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EM Matters Summary - 14 September 2016

Core Content

The document outlines the current state of Emerging Markets (EM) in the context of global market dynamics, particularly focusing on the "yield grab" trend and its implications for EM bond markets. It highlights the key drivers of inflation and interest rate movements in various EM regions, including Latin America, CEEMEA, and Asia, while also addressing the risks and opportunities for investors.

Main Points

Global Market Trends

• The "lower for longer" global interest rate environment has been the dominant theme for 2016.
• Markets have become overly complacent about the possibility of a second Fed rate hike, but concerns over policy exhaustion in Japan and Europe suggest a potential "rougher ride" in the near term.
• The JPY has strengthened, acting as a key circuit-breaker for USD/CNY and dampening capital account vulnerabilities in China.

EM Bond Performance

• EM bonds have performed strongly in this environment, with a cumulative return of about 15% year-to-date.
• Despite lagging behind precious metals and German bunds, EM bonds remain one of the strongest global assets.
• However, much of the momentum from the yield grab may have been exhausted, with the potential for a short-term "market squall" due to near-term Fed rate hike expectations.

Inflation Dynamics

• Inflation in many EMs is expected to fall sharply due to declining food prices and wide output gaps, opening up room for substantial rate-cutting cycles.
• The document identifies Brazil, Colombia, and Argentina as key EMs where inflation is likely to drop significantly, creating opportunities for monetary easing.

Key EM Regions

Latin America

• Brazil:
  • Headline inflation is at 9.0% y/y, driven by food inflation of 16.8% y/y.
  • We expect inflation to fall to the 4.5% y/y target by year-end 2017.
  • The Central Bank of Brazil (BCB) is likely to implement a total of 525bp of rate cuts over the next 6-9 months, bringing the policy rate down to single digits by mid-2017.
• Argentina:
  • Inflation has entered a steady downtrend following initial spikes due to tariff hikes and peso devaluation.
  • The monthly inflation rate is expected to settle in the 1.5–2% range in Q4, with the annual rate dropping from 41% by year-end to 22% in May 2017.
  • The central bank may formalise an inflation-targeting regime in September 2016.

CEEMEA

• South Africa:
  • Food inflation is expected to fall sharply, shaving 1.0–1.2pp off headline inflation in 2017.
  • CPI is forecast to average 5.3% in 2017, down from 6.2% in 2016.
  • The South African Reserve Bank (SARB) is likely to cut rates in H2 2017, but political risks and a potential downgrade to 'junk' status in December may keep the bank cautious.
• Russia:
  • Food inflation has already collapsed, contributing to the sharpest disinflation in EM over the past year.
  • The Central Bank of Russia (CBR) is expected to cut rates by 50bp on 16 September, with further easing anticipated.
  • Inflation is projected to fall to 5% by mid-2017, allowing for a 350bp rate cut.

Asia

• Philippines:
  • A unique outlier in EM due to a booming domestic demand growth of 12%+ y/y.
  • The country is the only major EM expected to see rate hikes in 2017 for the "right" reasons.
• Taiwan:
  • A technical rebound in inflation is being driven by demand for electronic components and China's stimulus, but structural headwinds suggest further rate cuts are likely to support growth and inflation.

Key Risks and Opportunities

• US inflation shock: A potential rise in headline CPI from ~1% y/y to 2–2.5% could trigger a significant acceleration in wage inflation, impacting the "lower for longer" narrative.
• Policy risks: The BoJ and ECB have announced policy reviews, suggesting they may be running out of ammunition and ideas.
• Political risks: South Africa and other EMs face political uncertainties that may affect market stability and central bank decisions.
• Rate-cutting opportunities: EMs with high nominal yields, wide spreads to USTs, and potential for sharp inflation declines are expected to benefit from rate-cutting cycles.

Conclusion

The EM 'yield grab' is likely to resume after a period of complacency, with the greatest opportunities in countries where inflation can fall sharply, such as Brazil, Colombia, and Argentina. While the US remains a key influence, the potential for a US inflation scare and the ongoing policy challenges in Japan and Europe suggest that EMs may still benefit from a more accommodative monetary environment in the coming months. The Philippines stands out as an economic outlier, while Russia and Poland are expected to diverge in their monetary policy paths.