Concerns Over Slowing U.S. Economy Steal Momentum From Emerging-Market Rally

The Federal Reserve’s decision to reduce interest rates Jan. 3 helped extend a monthlong rally in emerging-market debt, but after the second Fed rate cut last week, investors’ enthusiasm began to wane.

“People are now asking: How much higher can a risk asset go in this environment?” said Paul McNamara, an emerging-market strategist at Julius Baer Investment Management in London.

Optimism that lower U.S. rates will reduce emerging-market countries’ borrowing costs and spur growth has been replaced by increased concern a slowing U.S. economy might turn into a recession and hurt economies from Latin America to Eastern Europe and Asia. The surge in supply of new emerging-market dollar- and euro-denominated bonds in January also hurt demand for the debt.

The rally began in early December after the International Monetary Fund bailed out Turkey and Argentina with promises of multibillion-dollar loans. The Fed cut its benchmark interest rate by half a percentage point Jan. 3, lowering borrowing costs worldwide.

Prices of bonds from such issuers as Mexico, Brazil and Russia soared as much as 10% in December and January. Mutual funds that invest in emerging-market debt were among the best performers among fixed-income funds last month, returning 5.8%, according to fund tracker Lipper Inc.

In recent days, however, there have been signs the market is cooling. Investors have been less willing to buy, causing sellers to offer better terms. On Monday, Petroleos Mexicanos, Mexico’s state oil monopoly, sold $1 billion in seven-year bonds that paid higher-than-expected interest rates.

“Emerging markets have had two months of outperformance,” said Tony Volpon, a vice president for emerging-market debt with Bank of America in London. “Whoever waited until now has been hurt.”

Peter Stiler, fixed-income manager at Van Eck Associates, and other investors said they don’t plan to sell holdings for the moment, a signal that a sudden drop in prices of emerging-market bonds is unlikely, analysts said.

Investors want more evidence on whether the U.S. economy will slow, and that may take months, analysts said.

The latest reports suggest U.S. economic growth is easing. U.S. business other than manufacturing expanded in January at the slowest pace in 3 1/2 years, according to statistics published Tuesday. Sliding U.S. and global growth may slash the price of commodities, hurting emerging economies that depend on exports of oil, gas and metals.

“The Federal Reserve easing is, in general, good for emerging markets, but the depth and degree of the U.S. slowdown will not be known until around mid-year,” said Richard Madigan, who helps manage $600 million in emerging-market debt at Offitbank Funds in New York. “The U.S. economy is classically caught in an age-old battle between greed and fear at the moment.”

Overall, emerging-market economies are set to grow 4.4% this year, according to the Institute of International Finance. That means emerging-market nations will keep trying to tap international markets even if borrowing costs start to rise.

“The big thing that could prevent another rally is oversupply,” said McNamara at Julius Baer. “But these levels are still looking attractive to issuers.”