How Fed Tightening Endangers Emerging Market ETFs

Includes: EEM, EMB, EMLC, PCY, VWO
by: Tom Lydon

Investment managers have piled into the developing markets, riding the flow of easy money. However, once the money supply tightens, emerging market exchange traded funds could fall into a recession.

With rising expectations of Fed tightening, the U.S. dollar will strengthen, prices of dollar bonds will decline and dollar funding will reverse, reports Martin Wolf for the Financial Times.

As issued bonds lose value, emerging market borrowers will have to provide more of their domestic currency as collateral, which will squeeze their own cash flows and pressure corporate spending, potentially resulting in a recession in the emerging markets, or a so-called doom loop, according to Wolf.

"In such an event, the doom loop would surely also swallow the stocks of developing markets," John Rekenthaler, Vice President of Research for Morningstar, said. "They likely would not decline as far, but emerging markets have become so large and so connected with other economies that there would be few places to hide with a stock portfolio."

The flow of money is not consistent, and the end to easy money in the U.S. could leave the emerging markets without enough when they need it the most.

"Late in economic cycles, when capital is least needed by borrowers, it is most readily available from banks," Rekenthaler said. "Conversely, money tightens, sometimes to the point of unavailability, during recessions, when risk avoidance becomes the prime goal. This of course is when capital is most needed."

So far this year, speculation of Fed tapering has already pressured emerging market bond ETFs. For instance, the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA:EMB) is down 8% year-to-date, PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA:PCY) is down 10.7% year-to-date and Market Vectors Emerging Markets Local Currency Bond ETF (NYSEARCA:EMLC) is down 8.6% year-to-date.

Meanwhile, emerging market stock ETFs have not fared any differently, with the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) down 6.5% year-to-date and the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) down 7.3% year-to-date.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.