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The emerging markets (EM) local debt sector (as measured by the JP Morgan Government Bond Index – Emerging Markets Global Diversified) just posted its worst calendar-year performance since 2013, returning -8.75% against the headwind of higher EM local interest rates. The underlying culprit? EM inflation surprised to the upside in 2021, forcing a number of EM central banks to raise their policy interest rates in an effort to curb the impact.
Although overall EM inflation did not look materially different from that of the developed world last year, the policy response as of this writing has been starkly different: EM central banks as a group have hiked policy rates aggressively, whereas the US Federal Reserve (Fed) and other developed market counterparts have scarcely budged rates from the zero-bound range (Figure 1). So what now?
Figure 1
It’s all (or mostly) about EM inflation
Many clients have asked us lately if the EM local debt sector’s poor recent performance is likely to persist through 2022. We don’t have a crystal ball of course, but there are good reasons to believe elevated EM inflation (and, by extension, rising EM local rates) may prove to be more of a transitory — less “sticky” — phenomenon than in the developed world:
- EM inflation tends to be very heavily influenced by moves in commodity prices, which represent a meaningfully larger portion of the total consumption “basket” for many EMs than they do for developed markets. While commodity prices may continue on an upward trajectory in 2022, we think their year-over-year change is unlikely to be as dramatic as last year, with the resulting “higher base” effects helping to bring headline EM inflation rates down this year.
- Developed market economies have more or less closed their output gaps — the difference between actual GDP (output) and potential GDP when at full capacity — via stimulatory fiscal policies enacted amid COVID-19. Most EMs, by contrast, have not had the same fiscal space to combat the crisis, allowing their economic outputs thus far to remain well below year-end 2019 levels. Given their still sizable output gaps, EM countries are more likely to experience growth without inflation running amok.
- As noted, most EM central banks have been very orthodox so far in their handling of monetary policy and have “front-run” developed market central banks, particularly the Fed, by hiking interest rates sooner rather than later. Therefore, we believe EM local debt markets may be poised to demonstrate resilience this year, even in the face of a potentially more hawkish Fed in 2022.
Final thoughts on EM local debt
While there are still many unknowns on the horizon for 2022, two things seem fairly certain from our perspective: 1) EM local assets are generally under-owned by global asset allocators; and 2) there appears to be a healthy amount of skepticism already priced into many of these assets. Accordingly, we believe now may be an opportune time for discerning investors to seek out attractive entry points into some EM local debt markets.
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