The month of April was characterized by a significant sell-off in US Treasuries on the back of stronger data in the US and fears of sticky inflation. Furthermore, explains Anisha Goodly, Managing Director, Emerging Markets, TCW, the escalation of geopolitical risk in the Middle East led to higher oil prices and volatility, before easing slightly at the end of the month. In the short term, the economic and inflationary prospects of emerging markets remain good: global growth continues to show some pockets of unexpected resilience, China's lopsided recovery gathers steam and emerging market inflation gradually slows. Some large countries, such as India and Brazil, show robust economic growth, the TCW expert points out, while others are starting to change direction after brief economic slowdowns or shallow recessions.
2024 will be a period of transition towards a more favorable environment in the medium term for emerging markets, thanks to more accommodating monetary policies in the main economies, the potential weakness of the dollar and the refocusing of the large emerging economies towards the objectives of potential growth and of inflation.
The fundamentals of emerging markets are reasonably solid and sovereign defaults are not expected for 2024.
Compared to a debt/GDP ratio that exceeds 100% in developed economies, it stands at 67% in emerging markets. Furthermore, rating upgrades are expected to outnumber downgrades for the first time in a decade. Recent improved countries include: Argentina, Benin, Brazil, Ivory Coast, Jamaica, Qatar, Turkey and Uruguay.
Focus on monetary policy
In the short term, the market will be driven by expectations about US monetary policy and global growth. Volatility is expected to decline as there is greater clarity on the start of the Fed's easing cycle, which could push flows into emerging markets and other risk assets. For the current year, emerging market hard currency returns are expected to be driven largely by carry and supported by lower US rates.
As for the local currency, Anisha Goodly points out, Emerging market real rates continue to remain attractive compared to developed market rates. In Brazil and Mexico the ex-ante real rates are around 6-7%, in Colombia around 5%, in Indonesia and South Africa at 3-3.5%, well above the US real rate which stands at 2.1%. The recent sell-off in local currency duration was not only driven by rising US yields, but also by increased volatility in US rates. As the volatility shock fades, it is believed that central banks in emerging countries with strong disinflationary tendencies will be able to cut rates, even if the Fed postpones the rate cut again.
The dollar is weakening
The US dollar is found in one oscillation band since the beginning of 2023 and, in our view, should start to weaken once markets are convinced that the Fed is on the path to easing. Another important factor for the dollar's performance in the future will be global growth. Despite being at the beginning of the economic cycle, global Purchasing Managers' Indexes (PMIs) are starting to improve, while demand for raw materials is also increasing. The European growth prospects, says the TCW expert, are improving, after taking into account the increase in rates and the decrease in demand from China, which hit Europe in 2023. Furthermore, while the Chinese recovery is been uncertain and uneven, This year's China data surprised on the upsidethanks to a series of more targeted measures, including interest rate cuts, the removal of building restrictions and local government debt swaps, which are starting to have a positive impact on the economy.
Risks to monitor
Geopolitical risks remain a source of concern. Although our baseline scenario for the war between Israel and Hamas assumed that the fighting would remain within the region, the recent escalation between Israel and Iran, with its allies, has increased the probability of an expansion of the conflict which is feared will continue for a long time.
On the electoral front, the American elections could be a source of volatility in the second half of the year, given the divergence between the candidates' trade and foreign policies. If Donald Trump were to be elected president, he could impose his controversial 60% tariffs on China and also hit long-standing American allies (Canada and the European Union) with huge new tariffs. US data suggests a soft, rather than hard, landing. However, the risk remains that high rates maintained for a long periodplunge the US economy into a negative spiral, causing a widening of spreads, in particular those of high-yield bonds.
