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Signals & Noise: Four Themes Driving Emerging Markets
- Expectations for constructive emerging market carry in the coming period are linked to high rates and a range-bound dollar, potentially enhanced if a Treasury buyback scheme reduces yield curve volatility; however, a failure of this scheme could increase the term premium, triggering expectations of deficit cuts or market intervention that would weaken the dollar against emerging markets.
- Forecasts anticipate persistent global inflation through the fourth quarter and a potential for more rate hikes, with the firm projecting three hikes by the first quarter versus the market's pricing of two, though local inflation momentum—particularly core inflation at its highest since COVID—is expected to make emerging market rates and credit spreads more sensitive to rising global yields.
- Strategic positioning remains cautious regarding emerging market rates and credit spreads due to inflation risks and potential equity risk-off scenarios, even as local market valuations are viewed as attractive and the firm anticipates emerging markets can absorb further hikes given robust global growth.
- Specific rate hike timelines suggest the Fed likely skipped a September move due to elections and may only act in December, with the resulting real Fed funds rate of 1.25% viewed as non-restrictive and not a game-changer, while U.S. equity weakness is seen as positive for currencies via a weaker dollar but negative for credit spreads.
- A forecast predicts the Chinese currency will reach 6.60 against the US dollar by year-end, supported by a constructive outlook from a September Trump-Xi summit and an expectation that Chinese exporters will increasingly convert large surpluses into domestic currency.
- Risk factors include the potential for an oil spike driven by Iranian tensions prior to the midterms, which could cause major price impacts on crude stocks, and the risk of widening hyperscaler U.S. investment grade bonds spilling over into emerging market credit alongside volatility from the midterms and Fed policy shifts.
- Current positioning is noted as long based on EMFX sentiment indicators but not extreme enough to trigger a contrarian sell signal, despite models issuing sell signals for risk assets and sovereign credit spreads against U.S. high yield, prompting a plan to add hedges and delay cash deployment until better opportunities arise.