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Macro risks have multiplied and intensified on many fronts over the past quarter: the risk of recession, of higher and more persistent inflation and of sharper interest rate hikes. In addition, commodity prices could yet spike again if China rebounds or Russia ‘weaponizes’ its energy exports. For EM, this makes for a difficult environment. Its best hope is a recovery in Chinese growth.
In an environment of heightened uncertainty, investors are responding to changes in data with sharp swings in asset prices. In particular, having priced in successively higher terminal interest rates for the US throughout Q1 and most of Q2, investors now appear convinced that the imminent economic slowdown will be sufficiently pronounced to slow inflation and thus reduce the need for aggressive Fed tightening. As a result, the peak in the policy rate is now seen at 3.7% by February 2023, and is expected to decline to 3.0% by January 2024 as the Fed would try to avert too sharp a recession. A corollary of the changed market outlook has been a sharp drop in commodity prices (e.g. oil, copper and wheat) by ca. 30% from their recent peak. This has implications for emerging markets, which generally trade large amounts of raw materials (either as inputs, exports, or both). Yet, the recent decline in commodity prices does not reflect an improvement in fundamentals - such as an increase in supply - but instead a shift in speculative positions in anticipation of a recession. As such, they are apt to reverse if oil exports were to be ‘weaponized’ by Russia or a Chinese rebound increased demand for raw materials.
Despite the harsh global downdraft in the form of fading demand and tightening financial conditions, there are some positive factors supporting emerging markets. Because of higher inflation and lower central bank credibility, EMs have engaged in monetary tightening cycles much earlier than DMs, in some cases up to one year before. This may also allow some of them to exit their cycle sooner, supporting growth. Indeed, the IMF forecasts that the EM/DM growth differential, which had dwindled to below one percent during the pandemic, is set to revert to its long-term average of 3.6% points in favour of EM. In addition, while a stronger dollar (weaker EM currencies) raises the cost of debt servicing for EMs, it also makes their manufactured exports more competitive. Finally, despite the strong headwinds for EM, the asset class outperformed its developed market counterpart by 2.9% points during H1 2022.
Market Strategy: Since our last quarterly publication, inflation has surprised to the upside, markets have upped their expectations for rate hikes and have begun to price in an early Fed ‘pivot’ towards rate cuts from February 2023. A corollary is a heightened risk of recession that will help quell, if not quench, inflation. We expect a scenario of a prolonged slowdown, possibly morphing into a recession, and accompanied by decelerating inflation, albeit still at a multiple of target levels. However, we also believe that policy rates will need to rise higher than currently priced in by markets.
The main counterpart to this gloomy scenario is a potential economic rebound in China as authorities may shift their emphasis on regulation, de-leveraging and equal distribution towards a focus on growth, which is currently on track to sharply underperform the official target. This suggests a world economy that will become increasingly de-synchronized and - as de-globalization advances – also more fragmented. The flipside of this is that it opens the door for opportunities through judicious country selection.
If China’s rebound materializes – as is our assumption, to a limited extent – it will provide additional support to commodity prices. We previously oriented our allocation along commodity lines in the wake of Russia’s invasion of Ukraine. We now refine it further as the first knee-jerk effect has passed:
|Europe, Middle East and Africa|
Note: Up/down arrows indicate a positive/negative change in our asset allocation compared to the previous quarterly outlook. A dash indicates no change.
Source: City of London Investment Management
*The publication reflects asset performance up to 30 June, 2022, and macro events and data releases up to 13 July, 2022, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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