What's next for Asia and Emerging Markets?

The global recovery was led by Asia and E.M. markets following the global financial crisis in 2008 as a more straightforward monetary policy in China preceded the turn in U.S monetary policy.

Even though China has been loosening up its policies for almost a year now, the amount of easing indicated by M2 growth or overall lending growth is smaller than in previous cycles. This is partly because China is trying to restructure its enormous and heavily leveraged real estate sector while also pursuing a COVID containment strategy that involves closed-loop production and intermittent consumer lockdowns.

Forecasting key risks in Emerging Markets

U.S. stocks staged a recovery in early August on the optimism of a FED pivot stemming from a fall in commodity prices, deteriorating housing market statistics as home sales continue to fall, and jobless claims hitting an eight-month high. However, the FED has re-instated that it remains on its way to bringing down inflation, and we will see further hikes in the future, albeit at a slower pace. Although it is plausible that the Fed will reduce the pace of policy tightening, that does not mean it will stop hikes soon. Per the PCE index, the Fed's policy rate is still more than three percentage points below inflation.

On the other hand, China's economic growth appears to be suffering due to decreased demand, uncertainty caused by the zero-Covid policy, and a slowdown in the property sector. China's property sector remains a drag on its economy. In 1H22, China's property investment dropped 5.4% YoY, and the forward indicators like new home sales and construction start all registered double-digit contraction.

On the political front, E.M.s are plotting their course in a world dominated by U.S.-China competition and are keeping options open. For example, following Russia's invasion of Ukraine, several E.M. nations did not vote on a motion to exclude Russia from the U.N. Human Rights Council. Instead, many E.M. countries might join a non-aligned movement similar to the Cold War.

Preparing for the uncertain future

The risk-off environment is expected to continue as the length of the FED's hiking cycle is still uncertain. The Fed is still tightening aggressively, raising the risk of a hard landing. Further tightening could widen credit spreads as expectations for defaults in a recessionary environment rise. China's delayed-Covid recovery means more defaults are expected in the Chinese property sector before stabilization measures take broader effect. Capital preservation is vital in this environment.

The dollar's strength could probably continue while the Fed aggressively tightens. However, the recent yen weakness could continue as rate differentials with Japan and the rest of the world continue. The rewiring of global supply chains and the transition to net zero means that this is more likely to be a more volatile world, and this new regime won't be temporary.

The volatility in the Asia high yield (H.Y.) market will diminish in the coming months as credit fundamentals for non-Chinese issuers remain steady. Unlike most developed countries, further policy easing is in the cards in China as authorities seek to moderate the economic slowdown and stabilize the property sector. This presents an opportunity to select higher-quality issues in the high-yield segment surgically. Moreover, many E.M. central banks raised rates early and to levels much beyond pre-Covid levels. For example, State bank of Pakistan started raising rates as early as September 2021. Similarly, The Central Bank of Egypt raised rates by 100 bps in March this year. Inflation may moderate as developed-market (D.M.) central banks tighten policy, allowing many emerging-market (E.M.) central banks to halt rate hikes before the end of 2022.

The U.S 2-year yields are at the highest since 2007 at 3.55%, while the 10-year yield has increased to 3.29% after LSM manufacturing index was unchanged in August. Although yields may further go up if the FED proceeds with more aggressive hikes, we think this is an opportune time to start adding modest amounts of high-yield U.S. bonds to balance out the credit risk that comes from developed-market credit.

China's rebound insight

The Chinese economy is under short-term pressure, but the economy is not on the verge of a severe housing catastrophe. Chinese households have high savings rates, enabling them to deal with interest payments. This is nowhere near 2008 in the U.S. or Europe, when homeowners with a lot of debt couldn't make their actual payments.

If we look forward to the future, a fall in commodity prices usually signals that the end of a bear market is near, and since mid-June, there have been significant drops in the price of copper, iron ore, and, most recently, oil. Furthermore, the Chinese government has already started to fine-tune its policies to boost demand and stabilize the property sector by taking steps such as lowering mortgage rates and relaxing purchase restrictions.

For China, we expect a strong rebound in economic activity in the second half as Covid-19 lockdowns lessen and regulatory restrictions on tech and other industries relax. China's increasing closeness with Russia has also generated a new geopolitical dimension that necessitates additional compensation for owning Chinese assets.

The credit outlook, meanwhile, is improving. Demand should increase with expected fiscal support for infrastructure investment, and spreads on short-term local government financing vehicles should benefit. Opportunities have started to emerge as the region opens its doors. The reopening of China should benefit Asia & Emerging markets as a whole. We see Asian high-yield debt as a potential opportunity for risk takers, though they should still prepare for a bumpy road ahead.

Summary & Conclusion

Long-term inflation expectations remain above 3%, triggering aggressive Fed action to curb aggregate demand. Yields are expected to increase to record levels if the FED signals an aggressive tightening outlook in the next meeting. Negative sentiment persists across all regions except China, where the government has started to take steps to boost demand.

It is better to remain cautious for now, given the macro headwinds. The dollar strength will continue with the rate hikes as the FED pushes on. Investment grade bonds are preferred to increase defensiveness and preserve capital. Volatility is expected to remain high in equities in Q3, favoring bottom-up stock picking. The rotation to value stocks continues as the valuations become relatively cheap on a forward P.E. basis.

The risk of a hard landing increases as the FED continues with the rate hikes. The risk of a hard landing is not priced-in, and further tightening could widen credit spreads as expectations for defaults in a recessionary environment rise.

Opportunities exist for investors with the cleanest portfolios and available liquidity. Focus on defensive companies with sticky recurring revenues, high and stable margins, and strong cash generation.

Sentiment in the real estate market remains nervous as current pending transaction activity points to one of the lowest quarters of investment since 2020.