MERCER WEBINAR: Using Emerging Markets for Diversification in a Volatile Global Environment
Geopolitical risks, energy transition, AI development and elevated debt have led to macro volatility. Inflation is also a stubborn global problem. Against this backdrop, Emerging Markets offer both diversification and growth potential.
Gustavo Medeiros presents his thoughts on using EM for diversification in a volatile global environment.
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Transcript is available below.
Transcript
Gustavo Medeiros: Thank you very much, Adam. Thanks everybody for dialling in. It's a massive pleasure being here with you at Mercer's today to talk a little bit about using Emerging Market (EM) diversification in a volatile global environment.
My name is Gustavo Medeiros. I'm the Head of Research at Ashmore Group. I've been with Ashmore for about 13 years. I will start the presentation by talking a little bit about Ashmore and what we do, and then go straight on to the main topic. Hopefully, you can see the title for the presentation on screen.
So, who is Ashmore? We are an independent asset management company, focused exclusively in Emerging Markets. Our first EM debt fund dates back from 1992, when the company was still part of the Australia and New Zealand Group (ANZ). A management buyout followed in 1999, and we listed the company in an initial public offering (IPO) in London in 2006. Today, Ashmore manages around USD 50bn across EM debt, EM equities and alternatives. We have offices in London, New York, and Singapore, which are global trading and investment hubs. But we also have local offices in EM countries like Mumbai, Jakarta, Riyadh, Dubai, Bogota, and Lima.
So this presentation has two parts. We're going to start by talking about the role of EM assets in an environment full of structural challenges, such as higher inflation and higher geopolitical risks that we've been witnessing more or less since 2021-2022. The second section will focus more on the recent developments in the EM asset class, which in a nutshell has been very resilient to the many macroeconomic shocks that took place over the last two years. In fact, growth, surprised to the upside across many EM countries and the majority of EM countries have outperformed developed world countries, thanks to better macro policies that were implemented post-pandemic. In particular, smaller fiscal expansions, and a quicker reaction to inflationary spikes by EM central banks, allowed for a much better macroeconomic foundation. And again, allowing for better economic growth with lower inflation. This is something that we're going to be showing you over the presentation.
Another element that corroborates this better macroeconomic environment is the fact that rating agencies have been rewarding recently EM countries with more upgrades than downgrades, and so those are key developments that explains and corroborates this newfound resilience of EM economies and EM assets that are quite important.
But in terms of inflections, which is another theme that we're going to be discussing, there were two key inflections in the macro space that already took place. We had a massive improvement on the growth premium – the difference between EM GDP (gross domestic product) growth to the developed world has improved for two consecutive years, and that's the first time that has taken place since 2010.
The other important macro inflection was the fact the US dollar peaked in Q4 2022, and has since then been in a downward trend. These two factors tend to be self-reinforcing, and that typically tends to lead to a much better environment for EM asset prices and EM fundamentals as well, which is something we're going to be sharing and discussing in the next slide.
So the third and final inflection that we're waiting to see, or in a way started to happen in 2024, is in the equity space: EM earnings per share to start outperforming quite significantly. This is, in our view, what would trigger significant reallocation away from US assets towards emerging markets, and that could actually lead to again tighter risk premium rewarding EM fixed income further, something that we're already seeing taking place over the last two years.
Obviously, there are tail risks that are still present. The geopolitical and political risks that we mentioned were quite important, and inflationary spikes were also tail risks that are key to monitor. But obviously the key one that we're monitoring short term is the US election on 5 November. A lot will depend on the election, including the next chapters of the geopolitical developments, both in Ukraine and the Middle East, as well as potential fiscal expansion in China, all topics that we're going to be covering during this presentation today.
But we start the presentation on slide number 5, really talking about the big picture.
It's important to note that most of us have lived through an extraordinary period where inflation remained at extremely low and subdued levels, and that this actually may be the exception rather than the rule. If you look at the left-hand chart of this slide, you can see that the 1992-2020 period was characterised by very low inflation, but also low volatility of inflation. It's only comparable with the peak of the ‘golden era’ of the Victorian period in the UK. This chart here shows inflation in the UK over the last 800 years.
You can also see on the right-hand chart that inflation volatility depicted by the light blue line has been on a downward path, and we did have quite a lot of inflationary spikes over the years, particularly during the First World War and the Second World War. But the overall decline in trading volatility has been clear and present, but we also again see the lowest level of inflation volatility over the last 20 years.
The question is, was this ‘Goldilocks’ era thanks to central bank policies? Or was there a number of structural factors that are also important? As you can see on slide number 6, most of the structural factors from the 1980s to 2020s which were driving an era of Goldilocks (i.e., higher than expected growth, but lower than expected inflation) either stalled or went into reverse. So, in the monetary policy space, we moved from an era where we had rigid inflation target regimes implemented in New Zealand in the late 80s, early 90s, to an era where central banks have different targets, including an average target in the US, for example. We moved from economics that had very tight fiscal policies to populist fiscal policies across the world. In the US, we've seen that in the form of the Tax Cut and Jobs Act industrial policies during the Biden administration and ‘helicopter money’ during the COVID era.
In terms of trade, we moved from a massive liberalism era characterised by the fall of the Berlin Wall post-1989, and China joining the World Trade Organization (WTO) in 2000/2001 to an era of protectionism, more trade wars, tech wars, etc. And obviously in energy policy, we have a big contrast of today compared to the 1980s, and when we had big capex (capital expenditure) apex in the 1970s.
But also, we have the retracement, or the slowdown at least, on the massive capex that took place in 2010 that resulted in the shale oil boom and shale oil revolution in terms of social policy. I think a key trend to monitor here is the fact that the 1980 to 2020 was an era where globalisation led to a massive increase in inequality within the developing world countries. And this is important, because typically higher levels of inequality leads to a deflationary period of time. Now we have significant policies, post-COVID in particular, that were designed to reduce the levels of inequality. So again, I mentioned helicopter money, the massive fiscal stimulus with paychecks granted directly to the population and small companies across the developing world that were financed by monetary policy. But we also have the return of stronger unions. And we've seen that in the United States, where port unions managed to get a 62% pay rise over six years after threatening to call mass strikes on the east coast of the US.
Finally, in terms of the balance sheet, we have the highest levels of debt since the Second World War. And high levels of debt in the past have actually demanded higher inflationary levels to erode that debt. It's hard to see politicians taking the right stance here, which is to impose massive fiscal discipline to the level that is necessary, at least.
Now we have also structural challenges in the form of geopolitical risks. In a nutshell, the end of the Pax Americana era really started about ten years ago, when Russia first invaded Ukraine, and woke the world up to geopolitical fault lines which have been in the past contained, or suppressed, either by the US itself, which acted as a hegemon pretty much since the fall of the Berlin wall, or the early 1980s, depending on how you want to do the analysis. So, we've seen increased conflicts both on the western fault lines, which goes down from Finland and Kaliningrad in Russia to the end of both sides of the Arabic Peninsula, but also the Horn of Africa, and obviously the key one to monitor, which could be very, disruptive to the global economy, is the Eastern fault line going from Siberia to the South China Sea.
Slide number 8 shows that geopolitical risk matters for macro, particularly because wars are quite expensive. We see on the top right chart that NATO has a rule stipulating each member country spends 2% of their GDP at the very least to be part of the alliance. But the 2% of the GDP is not the cost of wars, that's the cost for deterrence.
If you look at the bottom chart, you see that the US fiscal deficit widened to about 20% of GDP during the Second World War. Needless to say, this is extremely inflationary, right? So, a quick rule of thumb, which I think is very important but not a lot of investors pay attention to, is that during times of geopolitical conflict it really pays to buy places or to invest in geographies that will provide you with peace of mind. So countries that are likely to be neutral to geopolitical conflict, should be trading at a pretty large premium, and should be seen as safe havens. Right? And if you look across the world, countries ranging from Latin America to Africa, Eastern Europe, Central and Southeast Asia, are very likely to remain neutral to geopolitical conflicts, and in our view, these places should actually trade at a premium.
But again, moving towards the most important part of this presentation, how did we get here, and what are the big-picture trends impacting EM asset prices that are important to monitor going forward? The first one to acknowledge, I think, is the fact that from about 2010 until 2022, EM assets were suffering significantly as a result of a massive inflow of capital from the rest of the world into the US. So, this US exceptionalism had two distinct periods, in our view.
First, from 2010 until 2016, a number of EM countries started to struggle with a balance of payment crisis. Europe had its own crisis as its banks were in trouble because the yields on their sovereign debt widened significantly, putting into question the sustainability of their balance sheets. Japan was still stuck in deflation, while the US had actually recapitalised its banks. And then, from 2012 until 2016, you had the monster boom of shale oil that actually allowed for a much better macro environment in the US. And that was a fundamentally driven period of US exceptionalism. But from 2017 onwards, as you can see on the right-hand chart, the US has been attracting more capital thanks to financial engineering.
This chart basically shows that the US fiscal deficit has been expanding or widening in a procyclical fashion since the Tax Cuts and Jobs Act was implemented. So, in a nutshell, if you look at the unemployment rate, the grey line on this chart, on the inverted axis on the left-hand side, the US economy has been – with the exception of the 18 months of the pandemic – running at full employment, and during this period of time the US economy should be actually running balanced fiscal accounts. In contrast with that, if you look at the average fiscal deficit, since 2017, the US has been running a fiscal deficit of around 7% of GDP every single year during this period, or a 5% fiscal deficit if you exclude the pandemic.
So obviously, this financial engineering had an impact in particular, in the US that was a massive boom for the return on equities of American corporations. After all, these companies benefitted both from paying less taxes, thanks to Trump tax cuts, and also from an expand on the top line hanks to Biden supply-side policies, with the second round of paychecks that also came during the Biden administration, taking place in an economy that was already overheating. And that's a very important part of the macro picture that not a lot of people are paying attention to. I think that it's very unlikely we're going to see a continuation of this fiscal deficit to the extent that this is an unsustainable trend that will be checked by hard constraints.
The other way of looking into this exceptionalism is to look at external accounts and start thinking about the impact of debt on the dollar. The fact of the matter is that when the US was running these large fiscal deficits, that also meant a large current account deficit, because the government is spending more than the government is raising. Either the private sector is running massive saving on their own accounts, or the US needs to get this capital from elsewhere. And as the US was attracting capital flows, you can see that the net international investment position here is basically measuring the stock of capital deployed in the US from foreigners versus how much capital Americans have invested abroad. Today, foreigners have about USD 57trn of assets in the US and Americans have only about USD 36trn of assets abroad. So in debt terms, the US runs a net liability of USD 21trn to the rest of the world, which is the most imbalanced economy across the largest economies in the world that I've seen across my 25-year career of investing in emerging markets.
You can think about it as an increase from USD 7trn net liability when Trump came to power to USD 21trn, tripling the net liability as the US, and acting as a hoover of capital to the rest of the world. And that obviously, was putting a lot of pressure on the dollar. You can see on this line number 10 that the dollar, the green line, which is a dollar index that we know and trade, was obviously increasing quite significantly. A second lag of the dollar increase took place precisely at the same time of this US exceptionalism.
The light blue line on the left in chart shows the trade weighted dollar in real terms. So that's the most important line, because it basically shows the currency inflation-adjusted terms. This chart goes back from 1974, and it doesn't make a ton of sense to look at in just nominal terms. You can basically see that the peak dollar that we've seen in Q4 2022 was actually about 10% above the peak dollar we've seen during the.com crisis in 2001, which coincided with also another period in which foreign investors were bringing capital to the US to a very large extent, and also about 10% below the 1985 Plaza Accord, when the dollar was so unbearably expensive that the US Treasury Secretary agreed on coordinated intervention with the Finance Ministers of Japan, France, the UK, and Germany in the Plaza Hotel in New York City. This lead to a massive depreciation on the dollar for three consecutive years.
So again, I think that this dollar strength has been going hand-in-hand with this financial engineering of procyclical fiscal policies, and as the fiscal accounts and the macroeconomic environment starts to adjust, we're very likely to see the reversal of that. As a matter of fact, we were starting to see already the US dollar depreciating from the peak of Q4 2022, as I mentioned. If you look on the right-hand side, the US dollar is about 35% higher today in inflation-adjusted terms than it was in 2010. And the mirror image of the dollar strength is EM FX weakness. EM currencies are about 20% cheaper today than EM currencies were in 2010 in inflation-adjusted terms.
Where are we now? And what was the consequence of this better fundamental picture that I mentioned, and the dollar reversal? You can see on this chart that EM fixed income has already been the best performing asset class across global fixed income on the left-hand chart. You can see that local currency bonds went up by about 25% over the last two years, or around 12.5% per year. And that compares with the Global Aggregate Index, which was up slightly more than 10% over this period. On the right-hand side, you can see that sovereign high yield went up by 40% over the last two years, which is the equivalent of around 20% per year, which is a much better performance than US high yield that rose by around 12% and 25% over the same period, which is equivalent to only 12.5% per year.
And on slide number 12 here, it's a relatively complicated chart, but is going to be very intuitive for consultants such as yourself. It shows basically the risk-adjusted return across the key EM fixed income asset classes, and it compares that with some of the core global fixed income asset classes that are the key benchmark for global investors. On the left-hand chart, you see the efficient frontier from 2002 until 2024, which is, broadly speaking, the period of time that we have track record for the modern indices in emerging markets. You can basically see that EM investment grade corporate debt has been outperforming US corporate investment grade debt by about 75 basis points over this long period of time, but EM high yield marginally dominated by US high yield and EM local currency bonds underperforming quite significantly.
But obviously you can see that if we look into an environment or a time in which the dollar was selling off and EM currencies were strengthening, this efficient frontier looked very different. So, in the five years up to July 2008, it was a golden era in emerging markets, when the dollar was selling off and EM was outperforming significantly. EM local currency bonds returned more than 15% on annualised terms for five consecutive years with slightly more than 8% volatility. So, we're talking about three times higher total returns than the average over the last 20 years with 50% less volatility. You can also see that high yield corporate EM bonds outperformed US high yield by about 400 basis points with basically the same volatility. And that is a much better performance again than we've seen over the last 20 years on average, and even in the investment grade space, the outperformance of EM corporate investment grade was actually 200 basis points versus US corporate investment grade, which is again higher than the 75 basis points we've seen on average.
So the message here is clear, if we move to an environment where the dollar is weakening and EM growth is reprising to the upside, it's very likely that we're going to continue to see risk premium tightening across EM asset classes. And the higher the risk premium available and the more undervalued asset prices are, the higher the total return becomes. Therefore, high yield and local currency bonds have higher total returns. But even for clients that are very risk averse and are only keen to diversify their global exposure to investment grade asset classes, you can also capture higher risk premium on the investment grade part of the asset class.
Now, these next two slides I'm going to skip through relatively quickly, because I've already mentioned this story. The light blue line shows GDP growth across the main EM countries. And you can see that basically EM GDP has been at around 4% in 2022 and last year and actually improving to around 4.2% in 2024, despite the fact that Chinese economic performance has been rather lacklustre, whereas in the developed world we've seen a significant decline on GDP growth last year from 2.5% to around 1.5%, and this year likely to be sideways. So, the gap between EM and DM GDP growth on the yellow line has been increasing and increasing for the second consecutive year in 2024, which is a very important development. Also important to consider is the fact that inflation had already converged towards central bank targets in 2023. This is the average inflation across EM versus the average inflation across EM. You can see that inflation was on average in 2023 around 2.5%, and is likely to be around the same level, whereas in in the developed world inflation was still very much above the target. So, better growth and inflation developments allowed for rating agencies to finally recognise better fundamentals, and in 2024 you can see year-to-date, all three rating agencies have been upgrading more EM countries and downgrading.
You can also see that S&P has been leading the pack in terms of recognising the better fundamentals. Fitch is the second, and Moody's is the laggard here. Fitch has been upgrading more countries over the last two years, and with Moody's, 2024 is the first year that we see net positive upgrades. You can see in the bottom right chart here, that all three rating agencies have more countries with positive than negative outlook, and this chart also corroborates our own quantitative analysis. A paper that we published in June this year shows that about 36 countries in emerging markets have fundamentals that justify them being candidates for upgrades within the next six to 12 months, and about only 10 to 12 countries in emerging markets should be candidates for downgrades.
So, despite the better fundamental performance and the better asset price performance, if you look across emerging markets, you have a much better, much higher, level of yield. The
higher level of nominal yield is nothing different, but what is important here is, if you're a local currency bond investor, what you're actually looking for is the level of real interest rates that you get paid.
This chart looks into one-year government bonds across the most important countries in the world today, compared with their 2025 inflation expectations. So the third set of columns shows the excellent real interest rates. So how much you should expect to earn in terms of yields after adjusted for inflation? If you buy a one-year government bond in these countries, and you hold these bonds to maturity in a way, it is a little bit of a cash proxy, right? And you can see that the US offers around 2% real interest rates today, if inflation ends up at close to 2.2%. But many countries, most EM countries, are above the US, and if you look in aggregate at the GBI EM, which is a local currency bond benchmark, has 6.4% nominal interest rates and inflation expectations of around 3.4% for 2025, which results in excellent real interest rates of 3%. That's the highest level that I've seen in nearly two decades of investing in emerging markets. You can see that is also very high compared to the developed world, where you have only slightly less than 1% real interest rates.
And by investing in off-benchmark countries, including in Latin America, you can actually capture an even higher level of real interest rates and also non-interest rates. So, EM local currency bonds are extremely attractive at the moment, and that also matters to EM equities as we're going to see and discuss within the next few slides.
So, flipping to talking a bit about EM equities, I think the first point to recognise is that we are in a much better environment, partially, thanks to GDP growth. But here it's not really the absolute GDP growth picture that matters. You can see on the left-hand side that EM GDP has been outperforming DM pretty much across the last 20 years. And yet we have periods of time in which EM equities actually underperformed significantly. As a matter of fact, empirical analysis and fundamental research shows that there's zero relationship between the GDP growth and equity performance across the countries that we analyse.
However, the relative performance matches matters a lot, and if you look at the chart on the right-hand side, you see the relative growth differential between EM countries and developed world countries on the light blue bars overlaid against the ratio of returns from the MSCI EM to the developed world countries, and you can see the period of time in which EM growth is surprising to the upside and outperforming on a growing scale the developing world countries, EM stocks are outperforming, and during the period of time that EM growth has been declining, vis-a-vis developed world, EM stocks have been underperforming.
You can also see on the chart that we have a one-year lag on the turning point from 1999 to 2000 as EM growth started to inflect to the upside, EM stocks underperformed. After all, all investors wanted was to buy dot.com stocks back. Then the same took place from 2009 to 2010 when EM growth started to surprise to the downside and deteriorate vis-a-vis the developed world, but nobody wanted to buy US stocks, and people were very cautious of developing word stocks post the Global Financial Crisis (GFC), so perhaps this time is not going to be different than in 2023, which was the first year we had EM underperformance, due to the poor performance of Chinese stocks and the outperformance of the ‘Magnificent Seven’ of US tech stocks, EM stocks underperformed.
And the other relationship that really matters, as I mentioned, is the fact that EM stocks typically outperform when the dollar is selling off and underperform when the dollar has rallied. On this chart, you have the ratio of returns of MSCI EM to the S&P 500 on the blue line overlaid against the trade weight dollar on an inverted axis here. So you can think about that as the grey line going lower, EM FX is selling off and vice versa. And you can clearly see there is a strong relationship on that factor. So again, the dollar peaking in Q4 2022 was another key turning point.
And where does it leave us today in the equity space? US stocks are trading at the most expensive levels of valuations since 2001 and 2021. This chart shows the Robert Shiller price-to-earnings ratio, which is basically the ratio of current prices to the average of earnings over the last ten years, which is a pretty useful indicator, because it moves out peers of extraordinary earnings per share that typically happens at the top of the cycles that we see across the world. And again, in my view, this 7% excessive fiscal deficit that has been taking place in the US since 2017 has been boosting the earnings per share.
So again, the capex ratio is a very useful indicator, because it helps to insulate from some of this extraordinary environment and even smoothing that out you still have very expensive levels of valuations, EM stocks trade at the steepest discount over the last 15-20 years vis-a-vis US stocks.
Now finally, on slide 19, what really matters for EM equities to actually start outperforming significantly is for earnings per share to break through this USD 100 earnings per share. That was the peak in the previous cycles in 2010 to 2014, then in 2017 and 2021, and the improvement that we're seeing in earnings per share in 2024 has been led by the EM technology stocks, obviously buoyed by the nascent EM boom, which is important, because in our view, in 2025, we're going to see a pretty important cyclical development. We're likely to see the replacement cycle on the electronics goods space kicking in for the first time since the pandemic.
So if you look across earnings per share, this improvement in 2024 has been backed obviously by South Korea and Taiwan, which are key countries that have a lot of companies in the semiconductor space, also by China, but also countries like Chile, Peru, Philippines, Thailand, and South Africa are seeing actually double-digit earnings per share growth in 2024. And all these countries, with the exception of Taiwan, as you can see on the table on the bottom of the chart, trades at extremely low levels of valuations today.
And so that's very important, because EM assets are at a critical point where the macro picture has already reflected and is surprising to the upside, and is improving in favour of EM. The micro picture is starting to improve, and it's starting to inflect, but the valuations are yet to resolve. And the second part of this table is my favourite part of the analysis. If you look at the one the inverse of the price to earnings, you can actually see the earnings yield that you capture when you buy US stocks or EM stocks, and that really matters, because if you want to compare equities with other asset classes like fixed income the earnings yield provides a pretty good yardstick.
The S&P 500 today offers around 4.5% earnings yield, which is only 0.5%, 0.6% above the 10-year government bond or US stocks are 2.5 standard deviations expensive vis-a-vis bonds over the last 20 years. And if you look within EM, we actually have 8.3% earnings yield, and that's equivalent to 3.5% to 4% higher than the 10-year government bond across EM countries, which is only marginally expensive vis-a-vis the last 15 years. And if you look at the distribution of the Z score, it's pretty attractive, and many countries have very attractive earnings yields in the double-digit levels.
And again, as EM central banks start to cut policy rates, the gap between the earnings yield and the 10-year government bond is likely to increase significantly, which, in my view, is likely to unlock significant value on the stock market.
Now, finally, I'm going to offer you a few words about China, the elephant in the room on EM stocks, which represents about a quarter of the exposure on MSCI EM today. Two weeks ago, we saw the most impressive policy development in China, a rare synchronised, coordinated policy move where the People’s Bank of China (PBOC) and the Politburo announced significant measures to combat deflation. Importantly for equity investors, the PBOC has allowed banks to lend up to RMB 800bn, which is a bit more than USD 100bn at relending rates, which is around 2.25% for financial corporations to buy back stocks.
And prior to that, quite a lot of private companies in China had already announced very large buyback programmes. Alibaba, for example, had announced a USD 35bn buyback program which would allow Alibaba to wipe out about 24% of their free float when they announced. So those are very meaningful buyback programmes and as we know, as these buyback programmes happen, earnings per share should mechanically improve because the denominator is getting smaller. Even if earnings aren't changed, we're likely to see earnings per share increasing across the Chinese space.
Obviously, the most important measures that we're waiting to see are fiscal expansions to backstop the housing malaise and also to backstop the negative sentiment that is coming, and improve consumer consumption across China. We're likely to have an important press conference on fiscal policy by the Minister of Finance this Saturday (12 October). In my personal view, we're likely to see any significant policy development being executed. Perhaps it gets announced, but the execution of it is likely to happen only post-US elections, to the extent that China wants to keep some ammunition in case the US starts threatening China with tariffs.
But having said that, what I think matters here again is the Chinese stock market is very likely to have been backstopped by these core measures. The MSCI China Index is year-to-date up 26%, even after the 8% correction seen over the last two days, which is actually one of the best performing markets in the world, outperforming even the almighty NASDAQ.
So, China policy is starting to turn, but it's turning at a time where valuations have been distressed, and I think that this backstop matters for equity investors. Fiscal policy is likely to be slow and gentle to come, but it's unlikely that we're going to see China completely melting down. And again, that should be enough for equity investors to be able to capture very large excess returns.
Finally, when should investors increase asset allocations? We obviously have been seeing quite a lot of volatility since August, when we had an unwind of the Japanese Yen carry trades, and when semiconductor stocks started to trade with a very high volatility as well.
These periods of volatility are, historically speaking, pretty good periods to add exposure. You can see on this table that if you bought sovereign EM debt one month subsequent to the volatility spike that is defined by a 10% increase on the VIX vis-a-vis 60-day moving average, you actually captured 140 basis points, higher returns than the average returns of the asset class since inception and in the EM equity space, you'd have actually got 8.1% returns on average within the next 12 months following the volatility spike, which is about 570 basis points higher than the 31 average annualised returns on EM equities. So, this volatility prior to the US election is an interesting opportunity.
The other consideration for investors that I think is important for me to touch upon is the Federal Reserve (Fed) easing cycle. At the beginning of August, the market was pricing in 160 basis points of cuts within the next six months. That is a very, very large degree of pricing straight out of the gates. We have only seen the market pricing in aggressive cuts within the first six months of the easing cycle during the dot.com bubble and the GFC. So that's something that investors should obviously take into consideration and consider. But again, I think that every cycle is different, and this cycle has its own idiosyncrasies.
We can see on the right-hand side, that the latest expansion cycle that started in Q4 2023 has been a very shallow expansion cycle, particularly shallow compared to the COVID cycle, but obviously, also shallow compared to the previous cycle, when typically the G20 OECD lead indicator gets all the way to 101, or the peak of the cycle, this time around. This shallow cycle is interesting to notice, because shallow expansion cycles typically are preceded by shallow downturn and recession cycles as well. And what gives me confidence that we're likely to see a shallow, downturn cycle is also the fact that central banks have a tremendous amount of ammunition to cut policy rates in a downturn, which should support both asset prices and economic activity.
So then, our final slide has a final considerations about US elections. I think that the key to monitoring 2025 is going to be policies on immigration and trade, and we're likely to see meaningfully different policies depending on who is in the White House. Obviously, Trump is going to be much more hawkish, both in terms of immigration and trade. And that's going to have an impact on the labour market in the US. In the case of immigration, and to some Central American countries in particular, if Trump does close the immigration channel, and even force for mass deportation.
However, on the trade policies. I think that Trump is going to threaten with a huge amount of tariffs across countries, but one point that not a lot of people have been talking about here is that Trump, JD Vance and Robert Lighthizer all have been saying that tariffs are actually a mechanism to force countries with large surpluses to reduce their large surpluses against the US, and they've been saying that they're going to say they're going to force China, Europe, Japan, Taiwan, Korea, all countries that have been running large surpluses against the US, to strengthen their currencies against the dollar. And if they don't do so, then they're going to be subject to very large tariffs. I think that a key component is more the second phase of the trade war that is likely to start in 2025 if Trump comes to power.
Obviously, if the Democrats win the election, we should see less volatility, but if you look to 18-24 months down the line, it's not going to be a significant amount of change in geopolitics. I think we have more upside surprises potential than downside in the short term, if Trump wins the election. Trump has a better relationship with both Israel and the most relevant players in the Gulf, and you also force the hand of both Russia and Ukraine to reach a ceasefire in a peace process down the line if he wins the election, whereas Kamala Harris is an untested leader in foreign policy, she’ll have to earn the trust between the different players and the base-case scenario would be for her to continue with the policies from the Biden Administration that didn't allow for a lot of breakthroughs in terms of stabilising the conflict.
And finally, in terms of economic policies, most analysts are expecting a fiscal expansion if either Republicans or Democrats win the election. However, as I mentioned, I think there are three key constraints that are going to be important to monitor that won't allow for a significant fiscal expansion from here. Instead, what we're actually likely to see within the next four years following the US election is some degree of fiscal consolidation. These three constraints are bond vigilantes, inflation, and Congress, and they all have been already operating. We've seen inflationary spikes after Biden's policies of the second round of paychecks and the supply-side policies. We've also seen US Treasury yields widening from 0.5% to 5%, mostly on days in which you have negative fiscal headlines coming from the United States. So, bond vigilantes are back and are important to monitor.
And obviously, the US is spending more than 4% of GDP today in 2024 to service its debt, which is 50 basis points more than its overall military spending, which is around 3.5%. That obviously is very uncomfortable for Congress, to the extent that they have less discretionary spending. That is not a desirable picture.
So, that brings me to the summary. We have a very complicated big picture in the overall asset classes. Global investors face higher inflation, volatility, higher geopolitical risks. And this challenging geopolitical environment should call for a more diversified asset location policy both in terms of asset classes and countries. I think we haven't seen a huge amount today of that, and that is very obvious when you look at global equity allocations, and when you look at the overall benchmarks, which are still very concentrated in a single country.
But today, investors have alternatives, because against this backdrop, EM country fundamentals have been improving. EM debt has been outperforming DM debt over the last two years, pretty much across all asset classes, and two key inflection points have already taken place. The EM growth gap to DM has already inflected and turn positive, both in 2023 and 2024, and the dollar has peaked again since Q4 2022. These trends of weakening dollar and better EM GDP growth tend to be self-reinforcing as dollar weakness typically boosts liquidity in the rest of the world, and boosts asset prices in the rest of the world.
And yet very few investors have the adequate level of diversification which, in my view, almost guarantees that we're going to see a much longer bear market dollar cycle in line with the bear market dollar cycles that we've seen post-1985 and post 2001-2022.
Finally, the superior EM fundamentals are likely to be recognised as rating agencies keep upgrading more countries than down ratings, and the recent developments are also supportive for EM assets. The Fed starting its easing cycle with a 50 basis points cut is likely to allow for EM central banks to cut policy rates quite aggressively. That's going to boost both local currency and equity assets, and we're also likely to see more certainty following the US election, if not in the near future if Kamala Harris wins, or within a few months and a quarter if Donald Trump wins.
So, happy to answer any questions, and thank you very much for your time.
Adam Schain: Looks like we're good. Alright. Well, thank you, everybody for joining, and thank you, Gustavo, for your time.
Gustavo Medeiros: Thank you very much. My pleasure. All the best.