The Fed is walking a tightrope to curb inflation
The annual inflation rate in the US reached 7% as of the end of December 2021, its highest level in four decades. This figure is all the more extraordinary when remembering pre-pandemic days when the Fed was struggling to maintain an inflation rate close to its 2% target. The pandemic has brought forth a flurry of issues that have contributed to this significant rise in the inflation rate. The key drivers included supply chain disruptions, goods and labour shortages as well as rising commodity prices.
Over the past two weeks, Russia’s invasion of Ukraine has pushed commodities prices and in particular that of oil sharply higher. The unfolding of events is near impossible to predict. However, if the war in Ukraine does not impede global growth substantially and financial stability is not threatened to a worrying extent, we believe Central Banks globally will stick to their initial mandate and focus on rising inflationary pressures. Our outlook below focuses on a scenario where global financial stability is not altered to an extent that would derive Central Banks from their tightening intentions.
Until those geopolitical developments, the largest contributor to inflation over the past year has been supply chain disruptions and logistics bottlenecks. Going forward, an important threat could come from the labour market with workers demanding higher wages to compensate for higher prices and a deteriorating purchasing power.
In order to contain inflation expectations and prevent an inflation spiral from happening, the Fed will have to tighten its monetary policy, in other words, raise interest rates. Unfortunately, higher rates will weigh on consumer demand and only tackle the consumer-side of inflation whilst not addressing the supply-side of the matter. The Fed is hence facing a particularly difficult situation where it needs to contain inflation dynamics and tighten its monetary policy at a time where business activity and growth prospects remain fragile. The latest geopolitical developments are threatening global growth and making Central Bank’s mandates even more difficult. The pace of monetary tightening and the Fed’s flexibility in navigating this environment will be crucial in limiting risks to the global recovery.
Away from the US, we think that Emerging Markets are in a much better place today than during the taper tantrum in 2013 to withstand a Fed tightening cycle. We consider Emerging Markets’ external accounts to be much healthier on balance. In 2021, fewer emerging economies were relying on short-term capital inflows to finance their current account deficits than in 2013. In addition, many Central Banks across Emerging Markets – Brazil, Mexico, Chile, South Korea, Czech Republic to name a few – have acted quickly and already embarked on a tightening cycle in order to tackle inflationary pressures.
Unlike financials, many sectors will suffer from an inflationary environment
In environments with relatively high inflation and rising interest rates, cyclical sectors such as energy, including clean energy, and financials usually tend to outperform. We expect the financial sector to be a big beneficiary of the tightening cycle we are about to witness in the US. Rates charged by financial institutions to their customers are tied to Central Bank’s interest rates. financials’ profits are hence directly linked to interest rates and their margins should expand as interest rates rise. Away from financials, we believe corporates will have to pay particular attention to their cost base in order to tackle rising prices. If corporates are unable to pass on the increase in their production costs, their margins will suffer as a result. We therefore assume that corporations with a robust cost discipline in place will navigate this inflationary environment better than others. On the currency front, higher interest rates in the US should lead to USD appreciation. The rationale behind this phenomenon is that higher interest rates should drive asset yields higher and attract investor flows. The corollary to a stronger USD is that local currencies are likely to weaken. Consequently, issuers whose balance sheets exhibit a currency mismatch could suffer in the coming months. With that in mind, Emerging Markets countries that have borrowed significantly in USD need to manage their liabilities and current accounts carefully.
Active management and issuer selection will be key
In such an environment, being active in issuer selection will be key, in our view. There are notably several issuer types we warrant a cautious approach with. Firstly, we expect highly levered issuers to be especially vulnerable to a move higher in interest rates. Higher rates imply higher funding costs, which can be painful for issuers who are heavily reliant on wholesale funding and high debt levels to finance their operations.
Secondly, it will be important to monitor the potential currency mismatch between issuers’ assets and liabilities. An issuer raising funds in USD might face difficulties in refinancing their debt as the USD appreciates and the value of their liabilities rise. Those issuers could see their credit profile deteriorate in a strengthening USD environment. Out of two issuers with an equivalent credit profile, we believe the one whose liabilities are largely denominated in local currency will face a smaller default probability than the one relying largely on USD funding. We therefore think that portfolio managers lending in local currency are somewhat sheltered from risks arising from a stronger USD. In such an environment, local currency lending represents an attractive opportunity. That being said, we would warrant those portfolio managers to hedge their currency exposure through derivatives in order to limit portfolios’ exposure to local currency depreciation.
Finally, weaker countries might experience hyperinflation coupled with a potential currency crisis. In those environments, Central Banks usually need to tighten their monetary policies swiftly and significantly, leaving issuers with considerably higher borrowing costs. On a positive note, various Central Banks in Emerging Markets have already hiked their interest rates which should protect their local currencies and economies. We therefore tend to avoid issuers whose main business activities are in countries with weak monetary policy frameworks in place.
In 2022, volatility in financial markets has been high and this trend has been exacerbated by the war in Ukraine over the past two weeks. Whilst such a backdrop represents various risks, we believe fundamentals in Emerging Markets are more solid than during the taper tantrum in 2013. A volatile environment usually offers compelling entry points and issuer return dispersion. In our view, Emerging Markets provide numerous attractive opportunities. Nevertheless, hedging strategies and a robust diversification will be key tools for alpha generation in the coming months. Bearing this in mind, at Blue Orchard, public debt portfolios have interest rate hedging strategies in place which should benefit the funds when interest rates move higher.
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