Nov 14, 2022

Thoughts From The EM Team - October

By Jonathon Mershimer, CFA

Thoughts From The EM Team - October

October was the latest in a string of months engendering superlatives to scale the key events. Indeed, if we observe the 14.05% return for the Dow, we are looking at the best return for the index in the month of October on record and the best return in any month since January of 1976. The broader domestic indices also posted strong performances, albeit less anomalous. The S&P returned 8.09% while the Nasdaq was a relative laggard with its 3.94% return. Emerging markets generally underperformed their developed market counterparts as the MSCI EM returned -3.10% relative to the 6.06% return for the MSCI ACWI. While the index level moves are relatively docile by recent standards, there were many moving pieces underneath the headline.

Having been central to the market narrative all year, politics and geopolitics were again front and center. The political arena generated a series of superlatives as the troubled administration of Liz Truss came to an end after just 45 days, marking the shortest tenure for a Prime Minister in British history. Volatility in UK markets prompted an intervention from Bank of England (BOE) to calm markets following the sharp reaction from bond and currency traders to the fiscal largesse in Truss’s original plan. Much of that negative shock to risk assets was unwound as the market regained confidence following Rishi Sunak’s appointment to succeed Truss. Acknowledging the importance of the market’s perception, Sunak promptly set out to restore credibility in the government’s fiscal stance.

The yield on 10-year gilts peaked near 4.50% in the front half of the month and ended October nearly a full 100 basis points lower at 3.51%. Suffice it to say that monthly moves of this magnitude are quite rare for gilts. The GBP appreciated with a similar trajectory and ended the month some 2.68% stronger against the USD. This calming of volatility was relevant to broader markets as fears of potential contagion from the LDI driven stresses among British insurers had been percolating and conjuring conversations about potential sources of tail risk lurking in unsuspected corners of the market.

The second major political event of the month was the second-round runoff of the Brazilian election. Recall that the first-round vote, which included gubernatorial elections, resulted in a more center-right leaning congress than had been anticipated. That result gave some momentum to the incumbent Bolsonaro and tightened the polls throughout the month. This was generally taken positively by financial markets as it increased the probability of either a Bolsonaro victory (relatively unlikely but non-zero probability) or a more market friendly and pragmatic Lula administration. In the end, Lula won the presidency. The superlative qualification: this was the tightest presidential race in Brazilian history.

While the prospect of a Lula administration had long been viewed with trepidation by the market, the absence of a strong mandate has been viewed as a significant moderating force. While the tight race was viewed positively in that light, it is also potentially unsettling in that a narrow gap increases the probability of a challenge from the Bolsonaro contingent who had already expressed concerns about the electronic voting system. A formal challenge is a tail risk, but the market will be closely monitoring social sentiment and the potential for disruptive protests or trucker strikes. The performance of Brazilian asset prices tells us that the aforementioned moderating force notion dominated sentiment, as the BRL appreciated by 4.55% on the month and the equity market generated a return of 8.62%. The market will be awaiting the cabinet appointments from Lula to see whether the moderation thesis is supported.

Shifting our attention to China, we recall that the intersection of politics and economics has always been a critical consideration for investors. This is especially true this year. To be sure, this is broadly true for investors in emerging markets as recent history has presented the market with a procession of political and geopolitical events that have meaningfully impacted the investing landscape. This context is a large contributing factor to the sharp negative response of Chinese asset prices following this year’s Party Congress in Beijing. To scale that reaction, we note that the MSCI China index returned -16.81% for the month and that several China related ETFs hit their lowest levels since 2009 in the days following the Congress.

While the result of the Congress was largely in line with expectations, given Xi’s reappointment to the preeminent positions within the party was effectively a foregone conclusion, the composition of the Politburo Standing Committee illustrated a totality of political influence that surprised the market negatively. Indeed, the most influential political body is now full of loyalists while the absence of an heir apparent points toward at least another decade of Xi’s thought determining the trajectory of the economy. Xi and his economic vision had already been the guiding force for policy; the Congress simply made this influence more obvious and its potential duration more explicit. It is important to note that the Congress itself was focused on a political transition (which itself lasts until the Two Sessions in March of 2023) and the high-level designs and ambitions for the coming five years, not near-term policy. In addition to the overarching message that Xi’s economic thought will guide the economy, security and common prosperity ranked high among the meeting’s focal points. These are not new ideas but assessing the way they interact with the economy will remain a focal point for market attention.

While these longer-term economic modalities will certainly create winners and losers, the near-term economic and market trajectory is most directly influenced by zero-covid policy and the property market. As a poignant illustration of this fact, we need look no further than the inability of this year’s measured policy stimulus to durably underpin the property market, broader economic activity, or consumer confidence. Piece-wise stimulus efforts thus far this year, several of which were initially cheered as potential game-changers by the market, have each fallen flat over time. Thus far, we have not seen any substantive signal that a change in covid policy is imminent. In fact, the Congress itself and the communication preceding it only served to reiterate the political commitment to the current zero-covid paradigm. This reiterated commitment certainly soured market sentiment. A potential change in covid policy would be one of the most important near-term inflections for both the Chinese economy and the broader market. Given that fact, we expect official language to be closely monitored by the market.

The annual International Monetary Fund (IMF) and World Bank meetings resumed in Washington D.C. in October after a two-year hiatus. Unfortunately, the main takeaways from this year’s meetings were relatively gloomy. Here, we will simply share a brief excerpt from the most recent IMF report:

“Global growth is forecast to slow from 6.0 percent in 2021 to 3.2 percent in 2022 and 2.7 percent in 2023. This is the weakest growth profile since 2001 except for the global financial crisis and the acute phase of the COVID-19 pandemic.”

“The economic outlook depends on a successful calibration of monetary and fiscal policies, the course of the war in Ukraine, and growth prospects in China. Risks remain unusually large: monetary policy could miscalculate the right stance to reduce inflation; diverging policy paths in the largest economies could exacerbate the US dollar’s appreciation; tightening global financing could trigger emerging market debt distress; and a worsening of China’s property sector crisis could undermine growth.”

The macroeconomic backdrop remains one of tight labor markets and inflation that is at uncomfortable levels relative to targets; this is exactly the reason the IMF report notes the importance of calibrating monetary and fiscal policies. That said, 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 Federal Open Market Committee (FOMC) members, a marked decline in Job Openings and Labor Turnover Survey (JOLTS) job openings, and hikes from the Bank of China (BOC) and European Central Bank (ECB) that were taken as dovish by the market. That narrative was challenged by hard data in the US, namely the nonfarm payrolls report showing 263k jobs were added in September and inflation data that showed headline CPI at a higher than expected 8.2%.

As we approached the end of the month and the November FOMC meeting, we saw a WSJ article that seemed to be deliberately intended to lean against that pivot notion. Such an effort shouldn’t be surprising as the relief in risk assets over the month generated the largest easing in financial conditions in one bank’s index that includes data back to 2009. Yet another superlative for the month. As we approach the FOMC meeting, we note that this increases the incentive for the Fed to appear resolutely hawkish lest the market unwind some of their hard-fought tightening. All said and done, the yield on the 10-year Treasury ended the month higher at 4.05% with a terminal Fed Funds rate priced just inside of 5% in Q2 of 2023. That terminal rate pricing also increased by approximately 0.40% over the course of the month.

The perceived hawkishness of the Fed will remain a key determinant for the performance of risk assets. We will have greater clarity on this following the November 2nd meeting. In any case, the market will be looking for signs of easing in inflation readings and any loosening from the labor market. In addition to hard data on those variables and the Fed meeting, the midterms in the US will be a key event in November.

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 November 2022 and are subject to change at any time due to changes in market or economic conditions. The information has not been updated since November 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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