The current inflationary shock is a global phenomenon, caused by supply chain disruptions and the impact of the Russian-Ukrainian war on food and commodity prices, with consequences for nations around the world. The reaction of policy makers varied from country to country, which contributed to high differentials between real – or inflation-adjusted – interest rates in developed markets (DM) and emerging markets (EM). We believe this could provide investors with opportunities for uncorrelated returns in the form of local emerging market debt. And yet, investors need to be discerning.
EM inflationary momentum remains strong, with results strongly correlated to those of DM. Similar to our outlook for emerging markets, we expect inflation in emerging markets to peak, with a gradual downward trend this year and into 2023. Given the magnitude and persistence from this episode, however, we do not expect inflation to decelerate back to previous trend levels until 2023.
Emerging market central banks, which have built their inflation-fighting credibility over decades, have diverged in their policy responses recently, with some opting to raise interest rates ahead of the US Federal Reserve. There were also some notable outliers among the 80+ emerging countries:
- Some countries suffered a particularly large inflationary shock, as evidenced by Poland, where the war in neighboring Ukraine had an outsized effect on the influx of refugees, supply chains, spending pressures and commodity prices. raw materials.
- The secular erosion, exemplified by Mexico, has manifested itself in the form of more structural pressure on prices, rising inflation expectations and questions about long-term central bank independence. .
- Policy-making missteps have exacerbated problems for countries like Turkey, which has resisted raising interest rates even as inflation surged to 74% year-on-year. another in May.
Overall, we expect emerging market central banks to take inspiration from the US as more clarity emerges on the US economic outlook and the Fed’s tightening path. EM inflation is more likely to remain elevated than DM inflation, given that food and energy have higher weights in EM inflation index baskets as well as fiscal policy propensity EMs to adjust to inflationary shocks.
Analysis of the global interest rate landscape
Real rate differentials between EM and DM are unusually high (see chart 1), with EM policy rate adjustments looking more mature on average while DM central banks are generally earlier in their hike cycles. This can offer emerging market investors a rare opportunity for uncorrelated return potential in the form of local emerging market debt, denominated in an issuer’s home currency.
As in other economic cycles, emerging market currency appreciation should play an important role in disinflation. This will likely be reinforced this time around by high levels of real carry – borrowing in lower-yielding currencies to invest in higher-yielding currencies – in EMs relative to DMs. We are already seeing this starting to happen in Brazil, where the central bank’s policy rate has risen to 13.25%, after more than 11 percentage points rise in this cycle, and where the Brazilian real has gained around 10% against the US dollar. – so far as of June 14, according to Bloomberg.
To become more bullish on EM currencies more broadly, we would need to see this self-reinforcing momentum widen and strengthen, especially in the wake of past false starts. Caution is now called for given the uncertain influence of global risk factors, such as those stemming from the war in Ukraine.
If this momentum takes hold, it could mark a major break with the last decade of US dollar dominance. Until the outlook becomes clearer, we seek selected opportunities to generate potentially high yields in emerging market local debt, for example by avoiding Polish local bonds and favoring Brazilian local bonds instead. Greater divergence between countries and regions strengthens the case for relative value opportunities within emerging markets and can provide opportunities for portfolio diversification.
Please note that the following contains the views of the manager as of the date indicated and may not have been updated to reflect real-time market developments. All opinions are subject to change without notice.
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