Monthly Macro Update, July 2023
Little in the macro and investment landscapes is playing out quite as anticipated so far in 2023. Calls for a recession in the U.S. and a pivot by the Federal Reserve turned out to be premature. The U.S. dollar stayed broadly stable, while prospects for
persistent strength in China’s post-lockdown economy faltered.
Yet even with higher U.S. rates and the China disappointment, emerging market stocks and bonds delivered positive returns.1 Could this positive performance continue? In their monthly debate about the outlook for markets, The Rohatyn Group’s analysts and portfolio managers flagged growth as a critical factor to watch. Outside of Europe’s worsening prospects, EM ex-China is showing resilience, as is U.S. activity, while modest stimulus in China is likely to keep the economy chugging along. Another is the repricing higher in the path for U.S. rates. So far, rising U.S. rates reflect mostly diminishing recession risks after the spring-time bank turmoil. If renewed inflation pressures were to challenge the current market view that U.S. rates are close to their peak, it would represent a potential headwind for risky assets.
Crawling towards reflation
The long-standing Global Strategy Meeting consensus still stands: the U.S. is shifting towards a regime of “reflation” as inflation subsides and the Fed cuts rates. However, progress with this transition from the current “stagflation” stage is taking longer and the path is turning riskier. The U.S. curve has repriced significantly, pushing the earliest rate cuts from as early as July three months ago to mid-2024; two-year yields are approaching the pre-bank failure highs of 5%. The jump in yields reflects mainly
surprising U.S. economic resilience – including persistently strong labor markets and green shoots in rate-sensitive areas like housing. Against this backdrop, it became increasingly evident that the Fed’s June pause was not a pivot, and at least one more rate hike is likely in store. Insofar as the economy holds up well, markets may be able to manage the prospects of higher rates for longer – as the Fed is guiding. Markets also seem comfortable with this picture as long as inflation keeps grinding lower; otherwise, the U.S. may require tighter financial conditions via a higher terminal rate – a headwind for risky assets. This uncertainty, coupled with recent gains in asset prices, turned the GSM’s tone towards markets more cautious compared to
past months.
China: slower for longer?
The picture for China’s economy keeps disappointing, including the latest surveys showing persistent sluggishness in manufacturing and weakening services’ momentum. With the scope for forceful stimulus likely limited, TRG analysts argued, the current soft patch could last longer – a risk to the market consensus calling for a second-half turnaround. The stimulus debate covered two aspects: magnitude and structure. On the former, policymakers are prioritizing financial stability over maximum growth, implying less appetite for the traditional re-leveraging mix of aggressive expansion in credit and public works, plus housing incentives. Second, so far policymakers are favoring timid monetary-side measures (lower interest rates, loan swaps)
over fiscal stimulus (tax incentives, handouts) – a structure that appears ill-equipped to address the pessimism among consumers and private business. Weaker growth would not lead to financial instability, however: China has the policy space to keep rolling over and refinancing troubled exposures over an extended period. One consequence of this “no default” strategy is less scope for stimulating growth. With the renminbi near the weakest levels in the cycle (above 7.2), MSCI China giving back half of its post-reopening gains and many trades linked to China growth unwinding, participants agreed that a fair amount of bad growth news was already in the price.
From macro to idiosyncratic
The subject of differentiation remained an area of focus for TRG’s macro analysts and portfolio managers, who offered multiple reasons in favor of selectivity at the asset class, country, and single-name levels. In the near term, recent gains in EM stocks, currencies, and bonds may leave markets more vulnerable to a reversal, with some pointing out to stretched positioning and, in some cases, eroding valuation cushions. Renewed uncertainty about the peak in U.S. rates, China’s growth path, and geopolitics following turmoil in Russia strengthened the need for selectivity, too. Others flagged the wide dispersion in returns seen during the first half of the year, including large performance gaps between higher and lower yielding currencies and the outperformance of assets exposed to some secular themes, such as optimism about the productivity-enhancing power of artificial intelligence. Taking a broader perspective, participants agreed that the range of potential outcomes for the main macro challenges continues to narrow: the Fed seems to be in the final stages of its tightening cycle, Chinese policymakers are adding stimulus to aim to ensure growth reaches their modest growth target, lower commodity prices mean further disinflation ahead. A global backdrop where extreme macro scenarios appear more distant could allow for idiosyncratic factors to keep driving performance.
The China-EM “decoupling”
Despite China’s lackluster economy, GSM participants flagged the good performance of EM assets elsewhere and the implications for future returns. Whereas MSCI EM rose 5% in the first half, that figure doubled excluding China; LatAm currencies outperformed Asia’s (ex-Japan) by four percentage points in June alone. Part of the story may be a function of limited global spillovers from China’s consumer-led rebound. Indeed, markets scrambled to upgrade China growth estimates after the reopening, but this optimism did not lead to upward revisions elsewhere in EM. More recently, EM ex-China growth prospects are creeping up (and China’s lower). Others posited that China’s normalization, even if slower than market expectations, is
acting as a floor on growth and sentiment towards EM as it provides clarity about the economy’s path, in contrast to the uncertainty during the zero-Covid phase. The talk of EM growth differentials shifted to a broader discussion about currencies. Whereas the weak renminbi and yen keep weighing on regional currencies, the Euro’s recent performance has been highly dependent on the central bank’s hawkishness – a stance that the continent’s deteriorating growth prospects makes increasingly fragile. There was no strong consensus about the dollar’s path against the majors, though risk takers saw further scope for depreciation versus EM (particularly against higher-yielding currencies).
