Figure 1

The EM central bank policy response

On the interest-rate front, the combination of stronger economic growth and higher inflation has prompted a number of EM central banks to pivot from cutting policy rates to raising rates instead. The starting point for this new rate landscape was EM policy rates that, until very recently, were mired at historic lows (Figure 2).

Notably, three major EM central banks — Brazil, Russia, and Turkey — have initiated rate-hiking cycles. Barring unforeseen developments, some of their EM counterparts in Central Europe should follow suit in the coming months. Given that inflation has been more contained in Asia so far, rate hikes there are less likely this year, but it’s reasonable to assume the next move in those EMs’ policy rates will be up as well. We view rate hikes from ultralow levels as an effort by EM central banks to narrow the gap between their current policy rates and their estimates of neutral policy rates. In the case of some EMs (Brazil, Turkey, Hungary), recent concerns about currency depreciation have also generated a focus on supporting their struggling currencies.

Looking ahead at this stage, we do not expect policy rates in most EMs to extend much beyond neutral, if at all. Some higher-yielding EMs have been successful in lowering inflation in recent years, thanks to a lengthy period of weak economic growth, which helped keep demand (and thus prices) in check, as well as their central banks’ improved commitment to average-inflation targeting. We believe these factors should help to anchor average inflation at or below target in many EMs next year, potentially slowing or even calling a halt to their rate-hiking cycles. (Due to its unique economic circumstances, Turkey is likely to remain an EM outlier with regard to inflation.)

We also see growing concern among some EM central banks around US Federal Reserve (Fed) policy direction going forward — specifically, the risk that the Fed could fall behind the curve, so to speak, in its inflation-management strategy and be forced to raise its policy rate more quickly than planned. (In part, recent and anticipated EM rate hikes are designed to offer investors a more attractive risk premium until developed market (DM) central banks begin to “taper” monetary policy later this year or early next.) In response to such a US scenario, EMs that have a greater degree of policy flexibility may be inclined to use it in the period ahead to stay competitive as an investment destination.

The Czech Republic is an example of an EM central bank whose solid inflation track record and relative financial stability could allow for unconventional policies. However, the Czech National Bank appears to be more focused on gradually raising its policy rate and on providing scope for stimulus measures to combat the next economic shock, whenever that might be. Other EM central banks — Hungary, Poland, and Israel, along with Indonesia and the Philippines — will have to navigate incremental pullbacks from asset purchases undertaken amid the COVID crisis.

Figure 2

Risks to our outlook

As of this writing, we would divide risks to our outlook into two categories:

1. Higher-than-expected DM inflation could necessitate further EM rate hikes as DM inflationary pressures spill over to many EMs, via both direct price increases and the specter of renewed EM currency weakness. We see this as a more medium-term risk that could arise in the second half of 2021 and beyond.
2. A populist wave across EMs after a multiyear period of subpar economic growth could put EM currencies at risk, while also creating a need for a higher risk premium. This risk is most immediate in Turkey, followed by Brazil. Upcoming national elections could produce surprises, as the recent election experience in Peru demonstrated.

Potential market implications

• EM equities: Since the 1990s, EM equity investors have been trained by the market to fear higher inflation. “Inflation,” as the adage goes, “is the worst tax on the poor.” It erodes real wages and compels many consumers to buy sooner and save less. In addition, EM countries that experienced soaring inflation in the past often needed to raise interest rates aggressively, which restrained economic growth and increased the cost of capital for companies seeking to invest and grow. In more recent decades, most EM central banks have become more disciplined about targeting average inflation ranges, which resulted in a sustained period of fairly tame inflation, aided too by slower economic growth related to the COVID-19 lockdowns.
  
  This is now changing because many EM economies are in the midst of reopening (or soon will be) and beginning to grow faster as a consequence. As EM equity investors, we find ourselves in the strange position of “rooting for” inflation to return to the developing world, as long as it is being driven by more people getting back to work, manufacturing capacity coming back online, and consumers stepping up their spending — in short, by fundamentally sound economic drivers. In EM equity investing, we need to recognize and adapt to this inflation paradigm shift: Inflation won’t always damage returns. Rather, if accompanied by strong, healthy economic growth, inflation (even if it proves to be persistent) can actually provide a tailwind to EM equity returns.

• EM debt: EM fixed income investors are, of course, less inclined to “cheer on” inflation, as rising price pressures often lead to higher policy rates and lower interest-rate returns. Countries starting from a low policy-rate level and those whose central banks have less inflation-targeting credibility are most at risk, in our view. Although EM inflation-linked bonds (“linkers”) may offer some degree of inflation protection in this environment, the opportunity set is limited. And there is often an undesirable liquidity trade-off in switching from nominal EM bonds to inflation linkers.
  We expect current EM rate-hiking cycles to be short-lived, as there is still considerable slack in most EM economies. As a result, we may see better duration entry points as the year progresses. To gauge the timing of this turn, we believe it will be important to watch Fed behavior and signals going forward. On a brighter note, we expect many EM currencies to appreciate as the yield gap with DMs widens in EMs’ favor and as the US dollar faces its own inflation headwinds and mounting twin deficits. On balance, we believe EM currency strength and relatively higher coupon rates should help offset the negative price pressures from interest-rate hikes in local markets, potentially leading to attractive total returns for EM debt investors.

Final thoughts on emerging markets inflation

Across different EMs, future paths of inflation may well diverge from one another based on each country’s particular economic conditions, currency behavior, policy actions, and other factors. Accordingly, EM country, sector, and individual issuer selection will remain critical from an investment perspective, in our judgment. In general, though, we believe the threat of rising longer-term emerging markets inflation is less acute than many observers seem to be bracing for.