Active Thinking: EMs ride the tide

Why EM bonds could ride the crest of a wave as inflation eases.

17 June 2024

Following its decline from 2022 highs, global inflation has appeared rather stickier in early 2024. But Mike Biggs, Investment Manager, Emerging Markets Fixed Income, believes conditions are in place for the downtrend to reassert itself, highlighting potential opportunities in EM bonds in an uncertain environment for global economic growth.

In the second half of 2023, US inflation was broadly lower than had been expected, and markets were quick to price in aggressive rate cuts. Rather too quick, as it turned out.

By early January, markets began to backtrack on the six or seven rate cuts that had been priced in. As inflation unexpectedly picked up again, US Treasury bonds sold off, with a knock-on effect on riskier assets, including EM bonds. By early June, markets were pricing in only one or two cuts by the Federal Reserve in 2024. This dramatic shift in expectations has been founded largely on the premise that persistent inflation is here to stay. We believe the consensus may have shifted too far.

Excessive inflation pessimism could be an opportunity

The market was wrong to price in aggressive rate cuts before, and we believe it is wrong again to take all but one cut off the table for 2024. In our view, the underlying trend of declining inflation remains intact, and the factors behind the latest resilience could prove temporary. In our scenario, softer inflation over the second half of 2024 would enable central banks to put meaningfully lower interest rates back on the table into year end, thereby supporting risk-based assets, such as EM bonds.

Duration and the inflation outlook

Duration

Inflation: less ‘sticky’ when you look beyond the headlines

The firmer inflation prints we have seen during the second quarter, especially in services inflation, have come as a concern to some investors. However, in our view, the stabilisation in services inflation is really not so much an indicator of an over-heating economy, but rather reflects the lag effect from the way services like motor insurance and mobile phone costs are subject to regulatory and contractual lags. Private measures of housing rentals already show a decline in inflation, and we would expect rental inflation in the CPI to follow in time. In the US labour market, more subdued trends in the job quits rate and hiring intentions suggest that wage pressures are cooling.

Notwithstanding the scope for an occasional outlier, our expectation is that the conditions are in place for a slowing in payroll numbers during the second half of 2024. Meanwhile, with goods inflation already turning negative and services inflation set to move from stabilisation to decline, our expectation is for inflation to cool more than the market is anticipating over the second half of 2024. In EMs, we have seen declines in oil and fertiliser prices, helping inflation to come back down to 2013-2018 levels. Remember not so long ago everyone was worried about the last mile in the inflation journey being the most difficult; in EMs, we are seeing very little evidence of that. In fact, the average spread of EM over US inflation has been 1.75% over the last 10 years – now the spread is just 0.35%, reflecting how well EMs have done on the inflation front lately.

Growth outlook: sugar rush from US fiscal stimulus is wearing off

Last year, we expected US growth to be weaker than it turned out, largely because the credit impulse – our measure of the change in the flow of credit relative to the size of the economy – was negative. We expected excess savings from the pandemic years to support domestic demand, but what we had not anticipated was the sheer scale of the fiscal stimulus. The budget deficit widened to 6.5% of GDP relative to expectations of around 4%, and the IMF estimates a fiscal impulse of around 2% of GDP. This would have been enough to add 1% to 2% to GDP growth, and these factors lifted US economic activity above our expectations. Now, although the credit cycle is turning positive, the fiscal stimulus effect is beginning to reverse. This fiscal headwind could lead to softer growth in 2024, which should be enough to undermine the recent theme of US ‘exceptionalism’ that has helped to drive US dollar strength. We are not expecting substantial weakness from the fiscal stimulus reversal, just softer growth that keeps the Fed in two minds; not enough to be negative for risk assets, but enough to quell talk of any need for higher rates.

Growth outlook beyond the US: fair to middling, at best

In Europe, the credit impulse has turned positive, but the tailwind from the running down of excess deposits is likely over. In China, try as they might, the authorities have had no success in turning lending numbers around, so the credit impulse has stayed around zero. China’s first quarter economic growth was very strong at 5.3% year-on-year but we expect it to be much weaker in Q2. Overall, looking at the big picture, global PMIs are holding around 50, so on the soft side relative to what we have seen over the last decade. GDP is growing at about 3.3%, in line with the fairly weak environment we saw between 2012 and 2018. All in all, we are neither looking at a collapse in growth that justifies being very risk averse, nor roaring rates of growth that warrant interest rate hikes.

Global Growth - fair to middling

Although people have been very positive on the US macro data, the US surprise index is actually negative, whereas it is positive in Europe, the G10 group and within EMs. Overall, growth surprises are more positive in EMs than the G10. If these developments are maintained, they would contribute to a US dollar moving sideways to weaker and to EM FX strength.

Where we see the investment opportunity

Last year we saw US rates coming down, the US dollar weakening on the back of it, and EM FX doing well. The tables turned early this year, with the bigger-than-expected inflation, robust payroll numbers, US dollar strength and rising yields – in fact they rose, so far, by around 60 basis points. This leaves us with what we see as a much more attractive opportunity – there is real value in EM now. As the below chart shows, EM yields are high relative to history, all the more so if inflation comes down as we expect. Even in the US, Europe and the UK, real yields are considerably higher than over the last decade, so we would expect significant moves if inflation moderates as we expect.

EM real yields and inflation expectations

In our view, the stronger growth numbers and the spike in inflation we have seen in over recent months present an opportunity. This time, for the reasons we have outlined, the recent resilience in inflation really could be ‘transitory’. If we are correct, helped by other factors such as some element of US dollar weakness, we anticipate long duration and EM FX exposure to deliver good rewards. Should interest rates fall, as we expect, in response to moderating inflation, a scenario of growth slowing by more than anticipated should be supportive for duration, while rate cuts even as growth remains resilient should benefit risky assets, such as EM FX.