Snapshot

Economics

EMD Relative weekly notes: Week Ending June 26, 2020


James Barrineau

James Barrineau

Head of Global EMD Strategy

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EM Central Banks: #Winning

Lower rates in developed markets are always beneficial to emerging markets, sometimes in differing ways and in different measure, depending on the particular characteristics of the economic cycle. This time around, the aggressive loosening of monetary policy in the developed world has met some structurally positive trends in emerging markets in a way that will likely change investing and perhaps market structure for years.

One of the structural positives in pre-pandemic EM was declining inflation volatility. This gave central banks additional degrees of freedom, and by and large real interest rates were lower as investors, both domestic and international, were better able to gauge potential returns for investing in stable, lower inflation environments. This can be seen easily by the fact that the yield of the local currency index fell from 6.87% in mid-2018 to about 5.2% at the beginning of this year. In our view, the benefits of this were multiple: lower funding costs for domestic borrowing for both sovereigns and corporates, a more stable banking foundation, and a more predictable investment regime for both foreign direct investors and local companies.

Post pandemic, rates dropped quickly to zero in the developed world, along with additional supports to fixed income markets. Since the end of March, the average local yield in the index has plummeted by about 100 basis points to 4.55%. Brazil has slashed rates to 2.25% with talk of another potential 50 basis points – for a country that was thought to have a deeply structural inflation problem just a few years back. Real rates are negative for Central European countries, and countries as varied as India, Turkey, Peru, Chile, South Africa and Colombia.

So while all of that is unquestionably beneficial, a wizened international investor would likely look askance at the ability of these countries to maintain real rates this low given the history of the asset class. Instead of us rendering an opinion, we can point to the ultimate arbiter, Mr. Market. And so far, central banks are winning. FX volatility, after a pandemic spike, has gently declined to a long-term average and has stayed stuck at that level for weeks (see Figure 1). The verdict must be that investors are quite comfortable with the new regime, given the alternative of zero nominal rates elsewhere.

Figure 1 – EM FX volatility

EME_Image_1_6.30.2020.png

Source: Bloomberg. The chart above depicts the 30-day moving volatility of the FX component of the JPMorgan GBI-EM Global Diversified Index for the period of December 26, 2019 through June 23, 2020. There is no guarantee that historical trends will continue.

Should this currency stability at much lower rate levels persist, we anticipate a further structural development: more borrowing by sovereigns in their local currency than in the dollar market, and the growth and deepening (finally!) of corporate investing in local currency which has so far been nearly non-existent in the big picture.

To be sure, growth in emerging markets is also likely to be lower for longer. We believe one absolute prerequisite for ameliorating that problem is policy flexibility. That is open to EM central banks in an unprecedented way right now, and that enhances both medium-term future growth prospects and the eventual structural improvement in EM market access to the benefit of both countries and investors.