investment insights
Emerging markets, rising rates and diverging fortunes
Lombard Odier Private Bank
Key takeaways
- Many emerging markets’ central banks have raised interest rates as economic recoveries triggered inflation
- Tighter monetary policy and poorer vaccine access have narrowed the difference in GDP growth between emerging and developed economies to its smallest gap in two decades
- Current account balances in most emerging markets still offer a buffer against external shocks
- Many emerging market corporates’ fundamentals are sound; we maintain an overweight position in hard currency credit
- We are neutral on emerging equities and have a bearish outlook on most emerging currencies.
As the US and European central banks wait for a full recovery before raising interest rates, many emerging markets are already combatting inflation by increasing the cost of borrowing. That is placing potential limits on growth, even before their economies have fully rebounded from the pandemic. Since we have addressed China’s challenges in recent publications1, this article focuses on other emerging nations’ outlooks.
Emerging markets are fighting Covid with lower vaccination rates2 and some of the world’s highest mortality and infection levels. As we publish, 54%3 of Brazil’s population had received two doses of a vaccine and the country had recorded the world’s second-highest mortality rate, at 287 deaths per 100,000 population4. In Russia, where the comparable rate is 156 deaths, one-third of residents are fully vaccinated and in India the figure is 22%, with a mortality of 33.
Poorer access to vaccines in most emerging countries inevitably slows the re-opening of their economies. At the same time, globally recovering demand has created shortages. This has driven commodity prices from crude oil and gas to shipping containers, steel and soybeans5, increasing consumers’ food and energy bills6. Annual inflation in Brazil has recorded its fastest gains in more than five years, to reach 10.4%7, and has risen to 7.5% in Russia and 4.4% in India.
Lift-off
However, unlike developed economies, central banks in some emerging nations have not been able to treat inflation as transitory. With consumer prices far in excess of central banks’ targets, both Brazil and Russia’s policymakers have responded by increasing their interest rates this year (see table). The Russian central bank increased its benchmark rate by 75 basis points, to 7.5%, on 22 October. With real interest rates just positive, the Russian hiking cycle may be close to their peak, with another 25 to 50 bps of increases likely. Brazil’s central bankers meet again this week, and market positioning suggests another rate rise of as much as 150 bps. In contrast, India’s central bank remains accommodative, using other tools such as reverse repo rate auctions, to limit liquidity in the economy.
Because of rate hikes and the slower rebound, the difference between gross domestic product (GDP) in developed and emerging markets narrowed from 2.5% in 2020 to 1.2% this year, according to the International Monetary Fund (IMF). That is the smallest difference in at least two decades, underlining the challenges facing nations trying to stimulate domestic economies (see chart).
Fiscal parameters
For the moment, current account balances in most emerging markets offer a buffer to weather any external shocks. Russia’s fiscal policy presents few risks, thanks to its dependence on oil, and it will probably record a balanced budget in 2021. Public debt remains less than 20% of GDP and largely domestically held, insulating public finances from foreign borrowers and exchange rates.
India’s economic growth, supported by its demographics, looks strong enough to allow the government to retain its relatively conservative fiscal stance for the next year or more.
Still, many economies lack the fiscal firepower to continue stimulating growth. During the pandemic, Brazil’s spending pushed its deficit to 14% of GDP. A year ahead of a general election, Brazil’s government nevertheless plans to press ahead with more spending into 2022, risking further inflation. As a result, Brazilian assets suffered last week, showing that markets are monitoring governments’ efforts to reign-in public spending.
In the Gulf region, the United Arab Emirates and Saudi Arabia are well positioned to scale-back fiscal spending. The price of oil is boosting their economies, allowing them to reduce expenditure after the pandemic while maintaining low levels of government debt. Both have substantial buffers in the form of foreign currency reserves and sovereign wealth assets, along with large and widening current account surpluses, allowing them to continue attracting investors.
The oil divide
Oil markets have exacerbated budget pressures for many. With crude prices increasing almost 40% this year and 75% since April 2020, there is a clear divide between emerging market net exporters and importers. We expect high prices to continue with Brent crude8 remaining around USD 80 per barrel over the next six months.
There are relatively few winners from higher energy prices. The Gulf States, as well as Russia, Colombia, Malaysia and Mexico, where oil accounts for one-tenth of goods exports, have all seen revenues rise. Russia is unusual in being a net exporter of oil, gas and coal, earning more than half of its export revenue from energy. Other emerging economies, including China and India, are net importers of all three energy sources.
China’s demand for commodities remains an important source of emerging markets’ growth. The world’s second-biggest economy is the largest trade partner of countries from Brazil and Peru to South Africa and Saudi Arabia.
Any lengthy slowing of China’s economy would present a risk to emerging market exporters. For now though, China’s economic slowdown this year remains rooted in its domestic power shortages and the challenges of its property market. These have lowered our expectations for China’s growth this year, to an 8% gain in gross domestic product, but leave our 2022 outlook unchanged at 5.5%.
Emerging assets
The IMF has provided record reserves in the form of USD 250 billion special drawing rights (SDRs9) to emerging countries. However, the amount of sovereign debt remains a concern, and we are therefore underweight emerging market government bonds.
We expect high inflation to weigh on emerging debt in local currency in the coming months, and instead prefer the hard currency credit segment. Emerging corporates’ earnings remain positive and net leverage is close to its lowest levels since 2011. These fundamentals should cushion the segment against higher rates, and we therefore keep our overweight position in emerging corporate credit. Any improvement in global risk appetite would be rapidly reflected in the asset class.
We remain neutral on emerging equities. Valuations are historically high, but improving vaccination rates, reopening economies, rising yields, inflation and oil prices should all support cyclical stocks in 2022. On the other hand, concerns over China’s growth and the stronger US dollar have undermined earnings expectations, which still lag developed stock markets.
We adopted a bearish outlook on emerging currencies in the second half of this year. We expect more depreciation pressures as trade balances worsen: slowing global exports will probably coincide with a recovery in imports, as domestic demand normalises. We believe that the Chinese renminbi, Taiwanese dollar, Indonesian rupiah, Israeli shekel, Mexican peso and Russian ruble should all fare better among emerging currencies. The Russian currency has gained almost 13% against the US dollar this year. We are cautious on the Thai baht, Turkish lira, Polish zloty, Colombian peso and Brazilian real. Declining demand for Brazilian assets has meant that the real has fallen 13% against the US dollar since July.
Emerging economies have not yet fully recovered. With world trade likely to level-off next year, the gap in economic growth compared with developed nations will remain historically narrow. While the first half of 2022 will remain challenging for emerging markets, once vaccination rates are higher and central banks’ hiking cycles complete, the second half of the year may offer opportunities to outperform developed markets.
1 https://www.lombardodier.com/contents/corporate-news/investment-insights/2021/september/evergrande-prompts-china-to-put.html
2 https://ourworldindata.org/covid-vaccinations
3 https://ourworldindata.org/covid-vaccinations?country=OWID_WRL
4 https://coronavirus.jhu.edu/data/mortality
5 https://tradingeconomics.com/commodity/soybeans
6 https://www.lombardodier.com/contents/corporate-news/investment-insights/2021/october/winter-is-coming--what-should-we.html
7 https://www.bcb.gov.br/en
8 https://www.bloomberg.com/quote/CO1:COM
9 https://www.imf.org/en/News/Articles/2021/07/30/pr21235-imf-governors-approve-a-historic-us-650-billion-sdr-allocation-of-special-drawing-rights
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