The Russian invasion and resulting sanctions roiled markets, but Invesco Fixed Income’s Global Debt team still believes international fixed income can outperform over the next 2-3 years, led by emerging markets.
At the start of the new year, before tensions escalated, the Invesco Fixed Income Global Debt team’s outlook on Russia was favourable, based on a fundamental view that inflation was peaking and the end of its interest rate hiking cycle was near. In January, our view began to shift based on escalating rhetoric, and by February our perspective on the country’s risk/reward tradeoff altered as rhetoric became increasingly bellicose.
At this point, Russia faces draconian sanctions in the aftermath of the invasion. Without a clear near-term resolution or exit path, uncertainty has led to sharp moves across risk assets, especially Russian assets. While the situation continues to evolve, with tragic humanitarian and long-term geopolitical impacts, from an investment perspective, our global outlook for risk remains relatively unchanged.
Towards the end of last year, we outlined broad conditions that could set the stage for international fixed income to outperform over the next two to three years, led by emerging markets. While these conditions have been impacted by Russia’s actions, we believe they remain on track, or in some cases, could be more favourable going forward.
Conditions for potential emerging market outperformance:
- High nominal emerging market interest rates, with potentially high real interest rates in the near future – provided inflation ultimately declines
- U.S. dollar weakness, or at least stability
- Stable to higher commodity prices and improving terms of trade
- Attractive valuations
- Extreme bearishness toward emerging market assets
- Predictable path for U.S. financial conditions, especially interest rates
Global interest rates – central banks remain on track
We see this crisis as a temporary market shock, and do not anticipate overall global growth and inflation trends to be derailed. While the impact on growth and inflation will likely vary by region, we do not believe this event will significantly alter global central bank actions.
In the U.S., we expect the economic impact to be limited. The U.S. economy has been regaining momentum after the Omicron wave and appears to be starting the next stage of re-opening toward the new normal. That being said, the conflict is likely to boost energy and other commodity prices and further disrupt supply chains. Even though the region around Ukraine is not key to global production and distribution, even a small disruption can affect highly connected supply chains, as we saw in the Suez Canal episode, and they are already quite clogged.
We anticipate the U.S. Federal Reserve (Fed) will likely initiate its hiking cycle with a sustained series of hikes, and then take stock around mid-year. As financial conditions are tightening already via equities and credit spreads, the current crisis may cause the Fed to be less aggressive in its initial hike and more cautious with its forward guidance — and to not rush to start quantitative tightening.
In the eurozone, the growth impact is more relevant. The crisis imposes a major shock on European energy prices and supply; it is a hit to consumers’ real income and production may be disrupted by energy shortages. Europe is also close to the conflict, which could impair consumer confidence, in addition to leading to a potential refugee crisis.
While eurozone inflation is high, there is, so far, limited evidence of wage growth, and we believe inflation is unlikely to become entrenched after years of running very low. Market expectations of European Central Bank (ECB) rate hikes this year had become increasingly hawkish, but we expect the ECB to proceed more slowly now in removing monetary policy accommodation.
We see some growth slowdown in Asia, but economic activity remains elevated and supported by accommodative policy. In India, the government recently reduced its growth target but it remains over 8%.2 We expect growth in China to be between 5% and 5.5% this year, and China has indicated the likelihood of additional policy easing.
Most emerging market central banks, in contrast, became increasingly restrictive in 2021, raising rates significantly and preempting the Fed’s anticipated tapering by responding to higher domestic inflation. As a result of this earlier tightening cycle, emerging market interest rates have generally risen sharply versus U.S. rates and have reached attractive levels, in our view. Interest rate spreads between emerging markets and developed markets, when adjusted for structurally lower rates in Central and Eastern Europe, are at their widest level in a decade. We expect high real interest rates to follow high current nominal interest rates, as inflation in emerging markets is likely to decline this year, beginning in the second quarter. While growth may slow and inflation may rise due to this conflict, we believe emerging market interest rates remain attractive.
U.S. dollar strength may be behind us
Despite this year’s market challenges, the U.S. dollar has remained relatively stable. We continue to believe the factors contributing to U.S. dollar strength are now behind us. The direct economic impact of COVID-19 has passed, and we believe we have reached the peak in disparate policy expectations between developed and emerging markets. Given current interest rate expectations, sizeable currency premia have already been built into markets. With policy differentials priced in and interest rate volatility declining, we believe emerging market currencies will likely benefit disproportionately, as high U.S. twin deficits (budget and current account) ultimately weigh on the dollar.
Stable-to-higher commodity prices help support emerging markets
Until now, sanctions on Russia have been crafted to maintain energy stability. While there is speculation about potential scenarios if Russian oil is taken off the market, we do not anticipate a sustained price spike, as we believe other oil suppliers would come online to meet demand. Across a variety of commodities (wheat, soy, metals), we see the potential for emerging market agricultural producers and miners, such as South Africa, Argentina, Peru, Chile, and Colombia, to benefit if demand is diverted from Russia. An environment of relatively stable-to-higher commodity prices is generally positive for emerging markets.
Valuations and investor bearishness toward emerging markets
While recent volatility may begin to entice intrepid investors, it has scared off others, and the emerging market fixed income category remains in outflows. Nevertheless, we believe emerging market assets offer a potentially exceptional opportunity from a valuation perspective.
1 Source: Bloomberg L.P. Data as from Dec. 31, 2011 to Feb. 28, 2022.
2 Source: India’s National Statistical Office, Feb. 28, 2022