By Pramol Dhawan, Head of Emerging Markets, and Lupin Rahman. Head of Emerging Market Sovereign Credit at PIMCO
The varied responses of individual countries to global inflationary pressures have contributed to elevated real-rate differentials between developed and emerging markets.
The current inflationary shock is a global phenomenon, driven by supply chain disruptions and the Russia-Ukraine war’s impact on food and commodity prices, with consequences for nations worldwide. The response of policymakers has varied from country to country, contributing to elevated differentials between real – or inflation-adjusted – interest rates in developed markets (DM) and emerging markets (EM). We think this could offer investors opportunities for uncorrelated returns in the form of EM local debt. And yet, investors must be discerning.
EM inflationary momentum remains strong, with outcomes highly correlated to those in DM. Similar to our outlook for DM, we expect EM inflation to peak, gradually trending lower this year and into 2023. Given the magnitude and persistence of this episode, however, we do not expect inflation to decelerate to prior trend levels until after 2023.
EM central banks, which have built credibility fighting inflation over decades, have diverged in their recent policy responses, with some electing to raise interest rates ahead of the U.S. Federal Reserve. There have also been a few notable outliers among the more than 80 EM countries:
· Some nations have experienced a particularly large inflationary shock, as exemplified by Poland, where the war in neighbouring Ukraine has had an outsized effect on refugee inflows, supply chains, spending pressure, and commodity prices.
· Secular erosion, as exemplified by Mexico, has surfaced in the form of more structural pricing pressure, rising inflation expectations, and questions over the long-term independence of the central bank.
· Policymaking missteps have exacerbated problems for nations such as Turkey, which has resisted raising interest rates even as inflation has surged, rising to 74% year-over-year in May.
Broadly, we expect EM central banks to take their cue from the U.S. as more clarity emerges on the U.S. economic outlook and the Fed’s tightening path. EM inflation is more likely to remain elevated than in DM, given that food and energy have higher weightings in EM inflation-index baskets as well as the propensity of EM fiscal policy to accommodate inflationary shocks.
Surveying the global interest rate landscape
Real-rate differentials between EM and DM are unusually high (see Figure 1), with EM policy rate adjustments looking more mature on average while DM central banks are generally earlier in their hiking cycles. That may offer DM investors a rare opportunity for uncorrelated return potential in the form of EM local debt, which is denominated in an issuer’s domestic currency.
As in other economic cycles, EM currency appreciation should play a strong role in disinflation. This will likely be reinforced this time around by high levels of real carry – borrowing in low-yielding currencies to invest in higher-yielding ones – in EM versus DM. We are seeing this beginning to play out in Brazil already, where the central bank policy rate has risen to 13.25%, after more than 11 percentage points of hiking during this cycle, and the Brazilian real has gained about 10% against the U.S. dollar year-to-date as of 14 June, according to Bloomberg.
To become more bullish on EM currencies more generally, we would need to see this self-reinforcing dynamic broaden and strengthen, particularly in the wake of past false starts. There is further reason for caution now given the uncertain influence of global risk factors, such as those stemming from the war in Ukraine.
If this dynamic does take hold, it could mark a major break from the past decade of U.S. dollar dominance. Until the outlook becomes clearer, we look for select opportunities to generate potentially elevated returns in EM local debt, such as shying away from local Polish bonds and instead emphasizing local Brazilian bonds. Greater divergence among countries and regions reinforces the case for relative value opportunities within EM investing and may offer opportunities for portfolio diversification.