IMF 2024 Spring Meetings Takeaways: Emerging Market Stars Shine Bright

EM investors and policy makers are enjoying their moment

At the 2024 IMF Spring meeting, most of the concerns over emerging markets (EM) from the Fall 2023 meeting – from global rates to specific problematic EMs – had been addressed. The mood at the IMF Spring meetings was notably upbeat, which was a refreshing change from the amount of concern expressed about US fiscal policy and global markets at the Fall meetings in Marrakech. Over those six months, US 10-year yields peaked at 4.99, declined to a low of 3.79 and sold back off to 4.63. It’s been a wild ride, but emerging markets digested the volatility and higher rates remarkably well.

There are good reasons markets faired so well and sentiment improved. The market is still pricing in just under two interest rate cuts by the Federal Reserve this year and this pricing is still validated by the Fed’s dot plot. The IMF upgraded US growth forecasts for 2024 by +0.6% of GDP and Chinese PMIs are back to expansion. Most importantly, there has been a very large loosening of financial conditions since the Fed pivot in December.

EM investors and policy makers have further reasons to celebrate. There aren’t any bad EM stories right now, with almost all of the typical problem cases in EM making meaningful policy adjustments. While top line index performance is lackluster due to the sell-off in US Treasury yields, there have been exceptional returns for lower-rated sovereigns. Almost every one of those low rated credits is attempting a policy U-turn (or at least some reforms), and so it would be unfair to characterize these returns as a “Dash for Trash” even if it appears that way at first sight. Most investors were able to capture some of this alpha.

J.P. Morgan EMBI Global Diversified Index Total Returns

Source: JP Morgan. Past performance is no guarantee of future results.

The index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Surveys show that investors expect goldilocks to continue through at least the end of the year. Recession is no longer the baseline scenario and core PCE is expected to remain below 3%. The Fed is expected to cut interest rates one or two times and long-term interest rates are expected to remain not too far from 4.5%.

However, there is reason to believe this complacent view may be a mistake. The December pivot by the Fed was the primary catalyst behind the magnitude of the market move. Given the strength of US employment and inflation data received since, the pivot is looking more and more like a policy mistake. The Fed would need to see more than a few months of benign inflation readings before it can cut rates and the timing of the first cut would be uncomfortably close to the US Presidential election. There is a reasonable chance that high for longer US rates could turn into higher for longer US rates and this could be too much for goldilocks to withstand.

US interest rates will stay high for longer but nobody cares (for now)

The outlook for US inflation is particularly troubling. The IMF narrative was that walking the “last mile” for inflation to converge to target could take even longer than expected. However, a large portion of last year’s disinflation was due to non-core prices like food and energy. Those prices are no longer declining and have posted surprisingly strong gains to start the year. Demand in the US has remained strong as the labor market is still tight and growth keeps surprising to the upside. Uncertainty about both energy and goods supply has also increased due to risks from a widening Israel-Gaza conflict. Even more concerning is that core inflation appears to be increasing again and fiscal pressures might be to blame.

Decomposition of inflation drivers.

(Percentage point deviation from December 2019; three-month average inflation, annualized)

Source: International Monetary Fund. Data as of April 2024. Past performance is no guarantee of future results.

There was a level of acceptance during the meetings that US fiscal policy would remain expansionary for years to come but that it would not pose a major problem for the US or the rest of the world. IMF estimates, however, show a material contribution from fiscal shocks to core inflation in the US. As the Fed keeps rates high, the combination of deficits and high rates is also leading to an exploding contribution of interest expense to the deficit. The risk is that persistently loose fiscal policy eventually raises long-term inflation expectations. If the Fed needs to shift gears from high for longer to rate hikes, it will break the spell cast by the expectation of future rate cuts and easy financial conditions.

Decomposition of changes in US core inflation

(Percentage points)

Source: International Monetary Fund. Data as of April 2024. Past performance is no guarantee of future results.

Interest payments

(percent of revenues)

Source: International Monetary Fund. Data as of April 2024. Not intended as a prediction of future results. For illustrative purposes only.

China is doubling down on industrial policy but so is the rest of the world

There were continuing concerns about China’s unwillingness to rehabilitate its property sector and risks that China could experience deflation this year with 5% real GDP growth translating into only 4% nominal GDP growth. Deflation in China would be particularly worrying given the very high levels of total economy debt. But these fears most likely reflect peak pessimism in China where investors remain uniquely bearish. The Chinese economy appears to be bottoming with Chinese PMIs back in expansionary territory and new reports of a massive bailout effort to complete that backlog of unfinished homes that would be funded by PBOC QE! If policy makers follow through, it would likely mark the low in Chinese interest rates and result in a sharp change in sentiment towards China.

Chinese policy makers are already providing stimulus to China’s old economic model of manufacturing including high tech manufacturing. Just as in the past, this is hugely beneficial to commodity markets and to many emerging markets. However, the rest of the world is becoming frustrated with the flood of cheap products hurting domestic profitability. It is only a matter of time before the US increases tariffs on Chinese products and this will happen under a Biden or Trump Presidency. There is clear bipartisan agreement that Chinese overcapacity is undercutting US producers and the only question to be resolved by the US election is the magnitude of the US response. Chinese export overcapacity was one of the few global disinflationary forces and tariff policy could reverse it.

It isn’t just the US that wants to retaliate against China. Europe wants to put tariffs on Chinese electric vehicles. Chile and Brazil just put tariffs on Chinese steel. According to the IMF, there were 3,200 new restrictions on trade in 2022 and 3,000 new restrictions on trade in 2023, up significantly from 1,900 in 2019. Additionally, industrial policy is a global trend with the US subsidizing its own green energy investment as well as chip manufacturing. As global trade gets fragmented along geopolitical fault lines, the main one being the US or China, it is rational for countries to secure their own production and supply chains. The result leads to a reduction in global trade, especially between competing trade blocs.

Many EM central banks adjust policy to incorporate high for longer

Emerging market central banks, who like the Fed still need to “walk the last mile of disinflation”, used the Spring meetings to communicate a tightening to their monetary policy stance. Brazil and Mexico were the most active each, with multiple central bankers meeting investors at multiple events.

Brazil changed its rate path guidance to be meeting dependent while communicating a shallower cutting cycle from the previous pace of 50 bps of cuts per meeting. Mexico communicated strongly that it had not just embarked on a cutting cycle and that it would remain on hold at the next policy meeting. In both Mexico and Brazil, inflation expectations remain too high above target for central bankers to consider additional cuts. Indonesia, where inflation is already within target, hiked interest rates to contain an exchange rate overshoot that could feed back to inflation expectations.

There were some central banks, most notably Chile, who did not see any impact from the Fed’s policy stance on domestic inflation and communicated they would stay the course on rate cuts. The market, up until recently, has punished their exchange rates for it. As outlined in the Fall IMF notes, the currencies of countries with high real interest rates and hawkish policy stances should continue to perform well even if the Fed remains on hold for longer.

Current easing cycle: changes in the market-implied trough (terminal) rates between 12/27/2023 and 4/22/2024 (bps)

Source: VanEck Research, Bloomberg. Data as of April 2024.

Mission accomplished for the Common Framework and the Global Sovereign Debt Roundtable

Zambia, who had the unfortunate luck of being the crash test dummy of the common framework, just recently reached an agreement with the majority of its bilateral and private creditors. The landmark agreement is the result of a multiyear process of Paris Club creditors achieving a mutual understanding with their Chinese creditor counterparts about what restructuring terms are acceptable to both groups. Now that the learning process is over, future restructurings for low income countries should proceed much faster and the shorter timeline for restructurings makes all defaulted sovereign debt have higher net present values (NPVs). There are a number of EM sovereign restructurings that are nearing completion, including Ghana, Sri Lanka, Ukraine and Ethiopia. Because of this progress, the Common Framework was no longer a major topic of discussion.

The last remaining obstacle is for governments to reach agreements with private creditors who continue to search for creative solutions to capture a little more value while remaining within the restructuring constraints provided by the IMF’s debt sustainability analysis and comparability of treatment with official creditors. In Zambia, this took the form of a value recovery bond with triggers related to the IMF upgrading Zambia’s debt carrying capacity or Zambia’s exports and fiscal revenues exceeding IMF projections. Similar instruments are being discussed in Ghana and Sri Lanka where it appears agreements with private creditor groups are close. It will be interesting to see how much value these value recovery instruments hold over the long term as similar instruments from past restructurings have often not performed as well as expected.

Ukraine is the most interesting case of an expectations gap between what the official sector needs for a country’s debt sustainability and what private creditors want. There is no longer discussion of Ukraine winning the war with Russia and a negotiated stalemate appears to be the best potential outcome near term. However, creditors are actively discussing with the government restructuring terms that would restart coupon payments to private creditors! It appears both unethical and strategically bizarre to pay anything to private creditors while Ukraine’s sovereignty is at existential risk and it is struggling to buy ammunition and pay its military. At the same time, the IMF is pushing for a restructuring that incorporates the downside scenario from its debt sustainability analysis into restructuring valuations.

There weren’t any truly negative EM stories

Argentina, Turkey, and Nigeria have exciting reform stories and meetings with policy makers were standing room only. Brazil, Mexico, Ecuador and Angola presented well while Colombia, Panama and Saudi Arabia were more complicated stories. However, there were not any emerging market countries that raised investor’s alarm bells over an imminent crisis and this was a refreshing change from previous meetings.

In Argentina, investors are extremely constructive due to Milei’s economic team already achieving a primary surplus in the first quarter of his new government. Hyperinflation is no longer a concern and the pace of disinflation is much faster than forecasters expected. The economy, however, is in a deep recession and the exchange rate policy remains unsustainable. Dismantling exchange rate controls and making the fiscal adjustment more sustainable will be the keys to Argentina’s success over the medium term.

In Turkey, the central bank hiked the policy rate by 500 bps to 50% in March due to higher-than-expected inflation and too strong domestic demand. With President Erdogan’s support, the economic team has unwound most of the unorthodox policy measures and the economy shows signs of rebalancing. The central bank has aggressive inflation targets of 36% by year end 2024 and 14% by year end 2025. While these targets are likely too optimistic, investors believe policy rates are high enough to more than offset potential Turkish lira devaluation.

In Nigeria, policy makers have taken bold steps to dismantle the exchange controls of the Buhari administration and to clear the sizable foreign-exchange backlog. After initially overshooting, the Naira has recovered value rapidly with many foreign investors participating. It was hard to miss the good feelings shared between investors and policy makers during Q&A sessions. But there are still critical challenges ahead for Nigerian policymakers including tackling sizable fuel subsidies and creating a credible monetary policy framework with well-defined inflation targets and positive real interest rates.

Ecuador did not hold many investors meetings due to being very close to reaching the just concluded 4 year $4bn EFF program with the IMF. Policy makers stressed their commitment to reaching an IMF agreement and to implementing a credible fiscal adjustment that would allow them to regain market access sometime in the not too distant future.

Brazil continues to over-deliver on the growth and disinflation fronts, and its external position is comfortable. However, Brazil is yet to fully exorcise its fiscal demons. The new fiscal framework approved in 2023 guarantees that expenditure growth cannot outpace revenues, which is a good sign for primary balances and debt stabilization. But tax reform remains key for the medium-term fiscal outlook. Until there is more certainty on the fiscal side, the central bank might need to keep its real policy rate high for longer.

Mexico’s key storyline is monetary prudence against the backdrop of sticky inflation and election uncertainties both in Mexico and the U.S. Mexico’s fiscal cycle is being frontloaded, negating the impact of high real interest rates on the economy (especially services). Near- and friend-shoring should be growth -positive, but they can also affect monetary policy going forward.

Angola might finally get a much-needed positive catalyst in the form of stabilizing (or even improving) oil production as maintenance issues are now resolved, while a more flexible exchange rate leads external adjustment via imports’ decompression. Authorities continue to push forward reforms – including full commitment to fiscal targets - and growth returned to positive territory.

Panama is on track to lose its investment grade status this year, and a lack of clear underlying strategy to improve fiscal outcomes is a key reason why. Another near-term problem is that local politicians seem to underestimate the potential fiscal impact of losing the arbitration process with First Quantum. The likely outcome is that Panama’s rates will have to go up and its debt/GDP ratio will stop declining.

Colombia plans to run a fiscal deficit this year that will be the same size as the deficit ceiling from the fiscal rule in order to maximize spending. The risk is that any slippage would lead to a breach of the fiscal rule and subsequent rating downgrades. The Ministry of Finance promises it will cut expenditures to investments if necessary to avoid this scenario which would further dampen already low growth. Additionally, inflation expectations are not as strongly anchored as in other countries, and the government's spending plans makes it even harder for the central bank to achieve its inflation target.

Saudi Arabia's story was disappointing. The country might be moving from twin surpluses to twin deficits, and this is not reflected in valuations. A lack of clear medium-term fiscal strategy also generates confusion against the backdrop of seemingly “never-ending" issuance as new debt is more expensive and the maturity profile gets heavier. Authorities also started to realize that mega-projects might be more difficult to implement, weighing on plans to diversify the economy. Rising regional geopolitical tensions is another reason to remain cautious, despite high oil prices.

Looking Ahead

The prevailing consensus among investors suggests that both US interest rates and the US deficit will persist at elevated levels for an extended period, While US exceptionalism can continue for years without causing any accidents, US inflation appears poised to rise in the coming months, potentially disrupting the narrative of a gradual convergence towards target levels. Such a development could destabilize the complacency fostered by accommodating financial conditions.

Emerging markets have been able to digest this new reality remarkably well. Formerly troubled nations like Turkey and Argentina are actively pursuing substantial reform initiatives, while Zambia's successful restructuring agreement with bondholders signals the potential for similar resolutions with other defaulted sovereigns. This period heralds a shining moment for emerging markets on the global stage.

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