The global economy and markets have been grappling with a series of shocks, which are complex, diverse and often mutually reinforcing. While the high degree of uncertainty that has characterized the prospects for markets throughout the year persists, the sands are starting to shift in three critical areas: the outlook for China, the inflation challenge and the Ukraine conflict. Further visibility on these fronts would have important implications for asset allocations. After all, many of the trades that did well over the past year – such as long the dollar, betting on rising yields or favoring advanced over developing market equities – have struggled in recent weeks, hinting at a potential inflection, or at least a less favorable risk-reward.

Market sentiment is on the mend, with financial markets in emerging and industrialized economies alike taking on positive momentum. Evidence spans across asset classes and various market gauges. Measures of asset price volatility have come off 2022 highs in both bonds and equities. Meanwhile, Chinese stocks – one of the main underperformers in emerging markets this year – bounced by nearly a quarter in November, according to the MSCI China Index. Equities also rebounded in Europe, even though the consensus expects a recession as early as the current quarter. Newfound optimism around the economic outlook partly drove the move, with many anticipating a less severe contraction as energy costs fall to levels seen last summer. Some haven assets are well off recent peaks, notably the U.S. dollar which enjoyed near uninterrupted gains since mid-2021.

China’s investment narrative is shifting for the better as concerns over the trajectory of its economy and policy subside. The factors responsible for China’s slowdown are both cyclical and structural in nature. Policymakers’ commitment to a strict zero-covid strategy is leading to recurrent lockdowns, popular dissatisfaction and mounting fiscal and economic costs. The second major drag on growth comes from the structural adjustment in the property sector, which is at the center of a broader deleveraging policy. Now policymakers are pivoting by relaxing pandemic restrictions and expanding measures to prop up property developers. The former provides a path towards eventual re-opening -- the most senior official in charge of the pandemic response signaled a “new stage…with new tasks” in the fight against the virus on December 1. The latter reduces risks of a disorderly adjustment triggered by cascading bankruptcies among homebuilders. Both entail prolonged processes with scope for setbacks along the way. For instance, Covid cases are surging ahead of the winter period and Chinese holidays. Meanwhile, structural challenges linger, above all the transition away from prioritizing the economy in favor of security and self-sufficiency confirmed in the 20th Party Congress. From a market standpoint, however, we believe the new measures are a reason for near-term optimism.

The relentless, generalized tightening in global financial conditions may be approaching an inflection point, as markets begin to anticipate a pivot by major central banks, particularly the Fed. After lifting rates to a thirteen-year high of 1.5% last month, the ECB highlighted “substantial progress with withdrawing” liquidity and signaled greater concerns about downside growth risks. Similarly, the early-November FOMC statement included new language that policymakers will “take into account the cumulative tightening of monetary policy” and the lags with which it acts. To be clear, Chair Powell stressed that the Fed still had “a long way to go in restoring price stability,” but he also added that the December 14 meeting may mark the “time for moderating the pace of rate increases” – markets are pricing in a terminal rate approaching 4.9% currently. Peak inflation seems to be behind as prices of goods and commodities inflect lower, but signs that core pressures are easing are more tentative amid resilience in labor markets (see Exhibit 2). Central banks, however, appear to be closer to the end of their tightening cycles. By telegraphing that they may slow the pace of rate hikes going forward (as Canada and Australia already did) and assess the impact of past tightening, they limit the risk of overdoing it with negative implications for growth and financial stability.

Lastly, market participants’ perception of the war in Europe seems to be shifting. Ten months into what has become a war of attrition, neither side has delineated a viable path towards a cease fire and eventual peace; Russia’s recent attacks on civilian infrastructure appear to be a strategy aimed at inflicting further hardship on the population as winter approaches. Markets, however, appear to have learned to live with the war’s fallout, including disruptions to commodity markets. Prices for most of the commodities that surged in the aftermath of the invasion, such as oil and grains, are near or back to pre-war levels (see Exhibit 3). The energy crunch is still playing out, with Europe front and center. The continent has successfully filled its gas storage sites ahead of the winter in response to the shock. Russian oil, meanwhile, found eager buyers in China, Turkey and India. New sanctions on Russian exports in early December could disrupt the flow of oil and Europe is unlikely to avoid a recession. Yet the perception that the range of outcomes is narrower is allowing markets to look past some of the geopolitical uncertainty and economic downside, insofar as the more extreme scenarios remain remote.

As these macro factors keep shifting, investors will want to stay attuned to potential opportunities created across the emerging market complex. Past bear-market bottoms for emerging market equities, for example, have been associated with a Federal Reserve pivot, a weak dollar or both. At the very least, these shifting conditions point to opportunities to shift allocations from the overly defensive strategies that have outperformed so far in 2022, such as long positions in the U.S. dollar, or developed over emerging market equities. Many spots in EM provide compelling opportunities to express a less defensive stance: several credits with solid fundamentals offer historically high yields, and downward earnings adjustments have gone much further than in developed markets. Wide performance dispersion between asset classes and within EM reinforces the case for selectivity – a trend we suspect will persist in 2023 as the sands keep shifting.


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