In April, we argued that emerging markets (EM) fixed income was better positioned to withstand the oil shock than it had been in 2022 and that we believed the asset class was poised for a strong rebound if de-escalation occurred within a relatively short time frame. De-escalation took longer than both we and the markets had expected, with the full-blown war lasting much longer and remaining unresolved. Yet the rebound thesis was correct.

The Strait of Hormuz partially reopened in June, then closed again in July. At the time of writing in early September, its status is uncertain, given that a significant volume of trade has gone dark, with vessels switching off their transponders. Oil prices are off the heights seen in March and April but remain more than 50% above their levels at the start of the year. Despite this, the inflation shock has been milder and shorter-lived than expected and is likely to fade faster than it did four years ago. As a result, pre-war trends have returned, as expected. Inflows into EM fixed income were interrupted only in March and resumed in April, while the credit rating upgrade trend we had been observing continued through Q2 and Q3 despite the war.

The second global inflation shock that markets were pricing in back in March did not materialize with anything like the magnitude of 2022.

Headline inflation spiked, but core measures remained broadly anchored. While some EM central banks raised rates, most did not need to, and certainly not to the extent markets had priced in back in March. This likely reflects the considerable credibility they have built over the past four years relative to their developed-market peers.

This outcome vindicates the core argument of our April article. After four years of restrictive monetary policy globally, the pass-through from an oil supply shock to consumer inflation is structurally smaller than it was in the aftermath of the pandemic, when policy was extremely loose and aggregate demand was rebounding amid supply constraints. This more muted inflation shock, combined with yields that remain elevated, has allowed the asset class to remain resilient and deliver positive YTD returns, a sharp contrast to the double-digit negative returns of 2022. Moreover, recent inflation data suggest that this inflation cycle will also be much shorter-lived than the 2022 cycle, which would bode well for fixed income.

Read the full ‘Thought Leadership’ article at the link below