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
July 11, 2024
Decoding the Global Macro Environment: A Top-Down Perspective and the Related Implications for Emerging Markets Heading into 3Q 2024
Top-Down Observations
Themes Influencing Investment Decisions Entering 3Q 2024
Three factors came together in the first half of the year to maintain market sentiment at a time of a major change in expectations regarding interest rate cuts by the U.S. Federal Reserve and what this would enable other central banks to do: (i) confidence in continued U.S. economic exceptionalism, (ii) excitement about technologically-driven innovations that will boost longer-term productivity, and (iii) belief that, when push comes to shove, the Fed will support both the economy and markets as needed.
These three factors have boosted market valuations as market expectations of 2024 Fed rate cuts have declined from 6 to 7 to just 1 to 2, with talk in some quarters of a rate hike. They have enabled most countries to signal upcoming rate cuts, with some already embarking on them, and they have coincided with economic recoveries in China and Europe, albeit more timid than many had hoped for.
Looking forward, we are also excited about the potential productivity gains that the generative AI revolution and other innovations stand to unleash. They come at a time when for more than a decade , durable high growth in advanced countries has become harder to sustain, both overall, and in a manner that is inclusive and consistent with respecting the planet’s sustainability.
We do worry, however, about the other two factors. Already there is some evidence that the U.S. economy may be slowing at a faster rate than most expect, including the Federal Reserve. Considering the erosion of financial buffers, including pandemic savings and debt capacity for low-income households and small businesses, we assign a 35% probability to the economic recession scenario.
We are also less confident about a timely Fed reaction function. Burned by its policy mistakes, the Fed has become excessively data-dependent in its policy formulation and communication. As such, by the time the data turns, the Fed could well be too late for a rate-cutting cycle that avoids undue damage to the economy and that risks financial instability elsewhere in the global economy.
These considerations are consistent with our thinking on a better way to manage emerging market investments. It is an approach that prioritizes the combination of “beta-agnostic” positioning, cycle-resilience through careful security selection and structuring, and agile allocation among the many risk/return streams in the EM asset class.
Global Growth
Central Bank Policy
Global recovery remains resilient
Policy path divergence
Pockets of resilience despite lackluster global/regional growth from a historic perspective
Fading U.S. exceptionalism
Lingering economic uncertainty from China amid still limited policy support
Political uncertainty in Europe drives subdued growth outlooks
EM-DM growth differential remains solid
Policy path divergence by DM Central Banks
Cautious EM easing/pausing amid volatile DM rates outlook and sticky core inflation
EM central banks with real rate buffers able to ease policy despite Fed uncertainty
EMFX pressured by move up in U.S. rates and repricing of monetary policy easing trajectories in EM
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 and implications for fiscal policy, inflation and foreign policy
Except for Venezuela, most major EM elections are out of the way
Israel-Hamas conflict: risk of broader regional conflict with implications for oil prices and global inflation
Russia-Ukraine conflict lingers
Source: Gramercy. As of July 10, 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 resilience persists albeit signs of fading U.S. exceptionalism
Global real GDP expectations remain around 3% with a solid EM-DM growth differential of around 2.5%, roughly 40bps above the 10-year average. In the second quarter, U.S. data was mixed but on balance it still largely supported a soft landing whereby activity slows moderately, and inflation continues to retreat, allowing for policy easing later this year. Recent strength in U.S. services being offset by a still solid but loosening labor market and slightly better than expected inflation prints in May support this narrative. However, the lagging effect of high rates and tight credit could cool growth more than anticipated in 2H with some signs of an increasingly strained consumer and in turn increase the chances for a more material adjustment in rates. In Europe, activity remained subdued with an expectation for moderate improvement in the second half of the year.
China’s growth continued its uneven trajectory with robust contribution from the external sector notwithstanding sluggish domestic demand amid the ongoing property market correction. Market consensus for 2024 real GDP growth inched up towards 5% throughout the quarter on some solid data prints as well as incremental stimulus. The upcoming 3rd Plenum of the 20th Party Congress, which usually focuses on economic issues, is set to begin July 15th and should provide an update on the latest reform initiatives although we do not expect a major shift in approach. Markets will watch for details on measures to contain risks related to property as well as efforts to boost productivity with rural land and fiscal reform. Speculation over PBoC bond buying continues although we see further use of the PSL as well as tweaks to monetary and fiscal policy as most likely.
DM monetary policy divergence
The second quarter confirmed market expectations of central bank policy divergence from the systemic central banks amid uneven growth and inflation dynamics in the U.S. and Europe. While the U.S. Federal Reserve (Fed) has remained on hold and in a “data dependent” mode amid a still robust U.S. labor market, the European Central Bank (ECB) and Swiss National Bank (SNB) launched the easing cycle in DM, delivering one and two 25bps rate cuts, respectively. Meanwhile, the Bank of England (BoE), has also signaled it might be inching closer to easing policy as well, possibly as early as August.
The Fed remains the conspicuous exception among the systemic central banks, preferring to remain in a wait-and-see mode. While markets still expect close to 50bps of interest rate cuts from the Fed by the end of 2024, domestic political developments ahead of the U.S. Presidential Elections have arguably increased the odds of a less benign scenario for emerging markets. Such a scenario involves increasing concerns about the medium-term U.S. fiscal trajectory driving higher inflation expectations and a larger medium-term risk premium built into the UST curve. We expect global investors to increasingly focus their attention during 3Q on the economic and geopolitical implications of the potential U.S. Election scenarios and calibrate investment decisions in EM on perceptions about relative winners and losers among emerging economies.
For most major EM economies, inflation has continued to move lower, but, with few exceptions, generally remains above structural target levels/ranges. This, combined with more challenging global top-down conditions emanating from a stronger USD and rates on hold by the Fed, has contributed to slowing down or putting on hold monetary policy easing cycles in EM. Looking forward to 3Q24, we expect the continuation of a cautious approach by EM policymakers in the absence of a material shift in global macro sentiment, which could arrive as the quarter progresses should the Fed clearly telegraph an intention to start its own easing cycle in September. In this context, a stronger coordination between monetary and fiscal policy channels by EM authorities will be required to support EM asset performance and catalyze inflows toward EM economies.
Elections and wars remain key drivers of event risk
The wars in Ukraine and Gaza remain risk factors prone to escalation that markets will need to carefully evaluate during the third quarter. In the case of the former, investors will be assessing the impact of a potential new Trump Presidency on the willingness of the U.S. to continue to provide massive financial and military support to Ukraine and, by extension, Kyiv’s ability to resist Russian pressure. In the latter, market focus will be on risks that the conflict spreads to the broader region if Israel and Hezbollah, the powerful Iran-backed militia based in Lebanon, abandon restraint and descend into a full-scale military conflict.
On the election front, EM investors will have to incorporate the outcome of elections in France and the UK at the very start of 3Q into their capital allocation decisions. Both have important implications for European and UK economic, foreign and security policy with the potential to directly impact a number of emerging markets. This being said, market focus during the third quarter will be by far on the run-up to U.S. Presidential and Legislative Elections in November. Concerns about President Biden’s health and his capacity to fulfill the duties of the Presidency for another four years in case re-elected emerged at the start of the quarter, creating some uncertainty around the candidacy on the Democratic side. However, due to former President Trump’s unparalleled unpredictability and ad-hoc nature of policymaking, the main uncertainty for markets will be related to divining the policy direction of a potential Trump 2.0 Administration on a variety of issues with paramount market significance, including U.S. tax, trade, and immigration policy, foreign relations and attitude toward China, Russia/Ukraine, the Middle East etc., relationship with the Federal Reserve, attitude toward social and environmental issues and the climate crisis, among many others.
Meanwhile, many of the critical elections from the heavy EM electoral calendar in 2024 took place during the past quarter and their initial policy implications will play out during 3Q. In May, South Africa’s general vote resulted in unprecedented erosion of the ruling ANC support to just 42% from 57% in the last vote held in 2019. The outcome launched coalition discussions with major parties and led to a national unity agreement among the ANC, DA, IFP as well as smaller parties. President Ramaphosa was re-elected at the first sitting of Parliament. The market reacted positively to the coalition government and avoidance thus far of including the populist and market unfriendly EFF and MK parties. Looking ahead to 3Q, governability and durability of the unity deal will be in focus as the power sharing arrangement is executed in practice.
In Mexico, Claudia Sheinbaum of the incumbent Morena Party won by a landslide with 60% of votes. Morena along with its allies unexpectedly landed a supermajority in the House and workable supermajority in the Senate, giving the Sheinbaum Administration a very strong mandate to execute policy. The strength in Congress also provides the authorities with a wider array of options to support Pemex. The peso initially weakened in the aftermath on concern over judicial reform and institutional risks but has since retraced some of its losses on constructive cabinet appointments including continuity with the reappointment of Rogelio Ramirez de la O as Minister of Finance and Marcelo Ebrard as Minister of Economy, as well as a continued cautious monetary stance. The new Congress takes over in September while Sheinbaum will be inaugurated on October 1st. Judicial reform, if passed in late 3Q or early 4Q could regenerate some market volatility with investors looking to a fiscal consolidation and possible Pemex plan put forth in the 2025 budget in November.
In India, the largest and logistically most complex election in human history, with close to 1 billion eligible voters and spanning a period of 45 days, concluded during the second quarter. Prime Minister Narendra Modi won re-election, but in a less convincing fashion than expected by markets, and he needed the support of coalition partners with a history of fickly policy positions to form a government. This led to some rethinking by market participants about the prospects of aggressive economic reforms that have been perceived as likely in the event Modi were to secure a decisive victory giving him a strong mandate for reforms. Nevertheless, we expect to see easier/less controversial initiatives such as public spending on infrastructure improvement to continue unabated, supporting GDP growth in a 6.5-7.5% range. Overall, India’s economy remains one of the brighter spots in the ME universe, anchored by solid growth dynamics and prudent economic policy management.
In Venezuela, the opposition successfully united behind MUD Candidate Edmundo Gonzalez who is set to compete against Nicolas Maduro in the Presidential Election currently scheduled for July 28th. The main face of the opposition, Maria Corina Machado, who is banned from running, endorsed Gonzelez and has been actively and effectively campaigning on his behalf. The strength and momentum of a united opposition has increased the probabilities of an opposition victory as well as a delay of the election. However, incentives persist for a recognized Maduro outcome. In this vein, the Carter Center and UN remain set to observe the vote later this month. Meanwhile, the U.S. wound down General License 44 and moved to a special license framework whereby companies like Chevron have sought and obtained approval for operations.
Investment Strategy Review and Outlook
Multi-Asset
Our multi-asset commingled strategy celebrated its Three-year Anniversary in the second quarter, a notable moment in seeking a better approach to emerging markets.
Our philosophy centers on 26 years of observing EM asset class behavior, and common threads among unhappy EM investors. In capitalizing on those co-behaviors and solving for those threads, we believe an active, multi-asset class approach with more balanced liquidity can yield attractive absolute returns. These last three years have offered a rapid set of negative conditions to test our philosophy and suggest the approach is indeed working as intended. Coinciding with a historical drawdown in emerging markets, we experienced the Russian invasion of Ukraine, U.S. inflation shocks, Federal Reserve accelerated rate increases, a U.S. banking crisis in confidence, and escalating conflict in the Middle East. Through it all, we have observed structural capital preservation, compelling capture ratios, and strikingly apparent statistical differentiation from global asset class returns streams.
Looking ahead, we are excited by the investment prospects for multi-asset. In private markets, our platforms are maturing and networks expanding, increasing efficiencies and yielding new opportunities. Our team is growing and the increase in scale is palpable. In public markets, EM is achieving higher growth with better fundamentals than DM counterparts while still broadly trading in firmly dislocated territory.
At quarter end, the strategy has put to work or earmarked the majority of its dry powder after substantial inflows. Several new fundings have kept private credit and special situations slightly above their strategic weightings rather than opportunistic allocations. Performing public credit has also been increased with a focus on higher duration in an explicit view of interest rates. Finally, the strategy maintains broader market tail insurance, that despite its small percent of NAV, could be impactful and smooth volatility should nerves increase ahead of U.S. Elections or amid Fed communications.
Founder and CIO, Robert Koenigsberger, appeared on CNBC where he discussed A Better Approach To Emerging Markets. Watch the video HERE.
Please see the Multi-Asset Strategy video for more information about the team and their process.
Capital Solutions
The volatility observed in the global markets persisted through the second quarter, leading to significant fluctuations in the U.S. Treasury market. This instability resulted in periods of uncertainty, providing emerging market companies with limited opportunities to access public markets—a trend that was present in 2023, thus far in 2024 and is anticipated to continue this year. During these brief windows, access to the public markets was predominantly available to large investment grade issuers, with only a few high-yield issuers managing to break through. According to BondRadar data as of June 30, the total number of EM corporate primary issuances during 2Q24 was US$80bn. This is split between $59bn from investment grade issuers and $21bn from high yield issuers. The 2Q24 total issuance is up 45% from 2Q23 and up 41% from 2Q22 but down from 2021 and 2020.
This environment of high interest rates and constrained access to public markets has further boosted the demand for our private credit strategy. We continue to receive inquiries from larger companies who choose to incorporate our highly secured structures into their financing strategies.
Also, some of the theses we identified earlier in the year are materializing. The Mexican nearshoring thesis has allowed us to book assets in areas such as power generation, providing much needed access to power to several industrial players. Furthermore, the materialization of that thesis has allowed us to secure attractive opportunities where we are supporting the construction and development of warehousing capacity for multibillion-dollar public companies that are market leaders in their space.
Brazil, which has taken advantage of its first mover approach to fight inflation, continues to thrive which has allowed us to benefit from our focus on the agribusiness sector where we continue to find high quality borrowers that are willing to work with us in highly secured transactions pledging their commercial flows to our financings.
Another trend we have identified is how the metals & mining complex has sustained a recovery cycle on prices, particularly in the transition metals segment. This is generating interesting CAPEX opportunities in LatAm, where assets are among the most efficient within the global cash-cost curve. We have capitalized on the good performance of some of our existing positions, deployed capital in Q2, and have a robust pipeline.
Finally, the high-rate environment continues to show the uncorrelated nature of our private credit strategy in comparison with our developed market peers. While high yield companies in the U.S. are struggling with their maturity walls in the new rate environment, often to unsustainable levels, our borrowers have exhibited more consistency.
During the second quarter, we deployed a total of $211 million, in a combination of new deals, upsizes to existing loans and platform loans. The loans were directed towards the agribusiness, O&G, real estate, power generation, mining, healthcare, and financial sectors and diversified across Brazil, Mexico, Colombia, Peru, and Africa. Additionally, we have over $150 million already committed and in the process of being funded. At the close of the second quarter, we had a pipeline of $160 million in the advanced due diligence stage and almost $1 billion in early-stage deals. The pipeline is comprised of both our established platforms as well as single transactions, allowing our team to diversify the portfolio by investing in different industries and countries including sectors such as cement in Turkey, financial institutions and fintech’s in Mexico, agribusiness in Brazil and Peru, mining in Peru, industrials in Chile, O&G in Africa and Mexico, real estate in Mexico and Costa Rica, among others.
Please see the Capital Solutions Strategy video for more information about the team and their process.
Emerging Markets Debt
The ECB completed its first rate cut, kicking off their rate cutting cycle, with Lagarde pointing to more potential cuts while remaining cautious. In emerging markets, in addition to grappling with developed market monetary policy uncertainty, we had three elections during the second quarter – South Africa, Mexico and India – that each produced surprises versus market consensus.
Under these volatile conditions, hard currency emerging markets debt was resilient during the second quarter, with positive returns in both sovereigns and corporates. Hard currency corporates outperformed on the back of higher carry and some, albeit low, spread compression while hard currency sovereign returns were more muted as spread widening in the high yield bucket offset the positive impact of carry and rates. Local currency sovereigns experienced more volatility and negative total returns for the quarter in the context of broader global macroeconomic uncertainties and surprising election in South Africa, Mexico and India.
Looking forward, we believe the outlook for emerging market debt remains constructive, driven by resilient emerging market fundamentals and a potential soft landing in the U.S. that will allow the Fed to embark on a rate cutting cycle during the second half of 2024. Despite mixed macroeconomic data in the U.S. during the first half of the year, we believe the picture that is emerging is one of a slowing U.S. economy with continued disinflation, albeit at a slower pace. As such, we have been surprised by the more hawkish rhetoric coming from the FOMC and believe that in looking not to repeat the mistakes of the past with the mistaken ”transitory inflation” narrative, they may wait too long to start cutting interest rates, thereby increasing the likelihood of the downside of a recession. While this hard landing scenario remains a tail risk, it is one that has grown in probability and may continue to do so the longer the Fed takes to act. In this tail scenario, high yield emerging market assets will be more vulnerable while investment grade assets should be insulated by flight to quality dynamics and longer duration profiles that will benefit from even lower rates. Longer duration emerging market assets with a lot of convexity should also fare better. In local currency, a lack of obvious triggers in the third quarter suggests a more cautious and selective approach.
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 Brazil, Mexico, Peru, Argentina, Venezuela, Puerto Rico, and developed markets, including the United States and the United Kingdom. As we look forward, we are in the 5th year of capitalizing on a specific Colombian sovereign risk opportunity. The strategy has realized over 1,200 individual Sentencias claims and the team continues to seek outsized returns via these Colombian Sentencias (sovereign risk).
We are also seeing attractive opportunities in secondary transactions involving legal assets. We often seek to structure these investments with insurance to protect against the downside. Finally, we are seeing interesting opportunities in real estate development in underpenetrated markets in the United States, Europe, and Latin America. Higher rates have stressed balance sheets and are beginning to create the forced selling of assets, including from major REITS facing liquidity challenges. As a result, we believe there could be compelling specialized opportunities.
Conclusion
The recent quarter has been marked by significant fluctuations and uncertainties, influenced by the Federal Reserve’s reliance on data and the postponement of the anticipated “Powell Pivot.” The market appears ready to revert to a strategy of seeking yields, a tactic that was overbought at the end of last year. We continue to be drawn to the potential resurgence of dislocation recovery and the inherent carry found in both public and private markets. We are equally enthusiastic about the current opportunities for opportunistic and special situations in the market. However, the ongoing conflict between liquidity, growth, and persistent inflation persists. Consequently, we foresee ongoing market volatility, which will provide opportunities for strategic capital allocation informed by our comprehensive understanding of the asset class. Our guiding principles of resilience, optionality, and agility, or “ROA,” will steer us toward achieving our desired returns without committing non-recoverable mistakes. By adhering to our strategy of “planning the trade and trading the plan,” we intend to continue to navigate and leverage market volatility to our advantage, thus providing a better approach to emerging markets.
On February 1st, Gramercy hosted a virtual roundtable discussion. First, Scott Slayton, Partner, Chief Strategist at Capital Creek Partners moderated a fireside chat between Mohamed A. El-Erian, Chair and Robert Koenigsberger, Managing Partner and Chief Investment Officer. Next, Timothy Reick, Chief Executive Officer at HRC Group moderated a discussion between Gramercy’s Investment Strategy leaders.
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
20 Dayton Ave
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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