The start of 2022 has witnessed a strong sell-off across risky assets, due to expectations for a faster and deeper monetary adjustment in the U.S. Losses in fixed income markets were due to both spread widening and higher Treasury yields. Atypically, returns in emerging market debt local markets have so far behaved remarkably well. Is this the start of a turnaround for local EM, or is too early to tell?
Structural growth issues have been among the root causes for underperformance of the local EM asset class in the last decade. A combination of a lack of reforms and either incompetent policymaking and/or political uncertainty in key EM countries has had a detrimental impact on investments and created greater reliance on external trade. In the last two years, COVID hit EM economies more deeply, with less ammunition than developed market countries to stimulate the economy, and with less access to vaccinations. As a consequence, EM currencies adjusted lower, especially against the U.S. dollar, not only because of capital outflows but in some cases also as a policy tool to maintain a competitive advantage and help current accounts. With respect to global growth, we believe the withdrawal of stimulus measures and the moderation to trend growth are likely to start favoring EM on a relative basis while acknowledging that the effect will kick in only gradually. As such, we attribute a large part of the recent outperformance to market factors like defensive positioning and cheap valuations, especially in some of the commodity exporters in Latin America and Africa.
Given the high weighting of food and energy in the typical EM inflation basket, as well as ongoing supply chain factors, inflation over the past year proved more pronounced and sticky than anticipated. Accordingly, EM countries had to adjust monetary policies earlier and more dramatically, though inflation is still running well above target into 2022. Nevertheless, even if inflation proves more persistent, the pressure on EM local bonds should diminish over time as the market has priced a significant amount of rate hikes already. In our view, real rates on a forward-looking basis look more attractive now in a handful countries, while DM real yields are still in negative territory and only started to rise more meaningfully in recent weeks. In the near term, we see a continued sharp rise in U.S. real yields in an environment of elevated EM inflation as the key risk to our more benign medium-term outlook.