Authored by:
Robert Koenigsberger, Managing Partner & Chief Investment Officer
Mohamed A. El-Erian, Chair
Petar Atanasov, Director & Co-Head of Sovereign Research
Kathryn Exum, Director & Co-Head of Sovereign Research
October 9, 2024
Decoding the Global Macro Environment: A Top-Down Perspective and the Related Implications for Emerging Markets Heading into 4Q 2024
Top-Down Observations
Themes Influencing Investment Decisions Entering 4Q 2024
The Federal Reserve’s aggressive (50 basis point) start to its interest rate cutting cycle supports our view that the U.S. has a 55% probability of soft landing its economy, opening the way for other countries to reduce their interest rates, enhance their growth momentum, and retain ample access to international capital markets. It is a much hoped for outcome, especially in the context of high geopolitical and political uncertainties.
We also continue to monitor the risk of a U.S. recession which we currently assess at 35% in light of the challenges facing lower income households who have exhausted their pandemic savings, incurred more debt and maxed out their credit cards. The wellbeing of this segment of society, and the associated risk that weakness in consumption demand could migrate up the household income ladder, are heavily dependent on the continued strength of the labor market.
The remaining part of the distribution of potential outcomes, 10%, relates to positive supply side shocks associated with the broad application of truly transformational innovations in AI, life sciences and sustainable energy. It is a scenario that points to higher productivity and growth, accompanied by significant dispersion both within and across countries.
Overall, the favorable implications for emerging economies of this relatively solid distribution of potential outcomes stands in stark contrast to the risks associated with highly uncertain geopolitical and political environments. Of particular note, conflicts around the world that have already resulted in the massive destruction of so many lives and livelihoods while risking escalation; a tight U.S. Presidential Election; persistent China-U.S. tensions, and the loss of influence of the traditional center parties in European politics.
Thanks to consistently accommodating financial conditions, the relatively elevated market valuations of recent months have been able to sideline these uncertainties, benefiting instead from the attractive prospect of a U.S. soft landing AND sizeable Fed rate cuts in the next 12 months. This is also why we believe that cautious security selection and solid structuring are key to the resilient portfolios needed to navigate what on the surface appears to be a favorable equilibrium, but underneath, has notable elements of potential volatility.
Global Growth
Central Bank Policy
U.S. soft landing narrative questioned?
Early stages of policy convergence
A “one mandate” Fed?
Pockets of resilience despite lackluster global/regional growth from a historic perspective
China stepping-up policy support as external rate backdrop evolves
Political uncertainty in Europe drives subdued growth outlooks
EM-DM growth differential remains solid
DM central banks begin to converge in easing monetary policy
Tailwinds for EM CBs with real rate buffers amid start of Fed easing cycle with an aggressive -50bps opening
EM Local debt caught in crosscurrents of DM rates and growth outlook; focus on idiosyncratic stories
Volatility
U.S. Elections & Geopolitical Risks
Opportunity for active management
U.S. Elections take center stage
Dislocations possible amid technically driven U.S. rates volatility and evolving growth narrative
Significant U.S. Treasury supply in 2024
Pockets of event risk could arise
Interest rate volatility could progressively converge into credit risk induced volatility
U.S. elections at the forefront with global implications from fiscal, trade & foreign policy and inflation outlook
All major EM elections are out of the way
Middle East conflict: risk of broader regional conflict with implications for oil prices and global inflation
Russia-Ukraine conflict lingers; U.S. elections outcome to influence trajectory
Source: Gramercy. As of October 8, 2024. The information presented is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass. There can be no assurance that investment objectives will be achieved. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.
Growth uncertainty now outweighs inflation risks
While the global economy continues to expand at a solid but softening pace, growth concerns and the labor market took hold in bouts throughout the third quarter. Our base case for a soft landing in the U.S. remains, but with a fat tail risk of a recession. Consumer spending continues to hold-up with solid retail sales data albeit with clear loosening in the labor market, typically a lagging indicator, with softer payroll gains, a higher unemployment rate and fewer job openings. Inflation is now closer to the Fed’s objective but still above target. The path to normalization of the rate environment should help shore-up activity with a lag.
In Europe, we anticipate further cooling of activity, most notably with recent weakness in services, and incremental disinflation with a degree of sustained country divergence. This leaves the door open for the European Central Bank (ECB) to further its cutting cycle.
In China, activity indicators lost momentum with stabilization in composite PMIs by the end of the quarter amid challenged domestic demand. The external sector continued to hold up well but could face some moderate headwinds in 4Q partially offset by some front-loading ahead of possible U.S. tariffs in 1Q25. The authorities have continued implementation of incrementally supportive measures and flagged further action to come. On the heels of the Fed’s surprise 50bps cut, the PBoC’s September monetary package of rate cuts and property support represents an increased momentum of support and should help boost activity closer to the 5% target for this year. Further normalization of global interest rates should provide China with room for greater loosening into 2025, although there are structural limitations to the tools that the government has and has been willing to utilize.
Fed easing and converging Developed Markets (DM) monetary policy provide tailwinds for Emerging Markets (EM) assets
As we enter the last quarter of 2024, the divergence in monetary policy by the systemic central banks that characterized the first half of the year has made way for an increasing convergence toward a global easing of financial conditions. Notably, the one highly conspicuous hawkish standout from the 1H24, the U.S. Federal Reserve, has joined its global peers in initiating a rate-cutting cycle. All else being equal, falling interest rates in DM are likely to have a supportive effect for EM assets across the board. We expect gradual, but steady policy easing by the systemic central banks over the fourth quarter.
In mid-September, the Fed chose the more aggressive option (50bps vs 25bps) for the start of its cutting cycle, lowering the Fed Funds target rate to 5.00%, from 5.50%. This signals to us that Chair Powell and most of his colleagues are increasingly focused on the second part of their dual mandate, maximum employment and preventing potential pronounced labor market weakness, as they grow more comfortable with the inflation outlook for the American economy. In the context of a Fed pivoting in a dovish direction, markets have priced in about 200bps of further rate hikes by the end of 2025. Meanwhile, the Fed’s own latest projections point to a further 50bps of cuts in 2024 and another 100bps in 2025, potentially taking the policy rate down to a 3.5% area by the end of next year.
This outlook is likely to be supportive for EM assets, especially if accompanied by a more significant softening in USD strength and could create additional space for faster pace and/or larger scale of rate cuts by EM central banks. Yet, we remain cognizant that elevated market expectations about the Fed’s easing trajectory using the FOMC’s own projections carry certain risks for EM should investors grow disappointed by the pace and/or scope of Fed easing. However, we do not expect this type of dynamic to materialize in the current quarter.
Looking ahead to the coming months, the main risk that we see on the horizon for this constructive Fed policy backdrop for EM comes from the U.S. Presidential and Congressional Elections in early November. Specifically, we note that some of the most prominent economic policy proposals discussed by former President Trump such as universal tariffs on imports as well as significant curbs on immigration could put significant upward pressure on the U.S. inflation outlook and materially alter the market’s expectations regarding the path of Fed policy in 2025.
Elsewhere in the DM monetary policy universe, the ECB delivered a second rate cut in its easing cycle when they lowered the deposit facility rate by 25bps to 3.50% in September and provided balanced forward guidance that we think points to a continuation of measured rate cuts. The Bank of England (BoE) also got a head start on the Fed when it cut 25bps in early August. The BoE appears to be gaining more confidence in the inflation outlook and could be able to accelerate the pace of cuts during the fourth quarter, in our view.
U.S. Election in focus
The U.S. Presidential race on November 5th remains too close to call in our view. However, given that states with high union presence remain key to the path for victory, both parties remain committed to pro-worker and national industrial policies, including pressure on China. A divided Congress, as is currently expected, should limit the scope of policy execution while a surprise red or blue sweep would deepen implications. Regardless of the outcome, the increased preference for nationalistic policy and high political polarization likely means some continuation of political and geopolitical uncertainty.
We expect a Harris Presidency to promote key alliances including NATO and the Quad while continuing support for Ukraine and Israel. Pressure on China will persist in critical sector areas including semiconductors, EVs and steel but would be complemented by diplomatic efforts to keep the risk of conflict in check. Nearshoring and supply chain resilience remain in vogue and relevant, although with room for strategic partnerships in markets for natural resources and critical minerals such as Indonesia and Africa. We expect continued incremental expansion of the U.S. position in Africa, bolstering AGOA (Africa Growth and Opportunity Act) which is up for renewal next year as well as efforts to counter Chinese investment. We think there will be broad support for USMCA renewal with room for climate provisions and enhancements, in part dependent on implementation of the domestic reform agenda. In Venezuela, we do not see a significant departure from the current targeted sanctions approach.
Under another Trump Presidency, key differences from Harris would likely encompass reduced support for Ukraine, more expansive and punitive tariffs, pressure on Europe to boost defense spending and prospects for a possible erosion of support for Taiwan over time. In the case of China, the most aggressive “60% tariff on all goods” scenario could shave some 2.5% points from Chinese growth but we would expect a step-change in stimulus to partially offset the impact. For Mexico, USMCA renewal talks will likely be utilized to attempt to gain ground in impeding Chinese re-exports and access to the energy sector while tariff threats could be used for immigration pressure. While still uncertain, we think a more transactional strategy will be adopted in the case of Venezuela policy.
In the meantime, the wars in Ukraine/Russia and the Middle East have both entered what seem to be new and potentially more dangerous/escalatory phases. Ukraine’s surprise incursion into Russia’s Kursk region has generated additional uncertainty about the trajectory of the conflict and Kremlin’s reaction function given increasing fighting/Ukrainian attacks on Russian soil. In the Middle East, the simmering hostilities between the Lebanon-based Iran-supported Hezbollah militia and Israel escalated meaningfully at the end of 3Q amid massive Israeli air-strikes against Hezbollah targets in Lebanon.
While global diplomatic efforts have been ongoing to avoid a full-scale/wider regional war, unfortunately the risk that military confrontation between Israel and its neighbors escalates seems to be growing higher as we move into 4Q. In the event that wider regional conflicts break out, the main impact on EM credit markets would likely come from general market risk-off sentiment as well as via global oil/energy prices that are likely to spike under an escalation scenario.
In China, we do not anticipate major developments from the ASEAN, BRICS, APEC or G20 Summits throughout October and November. Recent ramp-up in military exercises and incursions into Taiwanese airspace are likely to continue with room for accretive escalation particularly in the case of inflammatory remarks in President Lai’s National Day address on October 10th. The Central Economic Work Conference in mid-December should set the tone for policy into 2025.
Following major elections in Indonesia, Mexico, and South Africa earlier in the year, the inauguration of new Presidents in Indonesia and Mexico will occur on October 1st and 20th, respectively, while the GNU (Government of National Unity) in South Africa has contributed to renewed investor optimism amid progress in select policy areas. In 4Q, fiscal policy will be in focus in all three countries as markets await a Finance Minister appointment in Indonesia, consolidation plans in Mexico and prospects for tax outperformance related to pension reform in South Africa’s Medium-Term Budget Policy Statement.
Investment Strategy Review and Outlook
Multi-Asset
In the third quarter, our multi-asset strategy exhibited strong absolute return in the face of volatile markets, with positive contribution from both private and public market strategies.
As rates fell in August, the strategy took profits in the public credit tactical overweight via the sale of long duration investment grade positions after having materially added in May. The strategy maintains limited exposure to local currency, leans slightly in favor of high yield after the investment grade reduction, and currently comprises approximately 25% of our allocation.
In private credit, the strategy upsized select existing exposures and added two new deals to the portfolio. The new exposures include a secured term loan to a Mexican construction company, and a secured equity acquisition financing facility for the purchase of the largest zinc producer in Peru. Private credit remains a tactical overweight (>35%) in favor of opportunistic strategies.
In opportunistic credit/equity we saw PDVSA bonds rally ahead of elections, as well as JPMorgan’s decision to re-weight Venezuelan bonds, including those of PDVSA, in its widely followed emerging-market debt indexes. The strategy capitalized on the strength and has re-assessed the cross-asset opportunity in Venezuela.
Our multi-asset strategy previously disclosed that it had provided working capital funding for a new litigation finance facility. The deal came with enhanced special situations economics ahead of the closing of the public facility (when the binding of insurance would take place). The public facility (and insurance binding) closed in August, which significantly derisked the strategy’s position but allows the strategy to potentially benefit from additional upside.
The global hedge strategy is designed to provide an additional layer of tactical hedge or tail insurance protection should the need arise, and risk/reward structures be attractive. Post FOMC rate cuts, there is currently no added protection to the already inherently hedged multi-asset approach. This may change going into the final stretch of the year, which includes a high-profile U.S. election and potentially increased scrutiny over U.S. labor markets.
Multi-asset portfolio design is the most powerful lever to control risks and influence returns. Looking forward, we are excited by tailwinds from the Fed cutting cycle and their typical influence over public markets. While the multi-asset return streams are highly differentiated, it is under these conditions that we believe the wholistic portfolio may achieve its full potential from a risk/return perspective.
Founder and CIO, Robert Koenigsberger, appeared on Bloomberg Surveillance, watch the video HERE.
Please see the Multi-Asset Strategy video for more information about the team and their process.
Capital Solutions
Global markets continued to experience volatility throughout the third quarter, marked by fluctuations in the U.S. Treasury market. This persistent uncertainty has limited opportunities for emerging market companies to access public markets, a trend that has lingered over the past 18 months. However, as the summer drew to a close, activity began to pick up, with a few high yield issuers managing to re-enter the bond markets. According to BondRadar data as of September 2024, EM corporate primary issuances during 3Q24 from high yield issuers amounted to $12bn. This issuance marks a 1% decrease from 3Q23 while a 137% increase from 3Q22, although still down compared to 2021 and 2020 levels.
Despite some HY issuers returning to the bond market, the trend remains clear: borrowers looking for execution certainty have found better outcomes in the private credit space. We continue to see large, public borrowers turn to private markets for financing, as demonstrated by our work with a prominent Turkish conglomerate and a leading mining company in Peru this quarter. This shift underscores a broader trend, where public companies seek more reliable, secured financing alternatives.
Several macroeconomic themes continue to shape private credit deployment opportunities across different regions. In Mexico, nearshoring has emerged as a powerful catalyst, boosting investment as industrial activity expands, while the recent government initiatives have added some volatility that we are monitoring closely. Meanwhile, Brazil is benefiting from its anticipated tightening cycle, which has made USD-denominated financing increasingly attractive as inflationary pressures stabilize. Chile, after several years of relying primarily on domestic funding, is once again looking to international markets for financing. At the same time, Turkey faces a stark challenge, as lira financing has become prohibitively expensive, with local interest rates exceeding 60%, a sharp departure from the previously low real rates maintained for many years.
This environment of high interest rates and constrained access to public markets has only increased the demand for our private credit strategy. Borrowers are drawn to the flexibility and tailored solutions we offer, which is why we continue to see inquiries from larger companies looking to incorporate our secured structures into their capital stack.
Overall, we deployed a total of $203 million in the third quarter, through a mix of new deals, loan upsizes, and platform loans. These were diversified across sectors such as real estate, oil & gas, logistics, mining, and financial services. Geographically, our investments spanned Brazil, Mexico, Colombia, Peru, and Costa Rica. As of the end of the quarter, we have over $105 million already committed, and an additional $120 million in the advanced due diligence stage, with over $1 billion in early-stage deals. This pipeline includes opportunities in Turkey’s food sector, fintech in Mexico and Colombia, agribusiness in Brazil, Peru and Colombia, mining in Peru, power in Mexico, real estate in Mexico and Costa Rica and industrials in Chile.
Please see the Capital Solutions Strategy video for more information about the team and their process.
Emerging Markets Debt
The third quarter of 2024 was dominated by expectations that the U.S. Federal Reserve would finally embark on its rate cutting cycle and in mid-September they delivered with a dovish 50bps cut. Policy rates were reduced to 4.75-5.0%, and the dot plot signaled a year-end rate of 4.25-4.50%, implying another 50bps of rate cuts between the November and December meetings. The larger cut came amid a dovish shift to the Fed’s inflation and unemployment projections compared to June. This was qualified by the 2025 PCE inflation that was lowered two-tenths to 2.1% and the unemployment forecast that was raised two-tenths to 4.4%. The balance of risks for the committee has objectively shifted from inflation to unemployment; however, Chair Powell spent much of his press conference reassuring markets that while the job market should be watched closely, it remains relatively balanced, and the U.S. economy remains squarely in the soft-landing scenario. Reaction to the FOMC was positive and capped a quarter of strong returns for risk assets, including emerging market debt. Local currency sovereigns, driven by low beta currencies, benefited the most from the macroeconomic backdrop and outperformed other emerging market debt sub-asset classes with a total return of 8.8% during the quarter. Hard currency sovereigns and corporates also posted solid returns of 5.8% and 4.3%, respectively, during the quarter, taking year-to-date returns into high single-digit territory in what some investors would characterize as a say has been a volatile year.
Looking forward, we believe this easing cycle represents a significant opportunity for EM debt. Historically, the average cumulative return of the EMBI Global Diversified Index (“EMBIGD”) was 19%, 39% and 50% in the 1, 2 and 3 years, respectively, following the conclusion of a hiking cycle in the U.S. (data sourced from Bloomberg and JPMorgan) There is no reason to believe that this time should be different. In fact, there are three primary reasons why we believe EM debt returns should be robust in this easing cycle as well.
1) Fed easing creates space for EM central banks to follow suit, leading to a positive feedback loop to local growth and fundamentals. When the Fed begins to cut rates, several key EM central banks may find themselves in a position to follow suit and lower interest rates, thereby boosting economic growth and fundamentals domestically by making borrowing cheaper for corporates and consumers.
2) Alluring yields in EM are boosted by solid fundamentals, EM economies have demonstrated remarkable resilience, driven by several key factors: proactive central banks implementing effective monetary policies, prudent macroeconomic strategies, substantial foreign exchange reserves providing stability, and proactive liability management during low interest rates. This robust framework fueled economic growth, with EM GDP surprising at 4.3% in 2023, significantly outpacing the 1.6% growth in developed markets; similar trends are expected by the IMF for 2024. Additionally, positive structural reforms have led to a wave of credit rating upgrades for EM sovereigns, which in turn have enhanced corporate credit ratings. This upward trend in ratings reduces borrowing costs, thereby strengthening fundamentals and setting the stage for improved bond performance over time.
3) Improved global risk sentiment could drive inflows into the asset class following years of substantial outflows EM bond funds faced substantial outflows of approximately $90bn in 2022, with the flows evenly divided between hard currency and local currency. This trend continued in 2023, resulting in an additional $34bn in outflows, $25bn of which came from hard currency. As of August 2024, there were additional outflows from EM debt of $16bn, bringing the total cumulative outflow to $134bn since early 2022. In contrast, U.S. investment grade and U.S. high yield bond funds saw cumulative inflows of $241bn and $17bn, respectively, from 2022 through August 2024 (data sourced from JPMorgan).
We believe these trends indicate that investor allocations to EM debt are at multi-year lows, positioning the asset class for a potential rebound now that the Fed initiated its easing cycle and global risk sentiment is improving.
While the global macroeconomic environment has become more favorable for EM debt and fundamentals are improving, we believe active management is essential for navigating the diverse opportunities within the EM debt space as well as addressing potential tail risks, such as rising geopolitical tensions or increased volatility surrounding the upcoming U.S. Presidential Election in November, which may impact some EM economies and companies more than others. The significant potential for dispersion of performance within EM debt underscores the necessity for a strong team of EM research analysts and portfolio managers who possess a deep understanding of the intricacies of EM credit.
Please see the Emerging Markets Debt Strategy video for more information about the team and their process.
Special Situations
The Special Situations team continues to focus on the successful management and monetization of our existing portfolio of legal assets in emerging markets, including in Puerto Rico, Brazil, Mexico, Peru, Argentina, Venezuela, and developed markets, including the United States and the United Kingdom. In August, the Special Situations team entered into a supplemental facility with Pogust Goodhead, which seeks to provide the prominent plaintiffs’ law firm with working capital to fund costs associated with their portfolio of environmental and antitrust cases in Brazil including a case against BHP and Vale arising from the Samarco/Mariana Dam collapse in 2015.
Elsewhere in litigation finance, we are also seeing attractive opportunities in secondary transactions involving legal assets, law firm portfolio loans, and claim funding opportunities. Similar to past deals, we often seek to structure these investments with insurance to protect against the downside. Likewise, through our network of relationships in the U.S., Europe, and Latin America, we are evaluating a number of attractive deals with high potential returns with similar downside protection characteristics, including the potential applicability of our unique insurance capabilities. Sectors of focus include work force housing in underpenetrated markets, as well as select digital infrastructure assets that have both developed and developing market applicability.
Conclusion
In conclusion, we expect the dislocation recovery in emerging markets to accelerate with the recent commencement of the rate-cutting cycle. This shift, combined with clean technicals and anticipated inflows, will likely support and sustain the rally in these markets. However, we must remain vigilant as we forecast continued volatility driven by the Federal Reserve’s data dependency, upcoming U.S. elections, and various geopolitical risks. In this dynamic environment, our strategy remains steadfast: we will meticulously plan our trades and execute them with precision to capture the anticipated upside, thereby avoiding the regrettable scenario of missing the dislocation recovery. By maintaining this disciplined approach, we aim to navigate the complexities of the market and maximize our opportunities for growth.
Gramercy Managing Partner and CIO, Robert Koenigsberger, spoke with our Chair, Mohamed A. El-Erian, about the motivation, the development and the implementation of a better approach to emerging markets. Watch as they discuss where allocators often go wrong and how they might combat these factors to bring stronger results to their portfolio.
About Gramercy
Gramercy is a global emerging markets investment manager based in Greenwich, Connecticut with offices in London, Buenos Aires, Miami, West Palm Beach and Mexico City, and dedicated lending platforms in Mexico, Turkey, Peru, Pan-Africa, Brazil, and Colombia. The firm, founded in 1998, seeks to provide investors with a better approach to emerging markets, delivering attractive risk-adjusted returns supported by a transparent and robust institutional platform. Gramercy offers alternative and long-only strategies across emerging markets asset classes including multi-asset, private credit, public credit, and special situations. Gramercy’s mission is to positively impact the well-being of our clients, portfolio investments and team members. Gramercy is a Registered Investment Adviser with the SEC and a Signatory of the Principles for Responsible Investment (PRI), a Signatory to the Net Zero Asset Managers initiative and a Supporter of TCFD. Gramercy Ltd, an affiliate, is registered with the FCA.
Contact Information:
Gramercy Funds Management LLC
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Greenwich, CT 06830
Phone: +1 203 552 1900
www.gramercy.com
Joe Griffin
Managing Director, Business Development
+1 203 552 1927
[email protected]
Investor Relations
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