Emerging Market Investing Through Inflation

Guy: Before we “Cut to the Chase” on potential opportunities, I like to begin with the basics so in this regard - Could you set the stage a bit by giving us a general overview of the asset class?

Todd: Emerging Market debt consists of three differentiated investment opportunities; hard currency sovereign and corporate debt as well as locally issued government debt. Each of these sectors has different risk characteristics and as such they have different return potentials depending upon the macro environment. Hard currency sovereign debt is frequently borrowed in dollars and sometimes euros. We have a team of analysts that follow these countries to help make sure they can afford to pay us back. As the risk to paying us back goes up, we assign a higher risk premium and obviously expect higher and higher yields.

Emerging market corporate debt (that we invest in) is also usually dollar denominated and we have a separate global team of credit analysts to monitor the creditworthiness of a large variety of issuers across numerous sectors. Lastly, countries also borrow money in their local currency to tap into government, insurance, pension and other local savings. Our sovereign team considers local in their analysis with variables such as real yields and currency valuations playing a large role in our decision-making criteria.

Guy: That was good - I like how you simplified the various components. Could you tell me how Emerging Market countries have generally responded to the economic impacts of the pandemic?

Todd: Across the developed world we have witnessed unprecedented fiscal and monetary stimulus to offset the health and economic impacts from the pandemic. However, emerging economies have had to respond in a more constrained way. They are limited because their funding sources are more credit constrained than the developed world and their ability to conduct unconventional monetary policies, such as quantitative easing, is much more limited. In our view EM will take longer to recover to pre-covid GDP levels and the sovereign debt metrics are looking relatively worse, which partly explains why EM looks much more attractive when comparing like assets to the developed world.

Guy: I can see how policy makers of Emerging economies are having a much more difficult time trying to manage the challenges, but can we specifically talk about the inflation challenges they face. Inflation headlines are dominating the news in the U.S. and I’m curious how this story is unfolding in EM economies.

Todd: That’s a great question and topic. The inflation discussion, the policy makers response, and commodity price movements impact all three of the assets we consider owning in our emerging market bond portfolios. But for today I’ll focus more on the local currency asset discussion and leave other discussions for a later day. The Bottomline is that inflation is a broad sweeping problem with the exception of Asia right now. Eastern Europe and Latin America are suffering the worst of it, relative to where they were pre-pandemic. However, their central bank’s policy responses are very different than what we are seeing from the FED. For example, Brazil is likely going to raise rates by 8 to 9 percent in a six-month period of timeⁱⁱ. Colombia, Chile and Peru are following suit in a smaller size. Russia has been raising rates in clips of 100 bps and countries in CEE, who have been very dovish for years, are moving in a much more aggressive way shifting rates from near zero to 3 or 4 % in a short amount of time. In general, the policy credibility is there, but inflation expectations are less anchored than what we are used to in the U.S. and therefore they cannot afford to not be proactive.

Guy: Ok, so emerging market central bankers are tightening monetary policy so why are emerging market currencies continuing to weaken? My understanding and feeling are that higher rates attract foreign capital as well as local investor money seeking higher incomes, so I thought, that combination typically pushes the currency higher?

Todd: That’s the million-dollar question. What we have now is a market fairly comfortable with a stronger dollar and the anticipated FED tightening favors this view. However, a couple things are happening that we see as potentially very supportive of local rates and some emerging currencies going forward. First of all, currency valuations are becoming cheaper and more undervalued when measured in a variety of ways, such as in trade weighted terms or purchasing power parityⁱⁱⁱ. And when we look at ex-ante bond returns assuming inflation moderates next year, rates suddenly look very compelling to us.

I think the challenge is transitioning from this current risk challenged, strong dollar environment to a new paradigm wherein investors seek the ex-ante return that is accumulating in these markets where policy makers have reacted aggressively to current inflation dynamics. In other words, assume a world where inflation moderates and becomes somewhat transitory, albeit less than we originally thought. If this were to happen the markets would likely moderate the Fed’s tightening path and many emerging economies would likely go from tightening to easing or at a minimum halting their tightening cycle. IN this environment I would expect a reversal of some of the dollar’s strength and some very large interest rate moves in markets like Russia, Brazil, Chile and Hungary. To name a few of our favorite ways to ultimately express this view.

Guy: I see, that makes sense. When do you think this will happen? I realize you don’t have a crystal ball, but what are you looking at to get a better understanding of the possible timeline?

Todd: Well, the transition is happening. But some prices are still going up and therefore headline inflation levels are still moving higher. And when I say I see it is happening I am referring to the prices for many tradable goods actually moving lower as demand for goods subsides. Also, Shipping costs, if you look at the Baltic Index, for example, it is off 44% from the highs just a couple months ago. We also know that bottlenecks are starting to subside as companies readjust their supply chains, as the shipping bottleneck gets resolved etc. When talking with port operators in California’s Long Beach we hear that the bottle neck is subsiding, but it likely won’t be back to normal until late spring or early summer.

Guy: That’s interesting. So, do you think it’s possible that just when we get most alarmed and the media pays the most attention to the inflation story that it may actually be peaking?

Todd: In my opinion, there’s no question that we are peaking in the next couple months. However, what the bigger question is, and what’s most important for asset prices is where does inflation level off. Do we go back to the 2019 levels? Unlikely. But as we converge back to lower levels it will be hard to extrapolate what central banks should be doing. Will markets still be saying that the FED is behind the curve?

Guy: I would suspect that some of the commodity price inflation we see, should be good for EM – am I right about that?

Todd: Absolutely. The most obvious example is the Middle East or other oil exporting credits trading better than countries that rely on tourism for example. In general, when we look at many countries, they have benefitted in some ways due to higher prices because they are exporting goods and commodities and getting more revenue. The net result is that EM balance of payments generally look really good in our view. Especially when compared against 4 or 5 years ago when global demand and commodity prices were lower. I could go into more detail on this topic as it relates to sovereign and corporates, but I’ll save that discussion for another day with one of my colleagues who specialize in these areas.

Guy: Well, that’s a good place to stop. Thank you for your insights on emerging markets, their central banks, currencies and inflation. It seems to me that with so many incongruent and aggressive actions from global central bank officials that 2022 is going to be a very interesting year. Thank you for your time and insights, Todd.

Todd: Thank you.

Endnotes
¹As of September 30, 2021. At estimated fair value. Includes all MetLife general account and separate account assets and unaffiliated/third-party assets managed by MIM. See Total AUM Fact Sheet for further information.
² As of September 30, 2021. At estimated fair value. Includes all public fixed income assets managed by MIM.
ⁱ As of 9/30/3031
ⁱⁱ Bloomberg forward curves
ⁱⁱⁱ Bloomberg

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