Capital IdeasTM
Investment insights from Capital Group
Emerging Markets
Flavio Carpenzano
Harry Phinney
- Historically, emerging market (EM) local currency debt has tended to weaken with rising US interest rates, but our research shows that much of this has generally occurred before Federal Reserve (Fed) interest rate hikes have taken place. As the Fed has started to raise rates, it may be that most of the EM local currency debt weakness is behind us.
- Compared to the tightening cycle in 2015, EM fundamentals are in decent shape. Although core inflation is higher and fiscal positions have deteriorated, both seem more contained than in developed markets. External balances remain solid and there has been a broad reduction on reliance on external financing within EM.
- Valuation opportunities appear strong in EM local currency debt, with attractive real interest rates and undervalued exchange rates.
Introduction
Hawkish comments from Fed officials over the past few weeks have led to increased market expectations for higher US interest rates. US 10-year real yields have seen the largest two-month move since the 2013 taper tantrum, as shown in the chart below.
US real rate rises similar to the 2013 taper tantrum
US 10-year real yield
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Data as at 26 May 2022. Source: Bloomberg generic 10-year real yield
US tightening cycles have generally been a source of stress for EM economies in the past1 and, recently, have been a factor in EM local currency debt volatility, with swings in the pricing of the timing and pace of monetary policy normalisation in the US affecting local currency debt.
The current period of volatility is also characterised by the fact that three major global central banks – the US Federal Reserve, the European Central Bank and the Bank of England – are all tightening monetary policy at the same time, which should lead to tighter financial conditions globally. The chart below shows how global quantitative easing and quantitative tightening influence US financial conditions. It suggests that US financial conditions could tighten further from here, given the current reduction of central banks’ balance sheet holdings.
G4 QE holdings compared to US financial conditions
12-month change, USD
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Data as at 30 April 2022. G4: US, UK, Japan, eurozone. QE: quantitative easing. Sources: Bank of England, Bank of Japan, European Central Bank, US Federal Reserve, Goldman Sachs
EM local currency debt tends to weaken when US rates rise
EM local currency debt has tended to weaken during periods of rising US interest rates. This is because rising US rates often coincide with a stronger US dollar and weaker EM currencies, and because higher US rates generally mean a narrower interest rate differential with EM, reducing the compensation investors receive for EM country risk.
US dollar likely to be overvalued/EM currencies undervalued: The US dollar is currently overvalued based on our fundamental in-house model of exchange rate valuation. However, given the differences in the growth outlook and real interest rate differentiation between the US and the rest of the world, this is likely to remain the case for some time. EM currencies are generally undervalued, based on our model, but some faster growing economies may see some appreciation in their exchange rate versus the dollar. Most EM currencies have actually appreciated versus non-dollar developed market currencies year-to date, reflecting this undervaluation2.
But EM/DM interest rate differentials are relatively high: Interest rate differentials fell to a decade low in 2020, but rose again in 2021. EM central banks started to normalise rates in 2021 ahead of developed market (DM) central banks, either because inflation rose on the back of tight labour markets (e.g. in Eastern Europe and Russia) or because of pressures on policy credibility and public finances (e.g. Latin America). Both nominal and real interest rates have moved higher, particularly in the higher yielding countries, which are typically the most vulnerable to Fed tightening.
EM real yield differential rising
EM real yields minus US real yields
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Past results are not a guarantee of future results.
As at 26 May 2022. EM yields calculated using GBI-EM Broad Indices. US yield is the Bloomberg generic 5-year index. Inflation is core CPI for the individual countries. Sources: Bloomberg, Capital Group calculations
1. EM local bonds (GBI-EM Global Diversified Index) suffered a peak-to-trough return of -22% over three years from the 2013 taper tantrum. Source: JPMorgan
2. As at 20 May 2022.
Risk factors you should consider before investing:
- This material is not intended to provide investment advice or be considered a personal recommendation.
- The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
- Past results are not a guide to future results.
- If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
- Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.
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