A combination of factors prompted a shift in expectations around US interest-rate cuts, resulting in a diverse range of returns in fixed income markets.

At the very start of the year, markets were pricing in around 150 basis points (bps) of cuts by the US Federal Reserve (Fed) over the course of 2024, but higher-than-expected inflation and surprisingly strong jobs data prompted a revision of this. Furthermore, minutes from the Fed’s January meeting showed that most of its members thought moving too quickly to cut rates carried a bigger risk than keeping policy tighter for longer. US Treasury yields rose and the US dollar strengthened, and by the end of February, only 85bps of cuts were priced in by the market.

Against this backdrop, EM debt had a mixed month. The local bond index (JP Morgan GBI-EM) fell by 0.6%, driven by EM FX (local bond returns were marginally positive). EM FX came under pressure from the strong US dollar given the sharp rise in US Treasury yields over February. In the sovereign hard currency market, the JP Morgan EMBI gained +1.0%, led by the high-yield segment (+2.6%), while the investment-grade segment returned -0.6%. Turning to corporate debt, it was another positive month, with the JP Morgan CEMBI returning +0.7%. A continued tightening of credit spreads, reflecting the increasing likelihood of a soft landing for the US economy, helped this market - especially the high-yield segment.

Top-down positioning at the end of February 2024

For illustrative purposes only. For further information on the investment process, please see the important information section.

From a top-down risk perspective, we have retained our overweight target. We have trimmed our overweight target for EM hard currency debt. Although we believe we are past the peak in US yields, there are growing risks around a continued US Treasury sell off and/or challenges in the banking sector. In the EM local currency space, we increased our target overweight exposure. Despite EM inflation likely to be volatile going forward, we believe that interest rate-cutting cycles have further to go in emerging markets. We continue to run a modest overweight in EM currencies, acknowledging strong underlying country fundamentals, high carry and healthy external balances.

Outlook

The global inflation picture continues to be one of moderation overall. Recent data releases have led markets to become more confident of a soft landing (rather than a recession) for economies, especially the US. While financial markets are likely to remain volatile, we continue to be constructive on the medium-term outlook for returns from the EM debt asset class.

Many EM economies have solid fundamental foundations. The more fragile economies are receiving plenty of support from the IMF and other multilaterals. Furthermore, with much of the painful interest-rate hiking now behind them, most EM economies are in an enviable position relative to developed markets overall, with most EM central banks either having completed their hiking cycle or beginning to cut rates. EM bond market valuations look attractive – with some markets still pricing in significantly more risk than we believe is justified.

While fewer rate cuts are now priced into the market, US interest rates are likely to remain on a downward path. Furthermore, healthy global economic activity (especially in the US), improving terms of trade and commodity prices should also provide a healthier backdrop for EM assets. We also see tailwinds from within emerging markets, with EM growth set to recover in 2024 as proactive EM central banks seem to be managing to bring down inflation (providing room for rate cutting) and external accounts having corrected since the large deficits seen in 2022.

In Egypt, the market reacted very positively to the news that the UAE has agreed a US$35 billion real estate deal, with US$10 billion of this inflow arriving in March. This deal is on top of Egypt’s programmes with the IMF and the EU, which are likely to exceed US$20 billion in total. This funding news caused the country’s hard currency bonds to rally (+21%), leading the JP Morgan EMBI over February. In contrast, the Egyptian pound weakened substantially, as market participants brought forward their expectations of devaluation of the currency, which occurred in early March along with an emergency 600bps rise in interest rates from the central bank. For further reflections on recent developments in Egypt, please see a recent piece by Thys Louw, who shares insights gained from his recent trip to Cairo.

Inflation printed above expectations in Zambia at 13.5% year-on-year in January, as currency weakness translated into higher import prices. However, the central bank subsequently hiked interest rates by 150bps, which helped the currency to appreciate and should start to bring down inflation. The government also agreed the sale of a copper mine, which is likely to improve copper production and further help the currency. Regarding the country’s debt restructuring, positive progress came in the form of China and India signing a memorandum of understanding, but the outlook remains uncertain for eurobond holders.

Monetary policy setters in Nigeria hiked domestic interest rates by 400bps in February, as the central back shifted its focus back to inflation targeting. However, as it also widened the rates ‘corridor’ (effectively allowing market rates to follow the policy rate less closely), the extent to which the rate hike will tighten financial conditions is questionable. The hike also aimed to help alleviate pressures on the currency, but liquidity will need to be tightened further to stabilise the naira. The government issued a large amount of domestic debt, with yields pricing at 19%. We expect further pressure on local bond yields as the authorities keep financial conditions tight.

Kenya issued US$3 billion of new debt over the month, 50% of this was in local currency and 50% was in US dollars. Both issuances went well, with strong foreign participation in the local auction. This issuance assuages any June 2024 default fears. The Kenyan shilling appreciated over the month due to the large inflows from the local bond issuance, despite the country being added to the Financial Action Task Force (FATF) grey list. In contrast, Uganda was removed from the list.

In Ghana, cocoa prices spiked on lower-than-expected supply, partially offsetting the economic impact of lower trade volumes. On the political side, there was a cabinet reshuffle; the finance minister was replaced, but this is not expected to have a large impact as he remains an advisor to the government, and it is yet to be seen if there will be any implications for the debt restructuring.

The region’s benign inflation trend continued, with CPIs remaining at low levels and below expectations. Trade activity for January was also strong. However, base effects of the Lunar New Year were relevant in both cases.

China had its eight-day Golden Week during the month, with initial data revealing a return to pre-COVID levels in terms of the number of people travelling but per capita spending remaining lower. There was a drop in the current-account surplus for the fourth quarter, driven by higher tourism numbers, while exports and imports were both higher than expected. Deflation continued, with the CPI printing at -0.8% year-on-year.

Data for China’s property market remained weak. New home sales among the top 100 property developers have fallen 49% year-on-year, despite the policy easing that has taken place over the period. In a further attempt to boost sales, the People’s Bank of China cut the five-year loan prime rate by 25bps in February; this followed the 50bps cut in the reserve requirement ratio in January.

In India, economic activity remained robust, with both the manufacturing and services PMI figures higher than the already strong figures from January. The government announced that it plans to continue with its fiscal consolidation measures and is intending to further reduce its deficit to 5.1% in 2024. On the monetary policy front, the central bank kept its key policy rate on hold as it continued with its cautious position.

Core inflation in South Korea fell over January to 2.5% year-on-year from 2.8% in the previous month, while the central bank turned more dovish in its communications. In other developments, the authorities are supporting domestic equity markets into the election on 10 April.

In the Philippines, strong remittance data helped the peso. CPI inflation fell to 2.8% year on year. This bigger-than-expected drop was broad based, driven by improving food and energy prices.

The deflation trend also continued in Thailand. This, combined with very weak growth, should create room for the central bank to begin its rate cutting cycle, which the prime minister is also pushing for. Benign inflation dynamics should also reduce the central bank’s concerns around currency weakness. Tourism flows have been improving, but the country is likely now past the peak in the seasonal flows.

General elections were held in Indonesia over February. The result was largely as expected, as reflected in the muted market reaction. All eyes are now on who will be selected as key cabinet members, especially the finance minister, and how the government will fund the election promise of the ‘free food program’. Weak exports weighed on the trade balance, and other disappointing data included a larger-than-expected balance of payments deficit.

Turning to Malaysia, the ringgit’s exchange rate with the US dollar is approaching the lows of the Asia financial crisis, having been subject to political noise. This prompted verbal intervention from the authorities.

In Argentina, President Milei’s large fiscal adjustments are starting to feed through into economic data, with fiscal numbers for January showing a surplus. This helped the country’s hard currency bonds to stage a significant rally over the month. However, the spending cuts have also begun to create tensions between Milei’s administration and several provincial governors whose funding has been reduced. Some governors responded with economic threats, including halting oil and gas exports to Buenos Aires. The reduced funding added to the woes of one province, which announced a debt restructuring. On the inflation front, January figures were not as high as feared, albeit still at elevated levels, at 20.6% month-on-month.

In Ecuador, the finance minister is seeking a multi-year IMF programme and has implemented new fiscal measures to get the country closer to a deal. This includes raising VAT from 12% to 15% and cutting subsidies to save a further US$500 million. This sent sovereign hard currency bond prices sharply higher, gaining 19% in the JP Morgan EMBI. In addition, the 2024 budget showed a reduction in the headline fiscal deficit for the year ahead.

Inflation data in Brazil was more mixed over the month, with January data slightly higher than expected but mid-month numbers slightly lower than expected. However, the overall downward trend remains on track and the central bank’s cutting cycle looks likely to continue. Real rates in Brazil remain very high, with the official policy rate at 11.25% and inflation around 4%. In other data, exports rose 18% year-on-year, driven by commodities such as oil and sugar, while the current-account deficit was lower (better) than expected.

Inflation was higher than expected in Chile, but this was largely discounted by the market given the methodology changes in the underlying basket weights that took place over the month. Trade data showed that the country is running a trade surplus, which was larger than expected, with agricultural and mineral exports performing well. In other news, large scale forest fires broke out over the month across several regions, with the death toll over 100 at the time of writing. There is likely to be a fiscal cost related to repairing the damage caused by the disaster.

After a strong period of economic growth, activity data in Mexico has started to turn more negative, suggesting that growth is likely to deteriorate, albeit from strong levels. January saw much weaker-than-expected retail sales, while the bi-weekly inflation data was also weak. This more muted growth backdrop will help the central bank begin its rate-cutting cycle in March, when it is expected to cut rates by 25bps. In political news, with the election looming in early June this year, President AMLO presented 20 reforms to congress, including allowing workers to retire on their full salary – if approved, this would impose a significant fiscal cost. However, these are not expected to be passed by congress. Lastly, the trade balance was in surplus at US$11 billion versus US$5 billion expected, helped by both weaker imports and stronger exports.

In Peru, the finance minister announced an austerity programme to try to meet the fiscal deficit target of 2% of GDP in 2024. The 2023 current account numbers showed a surplus of 0.6% of GDP, while economic activity declined in January on a year-on-year basis due to weaker domestic demand. On the monetary policy front, the central bank delivered a 25bps rate cut as expected, with the policy rate now at 6.25% and inflation at 3%.

Economic data in Colombia was disappointing for January, with weak activity and domestic demand. This will likely lead to an acceleration of rate cuts from the central bank, depending on inflation, with the finance minister quoted as saying a 100bps cut was possible; a 50bps cut appears more likely.

Panama managed to tap the primary market in a large issuance of over US$3 billion, which should mean that the external issuance is now complete for the year. The deal was oversubscribed (by roughly 6x), despite the challenges facing the country, as the yields on offer were particularly attractive for an investment-grade credit.

In the frontier markets space, there were ratings upgrades for Costa Rica and Paraguay over the month, although these were largely priced by the market.

Following on from January, growth data remained soft in Central and Eastern Europe (CEE). However, there were some more encouraging data points in February, with PMIs improving, although hard economic data remains weak. Economies in CEE should start to recover as real incomes improve over the coming months. Turning to inflation, in general it continues to print below expectations across the CEE 5¹, except for Romania, with the seasonal repricing of goods in January being weaker than expected. However, core inflation momentum is picking up somewhat; while it remains soft, this is a growing risk over the next few months, especially in markets where real wage growth remains high, such as Romania and Hungary.

Turning to monetary policy, the Czech National Bank cut rates by more than expected with a reduction of 50bps, accelerating from the last cut of 25bps, and the accompanying comments from the central bank members sounded increasingly dovish. This weighed on the Czech koruna. In Hungary, the central bank also accelerated the pace of cuts (from 75bps to 100bps), with the key policy rate now at 9%. The bank has signalled that this shift in gear is temporary, but there appears to be some political pressure to normalise interest rates to levels more in line with the rest of CEE. The National Bank of Romania kept rates on hold as expected, with guidance that rate cuts may begin in May. In Poland, the central bank remains the most hawkish in the region, with the PiS (opposition party) appointed monetary policy committee members highlighting the inflationary risks from administered price changes (removal of anti-inflation shields such as lower VAT and the energy price cap) later in the year. There are also increasing signs that the government may try to remove central bank governor Glapinksi in the coming months, which could lead to political and market volatility.

More clarity was provided on EU fund flows for 2024. These should be positive for Poland, but the EU Commission started an infringement procedure against Hungary over the passing of a controversial bill that is seen as undermining political freedom. This process could eventually lead to a further freezing of Hungarian flows from the EU. For now, Hungary will continue to receive EU flows, and over the month education reforms unlocked further support.

Turning to the rest of the region, tight monetary policymaking continued in Turkey, keeping money supply and credit growth in check. There were also tentative signs that this is helping the current account to rebalance somewhat. Overall growth indicators remain relatively strong, with GDP growing at 1% quarter-on-quarter in Q4 despite the high policy rates. Consumption, in particular, may remain relatively resilient following a large (50%) wage hike and expectation of similar hikes to pensions in the coming months. This, combined with administered price changes after municipal elections in March, suggests that inflation risks remain to the upside, and that monetary policy might have to remain tighter for longer, and by more than is currently priced by the market. Since month end, the February inflation print was higher than expected.

In Israel, the growth backdrop remains challenging given the ongoing conflict in Gaza, and the related geopolitical uncertainty is keeping the central bank cautious – as reflected by it keeping rates on hold in February (a cut was expected). The conflict is weighing on the budget, and the budget ceiling has been set at a 6.6% deficit, which is a large fiscal loosening from last year.

Fiscal news in South Africa has been relatively positive in terms of the recently announced budget, while monthly fiscal data has also been surprising to the upside. However, while the budget painted a positive near-term picture, concerns over the upcoming election are weighing on investors’ minds. Turning to inflation, headline CPI was lower than expected at 5.3% vs. 5.4%, however core inflation was higher than expected, driven by financial services and transport.

¹ Poland, Hungary, Czech Republic, Romania and Serbia

It was another positive month for EM corporate debt markets, with the JP Morgan CEMBI returning +0.7%. This was driven by a continued tightening of credit spreads, especially in the high-yield segment (which returned +1.6%), reflecting an increasing likelihood of a soft landing for the US economy. In high-yield markets, the positive return from spread tightening more than offset the weakness from US Treasuries, and issuers within Ukraine and Turkey performed well. Turning to the investment-grade segment, this delivered a flat return (+0.1%), as this area of the market is more susceptible to the moves in Treasuries, and spreads did not tighten sufficiently to offset this.