COVID-19 and the war in Ukraine highly impacted the global economic and policy cycles, but now that the base effect of these shocks is fading idiosyncratic domestic factors will regain the main drivers of diverging cycles in the second half of this year, according to the Swiss Re Institute.
As growth, inflation and interest rate trajectories are diverging analysts stated in a recent report, noting that more rate hikes in many advanced markets are likely, while emerging economies appear to be turning a corner.
At the same time, they also pointed out the existing heterogeneity among emerging markets too.
In emerging Asia, broadly speaking inflation has fallen back to target, or will do so soon, according to the report this gives central banks room to loosen policy and focus on achieving a soft landing for growth.
In China, too-low CPI inflation/PPI deflation due to weak domestic demand led the central bank to cut interest rates in June. Vietnam, meanwhile, started cutting rates even earlier in March and at 100 basis points at a time, in the face of weak exports.
Analysts noted that the current policy trade-offs for emerging looks better than for advanced markets, where delayed acknowledgment of the inflation issue meant a later lift-off for rates. Their tighter bias is expected to prevail over the short term, perpetuating growth slowdowns into 2024.
The expected divergence in interest rates between advanced and emerging Asian markets means that Asian currencies will likely face depreciation pressure against the US dollar.
In emerging Asia, currency depreciation combined with lower inflation has meant less need for a very sharp adjustments in interest rates, the report highlighted.
In contrast, the report revealed that financial conditions in Latin America remain much more restrictive than in Asia. From early 2021, central banks there embarked on the sharpest monetary tightening cycle of all regions, likely with the dual intention of dampening higher inflation and minimising policy divergence vis-à-vis the US to prevent capital flight.
This “fear of divergence”, analysts explained, resulted in historically high real interest rates, and also avoidance of FX weakness and passthrough to imported inflation. But it comes at the cost of growth.
The Swiss Re Institute expects gross domestic product (GDP) growth of 1.1% in Latin America this year, while their forecast for emerging Asia is 5%-plus.
Central banks in Latin America are now also poised to start cutting rates as economies see gradual but steady progress on disinflation.
Analysts noted that those that raised quickest and firmest (Brazil) are ahead of the curve, while those that did not suffered second waves of inflation (Colombia) and are behind. In other smaller markets like Uruguay (-25bps), Costa Rica (-50bps) and the Dominican Republic (-75bps), interest rates cuts are already underway.
According to the Institute, how soon and by how much different central banks can cut interest rates this cycle may depend more on cumulative misses.
This is because, historically, inflation and central bank targets in emerging markets tend to be higher, so actual inflation in this cycle has been closer to objectives, for more time, than in advanced economies.
Analysts explained: This also matters for insurers because for the industry, with respect to inflation, “bygones are not bygones”: price levels matter. Once global inflation rates fall back to target elsewhere, Asian insurers will have benefited from years of price levels closer to what their reserving assumptions had factored in.
“They have experienced less “excess inflation”, and so even though interest rates cuts may lower asset returns, there is also less need to “make up” for costs of claims that turn out to be much higher than anticipated.”
However, analysts concluded that it is still too early to name definitive winners and losers given significant uncertainties on the horizon, such as El Niño weather phenomenon.
