EMD gives real returns

Lower inflation in emerging markets and higher real interest rates make emerging market debt (EMD), especially denominated in local currencies, more than attractive. This is written by portfolio manager Kirstie Spence from Capital Group.

“With inflation looking set to remain higher for longer, it is interesting to look at the differences between developed and emerging markets. Central banks in developed markets have struggled over the past decade to bring inflation up to par. However, many EMs are continue their long-term efforts to reduce inflation.

In recent years, inflation in the emerging countries has been relatively more contained than in the developed markets. There are two main factors that have kept inflation under control in emerging markets.

Delayed economic recovery

Firstly, the EC is facing a weak economic recovery after the Covid-19 pandemic. Both emerging and developed countries have seen their GDP contract, but lower budget spending and lower Covid vaccination rates in emerging markets have further slowed the economic recovery there. A weak economic recovery and output gap are usually accompanied by lower inflation rates.

Secondly, the central banks in the EM countries have been more proactive with interest rate increases. This has a number of reasons. For example, rising commodity prices have hit a number of emerging countries harder than developed countries. Food prices in particular have accelerated, as both Russia and Ukraine are major exporters of food. Let the price of food in the EM countries be the largest component of inflation.

Proactive central banks

EC central banks have also traditionally faced different challenges than their counterparts in developed countries. They need to do more to prove their credibility and avoid anchoring inflation expectations.

That said, EM central banks are used to inflationary cycles that allow them to use interest rates more broadly to address inflationary concerns. The fact that most central banks in emerging markets have not engaged in quantitative easing during the pandemic means they can use interest rates better to address inflationary concerns than central banks in developed countries.

Central banks in EM are used to inflationary cycles that allow them to use interest rates more broadly

Finally, higher interest rates help protect emerging countries from capital outflows if the Federal Reserve starts raising interest rates. Emerging markets often suffer from capital outflows during periods of rising US interest rates, as these tend to mean a smaller interest rate differential with emerging countries, meaning investors are less compensated for emerging market risk. Emerging economies’ central banks must therefore be ahead of interest rate hikes in anticipation of the Federal Reserve’s actions in 2022 and beyond.

Higher real yield differentials

The accelerated interest rate increases by the EC central banks have pushed up the nominal and real interest rate differentials between the EC and the US. Real bond yields from emerging markets are now mostly positive.

Currency increase ahead

Overall, Capital Group believes that most emerging countries are in a relatively strong position to face any challenges in the coming months. The current market environment lends itself particularly well to local currency debt in emerging markets with high real interest rate differentials.

Given the starting position of exchange rates in EM and the likely good growth in most emerging countries, we expect local currencies to contribute positively to total returns this year.

The first half of 2022 has presented investors with many different challenges, and this uncertainty is likely to continue for the foreseeable future. Despite this, emerging markets generally look good compared to their counterparts in developed countries.”

Signed: Kirstie Spence
Kirstie Spence

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