Monday digest

Posted 5 December 2022

Overview: December begins in almost good cheer
December has begun on a positive footing for investors, with market participants choosing to focus on the positives rather than the negatives, and most equity markets now trading above bear market territory again. The release of Federal Open Markets Committee (FOMC) meeting minutes at the end of November gave investors enough reasons to buy risk assets. The minutes were in line with previous statement from Powell, but inflation data had turned less scary in the meantime. With news headlines full of stories of tech firm staff layoffs, signalling an easing of tight labour conditions, markets began to see an end to endless rate rises. Current interest rate futures have US interest rates peaking below 5% and with that peak brought forward to April next year (rather than above 5% in May/June). In other words, it is no longer premature to contemplate the Fed going easier or at least less aggressive at slowing the US economy.

The release of above-forecast US non-farm payroll data might have dealt a blow to the dovish narrative. While surrounding labour market data has shown reasonable signs of a slowdown, it is not yet feeding through to the most important US national labour market surveys. The US picked up another 263,000 employees in November, another outsized month of job growth. Meanwhile, the unemployment rate stayed the same at 3.7%. Lots of jobs being filled while the unemployment rate stays the same ought to mean more people returning to the labour market. Yet the number of people in work or seeking work went down from 62.2% to 62.1% of the working age population.  Even worse, they worked fewer hours and the rate of growth of average hourly pay went up slightly to 5.1% year-on-year. So, it’s all very confusing, and markets were skittish as a result. But despite Friday’s volatility, markets have been experiencing more stability over the past couple of weeks, with investors less fearful to invest into risk assets. This seems like a better test of household inflation expectations than just asking people what they expect the rate of inflation to be next year: they are putting their money where their views are.

It is still not all plain sailing though, particularly with geopolitical risks lingering in the background. While China has not been the largest buyer of cheap Russian oil and gas supplies (the honours belong to India and Turkey), last week President Xi Jinping said China was willing to expand energy trade links with Russia in the future. So even if the markets present good opportunities, the political risks of investing in China will remain apparent while the Xi regime remains in place. The recent sentiment shift has been encouraging. However, it also means that market levels remain vulnerable to a whole host of factors that are fiendishly difficult to forecast – from central bank agendas and desire to reassert their credibility, to the geopolitics of China and Russia, to the level of consumer demand destruction from higher (energy) prices and interest rates that will eventually hurt corporate profits. Last week felt calm, and although we hope things stay that way, we would not bet on it.

Emerging markets still defying gravity
Emerging markets (EMs) are usually highly sensitive to the ebbs and flows of global growth. Investors see EM assets as high risk but potentially high reward, meaning buyers are plentiful when the going is good, and harder to find when things look bleak. In that respect, 2022 looked like an arduous task for EMs: global growth has stalled, interest rates are rising at the quickest pace in a generation, and the US dollar has been exceptionally strong. Many of the larger EM companies have substantial dollar-denominated debts, so this can prove a toxic mix for developing nations. And yet, in many respects, EM assets have held up surprisingly well. This may sound strange, considering MSCI’s EM index has lost around 20% of its value this year, but context is key. The S&P 500 has fallen by a similar amount in local currency terms, while the technology-heavy Nasdaq index has fallen by nearly a third. The comparison to US tech stocks is particularly significant, since both are considered long-term growth assets that are highly sensitive to financial conditions. Tech stocks have taken the hit, but EMs have got off much easier.

Everyone except China has done very well and generated positive returns. Brazil in particular has seen a lot of positivity, despite investor concerns about the return of left-wing President Lula. Strong commodity demand certainly helped as well. At the EM headline level though, all of these have been outweighed by negativity towards China. The world’s second-largest economy has been crippled by Beijing’s zero-Covid policy, along with a severe liquidity crunch in its property sector, and questions over the strongman leadership style of President Xi. With all this in the background – not to mention Russia’s war on Ukraine – EMs could have seen a dramatic fall this year, significantly underperforming developed market counterparts. That most EMs have not is testament to their resilience. Central banks frontloaded their monetary tightening last year, allowing them much more leeway in 2022. Commodity exporters were also helped by rallying energy prices earlier in the year, but even EM nations without these exports have held up well. Underlying this has been a sustained improvement in economic fundamentals. Even though risk appetite has sunk this year, there is a sense that EM risks (excluding Russia and China) are themselves lower, at least compared to previous global downturns.

There is an oddity to this though. For half a decade, analysts have talked about the growing trend of ‘deglobalisation’: the fading or reversal of international trade, which had been marching forward since the 1980s. COVID exposed fragilities in global supply chains, particularly around medical supplies, which increased the incentive to ‘onshore’ production or development in key industries. Onshoring by western countries and the removal of trade links should be bad news for EMs, forcing a structural decline in exports. China’s meteoric rise in recent decades was initially down to its comparatively cheap labour and production costs. As the world’s second-largest economy has matured, those costs have caught up with the developed world. If Chinese production is no longer cheap – and the geopolitical risks are higher – there is little incentive for companies to move there, other than tapping into the enormous Chinese market to sell their products.

Of course, moving out of China does not necessarily mean moving back home – and companies might just as well look for cheaper production sites around the world. This has happened to an extent; India and Vietnam have seen massive production growth. But this process takes time. The trade flows between the US and China, while lower than they were a few years ago, are still huge, and that capacity cannot be easily replaced. These are the key question that investors and policymakers must grapple with in the years ahead. Building trade links takes time, and there is a lot of political pressure to move production back onshore, rather than finding somewhere else. The good performance of EMs outside of China this year suggests globalisation is far from over, but whether the decline is permanent or temporary will depend on politics.