Rising yields and mixed recoveries in emerging markets

Putnam Fixed Income team, 03/11/21

  • Recovery will differ in emerging economies, with many trailing an acceleration in U.S. growth.
  • Inflation in developing countries will follow the global trajectory, but currency moves can create headwinds.
  • As U.S. Treasury yields trend higher, EM yield curves have started to price in rate hikes.

We believe emerging market (EM) fundamentals have improved and data has surprised on the upside despite mobility restrictions and elevated Covid-19 cases. Still, higher U.S. rates remain a risk and growth in emerging markets is likely to trail that of other major economies.

Differing stages of activity across regions

In emerging European countries, Covid-19 cases remain elevated as new viral strains take hold. Reopening plans in many of these places are vague, and there has been little material improvement in mobility. On the vaccination front, supply constraints continue to curtail progress. Given the issues with supply and distributions, these countries have ordered vaccines from Russia and China.

In Latin America, vaccinations have started to roll out, albeit with a lag. Chile has led the region with about 16% of its population being vaccinated. The country is also likely to lead in the growth acceleration phase as households withdraw from pension savings, boosting economic activity. But Brazil remains a laggard and has extended lockdowns, reducing optimism over a recovery in the near term. Brazil’s first Covid-19 wave never really ended; it plateaued at a relatively high level. Brazil is one of the countries that has potential to reach herd immunity through natural exposure to the virus. This move toward herd immunity keeps the medium-term recovery intact.

In emerging Asia, the resilience of the technology sector continues to buoy activity.

In emerging Asia, the resilience of the technology sector continues to buoy activity. Economic indicators in technology-dominant North Asian countries remain strong. However, there are bottlenecks in the semiconductor industry. Shortages in specific materials have inflated input prices and are expected to affect the auto sector in particular. India’s central bank may raise the inflation target, according to a press report. It remains to be seen if this “growth enhancing” shift in policy will be viewed favorably by global markets.

The inflation games

We believe inflation in emerging markets will follow the global inflation trajectory. The energy base effect (the distortion in monthly inflation that results from abnormally high or low levels of prices in the previous year) will likely lift headline numbers in the coming months. Food inflation can vary across countries. Those with higher exposure to agricultural commodities — through trade channels — will have higher food inflation. In countries relying mostly on their own food production, food inflation will be a function of seasonal factors. Food inflation has a larger weight in emerging market CPI baskets.

If accelerated growth in developed economies raises the prices of goods and services, it will pass through to emerging market inflation numbers. The effects of currency movements on inflation are also likely to play a significant role in 2021. As central banks in developed economies move a step closer to tightening monetary policy, headwinds in currency markets can become headwinds for inflation in emerging markets.

Inflation chart

Rate hikes on the horizon as Treasury yields rise

As U.S. Treasury yields move higher, emerging market yield curves have priced out rate cuts and started to price in rate hikes in select countries. Central banks in emerging economies, with the exception of a few, are unlikely to cut rates further. These policy makers will have to follow the global rate markets even if growth slips, as global inflation concerns rise and pressure builds up in local currencies.

The timing of rate hikes will likely be determined by global risk appetite and volatility in local currency markets. If the fiscal tantrum continues or the Federal Reserve announces its plans to taper asset purchases in 2021, those hikes can be front-loaded. When developed-market rates rise, emerging market “fundamentals” will take a back seat in determining asset prices.

A better outlook?

The broad outlook for emerging markets has improved as vaccinations gather pace. But many emerging market countries are poised to lag the United States and other developed economies during the growth acceleration phase. The United States will likely lead the global recovery. Therefore, from an investment perspective, investors may need more convincing emerging market stories before pumping funds into these countries.