Opportunities in Globalization Rewiring
- We see emerging markets better withstanding volatility and benefiting as supply chains rewire. We switch our EM debt preference to the hard currency from local.
- Developed market stocks slid last week and long-term bond yields jumped as markets focused on U.S. fiscal challenges. We see long-term yields rising more.
- All eyes are on U.S. inflation this week after softer-than-expected data in the last CPI print. We see persistent wage pressure keeping core inflation sticky.
Last week’s bond yield jump and stock tumble underscore we’re in a new regime of greater volatility. A renewed focus on U.S. fiscal challenges and surprise policy tightening in Japan have stirred up volatility in developed markets (DM). We think emerging market (EM) assets have an edge as their central banks cut rates and benefit from rewiring supply chains. What’s in the price is key. We rotate our EM bond preference to favor hard currency and stay granular in EM stocks.
Trade activity between nations dipped between World War One and World War Two (yellow shaded area in chart) before surging in the decades after World War Two as globalization took shape. Yet trade as a share of global GDP has plateaued (orange line) since the 2008 global financial crisis – one sign that globalization is under pressure. We see a world of fragmentation ahead: Competing defense and economic blocs are emerging. Multi-aligned nations are set to grow in power and influence, and we expect many major EMs to fall into this camp. As global fragmentation plays out, countries and companies are increasingly prioritizing security and resiliency – through industrial subsidies, export controls, and other tools – over maximum efficiency. We see this shift in priorities accelerating the rewiring of supply chains as nations aim to bring production closer to home. All this favors selected EMs, in our view.
Against that structural backdrop, we also favor broad EM exposures over DMs in the short term. DMs are experiencing bouts of volatility and we see the risk of more. The Fitch Ratings downgrade of the U.S. credit rating last week and the U.S. Treasury’s sizable borrowing needs put a spotlight on the challenging U.S. fiscal outlook. We think EMs are relatively better positioned to withstand some of this volatility. That’s partly due to EM central banks nearing the end of their rate hiking cycles. Some have started to cut policy rates, like in Chile and Brazil. Yet they’re not immune from a sharp hit to risk assets, in our view.
We put our new playbook in action again by gauging what’s in the price. We flip our overweight EM local currency debt to neutral and turn overweight EM hard currency debt on a six- to 12-month tactical horizon. We had been overweight EM local currency debt since March on attractive yields from EM central banks nearing the end of their hiking cycles and a broadly weaker U.S. dollar. We began to reassess our view on local currency in July: Yields have fallen closer to U.S. Treasury yields. Rate cuts seem largely priced in and could put downward pressure on EM currencies, dragging on local currency returns.