Watch video

Transcript is available below.

Stephen Rudman: Welcome and thank you for watching Ashmore's 'EM in 10'. My name is Steven Rudman, I'm a member of the Ashmore New York Client Team. Today, I will be asking Gustavo Medeiros, Ashmore's Head of Research, some timely questions about recent events and performance in emerging markets for our 'EM in 10' monthly video review. Gus, welcome. Let's start with you telling us about the year-to-date market dynamics.

Gustavo Medeiros: Hi, Steven. Thank you very much. Yes, it's been an interesting start of the year, and a very bumpy road for 2022. If you want two indices that characterise the year, and shows you the summary of it, you just have to look at the NASDAQ and the long bond index in the United States, as both are down close to 20% year-to-date. Those are very big numbers.

In April, the NASDAQ had its worst performance since 2008. Obviously, that's on the back of a more hawkish US Federal Reserve (Fed) than expected at the beginning of the year – market dynamics that we're going to talk about. Obviously, in that environment, Emerging Market (EM) debt and EM equity asset prices are not immune. We also have the Russia and Ukraine conflict that had led to some headwinds. But interestingly, most of the year-to-date performance (or poor performance) has primarily been due to the poor performance of US Treasuries. So, that's a good preamble to our conversation.

Stephen Rudman: Thank you. So, to that point, why is the dollar so strong?

Gustavo Medeiros: Well, there are three key market dynamics that are driving the dollar stronger. Obviously, the first one is that the Fed has been much more hawkish than most other central banks in the world. Two-year US Treasury bonds have increased in yield terms at a much faster pace than two-year European rates and also two-year Japanese yen rates. As a matter of fact, the dollar index has been very strong primarily, as always, as a result of the Japanese yen and Euro weakness. ±Japanese yen underperformance has been very closely following the yield differential between 10-year US Treasuries and 10-year Japanese Government Bonds (JGB), and all this obviously has a very key dynamic impact on the euro as well.

The euro seems to be pricing in a lot in terms of political and geopolitical risks. In the note we published last Friday I mentioned that Emmanuel Macron had just won the presidential election in France, which was a relief to the extent that it reduced tail risks. But also, if you look at the dynamics of the DAX, Germany's main index, vis-a-vis the IFO sentiment survey of business expectations, you'll see that the DAX has already declined about 20% compared to 12 months ago. This is tracking very closely the decline that we've seen in business conditions or expectations of business depicted by the IFO. The IFO has declined to a level that is similar to what we've seen in 2008, and also during the COVID crisis in 2020. So, if we do not get further intense supply disruptions, the question for investors here is whether a lot of the geopolitical risks are already priced in.

The other interesting element is that the two-year European rates, or the 10-year differential between European rates and US rates, have been at a much higher level than what the euro/dollar levels would suggest. More importantly, the European Central Bank (ECB) has been signalling their intentions to hike policy rates in 2022 as a result of higher inflation. That is going to be a very important reversal because Europe has retained its negative interest rate policy (NIRP) since 2014, which was a game changer for the euro.

When former ESB president Mario Draghi announced the ECB was cutting policy rates to negative levels the euro/dollar exchange rate declined from 135 to 105 in months. Similarly to the way NIRP was a game changer for the euro/dollar, we think that the exit of NIRP should also be positive for the euro. We think this dynamic is very far from being priced in. In fact, we think the dollar may be peaking here, and that if people are buying dollars at these levels, they might be caught in a bear trap, holding dollars at very poor levels.

Obviously, we're not saying that the current 103/80 level will not be broken (we're not technical analysts), but fundamentally  speaking, there's quite a lot priced in for the dollar already, and not a lot priced in for the reversal of these trends. Looking at all of these factors that were leading to a stronger dollar – a more hawkish Fed, weaker Japanese yen and weaker euro – might be peaking.

Stephen Rudman: So, with that said, do you think the dollar can maintain its current level, or do you expect to see a reversal in quick order. And do you expect the dollar to be priced higher or lower at the end of this year?

Gustavo Medeiros: In a nutshell, the market is pricing in a very hawkish Fed. The Fed started turning hawkish in the fourth quarter of 2021, when it became an imperative for the Fed to show that it really cared about fighting inflation. In the US, and across the world, people are concerned about the cost of living. And ahead of mid-term elections in November, the Fed is aware it must be seen to be doing something about inflation.

On a year-to-date basis, we’ve already seen a very strong sell-off in US stocks, a strong sell-off in US bonds, and a sell-off in Europe. All of this is leading to tighter financial conditions, and I don't think the Fed will want financial conditions to tighten much more than they have so far.

Our key view is that within the next month or even the next policy meeting, the Fed hawkish rhetoric will be dialled back or diluted. In fact, depending on what happens with the global economy, we could even have the Fed performing a U-turn, meaning all of the Fed’s policy plans will be delivered and already priced in the yield curve. This would therefore be consistent with the dynamics of the dollar peaking.

Stephen Rudman: Perfect. Thank you. Changing gears, what news and issues are coming from China? We know war in Eastern Europe has taken attention away, but China is an incredibly important piece of the global economy. So, what's the latest?

Gustavo Medeiros: Over the last week, there was a very important meeting of the Chinese politburo to discuss policy matters, and the message was very clear. They are supporting the real estate market and working closely with local governments to take further measures to support the markets.

They do not want the internet platform companies or big tech companies to suffer further after what they have already been suffering since October 2020. There is even speculation that Shenzhen and Shanghai might announce fiscal stimulus in the form of a coupon payments or consumption coupons which could be used to pay for goods through internet platforms like Alibaba.com, JD.com and Meituan, to support the economy. This approach is much better than just giving money to the population, as it would support consumption primarily for the people that need it the most.

On the back of this, last week saw very strong rebounds on Chinese stocks, while shares on the Hong Kong Stock Exchange were up close to 10% from the trough last week, which meant they completely decoupled from the rest of global stock market. During the COVID crisis, China was the first country to ‘bottom out’ of the sell-off. This time, they might also be leading, which other countries are still engulfed in a poor dynamic. We’ve been saying for months that it’s not a smart trade to sell out of Chinese stocks at current levels. We think there’s incredible value in the market at the moment, and we think that policy is working towards that direction of travel.

Stephen Rudman: Excellent. That's helpful, and it is nice to hear some positive thoughts about the opportunity to deploy capital. Finally, can you share your thoughts on the short-term outlook for EM debt and equity?

Gustavo Medeiros: In terms of EM equities, the underperformance of the Chinese market since October 2020 has been the biggest elephant in the room, and weighed on EM equities as a while. If China is bottoming, we think that the conditions are ripe for EM equities to perform quite well from here. EM equities benefit from a unique combination of attractively valued tech companies in Asia, China, Hong Kong, Singapore, South Korea and Taiwan in particular, and also very attractively valued resource companies in regions like Latin America, Africa and, to a lesser extent, the Middle East. So obviously this barbell – between resource companies and tech companies – sees both of them highly valued at the moment, making EM equities an attractive proposition.

At the same time, we’ve just had the worst beginning to the year since 1995 for Emerging Market dollar-denominated debt. It's very rare to have such a bad combination for emerging market debt. Although many people think this is due to the impact of the Russian war with Ukraine, looking at the data, most of the underperformance has come from the sell-off within US Treasuries. In April, we had the very rare experience of US Treasuries widening by more than 20 basis points and credit spreads widening at the same time. Typically, there is a negative correlation between US Treasury yields and credit spreads in emerging markets, (i.e., when US Treasuries are widening, credit spreads are tightening). Typically, in those rate times when both credit spreads and US Treasury yields are widening, it's a good entry point for investors.

And, if you look at the levels of the JP Morgan Emerging Markets Bond Index (Global Diversified) it is now trading at close to 7.5% yield to maturity. The high yield part of the asset class is trading close to 10.5% yield to maturity. These spread levels are extremely attractive, and have only been wider during the 2002, 2008 and 2020 crises. Again, we're talking about very dislocated markets here that may be bottoming, if the big Fed hawkishness is already behind us.

Stephen Rudman: Gus, thank you. That is particularly reassuring obviously given how much of a difficult year across the board it has been. If anybody has any questions or wants to further discuss some of these thoughts, please don't hesitate to ask. Thank you.

Gustavo Medeiros: Thank you very much.