Look who's emerging as the biggest star of 2023

Emerging Markets' Emergence
Emerging markets are back in the spotlight, emerging as 2023's biggest star so far after a decade in the shadows. Rock bottom arrived in October last year (not coincidentally about the time that Treasury yields and the dollar were peaking). Since hitting a nearly three-year low,  the MSCI Emerging Markets index is up more than 30%. 

There are many reasons for the resurgence, led by the weakening dollar and the reopening of China as discussed last week. Let's talk about each briefly.

The dollar has depreciated 7% since its high in October, pushing EM assets higher. Historically, the two have had an inverse relationship. Year-to-date, EM stocks and foreign exchange have enjoyed a strong run, though Goldman Sachs Group Inc.'s Caesar Maasry and Jolene Zhong point out that local credit spreads and rates have lagged the moves compared to developed-market peers. It's the differential in economic growth, however, that suggests EM stocks have further to go:

Consensus GDP expectations suggest a 3pp growth differential between EM and DM this year, though this differential is likely to decline into 2024 and 2025 to a "still healthy" 2pp according to Goldman Sachs forecasts. These estimates suggest further downside to the USD over the long-run, and we forecast roughly 2% appreciation of EM currencies by year-end. 

This is how Goldman illustrates that differential, which would be widened if the US slows down more than now expected. It suggests there is room for the dollar to weaken further (and hence for greater EM outperformance):

For a similar analysis, this chart comes from Gramercy. Emerging markets have in the past tended to be viewed as a geared play on the global economy as a whole — when global growth is strong, EM is stronger, and vice versa. But this year, it should be possible for the gap to widen even though the developed world is slowing down:

China's economic reopening as Covid-19 restrictions fall has been crucial, and has contributed to a surge for stocks in China and across the Asia-Pacific region. Here's BlackRock Investment Institute in its weekly commentary:

China's reopening brightens the view on EM as domestic demand restarts. Chinese assets represent a sizable share of EM indexes, so we see overall EM as a beneficiary of the reopening. Rising Chinese demand is likely to benefit other EM exporters with strong ties to China as growth rebounds, too... We see a more positive EM backdrop as DM central banks pause, the dollar weakens and China reopens. 

But while EM equities understandably dominate attention, emerging-market debt tends to be ignored. Few asset classes are more drastically out of favor, and last year saw record outflows from EM debt portfolios. Technical conditions should be more supportive in 2023, according to Marcelo Assalin, head of William Blair's emerging markets debt team:

We anticipate another year of limited net debt issuance. Higher funding costs in primary markets should encourage issuers to tap into more affordable multilateral and bilateral financing. We also anticipate flows coming back to dedicated EM debt portfolios, attracted by appealing valuations. 

Assalin argues in a note that EM debt is now attractively valued on both an absolute and relative basis. EM sovereign high-yield spreads appear particularly compelling to him, especially in relation to US high-yield levels.

The fact that many emerging central banks were obliged to start hiking in 2021, long before the Federal Reserve and the European Central Bank, has left many emerging-market sovereigns offering attractive yields, according to Assalin:

All things considered, we continue to believe that current valuations overcompensate investors for credit, currency, and local rate risk, as well as volatility — so EM debt may offer attractive value to investors with a medium- to long-term horizon and a willingness to tolerate a period of higher volatility.

Emerging-market treasuries have tried to boost their local currency debt issuance in recent years to reduce vulnerability to a sudden increase in the dollar. Many are now yielding well above the local rate of inflation, making them far more appealing than most developed-market sovereigns, as this chart shows: 

Bloomberg colleagues Sydney Maki, Selcuk Gokoluk and Zijia Song reported that emerging-market issuers are taking part in a global deluge of debt sales amid a decline in borrowing costs. Europe's debt market, they wrote, enjoyed its busiest week ever and US bond sales surged after a weak December:

In just two weeks, developing-nation governments have sold $41.5 billion in euro- and dollar-denominated bonds, marking the best start to a year in more than a decade, according to data compiled by Bloomberg. That's a 246% jump from the same period of last year and equals 41% of the sales for the entire 2022.

Despite such heavy supply, the growing demand for emerging-market assets has allowed the average risk premium on sovereign and corporate bonds to tighten to 338 basis points, the lowest level in nine months, according to data from a Bloomberg index. Here's a chart to illustrate that: 

Given all the enthusiasm surrounding EM debt, what will benefit? Fixed-income portfolios, no less. At least according to Mohamed El-Erian, who among many other things is chairman of Gramercy Funds Management. He and Robert Koenigsberger expect this year to be good for EM debt. In a report, they argue:

After an extremely tough year, we expect 2023 to be more positive with EM's high carry, a relatively stable rate environment and a China reopening story to support high single-digit to low double-digit returns for the asset class. While uncertainty remains regarding the macro backdrop, with potential recessions threatening the outlook in key economies, we remain cautiously constructive on EM debt given the level of drawdown already experienced in 2022, strong fundamentals and a good technical picture.

The current levels, they wrote, provide a good entry point for investors wanting to participate in the upside, which they think could be in the next 12 months to 24 months. They also make the fascinating point that in the last year, emerging debt has sold off in a way that rivals all the great EM debt crises of the last 30 years — which is strange because there hasn't been an EM debt crisis in the last year. These are the biggest selloffs since the inception of JPMorgan's benchmark EMBI index in 1994 (which arrived just in time for Mexico's default and devaluation disaster which became known as the Tequila Crisis):

On a total return basis, last year's selloff was the deepest since the Russian default of 1998 (which led to the Long-Term Capital Management meltdown), as is clear when viewed on a log scale:

If these past incidents are any guide, then, the last year has already seen EM government debt take a hit comparable to the Global Financial Crisis. Those past dislocations proved to be great times to buy, and now there is the added advantage that emerging markets aren't defaulting, the dollar is falling, and they offer superior yields. Therein lies the case for emerging-market debt, and it's a good one.  

Full of Sound and Fury, Signifying Something
For those who retired to bed at a healthy hour on Tuesday night in the US or Europe, the news from Tokyo was that the Bank of Japan had no new news. Yield-curve control — intervention to maintain 10-year Japanese government bond yields at 0.5% or below — will continue unchanged. Speculation that it would be significantly watered down or even abandoned altogether turned out to be wrong. Such a move would have brought foreign funds into Japan and strengthened the yen. Thus the radical weakening of the yen that followed immediately upon the BOJ's announcement showed that there had really been plenty of money betting on a change to YCC:

The BOJ's Eventful Non-Event
The yen went on an extreme round trip after yield curve control was left intact

Source: Bloomberg

But the end of YCC remains just a matter of time. As the Deutsche Bank foreign exchange analyst George Saravelos has pointed out, there are some reports that the BOJ may even own more than 100% of some benchmark 10-year bonds. This would imply, he explains, that "not only has it bought the entire stock, but it has lent it out to short-sellers who have sold it back to the BOJ." At the risk of stating the obvious, this isn't sustainable, and something must give before long.

That helps to explain the recovery of the yen after the initial shock. Twelve hours after the announcement, the currency was slightly stronger than it had been before the BOJ spoke. It was also helped by news from the US that was interpreted as bad for the American economy — and therefore good for the yen.

So Near Yet So Far
We have an outbreak of cold feet in the US, where stocks closed lower for the second straight day — the first time that has happened this year. Closely watched was whether the benchmark S&P 500 index would break decisively above its 200-day moving average, which currently stands at around 4,000. Bloomberg colleagues Vildana Hajric and Katie Greifeld noted it was was the index's fifth such attempt over roughly the past year to bust out above the long-term line. And once again, it failed.

To end Wednesday, the S&P 500 lost 1.6% while the Nasdaq 100 dropped 1.3%, snapping a seven-day winning streak, as weak economic data resurrected concerns over the country's growth outlook. This was despite an impressive fall for Treasury yields across the curve, even as two Federal Reserve officials — St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester — both called for more rate hikes.

That shouldn't be too surprising. The market is getting into the habit of fighting the Fed. Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, puts it beautifully, as follows:

Don't forget, the Fed told us a year ago that inflation is transitory and fed funds would be less than 1% by the end of 2022. And the two-year said, "You're so wrong," and rates shot up. And now the Fed is saying, "Nope, we're going to move funds to 5%" and the two-year is saying, "You're so wrong," and rates are dropping. So, I think this is why the dollar continues to be weak because rates here are dropping at a time when places like the BOJ are saying, "We are willing to let rates go higher."

The confidence that the top is in for rates in the US has never been stronger. At 3.47%, the 10-year Treasury yield is now no higher than it was seven months ago, and 96 basis points below its high from last October. Another illustration of markets' confidence that a recession will soon force the Fed to retreat and cut rates can be derived from the Bloomberg World Interest Rates Probabilities function (WIRP <GO>) on the terminal. This gives us a measure of what the futures market is expecting for the fed funds rate after each meeting over the next year, and so shows how much of a reduction is expected between March (now widely expected to be the top) and the January meeting next year. This implies a likelihood of three 25-basis-point cuts over that period, the most confident prediction for easing later this year since last June:

How Much Will the Fed Cut Fed Funds This Year?
Market estimates of the fall from the peak to Jan. 2024 are at a 6-month high

Source: Bloomberg World Interest Rate Probabilities

All of this is just what the stock market has been wanting. So why the unhappy response? The problem is that the bond market's confidence in an imminent easing is in turn conditioned by a belief that a recession is coming. A variety of data backed that narrative, and also offered support to the idea that inflation is coming sufficiently under control for the Fed to relent. Retail sales fell in December, against expectation. However, producer price inflation also fell. That should be good news both for the battle against inflation and for attempts to stimulate the economy, as it suggests that companies are being relieved of a significant burden. This is how headline producer price inflation has moved, both on the traditional finished goods basis, and on the final demand basis that was introduced in 2011:

Less Pressure from Producer Prices
Core PPI, by any definition, is descending from historic highs

Source: Bloomberg

The stock market, however, was inclined to interpret it negatively. Then in the afternoon came the Fed's Beige Book, its subjective collation of surveys and reports by economists and bankers at its regional branches. The two key sentences in the large document were:

On balance, contacts across districts said they expected future price growth to moderate further in the year ahead; and
On balance, contacts generally expected little growth in the months ahead. 
The two don't conflict. The former is good news. Evidence that inflation should come under control continues to build. The latter is the corollary; one of the best ways to reduce pressure on prices is to reduce economic growth. It's interesting that traders treated this so much as bad news rather than good. The last few weeks have seen a number of reports, even from houses as influential as Goldman Sachs, suggesting that a US recession can be avoided altogether. That's possible, but still looks hopeful. That some data pushing the needle only a little of the way back toward recession had quite such an impact suggests a lot of that hope was already reflected in share prices.

We can expect more waves of optimism and pessimism as the economic situation unfolds. For now, bad news for the US economy doesn't seem to be good news for the US stock market anymore, but it's still being treated as good news for the emerging markets. 

Survival Tips
With traders so unhappy to get just what they wanted — lower inflation and much lower bond yields — I'm reminded of a great scene from Monty Python's Life of Brian, in which Brian is accosted by an "ex-leper" who is furious with Jesus for curing him and depriving him of his livelihood of begging. As Brian said at the time, "There's no pleasing some people." That's one of my candidates for best line in the movie, but ultimately, I'd put it behind "What have the Romans ever done for us?" and "Yes, we're all completely different!" Any other nominations?

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of "The Fearful Rise of Markets." @johnauthers

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.