My daily commute ritual can either involve driving or taking the train. The one commonality is that I always listen to Bloomberg Radio on the way in. I am just a huge Tom Keene fan. Today there was an interview about tapering and the discussion centered around the impact of tapering on emerging markets. More specifically, that tapering is ‘bad’ for emerging markets. We have been hearing this for months, but rarely do we hear an explanation of why tapering may have a negative impact on emerging economies. I guess when things are stated enough in the financial press we should take them as fact and not want to ask why or we don’t ask because we feel like everyone else knows. Trust me, if you have a question about the financial markets you are not the only person with that question.
As far as tapering and emerging markets go, the core of the issue would be interest rates. Quantitative easing (QE) is basically a systematic program where the Federal Reserve buys fixed income instruments to increase the money supply and support economic activity. This creates extra demand for bonds and lower interest rates based on this demand. Investors seeking high yields have turned to emerging market debt which offers higher yields than domestic securities.
Here is where the potential negative comes in to play for emerging markets. Tapering is basically the slow discontinuation of quantitative easing. The demand for emerging market debt that has carried over from QE may start to dissipate. This basically leads to emerging market debt paying higher rates to continue to attract demand. Higher interest rates, depending on the economic environment, can lead to slowing economic activity. As emerging markets are more volatile, higher rates may have more of a negative impact on economic growth than would a rise in interest rates for developed economies like the United States.
So there you go, a quick and easy lesson on how tapering may have a negative impact on emerging market economies. The key now is to figure out how much of that may be priced into emerging market stocks. I’ll leave that one to the stock pickers of the world to work out.