Wall Street pins second-half hopes on emerging markets, including India

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With hopes for a monetary-policy pivot in the U.S. and Europe dashed, money managers from Goldman Sachs to Citigroup are touting interest-rate cuts in emerging markets as a major investment theme for the second half of 2023.

Local-currency bonds in the developing world are already outperforming U.S. Treasuries, with their average risk premium falling to a decade low. That’s prompted Goldman Sachs to advise its clients to lock in current yields in Indonesia, Israel and South Africa via interest-rate swaps, and Citigroup to recommend similar trades in India, South Korea and Brazil. HSBC, on its part, favors long-duration bonds especially in Latin America.

The optimism follows growing evidence that emerging economies are stealing a march over richer nations in achieving peak inflation and terminal rates. The roster of developing countries pausing their interest-rate hikes is growing: Taiwan, India, Indonesia, Poland and Mexico. Hungary even cut rates and signaled further easing, while Brazil’s central bank has opened the possibility of a rate cut in August.

“Emerging-market central banks have got on top of rising inflation expectations a lot quicker than their developed-market peers and are now reaping the benefits,” said Paul Greer, a money manager at Fidelity International. “Until recently we had felt EM central banks might wait until the Federal Reserve gives the green light on easing monetary policy for them to start cutting. We now think this will happen regardless of Fed policy.”

What enables developing nations to move quickly on rate cuts is a combination of high nominal borrowing costs, falling inflation and low currency volatility. The Citi Emerging-Market inflation surprise index has fallen in 11 out of the 12 months to May, showing how price pressures have been undershooting estimates. Unlike the U.S. or Europe, countries including Indonesia and Thailand have brought consumer-price growth within their target bands, while Brazil is on the verge of doing so.

“Many emerging markets were far more aggressive with policy rate hikes, never believed inflation was ‘transitory,’ and now provide investors with a substantial real-yield buffer,” said Aninda Mitra, Head of Asia Macro and Investment Strategy at BNY Mellon.

Interest-rate swaps, which involve exchanging a floating rate for a fixed rate and vice versa, have become the first stop for money managers as they dip their toes back into the dovish-pivot theme after two years of hawkish moves across the world.

Goldman Sachs says investors should agree to receive fixed rates in rupiah, shekel and rand and pay floating rates on them over a five-year tenor. The so-called receiver trades should focus on two-year Korea rates on expectations the Bank of Korea will start easing cycle in October, Citigroup says. It also recommends a two-year receiver trade in India and Brazil swaps.

Some investors are taking the bond route, preferring to own long-duration securities that become attractive in a falling-rate scenario. HSBC recommends the debt of Brazil, Mexico, Indonesia, South Korea and Czech Republic as disinflation is gathering pace in these countries and will be reflected in yields. Greer of Fidelity said his top picks include Brazil, Mexico, Colombia and Peru as Latin America is at the forefront of this cycle.

Strategists at Morgan Stanley added a voice of caution, warning in a note on Monday about the risks of so many of their clients being invested in carry trades.

“While low inflation might justify a steep easing cycle in EM, and even keep real rates steady, the sharp narrowing in nominal interest rate differentials that this implies would likely leave EM local markets vulnerable to shocks,” strategists James Lord and Ioana Zamfir wrote in a note.

A weaker trending U.S. dollar as well as a plunge in currency volatility are emboldening investors to take bets on assets denominated in local currencies. An index of carry trades in eight emerging-market currencies handed investors a near 5% return in the first half, the best since 2017.

“Historically high carry-to-volatility ratios are too attractive for investors to ignore,” said Eimear Daly, a strategist at Natwest Markets in London, adding that “despite the global growth concerns, this remains an EM carry trade environment.”