Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett argues that after a busy week for central banks, we could now be moving into a different era, while Paul McNamara discusses how the situation in the US, Europe and China will shape emerging markets and the longer-term effects of reshoring.

16 December 2022

David Dowsett, Global Head of Investments

This week marks the last full trading week of the year, but it was a busy week given the CPI data releases and monetary policy meetings in the US, the UK and Europe. All three central banks, having each raised rates by 75 basis points (bps) at their last meeting, raised rates by 50 bps each at this meeting. We expect commentary at the press conferences and projections of dot plots to grab market attention rather than the actual interest rate hikes themselves, but there will be quite a lot to watch for there too. Specifically, there is likely to be a focus on whether we will see a move above 5% for the terminal dot plot for the Federal Reserve (Fed).

Overall, however, I think this is likely to be the last week where interest rate trade normalisation dominates market sentiment. This is because we are moving into a different era in terms of how quickly central banks will raise interest rates. By the time of this week’s meeting, the Fed will have raised rates this year by more than 400 bps and so we are unlikely to be quibbling about whether to expect another 100 bps or another 125 bps from here. 2022 has been all about interest rates going up but as we move into next year, markets are likely to be more focused on earnings releases and individual data releases from key countries, in my view.

As these data releases and monetary policy meetings are all clearly occurring in the last full trading week of the year, there is likely to be some volatility as investment banks will not want to warehouse any risk either way.

Paul McNamara, Emerging Market Debt

The last couple of years have been challenging for emerging markets. During this period, any asset class remotely related to risk, and many asset classes not related to risk, have been hit hard.

One of the biggest challenges facing emerging markets (EM) is the strength of the dollar. Over the last year, the Federal Reserve (Fed) has hiked interest rates and US growth has been reasonably robust, while elsewhere, Europe has faced difficulties around energy supply and the European Central Bank has been relatively cautious in its interest rates hikes and China, a huge driver for the rest of the world, has continued to tackle Covid. Comparably, growth in the US has been reliable, and as a result we have seen one of the strongest years for the dollar on record, while EM currencies have been weak.

EM inflation has been tough but is starting to improve. In fact, the relationship between commodity prices and inflation is even stronger in the emerging markets than it is in the developed world, especially energy. In developed markets (DM), energy is approximately 5-6% of CPI, while it tends to be 12-15% in emerging markets. Energy affects the price of food, consumer durables and much more. The share of goods is much bigger than the share of services as a proportion of total CPI in EM relative to DM so the importance of energy in consumer price inflation is stronger in the EM world than the DM world. We have already seen energy prices come off more than 20%, and if they fall further, we expect the outlook for emerging markets inflation will improve and look healthy. This scenario would be positive for EM.

For next year to be better for EM, we need to see better growth in both China and Europe. We believe this is plausible and in the case that growth in these regions does outperform expectations then, in our view, EM is a strong place to position as currencies and bonds are attractively valued.

China has been all about Covid this year. We also saw a run of concerns about the property market and the bankruptcy of some of the property companies earlier in the year. However, it was clear by about Q2 this year that the Chinese government’s response was going to be sufficient to protect the housing market. Regarding Covid, Chinese vaccines do not seem to be materially less effective than Western vaccines and if China had opened up and tolerated outbreaks of Covid, as the rest of the world did, the chances are the death rates would be similar to those seen in the developed world. China can certainly afford to step down from its zero-Covid policy which has hampered growth and has made it very difficult for some of the commodity exporters in Chile, Peru and Brazil to prosper this year.

The US is walking a tightrope at the moment. We think the US will be fine, but the danger is that if we see a US boom, we would see a continued strong dollar, which is negative for EM currencies. The issue with the US is that as the housing market interest rates go up, mortgage payments go up and house prices come down. House prices are an important component of consumer wealth. So what the Fed is doing to slow the economy, is in fact slowing the economy. We want to avoid a recession because it would be a risk off event, making it much more difficult to raise capital and even as interest rates come down, the cost of capital to anybody with any credit risk goes up. At the moment, the base case is that the US is successfully walking that tightrope and a lot of the key drivers of the big spike in inflation we have seen, especially energy and shipping prices, but also the post Covid effects of supply chain disruptions, are beginning to drop out. The consensus forecast for US inflation at the end of next year is 4.3%, which is about half of the peak this year. This is not priced into markets at the moment. All US inflation has to do is conform to expectations without being accompanied by a recession and the US leg is supportive to EM.

The factor we are most worried about is the gas price. As everybody is aware, following Russia’s invasion of Ukraine, Russia broke its contracts to supply gas to Western Europe. In total, Russia only supplies about 9% of total energy use in Western Europe. The issue is that that percentage is very concentrated in a few key countries, especially Germany, Italy and Austria, and the supply from Russia is also disproportionately important in winter. The domestic sector uses nearly all its gas in winter, and for that reason, we saw huge spikes in European gas prices coming into the end of last year. While those prices have come down since, a lot of that reduction has been because buyers have disappeared, not because all the gas has been bought but because there is nowhere to store it. Europe, aside from Iberia, only has enough storage to account for about 14% of annual gas use. The storage is full, but storage is not enough to take Europe through even a moderately bad winter. Countries in the far West, such as Ireland and the UK, have very low levels of storage and these countries will be disproportionately affected. If we do have a tough winter, Europe is going to run out of gas and the economic effects of that will be disastrous and almost certainly result in a strong dollar. We have reached a point where Europe is dependent on the weather and if we have an average winter, we believe Europe will be more or less okay and that would be another risk taken out of the calculation for risk assets, positioning EM to rally. However, while temperatures were higher than average for most of November, and resulting gas consumption was lower and we saw storage fill up, now, the temperature is about four degrees lower than average, and gas use is much higher at the moment than it typically has been at this time last year. We believe Europe could run into trouble quite quickly.

The good news is that the world is very risk adverse at the moment. The most crowded trade is long the US dollar, and the dollar is considered overvalued. Holdings in emerging markets are exceptionally low, positioning in EM is at an all time low and positioning in risk is very low. If we get a mild winter, if China steps away from its zero-Covid policy, and if the US does not show signs of distress resulting from higher interest rates, these technicals mean that the world could be set for a sharp rise in risk assets which would be good for EM. We believe the asset class can fly under the right conditions early next year.

The idea that we are stepping away from globalisation, towards reshoring, is very important on a multi-year horizon. It is much more important for the exporters in Malaysia, Thailand and Indonesia and to a lesser extent, China and Mexico. The EU is sufficiently robust that we do not believe we are going to see car plants coming back from Slovakia, Poland and Bulgaria to Germany. We have not seen a lot of reshoring beyond the EU. All the foreign investment into Russia was for Russian domestic consumption. If reshoring continues, and that is not proven yet, there is a long way to go and a lot depends on the next US election. However, we think the balance of power within EM could change significantly and the countries that have done very well, such as Turkey, Mexico and some of Asia, will struggle relative to central Europe. Meanwhile the commodity exporters, South America and South Africa, will just be about the commodity cycle. Reshoring and the depth of globalisation are something we would need to adjust to but it would be a long-term trend.