How The Fed Affects Emerging Markets ETFs

In terms of asset classes, they do not get much different than emerging markets equities and U.S. government debt. At least that is what many investors are led to believe. However, the year-to-date returns of some popular exchange-traded funds tell a different story.

For example, the iShares MSCI Emerging Markets Indx (ETF) EEM is up 18 percent while the iShares Barclays 20+ Yr Treas.Bond (ETF) TLT is higher by 16.3 percent. That is not to say emerging markets stocks and longer-dated U.S. government debt are always intimately correlated, but those returns underscore the point that developing world equities benefit from lower U.S. interest rates, too.

The Fed's Influence

As investors have learned in recent years, even the mere speculation of hawkish action by the Fed can be a drag on emerging markets stocks, and the stronger dollar weighs on commodities, pressuring stocks in commodities-driven developing economies.

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“Emerging market (EM) assets are typically vulnerable to Fed rate hikes. Higher U.S. rates often buoy the U.S. dollar and weigh on commodity prices. The reaction is likely to be muted at the next rate increase. We expect the Fed to raise rates just once this year — likely in December — and to proceed cautiously given the unevenness of the domestic economic recovery, as highlighted by weak retail sales data released last week, and global growth uncertainties,” said BlackRock in a recent note.

While fixed income investors are enjoying the Fed's reluctance to raise rates, pushing assets in bond ETFs to record highs, resurgent emerging markets are also attracting new capital at an impressive clip. Year-to-date, EEM has hauled in $5.87 billion in new assets while TLT has added $795.1 million in new money. Only six new ETFs have added more new assets this year than EEM, the second-largest emerging markets ETF.

Dollar Strength And Emerging Assets

The weaker the dollar remains, the more appealing emerging assets are. Emerging markets governments and some corporations binge borrowed in dollars during the various versions of the Fed's quantitative easing programs. It looked smart as the dollar weakened against a plethora of developed and emerging currencies, but those emerging markets borrowers were caught off guard when the dollar started soaring several years ago.

“The lower for longer outlook for Fed rates extends investors’ reach for yield, and we see it further supporting EMs. It buys time for EMs to implement structural reforms, such as India’s recent tax reform and Indonesia’s renewed push for fiscal reform. This could enable select EMs to be more resilient when the Fed eventually normalizes rates,” added BlackRock.