Emerging markets walk a fine line

Putnam Fixed Income team, 02/17/22

  • We don’t expect the West to impose widespread sanctions in the event Russia invades Ukraine.
  • Emerging market central banks — taking their cue from the Fed — will likely remain hawkish.
  • A stable or depreciating U.S. dollar will be supportive of currencies and local markets in developing countries.

The global backdrop has been challenging for emerging market (EM) economies. Tensions between Russia and Ukraine, rising interest rates, and high Omicron variant infection rates have created headwinds. Still, emerging market assets — especially currencies and bonds — have proved to be resilient.

The Russian impasse

The outcome of the Russia–Ukraine conflict will depend on President Vladimir Putin, although there has been an urgent diplomatic push to defuse the crisis in recent days. U.S. President Joseph Biden and Germany’s Chancellor Olaf Scholz have been committed to diplomacy to end the standoff, and Biden warned of “severe costs.” The United States and Europe have threatened sanctions should Russia invade Ukraine.

Even though a military invasion or severe sanctions are not our base scenario, we must consider those possibilities. Russia’s annexation of Crimea in 2014 led to a set of sanctions, including the ban on technology for oil and gas exploration, travel restrictions on influential Russians linked to Putin and his inner circle, and the ban on provisions of credit to Russia, state banks, and energy companies. Currently, U.S. investors are banned from buying new Russian sovereign debt. The West could further tighten existing sanctions. Additional restrictions on buying Russian government and bank debt will affect international investors.

Widespread sanctions would push energy prices higher temporarily as Russia would be able to find new export channels. As in previous supply-driven oil shocks, EM energy exporters would benefit, and energy importers would be hurt. There would also be direct fiscal consequences. Many EM countries use subsidies and other tools to control domestic energy prices. An oil supply shock would affect those countries. But we believe any spillover to EM countries would be limited.

As the prospects for military action and sanctions wax and wane, financial markets have been volatile. On economic fundamentals alone, we believe Ukraine bonds are a poor bet. But if the European Union (EU), the International Monetary Fund, and the U.S. Treasury stand behind the country’s finances, the returns are likely to be high. The EU has proposed providing a 1.2 billion euro ($1.4 billion) aid package to Ukraine. Russian assets at current prices are also attractive because of the low likelihood of aggressive sanctions, in our opinion.

EM central banks take a hawkish turn

Inflation remains an issue globally, and emerging markets can’t escape its impact. Food shortages, elevated gas prices, and Russia–Ukraine tensions have added to inflation pressures. Some governments in Central and Eastern Europe have cut value-added tax on certain food and energy items to mitigate the impact of higher prices on households. But this is a temporary measure and can extend the period of high inflation.

Rising inflation brings us to the current interest-rate hiking cycle. Some emerging market central banks have led the way in tightening monetary policy, including Chile, Czech Republic, Brazil, and even Singapore. But as policymakers in developed countries — led by the Federal Reserve — turn hawkish, more and more EM central banks have little choice but to stay hawkish. While each country’s policies will differ, we expect less pressure on EM compared with previous G10 tightening cycles.

The currencies of commodity exporters with high interest rates, including Chile and Colombia, have appreciated recently against the U.S. dollar due to strong commodity markets. Chile’s peso has rallied as the central bank delivered a larger-than-expected rate hike in January and investors were encouraged by President-elect Gabriel Boric’s recent market-friendly signals. The Colombian central bank has also raised rates, allowing the peso to strengthen. Brazil — which is grappling with debt levels that have ballooned to around 90% of GDP and inflation of about 10% — appears to have a decent valuation cushion. Its policy rate, currently at 10.75%, is the highest among the central banks tracked by Putnam.

This cushion created by EM central banks is important in thinking about the attractiveness of EM local markets. Investors are pricing in aggressive rate hikes by the Fed, boosting the dollar’s rally. But as speculation of more aggressive rate increases eases, a stable or declining dollar will be supportive of EM currencies and local markets.

Omicron hampers economic activity

Leaving the geopolitical tensions and hawkish monetary policy aside, growth in emerging economies has slowed. Like the United States and Europe, the spread of the Omicron variant among developing nations has temporarily hampered economic activity, including manufacturing. In China, economic activity has slowed due to strict mobility restrictions and the lull during February’s Lunar New Year celebrations. This slowdown will likely spill over to EM countries with close links to China.

Manufacturing activity has trended lower in emerging markets

Emerging markets manufacturing

Notes: Purchasing Managers Indexes (PMIs) are nominal U.S. dollar GDP weighted.

Sources: Sources: Bloomberg, IHS Markit, Putnam Investments calculations, as of January 31, 2022.

The economic growth story, however, varies across countries. Brazil and Mexico have slipped back into recession, while some economies in Asia and Central and Eastern Europe (CEE) are growing at a decent clip. Improvements in supply shortages and auto production have supported some of these CEE and Asian countries. And as inventories build up, the boost from those sectors will likely start to fade.