Inflation is creating opportunities across emerging market (EM) debt. We believe the environment will favor investors with the 'full toolkit' at their disposal.
- Inflation may generate opportunities across EM rates, credit, and currency markets
- Inflation risks often lead to more extreme outcomes in emerging markets
- Don't forget to watch EM demographics—given the potential to exacerbate inflation
- Central bank trajectories reflects divergent fortunes
- Playing divergent fortunes in EM: using the 'full toolkit'
Inflation may generate opportunities across EM rates, credit, and currency markets
Inflationary forces may be creating many more investment opportunities across emerging markets than they are in advanced economies.
In advanced economies, we believe inflation risks currently appear transitory, likely to normalize without sweeping monetary policy reversals, potentially justifying a ‘buy the dips’ playbook. However, in emerging markets, in many cases inflation forces are amplified, requiring central bank intervention. Furthermore, inflation forces are highly varied across countries, given uneven recoveries.
Investors with the appropriate toolkit may be best placed to target potential absolute and relative long or short opportunities within and across many EM countries in EM rates, credit and currency markets.
Inflation risks often lead to more extreme outcomes in emerging markets
Food and commodity prices are larger inflationary forces in emerging markets
Many EM economies are acutely sensitive to rising global food and oil prices. World food prices are at their highest rate in a decade, while oil prices are approaching early 2019 levels (Figure 1) given elevated demand and activity, which is led by markets such as China.
Figure 1: Rising global food and oil prices have helped stoke inflation1
Brazil, for example, has seen pressure on both fronts. Food inflation comprises 22% of the Brazilian CPI basket (compared to ~15% in the US). Petrobras2 (the Brazilian energy multinational) increased domestic diesel prices during a painful wave of COVID cases. The price rises even led to popular anger and widespread worker strikes, political backlash and high-profile resignations, reminiscent of the 1970s crises in the West.
Amid the inflation pressure, the central bank has been forced to tighten monetary policy (Figure 2).
Figure 2: Food and oil prices have helped pushed Brazil into a hiking cycle3
The effects have been the opposite in other cases. An example is Thailand, which has even been flirting with deflation. A lack of commodity pressure has compounded the fact that the economy is 20% reliant on tourism, with the Delta variant further challenging the recovery.
This is particularly apparent when looking at Thai inflation over 2-years (Figure 3).
Figure 3: Thailand is facing muted core CPI and has needed central bank easing4
Fiscal and monetary stimulus policies are also creating severe EM inflation risks
Many economies have lower real rate policies than advanced economies such as the US. Examples include Brazil, Poland and Hungary, where real rates are ~-4.5% or less. This has resulted in currency devaluation, further amplifying the CPI passthrough from commodity prices.
Fiscal policies have also been aggressive in some regions. Brazil, for example, delayed its fiscal consolidation as COVID-19 cases surged. Debt-to-GDP was at ~90% at the end of 2020 versus ~61% from 2006-20195. Meanwhile, Eastern Europe has benefited from loosening EU fiscal rules since the start of the pandemic (Figure 4).
Figure 4: Certain countries have implemented aggressive fiscal stimulus policies6
Not all economies have implemented aggressive stimulus, however. Mexico has notably pursued a risk-averse budget balance and continues to hold rates at conservative levels despite a recent surprise 25bp hike in rates and subsequent 25bp tightening in August. This may help keep inflation relatively muted even amid its northern neighbor’s reopening push.
Combining policy accommodation and commodity passthrough risks we see eight economies with rising inflation risks (Figure 5).
Figure 5: Eight countries appear particularly at risk of rising inflation7
Don't forget to watch EM demographics—given the potential to exacerbate inflation
Demographic trends have been a major disinflationary force in advanced economies for the last 30 years8, but in many cases the opposite is true in EM.
For example: India, South America and Africa have growing working-age share of their populations, as evidenced by falling dependency ratios (Figure 6). A growing working-age population typically means rising demand for goods and services (as more of the population starts earning wages). Young demographics potentially helped spark the 1970s inflation shock in the West.
Figure 6: Falling dependency ratios could exacerbate inflationary pressures in South Asia, Latin America and Africa9
The opposite is true of East Asian countries such as China (a result of its historical ’one-child’ policy) and Eastern Europe, where demographic trends more closely mirror advanced economies.
Central bank trajectories reflect divergent fortunes
Some central banks are being forced into hiking to contain inflation
Central banks in Brazil, Russia, Mexico, Poland and Hungary have already been forced into hiking. In Brazil, rates started the year at 2%, and the market is pricing in a 8.25% policy rate by year-end. However, policy has so far failed to contain long-end yields. This has aided a sharp recovery in the Brazilian real (BRL).
Poland and Hungary have also already started hiking rates. We expect Poland to turn more hawkish still, as it is already on course to close its output gap this year given relatively advanced vaccination rates, creating potential mispricing opportunities. We expect the Hungarian rate curve to flatten as the central bank acts.
Others are in a trickier spot and keeping policy stable
Thailand, Malaysia and South Africa are mostly seeing ‘base effects’-related inflation and are likely to keep rates on hold (similar to the US) while relying on fiscal stimulus to provide a ‘floor’ to growth. Fortunes could change if the vaccination efforts in the West and China allow tourism to resume, which would be positive for the local currencies.
India, notably, is seeing inflationary pressures from food imports and demographic trends. However, COVID headwinds put the central bank between a ‘rock and a hard place’. Notably, this is an environment conducive to volatility (such as in the currency) and may offer investment opportunities.
Figure 6: Markets are pricing in a wide range of hiking cycles10
Playing divergent fortunes in EM: using the 'full toolkit'
In our view, divergent inflation dynamics create a wealth of opportunity across EM rates, credit and currency markets. We believe investors will be best positioned if they can implement long, short and relative value positions across emerging markets where appropriate using all the tools in our toolkit.
‘Underweight’ rates where central banks are hiking
In Brazil, we believe investors should consider a ‘curve flattening’ position: i.e. ‘underweight’ at the front-end of the yield curve and ‘overweight’ at the ‘belly’ (3 to 7-years). We also believe in a long bias in BRL given potentially attractive valuations relative to its 5-year real effective exchange rate (REER), carry potential and improving current account balance.
In Poland, we see similar value in an ‘underweight’ to Polish rates and in ‘curve-steepening’ trades (as a ‘short’ at 2-years and ‘long’ at 5-year maturities using interest rate swaps). Conversely, in Hungary we believe in ‘curve flattening’ positions from a more pre-emptive central bank approach to tightening monetary policy.
In areas with less inflation risk, such as Mexico, where we see transitory inflation effects similar to the US, we favor tactical opportunities to ‘buy the dips’ during periods in which we believe markets are ‘overpricing’ the risks of a hiking cycle (e.g. through tactical 5-year ‘overweights’ to maximize the ‘carry and roll’ dynamics and position for less rate hikes than markets expect).
In EM credit, we have recently favored high yield markets, primarily in sovereigns (e.g., the Dominican Republic, Colombia, Egypt) based on asset class valuations (in percentile terms) and given our expectation that a growth-driven rising interest rate environment will generally be supportive for higher-income, more growth-sensitive risk assets, such as high yield.
Implementing EM opportunities
We believe managers with specialized capabilities in local government, rates, hard currency corporate and sovereign credit and foreign currency capabilities will be best-placed to extract inflation-related opportunities within EM. Tools such as derivative instruments (e.g. credit default swaps, interest rate swaps) and strategies (e.g., outright ‘long’ and ‘short’ positions or relative value trades) and potentially unlock value opportunities. A fundamental ‘top-down’ and ‘bottom-up’ approach may also be advantageous.
Historically, emerging markets have been more volatile and differentiated than advanced economies, with many idiosyncratic market opportunities. Regarding inflation-related positioning, among other things we also believe investors need to consider:
- The reaction of real yields to changing inflation
- Each central bank’s individual ‘reaction function’
- The efficacy of monetary policy within an economy
- Sensitivity of foreign currency shifts
- Current account and trade balance dynamics
- Inflation forecasts versus market pricing
In our view, the current environment of divergent inflation profiles in emerging markets offers a wealth of potential for skilled EM investors to capture returns from idiosyncratic market opportunities.