Executive Summary
Central banks have entered tightening mode, often a threat to EM risk appetite, but we see opportunities
The MSCI EM equity index remains above its 2007 high while sentiment and flows have eased
EM is a stealth reopening play considering sector weights
EM fixed income doesn’t offer much yield for the risk
EM’s Sentiment Shift
Global central banks have turned to rate-hike mode. We track Global Monetary Policy shifts as they play a key role in determining where conditions are favorable or not favorable for investors. Just last week, interest rate increases were seen in the Czech Republic, Hungary, and Mexico. Before that, Brazil, Russia, and Turkey hiked rates. We’ll spare you the Dot Plots analysis from the US FOMC, but note that the Fed also made a subtle shift towards tightening.
Rising Policy Rates
The upcoming period of central bank policy actions will play a critical role in determining investors’ asset allocation. This week, we spotlight one of the most sensitive equity sub-asset classes to interest rates—Emerging Markets. EM was a hot pick early in the year by market pundits (as so often happens), and the MSCI EM index rose sharply in January but has since stalled out relative to the rest of the world.
Price, Sentiment, Flows
At Topdown Charts, our analysis focuses on a few important areas: price, sentiment, and flows as it pertains to adding a tactical edge to strategic views.
Price-wise, the MSCI EM index remains above its 2007 high while our composite sentiment indicator hovers at elevated levels. That combination is typically not the most bullish setup, but we noticed that the Sentix AC Sentiment Index for EM equities pulled back slightly in June. Moreover, the June Bank of America Fund Manager Survey revealed a large drop in portfolio managers saying they were overweight EM.
So perhaps EM is falling off investors’ radar even though price action on a long-term basis still looks decent. The chart of the week shows good price action amid declining sentiment.
Chart of the Week: MSCI Above 2007 Peak, Sentiment Softens
The Flow Show
There’s been a massive pullback off the spike late last year and in early 2021 when analyzing the chart of fund flows. Perhaps the media’s focus on the US re-opening trade and what the FAAMG stocks are doing has overshadowed overseas happenings.
Whatever the premise, we still believe EM stocks represent an opportunity on both an absolute and relative basis.
EM Composition
Emerging Markets have evolved to be more tech and consumer-driven, but it’s important to pay attention to the overall sector composition.
We like to classify sector exposure outside of tech as “old cyclicals” (financials, energy, materials, industrials) and “defensive” (healthcare, utilities, consumer staples). EM has a higher weight to old cyclicals than Developed ex-US and the USA, while EM has a much smaller weight to defensives.
Therefore, price-action that follows the global reopening and recovery narrative should benefit EM relative to the rest of the world.
What About EM Bonds?
We also favor EM equities over EM fixed income given the backdrop of rising central bank policy rates and very tight credit spreads.
There just isn’t much juice left in the yield tank to provide investors with enough compensation for risk. This week’s Weekly Macro Themes report digs into EM Sovereign CDS spreads as part of a review of EM Fixed Income —which are near historical lows. We saw similar spreads immediately before the COVID crash, so the risk premium has dwindled.
EM corporate bonds offer slightly better return potential versus sovereigns, but with EM CPI running around 4%+, real yields have dipped negative. As we highlighted last week, high yield just ain’t what it used to be—whether that’s in the States or EM. For that reason, we prefer EM equities to EM fixed income, and at a global level equities vs bonds.
Conclusion
After several months of relative weakness, EM equities present a renewed opportunity. We like how the index remains above the 2007 highs while sentiment has cooled off along with lighter fund flows. It might be time to sneak in exposure to emerging markets as we enter the second half - perhaps looking for seasonal dips to add.
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