Some investors seem wedded to the dated concept that emerging markets are a homogenous asset class. The rapidly diverging monetary policy cycle in EMs may be able to give them a rude shock.
Since December, central bankers across Latin America have been in decidedly hawkish mood. Chile has raised rates 25 basis points and Colombia, Mexico and Peru 75bp. Argentina has gone further still, raising the 15-day interbank rate almost 10 percentage points this year as the central bank has sought to provide a semblance of support for the peso amid the scrapping of capital controls.
Admittedly, Brazil, the region’s heavyweight economy, has not raised rates since July, but then again they are already at an eye-watering 14.25 per cent.
“In LatAm they have a tightening bias. There are no exceptions,” says Alberto Ades, global emerging markets fixed income and foreign exchange strategist at Bank of America Merrill Lynch, who forecasts more to come.
“We have continuous hikes [pencilled in for] Peru, Chile, Mexico, Colombia and Argentina,” as the first chart shows. (BofA believes Colombia will raise rates in coming months, before cutting again to deliver a net cut of 75bp in the remainder of this year.)
In contrast, central bankers in Asia have been showing their dovish side. Indonesia and Taiwan have both lowered rates, while China has loosened policy by cutting the reserve requirement ratio for big banks and injecting liquidity.
BofA expects this trend to continue, with rate cuts being planned in China, India and Indonesia, while in the Philippines, where it was anticipating tighter policy, they no longer are.
With the exception of those in South Africa, central bankers in the main economies of eastern Europe, the Middle East and Africa have been on hold, and rate cuts are more likely than rises, Mr Ades believes.
“Central Europe has an easing bias, particularly Poland, the Czech Republic, Hungary and Israel. Turkey and Russia will be easing going forward,” he says.
Mr Ades says this “paradox” essentially comes down to the decline in the price of commodities, a key Latin America export.
Neil Shearing, chief emerging market economist at Capital Economics, agrees, saying: “The commodity producing countries have seen their currencies fall very sharply, which has pushed up inflation. It’s above target in Chile, Colombia and Brazil.”
The obvious exception is Mexico, a net commodity importer where inflation is comfortably below target. Mr Shearing attributes the Bank of Mexico’s hawkishness to fears over the potential inflationary impact of the falling peso, which tumbled from 16.5 to the dollar at the start of December to a low of 19 pesos in February.
In contrast to the bulk of Latin America, many Asian countries are net commodity importers “so the decline in commodity prices has been good for them,” says Mr Ades.
“Inflation remains generally low. They have been able to keep interest rates low and even at the margin cut them,” thanks to the inflationary impact of weaker Asian currencies being outweighed by the feed-through from lower commodity prices, says Mr Ades, who also believes slowing growth in China has helped its neighbours keep inflationary pressures in check.
Interestingly even Indonesia, an Asian commodity exporter, has cut rates by 50bp in the past three months, with BofA pencilling in 50bp more by the end of 2016.
Mr Shearing attributes this to the fact that, after Jakarta cut fuel subsidies a year ago, the central bank raised rates to tackle the subsequent rise in inflation, rather than “looking through” this technical rise in prices as many central banks do.
Now this burst of inflation has washed through the system, the bank has scope to reverse last year’s hikes.
One might think the divergent monetary policies of Latin America and Asia would, therefore, help to smooth out real rates of interest (ie the difference between the policy rate and inflation).
Data from BofA suggests this is not really the case, however, as the second chart shows, at least based on the US bank’s projections.
While the current relatively high real rates in Indonesia and the Philippines are likely to fall, those in Brazil and Russia will surpass them. At the other end of the spectrum, real rates are forecast to turn negative in Poland and Israel.
However, Mr Shearing argues this should not be seen as particularly anomalous, with a country’s “correct” level of real rates dependent on where it is in the economic cycle, its trend rate of economic growth and the equilibrium level needed to equalise the supply of and demand for loanable funds.
The implications for investors are also less than clear-cut. As Mr Ades points out, the obvious trade might be to build a long position in Latin American currencies and a short position in Asian ones. Yet, he argues, the valuation dynamics paint exactly the opposite picture: Latam currencies are generally overvalued on a trade-weighted basis while Asian currencies are cheap.
Mr Shearing says the holy grail for bond investors is a country where rates are falling and the currency is stable, but such gems are “few and far between”.
Moreover, the recent rally in EM currencies, following a long decline, promises to further complicate the picture.
The Brazilian real and Turkish lira have now retraced their entire slide in December and January against the dollar, while the Colombian peso, South African rand and Russian rouble have recovered about three-quarters of their losses over the same period, and the Mexican peso has regained two-thirds of its losses.
The Chilean peso, meanwhile, has retraced its entire November to January sell-off and the Indonesian rupiah and Malaysian ringgit are back to where they were in October, notes Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
These rallies are likely to erase much of the inflationary impact of the prior currency declines, rendering central banks across the emerging world more dovish.
