Did the Fed hurt emerging markets?

This month's Federal Open Market Committee statement may have slightly reduced the pressure on China and developing economies. But we are still far from a full-on bull case for emerging market assets.

In its statement, the Fed said it was "closely monitoring global economic and financial developments" – another way of saying it is taking into account the volatility, growth fears, and inflation scares that have buffeted markets since the start of the year. However, there was little sign that the Fed is about to radically back down from the multiple rate hikes that it expects this year and come closer to the market's much more dovish outlook for U.S. monetary tightening.

An investor looks at an electronic screen showing stock information at a brokerage house in Nanjing, China, January 26, 2016.
China Daily | Reuters
An investor looks at an electronic screen showing stock information at a brokerage house in Nanjing, China, January 26, 2016.

Judging from the reaction of stocks, bonds and currencies after the Fed statement, the market is afraid of the risk that the Fed is mistakenly tightening into a slowing economy. We do not share the market's fears to the same extent. But if this risk-case scenario materializes, the U.S. dollar would experience temporary upwards pressure. In turn, this would exacerbate currency concerns in China and other emerging markets.

Admittedly, this dollar appreciation would likely be short-lived. Soon, the dollar would decline as the Fed reversed course and rethought its plans for tightening as the economy faltered. A weaker dollar would help alleviate pressure on the Chinese yuan and other emerging-market currencies. But, in this risk-case scenario, to assume a more positive outcome for the yuan and emerging markets on a permanent basis may be jumping the gun.

First, the U.S. dollar-yuan exchange rate does not depend solely on U.S. factors. It also depends critically on confidence in the outlook for China, Chinese policy-making, and Chinese yuan-denominated assets, which is currently changeable.

Second, a weak global growth outlook would further dampen exports from, and investments into, emerging economies. For emerging markets, the combination of higher bond yields and robust global growth is preferable to one of low yields and low and fragile global activity.

To be clear, in our base case, we do not think that the Fed's proposed path for rate hikes will be steep enough to dampen U.S. economic growth and lead to recession. Services and labor markets remain strong and are unlikely to be dragged down by the troubles in the U.S. energy sector. We also think the Chinese authorities are likely to be able to achieve an economic soft landing. Against that backdrop, we see global riskier assets – equities and credit – ending the year higher, supported by adequate policy responses. We also think that Hong Kong-listed Chinese stocks are pricing in an excessively dire base-case scenario and as such look good value relative to other emerging-market stocks.

The Fed's language, while somewhat dovish in its recognition of global trouble, did not clearly signal an imminent change of course. Such policy uncertainty does not help the outlook for emerging-market assets, on which we remain cautious. Regarding the yuan, our base case is a gradual depreciation to 6.80 against the U.S. dollar over the next 12 months, but with a 30-40 percent risk of it devaluing to more than 7.

Overall, emerging markets will likely still face a difficult outlook. This month's Fed statement did little to improve it.

Commentary by Jorge Mariscal, the emerging markets chief investment officer at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.

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