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Written by: Tom Nakamura and Tristan Sones | AGF
Investors are understandably paying a lot of attention to the U.S. Federal Reserve this year and wondering how long the central bank can hold off raising interest rates in the face of mounting inflation concerns. Yet perhaps they should consider that this U.S.-focused game of “Will it or won’t it?” is not the only game in town. In Emerging Markets (EM) in particular, a handful of central banks – including in Brazil, Chile, Mexico, Russia, Hungary and the Czech Republic – have raised rates over the past month or so, and in some cases dramatically.
This is hardly a uniform trend even among EMs (yet), and it would be going too far to see in it any kind of bellwether for how central banks in developed economies will proceed. In fact, the EM rate hikes suggest quite the opposite. Early last year, monetary policymakers around the world moved largely in lockstep to lower rates in an effort to combat the deleterious impacts of COVID-19. Yet today, with effective vaccines rolling out (albeit slowly in many cases), the world economy heating back up and inflation pressures on the rise, the global monetary policy landscape seem to be transitioning into a new and divergent phase. The rate increases in Emerging Markets can be seen as an early sign of that trend – and might well present opportunities to investors who are willing to broaden their scope.
Why are some EMs moving ahead of developed economies in raising rates? One obvious factor is the return of inflation. In Brazil, for example, annualized inflation hit 8% in May – the highest read for that month in nearly five years, according to Reuters; Hungary has seen inflation rise above 5%, which is well ahead of its 3% long-term target and the highest rate in the European Union, Bloomberg reports; in Mexico, inflation in the second half of July came in above expectations, at 5.8% annualized during the second half of the month, according to the national statistics agency INEGI. Given that many EMs have a long and troubled history of grappling with inflation and currency depreciation, pre-emptive rate hikes might not seem that surprising. And in several markets, for instance Brazil, inflationary pressures look fairly broad-based, as opposed to, say, the U.S., where the used-car market alone has helped drive above-target increases in consumer prices, as the Bureau of Labor Statistics reported in July.
Yet the return of EM inflation can also be seen as a positive signal for EMs, in the form of a return to economic growth. Hungary and Brazil, among others, recently revised their GDP growth estimates for 2021 upwards, and especially for commodity-intensive economies, a resurgence in global demand is clearly supportive of higher rates. For instance, Chile recently increased its growth projection for this year to 7.5% from 6%, in large part because of soaring global copper prices, according to Reuters.
Another factor in play is that EM central banks have more room to raise rates than they may have in the past. Often during previous global economic crises, Emerging-Market policymakers were if anything too hawkish in their response, out of a desire to protect their currencies at almost any cost. But not so when COVID-19 hit last year – EM banks lowered rates with unprecedented speed, which led to weaker currencies, but today gives them more leeway to move rates towards “normal.” Furthermore, one concern for many EMs during past recoveries was that higher rates would create unwanted currency strength, undermining exports. Yet, again, because rates – and currencies – started from such a low pandemic baseline, policymakers clearly view normalization as a relatively benign move. And finally, Emerging Markets – unlike developed economies – must pay close attention to their deficits (which generally soared during COVID) and investor confidence in their bonds. The market tends to reward those countries that take a more orthodox approach to monetary policy. In the face of high inflation, hiking rates, which can lower risk premiums overall and often strengthens the long end of EM yield curves, is one indication of that orthodoxy.
In most EMs, of course, policymakers are hardly worried about not being able to generate enough inflation, which remains a nagging long-term concern in developed markets. And it is important to consider EM monetary policy within the context of major central bank trends. So far, at least, the Fed seems to be sticking to its view that the spike in inflation (consumer prices increased at the fastest pace in 13 years in June, according to Reuters) is transitory, while the Bank of Japan and the European Central Bank have made it clear that they intend to remain accommodative. Importantly, that means EMs can be confident that the large central banks will continue to pump liquidity into the global economy, giving them some cover to tighten “early.” So, too, can some secondary developed economies – we have already seen policymakers in England, New Zealand and Canada assume a more hawkish stance.
This is not to suggest that the trend towards normalization will be seen across all Emerging Markets at the same time and at the same rate. Asian markets are actively grappling with the Delta COVID-19 variant, rising infection rates and lockdowns, so we would expect them to lag their EM counterparts in Central and Eastern Europe, the Middle East and Africa (the so-called CEEMEA region) and in the Americas. Even within the cohort that is raising rates, there are important variations, as each country has different vaccination rates, different current accounts, different politics and (obviously) different economies. Those realities will impact the extent and predictability of raising rates. Central banks in Brazil and Chile, for example, have laid out a longer-term path for normalization, in large part because inflation is running very high and currency concerns are acute. In contrast, the Czech Republic, for example, can be expected to be less inclined to telegraph rate intentions to markets, and will probably be data-dependent in its decision-making going forward.
The point is, the global economy is emerging from the COVID-19 environment in a non-uniform way, and we can expect central banks in different jurisdictions to respond in an accordingly divergent manner. For fixed-income investors, this could present country-specific opportunities in sovereign debt, both because certain countries will roll over into higher-coupon debt and because tighter monetary policy might alleviate inflation concerns. In FX markets, we can expect Asia to lag EMs in other regions, although there could be positive growth surprises later in the year. And the divergent rate environment could present some interesting plays across Emerging-Market versus developed-market currencies.
In short, we now live in a multi-speed world, as economies emerge from the pandemic environment at a different pace while facing different challenges. That is largely a good thing, at least compared to the uniformly sluggish (or worse) pace of the past year or so. And investors might do well to remember that there is more than one player in the game.
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