Insight

Emerging Market Macro Insights - May 2023

Emerging Market Macro Insights - May 2023
Key Takeaways
1

EM posted almost no rate hikes in April, the first month since the rate hiking cycle began. Colombia was the only country to hike.

2

Colombia’s president spooked markets with a cabinet reshuffle after a failed reform agenda. The peso fell and local interest rates rose.

3

Global central bank policy decisions continue to be driven primarily by their inflation mandates. In the US, we expect the Fed to pause and in Europe, we expect at least two more 25 basis point hikes.

Slowing EM rate hike cycle brings divergence and opportunity

In the three months leading up to the pandemic, emerging market (EM) central bank policy rates averaged around 4%, though there were regional differences (Figure 1). Developed market rate cuts in response to the pandemic allowed EMs to follow suit, helping them stem the pandemic’s fallout in the first half of 2020. EM central banks lowered their policy rates by over 200 basis points from their 2019 cycle peaks (Figure 1). While EM central banks were the first to act when the world reopened and inflationary pressures started to build, the persistence of inflation and, importantly, its strong link to inflation expectations, caused EM central banks to continue on a sustained and aggressive rate hiking cycle.

Beginning in mid-2021, a significant and consistent rate tightening cycle extended across the developing markets and only started to slow late last year. April 2023 would have been the first month with no rate hikes in EM, had Colombia not raised rates on the last day of the month on the back of continued inflation, stronger growth, and political uncertainty. Colombia also offset the news out of Uruguay that it was the first Latin American country to lower policy rates since the tightening cycle began. 

Figure 1: Average policy rate of EM central banks (%)
Figure 1: Average policy rate of EM central banks (%)

Source. Bloomberg L.P. Data from Dec. 31, 2014 to April 30, 2023.

Market pulse

After a few months of relative calm in Colombia, President Petro spooked markets once again by reshuffling his cabinet, including the replacement of Finance Minister Ocampo. The cabinet reshuffle came after several pieces of Petro’s reform agenda failed to move forward in Congress. Pension, health, and labor reform have faced opposition from inside the ruling coalition and President Petro is seeking to consolidate power with new cabinet appointments. Markets reacted poorly to the news. The Colombian peso suffered a 5% depreciation against the US dollar and interest rates on peso-denominated debt rose 50-60 basis points.1 Unfortunately, the political noise disrupted what could have been the first month of no rate hikes in EM since February 2021. Prior to the cabinet reshuffle, the market was split over whether the central bank would hike by 25 basis points or not at all. But the cabinet reshuffle caused the peso to come under pressure, leading the bank to err on the side of caution by hiking to provide stability to the market.

Now that we are in the final stages of the current global rate hiking cycle, we expect policy divergence to become more pronounced. Depending on their respective growth outlooks, EM central banks will likely attempt to either stay on hold for longer, even though real interest rates and interest rate differentials look healthy, or slowly inch toward rate cuts. We believe this creates the potential for “policy mistakes”, creating potential idiosyncratic opportunities in the asset class for active managers. Overall, the medium and long-term drivers of EM performance remain intact, in our view, and should continue to be tailwinds: an expensive US dollar, favorable growth differentials relative to developed markets and high nominal yields. 

Central bank policy update 

Global central bank policy decisions continue to be driven primarily by their inflation mandates — this clearly remains the case in the US and Europe. Concerns over financial sector stability remain front and center, but policymakers are focused on a separate toolbox to address those issues. We believe the banking system broadly is on stable footing and the systemically important banks will likely be willing to foot the additional bill to support the US Federal Deposit Insurance Corporation because it allows them to maintain their competitive advantage. 

The goal of Federal Reserve (Fed) tightening is to slow the US economy and recent banking sector stress will likely serve to tighten credit conditions — which is consistent with this goal. A key objective of market participants currently is to understand how much and how quickly financial conditions are tightening. This dynamic will likely leave the Fed somewhat more cautious going forward. We view a 25 basis point hike in June as the default, with the burden of proof being further significant economic weakening to justify a pause. However, given the volume of hikes already delivered and the fact that central bank policy cannot be permanently run on concurrent data, we believe a pause by the Fed is both imminent and prudent. At this stage, with available data on both inflation and growth, we still do not believe rate cuts are justified. Market pricing still implies a bimodal outcome with a higher probability of policy staying on hold at these levels, and a smaller probability that large cuts will be warranted. 

For the European Central Bank, we expect a minimum of two additional 25 basis point hikes, with the potential for more, given that it is generally considered behind the curve. But this will likely be contingent on how the data develop. Overall, we believe that global developed market central bank policy is broadly becoming less predictable. For example, the Bank of Japan initiated an 18-month review of policy then backtracked to say that policy could still change in that 18-month timeframe. The Reserve Bank of Australia paused for one meeting in March but resumed hiking in April, and similarly, the Norges Bank paused and then resumed hiking.

With contributions from Gerald Evelyn, Senior Client Portfolio 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 April 30, 2023.

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