Brazil’s central bank kicked off a monetary easing cycle on August 2, 2023, more aggressively than expected, reducing its benchmark interest rate by 50 basis points to 13.25% and signaling more of the same in the months ahead due to an improving inflation outlook. It is the third central bank in emerging markets (EM) to cut rates in recent months, preceded by Chile in July and Hungary, which was the first to cut rates in May of this year.
When runaway inflation first began sweeping across the globe, emerging markets central banks were generally ahead of the curve, raising rates much more quickly than their developed market counterparts. For example, Brazil began its monetary tightening cycle in March 2021, ahead of most others, and raised the Selic (the Brazilian federal funds rate) to a six-year high of 13.75% by August 2022. Now that inflation is seemingly coming under control in many markets, it appears that EMs could also be earlier in cutting rates.
The pace of the monetary easing cycle may not be as rapid and will vary by country. After a significant decline in EM headline inflation in the first half of the year, we expect a more visible reduction in core inflation in the second half. A backdrop of slow and steady rate cuts combined with reasonable growth in many EM countries should be positive for local currency debt. More stable market dynamics could likewise benefit select hard currency (U.S. dollar-denominated) sovereign and EM corporate issuers.
EM inflation should continue to slow in the second half of the Year
Emerging markets have historically struggled with inflation and last year was no exception. Higher commodity prices resulting from the Russia/Ukraine conflict (EM countries tend to be more sensitive to commodity prices given the generally higher weight of food and energy in inflation baskets), supply chain issues and weak EM currencies fed inflationary pressures.
This year, the surge in food and energy prices has abated, supply chain bottlenecks have eased, and the U.S. dollar has plateaued or weakened against many currencies. As a result, inflation has slowed both on a month-on-month and year-on-year basis in most EM economies.
Moreover, after surprising to the upside for the past couple of years, inflation surprises have generally now turned negative. This disinflation trend looks set to continue in the second half of the year.
That said, there remains a great deal of regional variation. Inflation is relatively contained in Asia. Whereas in Central/Eastern Europe and Latin America, not only has food inflation been persistent, but there has also been a broadening of price pressures to both core goods and services. Part of this has been due to rising inflation expectations, leading to higher wages. This suggests that inflation may remain above central bank targets/comfort zones for longer than previously thought in both regions, even though it has likely peaked and should trend lower.
Other EM central banks need a few more Catalysts
Given the general improvement in the inflation outlook, we (the EM debt team) expect a number of EM central banks to start cutting interest rates along the lines of Brazil, Chile and Hungary. Many EM central banks are ahead of the developed world in their monetary tightening cycle, having raised interest rates earlier and more aggressively to avoid de-anchoring inflation expectations. Turkey has been the main exception, with its policy of reducing interest rates despite high inflation, although it has now started to reverse this unorthodox policy following recent elections, almost doubling interest rates in June.
But while we believe the easing cycle is imminent, many EM central banks will only take this step when there is more certainty that inflation is on the decline, especially core inflation.
Many EM central banks aggressively hiked policy rates
Source: Bloomberg. Data as of August 3, 2023.
Looking ahead, the actions of the U.S. Federal Reserve (Fed) and the real interest rate differential between EM countries and the U.S. will be important factors. While it’s not yet clear whether the Fed is at the end of its hiking cycle or still has further to go, we’re unlikely to see the sharp upward pricing in U.S. rates that we have seen over the past year.
Countries across Latin America have been more aggressive in tackling inflation
Source: Bloomberg. Inflation rate as of April 2023 for Romania and Malaysia and as of May 2023 for other regions. Policy rate as of August 3, 2023.
Finally, the U.S. dollar will be important to watch as it will be difficult for EM central banks to cut rates in a strong dollar/weak EM currency environment. A strong dollar has often forced EM central banks to raise rates in the past, while a weaker dollar has allowed them to cut rates. U.S. dollar cycles (since the abolition of the Bretton Woods system in the early 1970s) have generally moved in clear bull and bear phases, with the average cycle lasting around nine years. If the most recent cycle ended in the fourth quarter of 2022, then it lasted 11 years from the low in June 2011. Aside from the fact that the U.S. dollar is overvalued on almost all valuation metrics, several factors support the case for a weaker dollar, including the Fed coming to the end of its rate hiking cycle. Although it is not clear that the bull market for the U.S. dollar has turned, the bulk of the broad dollar strengthening is likely behind us.
EM exchange rates could start to contribute to returns
EM exchange rates have been a drag on local currency asset returns over the past decade, but today most EM currencies look significantly undervalued based on our in-house fundamental-based valuation model, along with various other real exchange rate models.
While cheap valuations are never enough of a catalyst in-and-of themselves, the fundamental outlook of many emerging markets looks constructive, which could help support a turnaround in EM currencies versus the dollar. Inflation and cost of living concerns have put pressure on fiscal deficits, which have steadily risen over the last few years. That said, public debt levels are still below those of developed markets and remain manageable. There has been some erosion of foreign exchange reserves, but external balances have generally improved across many EM countries thanks to undervalued exchange rates.
We see the most value in Latin America, but Europe is looking increasingly attractive
A downward trend in policy rates, combined with decent overall fundamentals and relatively attractive nominal rates and positive real rates across much of the EM universe, indicate a reasonably constructive view of EM debt overall. This explains why, after over a decade of relatively muted returns, stronger performance of the asset class (as represented by the J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified and the J.P. Morgan Government Bond Index – Emerging Markets Global Diversified) so far this year could turn into a longer-term trend.
That said, selectivity will be key given the divergence in policy and inflation dynamics across countries, as well as varying relative and absolute valuations across issuers. We see potential value in Latin American local currency bonds given the combination of attractive nominal and positive real rates, moderating inflation and proactive behavior on the part of central banks. Macroeconomic conditions are looking better now than late last year and the tilt towards more positive fundamentals is likely to override political risks in those countries for now. Central and Eastern European countries are still struggling to curb inflation — and real rates remain negative — but the region is beginning to look more attractive.
Opportunities in dollar-denominated debt are more select and Idiosyncratic
Opportunities within the U.S. dollar-denominated sovereign universe tend to be more idiosyncratic. In the higher yielding, lower quality credits, we find the debt of distressed and quasi-distressed issuers to be attractive in cases where many of the challenges they face have already been priced in. Debt restructurings across this segment of the market tend to be more frequent but are likely to be limited to the most vulnerable economies.
Across the investment-grade (BBB/Baa and above) sovereign bonds space, valuations are less attractive. Nevertheless, the EM debt team sees value in select lower beta credits as a counterbalance to the high-yield positions held in certain portfolios.
Several EM corporate bonds appear reasonably cheap. We favor investing in a variety of these credits across eligible portfolios for both their relative value compared to similarly rated sovereign bonds and the potential diversification benefits they provide.
Real yields look attractive across some countries in Latin America
Source: Bloomberg. Data as of June 20, 2023. Real yields are represented by 5-year yields minus core inflation. *Real yield for Hungary is -12.1%.
As inflation slows across a number of emerging markets, central banks are likely to pivot toward rate cuts in the coming months and quarters. With fiscal and current account profiles looking largely benign or manageable for many of these economies, this anticipated shift in monetary policy alongside reasonably attractive valuations and fundamentals could lead to longer term gains for many credits across the asset class.