AN EMERGING WORRY FOR MARKETS / THE WALL STREET JOURNAL

Heard on the Street

An Emerging Worry for Markets

A U.S. Rate Hike Could Cause Fresh Turbulence in Emerging Marketsr

By Richard Barley

June 10, 2014 11:34 a.m. ET

Patience has paid off. In January, investors dumped emerging-market stocks, bonds and currencies, fearing a crisis like that in Asia in the 1990s. Now, emerging markets are among the year's best performers. That itself is reason for caution, however.

The turnaround has been sharp. By early February, the MSCI Emerging Market stock index was down close to 9%; since then it has outstripped the developed-market World Index, rising 14.5% from its lows. Dollar-denominated emerging-market sovereign bonds are up 9% year-to-date, while local-currency debt has returned 6%. Currencies have staged impressive comebacks: the Turkish lira is now up 3% this year against the dollar.

Over 70% of the first quarter's outflows from emerging markets have now been reversed, J.P. Morgan says.

The flash points that sparked the sense of crisis have receded. Tensions remain around Ukraine and Russia, but the fear of military escalation has declined. There was little, if any, spillover from Argentina's devaluation of the peso. Fears of a Chinese financial meltdown have faded. Most important, perhaps, a big external threat to emerging markets—the prospect of higher U.S. interest rates and a stronger dollar—failed to materialize. The Federal Reserve has been dovish to a fault.

With few alternatives to consider, investors once again appear to be indiscriminately reaching for yield. Emerging markets still offer higher yields than other asset classes: The J.P. Morgan EMBIG sovereign bond index and the CEMBI corporate bond equivalent offer yields north of 5%. The GBI-EM local-currency index yields 6.5%. Earlier this year the euro-zone benefited from outflows from emerging markets, but that trade now looks less attractive with yields on Spain and Italy well below 3%.

In the long term, higher growth rates should still prove a lure for investors. Emerging-market countries are forecast by the International Monetary Fund to grow 4.9% this year, versus 2.2% for advanced economies; the gap between the two has narrowed, but is still significant.

But the danger for yield-seekers is that the best of this rally is past. In particular, the rally in U.S. Treasurys, which has provided a benign backdrop for emerging markets, may have run its course. 

Rises in U.S. yields, particularly if they are sharp, are likely to cause turbulence. Even if yields rise slowly, it will be a headwind for emerging-market bonds. That may hit stocks too: the rally there has been driven by interest-rate sensitive sectors such as banks, not overall earnings, UBS notes.

Investors will then need to differentiate between countries again. Some previously in the cross hairs, such as India, have reduced economic imbalances that made them vulnerable; others, such as Brazil, Turkey and South Africa have done less.

With emerging markets having rallied so sharply, and with the supporting factor of U.S. rates hanging in the balance, there may be tougher times ahead.