Investors are rethinking what was the go-to trade in emerging markets at the start of the year: betting on rising short-term rates as rampant inflation forced central banks into action.
With global financial markets pivoting to strategies that take advantage of a recessionary environment, money managers are saying the developing world holds some of the best opportunities to profit from falling yields. Part of the allure is because emerging-market currencies got hammered amid a surge in the US dollar, which has just started slipping from its peak amid signs of an economic slowdown.
In the first half of the year, the prevailing mindset focused on rate hikes amid expectations that central banks would be more aggressive in face of the Federal Reserve’s policy of monetary tightening and rising inflation. Now, investors are starting to see value in wagers that developing economies will have to start cutting interest rates to avoid a recession.
“There is a lot of risk premium in EM curves and higher-quality countries should see a bid for duration on the back of global economic slowdown concerns,” said Jens Nystedt, a senior portfolio manager at Emso Asset Management in New York. “It’s peaking inflation and a global slowdown, but most of all, the excessive risk premium. Mexico stands out together with central Europe and possibly South Africa.”
JPMorgan Chase & Co. recently closed an underweight recommendation on local rates as the bank’s strategists turn neutral, citing global growth concerns and moderating commodity prices. The bank is gradually turning from payer — a bet that profits from the rise in interest rates — to flattener positions in emerging Asian countries like Malaysia and South Korea as well as in Brazil.
Investors across the globe are starting to mull taking more interest-rate risk on the view that bonds have been hit hard enough and that longer-dated rates have room to fall. Emerging markets would offer an extra advantage, that is high-risk premium in bond and rates curves.
“Heading into recessions or global growth slowdown, usually EM local rates are the EM macro asset class that outperforms, and we have in fact seen that clearly year-to-date” Davide Crosilla, a Goldman Sachs strategist said.
Even so, not everyone is ready to go outright overweight in emerging-market local rates just yet. Arnab Das, a global market strategist at Invesco Asset Management Limited in London, said it’s hard to argue going overweight duration for developing markets given it’s still uncertain whether inflation has peaked.
“I don’t think we’re in the ninth inning yet,” Das said. “I would maybe start to put my toes into the receiving positions, but I wouldn’t go all in,” he added, referring to interest rate swap bets that profit from falling rates.
Latin America is a place where many are still wary of adding receivers as swap rates keep rising amid growing fiscal risk. Brazil and Colombia’s long-end rates rose over the past month, even as five- and 10-year US Treasury yields dropped.
Still, for some investors that want to get ahead of the broader trend, extending duration holds some appeal. They expect to see rate-hike cycles pause or end, paving the way for building positions that profit from falling rates.
“Some emerging markets have done a very good job of managing inflation and hiking early,” said Whitney Baker, the New York-based founder of Totem Macro. “LatAm and Eastern Europe are nearly done with hikes.”