Many investors in government bonds would say that an ideal time to reap excess returns is after inflation has risen – pushing debt yields higher – but starts to fall again.

This principle applies as much to local currency government bonds in the emerging markets (EMs), as is does to debt issued by governments in developed economies.

We certainly have those conditions now – inflation in EMs peaked in January, after rising energy prices following Russia’s invasion of Ukraine, combined with the post-pandemic supply squeeze, caused prices to surge to levels not seen in some two decades. 

The subsequent decline in EM inflation this year has been as dramatic, and many emerging-market economies can now expect to have inflation back to central-bank target levels within the next six months (see Chart 1).

Source: Bloomberg, National Sources, abrdn, September 2023.

EM policy easing

For many emerging markets, interest rates were raised so much between 2021 and earlier this year that the subsequent fall in inflation has permitted the start of a monetary policy easing cycle. Slightly lower interest rates are bringing bond yields lower and pushing bond prices higher.

From a year ago, when market pricing forecast emerging-market central banks would continue to raise interest rates and hold them at their peaks for the foreseeable future, we now see more sensible pricing in EMs.

For example, most countries in central and eastern Europe and in Latin America are expected to cut interest rates over a one-to-two-year time horizon.

Compared with developed economies, the difference in monetary policy is no longer in the direction of anticipated changes in interest rates, but in their timing. 

For EMs, the bulk of the changes in policy rates are expected over the next 12 months. In DMs, bond markets are pricing in a chance of lower interest rates in the coming year, with a more significant decline only occurring beyond this period. 

Given that emerging-market central banks were around a year earlier than their DM peers to raise interest rates, intuitively this makes sense.

EM diversity

As investors in emerging markets, we are fond of pointing out that they are far from homogenous. The investment dynamics can vary a lot between countries.

Breaking down the EM world helps increase the level of insight we gain (see Chart 2). This chart shows the history of EM inflation by region, relative to the average of US and Eurozone inflation. We exclude Turkey and Argentina because their inflation issues are much more domestic than global, and they distort the averages.

Source: Bloomberg, National Sources, abrdn, September 2023.

It’s easy to see that there have been different dynamics at work in the last 18 months:

• Europe, Middle East and Africa. This region immediately jumps out. Central Europe has driven the rise in inflation, mostly because it suffered the biggest energy shock last year as it needed to replace Russian-gas supplies, but also because economies had grown quickly before the pandemic, creating conditions that made it easy for firms to pass through price increases (and easy for workers to demand higher wages).
  
  We still don’t think government bonds in this part of the world offer totally convincing value. Long-maturity bonds yield less than cash and although inflation will certainly be lower in a year’s time, the pace of price gains might not have returned to central banks’ target levels.

• Asia. This region is also eye-catching, because inflation was less strong than in developed economies thanks to more stable energy markets, fuel subsidies, less supply-side disruption during the pandemic and weak demand in the region’s largest economy, China.
  
  Long-maturity bonds in Asia now yield more than cash. A year ago, the very low yields on offer were not very tempting. But with inflation falling from even relatively low levels, and the outlook for regional growth uncertain, it’s become an interesting area to consider.

• Latin America. This region is really interesting. Inflation has fallen slightly compared with the US and European average over the past couple of years, but Latin American bond yields still offer a substantial premium to their developed market counterparts.
  
  Interest rates increased the most during 2021 and 2022 in this region, so this is where we think rates could fall the most and bonds could offer the best returns. Foreign investors hold as low a share of Latin American domestic government bonds as they have done for many years. They would do well to consider increasing these holdings.