Have EM Stocks Lost Their Immunity to Rising Rates?

Have EM stocks lost their immunity to rising rates?

Key Points

  • Stocks have faltered since mid-February as the bond sell-off accelerated and the U.S. 10-year yield surged above 1.3%.

  • EM stocks have taken the rise in yields the worst among major equity asset classes.

  • We provide five reasons why EM stocks can likely still perform well as rates climb this year.
     


Accelerating growth is generally a good thing for stocks, evidenced by bond yields and stock prices typically rising and falling together. Yet, emerging market (EM) stocks have faltered since mid-February as the bond sell-off accelerated and the U.S. 10-year yield surged above 1.3%. Since this year’s peak on February 17, the MSCI Emerging Market Index has fallen -7.3%, more than twice the decline in developed market stocks of -3.1%, as measured by the MSCI World Index. This begs the question: have EM stocks lost their immunity to rising rates? We provide five reasons why EM stocks can likely still perform well as rates climb this year.

EM stocks part ways with interest rates since mid-February

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Source: Charles Schwab, Bloomberg data as of 2/26/2021.  Past performance is no guarantee of future results.

Yields may not stop here

Bond yields may continue to climb, making this an important issue for EM stock investors to watch. Last week’s U.S. durable goods and Eurozone economic confidence reports were just a couple more examples that highlight the trend of better than expected economic data coming from around the world. Economists and bond markets appear to have underestimated the recovery.

Economic surprises continue to be on the upside

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Source: Charles Schwab, Bloomberg data as of 2/25/2021.

Thus far, the surge in the U.S. 10-year Treasury yield is not that unusual. If we look back at the past 10 years, we can see many other periods where yields surged by an average of 100 basis points over a period of about 200 days, similar to the recent episode that began on August 4, 2020. On average, EM stocks have tended to post gains, during these rapid surges in yield, as you can see in the table below.

Yield Surges and EM Performance

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Source: Charles Schwab, Factset data as of 2/26/2021.  Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly Past performance is no guarantee of future results.

Five reasons EM may regain immunity

While some volatility in EM stocks is to be expected, we believe there are five key reasons EM stocks can still likely perform well should rates continue to climb this year.

1)    It’s normal. EM stocks and bond yields usually move in the same direction, both driven higher by rising prospects for growth and inflation. The chart below illustrates the generally positive correlation between EM stocks and the U.S. 10-year yield. After periods of negative correlation (when bond yields and stock prices move in opposite directions) ahead of the recessions of 2008 and 2020, there was a return to the positive relationship typical of an economic expansion.

Positive correlation between EM stocks and bond yields 

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Daily rolling three year correlation.
Source: Charles Schwab, Factset data as of 2/24/2021.  For illustration purposes only.

2)    Yields aren’t the only thing rising. The sharp rise in the U.S. dollar and plunge in commodity prices during 2014-15 helped to undermine the performance of EM stocks in that period. The opposite has been taking place since the rise in yields began last year, with the dollar weakening (lifting EM currencies) and commodity price rising. If the trend of a weakening dollar continues, as we anticipate, this combination may act as a strong offset to any potential drag from higher interest rates.

Commodity prices

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Source: Charles Schwab, Bloomberg data as of 2/25/2021.

3)    There has been no indication of a sharp worsening of financial conditions in emerging markets, which could hurt stocks, from the recent rise in rates, as you can see in the chart below. This isn’t too surprising given that central banks see current inflation pressures as partly transitory and remain committed to providing ample monetary stimulus.

EM financial conditions index

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Source: Charles Schwab, Bloomberg data as of 2/25/2021.

4)    Ongoing global stimulus provides a potent boost to EM performance. The U.S. fiscal stimulus package currently working its way through Washington, a potential contributor to the recent rise in U.S. interest rates, may embolden governments around the world to adopt even more supportive fiscal policy. If the U.S. can add further fiscal stimulus while keeping inflation near target levels and maintaining easy monetary policy, other developed and emerging market economies may become less inclined to tighten policy prematurely. The current environment contrasts starkly with the backdrop during the periods in 2013, when rates rose amid global fiscal and monetary tightening, causing EM stocks to suffer.

5)    It’s unlikely that stocks would react negatively if bond yields were to continue to rise to meet the dividend yield on EM stocks. For the past 10 years, the yield on EM stocks has been close to the yield on global corporate bonds, as you can see in the chart below. The U.S. 10-year Treasury yield rose to 1.46% at the end of February, and the yield on corporate bonds, measured by the Bloomberg Barclay’s Global Aggregate Corporate Bond Index, rose to 1.64%. Yet, these yields do not yet provide competition to the notably higher EM stock dividend yield of 1.8%.

Stock and bond yields have overlapped for much of the past 10 years

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Source: Charles Schwab, Factset data as of 2/26/2021. Past performance is no guarantee of future results.

What to do

It may be the pace of the rise, rather than its magnitude, that is currently weighing on EM stocks. If interest rates continue to climb at a more moderate pace—which we think is likely—then EM stocks may rebound and rise alongside bond yields, as they have done historically. It’s our belief that the recent surge in interest rates doesn’t warrant reducing exposure to EM stocks, which have been the best performing asset class since the most current low in interest rates in August 2020. 

Michelle Gibley, CFA®, Director of International Research, and Heather O’Leary, Research Analyst, contributed to this report.

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