We close the first month of 2023 with a notably more constructive tone than we had for much of the preceding year. In broad strokes, this stems from the fact that several macroeconomic headwinds have started to inflect positively. As has been the case for much of recent history, monetary policy lies at the center of this shift in tone. Having gone through a massive and coordinated global monetary tightening cycle, an inflation shock, and the lingering disruptions from the pandemic, investors have begun to glimpse a flicker of light at the end of the tunnel.
That glimpse was sufficient to prompt a bid for risk assets, with a technical tailwind from the residual of light positioning from last year. The S&P returned 6.27%, the MSCI ACWI 7.17%, and the MSCI EM 7.89% while yields were generally lower, the dollar depreciated, and both bond and equity volatility declined. Underneath those headline moves were some meaningful factor rotations, as evidenced by the Nasdaq’s 10.72% return, the strongest January result since 2001. For reasons that we will discuss in more detail below, among the emerging narratives for investors were the ideas that bonds are back in vogue and the setup for non-domestic risk is improving vis-à-vis that for domestic.
Jerome Powell and the Federal Reserve continue to dominate conversational and mental space as the trajectory of the domestic policy rate remains a key determinant of sentiment. Given consistent signs of slowing economic momentum (and widespread expectation of a recession), what appears to be the beginning of a disinflationary process, and incipient signs of labor market normalization, the Fed is fully expected to moderate the hiking pace to 25 basis points in their February meeting. This would be the second consecutive meeting with a deceleration in hiking pace.
That deceleration is important for several reasons, not least of which is that it indicates that recent data have allowed some bounds to be placed on the inflation shock that started this cycle. Simply stated, we have likely seen the peak of headline inflation in most economies and that helps narrow the confidence interval around inflation projections. To put some numbers on that idea, we note that global headline inflation decelerated to 5.9% in December from 6.1% in November. We fully expect surprises, as recent history has humbled forecasters of macroeconomic variables repeatedly, but even the chastened central bankers are finding enough signal to justify a more measured pace of tightening. As we survey the manifest of recent central bank policy decisions, we now see several pauses, a much different picture than much of last year.
On the domestic inflation side, we saw declines to 6.5% on the headline measure and 5.7% for the core series in the CPI release this month. That print was in line with consensus, but the main point was that this left us with several months of inflation data that were consistent with the notion of easing price pressure. Contrarily, we recall the pain the market felt when the August inflation data contradicted the more sanguine reading from July. Elsewhere, Eurozone inflation declined from 10.1% to 9.2% on the headline, Brazilian inflation continued its decline to 5.79% from a peak that was north of 12%, and inflation in India came down to 5.72% from its peak near 8%. We are still well north of target levels, and we know base effects are impactful on these headline figures, but the direction of travel provides some measure of reassurance.
The market is comfortable with the goods disinflation story, the main open question resides on the services side and is largely a function of the labor market. While there is no debate that the labor market is tight, there is an open (and very important) debate about how much of a move we need to see in unemployment to generate the necessary easing in wage pressures. While unemployment remains low (the December reading was 3.5%) and the economy continues to add jobs (December nonfarm payrolls read +223k), there are some hints of positivity from the sequential decline in average hourly earnings and the Bureau of Labor Statistics' employment cost index. While there are many moving pieces that will determine how the labor market will evolve, the most sanguine interpretation of this result would be that it is evidence that wage pressures are easing without an increase in unemployment. Were such a result to realize in a durable fashion it would be quite constructive for the consumer and, by extension, broader economic growth. Indeed, the term “goldilocks” has been making more appearances in colloquial conversation.
Given that ambiance, we would expect lower yields and tighter credit spreads and that is exactly what we saw over the course of the month. The ten-year Treasury yield declined from 3.87% at year-end to 3.50%. We would have to go back to August to find a lower month-end yield. The curve remains heavily inverted, not far off the steepest inversion we have seen in this cycle. In credit markets, we saw investment grade spreads compress ~11 basis points and high yield tighten by 54 basis points on the month, reflecting that ‘bonds are back in vogue’ notion we mentioned previously. As further evidence of that, we would highlight that January issuance in EM sovereign bonds was a record high in the context of $38 billion. This follows a 2022 where the primary market was effectively closed for much of the year and issuance levels were anemic. Even with that large issuance, EM credit returned 3.8% for the month.
We mentioned several months ago that a potential change in covid policy in China would be one of the most macro-influential inflections in the current opportunity set. That policy change happened over recent months (with a rapidity that would be difficult to overstate) and the Lunar New Year in January provided an opportune lens for observing the economic behavior of a population that is emerging from several years of relatively stringent movement restrictions.
These observations evidenced a population that is returning to “normal” activity levels more quickly than had been imagined. This was illustrated by several activity measures and ultimately prompted several economists to, in varying combinations, increase their GDP forecasts for the Chinese economy and frontload the growth recovery in their quarterly projections for the year. With that, the Chinese market once again outperformed as the MSCI China index returned 11.78% for the month.
The combination of a less hawkish perception of the Fed, improved (and improving) growth prospects for China and therefore much of EM, and a more benign energy situation on the European continent creates a very bearish ambiance for the dollar. Given the depth and breadth of impact the dollar has on global allocation decisions, specifically the prospects for EM, the dynamics acting on the dollar warrant some attention.
The dollar was roughly 20% overvalued on long-term measures when we closed 2022, sitting at a level of relative strength not seen since the Volcker years. In the admittedly short observation period of January, we have also seen growth differentials shift against the dollar, largely as a function of the China reopening. If we consider the impact of interest rate differentials, we can see some medium-term dollar pressure coming from the easing cycle that will come at some point (that light at the end of the tightening tunnel) but the ostensibly aggressive cuts already priced in the rates market would suggest this doesn’t go much further in the near-term. All of this points to medium-term dollar weakness and significant volatility in fx markets. Indeed, dollar volatility is the highest it has been in the past decade and the drawdown in the dollar index from September through January month end is deep in the left tail of the return distribution. To be precise, the move sits at the 1.5% quantile of changes over similar periods since 1972- deep in the left tail.
Given the outsized impact that the dollar has on EM equities, the above factors coupled with the realized depreciation of the dollar have improved the relative outlook. Investor perception of that improved outlook has been illustrated by inflows into the asset class. One of the more recent tallies we saw had year to date EM inflows into equity funds at nearly $27 billion while inflows into EM bonds were $8 billion. The time series of those flows is generally up and to the right over recent history, as flows into EM equity ETFs have now been positive in each of the last seven weeks and have increased in magnitude over time.
Of course, within this more constructive EM backdrop, there is significant dispersion so we will highlight two of the underlying moves. Mexico delivered very strong returns on the month (MSCI Mexico returned +17.01% and the Mexican Peso appreciated by 3.51%); nearshoring remains a common topic of conversation here. On the other end of the spectrum was India (MSCI India returned -2.99%) where positioning and valuation have been relatively full which has left India as a funding source for exposures elsewhere in EM. In contrast to the inflows into broader EM, foreign investors have withdrawn some $3.4 billion from the Indian equity market thus far this year.
Adding further to the pressure on India was a short seller report that was published on January 24th focusing on a large Indian conglomerate group. We will not delve into the details of the report here, but there were several varieties of impropriety and governance related issues within the 88 questions posed to the company. The group responded in kind with 413 pages of textual refutation of the argument. Given the heft of the promoter group’s reputation, this report garnered headlines and attention and left the equities linked to the group down anywhere from 27% to 62% from the publication of the report. In addition to the potential idiosyncratic impacts on specific listed group companies, this is a further headwind to a market that was already under some pressure.
As ever, politics and geopolitics are fomenting in the background. Domestically, we have the debt ceiling conversations ongoing, but these are very much a tertiary consideration at present. Within EM, there are several elections that will have meaningful implications for their respective economies. We would highlight the Nigerian general election at the end of February, the Turkish general election in May, and the general election in Argentina in October among these. In the geopolitical realm, the war in Ukraine continues and we had headlines of additional armament support for Ukraine from Germany and the United States, among others, as we near the expected spring offensive. With respect to US-China relations, Blinken is expected to visit with his counterpart on the mainland in early February; that trip will provide another read on tensions that seemingly have been cooling in recent months.
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