EWZS - Applying Our Playbook To EM

2023-07-17 11:10:00 ET

Summary

• We favor emerging market to developed market 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’s 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.

Emerging market edge

The chart shows yield levels for the JP Morgan Emerging Market Bond Index Global Diversified (EM hard currency), JP Morgan GBI-Emerging Market Bond Index Global Diversified and the benchmark U.S. five-year Treasury.

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 take in the context of what’s in the price.

Evolving our playbook

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 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.

Market backdrop

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.

We look to U.S. data out this week for more signs that higher policy rates are cooling production and spending. CPI data across developed markets will likely show persistently high inflation - making central banks hold tight on policy. We’re also focusing on GDP and industrial data for China to gauge to what extent its economic restart is losing steam.

This post originally appeared on the iShares Market Insights.

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