Many investment banks are betting on the prospect of interest rate cuts in emerging markets in the second half of the year. Why does Morgan Stanley “pour cold water”?

Many investment banks are betting on the prospect of interest rate cuts in emerging markets in the second half of the year. Why does Morgan Stanley “pour cold water”?

How about the return on investment in emerging markets in the second half of the year?

In the first half of this year, many market participants were optimistic about emerging markets because of the prospect that emerging markets would be the first to cut interest rates, and related transactions were also profitable.

Entering the second half of the year, as the possibility of the Federal Reserve and the European Central Bank suspending interest rate hikes is shattered, a number of institutions including Goldman Sachs(326.61, 4.07, 1.26%)Morgan Stanley(86.41, 1.01, 1.18%) warned against falling bets on rate cuts in emerging markets.

Emerging market bonds, carry trade high returns in the first half of the year

In the first half of the year, Bloomberg’s index measuring the investment return of eight emerging market currencies against the US dollar carry trade rose by about 4.8%, recording the best half-year trend since 2017. Among them, the Mexican peso against the U.S. dollar arbitrage trading income as high as 18%, the rate of return of the Hungarian forint and Brazilian real also reached 15.4% and 14% respectively. JPMorgan .(146.61, 1.17, 0.80%)

Not only currencies, local currency bonds of emerging market economies have also outperformed US Treasuries, and their average risk premium has fallen to the lowest level in 10 years.

The performance of the emerging-market asset has been helped by expectations of rate cuts. In this round of global interest rate hike cycle, emerging economies preemptively raised interest rates about a year earlier than the Fed. And entering this year, there is growing evidence that emerging economies are ahead of developed countries in achieving peak inflation and eventual interest rates. The Citi Emerging Markets Inflation Surprise Index fell in 11 of the past 12 months to May, showing that inflationary pressures in emerging markets have been weaker than expected. Higher nominal borrowing costs, falling inflation and low exchange rate volatility give emerging markets more confidence in policy shifts: while Europe and the United States still maintain their “hawkish” stance, more and more emerging economies are suspending interest rate hikes , such as India, Indonesia, Poland and Mexico. Hungary has even started to cut interest rates and released a signal of further easing, and the Central Bank of Brazil has also opened up the possibility of cutting interest rates in August.

Fidelity International (Fidelity International) fund manager Greer (Paul Greer) said, “Emerging market central banks are faster than advanced economy central banks to control rising inflation expectations and benefit from it. Previously, we believed that emerging market central banks May wait until the Fed gives the green light to ease monetary policy before starting to cut rates, and now we think EM central banks will start cutting rates regardless of Fed policy.”

“Many emerging economies have been much more aggressive in raising (45.07, 0.55, 1.24%)( than advanced economies ) , Inflation was never viewed as ‘transitory’, which allows them to provide investors with a substantial real yield cushion today.”

They remain bullish on the ’emerging market rate cut’ theme

Entering the second half of the year, many analysts continue to be bullish on the carry trade. Eimear Daly, a strategist at NatWest Markets Plc in London, said: “The arbitrage-to-volatility ratio, which is currently at a historically high level, is too attractive for investors. Despite concerns about global economic growth, the current environment Still favoring EM currency carry trades.”

Barclays analyst Bum Ki Son also wrote in a note last Friday: “This (carry trade high return) trend will continue throughout the summer. The spread between emerging markets and the United States remains high, especially in Latin America and Hungary. , able to offer a higher premium than the core rate.”

Carry trade returns in the first half, however, were concentrated in Latin America, with investors betting on the South African rand and Turkish lira recording losses. Carry trades betting on the lira have lost more than 14 percent in the past month alone as the Turkish government began loosening foreign exchange controls. Bets on emerging-economy currency carry trades in the second half of the year should also be selective, according to strategists. Most fund managers prefer Latin American and Asian emerging market currencies.

Daly said, “(Emerging market currencies) carry trade is still the general trend, and you can’t fight it. However, investors must also realize that in addition to high interest rate differentials, if you want to obtain high returns, you also need the economies of the relevant economies. Fundamentals are strong and domestic political risk is low.”

Nomura Securities even believes that even if Europe and the United States also start monetary easing, which makes emerging market currencies start to weaken, it will not affect the arbitrage trade, but will “open up buying opportunities in some emerging markets, especially in emerging markets in Asia and parts of Latin America. (Brazil and Mexico) and South Africa. But it will also expose the vulnerability of other emerging market currencies, especially in Eastern Europe, the Middle East and emerging economies in Africa.”

In addition to carry trades, investment banks also continue to be bullish on local currency bonds from emerging economies.

Goldman advises clients to lock in current yields in Indonesia, Israel and South Africa through interest rate swaps and pay floating rates over a five-year period. Citigroup advises investors on similar deals in India, South Korea and Brazil. Citigroup said that the market expects the Bank of Korea to start an easing cycle in October, so attention should be paid to two-year South Korean bonds.

HSBC and Fidelity prefer long-term bonds because they believe that long-term bonds in some emerging economies will become more attractive in the ensuing environment of interest rate cuts, especially long-term bonds in Latin America. Specifically, HSBC is bullish on bonds in Brazil, Mexico, Indonesia, South Korea and the Czech Republic, as disinflation (falling inflation) in these countries is accelerating and will be reflected in bond yields. Greer said his top picks include Brazil, Mexico, Colombia and Peru, as Latin America is at the forefront of the current anti-inflation cycle.

Morgan Stanley: Cautious rate cuts fall short

But amidst the optimistic voice, there are also those who “splash cold water”.

Morgan Stanley strategist James K Lord warned that the rate cuts expected by emerging market investors may not materialize. He said that the further the Fed raises interest rates, the actions of central banks in emerging markets may be more restrained and cautious. The bank recently raised its forecast for the Fed’s terminal interest rate and is bullish on continued dollar strength.

“While low inflation in emerging markets is enough to warrant them starting a cycle of rate cuts and even keeping real rates steady, it also means that nominal interest rate differentials (with the US) will narrow sharply, which could leave EM local markets vulnerable to “The prospect could slow the pace of rate cuts in emerging markets,” he said.

As for Latin America, which investors are most optimistic about, he believes that the region’s “consumer price index decline is getting stronger and stronger, which can indeed support the continued decline of emerging economies in the region. However, the absolute level of U.S. interest rates may affect them. Market pricing in near-term rate cuts across the board constitutes some restraint, triggering a partial flattening of the yield curve.”

He also believes that in addition to interest rates, the economic situation in the United States will also affect the trend of emerging market assets. “If the US data shows that the risk of recession in the second half of the year is higher, then the world will face a very challenging economic environment, which is enough to drive global risk. A repricing of assets, including carry trades that drive investors away from emerging market currencies.” In such a scenario, he said, related currencies that benefit the most from a strong U.S. economy, such as the Mexican peso, would be the most vulnerable.