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Why EM central banks could diverge from Fed

As part of a new initiative, FSA is talking to market participants about key trends that shape fund selection. This week, Chris Kushlis at T Rowe Price, discusses the impact of monetary policy in emerging markets.

Emerging markets (EM) have demonstrated resilient growth and a decline in inflation in 2023. Looking ahead, many EM central banks are poised to embark on an interest rate cutting cycle, striking out ahead of their developed market peers. This development is constructive for EM fixed income investments. However, vigilance and careful monitoring of key factors such as China’s economic trajectory, disinflation trends particularly in core inflation and the sustainability of EM growth will be crucial in navigating the evolving landscape.

Interest Rate Cycle Turning in EM

With substantial progress made in bringing down inflation, EM central banks are about to start easing – leading the turn in the interest rate cycle. Not only did they start raising interest rates before developed markets, but they also hiked more. This creates a cushion for EMs to commence cutting, even as most developed markets are unlikely to be in that position anytime soon.

However, there is uncertainty in terms of how far EM central banks can go in this rate-cutting cycle. It’s possible that rates will not return to pre-hiking levels as conditions are different. EM central banks also need to be mindful of currency stability as they embark on rate cuts. The ongoing strength of the US dollar and the upward trajectory of US rates pose potential headwinds, particularly for low-rate countries that lack a sufficient carry cushion.  As a result, we expect EMs to leave a cushion of positive real rates as they deliver their cutting cycles. 

Chile has already taken the lead in initiating its easing cycle and other Latin American countries such as Brazil and Peru are following suit. In central and eastern Europe, Hungary has begun easing, Poland delivered a surprisingly large cut and we expect the Czech Republic to join in shortly. However, the Asia region is expected to delay rate cuts until 2024, as inflationary pressures were not as deep, reducing the need for aggressive rate hikes. Poland’s relatively large rate cut this month did take the market by surprise and has led to currency weakening – though this remains an outlier among the countries that are looking to cut rates. 

Vigilant on Food Prices

Inflation in EM has decreased rapidly following structural shocks from the pandemic and geopolitical events. While there are potential upside risks to food prices, such as the termination of the Russia-Ukraine grain deal and the return of the weather phenomenon El Nino, the impact is expected to be relatively modest compared to previous shocks. Vigilance on food prices is necessary, but the risks of second-round effects on inflation from these shocks should be contained.

The weather phenomenon known as El Nino, which occurs every few years and causes a rise in sea temperature in the Pacific Ocean with knock on implications for weather conditions worldwide, has returned. Select Asian and Andean countries of Latin America are likely most exposed but in different ways. For example, Colombia could face more drought conditions, while Ecuador and Peru could see more heavy rainfall. Even within countries the effect may vary; some of Brazil’s regions may see shortfalls of rain while others may experience higher than normal rainfall and stronger harvests. The risk is that the more extreme weather causes a disruption to agriculture, with knock on implications for food prices and inflation.

Three Key Factors that Impact EM Growth Sustainability  

EM growth has demonstrated resilience thus far, even in the face of a slowdown in the global manufacturing cycle and China’s economic growth. Similar to developed markets, the non-manufacturing side of EM economies have held up better, while China’s slowing economic growth is yet to translate into a deeper downturn for commodity prices. This is encouraging for EM, but it’s important to note that the quality of growth is mixed and there is geographic dispersion. Commodity exporters have been doing better relatively to more highly cyclical manufacturing export oriented economies.

Broadly speaking, services sectors have remained resilient, mirroring the trends observed in developed markets. This suggests a rotation in EM from goods consumption to services. Import compression has also played a role, which may help boost headline gross domestic product (GDP), but it is not necessarily indicative of sustainable growth.  Additionally, an inventory correction appears to have supported growth in EM, although its impact is unlikely to be long-lasting.

Looking ahead, the sustainability of EM growth will likely depend on three key factors. Firstly, the stability of commodity prices in the face of a weakening industrial cycle will be critical. Secondly, the tension between the manufacturing sector’s slowdown and the resilience of services sectors and labour markets will play a crucial role in determining overall growth. Finally, China’s ability to manage its economic stability will be a significant factor to monitor.

Constructive on Local Rates

The backdrop of disinflation and upcoming rate-cutting cycles in EM presents a favourable environment for local rates. Historically, long local rate positions have generated positive returns during rate-cutting cycles. Broadly, we also see more value in the EM corporate space but fundamental research and security selection is essential.

Selective currency positioning will also be crucial, as the interest rate differential is expected to weaken as EM central banks cut rates earlier than their developed market counterparts. Careful consideration of carry opportunities and risk management will be essential for investors navigating the EM landscape.

Chris Kushlis is chief of China and emerging markets macro strategy at T Rowe Price.

Part of the Mark Allen Group.