Taking it easier

It wasn’t until the late 1990s that central banks in the emerging world began adopting inflation-targeting regimes, following the lead of several G10 nations. These are monetary policy frameworks in which central banks make public a target inflation rate and attempt to steer actual inflation toward that rate, primarily via changes in policy interest rates.

Twenty-five years on, we are witnessing the coming-of-age of emerging market central banks. After the pandemic, many of them hiked policy rates early and aggressively to curtail elevated inflation, and they now seem ready to cut interest rates before the Federal Reserve begins “thinking about, thinking about” doing so. Such independent decision-making—by acting ahead of developed market peers—would have been inconceivable just a few years ago. In our view, this is a testament to their recent experience in battling price pressures, as well as to their hard-earned reputation.

The poster-child of these developments is the Brazilian Central Bank. It began hiking rates a full year ahead of the Fed; brought policy rates to a prohibitive 13.75%, where they have remained for a full year; and may now decide to cut them as early as August. Yet Brazil is not alone. Smaller countries like Uruguay have already delivered rate cuts, and markets are expecting many others to follow suit (Fig. 1).

Interestingly, lower nominal interest rates need not translate into weaker currencies, considering that in many of these emerging markets, real or inflation-adjusted interest rates are increasing thanks to the continued progress in their fight against inflation. In fact, we expect emerging market currencies to remain resilient—and in some cases even appreciate—against the US dollar in the coming months.

But it is not only in central bank policy through which many emerging economies are showing maturity. “Imitate, assimilate, innovate” was a phrase often used by jazz giants Clark Terry and Miles Davis to describe how they built creativity. Thirty-five years after issuing their first bonds under the Brady Plan, emerging market sovereigns are now approaching the innovation stage, particularly in the realm of green, social, and sustainable financing.

Chile, for example, became the first country in the world to issue sustainability-linked bonds. It did so in 2022, tying the issuance with targets and penalties related to the country‘s greenhouse gas emissions and energy mix. This year, Chile came back to the market with a novel issuance that incorporates targets around gender diversity, committing to ensure that, by 2031, at least 40% of the board members of companies under the Financial Market Commission‘s oversight are women.

In a time of rising sustainability challenges and scarcer global liquidity, these innovative bonds allow countries to simultaneously address both pressing issues, and we expect other nations to follow in Chile’s footsteps.

Investment implications

In this context, we keep US dollar-denominated emerging market bonds as most preferred in our global strategy. Their spreads against US Treasury bonds have tightened in recent weeks, led by the lower-rated high yield segment. Valuations of emerging market bonds are now fair on aggregate, in our view. Although spreads may narrow further if a US soft-landing scenario becomes more likely, our base case sees them trending broadly sideways for the rest of the year. We expect mid- to high-single-digit total returns for the asset class in a central scenario over the next six months, supported mostly by carry.

We also keep emerging market equities as most preferred. On the whole, manufacturing activity in emerging economies is in expansion territory, and the gap with developed markets has opened up further. The likely easing of monetary policy by many emerging market central banks should also be positive for several major economies. The MSCI Emerging Markets index‘s valuation, at 12x 12-month forward price-to-earnings, is largely in line with the 10-year average and is at a 37% discount to the S&P 500. On a price-to-book basis, the discount is even deeper at 64% versus the 10-year average of 54%. In our view, the gap does not factor in the better earnings growth prospects for emerging markets in 2024 relative to developed markets.

A strong US dollar, an uptick in geopolitical tensions, a pronounced US recession, and a slower-than-expected economic recovery in China are key risks to our views.

Co-authored with?Solita Marcelli, Chief Investment Officer Americas

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