Policy Divergence Creates Investment Opportunities – PIMCO
The rise in inflation has been a global phenomenon although the way local policymakers have responded, in Turkey and Mexico for example, has varied. This creates opportunities in specific fixed income markets, the firm says.
According to PIMCO, the fixed income manager, the different ways in which inflation has risen and how local central banks are trying to fight it have created opportunities to find value in select local currency debt.
The rise in inflation is a global phenomenon, aggravated by supply chain disruptions and Russia’s invasion of Ukraine.
Certain countries have moved in different directions, Pramol Dhawan, head of emerging markets, and Lupin Rahman, head of emerging market sovereign credit at PIMCO, said in a note.
“We think this could offer investors opportunities for uncorrelated returns in the form of EM local debt. And yet, investors must be discerning,” they said.
The authors of the PIMCO notes cited the case of Poland, where the war in neighbouring Ukraine has had a disproportionate effect on refugee inflows, supply chains, spending pressure, and commodity prices. In Mexico there is more structural pricing pressure, rising inflation expectations, and questions over the long-term independence of the central bank. Policymaking errors have exacerbated problems for nations such as Turkey, which has resisted raising interest rates even as inflation has surged, rising to 74 per cent year-over-year in May.
“Emerging market inflationary momentum remains strong, with outcomes highly correlated to those in developed markets. Similar to our outlook for developed markets, we expect emerging market inflation to peak, gradually trending lower this year and into 2023. Given the magnitude and persistence of this episode, however, we do not expect inflation to decelerate to prior-trend levels until after 2023,” the authors said.
An important point is that real interest rate spreads between emerging markets and developed markets are “unusually high.”
Emerging market policy rate adjustments look more mature on average while developed market central banks are generally earlier in their hiking cycles. “That may offer developed market investors a rare opportunity for uncorrelated return potential in the form of emerging market local debt, which is denominated in an issuer’s domestic currency,” the PIMCO manager said.
The authors said that emerging market currency appreciation should play a strong role in disinflation. This is likely be be reinforced this time around by high levels of real carry – borrowing in low-yielding currencies to invest in higher-yielding ones – in emerging markets versus developed markets.
“We are seeing this beginning to play out in Brazil already, where the central bank policy rate has risen to 13.25 per cent, after more than 11 percentage points of hiking during this cycle, and the Brazilian real has gained about 10 per cent against the US dollar year-to-date as of 14 June,” they said, citing Bloomberg data.