El Niño threat looks underpriced in emerging-market rally

Emerging-market bond bulls are betting the imminent end of central bank interest-rate hikes will help power up the asset class. El Niño may have something to say about that.

The periodic weather pattern that is currently forming in the Pacific Ocean typically results in hotter, drier conditions and therefore higher food prices in affected nations, giving policymakers more reason to keep pushing up borrowing costs. Among the developing-nation bond markets most at risk are India, the Philippines and Peru.

Investors aren’t yet discussing El Niño’s effects in depth, “which makes me nervous that we may be complacent to this risk,” said Eimear Daly, an emerging-market strategist at NatWest in London. “Markets are fixated on carry right now and not focused on what seems like increased stagflation risk.”

This year’s El Niño — the formation of a band of warm water off the coast of South America that disrupts atmospheric conditions and causes floods in parts of that continent, and lower rainfall in much of Asia — is set to be particularly severe as it coincides with record global temperatures. Adding to the threat of disruptions to food supply is Russia’s withdrawal from a deal that allowed Ukraine to export grain via the Black Sea; it sent wheat prices soaring more than 10% at one point last week.

Asia is particularly vulnerable to a climate-induced price shock due to the higher proportion of food in household budgets. Food comprises about 46% of the inflation basket in India, 36% in Thailand and 33% in Indonesia, International Monetary Fund data show. Many commodity prices are already elevated, with rice and sugar trading at multi-year highs.

Most exposed

Emerging markets are also more exposed to the inflationary impact of El Niño than their developed peers, Bloomberg modeling shows.

An incidence of the weather pattern may cause inflation in Argentina and Brazil to accelerate by an additional 0.75 percentage point, and by 0.5 percentage point in India and the Philippines, economist Bhargavi Sakthivel in London wrote in a research note last month, citing a model that looks at past El Niño events. That would drag down growth, possibly resulting in stagflation, she said.

Growing unease

Some money managers are already growing concerned about the potential impact on emerging-market debt.

“If El Niño proves to be intense — like in 2014 and 2015 — this can indeed change the inflation expectations in emerging markets for 2024 and affect the central banks’ behavior in many countries,” said Julio Callegari, head of Asian fixed income at JPMorgan Asset Management in Hong Kong.

It’s prudent to monitor the risk to long emerging-market positions as details of the severity become known, even if you don’t adjust the portfolio just yet, he said.

So far at least, investors don’t appear overly afraid. Emerging-market bonds have been rallying during the past month on optimism inflation is on its way down and central bank interest rates are close to — or already at — their peak.

A Bloomberg index of local-currency emerging-market debt has risen around 4% this year, beating the 2.7% gain of a global bond gauge, based on returns to dollar-based investors.

While the prospect of El Niño causing food-supply disruptions is a hawkish risk to the emerging-market inflation story, investors have largely looked through that threat, Goldman Sachs Group Inc. strategists including Kamakshya Trivedi and Caesar Maasry wrote this month in a note to clients.

“Moreover, if commodity prices stay at current levels, there is still a lot of meaningful disinflation to come through following last year’s inflationary shock,” they said.

India impact

One country where the impact of El Niño may be particularly pronounced is India.

The government last week banned the export of some rice varieties in an effort to lower food prices after consumer costs unexpectedly spiked higher. While the decision may help household budgets, it will add further pressure to global costs at a time El Niño is already raising concerns about crop damage.

It’s not just rice that’s adding to inflation. Tomato prices in some parts of the country have jumped as much as eight-fold this year as heavy rains damaged crops.

India’s consumer-price data was “probably the first evidence of El Niño and its possible impact on inflation,” said Brendan McKenna, emerging-markets economist and foreign-exchange strategist at Wells Fargo Securities LLC in New York. “Countries that have a high portion of their CPI baskets dedicated to food prices, if El Niño is that influential, those countries can see a spike in prices.”

Pricing error

With India a possible harbinger of broader food-driven inflation, emerging-market bond holders may find themselves wondering whether they have been too optimistic.

“Higher food prices will hurt large food importers and would throw a wrench into EM central banks of food importers plans to cut interest rates,” said Rajeev De Mello, a fund manager at Gama Asset Management in Singapore. “In view of the risk that El Niño might pose, investors might have been a bit quick to price cuts.”

What to watch:

• South Korea and Taiwan will both report second-quarter GDP data this week as investors look for signs China’s economic slowdown is weighing on its export-dependent neighbors
• Malaysia will publish June inflation Monday, with economists predicting price pressures will keep slowing
• Bank Indonesia is forecast to keep policy rates unchanged Tuesday after keeping its benchmark on hold for five straight meetings
• Hungary will also publish its rate decision Tuesday, with traders looking for further dovish signals after policymakers cut the overnight deposit rate in June
• Chile’s central bank meets Friday, with some analysts also forecasting a rate cut