MUFG: The global interest rate shock and emerging markets

June 20, 2022

As H1 2022 draws to a close, EMs remain in a tough spot as tighter financial conditions, slowing global growth, and a pick-up in macro and market volatility, continues to weigh on the complex.

We are in a global interest rate and high inflation shock with longer-dated government bond yields rising sharply, weighing on flows to EMs. EM inflation is broadening beyond volatile energy and food prices to more domestically driven components, as well as deepening past our above-consensus forecasts. We are convicted that peak inflation remains some months away for most EM economies and given widespread evidence of rising inflation expectations, it is likely to be some time before inflation returns to more “normal” levels.

As we look into H2 2022, it is fairly clear that the top-down investment backdrop has turned quite unpleasant for many EMs, however there is ample heterogeneity across the complex. We continue to prefer EMs with flexible policy manoeuvre, attractive risk premiums and commodity links – the GCC region, South Africa and LatAm stand-out as most favourable.

FX views

It’s been a mixed week for EM FX performance though overall levels are close to year-to-date lows. The latest central bank policy updates (BoJ, Fed & SNB) over the past week did not trigger a further strengthening of the USD’s bullish trend, but have contributed to higher volatility in the FX market. We anticipate an extension of global equity market weakness to continue to encourage a stronger USD especially against higher beta EM FX. Our analysis shows that USD/MXN and USD/ZAR have had the strongest correlations to developed market equity performance over the past month.  

Trading views

Last week’s volatility brought back the old trading adage of if you don’t like the P&L of your positions just switched off your terminal and come back 24 hours later. A key standout for us is that risk premium for EM FX seems low given the global narrative that is making the rounds. This lack of risk premium is similar to the way VIX has not moved up much to the selloff that we have seen in equities this year. For the week ahead our bias continues to be more on RV rather than the major USD/Fed view. We are getting more excited about the recovery in CNY and like North Asia on this and the fact many currencies have central banks leaning against the move.

Week in review

Not all GCC central banks followed the Fed’s 75bp hike given inflation is more transient due to the flexibility of local labour markets, widespread administered pricing and no passthrough from FX (USD pegged). As we have preciously catalogued, GCC banks exhibit one of the strongest gearing to higher rates within the emerging markets space – they’re the biggest beneficiaries given their access to sizable non-interest bearing deposit bases while loan books are principally floating rate in configuration. Meanwhile, May inflation in Poland surged to 13.9% y/y owing to higher food and core prices, whilst Hungary raised its 1-week depo by a further 50bp to 7.25%.

Week ahead and calendar

In the week ahead, we have rates decisions in Czech Rep. (MUFG: +150bp to 7.25%), Egypt (MUFG: +100bp to 12.25%) and Turkey (MUFG: hold at 14.00%). Finally, South Africa consumer price inflation is expected to rise further in May, breaching the 6% target ceiling, at 6.2% y/y on account of food, fuel and insurance prices.

Forecasts at a glance

We continue to expect the easing of pandemic effects to supporting recoveries, although the going will get tougher in EMs – key risks stem from a continued tightening in global financial conditions and a lower gear in China.

Core indicators

EMs witnessed a second consecutive week of inflows (USD0.2bn – week ending 10 June) this year, led by equity flows (USD0.9bn) which offset debt outflows (USD-0.7bn), with investors appearing to have used the recent sell-off in equities as a buying opportunity.