Markets globally gave back part of their early-year gains as the macro story turned more challenging. Upside surprises to both inflation and growth in the U.S. and Europe led to a sharply higher repricing in U.S. rates as well as renewed uncertainty around the Federal Reserve’s path. While many of the factors favoring emerging markets(“EM”) remain in place (compelling valuations, light positioning, and high carry), the asset class is likely to struggle without greater visibility on U.S. rates. This dynamic was a main takeaway from the latest debate among The Rohatyn Group’s (“TRG”) macro analysts and portfolio managers about recent developments and future trends in stocks, bonds, and currencies.
- Growth
The global growth picture continues to improve with signs of momentum favoring EM, as suggested by the EM-led jump in February Purchasing Managers’ Indexes (“PMIs”) and economic surprise indices. China’s rapid normalization remains a bright spot with its February manufacturing PMI approaching expansionary territory for the first time in half a year. While growth remains tilted in favor of EM (relative to industrialized countries), the major development of late is remarkable resilience in U.S. activity, including surprisingly strong hiring figures, spending, and green shoots in interest-rate sensitive housing. As such, U.S. strength raised fears that the economy may not slow enough for inflation to subside. So far, the recovery in China failed to generate a broad-based boost to EM: for example, the consumption-led rebound is benefiting strategies with exposure to tourism and trade (mainly in Asia), with more limited impact on commodities.
- Monetary policy
The GSM debate focused on the implications of renewed uncertainty about the path for U.S. rates, which represents a headwind to assets across the EM spectrum. Prospects for persistent disinflation, economic slowdown in developed markets, and the perception that the U.S. Federal Reserve (“Fed”) tightening was near its end contributed to the rally in risky assets from October through January. However, this narrative was challenged by recent signs of growth resilience and stickier inflation, resulting in higher U.S. rates, a stronger dollar, and choppier markets. The internal consensus singled a potential increase in the pace of interest rate hikes (to half-point increments) by the Fed as the main market risk going forward – this is the case even after markets already priced in a higher terminal rate and no cuts in 2023. By contrast, a “soft landing” scenario of gradual quarter-point hikes would encourage renewed risk-taking in EM. The critical debate about the pace of rates hikes will be resolved in the March 22nd Federal Open Market Committee(“FOMC”) decision.
- Differentiation
The EM complex – currencies, credit spreads, and equities – held up relatively well in recent weeks considering the sharp jump in U.S. interest rates and volatility. TRG participants argued the combination of compelling valuations and light positioning, among other factors, likely contributed to the relative resilience. Differentiation remains an important trend: on the equity front, for example, countries with close links to China’s reopening (Korea, Taiwan) are outperforming so far this year, as have some higher quality credits (Mexico) and sectors with depressed valuations (Greek banks). TRG colleagues believe that a defensive approach towards EM risk exposure is warranted given additional uncertainty, particularly around upcoming Fed moves and the implications for the dollar. Even strategies that have outperformed such as high carry may struggle if U.S. rates keep grinding higher as it may prevent EM central banks from cutting rates, which would ultimately undermine fundamentals.
- Idiosyncratic drivers
TRG participants argued that idiosyncratic drivers of EM performance will likely come to the fore when expectations for the Fed’s terminal rate finally stabilize (something that could occur as early as March 22nd) –a pivot from the current global macro risk dominated trading environment. Areas of potential opportunity include countries facing restructurings such as Sri Lanka, where an International Monetary Fund deal is moving closer after receiving support from China. Egypt is also undergoing a rebalancing aimed at restoring macro stability, and several countries will face general elections – with important implications for the future policy direction – including Argentina, Pakistan, Thailand, and Turkey. Chile, meanwhile, will attempt to rewrite its constitution again. TRG analysts argued the consequences of domestic policy decisions are becoming more relevant given the environment of high interest rates and weaker fundamentals in some cases.
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The information provided herein is for educational and informational purposes only, and neither The Rohatyn Group nor any of its affiliates (together, “TRG”) is offering any product or service hereby. The information provided herein is not a recommendation, offer, or solicitation of an offer to buy or sell any security, commodity, or derivative, nor is it a recommendation to adopt any investment strategy or otherwise to be construed as investment advice. Any projections, market outlooks, investment outlooks or estimates included herein are forward-looking statements, are based upon certain assumptions, and should not be construed as an indication that certain circumstances or events will actually occur. Other circumstances or events that were not anticipated or considered may occur and may lead to materially different outcomes. The information provided herein should not be used as the basis for making any investment decision. Unless otherwise noted, the views expressed in the content herein reflect those of the author(s) as of the date published and are not necessarily the views of TRG.
In fact, the views of TRG (and other asset managers) may diverge significantly from certain of the views expressed in the content herein. The views expressed in the content herein are subject to change without notice, and TRG disclaims any responsibility to furnish updated information in the event of any such change in views. Certain information contained herein has been obtained from third-party sources. While TRG deems such sources to be reliable, TRG cannot and does not warrant the information to be accurate, complete or timely, and TRG disclaims any responsibility for any loss or damage arising from reliance upon such third-party information or any other content provided herein.
Exposure to emerging markets generally entails greater risks and higher volatility than exposure to well-developed markets, including significant legal, economic and political risks. The prices of emerging market exchange rates, securities and other assets are often highly volatile and movements in such prices are influenced by, among other things, interest rates, changing market supply and demand, external market forces (particularly in relation to major trading partners), trade, fiscal and monetary programs, policies of governments and international political and economic events and policies. All investments entail risks, including possible loss of principal. Past performance is not necessarily indicative of future performance. The information provided herein is neither tax nor legal advice. You must consult with your own tax and legal advisors regarding your particular circumstances.
