What lies ahead for emerging markets?

Video Transcript

What is the growth outlook for emerging markets?

The outlook across emerging markets as a whole is decidedly mixed, with considerable variation across the regions of EM. So, for example, I think the outlook is brightest in Asia, where the economies are just opening up after a long COVID period of facing the challenges in 2021. As we've seen in other parts of the world, that opening up leads to a real natural lift in domestic demand in the economies – and they're just getting going.

However, in other countries, LatAm and central Europe in particular, I think the outlook is more challenging, based on two factors. The first is central banks are taking action to slow the economies down in order to deal with high inflation that they're facing. And in particular, some of the countries are quite well advanced along that path of hiking. We should start to see the impacts show up in the back half of this year.

The second is headwinds from developed markets – in particular as developed markets also begin the process of hiking interest rates and slowing domestic demand. But also we should see a rotation of demand from the goods that were consumed during the pandemic and the lockdowns to services and going out again, which are much more domestically oriented for those economies.

So I do see EM exports slowing down and that being a drag on growth, particularly in Latin America and central Europe as well.

How much of a threat is the war in Ukraine to the post-Covid EM recovery?

The war in Ukraine and the tragic course of events that have taken there is also a threat to emerging markets, not so much from the war directly, but from the spillover effects that we're seeing, particularly in commodity markets and food markets. So the war has broken out. It's been an absolute tragedy. I think the markets underestimated the probability of a war because these types of events are so infrequent. But what we've seen is that Ukraine itself is a major food producer for the rest of the world. It particularly exports food, wheat, and edible oils, and these types of items are going to be in shortage across the world.

The second threat from the war in Ukraine, though, is on the fertilizer side, where Russia and Belarus are major fertilizer exporters. They're under sanction. And that will make it harder for the rest of the world to make up for Ukraine's lost production. And the third threat that's going on is whether there'll be energy sanctions on Russia or not. So far, the U.S. and EU have largely avoided completely cutting off Russian energy exports to the world. But if they do so, that would create a deficit in the energy side. And we've seen some of that play out in terms of rising energy prices that’s starting to put pressure on inflation across the world.

What impact is inflation likely to have on EM over the next year?

Inflation has been the big challenge to both emerging markets and developed markets this year. It started last year. It's been a major surprise at how sharply inflation has surged on the back of reopening economies. In emerging markets, it's been particularly notable in Latin America and central and Eastern Europe.

It's definitely a threat to growth. Central banks are having to respond quite forcefully in order to get it back under control. Emerging markets in particular take inflation quite seriously. I would say central banks responding to inflation is actually a sign of institutional success of emerging markets where they put in place inflation targeting regimes over 20 years ago.

And so the central banks are acting very quickly to make sure that the initial surges in inflation, do not translate into second-round effects or unhinge inflation expectations. So a number of them have raised interest rates several hundred basis points, and they're continuing to go, I think they're, what they're trying to do is signal that they'll do what is necessary in order to bring inflation back under control. Right now, I think they're trying to navigate in a way by the stars, to use a phrase that others have used. But the inflation models that they're using have largely broken down.

And so what they're trying to do is fuel their way to what's enough in order to contain inflation. I think some of the countries are now quite late cycle, but others, like Asia, where the economies are just starting to open up, have not even begun to hike rates in a serious way yet. And that will become the focus, I think, over the course of the second half of this year and 2023.

Where could be the best opportunities in EM in the period ahead?

Right now, EM asset classes broadly are fairly challenged, and I think the opportunities in the next few months will be fairly limited. But I think broader opportunities will open up in the back half of the year and in 2023.

In particular, I like the local interest rates in countries that have done a lot of the hiking work and where I think that inflation may be starting to show signs of topping out or at least should be on a trajectory to top out in the next six months. So there we’ll see room for central banks to slowly begin to reverse course and cut rates potentially in 2023, making for attractive duration opportunities in that space.

In FX, I think it's a lot more challenging. I think it will be a lot more tied to the outlook for the broad dollar, which is being pulled up by the Fed's aggressive hiking action and belated hiking action. A lot EM currencies screen very structurally cheap, but it will be difficult for them to rerate in a sustainable way. I think they may be able to get some cyclical uplift if terms of trade improve, particularly for commodity exporters.

And finally, in the dollar bond space, I do see some valuation opportunities opening up in the high yield space, particularly relative to U.S. high yield opportunities. In the IG part of the US dollar space in EM, valuation is actually fairly tight and I think that reflects the defensive nature of some of the balance sheets in those countries that they've done a lot of work to shore those up over the years.

But broadly in the credit space, I think as the Fed continues to tighten financial conditions, the credit space overall will remain challenged. It's just that I think EM has priced more of that challenge in than other credit assets in U.S. dollars.