EM Assets Plunge Amid US Rate Fears, Stagflation Concerns

Key Takeaway

• Emerging-market bonds and currencies suffered their worst performance since September due to fears of persistent high US rates and geopolitical tensions.
• Societe Generale turned bearish on EM currencies in February, anticipating stagflation in the US with negative impacts on EM assets.
• Despite challenges, some markets like India and Turkey present investment opportunities, with firms staying nimble amid a strengthening dollar.

Emerging Markets Face Headwinds

April witnessed a significant downturn in emerging-market (EM) assets, with developing-nation sovereign bonds experiencing their most substantial decline in seven months. A gauge of EM currencies also dropped to its lowest point since November, driven by concerns over persistent high US interest rates and escalating geopolitical tensions. Despite a rebound in early May, the selloff has led many investors to reassess their previously optimistic outlooks. Societe Generale SA and Mackay Shields highlight the impact of a strengthening dollar and a reevaluation of the Federal Reserve's rate trajectory, dampening hopes for EM gains in the near term.

Stagflation Concerns Rise

The specter of stagflation in the US looms large, with potential adverse effects on EM currencies and shorter-maturity bonds. Phoenix Kalen from Societe Generale noted a shift from bullish to bearish sentiment on EM assets, attributing the change to the challenging inflation environment and central banks' struggles to control it. The anticipated stagflation scenario is expected to hit markets sensitive to US rates, such as Turkey, Hungary, and Latin America, particularly hard, while Asia might be less affected.

Inflows and Investment Opportunities

The weakening of EM currencies against the dollar and the narrowing of real rate differentials between EM and the US have made the asset class less attractive from a carry perspective, according to Valentina Chen from Mackay Shields. However, not all is bleak, as economic resilience in certain EM regions, notably Latin America, and investment opportunities in countries like India and Turkey, provide some silver linings. Mackay Shields adopts a nimble approach to EM currencies, cautious of fighting against the appreciating dollar trend.

Rate Cut Expectations and Market Reaction

The US bond market rallied following a disappointing US jobs report, reviving expectations for Federal Reserve rate cuts by the end of the year. This shift in sentiment saw two-year Treasury yields drop significantly, indicating a market adjustment towards a softer monetary policy outlook. The bond market's reaction, coupled with dovish comments from Fed Chairman Jerome Powell, underscores the market's sensitivity to economic indicators and central bank communications. The adjusted rate cut expectations have also influenced currency and stock markets, with the dollar weakening and stock futures surging in response.

Street Views

• Phoenix Kalen, Societe Generale (Bearish on emerging-market currencies and shorter-maturity bonds):

  "This year has disappointed the expectations early on regarding the claim of victory over global inflation... Inflation has proven to be a much tougher adversary for central banks to tackle, so optimism over the EM rates story for this year has really crashed and burned." "We are expecting some version of stagflation to materialize, with attendant adverse impact on EM currencies and short-dated EM rates."

• Valentina Chen, Mackay Shields (Bearish on emerging-market debt):

  "Emerging-market FX weakening versus the dollar has a direct impact on performance mathematically but it also translates into the lack of inflows coming to the asset class... US rate repricing narrows the real rate differentials between EM and the US. This makes the asset class less attractive from a carry perspective."

• Alexander King, Payden & Rygel (Bearish on emerging-market assets):

  "A key driver of the disappointment was the fact emerging-market policymakers were unable to go ahead with as many rate cuts as expected based on local inflation and growth dynamics... The fundamentals of many EM nations still look pretty good, but it’s just so dominated by Fed."