Monday Digest

Posted 6 November 2023

Overview: Central bank dovishness proves contagious
Last week, we noted how negative sentiment in stock markets can become a self-perpetuating destructive force for an entire economy as the investing public feels the heat of feeling poorer (at least on paper). But seven days later, we look back at an impressive stock market recovery that proved far more substantial and persistent than anyone would have dared to suggest possible. So, what has fundamentally changed? Well, not the economic data, where there has been no significant changes from the previous ‘not as bad as expected’ string of releases. What did change though was that – contrary to expectation – the US Federal Reserve (Fed) seemed to adopt a similarly somewhat dovish tone to the European Central Bank (ECB) of the previous week.

Few were expecting any interest rate move from the Federal Open Markets Committee (FOMC) this month, but a majority of commentators thought another 0.25% move in December likely given next month’s meeting has more research inputs. But after Wednesday’s meeting, Fed Chair Jerome Powell gave the strong impression the FOMC is becoming convinced their work is done; that the employment market is becoming less heated, wage growth is calming, and inflation is set to come back towards target. It felt like the opposite of the Fed’s September message and the market reacted accordingly.

In comparison, the Bank of England (BoE) is still in more of a bind. Its Thursday meeting concluded with the same ‘no rate rise’ decision as their US and European counterparts, while the BoE’s statement acknowledged the stress in the UK economy, with interest rates hurting many. Nearer-term measures of inflation in the UK also are helpful at the margin but the BoE’s biggest worry remains and differs in that measures of wage inflation are still uncomfortably high.

Indeed, overall the mix of monetary and fiscal policy globally has already begun to shift to accommodation. The fiscal supports from China announced last week, and Japan this week, are substantial and added to investor perceptions that the investment environment may be about to become friendlier. Of course, much depends on the US. We’ve repeatedly seen that bouts of equity market positivity have supported households and businesses with already strong savings balances. The tight US financial conditions leading up to the FOMC meeting have been loosened in only two days. Following relatively weak US employment figures today, FOMC members have to believe the easing in the US labour market is more than seasonal if they are to hold on to their new-found dovishness.

What last week’s market moves also suggest is that institutional investors have been short of risk assets, both in equity and bond markets, while private households have been diverting money into their savings rather than investment accounts. This type of rebalancing flow may be ‘short-term’ but it can still go on for some time. Nevertheless, this past week’s market action informs us that the ‘higher for longer’ rates perception that only just sunk in over October may have already reached its expiry date given central bankers’ unexpected dovish tones.

Does Emerging Markets growth always mean returns?
Why would you invest in Emerging Markets (EM)? In a word, growth. As the name suggests, developing economies generally have high potential to develop, and foreign investors are keen to get in on the action. It does not always work out, of course, but that is just part of the game: high risk comes with high reward. We have written a lot about emerging markets in recent months, from the obvious China – whose ’emerging’ status perhaps stretches the definition somewhat – to India, Brazil and Argentina. The risk-reward profile of EM investment means that for every India or Brazil success story, there are plenty of Argentina-style cautionary tales.

This simple mantra goes some way to explaining why EM assets are generally considered risk-on, doing well when global investors (primarily concentrated in wealthy developed nations) feel confident and vice versa. But in reality, things are a little more complicated. EM assets – certainly those in the benchmark MSCI EM index – have arguably been more affected by weakness in China (whose assets make up around 30% of the index’s total market capitalisation) than monetary tightening in the US and Europe this year. On the other hand, as we noted in recent months, Brazil and India have fared surprisingly well, despite weak global growth and tight financial conditions.

One obvious yet often overlooked complication for EM investors is that there is a world of difference between EM growth and returns on EM assets. China is the clearest example of this. Chinese gross domestic product (GDP) expanded from just over $11 trillion in 2015 to nearly $18 trillion in 2022 – meaning 62.4% growth, according to the World Bank. In that time its benchmark CSI 300 stock index grew just 10%, with plenty of volatility along the way. In contrast, the US economy grew just under 40% in the same period, but delivered 86% equity growth. Chinese stocks have sunk 8% this year, while US companies have added 10% to their share values. This reflects the fact that Chinese companies have faced huge problems – prompting an exodus of western capital. And yet, despite undeniable growth disappointment in the world’s second largest economy, the absolute level of growth has held up okay – certainly compared to the dire performance of Chinese equities.

When making the case for EM investment – either in a specific region or in EMs more generally – economists and analysts often point to growth-supportive factors, like weakness in the US dollar or supportive trade conditions. But those factors do not always weigh in favour of EM assets themselves. Indeed, they can often suggest foreign companies with EM exposure. Other asset classes – like corporate or government bonds – can often provide more exposure to EM growth. Growth, on its own, is rarely enough.