To read a full report, please download PDF from the link above

Global Macro – Emerging Markets

A difficult H1 2023 has complicated the outlook for emerging markets in H2 2023. On the one hand, we are on the cusp of rate cuts that are set to kick-off this month (see here) and softer commodity prices are reducing import bills for vulnerable economies. On the other hand, sticky inflation, tepid risk appetite, constrained access to funding and lacklustre domestic demand will test the commitment to rebalancing of public accounts and structural reforms. As ever, there will be winners the reflect either structural strengths that mitigate strains or bold policy choices that has left them well-placed to manage the cyclical adjustment. There will also be laggards where the combination of external shifts and domestic pressures have exacerbated pre-existing fragilities, setting back the recovery and stiffening the policy challenges ahead (see here).

US Fixed Income: Shift from inflation to growth fear

Macro View: Our view remains that the US cannot handle higher rates (for sustained periods of time) and that the US economy is close to falling in or will fall into a recession in 6-9 months. We also think that the US is suffering from an early onset of a credit crunch (which will potentially compound the recession too). The last, and always last indicator to confirm this will be the jobs market. The jobs market has been showing cracks in various categories and we think that the second half will see material slowing in both actual economic activity and hence job growth will slow and potentially go negative too. The inflation picture is still a bit murky but getting clearer with the passage of each month. Although the latest June inflation reports came in weaker than expected (and that has markets breathing a sigh of relief) the path for inflation will still be challenging. For one, until we actually see major job cuts, the wage side can still keep core inflation sticky and there is always a risk of a late cycle spike in energy prices, which could unwind some of the benefits of lower inflation lately. That said we think that markets will shift from inflation to growth fears soon.

Fed Policy: The Fed is closer to being done than in any real position to restart the hiking cycle to even higher rates. In other words, we expect the Fed to deliver on the hike that is priced in for July but that will likely be the last hike for this cycle. The July FOMC meeting will not have new forecasts; however, we expect chair Powell to emphasize they remain data dependent and hang the risk of another hike (after July) as a way of countering the market’s tendency to price in cuts once the Fed is done hiking. We do not expect back-to-back hikes in July and then September. There is also Jackson Hole where we can get more Fed view updates before the September FOMC meeting. We think the dots in September would still keep a 5.63% terminal rate for 2023. The forward guidance will be needed just in case inflation were to flare-up again later in the year.

Rates View: We have been holding two views in tandem, our first path where data would slow and inflation declines would introduce minor cuts later this year. The second path, which we were initially assigning a larger probability than the first path, where we thought if the regional bank turmoil of the 1st half was only a prelude to something bigger eventually breaking, that a.) it didn’t make sense for the Fed to hike further, b.) the Fed needed to incorporate the long and variable lags of policy along with other forms of tightening via the bank credit channel and c.) that all this would result in large cuts happening sooner (in the 2nd half). Given the resilience of the economy both of these paths are taking longer to realize. We still believe our medium-term views are employing the right framework in determining where we are in the business cycle, but for now, we are keeping an open mind that macro or financial issues won’t just surface without greater warning. Thus, we’ve lifted our rates path, acknowledging they will likely hike at the July FOMC by 25bp while pushing out larger rate cuts into 2024

FX Outlook

The US dollar on a DXY basis has weakened sharply recently and since the last Global Markets Monthly in June is about 2.5% lower with US dollar selling driven primarily by building evidence that inflation in the US is reverting back closer to target. This belief highlighted in the CPI data for June released last week will likely mean the 25bp hike by the FOMC next week is the last in this tightening cycle. Indeed, we believe there is a valid argument to be made that a hike next week is not necessary and investors may concur given the increased pricing of rate cuts in 2024. The DXY Index has fallen back below the 100.00-level for the first time since April last year when the FOMC and the markets were first realising that the inflation shock would require aggressive rate hikes. We agree with market pricing that the Fed tightening cycle will end next week and see risks of rate cut expectations being brought forward as the labour market weakens over the coming months. With more tightening still ahead for central banks in Europe, there is now a clearer window opening up for the dollar to continue on a gradual weakening path.

KEY RISK FACTORS IN THE MONTH AHEAD

• We turned bearish on USD/JPY last month and in that regard the risks this month are similar given we have maintained a strong bearish bias for USD/JPY. The bearish bias is based on the Fed ending its tightening cycle this month and then for the potential for the markets to bring the pricing of rate cuts forward. Hence, the primary risk is a more resilient US economy and yields remaining higher for longer than we expect. We also see a high chance of a YCC change and if this fails to materialize it could fuel renewed JPY selling. However, the risk of heavy yen selling on no YCC change is much less than the risk of heavy yen buying on a YCC change as a change to the long-held status quo is much more meaningful for the markets, JGB yields and the JPY.

• The main downside risks for EUR/USD include: i) the ECB signalling that that end of their rate hike cycle is near and dampening expectations for another hike in September or November, and ii) the emergence of evidence showing that the euro-zone and global economies are beginning to slow more sharply in response to higher rates. Recent market optimism over a softer landing has helped to weaken the USD alongside expectations that the Fed is close to the end of their hiking cycle. A continued loss of growth momentum in China in Q3 could begin to weigh down more on EUR/USD as well.

• The upside risk for USD/CNY will be a widening negative interest rate differentials over the US, should market expects more aggressive rate hikes from the Fed in its tightening cycle. Disappointment in the delivery of stimulus policy could serve another upside risk for USD/CNY.