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Emerging markets - asset allocation in a volatile world

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Senior investors share the factors influencing their investment decisions – from US monetary policy and inflation to the surge in energy prices.

Emerging market investors face a highly volatile environment in 2022. A sharp change in US monetary policy, persistent inflation, and a slowdown in the Chinese economy have all weighed down on the asset class. Against this uncertain economic and financial backdrop, asset allocation decisions are particularly challenging.

At HSBC’s 2022 Global Emerging Markets Forum, a panel of senior investors discussed the factors influencing their investment decisions – highlighting the tailwinds, but also uncovering some of the opportunities in this diverse and dynamic range of markets.

The influence of the Fed

In March, the US Federal Reserve made its first rate hike since 2018 – a major shift in US monetary policy, as the world’s largest economy started to reverse the extremely loose policy that had been in place during the pandemic. Recent history demonstrates that changes to monetary policy in the US can have a big impact on emerging markets. In 2013, the so-called “Taper Tantrum” was sparked by unexpected news that the Fed was about to slow its bond-buying programme.

Emerging markets are a liquidity taker, so when US financial conditions continue to tighten, then that will naturally draw liquidity away from the asset class.

Pramol Dhawan | Managing Director of Portfolio Management, Head of Emerging Markets, PIMCO

He described how emerging markets are an asset class at the perimeter, which investors move into for diversification and yield. But in a period when the core US risk-free assets are very volatile, it is very hard to confidently price the appropriate premium for emerging markets at the perimeter. At the same time, he said that spreads may not be sufficient to compensate investors in this particular cycle.

Despite all this, investors should not give up on emerging markets. “This is the time where active managers should be looking to unearth value,” said Mr. Dhawan. He pointed to debt that is trading at levels that indicates a recovery is likely to take place, as well as local currency markets where rates make up for the uncertainty over the Fed’s terminal rate.

Trading into headwinds

One of the most significant headwinds for growth in emerging markets this year is the surge in energy prices, which translates into bigger costs for many developing economies. Eastern Europe has been hit particularly hard.

But for some emerging markets, elevated energy prices can provide economic benefits. “The Middle East and Latin America are commodity exporters, accounting for a large proportion of the emerging market universe, and the high cost of oil and gas have helped support current accounts in certain countries,” said Polina Kurdyavko, Head of Emerging Markets and Senior Portfolio Manager, BlueBay Asset Management.

Another headwind is how emerging central banks react to Fed tightening, with Ms. Kurdyavko suggesting that its terminal rate could be higher than markets expect, even after upward repricing in recent weeks.

“The countries that would be most vulnerable in this environment are the frontier markets, which are the countries that do not have a deep domestic market to navigate through the low growth environment,” she said.

Inflation dynamics

Central bankers in both developed and emerging markets are working hard to control inflation. There are some initial signs, that in emerging markets, prices could be stabilising, said Diana Amoa, CIO, Long Biased Strategies, Kirkoswald Asset Management, citing a recent inflation surprise index that shows a balance between upward and downward surprises.

A deeper look into the numbers gives a more nuanced picture, she said. Downwards surprises have mostly been driven by headline inflation, due to the easing in energy prices. Upward surprises on the other hand, are more in core inflation, which makes it hard to suggest that inflation is actually improving.

“We are starting to have second-round inflationary effects, which we can see in some of the wage settlements that are being negotiated,” said Ms. Amoa. “Also in many emerging economies, there is monetary tightening but fiscal loosening.”

Away from energy prices, another area where inflation has caused concern this year is in agricultural commodities – especially in frontier markets that are dependent on imported food. In some countries, pressures have been alleviated by people going back to subsistence farming, while in other countries food security is more of an issue due to droughts.

The short-term pressures might abate, but the problem of food prices is actually more of a long-term trend. We will continue to see countries focusing on getting more domestic resilience in their food supply.

Diana Amoa | CIO, Long Biased Strategies, Kirkoswald Asset Management

Long-term growth prospects

Long-term investors in emerging markets are no strangers to volatility. But in the current wave of uncertainty, there is a lot to digest: global liquidity conditions, persistent inflation, and whether central banks have the tools they need to manage rising prices.

Investors in emerging markets are also aware that these developing economies offer some of the best long-term growth opportunities in the world. Those that can weather the near-term storm, will be well positioned to enjoy the next upward cycle in markets.

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