By the BlackRock Investment Institute
Inflation and hawkish central bank talk have spooked investors and led to bond losses not seen since the 1980s in developed markets (DMs). EM debt has also suffered, even ahead of the stress test of higher DM policy rates. The good news: Many EM central banks were early in raising rates to try to rein in inflation. This approach has created compelling yield and currency valuations, in our view. Broad indexes hide a lot of differentiation, so it’s key to analyse the underlying exposures.
Chart of the week
Emerging market local debt vs. U.S. Treasuries total returns, 2022
It’s been an annus horribilis for bonds everywhere this year – except in some corners of the emerging world. Why? Scarcity inflation has arrived. Supply shocks have created shortages of goods, energy and food that are driving up prices. This has spurred DM central banks to signal faster policy normalisation than markets expected and resulted in bond yields rocketing upward. Local-currency EM debt (the red line in the chart) has suffered alongside U.S. Treasuries (green line) so far this year.
It’s key to realise broad EM indexes hide a lot of differentiation. Local-currency debt of commodities producers such as Latin America (yellow line) and the Middle East & Africa have actually posted gains this year, outperforming debt of commodities-consuming Asia and Europe (purple line). The latter was directly hit by the fall-out of Russia’s invasion of Ukraine.
How about the risk of the Fed’s upcoming rate hikes? This has often spelled trouble for EM assets. Investors have tended to demand a higher risk premium for holding them. Fed tightening also has frequently come with a stronger U.S. dollar, pressuring EM entities with hard-currency borrowings. We see the Fed’s impact as more limited this time. First, the Fed is rightly racing to normalise policy, but we believe it won’t fully deliver on its hawkish rate hike plans in the end. Second, we expect the sum total of rate hikes to be historically low given the level of inflation.
We also see a strong starting position for EM debt, given cheapened EM currencies, improved external balances, decreased foreign ownership and attractive coupon income. The main reason: Many EM central banks have been ahead of the curve in raising interest rates to fight inflation, as we noted in Liftoff? EM has already taken off of November 2021. This means they are much further along on the path to policy normalisation than DM central banks. Real yields, or inflation-adjusted yields, have been edging into positive territory in some countries.
What are the risks? DM central banks could push rates to levels that destroy growth in an effort to rein in inflation. This would deal a blow to EM countries already struggling with high import prices of commodities and rising debt piles as a result of COVID relief programs. Alternatively, some EM countries could see runaway inflation, forcing their central banks to slam the brakes. And some could face social unrest in the face of fast-rising prices of food and other basic goods.
It’s important to realise broad EM indexes hide a lot of differentiation. EM equity indexes, for example, are heavily weighted toward Asia. The benchmark GBI EM Diversified local-currency index has a 10% cap on any one sovereign issuer, giving more diversification and exposure to commodities exporters. It also means investors may need to go beyond indexes to get the exposures they are bullish on – and avoid the ones they have little confidence in. EM assets tend to offer fertile ground for security selection, we find, compared with heavily researched asset classes such as DM large-cap equities.
Our bottom line: We maintain a modest overweight to EM local-currency debt amid an overall underweight to bonds. Much monetary tightening is already done, and valuations are compelling. We are neutral hard-currency EM debt. It is sensitive to rising U.S. rates, and valuations are now less attractive vis-à-vis U.S. credit. We prefer to take EM risk in debt, rather than equities. We prefer DM stocks because of EM’s challenged restart dynamics, inflation pressures and tighter policies.