The differentiated appeal of EM debt
- We like emerging market (EM) local debt within an overall bond underweight. Much monetary tightening has been done, and valuations are compelling.
- U.S. Treasury yields hit new three-year highs last week, and equities fell. We still think stocks can weather the yield rise in the inflationary backdrop.
- U.S. and euro area data this week may show how the supply shock of the Ukraine war is affecting growth. We expect Europe to be hit harder than the U.S.
Inflation and hawkish central bank talk have spooked investors and led to bond losses not seen since the 1980s in developed markets (DMs). EM debt has also suffered, even ahead of the stress test of higher DM policy rates. The good news: Many EM central banks were early in raising rates to try to rein in inflation. This approach has created compelling yield and currency valuations, in our view. Broad indexes hide a lot of differentiation, so it’s key to analyze the underlying exposures.
A tale of different EMs
Emerging market local debt vs. U.S. Treasuries total returns, 2022
Sources: BlackRock Investment Institute, with datafrom Refinitiv, April 2022. Notes: The chart shows the total returns for emerging market local-currency bonds compared with U.S. Treasury bonds based on the JP Morgan GBI- EM Global Diversified and regional (LatAmand Europe) indexes and Bloomberg U.S. Treasury USD index.
It’s been an annus horribilis for bonds everywhere this year – except in some corners of the emerging world. Why? Scarcity inflation has arrived. Supply shocks have created shortages of goods, energy and food that are driving up prices. This has spurred DM central banks to signal faster policy normalization than markets expected and resulted in bond yields rocketing upward. Local-currency EM debt (the red line in the chart) has suffered alongside U.S. Treasuries (green line) so far this year. It’s key to realize broad EM indexes hide a lot of differentiation. Local- currency debt of commodities producers such as Latin America (yellow line) and the Middle East & Africa have actually posted gains this year, outperforming debt of commodities-consuming Asia and Europe (purple line). The latter was directly hit by the fall-out of Russia’s invasion of Ukraine.
How about the risk of the Fed’s upcoming rate hikes? This has often spelled trouble for EM assets. Investors have tended to demand a higher risk premium for holding them. Fed tightening also has frequently come with a stronger U.S. dollar, pressuring EM entities with hard-currency borrowings. We see the Fed’s impact as more limited this time. First, the Fed is rightly racing to normalize policy, but we believe it won’t fully deliver on its hawkish rate hike plans in the end. Second, we expect the sum total of rate hikes to be historically low given the level of inflation.
We also see a strong starting position for EM debt, given cheapened EM currencies, improved external balances, decreased foreign ownership and attractive coupon income. The main reason: Many EM central banks have been ahead of the curve in raising interest rates to fight inflation, as we noted in Liftoff? EM has already taken off of November 2021. This means they are much further along on the path to policy normalization than DM central banks. Real yields, or inflation-adjusted yields, have been edging into positive territory in some countries.
What are the risks? DM central banks could push rates to levels that destroy growth in an effort to rein in inflation. This would deal a blow to EM countries already struggling with high import prices of commodities and rising debt piles as a result of COVID relief programs. Alternatively, some EM countries could see runaway inflation, forcing their central banks to slam the brakes. And some could face social unrest in the face of fast-rising prices of food and other basic goods.
It’s important to realize broad EM indexes hide a lot of differentiation. EM equity indexes, for example, are heavily weighted toward Asia. The benchmark GBI EM Diversified local-currency index has a 10% cap on any one sovereign issuer, giving more diversification and exposure to commodities exporters. It also means investors may need to go beyond indexes to get the exposures they are bullish on – and avoid the ones they have little confidence in. EM assets tend to offer fertile ground for security selection, we find, compared with heavily researched asset classes such as DM large-cap equities.
Our bottom line: We maintain a modest overweight to EM local-currency debt amid an overall underweight to bonds. Much monetary tightening is already done, and valuations are compelling. We are neutral hard-currency EM debt. It is sensitive to rising U.S. rates, and valuations are now less attractive vis-à-vis U.S. credit. We prefer to take EM risk in debt, rather than equities. We prefer DM stocks because of EM’s challenged restart dynamics, inflation pressures and tighter policies.
Yields on 10-year U.S. Treasuries rose to near 3% last week, levels not seen since late 2018. Equities ended down as the first-quarter earnings season gathered steam. We still think stocks can perform even as yields rise in the inflationary backdrop. The IMF forecasts much higher inflation and weaker growth, especially in Europe, due to the supply shock emanating from the Ukraine war. We believe downside risks to growth in China have increased amid Covid lockdowns.
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees.It is not possible to invest directly in an index.Sources: BlackRock Investment Institute, with datafrom Refinitiv Datastream as of April 22, 2022. Notes: The two ends of thebars show the lowest and highest returns at any point this year to date, and thedots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns aredenominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10- year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
The International Monetary Fund (IMF) is expecting weaker global growth and higher inflation – especially in Europe – due to the shock emanating from the war in Ukraine. We agree. This is a new supply shock on top of the existing one driven by the post-pandemic restart of economic activity.
The IMF now expects global growth to be 3.6% this year and next, a downgrade of 0.8 and 0.2 percentage points respectively. See the chart. The impact of the war is greatest on Russia and the euro area, which together account for two- thirds of the downgrade. The IMF also expects elevated commodity prices to drive headline inflation rates even higher. It now sees U.S. inflation peaking near 9% later this year. The IMF echoes our view that the supply-driven inflation puts central banks in a bind. They want to lift policy rates quickly but try to avoid slamming the brakes on the economy.
Where do we differ? The IMF projects inflation to fall back to target even without overly aggressive policy tightening. We see inflation settling for a time above target, at around 3%.
IMF cuts growth forecasts
IMF GDP growth forecast revisions, April 2022 vs. January 2022
Sources: BlackRock Investment Institute, IMF World Economic Outlook. Notes: The chart shows revisions to IMF growth forecasts made in April 2022 versus those made in January 2022.
1)Living with inflation
•We expect central banks to quickly normalize policy. We see a higher risk of the Federal Reserve slamming the brakes on the economy to deal with supply-driven inflation after raising rates for the first time since the pandemic.
•The Fed has projected a large and rapid increase in rates over the next two years. We see the Fed delivering on its projected rate path this year but then pausing to evaluate the effects on growth.
•Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
•We believe the eventual sum total of rate hikes will be historically low, given the level of inflation. DM central banks have already demonstrated they are more tolerant of inflation.
•The Bank of England hiked rates for a third time but signaled that it may pause policy normalization on concerns about the growth outlook from spiraling energy costs. This is the bind other central banks will likely face this year.
•The European Central Bank has also struck a hawkish tone, planning to wind down asset purchases and leaving the door open for a rate increase later this year. We expect it to adopt a flexible stance in practice given the material hit to growth we see from higher energy prices.
•Investment implication: We prefer equities over fixed income and overweight inflation-linked bonds.
2)Cutting through confusion
•We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
•We saw the confusion play out with the aggressively hawkish repricing in markets this year – and central banks have sometimes been inconsistent in their messages and economic projections, in our view.
•The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
•The sum total of expected rate hikes hasn’t changed much even with the Fed’s hawkish shift.
•Investment implication: We have tweaked our risk exposure to favor equities at the expense of credit.
3)Navigating net zero
•Climate risk is investment risk, and the narrowing window for governments to reach net -zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
•The West’s decision to reduce reliance on Russian fossil fuels will encourage fossil fuel producers elsewhere to increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater energy security accelerating the transition in the medium term, especially in Europe.
•The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
•We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
•Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, April 2022
Six- to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, April 2022