We explore the implications of a Fed hiking cycle on emerging market (EM) debt performance and where opportunities currently exist in this environment.
Most developed market economies are currently facing elevated inflation levels that are proving to be more persistent than policymakers and market participants originally expected. In the United States, the consumer price index rose by 7% for calendar year 2021, marking the highest headline inflation print since 1982. In response, the Federal Reserve continues to shift to a more aggressive policy stance to combat these cost pressures, including imminent Fed Funds rate hikes and a reduction of the Fed’s balance sheet.
We briefly explore the implications of a Fed hiking cycle on emerging market (EM) debt performance and discuss where opportunities exist in this environment. Historically, Fed hiking cycles can be a headwind for EM debt, as higher yields in the U.S. make EM securities relatively less competitive in the struggle for global capital. A notable example of this occurred in 1994, when aggressive Fed rate increases (the Fed Funds rate rose from 3.00% to 5.50%) led to massive underperformance in EM assets. The Bloomberg Emerging Market Aggregate Index (Unhedged) was down -13.74% for the calendar year. However, the same index fared much better during the last Fed hiking cycle, returning +5.05% for the 3-year annualized period (2016-2018) during which the Fed was again active on the policy rate front.
Export-reliant EM Economies May Be Better Positioned This Cycle
Emerging market debt performance is ultimately borne out by its fundamentals, and the good news is that Fed tightening cycles tend to coincide with positive growth trends, both in developed and emerging markets. This is evidenced by EM credit spreads having performed well during the last two Fed hiking cycles, with spreads modestly tightening in anticipation of hikes and bottoming out through the middle of the cycle (see chart below). Of course, no market backdrop is the same and this hike cycle is occurring in part to tackle cost pressures driven by supply side shocks. Nonetheless, we argue that the U.S. economy, and specifically key balance sheets within the economy (corporate and household), is healthy enough to support these higher rate levels, therefore avoiding a stagflation scenario. We believe this growth backdrop is a positive trend for specific EM countries where export demand supports both their economic and fiscal positions.
EM Credit Spreads Have Been Well-Behaved During Fed Tightening Cycles
Noted in the chart above is that EM spreads gap much wider when the Fed is aggressively cutting rates. Over the past two cycles this has been due to both financial (2008) and exogenous (2020) shocks. These are not environments where we want to be overweight emerging markets going into them. That said, we expect that future rate cuts should be less impactful on EM spreads, given the Fed’s hyperfocus on forward guidance, which serves to dampen financial market volatility, as well as the central bank’s concern, albeit indirect, about how prolonged volatility affects real economic output.
There Were Aggressive Rate Hikes By Major EM Central Banks in 2021
Many EM Economies Are Ahead of the Fed in Their Tightening Cycles
Looking ahead to 2022, a tailwind for the EM debt space is that many emerging market economies have already hiked rates and are effectively much further along in their cycles than the Fed. In 2021 alone, Brazil raised their policy rate by 725 basis points (bps), while several countries within both Latin America and Eastern Europe raised rates by at least 200 bps (see chart above). The implication here is that rate hikes put countries in a better real rates position, which tends to enhance bond return performance going forward. Further, China has shifted to an outright easing stance on both the fiscal and monetary front, which is expected to keep industrial import demand robust for commodities and basic goods supplied from fellow emerging market economies.
But Security Selection Is Crucial in This Environment
We believe there are opportunities to generate attractive returns in emerging market debt, but investors must be selective in their exposure. Various Latin American countries continue to deal with political risk and fiscal pressures that make their sovereign debt unattractive. And as of this publication, the Russia-Ukraine conflict presents a highly destabilizing situation in the region with contagion risk to broader EM assets globally.
In finding value, we rely on the EM sector’s differentiation—the potential opportunity set cuts across regions, industries, and structures, each with different beta, duration, quality and fundamental characteristics. Certainly, we find compelling opportunities in EM corporate names with strong balance sheets, but also ones that can better withstand global risks, such as steady revenue generating companies like beverage bottlers, basic goods, and utilities. Further, we find attractive EM-domiciled companies with U.S. dollar revenue streams, as their balance sheets are more insulated against local currency depreciation, particularly if the dollar strengthens in the face of more aggressive Fed hikes. That said, we are more cautious on the sovereign debt front, but favor select positions like Egypt and Indonesia local bonds which have mid-to-high single digit real yields, a positive current account balance, rebounding economic growth, and stable fiscal balance sheet. Finally, we are attracted to bonds with floating rate structures, which we believe helps better insulate exposure from the threat of rising developed market rates.
We continue to be watchful for shifting Fed policy, as it has some degree of impact on all markets, and we expect market volatility to continue throughout 2022. However, volatility presents opportunity, and we believe emerging market debt continues to provide that opportunity. Ultimately, emerging market debt’s strength is not only in its return potential but in its differentiation, and for that reason we believe the asset class should continue to play a role in multi-sector fixed income portfolios moving ahead.