Gauging Emerging Local Markets

Strategic asset allocation doesn’t typically preclude investing in volatile assets— when done judiciously it can likely benefit from them. A main ingredient is an accurate assessment of the risk and the return potential a portfolio requires. As we gauge the broad opportunity set available to investors, we believe one of the more volatile sectors may be offering a level of potential return that accounts for its risks.

Consider the sharp divergence in monetary policy cycles between emerging markets (EM) and developed markets (DM). EM hiking cycles are well underway and reaching maturity in some cases (e.g., Brazil), while core DM central banks are just beginning their hiking cycles, though a lot is priced in now (e.g., US). In our view, this policy rate divergence could be creating interesting investment opportunities in EM local markets. Global central banks have been confronting a broad-based acceleration in inflation, which has reached historically high levels. Because EM inflation has outpaced average DM inflation, EM central banks have appeared to respond more proactively and aggressively in comparison.

Assessing Risk: Peaking EM Inflation?

In line with global inflation trends, sequential EM inflation generally remains high. Persistent supply chain issues, along with strength in commodity prices, suggest that risks to inflation are biased to the upside. In the near-term, the escalating Russia-Ukraine war is adding further price pressure to commodities; namely, grains, oil, natural gas and metals prices.

While it may be early to call a peak in EM inflation, EM yields rose significantly in 2021 as inflation surprised to the upside. EM central banks responded appropriately by hiking rates well before the Federal Reserve’s (Fed’s) hawkish pivot.