The Fed, Biden, and inflation: the big questions facing EM debt investors

EM in Discussion

Mar 31, 2021

4 minutes

Peter Eerdmans
Peter Kent
Launching our second series of EM in discussion, Peter Eerdmans and Peter Kent cover key issues facing investors in EM debt such as the significant repricing of inflation, the Fed and US foreign policy.

The fast view

  • Since the beginning of 2021, fixed income markets have stalled as belief grows in the global recovery and reflation fears have gathered pace
  • The repricing of inflation expectations is weighted towards the short end of the curve. Further out, the yield curve suggests inflationary expectations are little changed
  • This supports our view that current behaviour should be viewed in the broader context of a multi-decade disinflationary trend. The short-term inflation picture may be affected by supply bottlenecks as economies recover, but we believe this threat to be transitory, not structural
  • Our base case expectation is that there will be a cyclical recovery that is beneficial for EM
  • A more orthodox and predictable US foreign policy is not expected to lead to a reset in relations with China or Russia. We see little likelihood of an intensification of the trade war with China, but relations with Russia will likely be more hawkish
  • Biden’s decision to re-join the Paris Agreement just hours after his inauguration signalled an intent to insert climate change into the architecture of global diplomacy and this is expected to have positive secondary effects throughout EMs

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Key takeaways

After 25 years of modest inflation, has the death knell sounded?

After the strong recovery that followed the market turmoil last March, investors have seen a marked shift since the beginning of 2021: with the exception of high yield, markets have contracted. This shift reflects investors’ reflation fears, which have gathered pace as belief grows in the global recovery story during the second half of the year.

Current estimates suggest: a significant shortening in the period until the US Federal Reserve’s first rate hike; a doubling in the pace once hikes start; and a sharp increase in the terminal rate.

Yet the repricing of inflation as a result of the economic pick-up is very much weighted towards the short-end of the curve, at the 2-year and 5-year bonds. Further out, expectations of inflation haven’t moved as much. This makes sense when the reinflationary activity over the past few months is set against the much longer disinflationary trend of the last twenty-five years.

By focusing on the current temporary effects of higher inflation, investors are missing out on the broader cyclical picture, which is favourable for EM. There will be supply bottlenecks as demand outpaces supply as economies recover, with an accompanying surge in inflation, but these should be transitory - this is not a death knell for the era of modest inflation.

What’s the outlook for EMD allocations?

Over coming months, various potential scenarios could play out and each will have different implications for EMD investors, we summarise these in the diagram below.

Our base case expectation is shown in the middle of the chart; we believe there will be a cyclical recovery and this is currently priced into markets. We also think rising inflation will be transitory in nature, rather than structural.

Figure 1: Consequent market outcomes for EM – the likely and the possible…

Consequent market outcomes for EM – the likely and the possible graph

Other potential scenarios are:

  • Reflation (top right): EMFX does well in a cyclical environment but interest sensitive assets such as bonds could struggle
  • Super easy Fed (bottom right): Everything EM does well in a weak environment for the US dollar as the cyclical outlook deteriorates slightly. This is not an unrealistic scenario
  • Recessionary conditions brought on by China overtightening or a deteriorating COVID backdrop (bottom left) would see the US dollar benefit from a flight to quality and EM bonds do better
  • Fed overtightening (top left): While potentially the most damaging scenario for EM assets, we see this as the least likely scenario due to the Fed’s average inflation targeting framework
A new era for US foreign policy?

As expected, President Joe Biden has provided a more orthodox approach to foreign policy, which has been widely welcomed - not just across EM - and will be positive for global growth prospects. Rather than a shift towards a completely new modus operandi, we see this as the US administration being keen to move away from an anomaly of a confrontational style under President Trump. Biden’s administration is showing a willingness to sign up to a rules-based approach, signalled by its re-joining of the World Trade Organization and the Paris Agreement on climate change. It has simultaneously shown that it will re-engage on human rights.

Yet this greater predictability does not mean Biden will prove a light touch. We still see signs of an ‘America first’ approach as nations look to recover from the pandemic, and compared with the stances taken by former presidents Clinton and Obama, Biden’s approach may appear more hard line. Certainly, we do not expect any reset in relations with China or Russia.

Perhaps the best that can be said about the likely development of Sino-US relations is we see little likelihood of an intensification of the current trade war, although the US has already said that it is not ready to lift tariffs on Chinese imports.

The new US administration is also expected to be more hawkish towards Russia. The list of disputes is long, including SolarWinds and Nord Stream 2, but we think any additional sanctions will be targeted.

Elsewhere we think the chances of a reboot in relations with Iran look unlikely ahead of that country’s election in June, while the US is also signalling that relations with Turkey are not top of its agenda. In both these countries we expect relations will just muddle through.

Why is climate risk moving to the fore?

On climate change, Biden’s decision to re-join the Paris Agreement just hours after his inauguration signalled an intent to insert climate change into the architecture of global diplomacy and this is expected to have positive secondary effects throughout EMs.

The EM investment universe contains many countries at risk from the climate crisis such as droughts and floods, much more so than DMs. Yet it also offers expertise in a number of greener investments (batteries, solar technology), likely to benefit as the US invests in greener infrastructure investments. Either way, it is clear that EM governments will need to play a key role in the planet’s transition towards a sustainable future.

General risks
The value of investments, and any income generated from them, can fall as well as rise.

Specific risks
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Geographic / Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated.

All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.

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July | Mid-year pause and reflect: our EM experts tackle your current questions and concerns.

Thursday, 8 July
We ask our panel of EM experts – spanning equities and fixed income – to shed light on the issues that matter to our clients right now. From inflation concerns and ESG dynamics to COVID-19 recovery rates – economic and social, and whether region-specific allocations make sense in EM – our panel will discuss the key areas of concern for investors.

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Authored by

Peter Eerdmans
Portfolio Manager
Peter Kent
Co-Head of Emerging Market Fixed Income

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

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