'm joined today by Karin Anderson--she is associate director of fixed income in Manager Research here at Morningstar--also Patty Oey--she is a senior analyst in Manager Research--to look at what the impact could be and, for investors who are looking for opportunity, what some of their best bets are.

Thank you for joining me today.

Patricia Oey: Thank you.

Karin Anderson: Hi, Jeremy.

Glaser: Karin, let's talk a little bit about, generally speaking, why people are concerned about what impact the U.S. monetary policy will have on emerging markets. What's the transmission mechanism there?

Anderson: There are two key things to think about. One is capital flows and two is emerging-markets currency weakness. When the Fed hikes I think there is a general expectation that more money will flow out of emerging markets and that's a move towards U.S. investments that are higher-yielding. So, it's kind of been a big reverse of risky assets to safer assets with now better yields.

Number two is EM currency weakness. For the past three years, really, EM currencies have been doing very poorly. I think everyone is expecting to see possibly another round of EM currency devaluations when the Fed hikes.

Glaser: I know it can be difficult to paint emerging markets with a broad brush. Patty, do you think that some are going to be more exposed to these trends than others?

Oey: Well, certainly, we have some very fragile economies in EM, and those will continue to have a difficult time. These are Turkey, Brazil, Russia. They tend to be commodity-oriented; they have high debt levels; they have high inflation. I think the real wild card here is actually China. It's not--I mean, China is kind of slowing. One of the reasons why the Fed punted in September was because China was slowing down. The government is trying to figure out how they are going to redirect the economy towards more consumer spending. The challenge here is that if things slow down in China and we see assets flowing out of China, maybe China can do like a policy misstep and that's what happened in the summer this year--that they made a misstep and kind of reverberated across the global markets.

Glaser: The fact that the Fed is trying to raise rates or wants to raise rates is certainly no surprise to the markets. This is widely expected. But we did see with the taper tantrum that emerging markets can be caught off-guard. Do you think this is priced in right now, or do you expect some heightened volatility?

Oey: Well, I think in 2013 everybody was caught off-guard, and that's why you had the taper tantrum. In 2012, emerging markets were starting to look a little better. We saw a lot of perhaps fast money flow in, and once we had the threat of rising rates, a lot of that fast money quickly moved out and that caused a lot of volatility. The Fed has been talking about raising rates for the last two years, and so everyone is expecting it. Some emerging markets are like, “Just get it over with. We’re tired of waiting.” The uncertainty is the tenor. I think everyone is thinking it's going to be fairly dovish because the global economic environment is still quite fragile.

Glaser: Karin, what are you hearing from managers?

Anderson: On the global and EM bond side, we're hearing they are generally all expecting some spike in volatility when the Fed does hike. But generally they are looking to get this done and kind of move on and hopefully find a few opportunities along the way.

Glaser: If we've had this weakness in bonds and in the equity markets in emerging markets, this kind of rate hike is already priced in and maybe widely priced in. So does that mean there are opportunities now. Have these become attractive from a valuation perspective?

Oey: I think it's tough to say. Valuations aren't very demanding, but there aren't really any catalysts on the horizon. So, I think it's quite tough.

Anderson: And speaking to the local-currency bonds, again, we haven't really heard of any managers really diving in yet in a big way. There was a big sell-off in the third quarter of this year on China fears. I think people are still kind of waiting for the dust to settle a little bit with the hike. One thing maybe to keep in mind, though, is that hard-currency-denominated bonds, and that includes EM corporates, they have held up pretty well this year and in the past couple of years because they're dollar-denominated. They are getting that dollar boost. What you do have to be careful with in the tougher markets, especially for credit, those issues can be hit very hard. So, that might be an area to keep an eye on.

Glaser: If you're an investor and you're waiting--if there is that pullback and you do want to dive into emerging markets and you think the time is right now… What are some of your favorite ways to do that? What are some of the best ways to access this?

Oey: Well, from the equity fund perspective, I'll highlight three. Our longtime favorite is American Funds New World. They invest both in emerging-markets companies and developed-markets companies that have a large exposure to emerging markets like global pharma. Another fund we like is the Virtus fund--Virtus Emerging Markets. That fund manager is very focused on consumer names that have growth drivers that are coming from the domestic markets. And then last fund I would highlight is the Harding Loevner Fund. They tend to have a little bit of a more risk-aware approach. They try to construct a less risky portfolio. They look for quality names and that's been a good fund, too.

Anderson: For the bond side, for EM bond funds, we like a couple--a lot that invest across the spectrum, so they invest in hard currency, local currency, and corporates: TCW Emerging Markets Income and T. Rowe Price Emerging Markets Bond. Those teams have done a very nice job navigating the space, kind of toning down local-currency exposure, which, as I've said, has been a really tough area. And then global bond funds invest typically quite a bit in emerging-markets issues as well. So, there we like the Templeton Global Bond fund and the Templeton Global Total Return fund managed by the same team. They really invest in emerging markets in a big way and have really picked their spots carefully and done a good job of that.

We also like Legg Mason Brandywine Global Opportunities--having a tough year because it is also very focused on EM but, again, very selective and has shown to pick good countries over time--and the PIMCO Global Bond team, which manages the global and foreign portfolios. They don't own quite as much in EM but generally that's been a good area for them as they navigate between that and developed markets.

Glaser: Karin and Patty, I certainly appreciate your take today.

Oey: Thank you.

Anderson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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