Inflation has been a hot topic among investors, particularly in the developed world, and central banks such as the Bank of England and the Federal Reserve are under increasing pressure to raise interest rates as a result.
However, this is old news in the emerging markets (EM), where many countries have already increased rates in an effort to stamp down inflation and stop their currencies from depreciating.
This accelerated as the US dollar strengthened, with countries ranging from Brazil to Russia and South Korea now tightening policy.
However, Wei Li, global chief investment strategist at BlackRock Investment Institute, said the result is that the emerging world now has a head start in normalising policy.
On average, interest rates across the emerging market countries now stand at 3.2% versus near zero or negative in the US and eurozone.
“Emerging market central banks historically have had less credibility, while inflation and currency pressures have been much greater. But many are acting earlier and faster this time to prevent things from spinning out of control,” she said.
Although this has “pressured growth” that was “already hurting” from a delayed vaccine rollout, it does make one asset class particularly interesting: emerging market bonds.
Traditionally, tightening by the Fed has often been difficult for emerging markets as investors start to demand more compensation for holding riskier assets. However, Li said that she does not expect rates to rise in the US until the middle of next year.
“The emerging market approach has created a large interest rate buffer versus developed markets (DM), lowered valuations and raised coupon income,” she said.
“This makes EM debt attractive versus DM credit in a world starved for yield and improved valuations and coupon income should help cushion any yield rises and prevent disorderly moves in EM bonds when the Fed lifts off, we believe.”
She did not expect a repeat of 2013’s taper tantrum, when the Fed cut back asset purchases and caused “havoc” for emerging market assets.
Li said rate increases are likely to slower and more incremental this time around, while emerging market countries were also better positioned against a stronger dollar this time around.
“Currencies have adjusted, foreign ownership has declined, and inflation-adjusted yields have risen,” she said.
However, not everything will do well. Investors should look towards emerging market local-currency debt as the best option, as current yields and currency valuations “compensate for the risks”.
It also has relatively low duration, or sensitivity to rising rates, and diversification benefits, with the strategist noting that BlackRock was “modestly overweight” the asset class.
Elsewhere, Li said that global inflation is likely to persist, but that the supply-demand imbalance should right itself next year and interest rates will remain low, particularly in the US and Europe where the central banks are more tolerant of inflation.
She also said that Chinese equities are a strong option for investors, despite the series of regulatory crackdowns this year that have spooked the market.
Performance of indices in 2021
Source: FE Analytics
“A growth slowdown has hit levels policymakers can no longer ignore and we expect to see incremental loosening across three pillars - monetary, fiscal and regulatory,” said Li.
“We believe global investors should raise their allocations to Chinese assets for potential returns and diversification, given the small benchmark weights and typical client allocation to Chinese assets. Allocations would need to increase significantly before they reflect a bullish view, in our opinion.”
Finally, she said investors needed to update their portfolios towards ethical and sustainable funds as governments target net-zero goals.
Although the timeline is to reach this by 2050, companies and investors should be looking at adapting today for the new future.
“The green transition comes with costs, yet the economic outlook is unambiguously brighter than a scenario of no climate action. We see sustainability-driven repricing as having just begun – with accelerating flows into ESG products a big drive,” she said.