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Fixed Income

Monetary Policy’s Effect on EM Debt

March 2019 - 3 min read

Rate expectations have changed materially across emerging and developed markets in the first quarter of 2019. What does this mean for emerging markets debt? Barings’ Ricardo Adrogué weighs in.

The Changing Behavior of Central Banks and the Impact on Liquidity
While central bankers in the U.S. spent much of 2018 hiking rates, and their counterparts in Europe began reducing easing measures, 2019 has been a different story. The U.S. Federal Reserve and European Central Bank have hit the pause button—instead taking on a more dovish stance—and China, already one of the fastest growing economies, has also taken actions to ease monetary conditions and spur growth.

This should be a good thing for emerging markets debt investors, right? Well, yes and no. A year ago, we wondered if monetary conditions were really as easy as investors thought, pointing out that while central banks had been in easing mode, commercial banks had actually been doing the exact opposite—implementing tighter lending standards, and effectively draining liquidity from the system.

So as investors began to worry that the removal of the monetary policy “punch bowl” would represent a significant headwind for emerging markets debt in the years ahead, we hypothesized that 1) monetary conditions were never as easy as most perceived in the first place, and 2) commercial banks would likely return to their “animal spirits” after ten years of licking their financial crisis wounds, and act as a balance to tightening central bank policies.

In actuality, the reverse has occurred to some degree—as central bankers have tipped back into easing mode this year, commercial banks have not been as aggressive as expected. In fact, according to data from the Bank of International Settlements, global cross-border banking claims barely grew in the year through the third quarter of 2018. Growth in such claims reached 10% at the end of 2017 but dropped precipitously as 2018 rolled on1. Ironically, this has effectively resulted in broadly the same liquidity conditions that we predicted a year ago—but we took a different road to get there.

The ripple effects of these monetary policies can be felt throughout emerging markets.

What Does This Mean for Emerging Markets?
Generally speaking, emerging markets have done well during periods of higher global growth and lower interest rates. As such, investors may wonder if the more dovish stance of developed market central banks suggest that we are entering a Goldilocks scenario for emerging economies. In our view, it’s possible—but it may not be that simple. While these actions are not necessarily creating tailwinds, they are certainly dissipating headwinds to some extent—which presents a strong positive for emerging markets.

Additionally, with the IMF forecasting positive economic global growth numbers over the next two years—with advanced economies at 2%, and emerging and developed economies at 4.5% for 2019—it appears that the economic backdrop should be supportive of the bull case for emerging markets.  

That said, we are still in the midst of a very uncertain period—and there are remaining risks surrounding trade negotiations, interest rate moves, currency fluctuations and more.

Not All EM Assets Are Created Equal
Despite the positive environment, there are areas of emerging markets that remain a concern. For instance, local currency denominated investments currently appear less attractive, on a relative basis, than hard currency denominated corporate and sovereign bonds. To some degree, this is because emerging markets, or at least their central bankers, have become a victim of their own success. Over the last decade, emerging market policy makers have become increasingly skilled at using their local currencies as “shock absorbers,” purposefully allowing them to weaken—or at least failing to support them in the open market.

Additionally, inflation rates in emerging markets have gradually become disassociated with currency depreciation, and have remained low in markets like Indonesia, Malaysia and Chile. Without this correlation, and without runaway inflation, there is less need for central banks to prop up local currencies. This results in the country’s exports being more attractively priced on the global market, thereby bolstering economic growth. But it also means that investors allocating to local currency bonds lack the tailwind of potential currency appreciation.

Conversely, we view hard currency bonds as attractive in the current environment—benefiting from the lower rate expectations and still-strong economic growth, but with reduced currency risk. Although even among hard currency bonds, investors need to be selective. Specifically, investors will want to be mindful of duration risk. While market sentiment has become significantly more dovish with regard to rate expectations this year, we believe it may be reaching a turning point. Indeed if investors begin to price in even marginally higher rate expectations, shorter duration investments—particularly corporate bonds—may prove to be the most attractive place to be in emerging markets in 2019.

In summary, there is much to be optimistic about in the current backdrop for emerging markets, which has improved markedly since 2018. That said, careful security selection, active management and risk mitigation remain paramount.

  1. Bank of International Settlements. As of September 30, 2018.

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