GSAM: The case for EM local bonds

5 oktober 2023

Inflation is falling rapidly across the emerging world in response to proactive monetary tightening by EM central banks, lower commodity prices compared to last year, supply chain improvements and stronger currencies.

Inflation in emerging economies has fallen more quickly than in developed markets (DM), with central banks in the latter having to address larger domestically generated inflationary pressures. Although there has been some recent volatility in the commodity markets, we believe a significant degree of disinflation is still in the pipeline for the second half of 2023, particularly as growth momentum is slowing.

EM Central Banks: From Pause Mode to Easing 

The EM Local bond market experienced its most aggressive rate hiking cycle since its inception in 2021 and 2022. But many EM central banks are either easing monetary policy or are poised to do so. These banks delivered proactive and aggressive monetary tightening in response to sharply rising inflation in 2021 and 2022, resulting in the highest interest rates in a decade. Many concluded their hiking cycles late last year and have since been on hold.

Faster-than-expected disinflation coupled with slowing growth and a high starting point for real rates have led several EM central banks to start cutting rates. Like the post-pandemic hiking cycle, central banks in Latin America (LatAm) have taken the lead, with the central banks of Chile and Brazil having already embarked on policy easing. We expect more EM central banks to follow suit over the next 18 months.

However, differences in how much inflation is falling suggest different central banks are likely to follow different monetary policy paths, underscoring the importance of active management. For instance, we anticipate further monetary tightening in Turkey and Russia, while many Asian central banks are likely to stay on hold. It is predominantly central banks in Central and Eastern Europe (CEE) and LatAm that are easing or set to ease. China’s central bank is also likely to continue to deliver targeted easing to counterbalance weaker-than-expected growth. 

EM Local Bond Rally Has More Room to Run

Assertive measures to counter inflation in recent years have resulted in high real rates and put EM central banks in a position to ease monetary policy ahead of DM central banks. EM local bonds, as measured by the J.P. Morgan Government Bond Index Emerging Markets (GBI-EM), have already rebounded sharply in anticipation of impending monetary easing, delivering a total return of 10% since their October lows and 7.5% year-to-date.2 Their performance has been in stark contrast with US rates, which have been volatile in 2023.

We believe EM local bonds’ strong performance has scope to continue. Historically there has been a strong correlation between peaks and troughs in annual inflation and subsequent peaks and troughs in EM local bond yields, particularly among high yield (HY) issuers. This suggests that the continued fall in EM inflation from recent peaks may coincide with additional declines in EM local bond yields, thereby extending the runway for potential GBI-EM returns.

In addition, EM central bank actions tend to exceed market expectations both when they are tightening and loosening policy. For example, the Central Bank of Chile initiated its easing cycle with a larger-than-expected 100bps rate cut to 10.25%. The dovish tone conveyed in its July meeting minutes implies that forthcoming meetings may involve similarly large rate cuts.

EM local bonds are also being bolstered by favorable developments in EM currencies, which have historically detracted from total returns for investors in major developed markets. For context, a deterioration in current account positions amid supply constraints and the commodity price shock exerted significant downward pressure on EM currencies in 2022, reinforcing inflationary pressures for EM economies relative to major advanced economies.

Fast forward to 2023, however, and EM currencies have strengthened, benefiting from attractive real rates and improved balance of payment positions (in response to aggressive monetary tightening and slower growth). Despite their appreciation and expectations of EM policy rate cuts, we think the appeal of EM currencies will persist as declining EM inflation should mean that EM real rates remain attractive.

A potential risk to EM currencies is a global or US downturn that would lead to the US dollar strengthening. Such an outcome could also impact EM local bond performance through heightened risk aversion. However, this is not our base-case scenario in the near term as recent signals suggest the US economy is still growing and inflation in the US is gradually falling. 

In summary, we believe the combination of high starting real rates—following historic tightening in 2021 and 2022—and accelerating disinflation portends an expansion in market-implied pricing for policy easing within select EM local bond markets in the coming months. Additionally, despite EM central banks embarking on rate-cutting cycles, we believe EM local bonds are likely to continue providing attractive yields over core DM bonds.