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Gustavo Medeiros: Good afternoon from London, or good morning or good evening if you're somewhere else watching this video in a different time zone. My name is Gustavo Medieros, I'm Head of Research at Ashmore, and this is another episode of ‘EM in 10’, where we will be discussing broad market events.

In terms of total returns, we've had a pretty bad first half of the year, and shocking returns across most asset classes. The MSCI World Index, for example, was down 21% for the first half of 2022, the S&P 500 was also down 21%, and the NASDAQ was down 30%.

The MSCI EM Index outperformed marginally, down 18% for the first half of the year, and Chinese stocks were down only 7%, partially led by the reopening of the Chinese economy, including Shanghai and Beijing, towards the end of the semester. In the fixed income space, we also had a challenging market environment. The Bloomberg Global-Aggregate Index was down 14%, which highlights mostly how global fixed income was completely unhinged. In the EM sovereign space, we were down 20% in dollar-denominated sovereign emerging market bonds. EM corporate dollar-dominated bonds were down 14%, and EM local currency bonds were also down by about 14%. So, it was very hard to find any place for investors to hide in that environment.

Towards the end of June, and at the beginning of July, we experienced a more challenging global environment as the market started to price-in higher risks of a global recession, and particularly the higher risks of a recession in the US economy. That was led by a few factors I'd like to cover today.

The first one, as we've been highlighting for many months now, is that financial conditions have been tightening quite significantly. So, if you look at 30-year mortgage rates in the United States, for example, we hit 6%, which when combined with much higher house prices obviously tells us that affordability of housing is declining quite significantly.

Turning to corporate bond yields, these also increased quite significantly. Equity prices, as we just discussed, went down quite sharply, and also the yields on government bonds increased quite significantly. In other words, the cost of doing business is going up quite significantly – at the same time that elevated levels of inflation have been leading to a very strong hit on the purchasing power of the population across the world.

These tight financial conditions – and specifically lower equity prices – are very likely to have a ‘feedback loop’ effect in the economy. To the extent that as CEOs are seeing their share prices down 20, 30 or even 50 percentage points, they're likely to propose adjustments to the boards of their companies. These adjustments typically come via staff layoffs, which would trigger that negative feedback loop that would bring on the recession. These recessionary fears, or these recessionary factors, are taking place at the same time as we've been going through an inflationary inventory cycle.

We've seen some bellwether large names in the corporate space – like Walmart, Target and Amazon – and some other names in the retail sector mentioning they had too much inventory in their balance sheets, which was likely to lead to a hit in profitability over the next few quarters.

We have also had global industry moving from a ‘just-in-time’ production model to what they are now calling a ‘just-in-case’ production model. This basically means having higher redundancies and higher inventory levels to avoid what they've been experiencing since COVID, which has been severe supply chain disruptions forcing the industry to shut down production to the extent that you don't have some of the parts of what you are producing. This has been most notable in the auto sector, but also across the board in many sectors.

And has been observed on the Purchasing Managers Index (PMI) which is a pretty good indicator we like to follow here at Ashmore. Global PMIs have been declining, particularly in developed markets (DM) quite significantly since April. In fact, PMIs in the developed world declined from 56.3 to about 52.2 points. A reading below 50 suggests an economic contraction.

But when looking into the forward-looking factors within the PMIs (i.e., new orders and current activity), you can see that in Europe and the US we already have PMIs in the low 50s. And that contrasts with emerging markets where PMIs have been increasing from 48.1 levels to slightly above 50. A good part of that has been the recovery of the Chinese economy, as the Chinese economy gets out of lockdowns, and also with other EM economies performing well. PMIs in Brazil, India, Vietnam, and a few other large emerging market economies have been quite strong, which has been keeping emerging market PMIs at a better level.

Nevertheless, that PMI relative strength didn't lead to an outperformance of EM assets to any clear extent. When investors start pricing-in a recession, they tend to try to get out of any high yield asset classes, or any equity asset classes, and that obviously has a knock-on effect for EM assets. But the fundamental backdrop for emerging markets is marginally better, and is improving, compared with the developed world.

Now the silver lining for that is we're likely to see quite a lot of deflationary pressures as a result of this inventory cycle, which has been exacerbated by much tighter financial conditions. If you look at energy prices, for example, they are down 24% from their peak, agricultural prices are down 20% from the peak, and industrial metal prices are down 38% from their peak.

Interestingly, on the industrial metal space, we see the spot price is at lower levels than the future prices for three months, six months, and one year. So, the curve is in contango, which means that the futures amounts are higher than the spot prices. This suggests there is not a shortage of goods on the spot market, whereas in the energy space (in oil markets, for example) the spot markets remain well above the future markets, which suggests this market is still relatively tight. This makes sense given the geopolitical situation with the war in Ukraine, and with Russia cutting or reducing the supply of gas to Europe. That is also leading to fears of a slower economy.

Another reason why financial conditions have tightened is that central banks in the developed world have finally ‘smelled the coffee’. They were behind the curve in 2021, and in 2022 have started hiking policy rates perhaps a little bit too late. We think a lot of central banks might be making their second policy mistake in a row. The first mistake was not tightening in 2021, the second mistake was tightening in 2022, when the global economy naturally slowing down because of the inventory cycle and as a result of much higher energy prices from prices and commodity prices in general, and the supply shock coming from the war in Ukraine.

EM central banks have been ahead of the curve. The policy rate in Australia is 1.35%, Canada 1.5% and the US 1.75%, and the central banks of all developed world countries are signalling further interest rate hikes are possible.

As we’ve been highlighting for a while, emerging markets have policy rates at much more elevated levels. And when you look at forward-looking indicators, for example two-year government bonds against expectations for 2023 Consumer Price Index (CPI) inflation, across most emerging market countries suggests two-year government bonds at higher levels than CPI expectations. This should anchor inflation expectations across emerging markets. By comparison, developed markets are not quite there yet.

But if you’ve been following our research, you’ll see that our long-term view is that it will be very challenging for central banks in the developed world to increase interest rates much higher than the level of inflation. With inflationary pressures, recession risks and inflation declining, we believe it's a matter of time before developed world central bankers are going to be forced to U-turn on some of their hawkish statements. That is likely to come on towards the end of the summer/beginning of the fall in the northern hemisphere.

If you look at an emerging market price activity, you can see that EM bonds are trading at very attractive levels. The credit spreads on the EMBI Global Diversified Index are trading at slightly above 500 basis points over US Treasuries. These are levels that we've only previously seen during the COVID crisis of 2020 and the 2008/2009 Great Financial Crisis. High yield credit spreads have been completely unhinged, trading close to 1,000 basis points over US Treasuries, and these are extremely distressed levels.

We think that there's quite a lot priced-in here, and that medium- to long-term investors could potentially do well to think about starting to accumulate assets here. But obviously if the environment remains turbulent over the next couple of months, with developed world central banks keeping a hawkish stance against this backdrop of recessionary fears, we could still see a relatively turbulent environment for the high yield part of the asset class. Investment grade credit is probably one area where you have value being created both of credit spreads and on the yield space that investors should be able to harvest more easily.

When you're looking at equities, you can see on these slides that the price to earnings ratio of the MSCI EM has declined quite sharply now from 15.5 times earnings at the beginning of 2021. The retreat to close to 10.5 times earnings, which is close to one Standard Deviation below the mean over the last 15 years, and is at a level that we’ve rarely traded at for a long time.

When you look at the table at the bottom of this slide, you'll see many countries are trading at extremely distressed levels. Brazilian stocks for example, are trading at 5.7 times earnings (a 2.5 Standard Deviation) below the 15-year mean. Colombian stocks are trading at 4.3 times earnings. Election risk is now out of the way in Colombia with the election of Gustavo Petro and his appointment of a very pragmatic finance minister who is likely to avoid quite a lot of the far-left policies it was feared Petro would like to implement. You can see across the board in Latin America and South Africa that valuations are quite attractive. Also in EM Asia, price to earnings ratios are below the long-term average across the board, except for India and Thailand. Again, we think this presents a good opportunity for long-term investors.

We've been mentioning several times over the last month that we are going through events that are likely to lead to a change in market leadership over the next years. The NASDAQ and US technology stocks have performed extremely well over the past 10 years. We think this is no longer going to be the case for the next decade. We think that emerging markets are the one place where you can harvest much better risk-adjusted returns and total returns over the next two to three years, and for and an even longer term than that.

That said, the current lower rates environment favours long duration assets, and during the month of June – and as we speak – we’ve seen a rotation away from value assets such as energy stocks, material stocks and other long duration assets, not only long-term investment grade bonds, but also technology stocks. We think this is a short-term trend, rather than something that will change the long-term picture that we’ve been discussing.

So that's all we wanted to cover today. I hope you find it useful. We'll see you next month for the next EM in 10. Thank you very much.