With US rate tightening underway, the spotlight is thrown back on EM policy rates. Within a day, at the time of writing, US equities have given back most of the initial gains in reaction to the 4 May US Fed hike of 'only' 50bps.
For EM equities, the bullish view is that many EMs have hiked already, whereas the bearish view is that global inflationary pressures have significantly deteriorated further since those hikes and real rates in much of EM are already negative.
Defending the faith in EM equities
The bullish view for EM equities that I have heard from some institutional EM equity portfolio managers is as follows:
Regardless of whether the Fed is ahead of or behind the inflation curve, EM policy rates have moved more proactively to counter inflation (below is a chart of cumulative policy rate changes since the start of 2021 – some of the best EM relative performers are in LatAm, eg Brazil, where rate hikes are among the largest);
Most EM equity markets are driven by local investors who have already reacted to these hikes; and
Therefore, these EM equity markets are less vulnerable to their respective central banks catching up with the inflation curve.
Risks to this view
The three risks to this view are that:
Inflation drivers for those EMs that import fuel or food, or are poor, ie a large part of household spend is dedicated to food staples, have undoubtedly deteriorated this year. Hiking rates early does not mean they have been hiked enough, particularly if external account (current account and currency) pressures are also present.
Below is a chart of real interest rates across EM, which can be viewed as a measure of whether central banks in those countries are ahead of (ie a positive real interest rate) or behind (a negative real interest rate) the inflation curve.
China and Vietnam are two rare EMs with positive real interest rates – causing some to doubt the accuracy of inflation data in these markets. The capacity for China to enact policy stimulus to counter its slowdown is explored in more detail in this report.
Although local investors do dominate equity trading volumes in most markets, the activities of the minority of foreign investors, who tend to be camped in the larger, more liquid stocks, can have an influence on the sentiment of those local investors that outweighs the foreign share of trading activity.
If the US Fed is behind the inflation curve, then a disorderly set of rate hikes to re-anchor inflation expectations could overwhelm all else when it comes to EM assets in general – this is a theme explored in detail by my colleague Patrick Curran.
Our Country Index in this context
The sustainability of macroeconomic growth and the credibility of policy are factors incorporated into our EM Country Index, where the weight attached to these factors can be customised.