 A broad recovery in EM is likely to be delayed amid struggles to battle COVID-19, but supply side inflation risks are likely to lead to steeper curves and higher risk premium in EM rates  Reflation theme resonates in India, Czech and Chile; Brazil is also on the path of policy normalisation…  … but we push back against implied tightening in China and Korea; position for easing in Mexico and Malaysia Reflation in EM? Not so fast… but inflation volatility is making a comeback A broad economic recovery across EM is likely to be delayed. That’s because we’re seeing a resurgence in COVID-19 cases across most EM regions, the emergence of more contagious strains and a return of social distancing measures in several countries. The inflation outlook though is a different story. After being largely subdued in 2021, we see increasing supply-side inflation risks, in particular in EM high yielders, combined with a strong rebound in global commodity prices. The result is likely to be tighter monetary conditions, especially with interest rates at record lows in most EMs. As a result, we expect EM local rates to price in higher inflation risk premiums as well as a higher term premium. We therefore generally remain positioned for higher rates, steeper curves and tighter bond-swap spreads in several markets. Our key convictions for higher rates exist in India (pay 5yr INR ND OIS), Czech (pay 5yr CZK IRS) and Chile (pay 2yr Camara swaps).

Moving along the path to policy normalisation Initial signs of policy normalisation within EM have started to resurface in a few markets and this poses a hurdle against any chase for carry in EM high yielders.

Policy tightening expectations are most aggressive in Brazil while Czech National Bank has signalled two policy rate hikes in 2021. Pockets of pressure in money markets have also emerged in certain Asian countries and a few central banks – like the PBoC and the RBI – are taking a more prudent approach towards liquidity operations with increasing concern around financial imbalances.

China, Malaysia and Mexico to buck the trend There are however exceptions. We still like duration exposure in China (buy 30yr CGBs) as we believe the consensus bullish outlook on the economy is likely to be tested as credit growth slows and local government bond supply is significantly reduced in 2021.

We therefore also push back against the pricing of implied tightening in China (as well as in Korea). Both Malaysia (buy 10yr MGS) and Mexico (buy 2038 Mbonos) stand out as some of the few markets within EM that could see further monetary easing. We also see a tactical opportunity to extend duration in South Africa (buy 2035 SAGBs), especially with the potential for a favourable upcoming budget.