Easing should be greatest and occur first in Central Europe and Latin America, Kumar said. In Central Europe, supply-chain problems and Russia’s invasion of Ukraine set off severe spikes in food and energy prices. Poland, Hungary and Czechia were hit especially hard, and their central banks vigorously hiked rates. Latin America saw a similar pattern in Brazil, Chile, Colombia and Mexico.
Rates remain on hold in most of these countries, Kumar noted. However, historically, when benchmark rates in emerging markets have remained at a sufficiently restrictive level for an extended period, the next move has tended to be the opening round of an aggressive easing cycle, he pointed out.
While Brazil and Chile have already moved to cut rates, Kumar said he expects most of the other EM countries will follow sooner rather than later. “We’re very confident that rates in almost every country have peaked,” he said. “Countries that hiked the most will cut the most. We see the biggest cuts coming in Brazil, Mexico, South Korea and Czechia. Much of this should happen in Q4 of this year and Q1 of 2024.”
Supportive cycle
The current rate cycle in emerging markets differs from previous cycles in an important way: This one isn’t about financial instability or currency weakness.
After the Great Financial Crisis of 2007-2009 and during the European debt crisis in the early to middle 2010s, for example, many emerging countries ran huge current-account deficits. Their currencies weakened and suffered massive outflows, pushing the currencies down further. Central banks had to raise rates to reduce the deficits and stabilize the currencies.
In the present cycle, however, the central banks continued hiking to tame inflation, even after their currencies did not experience the same balance-of-payment-related outflows as before, Kumar said. That’s put them in a position for the next shift toward easing, which is supportive of local-currency debt.
Green light ahead
The likelihood of an easing cycle isn’t the only reason to be bullish about local-currency EMD.
“U.S. monetary policy has always exerted a big influence on emerging markets, whether debt or equity,” Kumar said. “Our base case for the U.S. is that the Federal Reserve is either close to or at the peak of its tightening cycle, which gives emerging central banks more of a green light to ease.”
In addition, “the state of capital flows also looks favorable, as inflows into EMD — for hard-currency, denominated in U.S. dollars or euros, as well as local-currency issues — have been low for the past two or three years,” he said. “EMD tends to perform very well when valuations are attractive, as they are now, and inflows have been weak.”
It’s important for investors to understand how the drivers for local-currency EMD differ from those of hard-currency EMD. “One big difference is that while local-currency debt is much more exposed to global factors — particularly fluctuation in the value of the dollar and the rates in the core bond markets, such as the U.S. and Europe — emerging nations have more leeway in issuing more local-currency debt if they need to raise funds,” Kumar said. This offers the advantage of making local-currency debt less vulnerable to ratings downgrades. He noted that in the past couple of years, many emerging countries also have increased the maturity profile of their local-currency debt, including Colombia, Peru and Mexico.
The cumulative effect of these differences, Kumar said, is that “local markets for debt and currencies tend to offer investors more tactical situations to exploit than the hard-currency market does. Experienced, opportunistic managers can take advantage of this to benefit investors.”
Curve positioning
PGIM Fixed Income is currently positioning its EMD portfolios to be overweight local-currency debt. It maintains long duration and favors U.S. dollar versus EM currencies. Its biggest duration overweights are in Brazil, Mexico, Czechia and Korea, with underweights in Chile and Thailand.
Currently, a major challenge for EMD managers — and fixed-income managers generally — is how to position portfolios along the yield curve. Most yield curves are inverted, i.e., yields are highest in short maturities and decline as maturities increase — the opposite of a normal yield curve.
“The phenomenon of peak rates with inverted curves is unprecedented. So is the fact that so many country curves are inverted at the same time,” said Kumar. “In this environment, curve positioning can make or break a portfolio’s performance.”
A normal, positively sloped curve allows managers to profit from a simple “carry and roll down” strategy. Some part of capital gains on a bond is generated as the bond “rolls down” the curve — its maturity shortens. However, with an inverted curve, rolling down means selling the bond at a higher yield and lower price. Translation: Carrying and rolling down an inverted curve loses money, Kumar explained.
Eye on the prize
In addition to getting the right selection of country, currency and duration, Kumar said, “managers can succeed by being right not just about the amount of rate cutting, but [about] the timing of the cuts too. If you’re in the very front end of the curve, you have to be very careful because negative carry and roll will eat your lunch. That’s why we’re expressing our bullish view by emphasizing the belly of the curve,” where the yield differential between maturities is smallest, “to minimize or avoid the bleed from rolling down an inverted curve.”
It’s essential, he added, that investors stay focused on the probability that a rate-cutting cycle would be favorable to EMD portfolios. “Concentrating on the dangers of the inverted curve shouldn’t distract investors from the potential returns to be earned if, as we expect, rates fall and curves revert to their traditional positive slopes. Keeping your eye on the prize here can ultimately prove highly beneficial.”
Watch for tail risks
As always, investors need to watch out for potential risks in EM debt. Kumar is being especially vigilant on the El Nino weather pattern and inflation in the U.S. and across the emerging countries. El Nino has the potential to wreak havoc via extreme weather that can bear on economic growth, he said. The inflation numbers need to be closely watched as well, for an unexpected rise would be unfavorable to risk assets generally.
The potential durability of the current yield-curve inversion could also present a tail risk. “We can’t ignore the possibility that the bear steepening in the U.S. Treasury curve might persist longer than expected, which would negatively affect curves in emerging markets,” Kumar said. “Can it really hold? Can financial conditions tighten further? These things aren’t impossible, and we have to stay vigilant about them.” ■
