1.  Inflation remains elevated in emerging markets (EM) but is relatively contained

Higher inflation and in some cases, rising inflation expectations, has been a key focus for investors in 2021, in both emerging and developed markets. There are several factors driving the acceleration in inflation in EM, including base effects from the pandemic shock, supply side bottlenecks, high commodity prices (food prices form a much larger constituent of inflation in EM economies compared to developed markets), weak exchange rates in some cases, and a recovery in domestic demand. 

Headline inflation has been rising within EM

EM headline and core inflation¹

Data as at 30 September 2021. Source: Haver. Headline inflation is the total inflation in the economy based on a basket of goods and services consumed by an average family, while core inflation is headline inflation excluding the more volatile items such as food and energy. 

Base effects, supply side bottlenecks and commodity prices should eventually adjust, and it would be reasonable to expect the next few years to bring greater EM exchange rate stability. The longer term factors to watch include the recovery in domestic demand and any change in inflation expectations.  

EM countries, along with developed markets (DM), have seen sharp contractions in gross domestic product (GDP) brought about by the pandemic, which in turn has left large output gaps. Moreover, the EM recovery has significantly lagged that of DM, partially due to less pandemic induced fiscal spending.  Weak economic recoveries are typically associated with cyclically lower inflation rates.

Monetary policy plays an important role in longer term inflation dynamics, especially inflation expectations. On average, EM central banks have been proactive in hiking interest rates relative to DM central banks – despite weak domestic conditions. Tighter domestic financial conditions should help anchor inflation by depressing domestic demand and defending against currency depreciation. 

2.  Global growth – set to slow further, but should remain above trend

The International Monetary Fund (IMF) forecasts the global economy to grow at 4.9% in 2022, slowing from 5.9% in 2021. This largely reflects weaker developed economies, mainly due to supply disruptions and restrictions related to the virus. Economic growth in EM countries, meanwhile, has actually proved relatively resilient to new variants of the virus and continued supply side bottlenecks.

EM growth is expected to remain relative robust in 2022

IMF real GDP growth forecast for 2022

For illustrative purposes only.
As at October 2021. Source: IMF. Real gross domestic product (GDP): an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year. Yoy: year-on-year.

That said, there is a great deal of variation within EM. Those countries that are at the earlier stages of reopening their economies (e.g. India) and the commodity exporters should generally see faster economic growth, while those that are further along the process (e.g. Mexico), are more likely to see growth decelerating. Latin America in particular (driven by Brazil) is likely to see much slower growth given the speed of monetary tightening in 2021. Meanwhile, growth in central and eastern Europe should recover more strongly, benefitting from large EU transfers.

China was one of the first countries to re-open following the start of COVID-19 and had most of its boost to economic growth in late 2020 or early 2021. China has seen a larger-than-expected slowdown in 2021 driven by a normalisation in fiscal and monetary policy in late 2020 and a change to its regulatory regime mainly in 2021, including changes to technology regulations and housing policy. 

3.  Fiscal and external balances are at manageable levels

Fiscal balances

After a decade of weak growth, stagnant trade and falling commodity prices, EM countries have been forced to increase fiscal spending drastically with the pandemic. Fiscal deficits remain higher compared to previous EM peaks, while public debt levels are continuing to rise, although they are still well below developed market levels and remain manageable. Higher public debt levels can translate into higher inflation, lower bond yields and weaker currencies, for the more fiscally vulnerable countries.

External balances

On a more positive note, current account deficits (defined as when the total value of goods and services a country imports exceeds the total value of goods and services it exports) have improved across many EM countries. COVID-19-related restrictions impacted domestic demand more in EM compared to DM as developed markets were able to deploy large scale fiscal stimulus, while undervalued exchange rates also helped EM countries’ competitive positions. This may turn in 2022 in EM non-commodity exporting countries as domestic demand rebounds and COVID-19-related restrictions ease. Nevertheless, current account deficits are unlikely to be a major policy concern as higher yielding EM countries should retain current account deficits well below 2013 (and pre-pandemic) levels and the expected boost in tourism should support EM positions.  

4.  Less supportive liquidity backdrop, but rate increases should remain gradual

Developed market central banks are expected to pull back monetary expansion in 2022. Previously the US Federal Reserve (the Fed) had argued that it viewed the uptick in inflation as transitory. However, there are signs that it is wavering on this stance as broadening price pressures appear to be feeding into longer term expectations. If this is the case, we believe the Fed could take stronger, but still measured, actions to address inflation. The European Central Bank, meanwhile, has held its main refinancing operations rate at zero since March 2016 and does not seem likely to raise interest rates in the foreseeable future.

Compared to many DMs, more orthodox monetary policy has been maintained in many EM countries. This is because most EM central banks haven’t had the degree of flexibility or market confidence to engage in material quantitative easing activity. Now that economic activity has started to rebound and inflation has appeared, many EM central banks have already begun the hiking cycle, including most Latin American and CEEMEA (Central and Eastern Europe, Middle East and Africa) central banks (excluding Turkey), and this looks set to continue in 2022, with the possible exception of China at this stage.

5.  EM debt – more value in local curency debt, but selectivity needed

Local currency debt

US tightening cycles have generally been a source of stress for EM economies in the past and this has been a factor in EM local currency debt volatility in 2021, with swings in the pricing of the timing and pace of monetary policy normalisation in the US affecting local currency debt. EM local currency debt has tended to sell off as Fed rate hikes start to be priced in, but often don’t move or go the other way once Fed hikes are delivered. This suggests that much of the negative impact of the Fed moves may be behind us unless the markets re-price further hikes and/or bring hike expectations forward. That said, EM local debt could see pressure from rising inflation and fiscal deficits.

The actual level of interest rate differential with the US is also important to keep at a certain level to compensate investors for country risk. That interest rate differential was low in 2020 and has been increasing in 2021 as EM central banks have started to raise rates before DM central banks, particularly among the higher yielding EM countries. There is now a significant real rate premium compared with developed markets, presenting a valuation opportunity.

Interest rate differentials (EM minus DM)¹

Data as at 1 November 2021. Source: Bloomberg

External debt

EM external debt (i.e. the portion of a country's debt that is borrowed from foreign lenders) tends to be less affected by the timing of Fed rate hikes. If these hikes are accompanied by strong growth, then EM credit spreads often tighten. If US rates rise above a certain level, however, that can start to have an impact on external financing requirements for EM countries. Given how low rates are at the moment, we believe this is not a near-term risk.

Credit spreads are generally tight across the board within fixed income, including in US dollar-denominated EM debt. This means a lower premium for investors taking on credit risk. That said, we continue to see value in some areas of external debt, including some of the higher yielding issuers. 

Uncertainties lie ahead

The trajectory of the virus, its variants and the response of governments are clearly an ongoing key risk factor.

Inflation is a key uncertainty for 2022. A more benign inflation outlook that could be helped by easing supply constraints would allow the Fed to keep interest rates on hold for longer. This could allow a combination of disinflation and strong growth, potentially supporting EM assets. Alternatively, if inflation looks to be more persistent than expected, the Fed could hike earlier/more than expected, presenting downside risks to EM debt. 

China’s policy regime change and transition to higher quality growth is another uncertainty, especially due to the country’s importance in global demand and supply chains. However, while investors were understandably rattled by the spate of regulatory changes in 2021, it is important to understand that regulatory cycles are not uncommon in China and policy risks should always be taken into consideration when investing in any emerging market economy.

Finally, there is the risk of political uncertainty. Latin America, in particular, has seen a rise in social tensions after years of low growth, followed by the pandemic. Colombia and Brazil are set to hold presidential elections in 2022 – both countries have suffered from market stress in 2021, with Colombia losing its investment grade rating from two rating agencies. Mexico may hold a recall referendum on President Andrés Manuel López Obrador (AMLO), while Argentina will continue debt negotiations with the IMF. Outside of Latin America, elections are due to be held in Hungary, India and Kenya in 2022.