'EM in 10' update - September 2022
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, including:
- Gustavo’s post Federal Open Market Committee (FOMC) thoughts.
- The potential impact on EM assets.
- Global macro risks?
Transcript is available below.
Stephen Rudman: Good day. Today is Thursday, September 22nd, 2022. Welcome. My name is Stephen Rudman, and I am part of the New York Ashmore client-facing team. Today, we're going to share with you our ‘EM in 10’ with Gustavo Medeiros, Ashmore’s Global Head of Research.
Gustavo, welcome. I'll start with a question I'm sure is top and centre of everybody's mind. Simply, what are your thoughts based on the results of this week’s Federal Open Market Committee (FOMC) meeting?
Gustavo Medeiros: Thanks, Stephen. Yes, it was another interesting FOMC meeting. The Fed’s hiking cycle has been much faster than anybody anticipated, and it's fair to say that terminal rates are now also going to be much higher than anybody anticipated. The Fed has opted to hike policy rates by another 75 basis points for the third time. And they've signalled that the terminal rate is likely to go towards 4.4% by the end of this year and towards 4.6% by the end of next year. So, it's fair to say that 4% to 5% terminal rate is a fairly good range. The market is pricing a terminal rate of 4.5% to 4.6%, as we speak.
However, as we anticipated in April, despite having a much more hawkish Fed, the yields on 10-year and 30-year bonds have just started to break new highs compared to that April level. So, as we thought, even if the Fed was much more hawkish than people expected, it would be very hard for 10-year and 30-year yields to sell off to a much larger extent than what had already happened in April. Today, just after the FOMC meeting results were announced, we broke these levels.
We think that on a cyclical basis, we're still likely to see quite a lot of disinflationary pressure over the next few months. Over the last two months, we had inflation as measured by the consumer price index (CPI) at 0.1% and 0.3% month-over-month respectively, which is very different than the 0.7% to 0.9% we were experiencing for most of the previous 12-18 months. Therefore, we think there is already value building up on bonds, to the extent that the Fed hiking cycle is very likely to being close to fully priced in.
Considering that the hiking cycle has been much faster than expected, the likelihood of a recession has to be increasing. Such a recession would obviously lead to a flattening in the yield curve or lead eventually to the Fed cutting policy rates. The Fed is pushing back against that, but that's simply because the labour market is still not there. In summary, we think that bonds at current valuation levels are starting to look interesting, particularly in the Emerging Market (EM) space, but also across the board.
Stephen Rudman: Excellent, Gustavo, very helpful. Obviously dynamic times. Most of the people watching will want to know the potential impact on EM assets. So, can you give us your thoughts on what this all means for investors in emerging markets.
Gustavo Medeiros: Absolutely. First, it's interesting that despite the much more aggressive FOMC hiking cycle, and the dollar has strengthened quite significantly against the Japanese yen and against the euro in particular. The dollar index is overshooting as we speak. But EM equities have not been underperforming dramatically in relation to global equities over the last four months or so. Typically, when the dollar is strengthening, EM equities are underperforming. That's not happening at the moment. Furthermore, a few EM currencies are actually in positive territory for the year-to-date, including the Brazilian real, the Mexican peso, and the Peruvian sol.
Latin American countries are actually performing quite well, and that's before incorporating carry. These currencies have been paying carry close to double-digit levels, or more than double-digit levels, as is the case with the Brazilian real. At the same time, dollar-denominated bonds have also been quite resilient, particularly the high yield part of the asset class.
Again, typically, high-yield, dollar-denominated bonds will sell-off in line with S&P weakness, but they have not been selling off dramatically over the last few months. Actually, they have been trading at a very resilient level, despite the dollar index printing new highs.
As we've been saying this year, when assets outperform on the downside, they're likely to outperform as well on the upside. We're confident that EM assets will follow this pattern and will outperform developed world assets once this short-term, global macro crisis stabilises.
Just to give you an example, when you look into the sovereign space, triple-B rated bonds are now available with yields between 5% to 6%. Single-A credits are trading at 4.5% to 5%. These are quite interesting levels, considering that, the carrying is also attractive. The valuation, or the cash price that you're paying for these bonds is trading at a deep discount to par in some cases. As we have discussed, the very accelerated hiking cycle is likely to also accelerate the potential economic slowdown and force the Fed to cut rates further in the longer term.
Stephen Rudman: Very good, some encouragement there, obviously. Let's take it back out to the macroeconomic picture. What do you see as the main global macroeconomic risk as we move towards the end of the year?
Gustavo Medeiros: As we’ve been discussing, there are three key factors that have been weighting on markets during 2022. The first is the Fed hiking cycle, and as discussed, we think this is now probably close to being fully priced. The second is the war in Ukraine, and the third is China's zero-COVID strategy.
In regard to the war in Ukraine, there was some important news out on Monday. Russia announced the mobilisation of approximately 300,000 troops of reservists to serve in Ukraine. That comes on the back of some heavy Russian defeats in northeast Ukraine, so it seems Putin is doubling down. Also, in parallel, Putin announced a referendum in the Donbas regions that basically will declare them part of Russian territory. Zelenskyy has pointed out that if Ukraine tries to attack or retake these regions, Russia will use that as a pretext to increase or escalate the conflict, and using nuclear weapons is a possibility.
The market took that speech from Putin as a signal that we're likely to have a very long and protracted war, but the opposite might also play out. Of course, it is impossible to try to forecast this, but this is clearly a scenario where Russia has been suffering tremendous defeats and Putin is essentially playing his last card. Mass mobilisation is highly unpopular in Russia, and it's the first time Russia has announced one since the Second World War. The fact that Putin has made this gambit suggests he's running out of options. Therefore, there is potential for a truce, ceasefire or peace agreement to be made.
So, we could be moving towards a more binary scenario where we have the risk of an escalation of nuclear war, but we also have the probability of a ceasefire increasing at the margin. This certainly adds volatility and uncertainty, but also potentially some light at the end of the tunnel.
Finally, regarding China’s zero-COVID-19 strategy, as we mentioned on last month’s call, China confirmed the date of its party congress as 16 October. We believe there’s a strong likelihood (although this isn’t a consensus view) that the zero-COVID strategy will be relaxed post-party congress.
In our view, Xi Jinping doesn't want to start a new administration with China’s economy in tatters, or suffering as significantly as it has been. Instead, we are likely to start seeing macroeconomic reforms from the new politburo.
In parallel to that, we have seen some effective measures to backstop the problem in China’s real estate market, which reduces the fatal risk of a disorderly selloff of Chinese assets from here. These are assets trading at deep discounts to their fundamentals, which offers significant upside once COVID-19 fades into the rear-view mirror.
There is also the possibility that the west is fighting the Ukraine war with one eye on Taiwan. This is just me speculating here, but any ceasefire in Ukraine may have to be coordinated by China essentially forcing Russia’s hand. If we see China’s policymakers unwind zero-COVID and we have less uncertainty post-party congress and just before the US mid-term elections, that would be a win-win scenario. Again, this is a speculation, but in our view the likelihood of China zero-COVID being relaxed post-party congress is higher than the market anticipates.
Stephen Rudman: Thank you, Gustavo. I'll give you one last opportunity to summarise some these things. Obviously, some very interesting impacts on EM assets in general based on the Fed’s rate tightening. Some larger and sadly longer issues in Ukraine and of course, with China and COVID. Any thoughts in terms of direction as we head into the Autumn that we can share with our clients?
Gustavo Medeiros: Well, there's another EM event which is going to be quite important. We have elections in Brazil in October. It looks like the former president, Luiz Inacio Lula da Silva – Lula – is the front runner. There is not a huge amount of progress being made by the incumbent President Jair Bolsonaro, who should be increasing in the polls. But whoever wins the election, they will have a strong drive to implement a decent fiscal orthodoxy. Over the last weekend, we've seen Henrique Meirelles, the former Brazilian central bank governor during the first and second terms of the Lula administration, and minister of finance under Temer, actually coming to a party congress of the Worker's Party. He sat next to Lula and is basically campaigning for Lula to win the election. This is a pretty strong signal. It is Lula sending a message to the market that whoever is his minister of finance, he's going to be advised by orthodox economists like Henrique Meirelles. That has to be a positive fiscal signal.
However, if Bolsonaro wins, they're talking about potentially discussing the privatisation of Petrobas, which has been a massive taboo for Brazil for a number of decades. But if it does take place, it could be continuing towards the direction of reducing the size of the state of Brazil, which the Bolsonaro administration has been promoting. Bolsonaro has many problems and challenges, but he's been doing a decent job of running the Brazilian economy, particularly in reducing the size of the state
So, to summarise, I think we still have quite a lot of headwinds going into the autumn. Obviously, the more hawkish Fed and the uncertainties in the geopolitical scenario, will keep risk assets on the back foot. The S&P 500 has been trading quite soft throughout the year. We've had more than 25 days where the S&P 500 sold off more than 1%.
In that environment, high yield assets and other risk assets are selling off, particularly given that higher interest rates are one of the key factors driving the weaker S&P, so there are not many hiding places for investors.
We might have a relief rally after the selloff that we started experiencing in September that is likely to go for another maybe 10 to 15 days. Encouragingly, there are some potential catalysts on the horizon, such as the party congress in China, and the chances of a ceasefire in Ukraine, that could lead to a much more constructive environment for risk assets, particularly if we are indeed getting closer to the end of the hiking cycle. The Fed might start signalling that in the next couple of FOMC meetings, given how fast the hiking cycle has been so far.
In short, we're still very much in a challenging macro environment, but it's an environment that presents many opportunities. It's interesting to note that EM assets did not underperform, and in many cases outperformed, on this challenging environment year to date, despite Russia getting kicked out of the main EM indices. That suggests EM assets are quite likely to outperform on the upside once we turn the page.
Stephen Rudman: Excellent, very helpful, and encouraging. As always, Gustavo, we appreciate your insights. We like to use the phrase “volatility creates opportunity”. Sometimes it takes both courage and patience, but generally our experience with clients over the last couple of decades has been that these periods of market turmoil and significant drawdowns are usually fairly good entry points. But again, we recognise it does take both courage and patience, which is why we're here to help the cause. So, thank you for the guidance. With that said, until next time, wishing you all the very best.