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Hemant Baijal | March 3, 2022

Our positive view of emerging markets debt remains on track

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:

  1. High nominal emerging market interest rates, with potentially high real interest rates in the near future – provided inflation ultimately declines
  2. U.S. dollar weakness, or at least stability
  3. Stable to higher commodity prices and improving terms of trade
  4. Attractive valuations
  5. Extreme bearishness toward emerging market assets
  6. 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.

United States
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.

Emerging markets
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.[1] 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

More from Hemant Baijal

Our positive view of emerging markets debt remains on track
March 3, 2022

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Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

A nominal interest rate is the interest rate before taking inflation into account.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

Quantitative tightening is a monetary policy used by central banks to normalize balance sheets.

Currency premia occurs when the forward or expected future price for a currency is greater than the current spot price.

The opinions referenced above are those of the author as of March. 1, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.