Loose developed market (DM) monetary policy, rising commodity prices and effective COVID-19 vaccines are converging to drive global capital flows to emerging markets (EMs). In our view, these dynamics are likely to overshadow challenging domestic fundamentals and reboot growth in most economies, supporting local currency assets.
Capital flows to emerging markets typically accelerate following global recessions. Yet we believe the backdrop to 2021, while not without risk, has the potential to be record-setting for several reasons.
A strong synchronized recovery is anticipated. The cyclical rebound from 2020’s stop-start pattern is likely to be vigorous and highly synchronized globally in 2021. Vaccine distribution is set to be concentrated within the first half across advanced economies, and governments have committed to avoid premature fiscal retrenchment. Meanwhile, large negative output gaps (the difference between the actual and potential output) are anchoring low inflation and reinforcing DM central bank commitments to keep financing conditions extremely accommodative, which suggests negative DM real yields will persist beyond 2021.
Global manufacturing is robust. Emerging markets are typically a levered play on global manufacturing growth. Following the initial lockdown, manufacturing growth rebounded strongly and remained resilient during the second and third virus waves. Even if domestic demand remains relatively weak amid the COVID-19 flare-up and moderating fiscal stimulus, many EMs are well placed to benefit from a resilient global manufacturing cycle and the eventual boost from pent-up demand as mobility returns to normal.
Figure 1: U.S. dollar has weakened relative to emerging market currencies during periods of global manufacturing growth
A weaker U.S. dollar reflates EM growth. Dollar depreciation, the counterpart to rising EM capital inflows, increases the price of dollar-denominated EM exports and boosts the ability of EM countries to repay dollar-denominated debt. All else equal, the confluence of strong capital inflows, higher export prices and looser financial conditions should serve to boost EM growth.
Easier Fed stance drives EM capital inflows. Strong empirical evidence shows that changes in the U.S. Federal Reserve’s (FED) overall policy stance, as proxied by shadow short interest rates*, lead changes in capital flows to EM by three quarters. The Fed’s easing in 2009 was followed by a record of $440 billion of inflows in 2010. This cycle, shadow U.S. short-term rates fell 390 basis points during 2020, almost double the 2009 drop in rates. Flows to EM, which tentatively began to recover in April, have begun to accelerate. In November, $76 billion in foreign capital flowed to EM, the largest-ever monthly inflow. Given the atypical confluence of so many external factors and the dearth of yielding alternatives, it seems reasonable to expect that capital flows to EM in 2021 will not only exceed the average of $280 billion over the last decade, but also surpass 2010’s record.
Figure 2: Capital flows overshoot following global or local recessions
Strong fundamentals underpin a potentially vigorous recovery
The current appeal of EM runs deeper than a shift in external dynamics. The majority of EM countries have strengthened their economic fundamentals, providing the flexibility necessary to sustain major shocks. Sweeping economic improvements include reduced levels of inflation and foreign currency denominated debt, a more robust financial system, and greater exchange rate flexibility. (To learn more about how EM economic fundamentals are improving, read Harvesting Yield in Emerging Markets.) These stronger fundamentals are reflected in well-contained debt service costs. While sovereign debt in aggregate (measured by debt of the constituents in the JPMorgan EMBI-Global Diversified Index) has grown by 15 percentage points of GDP over the past five years, debt service costs have risen just 0.5 percentage points.
Stronger fundamentals are also enabling many central banks to follow their developed market counterparts for the first time, easing monetary policy and, in some limited cases, directly financing government deficits. In previous global recessions, many EM economies were forced to tighten policy to keep their currencies from weakening relative to the dollar and prevent ballooning in dollar-denominated debt service. We believe these economies, most notably Brazil and South Africa, should outperform their EM peers in an environment where strong external factors are poised to alleviate acute domestic financing constraints reflected in steep local yield curves.
Yet the landscape is increasingly bifurcated, with some countries faring much worse. A minority of countries with large dollar-denominated debts and relatively fixed exchange rates have seen debt service costs rise by more than one percentage point of GDP. This smaller subset could face material solvency risks going forward should an inability to secure a sufficient, timely vaccine supply preclude a strong economic recovery. We believe effectively evaluating the complex landscape requires deep expertise and global scope.
While sovereign credit spreads and real local government bond yields are below the historical average, they are attractive relative to equivalent domestic market corporate credit spreads and government bond yields, respectively, according to our analysis. EM high beta currency valuations and implied volatility remain similarly cheap to their G10 peers in our view. While not without risk, these attractive valuations amid the confluence of strong capital inflows, higher export prices and looser financial conditions, provide tailwinds for EM local bonds.
To learn about PIMCO’s sector-specific views within the emerging markets asset class, read “Emerging Markets Asset Allocation: Opportunities in a Time of Uncertainty”
*The “shadow rate” tracks the movements of various benchmark data when the federal (fed) funds rate hovers near zero and many economic models stop working. The “shadow rate” can stand in for the fed funds rate, drop below zero, and make those models functional again.
Gene Frieda is a global strategist and Pramol Dhawan is a portfolio manager covering emerging markets.