US regional banks are still experiencing intense pressure, and this has affected lending standards and liquidity conditions in the sector and the country as a whole. According to the Federal Reserve’s latest Senior Loan Officer Opinion Survey, banks of all sizes across US regions tightened lending standards on all loan categories in the first quarter, and loan demand was also reportedly weaker. Meanwhile, the rally in the US equity market has been peculiarly narrow—over 7% of the S&P 500’s nearly 9% returns year-to-date is attributable to just seven mega-cap tech companies.
In our view, the sharp tightening in liquidity conditions over the past several quarters will soon begin to translate into softer US labor market dynamics, economic conditions, and corporate profits. And although the performance of the mega-cap tech stocks has some fundamental backing from the recent advances in generative AI, a lot of the good news is already priced in.
At the same time, China’s recovery has been undergoing enhanced scrutiny as economic data for April underwhelmed expectations, implying a softer momentum after a strong first quarter. While the recovery in consumption remains on track, the property market and manufacturing demand appear to be losing steam.
Despite this, we think China’s recovery will persist, led by the services sector and aided by targeted policy support measures on areas such as housing. More broadly, emerging Asia looks set to contribute the most to global GDP growth in the coming quarters. Corporate earnings out of the region should soon start to fully reflect this economic reality.
Two main known unknowns are clouding the global economic outlook. Top of mind for all investors is the US debt ceiling debate. While the risk of a US default appears to be at its highest since 2011, our base case is that the US Congress will deliver a last-minute increase in the debt ceiling, as it has on 89 occasions since 1959. In the event of a failure to agree by the so-called “X-date”—when the US government will no longer be able to pay its debts—we would expect severe market distress, which would in turn force the politicians in Washington back to the negotiating table to cure the default in short order.
Of course, this would not come without long-term consequences, particularly in a period of intense debate about the role of the US dollar as the global reserve and trading currency. It is nothing to short of remarkable that protection against a US sovereign default today commands premiums above and beyond those for many emerging markets.
In addition, US-China relations remain tense. Although the timing of an expected US executive order governing outbound investments seems to have been pushed back, it lingers as a source of angst for investors. In our view, the planned restrictions will affect only new investments in private markets and will be limited to cutting-edge sectors such as AI, advanced semiconductors, and quantum computing. Having clarity on this measure would help lift the market overhang.
All in all, we are positioning portfolios cautiously, with a preference for fixed income over equities, a bias toward defensive strategies, and a positive view on geopolitical safe-havens such as gold. We also hold a preference for investments outside the US—emerging market assets among them.
In our view, the valuation discount of emerging market stocks in relation to other global equity markets is not fully justified by the fundamentals. In addition, some of the major external headwinds are fading as US interest rates peak and the US dollar weakens. We also see value in sovereign bonds where valuations are attractive relative to historical levels driven by the high yield segment, with specific opportunities in countries such as Colombia, Argentina, and Egypt.
Main contributors: Solita Marcelli, Alejo Czerwonko
Content is a product of the Chief Investment Office (CIO).
Original report - Investing in emerging markets: Look beyond the US in the second half , 24 May, 2023.