Global Weekly Commentary: Liftoff ? EM has already taken off
Key points
EMs lift off
Emerging markets have raised rates as they struggle with inflation, whereas the Fed has yet to lift off. We see their approach creating opportunities in EM debt.
Market backdrop
A meeting between the leaders of the U.S and China put guardrails on the relationship to prevent outright conflict but produced few tangible results.
Week ahead
U.S. core inflation data will provide a read on the intensity and nature of price pressures. We expect inflation to moderate next year but see it as persistent.
As U.S. inflation is hitting three-decade highs, market talk has been all about “liftoff:” When will the Federal Reserve and others start raising their policy rates? This is old news in emerging markets (EMs), where many countries have already raised rates to try to tamp down inflation. Their approach has pressured growth already hurting from a delayed vaccine rollout. This makes us cautious on EM equities, but has made selected EM debt more attractive in a world starved for yield.
EM head start in raising rates
Central banks’ current and implied policy rates
Sources: BlackRock Investment Institute and Bloomberg, November 2021. Notes: The chart shows the current and 1-year forward central bank policy rates. 1-year forward rates based on futures market pricing. Emerging markets policy rates are weighted based on the JP Morgan GBI-EM global Diversified Index. .
Central banks across the emerging world have been raising interest rates to try to contain inflation and prevent their currencies from depreciating sharply. The rate increases have accelerated as inflation has picked up and the U.S. dollar strengthened. A wide variety of countries is now tightening policy, ranging from Brazil to Russia and South Korea. The result? The emerging world has a head start in normalizing policy. A weighted average of EM policy rates now stands at 3.2%, as the red part of the left bar in the chart shows, versus near zero or negative rates in the U.S. and euro area. Market pricing (the yellow parts of the bars) shows much of the work is done in EM, whereas developed markets (DMs) have yet to lift off. This ties in with the much more muted response to rising inflation seen in the developed world, thanks to unprecedented fiscal–monetary coordination in helping the economy bridge the virus shock and new central bank policies of letting inflation run a bit hot. EM central banks historically have had less credibility, while inflation and currency pressures have been much greater. But many are acting earlier and faster this time to prevent things from spinning out of control.
What does the EM head start in raising rates mean for investments? We believe it supports EM debt. The hiking cycle has started well ahead of the Fed’s tightening – which has often spelled trouble for EMs as investors start to demand more compensation for holding riskier assets. The Fed has just started to taper asset purchases, and we don’t see it raising rates until the middle of 2022. The EM approach has created a large interest rate buffer versus DM, lowered valuations and raised coupon income. This makes EM debt attractive versus DM credit in a world starved for yield, in our view.
Improved valuations and coupon income should help cushion any yield rises and prevent disorderly moves in EM bonds when the Fed lifts off, we believe. Indeed, we don’t see a repeat of 2013’s taper tantrum when the Fed’s decision to cut back asset purchases caused havoc for EM assets. Why? First, the trajectory of rates matters more than the timing of liftoff, in our view. We see a very shallow rates path in DM this time, given the historically muted response to inflation. Second, many EM countries are now better positioned to weather Fed tightening and a stronger U.S. dollar. Currencies have adjusted, foreign ownership has declined, and inflation-adjusted yields have risen. There are exceptions, including EMs with weakening balances sheets or loosening policy, as country-specific risks always loom large in the diverse EM investing universe.
What do we like within EM debt? The big picture is that we expect fixed income to be generally challenged amid persistent inflation, and underweight government bonds as a result. We see EM local-currency debt offering the most relative opportunities in this context. Current yields and currency valuations compensate for the risks, in our view. And we like local-currency EM debt for its relatively low duration, or sensitivity to rising rates, and diversification benefits. It gives exposure to regions that make up a small share of EM equity indexes, such as LatAm. We prefer local-currency bonds of higher-yielding countries with solid current account balances. We also overweight Chinese government bonds for their relative high yields and diversification properties. We remain neutral on hard-currency EM debt.
Bottomline: We generally prefer equities over bonds in an environment of solid growth, persistent inflation and low real yields. Many EM central banks have started raising rates well before DM counterparts in an effort to contain inflation. This has dampened EM growth and tightened financial conditions – and has turned us cautious on broad EM equities and favor DM stocks. Yet it also has opened up opportunities in EM debt, against a backdrop of higher yields in a world starved for income. We are modestly overweight EM local-currency debt as we see valuations compensating for the risks.
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