Choosing a different path: divergent interest rate hiking cycles create emerging market opportunities

The last 18 months have seen a flurry of central bank activity. Before the pandemic, many EM central banks had begun to lower their policy rates. Meanwhile, the US policy rate peaked, and EM inflation remained subdued. 

Once the pandemic hit and DM central banks pivoted to extraordinary easy monetary policy, the flood gates were opened for EMs to follow suit. Most EMs brought real rates close to zero. A few, like the Philippines and Mexico, remained cautious, implementing limited or gradual cuts. Others, such as Brazil, Chile, Peru, Poland, the Czech Republic and Thailand pushed their monetary policies to the limit.

In early 2021, a reversal of extraordinary stimulus was on the cards with economic activity headed for recovery. The vaccine rollout gave the US a head-start in the global growth recovery, while most other DMs lagged behind. EMs remained, as expected, well behind. But, as the growth story played out, market attention shifted to inflation.

Inflation - transitory or persistent? Central banks respond

Base effects, the impact of comparing current price levels in a given month against price levels in the same month a year ago, drove up inflation around the world. However, price pressures were forecast to be transitory and peak in the second and third quarters of 2021.

This is now less certain. Stubborn supply chain challenges, as well as commodity inflation, are changing market and central bank perceptions and beginning to influence inflation expectations.

Starting with Russia and Brazil in the first quarter of 2021, EM central banks were forced to change tack with quicker than expected rate rises. Soon, the Central and East European (CEE) central banks followed suit. They moved before most Latin American countries. This is because some, such as Chile, Colombia and Peru, had not faced inflation challenges whilst others, like Mexico, had remained cautious on monetary stimulus.

During this time, market focus quickly shifted from one country to another, pressuring central banks to hike by forcing rates higher and often weakening currencies. In some cases, this impacted economic fundamentals, forcing an earlier reversal than was initially warranted.

While some DM central banks have recently joined these moves with the withdrawal of some stimulus, we believe the urgency to tighten is not only related to inflation concerns but also to financial stability. We believe the Fed’s steady, well-telegraphed unwinding of its extraordinary stimulus will ensure that EM central banks can adjust to positive real interest rates (and a significant spread over US real rates) by the second quarter of next year. By then, inflation in most EMs is expected to converge toward their respective targets as supply chain challenges fade. 

The only way is up for average EM policy rates?

The average policy rate of 20 EM central banks has risen from a low of 2.7% a year ago to 3.6% today (Figure 1), while DM central bank rate hikes have been limited to only small hikes by Norway and New Zealand. Most other DMs have announced plans to taper or are talking about future rate hikes.

While we expect the average EM policy rate to increase over the next few quarters, we believe it will be gradual and primarily based in Latin America. This is because the early hikers are nearing the end of their cycles and most of the Asian central banks will likely remain on hold. Countries that can maintain capital account surpluses and have more credible central banks will likely be in a stronger position to withstand market pressures to hike. Overall, we expect the pace of rate hikes to slow significantly by early 2022. 

Global central banks choose various paths

While idiosyncratic stories will likely shape the EM landscape, DM central banks are typically less susceptible to the current commodity and goods inflation. This is because these factors represent a smaller share of their respective consumer price indices. Meanwhile, service sector prices are generally expected to be under less pressure.

The picture of a very gradual reversal of stimulus, painted by the Fed and European Central Bank (ECB), gives other DM central banks some leeway in answering the ‘transitory versus persistent’ inflation question.

The Norges Bank, the Bank of England and the Reserve Bank of New Zealand are on the hawkish side, the Bank of Japan and the Swedish Riksbank are on the dovish side and the Bank of Canada and Reserve Bank of Australia are more aligned to the middle.

In Latin America, the hiking cycle was initiated early this year by Brazil, followed by Mexico in June (surprisingly) and Chile, Peru and Colombia later in the summer. Being mostly inflation-targeting central banks, we expect them to continue to normalise policy over the next few months.

In Europe, Russia was the first country to hike policy rates in March while Poland, Hungary, the Czech Republic and Romania hiked in the summer. Russia is near the end of its cycle and will likely only implement one or two more hikes.

In contrast, South Africa has not initiated a hiking cycle, as inflation has only become an issue in the last month. It remains to be seen when South Africa will be pushed to hike, but it is likely to be early next year due to its preference for growth. Turkey is an exception and has followed an unorthodox policy, having begun a cutting cycle in the face of persistently high inflation.

Asia differs from the other regions and most central banks are not expected to begin hiking cycles this year due to better underlying economic fundamentals. This includes current account surpluses and acceptable levels of inflation.

Most Asian central banks also appear comfortable with some currency depreciation and subsequent pass-through inflation. The Bank of Korea is the only central bank starting its hiking cycle and is focused on financial imbalances, such as an overheating housing market, versus inflation concerns.

Is policy shaking or stirring EM bond performance?

The recent global shift in central bank policy stance has led to negative performance in EM local market bonds year-to-date. This can be attributed to higher interest rates rather than weaker currencies.

There are also regional differences. Asia outperformed the Central and East European, Middle East and African (CEEMEA) countries, and CEEMEA outperformed Latin America. Chile and Peru were the worst performers, driven mainly by idiosyncratic political stories versus the external macro environment. 

While it is hard for an investor to be excited about nominal rates globally, given concerns about the persistence of ‘transitory’ inflation, various market segments are attractive from a technical, valuation or idiosyncratic perspective, in our view.

In EM local debt, we prefer to avoid countries with low short-term yields, such as in CEE. We favour curve flatteners for steeper yield curves in countries like Colombia and South Africa. Here central banks have not yet tightened policy. We favour long-dated paper in countries close to the end of their hiking cycles, such as Russia and potentially Brazil. In DM, we prefer avoiding longer-term maturities in core markets, such as the US and core Europe, and maintain a tactical stance toward the European periphery and DM countries in which a front-loaded hiking cycle appears to be priced in.

Conclusion

The opposing forces of fading policy stimulus and accelerated re-openings, supply chain disruptions, labour market dislocations in certain sectors, and the regulatory shift in China will likely contribute to a few more quarters of uncertainty and challenges. Bank of England Governor Andrew Bailey summed it up in a recent speech – as with competitive sports, we may now be in for ‘the hard yards’. While his comment may be extrapolated to other DM central banks, EM central banks are already well into those hard yards.

Amid the diverse central bank approaches across EM and DM, 2022 is being set up as a compelling opportunity in EM. We expect inflation to fade by the second quarter of next year and interest rate differentials to rise versus DM.