Emerging Markets Roadmap Q3 & Beyond 30th July 2021
2 For professional investors only Our Thinking on Emerging Markets – Q3 and Beyond: In our view, the backdrop is becoming increasingly complicated for emerging markets. Over recent weeks, market participants have faced a confluence of factors which have buffeted our asset class, including an increasingly hawkish Fed, the surprise RRR cut in China and the fervent debate over “peak” global growth. It is of no surprise that emerging markets (EM) rates and currencies have struggled; there has been much wood to chop. While we remain cautious on the desk, we believe there are still selective opportunities within EM to extract alpha. With further fiscal stimulus entering the system at home and abroad, the foundations for the cyclical rebound are solid; this backdrop is likely to support allocations to some EM rates and currencies, particularly those with a strong beta to global trade and commodities. Likewise, while monetary policy has peaked in both developed and emerging economies, we look for cases of divergence within the EM; we believe that cross market opportunities exist in markets where the hiking cycle is maturing, relative to those who have barely began. At the same time, we remain in the camp that near-term inflation pressure is transitory; the structural headwinds that have been prevalent over the last two decades are likely to dominate. As such, we believe there are selective carry prospects remaining within EM. Finally, we do not anticipate a repeat of the “taper-tantrum” last seen in mid-2013. Why? In our view, much of the “heavy lifting” in preparation for a higher-yielding environment was completed during the Q1 selloff. In other words, market participants are already in a defensive posture following the early year volatility. Below, we explore these themes in more detail, which underpin our cautious, yet selective, stance.
3 For professional investors only Theme 1: US-Led Global Recovery While the “peak global growth” debate is in full swing, looking forward, we believe that the economic recovery is in fine fettle. While there is some evidence of a “topping out” from the white-hot data we have grown accustomed to over H1, we believe that it is somewhat premature to drastically mark down the prospects of the global recovery as a whole. To do so would be missing the wood for the trees. The vast majority of global economic indicators still point toward a robust global recovery over the next two years. As we have noted in recent Roadmap publications, we expect an uneven or disjointed economic expansion which will exhibit significant regional divergences. Compared with our roadmap from Q2, our outlook for global growth remains little changed; we envisage an elongated technology-led and rivalry-fuelled multi-year economic expansion led by the US and China, with the rest of the developing and emerging world left behind. Though China has largely passed the recovery baton to the US, we see both economies outstripping the rest of the world over the course of this year. The United States is highly likely to lead the economic rebound; it is still the most dynamic large economy in the world and will likely recoil from the pandemic stronger and more resilient. The US is on course for its fastest pace of growth in almost 50 years. Beyond the underlying vigour of the US economy, the recovery will be underpinned by a combined force of robust fiscal stimulus and a vaccination program that outstrips most contemporaries. While the Delta variant remains a concern, the accelerating vaccination programme will likely broaden the recovery from goods to services; with household savings in excess of $5trn, the US consumer is well placed to buttress the economic expansion. While we expect China to be at the forefront of the global recovery, recent data suggests that the domestic economic expansion has decelerated. In our view, the natural moderation of Chinese growth makes sense and is of little concern when taken in the right context. Firstly, China is approximately 6 to 9 months ahead of the United States and is currently transitioning to its new “steady state” of economic growth. Secondly, a degree of the growth moderation is policy induced; the Chinese authorities have commenced the process of winding down the credit, fiscal
4 For professional investors only and quasi fiscal stimulus that was introduced in the wake of the pandemic. The name of the game for policymakers is quality over quantity. Conversely, we believe that most Emerging Markets are likely to lag the broader economic recovery this year. Why? While a basket of emerging markets will likely benefit from the cyclicality of the recovery and the resulting demand for commodities and capital goods, others have a distinct lack of domestic growth alpha. The cooling growth momentum in China, which remains the largest trade partner to EM, is an unwelcome development in this context. Particularly if the composition of Chinese growth shifts from investment to consumption. Likewise, many EM economies are highly exposed to the Delta variant as vaccine shortfalls become apparent, which is increasing the likelihood of shallow economic recoveries and ongoing fiscal slippage.
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6 For professional investors only Theme 2: Monetary Policy Divergence In normal circumstances, robust economic growth would likely spill over into other economies and generate a synchronised upswing. This backdrop typically induces a “risk-on” in global markets, drives capital inflows into EM, a weaker dollar and easier financial conditions all around. However, as noted above, we believe that we are heading into an increasingly asynchronous growth backdrop, which is driving monetary policy divergence between countries. While many EM central banks have commenced their tightening cycles ahead of the Fed, the hawkish shift at the June FOMC is a potent challenge. In our view, the change in Fed communication is symptomatic of concerns within the committee that transitory price pressure could result in a dis-anchoring of inflation expectations. Though the Fed continues on message that it is still a “long way from substantial progress”, to taper their asset purchases ahead of the two hikes implied by the dots in 2023, the hawkish message is likely to crystallise over the coming months. As China transitions toward its new “steady state”, a process which is around 6 to 9 months ahead of the United States, the PBoC has shifted to a neutral stance to cushion the resulting moderation in growth. While market commentators have become very excited by the recent RRR cut by the PBoC, we believe that this was no more than a policy “tweak” to guide the growth and policy transition; it is not the starting gun for an elongated easing cycle. That said, the PBoC’s pragmatic approach does remove a looming left tail risk of policy normalisation later this year. Broadly speaking, EM policymakers are somewhere in between. Many central banks have front loaded their tightening cycle in response to mounting inflation pressure. This is hardly surprising; historically, emerging markets have had a mixed experience with inflation, with less frequent periods of well anchored inflation expectations and in many cases, uncomfortable overshoots. Central banks in the Czech Republic, Hungary and Mexico have recently joined the hiking party, alongside those in Brazil and Russia. That said, other central banks, such BI or CBI, are behind the curve, thus far prioritising policy support in light of the Delta variant.
7 For professional investors only Drawing this policy calibration together, we anticipate a challenging backdrop for the emerging markets. As policy normalisation gathers pace in the US, we anticipate higher yields, a stronger dollar and tightening of financial conditions; this combination will pressure EM financial accounts. The resulting capital market outflows from emerging markets are likely to continue to force monetary policy synchronisation with developed markets, despite a sharp asynchronicity of their recoveries from the pandemic. The policy makers that are behind the curve are particularly vulnerable.
8 For professional investors only Theme 3: Sticky Inflation, Structural Headwinds The inflation debate continues to divide the investment community. On one side, market commentators are likening recent price pressures to the structurally high inflation of the 1970s. On the other, is the thesis that the inflation upside surprises in both developed and emerging economies are transitory. Taking stock, it is undeniable that there is "sticky" inflation in the system. In developed economies, this was poignantly illustrated by the US CPI print for June, which grew at the fastest pace in 13 years. There is a similar story in emerging economies; accelerating price pressure has already spurred policy makers across the complex to kick-off their hiking cycles. The inflation experience in both DM and EM has not gone unnoticed at the IMF; in its latest World Economic Outlook they note, "inflation is expected to return to its pre-pandemic ranges in most countries in 2022…however, uncertainty remains high...there is a risk that transitory pressures could become more persistent and central banks may need to take pre-emptive action". We firmly sit within the transitory camp; inflation is likely to peak over the course of H2. In our view, recent price pressure is a direct result of the rapid post-COVID rebound, where a post-lockdown surge in demand has been met with temporary pandemic related supply bottlenecks. At the same time, inflation continues to be propped up by commodity price base effects which will fade from the indices over the coming months. The recent BIS bulletin on this subject (BIS - Global Reflation? July 2021) neatly captures our thinking; “a closer look at the data reveals the pickup in inflation can be ascribed to base effects, increases in the prices of a small number of pandemic-affected items and higher energy prices". The BIS goes a step further, by pinpointing what is missing from the post-COVID recovery to drive sustained inflation; it would "likely require a material pickup in labour costs and an unmooring of inflation expectations...wage growth remains contained and medium term inflation expectations of professional forecasters and financial markets show little sign of de-anchoring". Beyond the short-term transitory disruptions, in our view, the long-standing disinflationary structural mega trends - such as technology, spiralling debt loads, demographics and inequality - remain dominant. In fact, we believe that many of these factors may have been exacerbated in the wake of the pandemic. For example, the pandemic has increased the pace of digitalisation and the role of technology; this is likely to be a permanent shift for many sectors of the economy.
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10 For professional investors only Even if we are wrong and inflation remains stubbornly high, much of this is already factored into market pricing. Thus far in 2021, 5Y5Y inflation swaps - referenced on the CPI index - have been in a 2.20-2.55% range, which is largely consistent with the Fed’s Average Inflation Target (AIT). While markets can both under-and overshoot, valuations are setting a high bar for inflation to be a surprise.
11 For professional investors only Bottom Line: In our view, the backdrop for emerging market rates and foreign exchange is likely to remain complicated over the next quarter. Why? Firstly, against a backdrop of US-led global growth, with the added complication of a lack of EM specific growth “alpha”, we believe that EM is unlikely to extract the same level of “pulled” capital into the asset class. The cooling growth momentum in China, which remains the largest trade partner to EM, is an unwelcome development. Particularly if the composition of Chinese growth shifts from investment to consumption. Likewise, many EM economies are highly exposed to the Delta variant as vaccine shortfalls become apparent, which is increasing the likelihood of shallow economic recoveries and ongoing fiscal slippage. Secondly, we believe that we are entering a regime of increasing monetary policy divergence, which is unlikely to be friendly to EM allocations. In our view, EM is unlikely to enjoy the same level of “pushed” capital into the asset class; as US exceptionalism takes hold over H2, we anticipate higher yields, a stronger dollar, tightening financial conditions and episodic pressure on emerging markets. Likewise, as capital flows away from EM, we expect further synchronisation of EM and DM monetary policy, which is an undesirable development as many economies continue to struggle with the Delta variant. That said, despite these challenges, we do see selective opportunities to add alpha in our asset class over the second half. With further fiscal stimulus entering the system, at home and abroad, the foundations for the cyclical rebound are solid; this backdrop is likely to support allocations to some emerging market rates and currencies. We favour emerging markets which have a strong beta to the demand for commodities and capital goods. Furthermore, while we believe that we are in a “peak” monetary policy environment, regional divergence, in our view, presents cross market opportunities. Particularly in cases where front loaded hiking cycles are maturing relative to those who have barely began. Similarly, given our transitory inflation outlook and the likelihood that the Fed will introduce a controlled normalisation of monetary policy under the AIT framework, we believe that there is alpha to be extracted in selective carry positions; we target the emerging markets which have robust structural underpinnings, despite the emergency fiscal packages
12 For professional investors only rolled out in response to the pandemic. Finally, while the environment is undoubtably tricky for EM, we do not expect a “taper-tantrum” event this year, which adds confidence to our selective bias. From a positioning standpoint, most market participants are already in a defensive posture; most of the heavy lifting was completed during the Q1 rout.
13 For professional investors only Other publications How the Indian Rupee Stands Out in the EM Universe, July 5, 2021 Europe’s Resilience to Shocks, June 28, 2021 My Thoughts on Currencies, June 21, 2021 China’s Corporate Debt and Defaults – A Sanguine Perspective, June 14, 2021 Our Thinking on Emerging Markets - Q2 and Beyond, May 25, 2021 Chinese RMB’s International Currency Status, May 20, 2021 My Thoughts on Currencies, May 19, 2021 Growth and Stability in Industrialised Countries: Rules Versus Discretion?, May 12, 2021 One Size Fits None, May 7, 2021 Is China's Bond Market Crowding Out EM?, April 27, 2021 The US to Export Inflationary Pressures through Trade Deficits, April 26, 2021 China Envy: The West Emulating China’s Big Government, April 13, 2021 Trouble in Turkey: Contagion for Emerging Markets?, March 30, 2021 My Thoughts on Currencies, March 29, 2021 Fiscal Stimulus Should Make the Dollar Smile, March 23, 2021 My Thoughts on Currencies, March 3, 2021 Frontier Markets, Sitting Between China and DM, March 1, 2021 The World is Underweight China, and Vice Versa, February 26, 2021 Why is the CHF so Strong? A Balance Sheet Explanation. February 18, 2021 Emerging Markets = China + EM ex-China, February 12, 2021 My Thoughts on Currencies, February 4, 2021 Emerging Markets FX: Keep the Faith, Baby, February1, 2021 E-CNY, January 25, 2021 A Structural Perspective on Global Market Cap Trends, January 12, 2021 My Thoughts on Currencies, January 6, 2021 Mother Hubbard and Emerging Markets: Is the Policy Cupboard Bare? Trade Regionalisation: A Tale of Three Continents, November 27, 2020 EM Local Markets, and the Rise of Index Tracking, November 23, 2020 My Thoughts on Currencies, November 18, 2020 Whatever It Takes, October 30, 2020 Our Structural View on Currencies: CNY > USD > EUR, October 28, 2020 Chile and the Peaking of ‘Globalisation 1.0’, October 27, 2020 My Thoughts on Currencies, October 5, 2020 Europe Needs a Weaker Euro, September 21, 2020 My Thoughts on Currencies, August 31, 2020 Taiwan at the Crossroads of Geopolitics and Technology, August 24, 2020 The US General Election, US Equities, and the Dollar, August 7, 2020 The US versus China: On the Use of Financial Sanctions, July 20, 2020 My Thoughts on Currencies, July 13, 2020
14 For professional investors only Further information Useful links Visit our website for more insights & details about our strategies www.eurizoncapital.com/UK Further information Useful links Sales & Business Development Matt Jones, Head of Distribution Email: firstname.lastname@example.org Mobile: 07716 639835 Business address Eurizon SLJ Asset Management 90 Queen Street London EC4N 1SA
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