EM inflation past the peak with the rate hiking cycle in the final stretch

EHSAN KHOMAN
Head of Commodities, ESG and
Emerging Markets Research –
EMEA
DIFC Branch – Dubai
T:+971 (4)387 5033
E: ehsan.khoman@ae.mufg.jp

RAMYA RS
Analyst
DIFC Branch – Dubai
T:+971 (4)387 5031
E: ramya.rs@ae.mufg.jp

LEE HARDMAN
Senior Currency Analyst
Global Markets Research
Global Markets Division for EMEA
T: +44(0)20 577 1968
E: lee.hardman@uk.mufg.jp

PAUL FAWDRY
Head of Emerging Markets FX Desk
Emerging Markets Trading Desk
T: +44(0)20 577 1804
E: paul.fawdry@uk.mufg.jp 

MUFG Bank, Ltd.
A member of MUFG, a global financial group

Macro focus

We catalogued back in November 2022 that is was worth being optimistic about the disinflation process in EMs (see here and here). Yet, whilst headline CPI clearly appears to be past the peak, core inflation – particularly services – remains above central banks targets (or implicit comfort zones) in many EMs. From a monetary policy perspective, EMs have tightened significantly over the past two years, taking real policy rates well into positive territory in most places, and we view this quarter is likely the last one of the current cycle when more EM central banks will be tightening than easing. We expect LatAm to lead the way on rate cuts in Q3 2023, whilst selected EM EMEA and EM Asian central banks should join in the final quarter of this year, with their numbers growing in early 2024.

 

FX views

The USD has continued to strengthen on the whole against EM FX over the past week with continued derived support from the sharp rebound in US yields. After the latest PCE deflator report for April revealed that core services inflation remained sticky, the release of the NFP report on Friday could tip the balance decisively in favour of another hike if employment growth remains strong as well. The deal to suspend the US debt ceiling if passed in Congress as expected will avoid another negative shock to the US and global economies. It is a supportive development as well for EM FX carry trades as it will help to support the current lower level of FX volatility.

 

Trading views

Local stories are at the fore in EMFX currently. The overall benign, carry friendly, environment is hiding some of the big dislocations taking place in particular currencies. Nowhere is this better seen than in Turkey or South Africa. We wrongly thought that the positive economic backdrop of low vol would help ZAR to recover somewhat over the last few weeks. This was far too optimistic given the local factors at play. Meanwhile, EM Asia has continued to disappoint with China’s problems and the low carry in the region at the fore. The China aspect we feel will continue given the backdrop there. While authorities may warn against the setting of the fixes is not giving any clear signals. More importantly not only is liquidity loose, it is getting looser with a lot of fresh injections being carried out.

 

Week in review

Turkey’s President Erdogan secured a new five year term – the laser focus remains on the sustainability of Turkey’s external dynamics through the Central Bank of Turkey’s (CBRT) FX reserves and the Turkish Lira (TRY). Our base case scenario is that authorities may respond with additional regulatory measures to address the risk of dollarisation, as well as to secure bilateral funding from other central banks or other sources, to ease pressures on the widening current account deficit. Meanwhile, Hungary cut its one-day deposit rate by 100bps to 17.00% – it’s first step in easing Europe’s highest policy rate. The South African Reserve Bank (SARB) raised its key policy rate by 50bp from 7.75% to 8.25%, in line with our expectations, taking the rate to its highest level since 2009. Finally, the Central Bank of Turkey (CBRT) kept its policy rate flat at 8.50%, in line with our (and consensus) expectations and critically did not offer any insights on forward guidance or about a policy change.

 

Week ahead

This week, headline inflation in Poland is set to decline by 0.5ppt to 13.9% y/y in May (consensus 13.4% y/y). Turkish Q1 2023 GDP is expect to increase by 0.6ppt to 4.1% y/y (consensus 3.5% y/y). Finally, May readings for EM EMEA PMI may tick downwards as corroborated by our nowcast models (see here).

 

Forecasts at a glance

Whilst EMs continue to grapple with much the same themes at the turn of the year, we view the outlook as a tale of two halves in 2023. A fading boost from reopenings, a global manufacturing cycle downturn and tighter financial conditions are lumpy headwinds that will weigh on EM prospects in the first half of 2023. However, China’s zero COVID policy exit, the eventual end of rate hikes and a US dollar peak, all offer significant tailwinds to the EM complex in the second half of 2023 (see here).

 

Core indicators

According to IIF data, there was portfolio outflows to the tune of USD-0.4bn as inflows into EM equity funds (USD0.1bn) were more than offset by outflows from EM bond funds (USD-0.4bn), last week.

 

CHART OF THE WEEK: YEAR-TO-DATE PERFORMANCE DRIVES EM OPTIMISM

EM EQUITIES, FX, RATES AND CREDIT (YEAR-TO-DATE), TOTAL RETURNS (%)