Fed rate hike to trigger 5-7% correction in EMs: UBS

Geoffrey Dennis of UBS in an interview to CNBC-TV18 says there is likelihood of the Fed changing its wording at the next FOMC meet to give more flexibility in terms of how quickly they raise interest rates after the end of quantitative easing (QE). It may change the phrase ‘considerable’ time in the next statement, says Denmis.According to him the Fed is likely to hike rates in the middle of next year and this could potentially trigger a 5-7% downside in emerging markets (EMs) but does not see a big sell-off if the rate hike is announced.With regards to the Indian market, Dennis says it is not as risky as other emerging markets because the fundamentals are much better. He feels the outperformance of the Indian market may be coming to an end, but does not expect it to underperform going ahead. At present the house is neutral on India.In case the Fed hikes rates, then markets like Taiwan and Korea would be favourites for UBS, says Dennis

Also read: Global cues biggest risk for mkt; see 5-7% fall: BofA ML Below is the transcript of Geoffrey Dennis’s interview to CNBC-TV18’s Latha Venkatesh and Sonia ShenoyLatha: What is the sense you are getting from the way in which we saw the risk aversion, not yesterday but certainly in the previous two days this week. Do you think now markets are wondering even in the US that valuations have gotten rich?A: I don’t think it is a valuation story to be honest. I think we really haven’t had a strong enough move in emerging markets to make the valuation story particularly stretched though they have gone up.I think what is happening is as we had anticipated we believe that at some point there would be heightened concern about the US economy being very strong and what impact that could have in terms of the timing of the Feds first rate hike which we look for by the middle of next year and also some potential increase in bond yields as well in the US. It is it is very hard to time this but what has happened in the last two-three days is a greater concern about when we might be talking about higher interest rates in the US and therefore higher bond yields as well.

Latha: What is your own estimate about what the FOMC might say on September 16-17 and when are you preparing for the rate hike?A: We are looking for the Fed’s first rate hike just before the middle of next year. As we know very well that Fed in on its schedule to continue tapering I should say and very soon Quantitative Easing (QE) program QE3 will be over. So in a sense we are looking for that to be followed eventually by higher interest rates. What we think could happen in the next FOMC meeting is the Fed may change the wording to really give themselves more flexibility in terms of how quickly they raise interest rates after the end of QE. They have been using the phrase considerable time, to indicate quite a long time after the end of QE before they raise rates. We wonder whether they might change that now because they want to have flexibility and if they do change then the markets would be nervous about that because the markets will perhaps rebuild the possibility that rates will go up soon enough. I don’t think it will be a really terrible news for the emerging markets, I just think it is going to inject some volatility into the markets and we have had a very good run in the last six months and we are due to have a fall. But I really don’t believe that valuations are particularly stretched yet in emerging markets.Sonia: If we do see a pullback or a correction in emerging markets, what could the quantum be you think, would it be restricted to about 5-10 percent and within that where does India feature on your list?A: I certainly don’t think it would be any more than 5 percent. Frankly I would be surprised if it is about 10 percent. I think it is more likely to be in the 5-7 percent range. We are up about 18-19 percent since the middle of March. Though a 5-7 percent pullback, an event which we knew is going to happen sooner or later anyway, the real anticipation of Fed moves. We think that is perfectly reasonable, I don’t think it should be anything more than that. Now where India fits in, of course India is one of the markets that have been labelled fragile, labeled risky - we do not believe India is anything like as risky as some of the other markets which are vulnerable to a slowdown in capital inflows like Turkey or South Africa or even Brazil. But given how strong India has been this year, up well over 20 percent and all the excitement about the election of Modi’s government and about structural reforms.

The fact that just a few days ago India was at an all time high, it would mean that India would suffer during any correction but I wouldn’t particularly expect it to be a big underperformer because the fundamentals are better than some of the other markets. Also the fundamentals are better in India than they were six-nine months ago.Latha: So would you say India’s outperformance perhaps ends now?A: I think that is the way to look at it. I think the strong outperformance we had in India this year with a gain of well over 20 percent. Quite honestly we felt the market may pull once the election was over. It has not gone up as rapidly post the election as it did before but it kept moving up to new highs.