'EM in 10' update - April 2023
Gustavo Medeiros, Ashmore’s Head of Research, answers some timely questions about recent events and performance in Emerging Markets for our 'EM in 10' monthly video review.
This month Gus answered the following questions:
- Can you please give us a brief review of last quarter.
- Can you share some thoughts on the banking crisis?
- What about the recent OPEC+ move?
- Finally, what is the impact of all this to EM?
- Is the Chinese RMB becoming a reserve currency?
Transcript is available below.
Stephen Rudman: It is Tuesday, April 4, 2023. Welcome and thank you for watching Ashmore's ‘EM in 10’. My name is Stephen Rudman, I'm a member of Ashmore’s New York-based client team. Today, I will be asking Gustavo Medeiros, Ashmore's Global Head of Research, his thoughts on the latest in Emerging Markets (EM) and global markets. Needless to say, it has been a busy time over the first quarter. So, Gustavo, welcome. I will start with a broad question: please can you give a brief review of what the first quarter has given us.
Gustavo Medeiros: Absolutely. Thanks, Stephen, it's good to be here and to do this again. Yes, the first quarter was a positive quarter overall. We had EM equities up about 4%, led by China, despite the fact that China had a bit of a wobble at the beginning of the year. Asia outperformed, and EMEA underperformed. The S&P was up 7.5%, but then, looking closer you can see that tech did very well with the NASDAQ up something close to 20% and with the more traditional Dow Jones index flat on the quarter. So, the top 10 names really were driving the equity market outperformance, and there was very narrow leadership.
The market is trading still on the adage that low rates are good for equities. But this is not so accurate if low rates are anticipating an incoming recession. I think there is a big discrepancy between what the global rates market is pricing versus global equity markets.
EM local bonds were up 5.2% with EM FX rallying 2.2%. Interestingly, the dollar index was down, but only by 0.7%, so EM FX outperformed. EM local currency debt also outperformed dollar-denominated debt. Sovereign debt was up 1.9%, with investment grade up 2.8% and high yield only 0.9. And corporate debt went up by 2.2% with similar performance of IG and high yield. In the commodity space, the commodity index was down 3.6%, led by energy. Natural gas halved in price, down 50% for the first quarter, while oil prices were down 7.2%, but that has since been reversed after the OPEC+ production cut was announced.
In summary, it has been a pretty positive start of the year, although I think there is a big discrepancy here between rate expectations and the yield curve starting to steepen very aggressively after trading at the flattest levels since 1980. Typically, that is a leading indicator for a recession ahead, but looking at the S&P500 right now it feels like a very different universe to the rates market. I suspect this discrepancy's going to be resolved in the coming months.
Stephen Rudman: Thank you. So, the surprise we got in the first quarter, in the second half of March, was the banking crisis, or the potential banking crisis. If you could share your thoughts on that, and what the real impact may or may not be.
Gustavo Medeiros: Sure. And we have two good pieces that I'm going to link to because they highlight the issue. So far, the banking sector crisis in the west is a crisis of confidence. Nothing different than what people do during extreme times. Now though, small and regional banks are in a pickle – either they lift deposit rates and lower margins, or they're going to lose deposits to the large banks and money markets.
So far, the confidence shock has been back-stopped by the Federal Deposits Insurance Corporation (FDIC), and the US Federal Reserve (Fed) lending mechanism, whereby a bank can use Treasuries or agency bonds at par as collateral for a very cheap loan at the overnight rate plus 10 basis points. But the real problem lies ahead, in our view, when commercial real estate starts cracking and banks that have not had a liquidity issue or a confidence crisis as a result of redemptions coming in (forcing them to sell Treasuries that are trading below par), are still are facing a credit issue.
The Fed won't be able to do anything to back-stop these banks, because the Fed cannot accept commercial real estate loans below par as it doesn’t have the ability of appraising these assets properly.
It’s important to remember that small banks are responsible for 70% of US commercial real estate loans, and play a very important role for local businesses in the regional space in the US. And this is interesting, because in 1981 then Fed Chairman Paul Volker was fighting in a similar inflation battle, and as a result of his rate-rising actions, almost 1,000 regional banks in the US went bust. As you know, Jay Powell has tried to emulate Paul Volcker with rate hikes, and that is one of the side effects.
So, I think that the crisis so far has been back-stopped because the liquidity crisis is no more. The FDIC together with this loan mechanism ensures banks can make front-end deposits. But I think we're going to see more issues coming back. And with banks, if the credit worthiness of the balance sheet looks bad, that's going to be a very much harder problem to deal with, and the longer that interest rates remain elevated, the higher the risk of that happening.
Stephen Rudman: Excellent, thank you. I suppose the story will continue to play out as we move forward depending on the economics. We have had another macroeconomic piece of news which is very fresh: OPEC+ cutting oil production. What are your thoughts on that?
Gustavo Medeiros: There is a lot of speculation of what motivated Saudi Arabia specifically to join Russia and co for a broad OPEC+ cut, and I think there are four possible reasons.
- First, Saudi is perhaps very worried about recession risks, and they're anticipating these recession risks and cutting oil production ahead of that.
- Second, they are not happy the US is not fulfilling its promise to replenish its strategic reserves at around $70 per barrel levels, which West Texas Intermediate (WTI) traded at a couple of weeks ago.
- Third, Saudi Arabia has decided to support Russia.
- The fourth thesis is that there was a relatively large shorting base on oil futures. And historically, they like to try to squeeze those shorts.
The reasons could also be all of the above. The situation here is that, if the OPEC+ discipline holds, and they can drive prices higher at the same time as cutting supply by about a million barrels of oil a day, this could be significant. But OPEC+ never manages to do exactly what they promise.
At the same time, Chinese demand for oil is increasing as international travel to China picks up. International travel should bring demand higher by about 700,000 to a million barrels of oil a day. This could take place where Western economies are going through the cyclical slowdown in manufacturing. We've seen yesterday ISM manufacturing at 46, which is very low levels. With the most impressive hiking cycle in more than 40 years, a banking confidence crisis, and high oil prices, obviously that will be negative for the global economy. If the oil price goes up to 100 dollars per barrel, that would deliver an inflationary shock not anticipated so far in the outlook, particularly if it happens in the short term. It could crowd out demand for everything else, and feed across to prices everywhere.
But looking at the broader picture, it shows we're in a trickier geopolitical environment today and a multipolar world. The balance of power in the Middle East has been shifting East, and with Saudi Arabia seemingly siding with the Russians here in terms of the OPEC+ decision.
Stephen Rudman: Yes, so a lot of potential implications there. With that said, we always try to draw things back to the actual impact on emerging markets. What are your thoughts, both from an equity and a fixed income standpoint?
Gustavo Medeiros: I think we're still confident on our view that investors should have most of their allocation in EM investment grade within the fixed income space, to the extent that a crisis is never a good omen for a recession and risks are never a good omen for high yield.
So far, that's working, particularly in the sovereign space. It's very interesting that local currency bonds that are outperforming in a period where high yield underperformed. There will be a time to double down in EM local and EM high yield. But most likely, that's after the Fed panics – when they cut rates into a recession and after the market is priced for the incoming recession, which is not happening so far.
In EM equities, I think our call remains that EM equities are still very undervalued versus US stocks. It's becoming a bit of a consensus trade across asset managers, but I think long term asset allocators are still very much hiding and don't have this position on their portfolios. We're hearing more and more agreement in terms of this massive discrepancy between EM valuations with and we have many catalysts that are likely to drive a correction on that.
EM growth is outperforming because of China’s economy reopening and the West going into a recession. We have the dollar starting to sell off, which started at the end of last year, but is a trend that continues this year and most likely will be a multi-year trend. We also have the fundamentals improving at the margin in EM, due to the China reopening story and friendly shoring, which is going to be a positive factor across many other EM countries like India, Mexico, Indonesia, many southeast Asian economies.
Those were our main views for to 2023 and they are still unchanged so far. I don't think the recent events call for any meaningful change in the way we're seeing things.
Stephen Rudman: Excellent, thank you. That's helpful, because I know people are looking for guidance as all of this news takes place.
One last final question. We've had a lot of noise about the Chinese renminbi taking over as the world’s reserve currency. We wanted to get your thoughts and to maybe ease people’s fears around that.
Gustavo Medeiros: Sure, yes. It has been pretty exaggerated, right? The West losing the reserve currency status is something that is going to take a long time to play out. It doesn't happen overnight.
We need to mention the fact that China is now bringing forward or incentivising the commodity exporting countries to settle their trade in renminbi. But just because commodities are settling for renminbi doesn't mean commodities will be priced in renminbi. You’re most likely still going to be looking at the price of oil in terms of dollars per barrel, not renminbi per barrel, in five year’s time, even if China is settling or trading with Saudi Arabia and the UAE in renminbi.
However, it's likely we're going to have an acceleration of the internationalisation of the renminbi. If countries and companies can settle trade in renminbi, then any sensible treasurer or reserve managers would hold some renminbi as part of their reserves, right?
This week, for example, interestingly Brazil announced it would start settling their bilateral trade with China in renminbi. At the same time, the Brazilian central bank said it would increase its renminbi position to more than 5% of its reserves, a larger share than the euro, if I'm not mistaken. That makes sense, as Brazil trades more with China than the US today, which is a fact.
And in a balance of payments crisis, you need to have renminbi to backstop anything impacting the ability of companies to finance their trade and to finance their transactions. Therefore, I think it is a natural development in a more multipolar world from a geopolitical perspective. If you trade across both sides of the aisle, you want to have your reserves diversified. I don't think that this is a threat to the reserve status of the US, and I don't think China wants to deal with the macroeconomic demands for them to become a reserve currency. And I don't think the US wants to lose this status today. But it's definitely a step towards the internationalisation of the renminbi.
Stephen Rudman: That's excellent, thank you, as I know we've heard a lot of concern about that. Simply, Gus, as always, thank you. Be well until the next time. If anybody has any particular questions, Gus and the rest of the team here at Ashmore are always happy to have a conversation and answer your concerns or questions. So again, thank you.