Last week’s bond yield jump and stock tumble underscore we’re in a new regime of greater volatility.
A renewed focus on U.S. fiscal challenges and surprise policy tightening in Japan have stirred up volatility in developed markets (DM). We think emerging market (EM) assets have an edge as their central banks cut rates and some benefit from rewiring supply chains. What’s in the price is key. We rotate our EM bond preference to favour hard currency and stay granular in EM stocks.
Globalization rewired
World trade as a share of GDP, 1870-2021
Source: BlackRock Investment Institute, Klasing and Milionis (2014), Penn World tables, World Bank, August 2023. Notes: The chart shows the sum of world exports plus imports, divided by world GDP. The yellow-shaded area highlights the period between the first and second world wars when trade integration fell materially.
Trade activity between nations dipped between World War One and World War Two (yellow shaded area in chart) before surging in the decades after World War Two as globalization took shape. Yet trade as a share of global GDP has plateaued (orange line) since the 2008 global financial crisis – one sign that globalization is under pressure. We see a world of fragmentation ahead: Competing defense and economic blocs are emerging. Multi-aligned nations are set to grow in power and influence, and we expect many major EMs to fall into this camp. As global fragmentation plays out, countries and companies are increasingly prioritizing security and resiliency – through industrial subsidies, export controls and other tools – over maximum efficiency. We see this shift in priorities accelerating the rewiring of supply chains as nations aim to bring production closer to home. All this favours selected EMs, in our view.
Against that structural backdrop, we also favour broad EM exposures over DMs in the short term. DMs are experiencing bouts of volatility and we see risk of more. The Fitch Ratings downgrade of the U.S. credit rating last week and the U.S. Treasury’s sizable borrowing needs put a spotlight on the challenging U.S. fiscal outlook. We think EMs are relatively better positioned to withstand some of this volatility. That’s partly due to EM central banks nearing the end of their rate hiking cycles. Some have started to cut policy rates, like in Chile and Brazil. Yet they’re not immune from a sharp hit to risks assets, in our view.
EM angle
We put our new playbook in action again by gauging what’s in the price. We flip our overweight to EM local currency debt to neutral and turn overweight EM hard currency debt on a six- to 12-month tactical horizon. We had been overweight EM local currency debt since March on attractive yields from EM central banks nearing the end of their hiking cycles and a broadly weaker U.S. dollar. We began to reassess our view on local currency in July: Yields have fallen closer to U.S. Treasury yields. Rate cuts seem largely priced in and could put downward pressure on EM currencies, dragging on local currency returns.
EM hard currency debt – issued in U.S. dollars and thus cushioning returns from any local currency weakness – looks more attractive. Hard currency debt is more diversified than local currency, based on J.P. Morgan indexes, and it could benefit from the rewiring of globalization. We also think lower credit ratings in EM hard currency debt are priced in given that yields are at a near 14-year high versus local currency bond yields, Refinitiv data show.
We prefer EM bonds and stocks as we see a rewiring of supply chains benefiting select countries that offer valuable commodities and supply chain inputs. That includes oil from the Gulf states; India’s chemicals and industrial manufacturing; South Korea’s battery and memory supply chain businesses; Indonesia’s nickel and cobalt; and Chile’s lithium. Some, like Mexico, could benefit from U.S. and other DM efforts to reshore production closer to home. That push includes the making of semiconductors – the technology powering artificial intelligence (AI) and a key part of major EM tech sectors. Yet as an investment opportunity, the AI mega force may be bigger within DM, supporting revenues and margins across sectors.
Bottom line
We are in a new regime of greater volatility – and we see EMs better positioned to withstand it, for now. We harness mega forces to find opportunities based on what’s in the price. We stay overweight EM debt overall but switch our preference to hard currency on its high yields. We like EMs that may benefit from rewiring globalization.
Market backdrop
Developed market stocks retreated and long-term government bond yields rose, with the U.S. 10-year Treasury yield jumping above 4% to near 15-year highs reached last year. We think the U.S. rating downgrade helped put a spotlight on the fiscal challenges it faces. Along with greater U.S. Treasury bond issuance, that could prompt investors to demand more term premium, or compensation for the risk of holding long-term government bonds – and push long-term yields even higher.
We’re watching July U.S. CPI inflation this week after softer-than-expected data in June. We expected the normalization in consumer spending to lead to a decline in goods prices. The key for us: persistent service price pressures from wage growth in a tight labour market. Payrolls data last Friday confirmed that tightness, with unemployment still near historical lows.
