EM local debt to shine as rate differentials remain elevated -PIMCO

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Local currency debt in emerging markets (EM) could offer investors a high-return, low-risk opportunity given the relatively steep differential in real rates between emerging and developed markets (DM), U.S. investment firm PIMCO wrote in a Thursday blog post.

As central banks across the world adjust policy to combat inflation, the varied approach and timing of moves has created “elevated differentials” between real rates in developed and emerging markets, the post said.

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“We think this could offer investors opportunities for uncorrelated returns in the form of EM local debt,” wrote Pramol Dhawan, head of the emerging markets portfolio management team at PIMCO, and Lupin Rahman, head of sovereign credit at the firm’s EM portfolio management team.

“And yet, investors must be discerning.”

Varied central bank reactions to inflation spikes that, in some cases, are the largest in decades are a trigger of the rate differential. While PIMCO expects EM inflation to gradually trend lower this year and next, they don’t see it slowing to pre-shock levels until after 2023.

Given the higher weighting that food and energy have in EM inflation, DMs could more faster return to smaller price changes.

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Some EM central banks hiked rates in anticipation of tighter monetary policy from the U.S. Federal Reserve, triggering the rate divergence not only to their developed peers but also among EMs.

PIMCO points to outliers given the outsized inflation shock to Poland from Russia’s invasion of Ukraine, a “secular erosion” that has affected inflation expectations in Mexico, and “policymaking missteps” like those in Turkey, where rates have fallen to 14% despite inflation shooting above 70%.

More broadly, PIMCO wrote, “we expect EM central banks to take their cue from the (United States) as more clarity emerges on the U.S. economic outlook and the Fed’s tightening path.”

The differential between EM and DM real rates is unusually high and their asynchrony “may offer DM investors a rare opportunity for uncorrelated return potential in the form of EM local debt, which is denominated in an issuer’s domestic currency.”

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PIMCO said currency appreciation should help ease EM inflation, singling out Brazil as the real is up over 8% versus the dollar so far this year and the benchmark rate has risen upwards of 11 percentage points so far this cycle, to 13.25%.

With the real one of the best-performing free floating EM currencies this year, PIMCO wrote of looking for “select opportunities” such as betting on local-currency Brazilian bonds while cutting exposure to Polish local debt.

“To become more bullish on EM currencies more generally, we would need to see this self-reinforcing dynamic broaden and strengthen, particularly in the wake of past false starts,” PIMCO said.

“If this dynamic does take hold, it could mark a major break from the past decade of U.S. dollar dominance.”

(Reporting by Rodrigo Campos in New York Editing by Nick Zieminski)