• A hawkish Bank of Japan and growing fears of a U.S. recession, compounded by election uncertainty and mixed earnings, sent global markets into turmoil in early August.
• A weaker dollar and forthcoming Fed easing may give EM central banks, including those in Asia, greater room to cut rates and better calibrate monetary policy to domestic conditions.
• But EM still faces headwinds if the U.S. growth scare turns global. The EM space, and Asia’s exporters in particular, need a revival in global growth and trade to outperform.
Global markets went into turmoil in early August, experiencing a massive unwinding of consensus positions that had hitherto been winning trades of 2024. A series of events triggered sharp risk-off moves beginning with uncertainty over the U.S. elections and discomfort over possible imposition of new trade tariffs, followed by a hawkish Bank of Japan (“BoJ”) and, finally, mounting fears of a U.S. recession after a weaker-than-expected July employment report. The capitulation was broad-based and fast moving, including unwinds on yen-funded carry trades that elicited outsized moves in currency pairs, steep corrections in the Magnificent-7 tech stocks and, at its lows, as much as a 25% drawdown in the Nikkei from its mid-July peak. (see Figure 1).
We examine these walls of worry and assess how they could affect global sentiment towards emerging markets (“EM”) in the coming months.
Trade tariffs
A note of caution was first expressed in the mid-July TRG Macro Conversation, which stated that “many assets are already taking a lot of credit for Federal Reserve (the “Fed”) easing, a soft-landing scenario, and the global export recovery; the risk of tariffs, by contrast, did not seem to be in the price.” At that time, these concerns were drawn from the historical experience of 2018-19, when the U.S. implemented additional tariffs averaging close to 20% on almost two-thirds of Chinese exports. But the more insidious effect was the unpredictability of tariff announcements that had a large bearing on Asian markets and close U.S. trading partners such as Mexico.
Ultimately, firms adjust by finding alternative supply chains to substitute for more expensive tariffed goods. As China’s loss of U.S. market share in tariffed goods fell, other Asian economies stepped up. MNCs diversified supply chains by relocating out of China, evidenced in China’s export surge to ASEAN over the last five years. Moreover, Chinese firms followed the money, deepened trade and investment linkages and economic ties with recipient countries, entrenching themselves more firmly into global supply chains. Mexico also stepped in to fill in the gap benefiting from its proximity to the U.S., the advantage from the USMCA trade deal, and a growing dependence on Chinese imports, too.
Trade and foreign direct investment flows could ultimately adjust to tariffs as long as trade diversion, not trade destruction, remains the underlying regime. But asset prices will not adjust in a similarly benign fashion to sudden tariff changes – over 2018-2019, when U.S. trade policy pivoted to China, random tariff pronouncements were accompanied by spikes in the USDCNY rate and broader EM FX, declines in Chinese and Asian equities.
Moreover, there is no guarantee that the global trade system will remain intact if the U.S. further increases tariff rates on China, imposes broader tariffs on countries that run a sizeable bilateral trade surpluses with the U.S., and if these measures were reciprocated with countervailing tariffs. Friend-shoring of supply chains on the basis of national security considerations, instead of cheaper production, will likely end up in rising costs and inflationary pressures for all. And the risk of further trade restrictions that reduces the vibrancy of an open global trading system cannot do any good for Asia’s trade dependent economies. These reasons formed the basis of our cautious assessment in mid-July.
Monetary Divergence and Fast Unwinds
On July 31, the BoJ hiked its policy rate by 15bps, to 0.25% and set out a schedule for reduced JGB redemptions. With Fed Chair Powell leaning slightly dovish 24 hours later at the July FOMC press conference by signaling that a September rate cut “could be on the table,” U.S.-Japan monetary policy divergence finally kicked in as a meaningful theme for currencies (see Figure 2).
USDJPY fell through 150 and the sharp appreciation of the JPY caused an unwind of JPY-funded carry longs across developed markets and EM FX. Some popular carry-trade currencies that had already endured large depreciations due to domestic policy concerns, such as Mexico’s and Brazil’s, came under additional pressure. JPY appreciation was also hugely negative for the Nikkei.
Growth fears
The July TRG Macro Conversation noted signs of global activity losing momentum with downside data surprises most pronounced in the U.S. It flagged the risk that “at some point the U.S. slowdown (if it persists and absent offsets from Europe or China) begins to raise tail risks to global growth.”
These concerns were ignited by a surprisingly weak ISM manufacturing print, weekly jobless claims rising to a one-year high, and mixed earnings results, including for many consumer companies. But the disappointing July jobs’ report on August 2 was a huge inflection point, with markets shifting decidedly to interpreting weak economic news as bad news. Until very recently, bad economic news meant higher chances of Fed cuts – and markets ran on optimism about lower rates – while downside growth risks were a secondary consideration. Put differently now growth fears, not inflation relief, have become the center of attention. And downside U.S. activity from here risks a growth scare that could at some point turn global.
The sharp stock selloff and surge in bond prices of the past few days suggests that investors are quickly rethinking the prevalent soft-landing narrative, replaced by rising concerns of recession or hard-landing and that the Fed may be behind the curve. Fed Funds futures, which before the bad string of data were pricing in fewer than three quarter-point cuts by year-end, are now pricing in more than four cuts with cumulative cuts approaching 225bps by the end of 2025, a magnitude that has historically occurred only during U.S. recessions.
To be clear, the U.S. appears far from recession as consumer spending is holding up well, fiscal policy remains expansionary, and financial conditions are easier; the ISM services index, released August 5, surprised to the upside, moving back into positive territory (51.4) and, later in the week, initial jobless claims moved lower. Moreover, July’s “ugly” job growth figure was +114K, which is near estimates of the breakeven pace (or the rate at which the labor force grows) under normal circumstances (meaning with smaller net migration than the surge of recent years). The burden of proof now lies in incoming data to convince markets that a U.S. recession is not in the cards – if that hurdle is cleared, the current selloff will begin to re-establish a trough as the market trades on a more constructive theme of a soft landing and inflation relief. Global markets are already starting to recoup some of their losses this week, thanks to a sharp reversal in the Nikkei and an ebbing of JPY appreciation pressures on the back of BoJ officials downplaying the odds of a near term hike.
Implications for Asia
With the USD falling and the Fed likely to cut rates, Asia appears to have greater room to ease. That would remove a dilemma for many central banks who could not cut rates before the Fed for fear of their currencies falling against the dollar yet were faced with weak domestic demand conditions. With the FX constraint now less binding, monetary policy that is recalibrated to suit domestic conditions would provide welcome relief.
But the region still faces export headwinds in the form of a worsening global growth backdrop and likely increased rhetoric on trade tariffs in the runup to the U.S. presidential elections. In effect, the main drag from Asian currencies for most of 2024 – the loss of a nominal currency anchor in the form of a depreciating JPY – was decisively removed with recent JPY strength. Even though Asian FX appreciation gives central banks the latitude to cut rates, the global mix of weak growth and forced JPY unwinds has ironically turned an improved currency outcome into a Pyrrhic victory. Asia needs to see a revival in global growth and its export cycle in order for its asset markets to outperform.
Vincent Low
vincent.low@rohatyngroup.com
Vincent has over 30 years of experience in covering global macroeconomics and markets. He is responsible for formulating investment ideas with PMs, strategists, and equity analysts and developing macro investment themes and processes for TRG’s public markets business. Prior to rejoining TRG, where he was previously CEO of its Singapore office and an Executive Committee member, Vincent held the role of Advisor to the Economics Policy Group at the Monetary Authority of Singapore. He also held roles as the Head of Currency and Fixed Income Strategy at Merrill Lynch, and Senior Economist for Southeast Asia at J.P. Morgan and Standard Chartered Bank. Vincent started his career at the Monetary Authority of Singapore in 1987 and received a Bachelor of Social Sciences in Economics from the National University of Singapore.
Luis Arcentales
luis.arcentales@rohatyngroup.com
Luis has over 20 years of experience in covering global macroeconomics and markets. He is responsible for formulating market strategy at TRG. Prior to joining TRG, he had a short stint as an independent macro researcher following a nearly two-decade career at Morgan Stanley in New York. In his role as Senior Economist, his primary focus was developing the macroeconomic and political outlooks for countries in Latin America, in addition to publishing on topics ranging from the business cycle to trade dynamics for the region. Luis started his career as an equity strategist at McGlinn Capital, a value-oriented asset manager in Pennsylvania. He holds an MS in Economics and a BA in Industrial Engineering from Lehigh University; he sits on the board of Lehigh’s Martindale Center for the Study of Private Enterprise and is a CFA charter holder.
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