Applying Our Playbook to EM
- We favor emerging market (EM) to developed market (DM) assets on a brighter macro backdrop. We get granular and harness mega forces, per our playbook.
- U.S. bond yields slumped last week on softer CPI inflation data. We think still tight labor markets will compel the Federal Reserve to hold policy tight.
- We look to this week’s U.S. data for more signs higher policy rates are cooling production and spending. We see policy staying tight even as activity weakens.
We tapped into what proved a stealth rally in EM stocks and bonds, along with the DM stock gains this year. We still think EM assets have an edge over developed market (DM) peers in the first layer of our new playbook, the macro assessment. Inflation is cooling enough in key EMs to allow policy rate cuts. We get granular in our playbook’s second layer to find countries and sectors we like. Our third layer harnesses mega forces to capture structural shifts within EMs.
We’ve preferred EM debt to DM long-term peers for some time. We went tactically overweight EM local currency debt in March, picking up higher yields for carry and benefiting from a broadly weaker U.S. dollar plus tightening spreads this year (yellow line in chart). Higher EM yields remain attractive but tightening spreads with Treasuries (pink line) lead us to consider switching to hard currency peers typically issued in U.S. dollars (orange line). But peaking DM policy rates should support EM currencies, bolstering EM local debt for now. DM rate hikes have hit EM hard in the past, but we think they’re in a different spot now thanks to improved external balance sheets. We think that’s why we’re not seeing the EM asset volatility as in the 2013 taper tantrum. The Fed’s plan to taper bond purchases then sparked sharp EM capital outflows and currency depreciation. It’s the opposite now: capital inflows and stronger currencies are boosting returns in EM local currency bonds.
A brighter EM macro and policy picture may also be underappreciated, in our view. DM central banks inching toward the end of rapid hikes is good for EMs – but a key difference is we think EM peers are closer to rate cuts as inflation falls. EM central banks were well ahead of DM peers in hiking – and some have hiked much more to bring inflation down quickly. Take Brazil: Policy rates have risen to just under 14% from 2% in 2021. When it comes to EM investing this year, much focus has been on China’s economy losing steam. But outside China, EM equities have staged a stealth rally with double-digit gains across Latin America and other parts of Asia. We see more upside there and more attractive valuations relative to DM economies as the policy picture and EM economic growth prospects improve, even as China’s restart sputters. That’s the first layer of our new playbook in action: our macro takes in the context of what’s in the price.
The second layer of our new playbook is about getting granular. We go beyond broad EM exposures to find the brightest macro backdrops across countries and the most attractive valuations under the surface. Within EM local currency bonds, we like Mexico for its quality tilt and Brazil for its exceptional carry from still-high bond yields. Our playbook also calls for being nimble. EM is not disconnected from global growth, so we are constantly watching for how that may affect the EM backdrop.
We also get granular in sectors and regions and use the third layer of our playbook – harnessing mega forces – to capture returns now and in the future. We see five big structural forces transcending the macro backdrop: digital disruption and artificial intelligence (AI), geopolitical fragmentation, the low-carbon transition, aging populations, and the future of finance. We see abundant EM equity opportunities through these mega forces – what matters is what markets have priced. The semiconductor industry is powering AI and is a key part of the EM technology sector. A rapidly growing population in India sets the country apart from DMs. India's system of digital payments also bodes well for the future of finance there, we believe: It could pave the way for a credit boom as banks adapt lending. We think the low-carbon transition presents an important opportunity for Latin America, especially for countries that hold large reserves of key resources like copper and lithium. The rewiring of supply chains due to global fragmentation could also have significant implications for countries like Mexico that could benefit if U.S. companies bring operations and production closer to home.
Bottom line: Our new playbook leads us to favor EM over DM assets. We see a brighter policy outlook as some EMs stand ready to cut policy rates. We get granular in EM debt across countries and in EM equities by harnessing mega forces.
U.S. bond yields dropped, and stocks climbed to 15-month highs last week as markets eyed an end in sight to the Fed’s rapid hiking cycle after the softer-than-expected June CPI data. Both two- and 10-year Treasury yields posted their sharpest weekly declines since the March banking turmoil. The labor market is key for what lies ahead for inflation. We see still-strong wage growth keeping core inflation elevated, compelling the Federal Reserve to hold policy tight.
The U.S. core CPI inflation for June came in at 0.2% month-on-month, down from 0.4% in May and below expectations.
One element of that was unsurprising: the drag from goods prices. See the chart. We expected goods prices to fall as consumer spending normalized following a surge in goods consumption during the pandemic. Some of that started in the second half of last year (see the orange bars in the chart) and it recurred in June, driven by a decline in used car prices. We see more goods deflation ahead, reinforcing our view that overall inflation will be on something of a rollercoaster in the coming months.
The real surprise was that core services inflation excluding housing was flat on the month. We think this could be a one-off and unlikely to happen again this year: It’s difficult to see how core services inflation can be so low with wage growth remaining strong. We still think core inflation is proving persistent at levels well above the Fed’s 2% target. And that’s why we think the Fed will still hike rates later this month.
1 Holding tight
- Markets have come around to the view that central banks will not quickly ease policy in a world shaped by supply constraints – notably worker shortages in the U.S.
- We see central banks being forced to keep policy tight to lean against inflationary pressures. This is not a friendly backdrop for broad asset class returns, marking a break from the four decades of steady growth and inflation known as the Great Moderation
- Economic relationships investors have relied upon could break down in the new regime. The shrinking supply of workers in several major economies due to aging means a low unemployment rate is no longer a sign of the cyclical health of the economy. Broad worker shortages could create incentives for companies to hold onto workers, even if sales decline, for fear of not being able to hire them back. This poses the unusual possibility of “full employment recessions” in the U.S. and Europe. That could take a bigger toll on corporate profit margins than in the past as companies maintain employment, creating a tough outlook for DM equities.
- Investment implication: Income is back. That motivates our overweight to short-dated U.S. Treasuries.
2 Pivoting to new opportunities
- Greater volatility has brought more divergent security performance relative to the broader market. Benefiting from this requires getting more granular and eyeing opportunities on horizons shorter than our tactical ones. We go granular by tilting portfolios to areas where we think our macro view is priced.
- We think dispersion within and across asset classes – or the extent to which prices deviate from an index – will be higher in the new regime amid the various crosscurrents at play, allowing for granularity. That offers more ways to build portfolio “breadth” via uncorrelated exposures, in our view.
- We think it also means security selection, expertise, and skill are even more important to achieving above-benchmark returns. Relative value opportunities from potential market mispricing are also likely to be more abundant.
- Investment implication: We like quality in both equities and fixed income.
3 Harnessing mega forces
- Mega forces are structural changes we think are poised to create big shifts in profitability across economies and sectors. These mega forces are digital disruption like artificial intelligence (AI), the rewiring of globalization driven by geopolitics, the transition to a low-carbon economy, aging populations, and a fast-evolving financial system.
- The mega forces are not in the far future – but are playing out today. The key is to identify the catalysts that can supercharge them and the likely beneficiaries – and whether all of this is priced in today. We think granularity is key to finding the sectors and companies set to benefit from mega forces.
- We think markets are still assessing the potential effects as AI applications could disrupt entire industries.
- Geopolitical fragmentation, like the strategic competition between the U.S. and China, is set to rewire global supply chains, we think.
- The low-carbon transition caused economies to decarbonize at varying speeds due to policy, tech innovation, and shifting consumer and investor preferences. Markets have historically been slow to fully price in such shifts.
- We see profound changes in the financial system. Higher rates are accelerating changes in the role of banks and credit providers, shaping the future of finance.
- Investment implication: We are overweight AI as a multi-country, multi-sector investment cycle unfolds.
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