Dec 13, 2022

Thoughts From The EM Team - November

By Jonathon Mershimer, CFA

Thoughts From The EM Team - November

Our October commentary highlighted the lengthy list of superlatives that had realized during the month. True to the market’s propensity for clustering volatility, we had a similar series of extreme outcomes in November. In framing our thoughts about the month, we recall two specific mentions from last month’s comments:

  • “the market is wont to run with any hint of a potential pivot from the Fed. In this most recent bout of pivot fervor, the market was keyed in on mentions of slowing the pace of hikes that popped up in several speeches from FOMC members…”
  • “In fact, the Congress itself and the communication preceding it only served to reiterate the political commitment to the current zero-covid paradigm. A potential change in this policy would be one of the most important near-term inflections for both the Chinese economy and the broader market.”

The inflection mentioned above happened this month as we saw the clearest signals of a potential light at the end of the zero-covid tunnel for the Chinese economy. The market has had several false starts with this type of inflection this year, but there is an important distinction between what we saw this month and those previous instances. That distinction rests on the fact that we are now seeing policy support for the property market as well as an indication of willingness to loosen the covid-related restrictions that have been crippling economic activity. Past instances of policy support for the market have generally targeted stabilization in the property market without wavering on the commitment to zero covid and the related impact on mobility.

The change in tone we referred to as an inflection above is a proper pivot in policy on the ground, and it came within an ambiance that traditional wisdom would likely have thought to be quite inopportune for such a change. Cases had been on the rise and eclipsed previous peaks during the month; at one point some 75% of the economy’s productive capacity was in a region designated as either mid or high risk. Social discontent had been fomenting, first around issues at Foxconn and then after a tragic incident in Xinjiang. The series of protests that erupted during the final week of the month was the largest since Tiananmen Square in terms of breadth. This placed policymakers at a crucial juncture with some critical decisions to make; covid policy was at a point of forced binary outcome. What followed was a series of policy directives that will meaningfully loosen covid restrictions and, seemingly, pave the way for a proper reopening of the economy at some point in 2023.

With the benefit of hindsight and the knowledge of this inflection in covid policy, we highlight the days following the Party Congress in October as a local trough in sentiment. The Party Congress reiterated the political commitment to zero-covid policy and prominently displayed the hegemony of Xi’s influence within the political economy. All said and done, the MSCI China index returned 29.71% in November, a monthly return which is clearly deep in the right tail of all monthly returns in recent history. The large contribution from the Chinese market itself along with a generally supportive risk environment led to relative outperformance from EM on the month, as the MSCI EM index returned 14.83% and the ACWI returned 7.75%. This was, by a large margin, the best month for EM in aggregate of the covid era.

Having observed reopening processes across various economies, the market will understand that the reopening process is unlikely to be smooth and linear. Given the starting point for positioning, sentiment, and valuation the first order consideration should be the substantive change in policy direction and the implications for activity next year. Beyond this, the market will be observing the policy response to the likely increase in cases and the response from consumer sentiment and activity levels as a barometer for the level of comfort in resuming economic activity. Economic data are likely to remain weak for some time (the releases this month illustrated this fact) but the forward-looking prospects are where investors will focus.

While not as ebullient as the Chinese market, equities in the US had another positive month as the S&P returned 5.58%. In continuation of what we saw last month, the market continued to run with the narrative that we are past the peak of Fed hawkishness. In addition to the move in equities, we note that the market’s pricing of the terminal rate moved further below 5% to ~4.90% (this was roughly 4.98% at the end of October) and the yield on the 10-year Treasury saw its largest decline of the year to end the month at a yield of 3.60%. There are several moving pieces underlying these moves that are worth noting.

The divergence between hard and soft data in the US has been notable for some time, with the hard data (mainly Consumer Price Index (CPI) and payrolls) seemingly lagging other high-frequency indicators of underlying economic momentum. The inflation data released this month provided the Fed with some hard data showing second derivative improvement on the inflation front. The main highlight from the October CPI data release was the decline in sequential momentum, particularly on the services side and in shelter-related measures. There were several other data releases that pointed in the same direction, prices paid indices in the Institute for Supply Management (ISM) manufacturing data would be a prime example.

Recall that the summer rally in risk assets leading up to Jackson Hole was undone by a combination of a reacceleration in CPI reading in the August data released in September and the sternly hawkish tone Powell delivered in his speech. The Fed will likely continue to talk hawkishly in that they will reiterate their commitment to returning inflation to 2%, but if the data continue to show an easing in sequential pressure, both the market and the Fed could be satisfied with the rate trajectory that is currently priced- this is the equilibrium we have been in recently. This, however, leaves a fair bit of leverage on the November CPI data that will be released just before the December Federal Open Market Committee (FOMC) meeting. A negative surprise there could recalibrate the market’s expectations for Fed policy.

In a sequence that felt oddly reminiscent of Jackson Hole (and thus drew the obvious parallels from market observers), Powell was slated to deliver a speech to the Brookings Institute on November 30th. Given the market had rallied in the preceding weeks, Powell could have crushed sentiment with nothing more than a page out of the Jackson Hole speech had he so desired. In actuality, we heard nothing new and that gave the market permission to run with the prevailing narrative.

Ultimately, the signal that the Fed is going to slow the pace of hikes in December has been unambiguous so the base case of a 50 basis point hike is strong consensus. Such a result in December feels as much a foregone conclusion (in market expectations) as was the 75 basis point hike that we got in this month’s meeting. In the background, the hawkish offset to the potentially slowing pace comes in the form of a peak rate that could remain higher for longer. The potential for such restrictive policy to weigh on growth has been reflected in projections of economic growth (the Bloomberg consensus for 2023 real US GDP growth is 0.4%) and in a yield curve that is becoming increasingly inverted.

As we end the month, the two-year to ten-year Treasury yield spread is inverted by some 70 basis points, a level of inversion has not been seen since the 1980s. This sends a clear signal about the market’s view of forward-looking growth prospects and policy rates. We also highlight two additional macro observations relating market prices to growth prospects: oil prices and shipping rates. Crude spot prices were lower by 7.18% on the month, the fifth negative month of the last six which now leaves us lower in spot price than the January close. Similarly, the Shanghai Containerized Freight Index extended its recent decline and moved lower by 27.55% this month. The decline from the recent peak in shipping rates is on the order of 75%.

As we think about the reopening potential in China, there are several macro considerations for the market to process in the coming weeks and months. On one side, we have a significant source of aggregate demand that has been largely dormant returning to the market- this should be a relative tailwind for growth, particularly in Asian economies. That increase in aggregate demand should, on the margin, be supportive of energy prices. While it could take some time for this to materialize, further normalization in supply chains should help reduce goods disinflation. For many of the related industrial commodity markets, the key observation will be the pace of property recovery in China.

The convergence of relative improvement in EM growth prospects supported by a Chinese reopening, a peaking of expectations for Fed hawkishness, and easing price pressures allowed for a significant weakening of the USD. Indeed, both the U.S. Dollar Index (DXY) and the broader Bloomberg Dollar Spot Index (BBDXY) notched their largest declines of the year at 5.00% and 4.83%, respectively. Among the outperforming currencies on the month were the South Korean Won (+8.06%), the Thai Baht (+7.94%), and the South African Rand (+6.69%). Somewhat curiously absent from that list (given traditional betas to risk rallies) is the Brazilian Real, which depreciated marginally on the month.

That monthly return for the Brazilian Real (BRL), however, fails to tell the story of Brazilian risk markets. As we ended October, we had noted that the market would be looking for evidence corroborating the notion of a moderate Lula administration. This evidence would have taken the form of a speedy appointment of a market friendly finance minister and economic team alongside some acknowledgment that fiscal prudence would be required. Instead, the appointment of his cabinet was pushed into December leaving the market with a protracted period of uncertainty while the names gaining prominence have not been those favored by the market. Fiscal moderation then came into question when the administration proposed a fiscal waiver that would allow some 200 billion BRL of spending to be permanently removed from the spending cap, potentially destabilizing the debt trajectory for the nation. Each of these developments were negative relative to expectations and incongruous with the moderate Lula notion.

As we write, the finance minister has not yet been appointed and the fiscal waiver has not been debated in congress. However, the tenor of these debates has effectively nullified the notion of a moderate Lula, in the near-term, and increased uncertainty. This will leave the market frustrated as the Brazilian economy, which had one of the most attractive macro setups coming into the election, is now in a potentially precarious position. 10-year local yields moved wider from the 12% context to 14% at the wides of the month, the trough to peak move in USDBRL was nearly 10%, and MSCI Brazil returned -2.89% on the month. There was clearly no shortage of volatility in asset prices.

Geopolitics remains a relevant driver of risk in the market. The market was served a sharp reminder of this mid-month when headlines appeared showing that an ostensibly Russian made missile had exploded in Poland and caused casualties. Emergency meetings were held by NATO and several other organizations, but the tension was eventually defused as the NATO Secretary General relayed that their analysis indicated the explosion was caused by a Ukrainian air defense system. Nonetheless, the contours of the war in Ukraine remain critically important for the global economy.

Biden also met with Xi in Bali, their first in person meeting since Biden’s election. The official readout noted “President Biden explained that the United States will continue to compete vigorously with the People's Republic of China, including by investing in sources of strength at home and aligning efforts with allies and partners around the world. He reiterated that this competition should not veer into conflict and underscored that the United States and China must manage the competition responsibly and maintain open lines of communication.” In addition to that, a photograph of the two leaders shaking hands made its way around global newspapers.

As we head into the final month of the year, the tone should be set by the labor market and inflation data that precedes the mid-month FOMC meeting. If that meeting plays out as the market expects, we will see a step down from the 75 basis point hikes of recent meetings. As always, the tone from Powell will be closely watched. In addition to this, the contours and trajectory of the Chinese reopening will be a key determinant of macro sentiment and positioning across markets. The response to cases that will likely rise will be key to watch, as will both the Politburo meeting and the Central Economic Work Conference that should take place mid-month. Those meetings will jointly set the tone for economic policy in 2023.

This information is not intended to provide investment advice. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, market sectors, other investments or to adopt any investment strategy or strategies. You should assess your own investment needs based on your individual financial circumstances and investment objectives. This material is not intended to be relied upon as a forecast or research. The opinions expressed are those of Driehaus Capital Management LLC (“Driehaus”) as of December 2022 and are subject to change at any time due to changes in market or economic conditions. The information has not been updated since December 2022 and may not reflect recent market activity. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable and are not necessarily all inclusive. Driehaus does not guarantee the accuracy or completeness of this informa­tion. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

About Jonathon Mershimer, CFA

Jonathon Mershimer, CFA, is a senior analyst on the Emerging Markets Team with a focus on macro and financial research.

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