Emerging Markets Local Currency Debt

Assessing Inflation’s Effects Across Emerging Markets

While challenges remain for emerging markets (EM) debt, technicals, in some cases, have caused market prices to overshoot their fundamental value to the downside, creating opportunities for active, bottom-up managers. The key themes that influenced EM earlier this year remain very much in place today, including war in Ukraine, inflation and a hawkish U.S. Federal Reserve, commodity price volatility and the slowdown in China’s growth. This challenging environment drove EM debt performance lower in the second quarter and caused spreads to widen even further across sovereign, local and corporate debt. The asset class also continued to experience outflows (with roughly $48.1 billion in redemptions through June 30), which exacerbated the already challenged liquidity in the market.1

Diverging policy response from EM countries

Most of EM central banks have built credibility fighting inflation over decades. Therefore, real-rate differentials between EM and developed markets (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.

Figure 1: EM minus DM real yields

GBI-EM yields deflated by current 12 months CPI. DM yield calculated as the weighted average of real yields for 10Y UST, 10Y EUR and 10Y JPY (65%, 30% and 5%).

Source; JPMorgan and PIMCO as of 31.05.2022

According to PIMCO there are also few notable outliers among the more than 80 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, they 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.

Local Debt: All Eyes on Fed, ECB

Ricardo Adrogué, lead Portfolio Manager of the Barings Emerging Market Local Debt Fund is a bit more cautious. While he sees the current market dislocation, he doesn’t expect significant improvement as long as the DM central banks remain in their hawkish stance.

On the one hand he sees financial conditions around the world having tightened significantly, which could suggest that the Fed is closer than previously thought to reaching the end of its tightening cycle. There are also indications that inflation is nearing a peak, or even beginning to turn around, in certain EM countries.

On the other hand, core inflation continues to show upward movement in most countries. In many cases, the countries where rates have sold off the most, which could in theory become the most attractive opportunities, are the ones experiencing the highest inflation. Eastern and Central European countries, like Czech Republic and Hungary, are examples where inflation is in the double digits and interest rates are near 7%-8%. However, for an opportunity to fully crystallize, he would need to see more definitive signs that inflation is letting up, which has not been the case so far.

More specifically the Portfolio Manager favours countries where central banks increased the rates the most aggressively such a South Afrika, Mexico, and Indonesia (both rates and currencies) or countries where economic growth and more gradual rise in inflation suggest a lesser need for interest rate hikes as rates get closer to peaking such as Colombia (rates only). He remains more cautious on the most vulnerable countries to the Ukrainian crisis such as Poland (underweight in rates but overweight zloty) and strongly underweight in countries where the increase of interest rates has been late or non-existent such as Turkey.

Key Takeaway

However, EM debt will likely continue to face challenges going forward given the sheer number of risks on the horizon. In this environment, opportunities are continuing to emerge, particularly in credits and countries where a challenging technical backdrop has caused spreads to widen beyond what fundamentals would suggest. However, as always, credit and country selection matter, and will continue to be a differentiator in performance. In our view, active managers that closely assess risk, and take a bottom-up fundamental approach to analysing credit, will be best positioned to navigate the challenging landscape.

Fund focus

For an active management strategy, we opted for the Barings Emerging Market Local Debt Fund which has been one of the most consistent strategies in the local EM debt area by generating alpha over every time horizon and positioning itself on the first quarter of its peer group most of the time.