Emerging Markets Ride the Bullish Wave

US monetary policy, the US and Chinese economies, conflicts and geopolitical risks continue to dominate the financial markets. But corporate earnings and business prospects also have a significant influence on prices, even if they are not in the headlines. Earnings developments continue to support stock prices to a large extent, especially in the US but also on many European stock markets.

Green light from the Federal Reserve?

Central bank and US inflation data sent mixed messages, but they did not seem to have unsettled global equity markets, explains the Cee and Emerging Markets Team at Raiffeisen Capital Management. Interest rate cuts were postponed in light of solid economic activity and labor market data. On the other hand, consumer and producer inflation rates were slightly better, meaning inflation fell somewhat faster than expected. This suggests that we should not see further strong upward pressure on US bond yields and the US dollar.

Fundamentally, this would be a positive for emerging market stocks and bonds, and could give central banks in many countries more leeway to cut interest rates if they do not have to fear major currency devaluations against the U.S. dollar. At least in theory. Whether this will materialize in practice remains to be seen.

Overall, it should be emphasized once again that, although emerging market stocks are considered a

A favorable backdrop for emerging market stocks?

But let’s get back to emerging markets as a whole. The emerging global economic and monetary policy environment could be quite favorable for emerging market stocks (and bonds), assuming there are no unexpected disruptions. There are investment opportunities in many countries, as evidenced by the large discount in valuations of many emerging market stocks relative to developed markets.

Favorable valuations, good growth and profitability

It is clear that these will not disappear completely in the foreseeable future, but they do not have to do so to offer investors good earnings prospects. It will probably be enough for the often very good profitability figures (dividends, return on equity, cash flow, etc.) of many companies based in these countries to attract the attention of international investors again. And if corporate profits were to increase, fresh money could flow into these markets, especially since most emerging markets will continue to grow at an above-average pace for some time to come. A possible break in the already mentioned downward trend in the coming months could be an indication of the start of this process.

Emerging Markets Ride the Wave

In the second half of 2023, US inflation came in significantly below expectations and markets were quick to price in aggressive rate cuts. A little too quickly, as it turned out, explains Mike Biggs, Investment Manager, Emerging Markets Fixed Income at GAM. In early January, markets began to backtrack on the six or seven rate cuts that had been priced in. As inflation unexpectedly picked up, US Treasuries were sold off, with a knock-on effect on riskier assets, including EM bonds. By early June, markets were expecting just one or two cuts from the Federal Reserve in 2024. This dramatic shift in expectations was largely based on the premise that persistent inflation is here to stay. We believe the consensus has gone too far.

Inflation Pessimism Could Become an Opportunity

The market has been wrong to price aggressive rate cuts in the past and we think it has been wrong again to discount all but one cut for 2024. In our view, the underlying trend of declining inflation remains intact and the drivers of the latest recovery may prove temporary. In our scenario, lower inflation in the second half of 2024 would allow central banks to put significantly lower interest rates back on the table until the end of the year, thus supporting risk-based assets such as EM bonds. Inflation: less “sticky” beyond the headlines.

The stronger inflation data in the second quarter, especially in services inflation, has raised concerns among some investors. However, in our view, the stabilization of services inflation is not so much an indicator of an overheating economy, but rather reflects the lag effect of services such as auto insurance and mobile phone costs being subject to regulatory and contractual lags. Private measures of housing rents are already showing a decline in inflation, and we expect CPI rent inflation to follow suit over time. In the US labor market, the weaker path of job churn and hiring intentions suggests a cooling of wage pressures.

Despite the possibility of an exception, we expect the conditions to be in place for a payroll slowdown in the second half of 2024. Meanwhile, with goods inflation already turning negative and services inflation set to move from stabilizing to declining, we expect inflation to cool more than the market expected in the second half of 2024. In EM, we have seen lower oil and fertilizer prices, which has helped inflation return to 2013-2018 levels. Remember, not too long ago, everyone was worried that the last mile of the inflation journey was the hardest; in EM, we are seeing very little evidence of this. In fact, the average EM inflation spread over the US has been 1.75% over the past 10 years – now the spread is just 0.35%, a testament to how well EM has done on the inflation front in recent times.

Growth prospects outside the United States

In Europe, the credit impulse has turned positive, but the tailwind from the reduction of excess deposits is probably over. In China, the authorities have failed to revive the lending situation, so the credit impulse has remained around zero. China’s economic growth in the first quarter was very strong at 5.3% year-on-year, but we expect it to be much weaker in the second quarter. Overall, looking at the bigger picture, global PMIs are holding around 50, so on the soft side compared to what we have seen over the last decade. GDP is growing at around 3.3%, in line with the rather soft environment we saw between 2012 and 2018. Overall, we are not facing a collapse in growth that would justify a major risk. While US macro data has been very positive, the US surprise index is actually negative, while it is positive in Europe, the G10 group and EM. Overall, growth surprises are more positive in EMs than in the G10. If these developments hold, they would contribute to a sideways or weaker US dollar and strength in EM FX.