Emerging markets herd can ride out the Fed: Analysts

Emerging markets have been hot. Some market pundits think it's a dumb money move made by the herd and tailor-made for a Fed-induced plummet.

Maybe not.

The Fed will once again decide whether to raise its key interest rate at a meeting on Wednesday, but a rough consensus seems to be forming: Emerging markets bonds will be okay, while the path of emerging stocks depends more on economic growth in the emerging markets themselves, and on the price of oil, than on a quarter-of-a-percentage-point rate hike by the Fed.

The move isn't irrational: In a negative-rate world, EM bonds are an obvious place to look for yield. And after an eight-year bull run for the U.S. stock market, the huge declines in EM stocks in recent years make them seem like a relative global bargain.

But investors do have some reason to be wary: Just look at the chart below showing how emerging markets assets reacted during two-month periods around the most recent Fed-related shocks — the so-called Taper Tantrum of 2013 and the initial Fed raise of 25 basis points in last 2015 — which led to a surge in 10-year Treasury yields.

The size of the recent move into emerging markets can't be denied. The 10-largest emerging markets currency debt funds pulled in more than $1 billion in August, according to Thomson Reuters Lipper data, a move that accelerated after the U.K. opted to leave the European Union. Emerging markets equity exchange-traded funds eclipsed flows into U.S. equity ETFs in August and took in near-$5 billion in the month. But it's been a smart move so far, with the peer group of EM bond funds up 13.3 percent this year, and the MSCI Emerging Markets Equity Index up near-15 percent.

There probably will be some impact on emerging markets bonds if the Fed raises rates, said Daniel Maddy-Weitzman, credit strategist at Bank of America Merrill Lynch in New York. But the impact on emerging-market bonds won't be that large.

In a report released this week, Merrill tracked a dozen bond-market episodes the firm classified as "shocks" over the last nine years. The sell-off around the 2008 collapse of Lehman Bros. was as huge in emerging markets credit as in any other market, with a loss of 27 percent. But no other bond-market shock has created more than a 5.8 percent loss in emerging markets corporate bonds denominated in Western currencies, Merrill found. More often, all the nervous chatter about "volatility" and "risk-on/risk-off" trading led to only a 1 percent or 2 percent dip.

"If the Fed is on watch and is sensitive to how the market reacts, I don't think we'll be at the worse end of that range," Maddy-Weitzman said. "The market can handle it."

Merrill also noted that growth is picking up in much of Asia, even as it moderates in the United States and Europe. The firm's economists think emerging markets growth in gross domestic product will average 4.8 percent next year, up from 4 percent this year and more than double the pace of the United States (2.1 percent) and the euro zone (1.1 percent). In the CNBC Global CFO Council survey released on Tuesday, a majority of chief financial officers from around the globe described the Chinese economy as "stable" — in the previous two surveys, CFOs described the Chinese economy as "declining."

Watchers of the MSCI Emerging Markets Index chart say to judge it on its own merits. While stocks tanked amid the Taper Tantrum, the move was much smaller than the rallies and sell-offs last year as speculation about China's economy waxed and waned. Emerging markets economies seem to be improving, but for nations like Russia and Brazil — which have been among the best-performing stock markets this year — betting on a continued rally depends on whether oil and gas prices can keep rising, according to Aymeric Forest, head of multi-asset investing at London-based Schroders.

"We are constructive on emerging markets, but you need to be selective," Schroders' Forest said.

There's another way the global oil glut story and central banking stance can continue to help emerging markets nations broadly, according to Merrill research. "A combination of lower funding costs in local currency and in external debt should feed into faster credit creation and economic activity in the emerging world. In fact, the negative interest rate environment in Europe and Japan, coupled with a dovish Fed, could even translate into a secular growth story for EM oil demand," Merrill analysts wrote in a recent global energy outlook.

Car sales continue to expand across key EM countries, with India and China posting year-over-year growth figures of 12 percent and 10 percent, respectively.

Analysts at Goldman Sachs who, like Merrill Lynch, are relatively sanguine about longer-maturity developing-world bonds, say emerging market stocks are at more risk than emerging markets bonds, but the overall expectation is still rates that are lower for longer and that the eventual hike won't do huge damage.

Merrill's Maddy-Weitzman pointed to several reasons a Fed rate hike of 25 basis points shouldn't be an actual shock to EM bonds.

For starters, bond issuance in that market has been light in recent years as growth slowed in emerging markets like China and Brazil, so fewer credits are shaky and credit risk may actually be diminishing, he said. And capital has been flowing into the region from investors moving out of European bonds since British voters chose to leave the European Union in June, he said. Last week was the 29th straight with inflows for emerging-market bond funds, and most new investors this year are sitting on gains.

Coupon rates on these bonds are still high enough to be attractive, even if rates increase a little bit in developed markets, Maddy-Weitzman added. The average yield-to-maturity is still 4.1 percent, more than double the payout of 10-year Treasuries.

"A variety of global factors are helping to depress bond sell-off once the next Fed hike occurs," Merrill analysts wrote in a recent report.

— By Tim Mullaney, special to CNBC.com