What Cooling Inflation, Rate Cuts Mean for Investing in Emerging Markets

Cooling inflation has sparked expectations of interest rate cuts, with markets anticipating the US Fed to begin easing monetary policy as soon as September.

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The global economic landscape is on the cusp of a significant shift as inflation cools and central banks worldwide prepare to pivot from their aggressive rate-hiking cycles to potential rate cuts.

This transition marks the end of an era characterized by elevated monetary policy rates (also called interest rates) and persistent inflation concerns, setting the stage for a new investment environment that could reshape returns across various asset classes.

Interest rates and inflation have been at the forefront of economic discussions since 2022 when central banks worldwide began raising rates to combat surging price pressures. This departed from the zero interest rate (ZIRP) era that had dominated monetary policy for over a decade. The US Federal Reserve, in particular, implemented a series of rate hikes totaling 525 basis points, bringing the federal funds rate to a range of 5.25% to 5.50% – levels not seen since 2001.

Interest rates have far-reaching impacts on financial markets and the broader economy. They determine borrowing costs for consumers and businesses, and when high tend to cool consumer spending and business investment. Regarding asset classes, high interest rates increase the attractiveness of fixed-income assets like corporate and treasury bonds relative to riskier investments like stocks. 

Disinflation, Rate Cut Expectations, and Asset Classes

As we move through 2024, there are clear signs that inflation is cooling across the globe. In the United States, the Consumer Price Index (CPI) has dropped significantly from its peak of 9.1% in June 2022 to 2.9% in July this year. Similar trends are evident in other major economies, with the Eurozone seeing inflation fall to 2.6% in the last month, down from a peak of 10.6% in October 2022. 

The European Central Bank’s interest rate cut from 4% to 3.75% in June was the first since 2019. And as inflation cools in Europe to near 2%, the European Central Bank (ECB) is reportedly considering further interest rate cuts.

Even emerging and frontier markets are experiencing disinflation—meaning their prices are still rising, though at a slower rate. India’s retail inflation eased to 3.5% in July from 5.1% in January and several African economies, including South Africa, Ghana, Ivory Coast, and Nigeria, reported slowing inflation rates.

This cooling inflation has sparked expectations of interest rate cuts, with markets anticipating the US Federal Reserve (Fed) to begin easing monetary policy as soon as September—Fed Chair Jerome Powell backed those expectations this week. Some central banks in emerging markets have already started this process, with countries like Zambia holding rates steady after previous hikes, while others like Botswana, Rwanda, and Namibia have implemented modest cuts.

The stock market has responded positively to these developments, with major indices trending upward on the back of encouraging inflation data and robust employment reports. Financial institutions and market analysts are increasingly confident that the Fed will implement at least a 25 basis point rate cut next month, a move that could have significant implications for various asset classes and sectors.

So how could interest rate cuts impact asset classes and their returns?

Historically, stocks have tended to perform well in the early stages of rate-cutting cycles, particularly if the economy avoids a recession. Lower interest rates can boost corporate profits by reducing borrowing costs and potentially stimulating economic growth. 

Sectors particularly sensitive to interest rates, such as real estate, utilities, telecommunications, and consumer discretionary, may see outsized benefits. Growth stocks, which derive more of their value from future earnings expectations, could also outperform as lower rates make future cash flows more valuable in present terms.

Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa. In 2022, rising interest rates caused bond prices to drop significantly. Recently, bond prices have been increasing due to concerns about an economic slowdown and expectations that central banks will lower interest rates to support the economy. 

With inflation now closer to target levels, central banks have more flexibility to reduce rates without worrying about reigniting inflation. This situation may create favorable conditions for investing in government bonds, which are considered safe-haven assets. Investment-grade corporate bonds may also benefit from falling rates and potential spread compression as economic conditions improve.

For gold, the bullion often performs well in environments of falling interest rates as investors flee a weakening US dollar. The metal is already gaining popularity, especially among central banks looking to reduce their reliance on the greenback. With US interest rates expected to fall, gold prices could rise further. This is good news for gold mining companies too, as they become more profitable when gold prices increase.

Charteris, a wealth management firm, predicts gold could reach over $3,000 per ounce in the next 4-10 months, up from around all-time highs of $2,500 now, driven by factors like increasing global debt or geopolitical tensions that could push prices higher even faster. 

This positive outlook for gold highlights its appeal as a safe investment during uncertain economic times, potentially attracting more investors seeking stability and growth opportunities. Other precious metals may follow a similar pattern. For broader commodities, the impact of rate cuts is less straightforward, as it depends on the balance between economic stimulation and currency effects.

Investors May Turn to Emerging and Frontier Markets for High Yield

Investors may increasingly turn to emerging and frontier markets, particularly in Africa, in search of higher yields as rates in developed markets decline. 

Countries with improving economic fundamentals, such as Nigeria with its rising oil output and growing foreign exchange reserves, Gabon whose high oil production is offsetting political uncertainties, or Kenya with its diversified economy, could attract significant capital flows.

These countries have seen widening spreads over US Treasuries, suggesting potential opportunities for yield-seeking investors. A Bloomberg report reveals that these nations’ dollar-denominated sovereign bonds have generally underperformed compared to their emerging and frontier market counterparts.

However, the past week has seen a notable turnaround, with bonds from these African nations outperforming in a broader risk rally. This improved performance coincides with growing expectations that the Federal Reserve may adopt a more accommodative monetary policy stance soon. 

This recent outperformance may indicate that investors are beginning to recognize the value proposition offered by these higher-yielding African sovereigns, especially in an environment where developed market yields are expected to decline. 

As the global interest rate landscape evolves, these bonds – including those of countries like Ivory Coast, Benin, and Senegal – could continue to attract attention from investors seeking attractive risk-adjusted returns.

Bottom Line: Investment Strategies and Market Outlook

As the investment landscape shifts, investors should consider adapting their strategies to capitalize on the changing environment. Diversification remains crucial, with allocations spread across asset classes and geographies to capture potential opportunities while managing risk. 

In fixed income, extending duration could prove beneficial as rates fall while equity investors might focus on high-quality companies with strong balance sheets, such as large telecom operators like MTN Group (MTNJ), Orange (ORAC), and Sonatel (SNTS). which can weather potential economic uncertainties.

The potential for rate cuts is likely to stimulate consumer spending by making financing for large purchases more affordable. This could boost sectors related to consumer discretionary goods and housing. Also, lower interest rates can improve corporate balance sheets by reducing debt costs, potentially freeing up capital for investment, research and development, or stock buybacks. These factors often make companies more attractive to investors, further supporting stock prices.

It’s worth noting that while the stock market often responds quickly to changes in interest rate expectations, the broader economic impact of rate cuts typically takes several months to fully materialize. This lag between policy changes and economic effects underscores the importance of maintaining a long-term perspective when making investment decisions.