EM – Ready for a more hawkish Fed?


By Natalia Gurushina
Chief Economist, Emerging Markets Fixed Income Strategy
Van Eck Partners Company

All eyes are on US Federal Reserve (Fed) today, and with widely expected rate hikes at one point in 2022 (around June, according to Fed Funds Futures), the question is what this means for risky assets, including emerging markets (EM). Past experience shows that Emerging bonds have performed rather well in the last two Fed bull cycles – so, can we sit down and relax? There are three counter-arguments suggesting that investors may need to take a more selective approach this time. First of all, US rates are currently much lower than at the start of previous bull cycles, which means we potentially face larger declines in emerging market total returns due to higher “risk-free” rates.

Second, Growth prospects for emerging markets are not so optimistic as before – the EM-US real growth differential (excluding China) is expected to fall below 1% in 2021/22, and China’s real GDP growth is expected to be closer to 5% in 2022 than 7% at the start of the Fed’s latest tightening cycle. These are the reasons why the market is obsessed with supply chain disruptions, high prices of inputs (raw materials), various COVID strains and, of course, the political orientation of SE. China is one of the very few emerging countries to have stepped up its stimulus measures, and the latest indicators of domestic activity suggest more targeted support may be needed in the future. Industrial production rebounded slightly more than expected in November (3.8% yoy), but retail sales and capital investment were below consensus, supporting the pessimistic GDP forecast of 3.11% on one year for the fourth quarter.

Finally, spread compression has accounted for a very large part of the total returns of emerging bond indices (both High Yield and Investment Grade) during the last two Fed bullish cycles (see chart below), but some EM spreads seem tight right now. For example, the investment grade sovereign spread (JP Morgan EMBIG IG Index) is close to multi-year lows (see chart below). The same goes for the spreads of High Yield and Investment Grade companies (JP Morgan CEMBI index, the chart can be provided on request). So stay tuned for the new Monthly Emerging Debt Report, in which portfolio manager Eric Fine talks about a “new state of nature”, where selectivity is key.

Chart overview: EMBIG spreads and US Federal Reserve target rate

Source: Bloomberg LP

JPMorgan EMBI Global Diversified Index is an unmanaged, market-capitalization-weighted total return index that tracks the traded market for U.S. dollar denominated Brady bonds, Eurobonds, traded loans and local market debt securities issued by entities sovereign and quasi-sovereign.

The JP Morgan CEMBI Broad Diversified Core (CEMBI CORE) index tracks the performance of US dollar-denominated bonds issued by companies in emerging markets.

Originally posted by VanEck on Dec 15, 2021.

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PMI Index – Purchasing Managers: economic indicators derived from monthly surveys of private sector companies. A reading above 50 indicates expansion and a reading below 50 indicates contraction; ISM – PMI Supply Management Institute: ISM publishes an index based on more than 400 surveys of purchasing and supply managers; both in manufacturing and non-manufacturing industries; CPI Consumer Price Index: an index of the change in prices paid by typical consumers for retail goods and other items; PPI – Producer price index: a family of indices that measures the average change in selling prices received by domestic producers of goods and services over time; PCE inflation – Price index of personal consumption expenditure: a measure of US inflation, which tracks changes in the prices of goods and services purchased by consumers throughout the economy; MSCI – Morgan Stanley Capital International: a US provider of equity analysis tools, fixed income securities, hedge fund market indices and equity portfolio analysis tools; VIX – CBOE Volatility Index: an index created by the Chicago Board Options Exchange (CBOE), which shows the market’s expectations for 30-day volatility. It is constructed using the volatilities implied on the options of the S&P 500 Index .; GBI-EM – JP Morgan’s Government Bond Index – Emerging markets: comprehensive emerging market debt benchmarks that track local currency bonds issued by governments in emerging markets; EMBI – JP Morgan Emerging Markets Bond Index: JP Morgan index of sovereign bonds denominated in dollars issued by a selection of emerging countries; EMBIG – JP Morgan Global Emerging Markets Bond Index: tracks the total returns of external debt instruments traded in emerging markets.

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Investing in international markets involves risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve increased risks related to the same factors as well as increased volatility, lower trading volume and lower liquidity. Emerging markets may present greater custody and operational risks and less developed legal and accounting systems than developed markets.

Any investment is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that the investment objectives will be achieved and investors may lose money. Diversification does not guarantee a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.

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