(Bloomberg) — The moment long awaited by emerging market investors as they endured the worst rout since the 2008 global financial crisis has finally arrived.
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It is a combination of two peaks. First, inflation: developing countries from India to Brazil are reporting lower consumer price growth, the first victories in a two-year war. Second, monetary tightening: from the US to the UK and Europe, bets on rate hikes that have been steadily increasing until last month are now moderating.
It’s still early days and there could be plenty of headwinds before these two trends consolidate, but expectations of a peak in borrowing costs next year are encouraging investors to turn back to emerging market assets. When monetary tightening ends, investors may find the developing world more attractive because stock and bond valuations are cheaper than in rich countries, real yields are higher, and battered currencies are brimming with carry.
“We’re more inclined to selectively add risk at this point,” said Lewis Jones, debt manager at William Blair Investment Management in New York. “The valuations of emerging market currencies are very attractive and central banks, especially among the basket of higher yielding countries, have tightened very aggressively and successfully in terms of expected levels of inflation next year. “
Benchmarks for emerging market bonds, both in dollars and in local currencies, rallied in October after recording declines in eight of the nine months this year. The benchmark equity index is recovering from the worst monthly fall since March 2020, while the currency index is rebounding from the longest streak of losses since 2019.
Part of the gains came from the euphoria earlier this month that poor economic data will push central banks, including the Federal Reserve, into a dovish pivot. While those hopes have since been dashed – with policymakers reaffirming their fight against inflation and the US labor market remaining strong – the case for at least a halt in tightening next year continues to find support.
“Aggressive central bank intervention, some eye-catching relief in rates markets and very heavy long positioning in the dollar have changed the short-term market narrative a bit and introduced price discovery in both directions” said London-based Paul Greer. fund manager at Fidelity International. “This creates tactical opportunities in the emerging markets universe.”
The main concern of the poorest countries over the past two years – runaway inflation – is easing. India recorded four consecutive months of declines in its consumer price index, while Brazil and South Africa also joined the inflation spike club. This has eased the pressure on some of the biggest economies to raise rates.
Meanwhile, money markets are reducing their bets on developed market terminal rates. They are now asking for a maximum rate of 5.8% in the UK, 3.15% for the European Central Bank and as low as 4.5% for the Fed, all down from the highs seen in September.
Greer expects the average sovereign risk premium to shrink by 100 basis points if the Fed’s bets come true. The gap stood at nearly 540 on Thursday, from a high of 593 in July, according to a JPMorgan Chase & Co index.
“A top or stability in US yields would be very positive for emerging market bonds,” said Eric Lo of Manulife Investment Management. The fund manager bought the battered South Korean bonds given their close correlation to the US and the fact that they could benefit from a rally in Treasuries.
Fidelity International took profits on some bearish currency positions and placed bullish bets on the Mexican peso and Singapore dollar. Greer said he was also taking more exposure to the duration of local-currency government bonds in Brazil and Mexico.
Waiting on the wings
Portfolio managers struggle to explain that these are selective bets and that it is not yet time to be bullish on emerging markets as a whole. Most investors are retreating from the clamor for a “Fed pivot,” which called for a dovish tilt from policymakers. The best hope now is for rate hikes to stop, even if rate cuts are further away on the horizon.
Analysts at Deutsche Bank AG said it was too early to turn bullish on currencies and local bonds, citing the risk of inflationary surprises that could lead to higher US rates and the fallout from Russia’s war in Ukraine. While several central banks have signaled the end of tightening cycles, including Hungary, the Czech Republic, Brazil and Chile, there is a risk that inflation will persist longer, hurting potential returns, they said. written in an email.
“The market has been in love with a Fed pivot for some time now and it’s still disappointed,” said Francesc Balcells, chief investment officer of emerging market debt at FIM Partners in London. “In any case, whether we are at the top of yields now or in the future, the risk-reward ratio for long-duration fixed-income asset classes, such as emerging market debt, is starting to look more attractive here.”
What to watch this week:
Chinese markets reopen on Monday after a week-long holiday, ahead of the Communist Party congress due to begin on October 16. President Xi Jinping is set to secure an unprecedented third term in power at the twice-a-decade rally
Price data from China will be closely watched. Consumer inflation likely accelerated in September, mainly due to higher food prices, while factory gate inflation likely continued to subside amid falling commodity prices
Meanwhile, the country’s trade report is likely to show slowing export growth, pointing to weakening external support for the economy
Brazil, India and Israel will also release CPI data that could offer clues to the outlook for monetary policy.
South Korea and Chile will likely raise interest rates. Mexico’s central bank will release the minutes of its September 29 meeting on Thursday
India, Malaysia, Mexico and Turkey will report industrial production
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