Inflation and expectations for inflation were the centre of attention in the second quarter. A change in messaging from the U.S. Federal Reserve in June led to higher asset price volatility across asset classes. The European Central Bank decided to keep rates on hold.
Inflation in Emerging Markets (EM) picked up, with the notable exception of India. Main inflation drivers were higher prices for food, oil and commodities. More countries recorded inflation levels above their respective Central Banks’ targets, with inflation close to, or at its peak in most emerging markets. However, demand pressure remained largely absent.
In China, the Yuan (CNY) climbed to a three-year high. This was partly attributed to strong inflows into foreign portfolio investments in Chinese equities. China also announced a hike in its foreign currency Required Reserve Ratio (RRR). This was the first time that the Peoples Bank of China has adjusted the RRR since 2007. As well, the central banks of Mexico, Brazil, Hungary, Czech Republic and Russia increased their policy interest rates. The Turkish central bank kept its policy rate unchanged.
Quarterly performance analysis
EM enjoyed a quarter of strong returns. In U.S. dollar terms, EM Hard Currency (HC) Sovereign gained with all regions delivering positive returns. Africa and Latin America were the top performers. EM local rates gained in light of rising inflation expectations, while EM FX also delivered positive returns. EM corporate debt gained and flows into EM bond funds were positive overall.
The Fund underperformed its benchmark in HC. The Fund’s directional positioning (overweight the Duration Times Spread) helped performance given the positive returns of the EM HC asset class. The Fund’s Argentine HC exposure was among the primary positive contributors. This, along with an overweight to Brazil, Ecuador and Indonesia. The Fund was hindered by an underweight to UAE and South Africa.
The primary contributor to performance was the Fund’s local duration investments. The Fund’s South African rates overweight, and a tactical positioning on Mexican rates also benefitted performance. An overweight to Colombian and Brazilian rates and an underweight to Chinese rates limited performance. The Fund’s EM foreign exchange (FX) exposure was the main negative contributor to the performance of the Fund, due to an underweight in the Thai Baht and an overweight to the Chinese yuan.
The Fund maintained a duration underweight vs. the benchmark during the period to hedge the portfolio in this inflationary environment. On HC, the Fund closed its overweight to Oman and moved to an underweight position as valuations became less appealing.
The Fund reduced its long exposures to Pakistan and Ukraine with the rising political noise and loss of central bank credibility. For the latter, this outweighed attractive valuations. The Fund increased its long positioning to Romania and Qatar. This, especially given the latter’s relative underperformance in recent months despite strengthening fundamentals. The Fund increased its positioning to Indonesia.
On Local Currency (LC), the Fund increased its overweight to South African and Mexican rates, but increased its underweight to Malaysian rates. The Fund closed its underweight position in Polish local rates.
In EM FX, the Fund increased its overweight exposure to the yuan, as a relative value bet vs. the New Taiwan Dollar. It also increased positioning to Brazilian Real (BRL) based on attractive valuations. The Fund closed its underweight on the Thai Baht (THB). The Fund cut its overweight to Poland Zloty (PLN) and entered the second half of 2021 with a neutral positioning on that country due to COVID-19 challenges and deeply negative rates. Throughout the period, the Fund tactically positioned itself in the Russian Ruble (RUB) based on attractive valuations and fundamentals, with geopolitical risk mostly priced in.
Looking forward, Amundi believes global macro conditions may be underscored by strong reflationary dynamics. Amundi also believes the Fed’s messaging suggested its focus is still on the labour market more than inflation. On a relative asset landscape, Amundi finds valuations in EM fixed income attractive compared to Developed Market fixed income. The evolution of the current loose financial conditions will be a key to cross-asset returns.
In EM HC, Amundi remains constructive on a medium-term basis. Higher commodity prices and forthcoming SDR (Special Drawing Rights) allocations are expected to improve the outlook for EM refinancing. This could reduce default concerns for frontier markets. In EM local rates, several central banks have already hiked rates, which provides further carry support at a time when EM real interest rates are already higher than real rates in the U.S. and other developed economies.
In EM FX, Amundi expects relative outperformance in selected EM high-yielding, commodity and current account surplus currencies. EM investors can potentially protect positions from bouts of U.S. rate volatility by broadening the funding of EM FX long positions beyond the U.S. dollar.