It wasn't that long ago that the end of Zero Interest Rate Policy ("ZIRP") seemed certain in 2015. When better than expected economic data was the norm, the general consensus was that the first interest rate hike by the Federal Reserve could come as soon as June 2015. Such expectations did not come without repercussions for emerging markets.
Quite a number had taken generous advantage of low interest rates with extensive borrowing. When the US dollar started to rally in the second half of 2014, emerging markets were confronted with some unpleasant news. As the value of the dollar went up, the value of the local currencies in most emerging markets went down.
Servicing outstanding debt in dollars becomes a lot more difficult under these circumstances. Furthermore, the possibility of higher interest rates means that more will have to be paid on interest. These developments make borrowing in dollars not as cheap as many had previously thought.
Trouble in emerging markets
While not everyone was affected in the same way, some emerging markets had a hard time coping in this new environment. The ones in most trouble were countries that had big deficits and needed to borrow as a result. Unlike countries with surpluses, staying away from borrowing is not an option on short notice.
Making things harder was the slide in the prices of many commodities, which more often than not were the primary means of income for many emerging markets. Countries were essentially getting hit from both sides. Not only would they have to pay more on their debt, but they were also earning less income. A good example of such a country is Brazil.
The economy is sliding in the United States
However, for the last couple of months, there are increasingly signs that changes are underway. Weak economic data in the United States are becoming more the norm than the exception. For instance, the month of April saw a poor jobs report after a long string of strong gains in the labor market. Other recent economic indicators such as retail sales are also suggesting that the economy in the United States is not as strong as once thought.
This creates a dilemma for the Federal Reserve as to whether they should go ahead with raising interest rates. While Quantitative Easing ("QE") has ended, ZIRP is still in place. Yet, the economy is struggling to grow and may even be sliding towards a recession if the data gets worse. A rate hike under these conditions may just be enough to push the economy over the edge and into a full-blown recession.
While the economy could still turn things around, a weak economy reduces the prospect of higher interest rates. One possible situation that the Federal Reserve may be confronted with later in the year is that the economic data does not make a persuasive case in either direction. Not strong enough to absolutely go ahead with raising interest rates and not weak enough to refrain from raising interest rates.
If the Fed goes ahead with raising interest rates and the economy falls into a recession afterward, you could have a repeat of what happened to the European Central Bank ("ECB"). The ECB was confronted with a recession after raising interest rates and was forced to repeal those rate hikes. The ECB eventually had to turn to QE after being reluctant to employ such a tool for a very long time. Something similar could be in store for the Fed.
Bad news in the United States is good news for emerging markets
While bad economic data may not be so great for the United States, it's good news for those emerging markets that have taken a beating due to the prospect of tighter monetary policy. It reduces the odds that the Fed can put an end to loose monetary policy and that should weaken the dollar versus other currencies. There are many who would benefit if the dollar drops.
Those countries that fell the most as the dollar rose should rally every time there's news that indicates loose monetary policy is here to stay. Emerging markets such as Brazil would really benefit if cheap borrowing is not coming to an end. Considering how much ground these countries have lost, there's the potential for sizable gains in emerging markets.
How to position emerging markets
Assuming that the United States continues to record worsening economic data and the Fed has to postpone raising interest rates and possibly even launch a new round of QE, emerging markets should be a beneficiary. An ETF such as EEM (NYSEARCA:EEM), which tracks the MSCI Emerging Markets Index, should gain from such an outcome.
A more risky approach is to buy emerging markets that have fallen the most when it seemed like interest rate hikes were imminent. EWZ (NYSEARCA:EWZ) is an ETF which tracks the MSCI Brazil Index. While such an approach carries a lot more risk, there's potential for stronger gains in comparison to general ETFs such as EEM.
At the same time, it's uncertain how the Federal Reserve will proceed with monetary policy in the coming months. The present situation could still turn around and tighter monetary policy may still become reality later this year on the back of improved economic data in the United States.
If this were to occur, a long position in emerging markets such as Brazil may not be so appropriate. Countries such as Brazil still have fundamental problems that will become a bigger issue in an environment where cheap borrowing is no longer available.
A more prudent approach would be to pick emerging markets that are not as strongly impacted by whatever the Fed does. One example of such an emerging market is Taiwan and an ETF which tracks the MSCI Taiwan Index is EWT (NYSEARCA:EWT).
If interest rates stay low, Taiwan should benefit as capital will be looking for any place where they can get a decent yield. Since markets in the United States are already at record levels, countries outside with superior growth prospects become an alternative worth looking into.
In the event that interest rates do go up, Taiwan should not be as negatively affected as some of the other emerging markets because of a more resilient economy due to the absence of high debt and deficits in the country.
Taiwan with its exposure to semiconductors found in booming sectors such as smartphones could actually benefit from a strong U.S. economy and the raising of interest rates that would be the result of that. Taiwan is therefore one way to play either outcome.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.