For the first time in four decades, investors in the U.S. and other rich economies are looking for a portfolio strategy that can beat high inflation and recession at the same time.

No one knows what form such a book of stagflation will take, but one thing seems certain: it will include some emerging market assets.

Stocks and bonds in poorer countries have fallen this year amid a tightening Federal Reserve and sharp consumer prices, and could sell off further if the global economy stalls. Yet it is in pockets of the developing world that the antidotes to stagflation exist: faster growth, accommodation policies and inflation-adjusted returns. This can open up opportunities in everything from Indian stocks to the Brazilian currency to Chinese bonds.

“Stagflation will force investors to look for global growth hotspots, and emerging markets will be first in line, especially those that are more immune to weakening global demand,” said Trinh Nguyen, senior economist at Natixis SA. “Countries that have huge domestic markets that are growing, and that not only protect their economies from the global recession, but also benefit from it, will do particularly well.”

The probability of a US recession has soared to 50% for only the second time since the 2008 financial crisis. Inflation in the world’s largest economy is showing signs of peaking but is expected to remain well above the Fed’s 2% target until at least 2024. In Britain and the rest of Europe, consumer prices are still rising and the energy crisis is making economic contraction likely.

This is unfamiliar territory for this generation of traders. Since 1982, risks to growth and inflation have gone hand in hand, while recessions have restored economies with low prices. But now CPI and growth have decoupled, both deteriorating and sparking an entirely new trading paradigm.

The key topics of such a strategy, according to financial managers, will be:

Heroes of inner growth

While stagflation in the US and Europe could hamper export-reliant emerging economies, it could favor countries with strong domestic consumer demand and less dependence on Western markets. This would benefit countries with domestically oriented companies, and India stands out in this regard.

The country, which derives just 12% of its gross domestic product from exports, is projected to grow at the fastest rate among major economies in 2023. Its stock market is one of the few to see an advance this year.
The Indian stock market is one of the few emerging markets that have posted gains this year

Less globalization, please

In general, countries that offer some relative isolation from Western economies may attract investment interest. This could take the form of less vulnerability to imported inflation, less need for foreign capital or monetary policy divergence.

Sue Trinh, head of Asia macro strategy at Manulife Investment Management, cites Indonesia, Malaysia and Vietnam as examples. Investors have already started favoring dollar-denominated bonds of these countries, pushing sovereign risk premiums to their lowest in seven, nine and two months, respectively.

“The economies most insulated from a negative demand shock are net exporters of food and energy, countries that are less dependent on foreign capital, and countries that still have policy space.” said Sue Trinh. “Economies best able to cushion a negative supply shock will have relatively lower weightings of food and energy in their consumer price indices and import baskets.”

The stimulus is not dead

China’s bias toward looser monetary policy, a popular theme for global investors since the start of the year, could become even more compelling. Declining factory inflation, a slump in the real estate sector and a flimsy recovery marred by Covid outbreaks have policymakers scrambling for further easing.

And the People’s Bank of China did just that on Monday, when it unexpectedly cut its one-year lending rate by 10 basis points to 2.75% in the first key rate cut since January. The seven-day reverse repo rate was cut to 2% from 2.1%.

“There is potential for some, though not all, emerging markets to outperform when stagflation affects developed countries,” said Yevgenia Victorina, SEB AB’s head of Asia strategy. “China, a key driver of emerging markets, will be unique in pursuing supportive policies amid tightening worldwide.”

A big advantage of the Yielder

Brazil is an oasis in Latin America, a continent where the general mood is gloomy due to persistent inflation and limited growth caused by tightening policies. National consumer price growth eased in July in response to one of the most aggressive hikes in emerging markets. As a result, Brazil posted a real yield of 3.68 percentage points, the highest inflation-adjusted rate among countries tracked by Bloomberg.

Given that stagflation can leave most countries with anemic real rates, Brazil’s yields are a potential lure for carry traders. China and Vietnam can also get positive results, which will give them an advantage.

But all this does not mean that emerging markets are not immune to stagflation in advanced economies. This would essentially be a blow to the overall asset class, causing portfolio outflows and sending investors to the safety of the dollar. It’s just that even in this turmoil, the only place where investors can get some growth, some stimulus and some profitability is in developing countries.

“The right global stagflation shock is unlikely to hurt emerging markets, but because stagflation-type risks are a spectrum, opportunities in emerging markets can help hedge against developed market risks,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank. .

Read: South Africa’s consumer finances hit by rising tariffs and cost of living

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