Monthly Macro Update, June 2023
The growing importance of differentiation and selectivity was front and center in TRG’s monthly Global Strategy Meeting (“GSM”) of the themes shaping the outlook for financial markets.
With major macro tail risks diminishing, attention is turning back to idiosyncratic factors as drivers of performance at the country, asset class, and single name levels, TRG’s macro analysts and portfolio managers contended. Plenty of global question marks persist, ranging from the durability and strength of China’s recovery to the timing of an eventual pivot by the U.S. Federal Reserve and the staying power of underlying inflationary pressures. But the range of potential outcomes to these challenges is narrowing. Additionally, it is not clear that there is a lurking global macro event that will dominate the market narrative, as accelerating inflation and central bank tightening did during most of 2022. A global environment where extreme macro scenarios appear remote, if it persists, makes emerging markets (“EM”) – with their asynchronous business cycles, policy mixes, and diverse strengths and vulnerabilities – a compelling vehicle for capitalizing on idiosyncratic opportunities in our view.
Subsiding Global Tail Risks
The role of global macro risks as the primary driver of market performance is diminishing, debated GSM participants, and this trend is likely to intensify going
forward. This observation reflects the perception that the range of potential outcomes for many of the dominant macro challenges are significantly narrower today. Bank failures did not morph into a systemic crisis, nor did the recent debt-ceiling standoff. The Fed seems to be nearly done increasing interest rates, with the market pricing in only one additional quarter-point hike in June or July. The cyclical bounce in China’s economy remains on track, even if its pace disappointed of late. Recent attacks on Russian soil failed to rattle commodity markets, suggesting that the risk of an extreme scenario – involving unconventional weapons or attacking a NATO territory – remains remote. Aside from an “unknown unknown,” participants pointed out that there was no obvious near term macro event with the potential to cause a sharp market repricing, in contrast to 2022 when the spike in inflation and aggressive rate hikes meant there was nowhere to hide (except for commodities and the dollar).
From Beta to Alpha
One theme dominated June’s GSM debate: differentiation. The focus on differentiation may seem understandable based on the wide dispersion in returns so far this year, from narrow leadership in U.S. stock indices (large-cap tech dominated) to ample outperformance by higher yielding EM currencies (like Mexico’s and Hungary’s) or from only half of MSCI EM countries outperforming the index (versus 75% in 2022). Discussions, instead, centered on the dynamics of this apparent beta to alpha handoff, which TRG analysts and risk takers saw as a reflection of subsiding global macro risks. In turn, greater visibility into big global debates – such as U.S. monetary policy, inflation, and China growth – opens the door for idiosyncratic factors to take the lead as performance drivers. The ongoing shift from beta to alpha should play out at the asset class, country, and individual security levels if it persists. Active management implications are straightforward: there is more space to capitalize on compelling valuations, fundamentals, and positioning for shifts in the business cycle or policies, with less risk of those factors being entirely overwhelmed by global developments.
There is more space to capitalize on compelling valuations, fundamentals, and positioning for shifts in the business cycle
or policies, with less risk of those factors being entirely overwhelmed by global developments
Weakening momentum in China became an intensely debated subject. Incoming data confirms the lopsided nature of the recovery with services improving driven by pent-up demand – a trend that we believe has room to go. But there are few, if any, signs of broadening strength: private capex remains lackluster, manufacturing is struggling, housing is faltering again, and sales of durables are weak. By prioritizing financial stability over maximum growth, the policy toolbox is now less potent as the old playbook of relying on credit, public works, and housing runs against the deleveraging objective. So while TRG analysts see cuts in the reserve requirement ratio and lending rates ahead, they argued that the scope for aggressive policy easing is limited. Risk takers singled out commodities as an asset class that may already be pricing in plenty of China pessimism, with the added advantage of providing some protection (relative to exposure to Chinese stocks) from uncertainty over regulation and geopolitical tensions. Another axis of differentiation is the optimism around artificial intelligence, which seems behind the jump in tech-related equity inflows into Taiwan and Korea and, despite China growth concerns, the outperformance within Asia of the low-yielding Korean won and Taiwan dollar.
Business Cycle Transitions
The GSM’s analysis of the business cycle keeps pointing to a transition in the U.S. from a regime of light “stagflation” – of subpar growth and above-trend inflation – to one of “reflation” as inflation subsides and the Fed eases. That remains the view from TRG economists, even after markets priced out most of the cuts expected through year-end. Lower energy prices are reinforcing the disinflationary trend in goods and, with time, should push core inflation lower, too. The discussion also touched on the risks of recession given the disconnect between strong corporate earnings and cautious forward guidance. Despite an inverted yield curve, incoming data does not point to a U.S. recession; globally, weakness in some sentiment indicators and manufacturing stand in contrast to resilient consumer spending and services. Whether the correction in goods consumption (from its post-pandemic surge) has run its course remains unclear, with implications for trade-focused economies in Asia. With policy rates already high and inflation gradually easing, there is more space to rely on counter-cyclical policy to cushion any growth downturn. Lastly, excess savings are still ample – in Europe, Japan and, to a lesser extent, the U.S. – allowing consumers to keep spending and reducing the risk of a deeper slump.