Insight

Emerging Market Macro Insights - April 2023

Emerging Market Macro Insights - April 2023

Elevated yields and slowing inflation make EM local debt attractive

We have become increasingly constructive on emerging market local debt, based on improved valuations and our outlook for a potentially weaker US dollar in the near term. Less volatility in core developed market rates should initially translate into a weaker US dollar, while emerging market rates will likely stay higher for longer, as the trend toward disinflation slows. Over the next couple of months, we could be entering a favorable period for risk assets in general since we expect the US Federal Reserve (Fed) to be more cautious around its communications and policy actions related to stronger data or disappointing inflation results, given recent events in the banking sector and tightening financial conditions. 

Market pulse

In Latin America, Mexico and Colombia each hiked rates by 25 basis points in March to 11.25% and 13%, respectively. Colombia may hike by another 25 basis points at its next meeting. In Central and Eastern Europe, central banks stayed on hold, but communications were mostly hawkish. South Africa surprised with a 50 basis point hike, versus an expected 25 basis points, due to worries about a weakening currency and its impact on inflation and inflation expectations. In Asia, the Philippines and Thailand hiked by 25 basis points, as expected. With more central banks at or near their terminal rates, and a more cautious Fed, we have become more constructive on extending duration in the asset class, with Latin America standing out as an especially attractive opportunity. 

Looking back at the first quarter, each month seemed to be characterized by a distinct theme: January started the year with risk-on sentiment and an appetite for duration risk. This faded quickly after the strong US jobs data in early February caused market participants to rethink the Fed’s path. Expectations of a more hawkish Fed put pressure on emerging market yield curves across the board. US five-year rates moved 60 basis points higher and emerging market rates adjusted accordingly, with a few idiosyncratic exceptions.1 Before this, the slowdown in the Fed’s tightening pace had raised the potential for rate cuts in emerging markets later this year.  However, in February, those rate cuts were mostly priced out, or, at least, pushed further into the fourth quarter of this year and the first quarter of next year. The US dollar’s weakening trend, seen since the end of September, also reversed. March, however, was characterized by another reversal of the Fed outlook, driven by events surrounding US regional banks and the forced acquisition of Credit Suisse by UBS. While we do not believe the global banking sector faces a systemic crisis in the near term, recent banking sector stress probably tempers the Fed’s enthusiasm for an aggressive continuation of its hiking cycle, as it raises the risk that something could “break”. Regional banks play a key role in the US economy and the fallout from the recent turmoil will likely be a headwind to growth. 

Regional Spotlight:  Central and Eastern Europe  | Notes from the ground

In March, we visited with policymakers, analysts, and local market participants in the Czech Republic, Poland, and Romania. Below are key takeaways from the trip.

Growth is slowing across the region, driven by negative real wage growth and reduced household consumption. Wages caught up somewhat in the first quarter, as labor markets are tight. But this has created a challenge for inflation, which likely will not decline to government targets over the policy horizon. While inflation may have peaked, it remains solidly in double digits, which prevents most central banks from contemplating rate cuts. Hungary may be the exception, with an overnight rate at 18%, and a policy rate at 13%.

Czech Republic

The Czech Republic's weak post-pandemic recovery has stalled, with declines in GDP in the third and fourth quarters of 2022. Though the labor market remains strong, and wage growth has surpassed forecasts, real wages have declined by as much as 10%, creating the largest impediment to growth and inflationary risk for the Czech National Bank (CNB).2 We view recent banking sector stress as broadly neutral for the monetary outlook, assuming there is no significant escalation. There is some concern about banks owned by West European banks, as the regulator may make it difficult to source capital from bank subsidiaries in the event of an escalation in stress.

The CNB has indicated a desire to smooth its monetary policy, and not over-hike or cut rates too aggressively. The current monetary stance is viewed by markets and the central bank as restrictive, and CNB Board members appear to agree on the need for currency strength to lower inflation.

Poland

Poland is preparing for parliamentary elections this fall, which are expected to take place in mid-October. The latest polls indicate a close race, with the ruling Law and Justice (PiS) party ahead but unlikely to secure a majority. A coalition of opposition parties led by the Civic Platform (PO) is predicted to form the next government, which would likely result in improved relations with the European Union. Fiscal policy is expected to remain relatively balanced and conservative, with only a moderate increase in spending, despite the elections. Inflation is currently high due to non-core factors in energy and food but is expected to fall gradually from March onward. Elevated core inflation and strong wage growth suggest that inflation will nevertheless remain high, making rate cuts unlikely this year. Central bank projections assume no rate cuts until 2025, when inflation is projected to return to target levels.  

Romania

Romania's economic activity slowed in the second half of 2022, but wage growth remains strong. The central bank expects headline inflation to fall sharply due to a reduction in food and energy prices, but underlying inflationary pressures remain high. We expect the central bank to leave rates unchanged at 7.0% through the rest of 2023. Romania recorded a current account deficit of more than 9% of GDP in 2022, and its fiscal adjustment is likely to be stalled by the 2024 elections.3 Some measures could improve revenues and expenditures, such as eliminating unnecessary tax breaks and adjusting capital expenditures. However, certain measures are politically sensitive, and the administration does not appear to feel significant pressure, especially because funding plans are ahead of schedule. Although European Union transfers and foreign direct investment have secured funding for the external deficit for now, it remains the economy's primary medium-term risk, in our view.

With contributions from Mohit Patel, Associate Product Manager, Invesco Fixed Income.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. 

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. 

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

Footnotes

  • 1

    Source: Bloomberg L.P. Data as of March 31, 2023.

  • 2

    Source: Czech National Bank. Data as of March 21, 2023.

  • 3

    Source: National Bank of Romania. Data as of March 23, 2023.

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