World stock markets have climbed higher this year after investors bet on several interest rate cuts by developed market central banks. Prospects of easing financial costs have benefited risky assets, but with inflationary pressure still persistent in the US economy, the Federal Reserve is reevaluating its inflation assessment, reversing early stock gains and injecting volatility across asset classes.

The Federal Reserve’s economic projections impact capital allocations, as its inflation outlook sets the risk-free rate used to determine return on investments. But the direct effect of a developed market rate cycle on Asian and emerging markets is typically more nuanced than a simple correlation, according to Rahul Ghosh, portfolio specialist in the equity division at T. Rowe Price, speaking to FinanceAsia.

“Historical factors like relative growth differentials, commodity prices and the US$ have been, if not more, relevant to equity market performances,” he said, cautioning not to paint all Asian economies and emerging markets with the same brush. 

Ghosh added that “higher financing costs makes it more difficult for countries to run larger deficits to finance growth,” a concern highlighted by the International Monetary Fund’s Fiscal Monitor report published in April, which calls for more durable and credible fiscal consolidation to reestablish sound public finances and to better deal with future shocks.

Still, what the Fed does cannot be completely ignored. Ghosh explained that “a delay in rate cuts from the US would keep the interest rate differentials between non-developed markets higher than anticipated, limiting the ability of Asian or regional central banks to stimulate domestic demand.”

Impact for Asian and emerging market investors

US 10-year treasury yields have climbed nearly 50 basis points since January, while 10-year paper for Eurobonds have also moved up for the year. Higher sustained rates in developed markets draws interests away from Asian equities and bonds, according to Franklin Templeton Institute investment strategist Christy Tan, which lowers Asian pricing and impacts markets where duration risks are significant.

Besides rate differentials, valuations can fall under pressure, she said, leaving outperforming sectors vulnerable to a sell-off. Technology stocks have extended last year’s outperformance but because they project earnings growth into the future, those market valuations are extremely sensitive to interest rate fluctuations, Tan said, adding that this could be an issue for upcoming, non-profitable tech companies which rely more on external finance.

As a prerequisite to containing underline inflation, financial conditions are expected to remain in a restrictive territory, noted Kevin Liu, chief offshore China and overseas strategist at CICC Research.

“This in return will cause market turbulence within the Asian and regional markets via sentiment and fund flows,” he said.

Speaking to FA, Liu expects markets to enter range-bound trading in the second quarter, suggesting investors to take a relatively defensive position by building exposure to high dividend plays and established technology stocks with earnings visibility, a so-called barbell allocation approach to weather the volatility.

The next move 

How Asian investors view any Federal Reserve move depends on the reason behind the decision. Lowering interest rates could be a positive signal for Asian markets, opines T. Rowe Price’s Ghosh, to the extent that rate cuts are coming from a position of strength. In this scenario, the US provides leeway for Asian central banks to lower funding cost for Asian corporations which enables a “risk-on” mode for global investors.

“But if rate cuts are seen as a response to a weaker economy, which is the case for the ECB rather than the Fed, then they are unlikely to trigger any large-scale flows back to Asia and investors may indeed stick with the perceived safe havens,” he said.

Adding to the various moving factors, the Federal Reserve is positioned to keep rates unchanged for the foreseeable future, writes US economist Thomas Simons of Jefferies. In a research note to clients, Simon says that while the Federal Reserve can cut rates, it does not need to, explaining that while the US central bank has sufficient capacity to provide accommodation, the economy does not require any in the current environment.

Ivy Ng, chief investment officer for Apac at DWS, said that any repositioning into Asian or emerging markets may only materialise when the conviction of a rate cut schedule becomes prevalent, given the typical association between interest rates and the performance of emerging markets. Until then, Ng expects the delay in interest rate cut expectations would likely exert pressures on the overall stock market.


¬ Haymarket Media Limited. All rights reserved.


Source link