The global reflation narrative is becoming mainstream. Upside growth surprises are piling up across the world and market-based inflation expectations are rising at a brisk pace – especially in the U.S. – pushing global yields higher. What does this changing landscape mean for emerging markets investors?
Past experience shows us that emerging markets have historically reacted positively to higher global rates, especially if the latter reflects an improving global growth outlook (i.e. genuine “risk-on” rather than “taper tantrum”). The charts below show that emerging markets debt, for example, performed quite well when the U.S. economy started to recover after the 2008 global financial crisis, and even better during the reflation episodes that were accompanied by the U.S. Federal Reserve’s rate hikes.
Emerging Markets Debt Performance During U.S. Federal Reserve Rate Hikes
2004 - 2006
2015 - 2019
Emerging Markets Debt Performance and U.S. Real GDP Growth after Global Financial Crisis
We see several ways to separate winners from losers in the current reflation episode.
- Most emerging markets will start normalizing rates well before the U.S. and developed markets. Some, like Turkey, have already raised their policy rates or, like Brazil, are expected to do so in the near future. The consensus view is that higher policy rates can boost interest payments as a percentage of budget revenue and/or as a percentage of GDP. However, a closer inspection shows that this problem may be more acute in less-developed emerging markets and in emerging markets regions/countries with wider budget deficits and a slower speed of post-pandemic fiscal adjustment, including Latin America, Middle East and North Africa. As emerging markets evolve and become “emerging markets graduates”, we believe risk premium embedded in local yields should compress and their nominal rates start drifting down – despite higher interest rates in developed markets. But this is a longer-term story that may not play out in 2021.
Net Interest Payments in Emerging Markets and Developed Markets
EM and DM, % GDP
EM Regions, % GDP
- Growth differentials matter, especially for emerging markets equities, emerging markets currencies and local debt. The faster recovery in emerging markets may become part of the global reflation story. The pace of vaccinations in individual countries may be an important differentiator in the coming months. Another differentiator would be the ability of some emerging markets (such as Mexico and Central Europe) to piggyback on developed markets (or China’s) recovery without over-spending or accumulating too much extra debt.
- Emerging markets expanded their policy toolkits. During the COVID-19 crisis, 18 emerging markets central banks had enough confidence to implement their own quantitative easing programs – buying local debt on their balance sheets and issuing local currency money liabilities against it. The list includes Chile, Czech Republic, Indonesia, South Africa, Colombia, the Philippines, Poland, Hungary and Romania among others. The International Monetary Fund’s (IMF’s) findings show that even though these programs were smaller than their developed markets counterparts, they helped to lower government bond yields without causing large-scale currency depreciations. Many central banks indicated that they will continue to use asset purchases in the foreseeable future, providing ample liquidity and acting as an “insurance policy” against much higher local rates in a way that was not possible during the previous reflation episodes.
- The pace of external debt accumulation varied during the pandemic. The overall increase in emerging markets external debt looks “manageable” at just under 3% of GDP, but one region really stands out in this regard. According to the IMF, the external debt in Latin America and the Caribbean jumped from 49% to 60% of GDP, and higher global rates can make it more expensive to refinance this debt. Central banks’ policies to target international reserves rather than currencies can help to minimize the impact of debt accumulation on sovereign credit metrics and ratings, reducing future borrowing costs. We saw multiple examples of such policies across emerging markets. This not only minimized the COVID-related reserve losses (a major difference compared to earlier emerging markets crises) but also paved the way for many “textbook” current account adjustments in 2020 and 2021. Larger external surpluses mean more FX inflows and even higher international reserves, which is also good news for emerging markets sovereign spreads, which often correlate negatively with reserves.
The Varying Pace of External Debt as Percent of GDP
While this outlook is optimistic, a key risk is that emerging markets spreads are lower in absolute terms. In 2004, sovereign spreads (as represented by the J.P. Morgan EMBI Global Index) were very high at around 500bps, and had significant room for compression. In 2015, while spreads were lower, U.S. Treasury yields were much higher, so all-in yields still had meaningful room for compression. Emerging markets currencies, however, don’t have that constraint, as levels are still very attractive. Point being that differentiating and being selective is important.