6 September 2023
The Disinflation in Emerging Markets - A Real Opportunity?
Driven by their high carry and better economic growth, Emerging Markets (EM) have shown a strong resilience year-to-date with local currencies posting a significant outperformance compared to Developed Markets (DM) peers. This EM foreign exchange (FX) strength has also improved the broader disinflation theme due to lower pass-through resulting from cost pressures.
We believe that, going forward, EM central banks will stick to their current cautious approach and maintain policy rates sufficiently above the US’. Until inflation is back to historical targets, the actual elevated rate differential will, ultimately, accompany the disinflation backdrop we observe in both core and headline data. This also means that, if growth disappoints, EM central banks are well positioned to start the easing cycle before their DM counterparts.
Even if EM central banks delay the rate cuts currently priced in the curves, EM local rates’ outperformance can continue with larger cutting cycles being priced. In fact, a prolonged period of high nominal rates could strengthen EM currencies even more compared to G10 peers, increasing disinflation, and leaving room for rate cuts later on. In addition, we suspect that positioning in EM is far from being crowded, as hinted by multiple positioning surveys.
In the chart below, we present one risk premium measure available to Fixed Income investors associated with each country. The black dot shows the average real rates over the past five years, and the green bar predicts the real rates over the next 12 months if the market and analysts' forecasts prove accurate - estimating how much premium investors will pick up over future inflation. It also quantifies the future monetary policy conditions offered by central banks, which will impact the currency's attractiveness and short-term rates for local and foreign investors.
This shows that most EM countries can still be considered attractive, even with some rate cuts being priced in the curve, as they could offer nominal rates significantly above inflation over the next months. This is the case in Latin America, where long-duration bets represent an attractive opportunity, particularly in Mexico or Brazil.
Senior Fixed Income Quantitative Analyst
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