In between the US and China

A quick look at cyclical conditions in the world’s largest economies today reveals a fairly hazy environment.           

Starting with the US, data supporting the probability of a “softish” landing have accumulated in recent weeks, as inflation has moderated while activity indicators have far exceeded expectations. At the same time, core inflation is uncomfortably high, and the labor market remains very tight. On balance, we think the Federal Reserve is likely to keep interest rates elevated for at least the rest of the year, which should in turn translate into below-trend growth for the US economy. A downside scenario where stubborn inflation forces the Fed to keep rates high well into 2024 or even raise them further needs to be contemplated. Neither can we rule out an upside scenario in which artificial intelligence breakthroughs allow the economy to enjoy a prolonged growth-inflation “Goldilocks” period.

In China, high-frequency economic indicators reveal a worrying picture. All sorts of readings—from investment and consumption to the external sector and credit availability—are delivering negative signals. The silver lining is that China’s top leaders meaningfully adjusted their policy tone during the recent Politburo meeting. They recognized, among other things, that the property market is going through “drastic changes in demand-supply dynamics,” and they dropped mention of the phrase “housing is for living, not for speculation” started by President Xi Jinping back in 2017. The meeting also called on the government to “revive the capital market“—a notable change in spirit compared to previous meetings. Authorities have slowly begun to walk the walk by delivering modestly lower interest rates and some capital market reforms. Given the depressed sentiment that prevails, China’s post-COVID recovery today depends on the strength of policy support in the coming weeks.

Even in a world in which the range of possible economic outcomes seems wide, we find no shortage of investment opportunities in emerging markets. It’s always helpful to remember that the performance of any financial asset is not just a function of the reality that transpires; it is also very much dependent on what’s priced in.

For starters, a fair amount of gloom is being discounted in emerging market stocks. One way to illustrate this is by breaking down a country’s overall market value into distinct pieces: those that are more tangible for investors today, and those that require investors to take somewhat of a leap of faith (Fig. 1). The more tangible items include book value and projected earnings just one year ahead. Those that require investors to “hope and dream” are earnings expectations more than one year out. The “hopes and dreams” component for the S&P 500 index stands well above the 75th percentile of the last decade. Investors place very few hopes on China and Latin America, where the metric stands below the 25th percentile of the last  10 years.

We hold emerging market equities as most preferred in our global portfolios in part because we see a good chance that the economic and earnings picture in many of these markets will turn out better than expected. In China, further stimulus measures can help stabilize sentiment. Brazil and Chile, on the other hand, have kicked off monetary easing cycles—which have historically been supportive of stocks—and present what we see as contained levels of political risk in the near term. In India, favorable demographics, high investment ratios, and comprehensive reforms offer above-average trend GDP and earnings growth potential, in our view. Moreover, the country’s external vulnerabilities have eased.

At the same time, this month we decided to downgrade US dollar-denominated emerging market bonds to neutral. Their spread over US Treasuries has compressed, driven by low-rated issuers. We think valuations are now fair, and increased selectivity is in order. Among others, we continue to find value in USD sovereign bonds from Colombia and Argentina, local-currency bonds from Brazil and Mexico, and USD bonds issued by a range of Latin American companies.

Co-authored with Solita Marcelli, Chief Investment Officer Americas

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