The cautious tone towards risk that characterized the past two monthly global strategy meetings took a constructive turn at the start of November.
Several factors underpinned this improved sentiment: The Federal Reserve (the “Fed”) seemed to adopt a wait-and see stance, and the U.S. Department of the Treasury’s (the “Treasury”) refunding update eased some concerns about bond supply. The wide gap between U.S. economic strength and sluggishness in Europe and China narrowed, helping limit dollar strength. Conflict in the Middle East, though still fluid, did not escalate; the technical picture also seemed supportive.
The three-month long, broad selloff in emerging market stocks and bonds is creating pockets of value in companies and countries with strong fundamentals and compelling narratives. Two conditions, the global strategy meeting (“GSM”) consensus agreed, were necessary for emerging market assets to perform: long-term yields holding below recent highs and relative stability in geopolitical tensions.
Rates: Peaking?
The persistent and volatile rise in long-term U.S. yields to new cycle highs, which has been driving the risk-off tone in both industrialized and developing market trading, again dominated the discussions. Many of the concerns that sparked the U.S. and global bond selloffs since July are still at play, including uncertainty over the market’s ability to absorb ballooning U.S. debt issuance and the Fed’s leaving the door open for additional hikes as growth stays resilient. Speakers stressed that recent developments, however, seemed somewhat inconsistent with yields making new highs. The Treasury surprised by cutting 4Q issuance and shifting it towards the short end. The fiscal picture remains worrisome, yet this news indicates that policymakers are responding to market concerns.
Incoming data, at the margin, showed that some cracks may be appearing in the U.S.’ Teflon-like economy: October business surveys came in on the weak side and some jobs figures were mixed, for example. The disinflation picture remains intact and oil prices retraced from their mid-October peak as concerns over escalation of the Middle East conflict subsided. The Fed, lastly, signaled that tighter financial conditions – driven by higher long-end rates and the dollar – meant it had less work to do (see Figure 1).
Rates: Debating Higher for Longer
These recent cyclical and policy developments, if they don’t turn out to be head-fakes, suggest that long-term rates have most likely peaked. However, they tell us little about the appropriate level of neutral rates – critical to assess the cost of capital and valuations over longer horizons. Besides a sense that that the post-global financial crisis decade of near-zero rates was the historical anomaly and the world would not return to that, the debate on neutral rates yielded more questions than conviction calls. Higher for longer would make growing government debt piles unmanageable; talk of the need for austerity, moreover, seemed to be the last item on policymakers’ minds: the U.S. is running the widest deficits outside periods of war or crisis, for example. Growing polarization and zero-sum approaches to policymaking, some noted, reduced the scope for reform and collaboration. Speakers also touched on the challenge of pricing the impact of structural forces, such as the shift towards trade and financial fragmentation, the role of AI in boosting productivity, pressures from aging, and the green transition. The question over the equilibrium neutral rate will remain a source of uncertainty; still, any near-term stabilization in long rates, the consensus thought, would likely act as a catalyst for risky assets to regain ground.
Positioning and Narratives
The GSM discussions tend to focus on fundamentals and their implications from markets, ranging from growth-inflation dynamics and how they interact with monetary policy to drivers of exchange rate misalignments and the interplay between governability and reforms. This month, talk of technical factors came to the fore after portfolio managers stressed their importance in rising volatility and shifts in cross-asset correlations. Surveys and other metrics indicate that bearish sentiment in bonds was at extreme levels and the picture for stocks was similarly oversold, suggesting a degree of potential capitulation (see Figure 2). Portfolio managers noted that investors, in the current earnings seasons, seemed to be generally shrugging off positive surprises; by contrast, shares in companies delivering any top or bottom-line disappointments were being severely punished. Others found that markets seemed inclined to quickly extrapolate from any news leading to a dynamic described as “sell first, ask later.”
One example is extrapolating from recent U.S. resilience into a belief that activity would be immune to higher rates. Against this backdrop, several countries and companies exhibiting stronger fundamentals and compelling stories had been caught in the broad selloff, opening interesting opportunities. Signs that positioning and sentiment was one-sided suggested that any snapback in markets could be sharp.
Geopolitical Risk: Here to Stay
The resurgence of conflict in the Middle East brought back with it the specter of regional and global instability. It also comes as a shock to a market that has largely adjusted to living with the Ukraine-Russia war as long as more extreme scenarios – such as the use of unconventional weapons or NATO involvement – remain remote. An initial reaction to the October events in the form of a spike in oil, gold, and volatility was partly reversed in the following weeks, as the sense that war would not spread to new fronts gained ground – a stance that so far has been right. The situation is complex and fluid, making it hard to predict, speakers agreed. Critical questions include whether the war will inadvertently escalate, its impact on regional relationships, and the fallout on domestic politics both within and outside the Middle East. Taking a step back, renewed tensions in the Middle East – along the Ukraine war, fighting in the Caucasus and flare ups in the South China Sea – are a reminder for markets that heightened geopolitical risk is a growing feature of a world that is becoming more fragmented. A higher geopolitical risk premium, some argued, is probably warranted in the current era of great power competition.
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