Higher-than-expected US inflation implies greater rate hikes and US dollar strength, which is negative for most emerging markets.
Real rates – policy rate minus inflation – measure how ahead or behind the inflation curve is a central bank. In the US, this is negative 7.6%.
Despite earlier rate hikes in many emerging markets compared with developed markets, negative real rates imply there is much further to go.
The exceptions to negative real rates in EM, for now, are the following:
Large EM: Brazil, China, Saudi Arabia;
Africa: Kenya, Tanzania; and
The EMs where policy lacks credibility and real rates are extremely negative include Lebanon, Sri Lanka, Turkey and Zimbabwe.
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;
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.
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.
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.