Incoming data suggest that the slowdown in the US economy is gathering pace and financial conditions are tightening. As the Federal Reserve notes in its latest Beige Book, which compiles anecdotal reports from the field, banks have “tightened lending standards amid increased uncertainty and concerns about liquidity.”
China, on the other hand, recently reported a broad-based recovery in the first quarter of the year—services consumption was particularly strong—and we expect full-year GDP growth to be above 5.5%. And as we described in our March report “Mind the differences,” while not totally immune to US and European banking stresses, banks in the developing world have exhibited resilience thanks to generally solid regulatory and supervision standards.
From a longer-term perspective, changes in the global economic and geopolitical order seem to be accelerating. During the IMF/World Bank meetings we attended in Washington DC this month, there was talk of a “geopolitical depression” unfolding, one in which tensions between superpowers intensify. China’s recent move to broker a diplomatic deal between Iran and Saudi Arabia reminds us of the country’s growing willingness to assert itself on the global stage. And French President Emmanuel Macron’s April visit to China laid bare that, while US and European worldviews are largely aligned, they can differ in key areas.
The role of the US dollar as preeminent global reserve and trading currency has also been hotly debated by the media and investors in the last few weeks. As described in our recent piece “The dollar is dead; long live the dollar,” we are confident the greenback’s reign will live on, yet it will likely have to make room for competitors along the way. China’s recent efforts to accelerate the internationalization of the renminbi are unlikely to yield overnight successes, yet they plant the seeds of a more diversified currency landscape ahead. Gold stands out as a clearer near-term winner in this context: Last year saw very strong central bank buying of the yellow metal following Russia’s invasion of Ukraine, marking the 13th consecutive year of net purchases and the highest level of annual demand on record dating back to 1950. We see central bank demand for gold remaining strong for at least another year.
With this cyclical and secular picture in mind, we think the importance of geographic diversification in investment portfolios, and the active mitigation of home biases, are more important than ever. The less-than-perfect correlation of emerging market assets to their global counterparts appears to us as a very desirable attribute.
In addition, emerging market stocks are trading at above-historical-average valuation discounts to US equities on both a price-to-earnings and price-to-book basis, which we do not think is justified by fundamentals and should tighten in the coming months. The real growth acceleration in emerging economies should start to trickle down to corporate earnings. Peak policy rates and the economic softening we expect in the US should support the investment case through a weaker US dollar.
We also see value in US dollar-denominated emerging market bonds, where valuations are attractive relative to historical levels driven by the high yield segment. We foresee mid-single-digit total returns (non-annualized) for sovereign bonds (JP Morgan EMBIG) in a baseline scenario over the next six months, supported by carry and moderate spread compression.
All in all, with large divergences emerging in the economic and geopolitical behavior across countries, we think highly geographically concentrated portfolios expose investors to a growing number of unknown unknowns.
Man contributor: Alejo Czerwonko, Chief Investment Officer Emerging Markets Americas
Content is a product of the Chief Investment Office (CIO).
Original report - The growing relevance of geographic diversification , 1 May, 2023.
