EMHC - EM Assets Have The Edge - For Now

2023-04-24 10:30:00 ET

Summary

• We are leaning into our preference for emerging market (EM) assets due to China’s restart, ending EM interest rate hiking cycles and a weaker U.S. dollar.
• Global stocks were flat on the week. PMI data showed economic activity holding up in the U.S. and Europe. Sticky UK inflation pointed to more rate hikes.
• This week’s GDP data in the U.S. and euro area will help gauge the economic damage from rate rises. We see hikes hitting growth later this year.

Transcript

Emerging market growth has been resilient. That may seem unusual after rapid rate hikes by major central banks.

Here’s why we lean into emerging market assets more than developed peers in the short run.

1) China’s restart boosts emerging markets

A pickup in Chinese demand and tourism has pushed emerging market activity above developed market economies since this year. That benefits emerging market equity indexes, since Chinese firms account for a big portion.

We also expect monetary policy in China to stay supportive given low inflation.

2) Rate hiking cycles ending

Emerging market central banks are nearing the end of their rate hiking cycles. Some have already paused hikes, like in Brazil and India.

We think rate cuts may occur sooner in emerging markets and would ramp up activity, supporting emerging market assets.

3) Favorable exchange rates

The strength of emerging market exchange rates also favors local currency debt. We don’t think central banks will need to raise rates to prevent currency depreciation, that could fuel inflation.

Why? The U.S. dollar has weakened against other major currencies as the market expects the Fed to end rate hikes. Stubborn inflation makes rate cuts this year unlikely, but we think the Fed will stop hiking once the damage is clearer.

We like emerging market assets and prefer higher-rated countries within emerging market debt, such as Mexico.

Our views flip on a strategic horizon due to structural changes like geopolitical risks.

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Our new playbook calls for quickly shifting portfolios based on how much damage is priced in. We went overweight EM stocks and our long-held preference for EM debt in March on a six- to 12-month tactical horizon, as they price in more rate hike damage than developed markets (DMs). We took advantage of near-term events favoring EM assets: China’s economic restart, pausing EM interest rate hikes and a weaker U.S. dollar as the Federal Reserve nears the end of its rate hike campaign.

Relative strength

Notes: The chart shows 12-month rolling total return of JPMorgan’s GBI-EM index minus the 12-month rolling total return of the Bloomberg U.S. Credit USD. This is referred to as the excess return. It also shows the difference between the S&P emerging market manufacturing PMI and U.S. PMI.

It may seem an unusual time to favor EM after major central banks’ rapid interest rate hikes. Yet, we’ve seen a clear resilience in EM economic activity (yellow line in chart) even as rising rates have slowed DM activity. Total returns for EM debt have jumped above returns for DM credit since mid-2022 (dark orange line) as a result. A key difference: EM central banks kicked off rate hikes as much as a year before DM peers. Some already stopped hiking, while DM central banks have more to do and likely won’t cut rates soon given stubborn inflation. Brazil’s central bank has held its policy rate at 13.75% since September. Central banks for India, South Korea and other nations have paused policy rates more recently. Rate cuts would help ramp up EM economic growth sooner than in developed economies. The International Monetary Fund still sees EM GDP growth about three times higher than for advanced economies this year and next, its April forecasts show.

We don’t think EM central banks will need to keep up with DM central banks’ rate hikes to avoid currency depreciation. EM currencies have, in fact, gained against the U.S. dollar as the Fed nears the end of its hiking cycle. Plus, EM debt is now more concentrated in local currencies than the dollar, JP Morgan index data show. We think that makes any future weakening in EM currencies easier to handle. This means EM central banks have paused and can begin cutting rates sooner than DM counterparts. We see DM central banks keeping rates higher for longer to fight sticky inflation, making rate cuts this year unlikely. This will all help EM economies keep outpacing developed economies this year, in our view. We turned overweight EM local currency debt again in March, after having a relative preference for most of last year. While fund flows show investors have favored EM stocks since 2022, flows into EM local debt remain more muted and have the potential to increase.

EM stocks' near-term appeal

Even with investors leaning into EM shares, they’ve underperformed DM stocks for over a decade. We don’t think EM shares are reflecting the likely growth outperformance of emerging economies this year. We went overweight EM stocks in February to get short-term exposure to China’s restart. The restart helped China’s Q1 GDP beat market expectations last week, in line with our view of growth around 6% for the year. It’s also helped EM economic activity outpace DM economies since the year started. We expect policy in China to stay supportive given very low inflation, and that benefits EM stocks: Chinese companies make up a large share of major EM equity indexes. The pickup in Chinese demand and tourism should especially boost Asian firms’ earnings and shares. Renewed demand for commodities is another positive helping emerging economies such as in Latin America.

Longer term, China’s powerful restart doesn’t change structural trends like aging populations and tensions with the U.S that will drag on long-term growth. We think the geopolitical risk of holding Chinese assets has risen. We see investors demanding more compensation to reflect that and risks from regulatory and government intervention.

Our bottom line

We like EM stocks and bonds over DM in the short run. We also prefer higher-rated countries within EM debt, such as Mexico, similar to our overall quality preference - especially within DM equities and credit. Higher-rated countries have falling inflation, more balanced external accounts, adequate currency reserves and lower debt-to-GDP levels. Yet, EM assets wouldn’t be immune to a risk asset selloff and U.S. dollar surge from more Fed hikes. Our relative views flip on a horizon of five years and over. We see geopolitical risks weighing on EM risk-adjusted returns, so we prefer DM equities in the long run. We also think DM economies will benefit more from the transition to a lower-carbon world than EM on that horizon.

Market backdrop

U.S. stocks paused as European stocks hit a 14-month high last week. U.S Treasury yields largely steadied after a recent rise on expectations for the Fed to hike rates in May. The March UK inflation data showed how sticky inflation is proving across major economies. Sticky inflation and the April PMI data showing economic activity holding up in the U.S and Europe suggest major central banks have more work to do to fight inflation. We don’t see them coming to the rescue with rate cuts this year.

GDP data in the U.S. and euro area this week will help gauge the economic damage from rate rises. We see hikes hitting growth later this year and no rate cuts in 2023 from major central banks. We expect the Fed to stop hikes when the damage is clear but think the European Central Bank will keep going to get inflation to target regardless of the damage that entails.

This post originally appeared on the iShares Market Insights.

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