Emerging market (“EM”) equity performance relative to developed markets reached new cycle lows, even as China launched measures to put a floor on its sinking market. Economic data in the U.S. keeps surprising to the upside, propping up the dollar to its strongest level in nearly three months. The first batch of elections failed to derail the global rally in stocks. But higher-stakes contests later in the year – Indonesia, India, Mexico, and U.S. elections – have the potential to reintroduce market volatility, as does the risk of worsening conflict in the Middle East and Europe. Cyclical considerations aside, powerful secular trends are shaping prospects for EM economies, and some may already be contributing to the wide dispersion of returns across countries. These crosscurrents, and their implications for future returns, dominated the latest monthly TRG analyst and portfolio manager discussion at the Global Strategy Meeting (“GSM”).

Rethinking interest rates

A recurrent debate in recent months centered on the inconsistency between expectations for imminent U.S. rate cuts and relative upbeat prospects for economic and earnings growth. In January, GSM participants believed that without a negative shock – a sudden growth slump or a bout of financial instability, for example – short-end rates seemed vulnerable as a March cut gets priced out (see TRG’s Macro Conversation: January 2024). This view hinged mainly on the observation that strong incoming data was leading to upward growth revisions, which provided space for policymakers to be patient. Since then, markets trimmed the probability of a March move to near 20% from roughly 75% in early January (see Figure 1). The bulk of the move came after the U.S. Federal Reserve (the “Fed”) Chair Powell signaled on January 31 that while “almost everyone” supports cuts in 2024, he didn’t think ”the Committee will reach a level of confidence” to start easing in March.

With March cuts now largely out of the picture, portfolio managers believed that the critical issue for markets is that the case for lower rates in 2024 remains intact. In other words, the recent repricing has been entirely about the timing of cuts, not the end destination of policy normalization. A rethink of the latter, the consensus agreed, would pose a challenge to risky assets by bringing back concerns over “higher-for-longer” rates. While lower rates are good news for future stock performance, the reasons behind the decision for the Fed to cut matter, too. If the Fed is cutting because of an impending recession, stocks usually falter; by contrast, if the motivation is to simply normalize policy – consistent with a soft-landing scenario – then historically markets tend to strengthen. Lastly, the stronger dollar was responsible for all of the local EM debt loses so far this year; rates holding up well, some noted, suggested investors are not turning bearish on the fundamental backdrop for emerging economies.

China outlook

China was the worst performing major EM stock market in 2023, and the first few weeks of trading in 2024 brought more absolute and relative downside (see Figure 2). The stock rout to multi-year lows pushed policymakers to announce a series of measures aimed at propping up the market, best captured by the so-called “national team” (comprised of state-owned institutions) reportedly buying some US$25 billion in local equities during January.

Participants thought that a structural allocation to China was harder to justify even if there is a case for a near-term rebound as valuations seem to be pricing in a lot of bad news. First, recent actions – verbal intervention, asset purchases, replacing the securities regulator, and curbing short selling – address the symptoms rather than the root cause of market weakness, which boils down to diminished prospects for growth compounded by policy and geopolitical tensions. Second, the stock selloff is not jeopardizing the financial stability objective. Foreign positioning is already low, the central bank is keeping a firm grip on the exchange rate’s daily fixing and various high-frequency financial indicators show little sign of stress. That means there are fewer incentives for policymakers to unveil overly aggressive actions directly aimed at boosting share prices, which could clash with the deleveraging policy. Rather than a certain stock market level, deleveraging progress requires low financial volatility to allow loan write-offs and gradual bank restructuring in the background. From a longer-term perspective, last, participants saw no grounds for policymakers to rethink national-security priorities, which creates further growth disappointment risk – the main reason behind the market derating.

EM through a thematic lens

Taking a step back from cyclical developments, the final part of the GSM discussion focused on secular shifts that are reshaping the global investment backdrop. One prominent mega trend is the end of the Great Moderation phase of low, stable interest rates and inflation, which gave way to today’s backdrop of higher rates and macro volatility. Associated conflict, aging, climate change, and decarbonization costs are also part of a paradigm shift for investors that has often been masked by lingering distortions from the supply and demand shocks unleashed by the pandemic and war. Some of these trends, participants noted, are already contributing to shape individual investment narratives. One example is the de-rating of China’s market, partly related to the intensifying rivalry with the U.S.; by contrast, interest and investment in Mexico – whose stocks are among the best performing in EM in recent years – is soaring due to its attractiveness as a nearshoring destination.

A different angle to this new investment playbook is through changes in traditional roles that various economic agents played in the past. First, policy “puts” are likely to be more limited. Mounting debt loads and servicing costs act as a constraint of fiscal policy, while the recent inflationary experience means central banks would be more hesitant to forcefully react to bouts of market jitters. China’s pivot towards self-sufficiency and national security – at the expense of growth and openness – is probably permanent, so markets will have to further adjust to a slowing China that no longer acts as a source of stability and demand. And the peace dividend of the past three decades is also behind; a great power competition is taking its place, and with it the challenges of trade and financial fragmentation, plus general geopolitical instability. Analysts and portfolio managers agreed that understanding how EM countries, sectors, and companies fit within these secular shifts could be a source of alpha, and thus a necessary part of any investment framework.


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