By Rodrigo Campos and Marc Jones

NEW YORK/LONDON – Developing market investors are watching, nervously, as the “rainmaker” of global markets – The U.S. Federal Reserve prepares for its largest rate hike cycle since 1997.

On Friday, more hot job data drove the benchmark for global borrowing costs, the to its highest point in two years. It prompted yet another gnashing of teeth by emerging market money manager who were already experiencing a hard year.

Deutsche Bank (DE:). The analysts at the DE-Institute point out that, while certain currencies have managed to keep their heads above water here and there in some cases, those who take the risk of hedge forex risk would not see a worse year than 2010 since they started.

All EM assets have been able to take advantage of Fed tightening.

The EM stocks, as assessed by MSCI’s 25-country MSCIEF, are flat for the entire year. That means they have performed 5% better over their developed market counterparts, which seems to be a trend according to Morgan Stanley (NYSE:)’s analysts.

“The notable outperformance of EM(stocks) following the first Fed (hike) is noted,” they stated, noting the fact that the MSCIEF, in Fed hiking cycles since 1980 has been up 17% averagely six months after the initial rate rise.

Morgan Stanley analysts may not have yet called for “buy EM,” however, they said that it suggested that “it indicates the time to become more bullish on EM.”

This could indicate that EM is poised to continue its gains.

(Graphic: EM stocks vs U.S. rates, https://fingfx.thomsonreuters.com/gfx/mkt/akpeznebevr/Pasted%20image%201644004392617.png)

There is one silver lining to the last year’s crash in Chinese stock markets: Many investors believe they can rebound this year thanks to support provided by authorities.

Pictet, an European fund giant based in Switzerland raised its views on Chinese stocks to “positive”, this week citing that support and the fact that Chinese stocks would likely be a great hedge in case of full-blown Russia/Ukraine military conflict.

“Chinese equities could recoup last year’s declines and narrow the valuation gap with their counterparts in the coming months,” the firm’s chief strategist, Luca Paolini, said.

(Graphic: Chinese stocks make tentative recovery, https://fingfx.thomsonreuters.com/gfx/mkt/zdvxoanempx/Pasted%20image%201643806581616.png)

DORMANT DOLLAR

Jonny Goulden, JPMorgan’s Head of Emerging Market Local Markets and Sovereign Debt Strategy, stated that a tighter Fed or other central banks would likely re-ignite bond market tensions quickly.

EM veterans are still haunted by the 2013-14 “taper tantrum”, shock that saw the Fed reducing its post-financial crisis support.

Since the beginning of this year, returns on JPMorgan’s hard-currency emerging markets bond index EMBI Global diversified have fallen by -2.6%. While they are at 1% for the benchmark local currency fixedincome benchmark, these are still very good.

Goulden wrote in a Friday note to clients that “the Fed tightening cycles remains the focus on EM”, but this year, these pressures are strangely materializing more in credit than in local market,” Goulden explained.

These forces would be expected to lead to greater dollar strength. But, EM Forex (year-to date) spot returns have been +1%.

Goulden stated that capital flows data supported the trend. Short-term flows also changed, with emerging market bond funds pulling in $1 billion and hard-currency funds suffering $2.3 billion outflows.

Deutsche Bank claims that Mexico, Poland (and the Philippines) have the strongest correlation with rising U.S yields since 2013. This is based on their 10-year benchmarks.

Deutsche analysts stated that “During large movements, we find all countries (except China) have provided negative return periods during extreme bearish moves U.S. Treasuries.” They also pointed out that Peru, Mexico, Turkey and the Philippines suffered the most losses.

DB analysts expect a U.S. 10-year yield of 2.25% at the end of next week. This would mean that a forex-hedged return on EM fixed income will outperform Treasuries based on a total return basis, which includes currency movements.

They stated that “However this wouldn’t necessarily be a strong buy argument at the moment in time.” We recommend investors take a cautiouser approach to the asset class, despite recent performance.

(Graphic: EM feels the Fed’s force, https://fingfx.thomsonreuters.com/gfx/mkt/znvnejlwbpl/Pasted%20image%201644002336846.png)