‘Emerging markets are more immune to global shocks today’

Geopolitical tensions have caused higher-than-expected global inflation, but they have not weakened global growth meaningfully. Emerging markets have become less sensitive to global shocks thanks to credible monetary policy and floating exchange rates. And let’s not forget there are strong structural investment stories in emerging markets... the demographics of India, reshoring in Mexico... 

There is ongoing debate around how restrictive interest rates really are. The US has stood impressively well to rate hikes. 

Growth has been resilient, consumer spending and investment have been strong, the labour market is still solid, and stocks have rallied despite rates markets pricing out rate cuts this year. All this put together does not point to overly tight financial conditions and may signal we should get used to high-for-longer rates.

Of course, higher interest rates can weaken the global economy, but it is worth noting that global growth has also withstood higher rates relatively well in the cycle.

The 2020s are likely to be a decade of higher inflation and interest rates relative to previous decades. It’s a decade of regime change from monetary excess to fiscal excess, globalisation to localisation, and, of course, peace to war. And you can see the impact in markets. 

Commodities, historically an asset class that outperforms when inflation is high, has been the best performing for two out of the three past years. Higher interest rates are likely to constrain returns from both bonds and stocks. 

Elections can lead investors to be cautious and temporarily take some chips off the table, but if policies remain investor-friendly, this should be a buying opportunity. From an FX [forex] perspective, we believe INR is well-placed to navigate the elections. The central bank has close to record reserves to manage FX volatility, and our fundamental valuation estimates the INR is slightly cheap relative to USD.

Looking at this from a US perspective, profits have been a bigger driver of S&P 500 returns than politics, and who is sitting in the White House matters less for corporates. Tax policy and tariffs would likely affect profits, at least until the gains or losses are competed out or priced into industries — but even tariffs may be a smaller concern given the US weaning from China that began in 2018. 

Historically, election years have been positive for US equities (S&P 500 +11 per cent on average in election years since 1928); volatility tends to rise in the months leading to elections on policy uncertainty; and bipartisan support for maintaining defence spending, moving tech IP out of China back to the US, and a focus on manufacturing, all of which are pro-cyclical. Fiscal austerity risks and policy disagreement could impact healthcare (high government contract exposure).

This feels like an inflection year in China. Our Global Fund Manager Survey showed pessimism toward China peaked in January. That same month, Chinese stocks slumped to a 50-year low relative to US stocks. And in April, Chinese bonds hit all-time highs versus US Treasuries, a reflection of angst on deflation. We’re not surprised by the growing optimism toward China, given the light foreign positioning in Chinese asset markets at a time policy has turned more stimulative, particularly toward the real estate sector, and the economy starts to recover. 

India could see $25 billion of foreign inflows in FY25 on the back of its inclusion in the JP Morgan EM Bond Index. While concerns around volatility from such flows are valid, India appears very comfortable to absorb potential shocks on the back of RBI’s robust forex reserves. We expect forex reserves rising further to $700 billion by the end of FY25, which, alongside an eminently manageable current account deficit at 1 per cent of GDP, offers a strong set-up for prolonged stability in the INR. At the same time, India is firmly on the path of fiscal consolidation, led by improved tax buoyancy and a productive expenditure mix favouring capital expenditure. These factors should offer adequate comfort to investors tracking Indian markets.

Recently the investment flows have been into India and out of China. India benefits from supply chain diversification and a growing labour force. It is also likely the second biggest beneficiary of the AI boom in EM. However, much will depend on improving infrastructure and skills. The government is focused on this opportunity with ‘Make in India’, which should result in rising foreign direct investment. Still, China remains very competitive and a leader in key technologies such as electric vehicles. However, crucial for foreign investors in China will be the return of domestic demand and attractiveness of the investment environment.

Both new and old economy look well positioned; in fact some old-economy companies have the opportunity to use tools presented by these emerging themes (for example, GenAI, digitisation, automation, energy efficiency) to grow more labour-light or asset-light, both of which translate to margin expansion (at least for a time) and earnings visibility. For example, many large US financials have grown more labour-intensive since the global financial crisis, with added layers of legal/compliance personnel, but generative AI may drive efficiency across these processes.