Morgan Stanley On Fed-Proofing Global Markets

Morgan Stanely, the Fed impact on global markets: what countries to avoid, which ones to consider buying

Global investors all know the mantra: strong dollar, weak commodities. Weak commodities, weak emerging markets.

Morgan Stanley thinks that, on balance, emerging markets are set to handle higher interest rates in the U.S.  Two things worth noting first: this is particularly true in countries where rates are coming down, like Brazil and Russia.  It is not particularly good for Mexico, where rates are going up.  Secondly, weak commodity prices is good for India and China, bad for Russia and Brazil. This makes it harder for investment advisors to outperform when stuck in a broad emerging markets index fund. They may want to hedge by adding positions to single country trades.

Here’s what Morgan Stanley thinks overall:

Economic fundamentals are moving in the right direction. When we think that Fed hikes are at least symbolic of U.S. growth, then countries tied to the U.S. (hello, Mexico) will do ok. Commodity prices are still supportive and expected by their commodity analysts to remain so in the medium term. Recent weakness in oil, notwithstanding. Improving fundamentals provide an important buffer to the adverse impact of higher market yields in the U.S., where foreign portfolio investors looking for safe haven fixed income will prefer Treasuries over, say, Mexican sovereign rates that yield only a 100 basis points more.

Valuations vary widely throughout this space, with India very expensive and Russia still very cheap. In fixed income, emerging markets still have historically high real yields, including in dollar terms. Emerging market corporate bonds are currently cheaper than U.S. bonds and have much higher yield, say around 7%. That’s a 400 basis point differential still over a 3% Fed rate once we get there. That’s still going to be very attractive to global investors.

Morgan Stanley says there are two important ways to generate alpha here:

1. Go long high yielders with strong anchors (like cash position) versus low USD yielders that are more vulnerable, like Argentina, Indonesia, Brazil in local rates, credit and forex; India in local rates and forex and Russia in local rates. They are not buyers of China bonds (yield way too low at around 2.8%), Hungary in local currency bonds and Chile, Malaysia and Peru in corporate.

2. Rotate into assets that have underperformed recently. This holds in particular for Mexico where Morgan analysts feel that the bull case of an improved NAFTA agreement is gaining momentum. As an aside, BlackRock is now neutral weight Mexican local currency government bonds.

Fed rates are going higher than the market believes.

“Concerns about Fed tightening will eventually resurface,” report authors say. Morgan Stanley Economics expects six more rate hikes by the end of 2018, significantly more than the 80 bps currently priced in.