Emerging market (EM) local-currency interest rates started 2012 with a positive tone as EM central banks actively eased monetary policy. The duration (interest rate) component of the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) returned 2.8% in the first quarter of the year. Adding that to the currency returns, the un-hedged index returned 8.3%, its best first quarter return since its inception.
The run in EM rates suddenly came to a halt in mid-March, however, as U.S. Treasuries re-priced downward on the back of improving economic data. So now investors are asking: Is this re-pricing in U.S. and global duration a harbinger of a more violent move towards higher rates in EM and therefore, of the possibility for disappointing returns?
To answer this question and draw conclusions about the likely future path of EM rates, including the linkage to U.S. rates, it is important to understand what drove EM rates lower in the first place.
Three factors have driven EM rates lower since 2Q11
Cyclical: The business cycle in emerging economies has been conducive to easing policy rates. Global growth decelerated noticeably in the second half of 2011, and this included most EM economies. On a quarter-over-quarter sequential basis, we estimate EM growth was slightly over 1% in the fourth quarter of 2011 and judging by the pace of industrial production and purchasing manager indexes (PMIs), economic activity is off to a slow start in 2012. Meanwhile, inflation rates fell on the back of a decline in commodity prices (mostly food prices) and slower growth.
Structural: The neutral interest rate – or the rate that would prevail if there were no inflationary or deflationary pressures requiring central bank action in one direction or the other – has shifted lower due to structural changes in EM and global economies, and indeed this shift has been commented on by a number of EM central banks, most vocally by the Brazilian Central Bank. This is no surprise – after all, the reduction in risk premia experienced in sovereign dollar-denominated credit default swap (CDS) markets has not been adequately mirrored in local currency markets, where inflation and foreign exchange transfer risks are more embedded in yield curves. Considering that inflation rates in EM have been converging with those of developed markets, and that convertibility risks have diminished due to rising foreign exchange reserves, one can assert, with a good degree of confidence, that the neutral rate cannot be the same as it was historically.
Global: The sharp and sustained reduction in rates in developed markets and the related liquidity injections have accelerated the drive towards lower rates in EM. In an environment where developed-market central banks have cut rates aggressively and for a very extended period of time, EM central banks have become more cognizant that having high real rates in that context will have serious repercussions in terms of capital flows and currency appreciation. This realization has traditionally been the norm in Asia, where rates have almost been a side product of currency drivers. To a lesser degree, the rest of EM is now going through a similar process.
Cyclical support for lower rates is losing steam, but structural and global factors should remain intact
Looking forward, we believe that the combination of these three drivers will set the tone for EM rates over the next few months. Our view is that the tailwinds from cyclical forces are subsiding, while those from structural forces are here to stay, and those from the global environment will continue to be supportive for some time.
The cyclical support for lower rates is fading given the surge in global liquidity and relatively high levels of resource utilization across EM countries, even after the slowdown in the second half of last year. The latter reinforces our belief that global, and especially EM inflation, is not out of the woods yet. That said, in the coming months, if only from a headline perspective, a number of EM consumer price indexes (CPI) should benefit from favorable base effects due to dramatic rises in food inflation in the first half of 2011.
Japan, UK, Canada, Norway, Sweden and Switzerland
We believe the structural component is here to stay, partly because the policy push for it remains very strong. It is partly fueled by the global context, i.e., in a world of zero rates the need for lowering the neutral rate has almost become urgent. The risk here is that the policy push towards a lower neutral rate becomes a political push towards regaining currency competitiveness, damaging institutional credibility and inflation credentials in the process. To gauge the durability and credibility of a lower neutral rate, it is important to assess the completeness of the macro framework: the consistency of fiscal policy in the face of a more assertive monetary policy, the composition of growth, external vulnerabilities and the checks and balances between politics and institutions, among other factors. A push for a lower neutral rate in the context of an inconsistent macro framework could potentially lead to inflation surprises and asset bubbles, both of which are ultimately very disruptive for markets.
The global driver is also likely to remain in place for some time: We have a relatively high degree of confidence that rates in developed markets will stay low for a prolonged period. Notwithstanding the improvement in economic activity in the U.S. in recent weeks, PIMCO’s view of the U.S. economy is still one of growth below potential for the foreseeable future. In Europe our views are even more bearish given the headwinds growth faces in the periphery and rising political risks. As we saw on a smaller scale this March, a sustained re-pricing in U.S. rates could very easily pave the way to a global duration selloff.
Investment Implications
Our cautious stance on the cyclical outlook combined with a constructive view on the structural and the global drivers suggests:
- The cyclical move lower in rates is losing some steam.
- The market’s mean reversion to higher rates in the future – reflected in steep yield curves in some countries – might be somewhat misplaced given our view that there's been a structural re-pricing in local yield curves.
In other words, while EM local rates will move higher again as the business cycle progresses, the cyclical highs will likely be lower than the previous highs, reinforcing the secular trend towards lower rates. In practical terms, this has specific investment implications. We like local rates that have the following characteristics:
- A strong credit quality component, which a) makes us comfortable that the macro-framework is resilient enough to support/offset a permanent adjustment in the neutral rate, and b) gives us confidence that in an adverse global scenario the central bank has the flexibility and maneuverability to lower the policy rate.
- We look for enough compensation for taking inflation risk, through exposure to high real rates.
- We want to be positioned in steep local curves to capture carry and the roll down in the yield curve, and as a means to express the view that mean-reversion will no longer be the norm.
Putting these three considerations together – strong credit quality, high real rates and steep curves – the local markets of Brazil, Mexico and South Africa all stand out.