In keeping with the theme of our recent blogs, another complicated week has passed in emerging markets (EM). It really is quite tricky for market participants in our asset class at the moment; not only are we faced with increasingly hawkish central bank rhetoric at home and abroad, we are also trying to reconcile ongoing bottlenecks in the energy markets, growth moderation in China and the resulting debate over “stagflation”.
Furthermore, risk sentiment continues to be clouded by lingering concerns over the pandemic and delta variant; we note a further deterioration in the news flow this week, with lockdown restrictions creeping back into countries within our universe and supply chain problems in the COVAX vaccination programme. At the same time, to make matters even more complex, idiosyncratic risks continue to flare on the ground, with increasingly worrying headlines emanating from Brazil and Turkey this week.
Political risks have once again flared in Brazil. The President, who has seen his popularity slide ahead of next year’s election, has forged ahead with controversial plans to increase social spending in 2022 and remove the costs from the spending cap. Under the initial iteration of the social spending plan for next year, households were entitled to BRL300 per month; the BRL61bn cost would have fallen within the spending cap. However, the President is now pushing to increase household support to BRL400 per month; of the projected BRL85bn revised cost, BRL25bn would fall outside of the spending cap. As such, if the President is successful, the primary deficit is likely to balloon next year and throws the validity of the fiscal anchors into doubt. In response, four members of the team which reports to the Economy Minister, have since resigned. The market response to the potential loss of fiscal discipline and resulting political fallout was swift; over the last week the BRL has slipped almost ~3.5% and is now ~8% weaker year to date. Looking forward, we believe political risk is likely to intensify ahead of the election next year; we remain neutral when it comes to the BRL and have local rates underweight positions relative to the benchmark.
Clouds were already gathering ahead of this week’s Central Bank of Turkey (CBT) meeting following the President’s recent decision to remove three members from the MPC, two of which had opposed the interest rate cut last month. That said, even the gloomiest of forecasts were surprised by the shock 200bp rate cut this week; the headline policy rate (16%) is now below both headline (19.6%) and core (17%) inflation. While the MPC assessment of the transitory outlook for inflation was broadly unchanged, they did introduce some new forward rate guidance; “the Committee assessed that, until the end of the year, supply-side transitory factors leave limited room for the downward adjustment to the policy rate”. While this guidance at face value could suggest that the CBT is now in a holding pattern for the remainder of this year, the market took little solace from this signalling; the TRY is now ~3.5% weaker relative to the dollar since the decision and is comfortably the worst performing EM currency this year. Looking forward, despite encouraging signals from the CBT, we anticipate future monetary policy risks in response to ongoing political pressure from the President; we remain neutral when it comes to the TRY and have local rates underweight positions relative to our benchmark.
As noted in our E.&.G.L.E-i blogs over recent weeks, we are cautious when it comes to emerging markets. In our view, the backdrop is complicated by peaking monetary policy support in the United States, the spread of the coronavirus delta variant which is disproportionately hitting EM relative to developed markets (DM) and the prospect a moderate growth slowdown in China. Looking forward, from a structural standpoint, we believe the complicated backdrop for EM is likely to persist. Why? The lack of domestic EM growth “alpha” is unlikely to extract the same level of “pulled” capital into our asset class; aging EM business models will fail to keep pace with the multi-year technology led expansion we expect in DM. Similarly, in our view, EM is unlikely to enjoy the same level of “pushed” capital into the asset class as the Fed commences the long-signalled tapering process. That said, we do not expect a “taper tantrum”; the market consensus is already very bearish when it comes to EM, where positioning in both rates and EMFX was largely squared off during the Q1 selloff. As a result, we believe that opportunities remain in our asset class. With further fiscal stimulus entering the system at home and abroad, the foundations for the cyclical rebound are solid; this backdrop is likely to support allocations to some emerging market rates and currencies, particularly those with a strong beta to global trade and commodities. Likewise, as noted in our August monthly publication, Taking Stock - Diverging Paths in EM, we look for cases of policy divergence within EM; (1) we seek to generate alpha from positioning in markets where the policy tightening cycle is maturing, relative to those who have barely began; and (2) target longer term market pricing undershoots and overshoots relative to central bank estimates of the neutral rate.
Taking Stock - Diverging Paths in Emerging Markets
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ESLJ-221021-I2
