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02 May 2023

Insights from the IMF and World Bank Spring Meetings

By Matthew C. Graves, CFA, Kevin X. Zhang

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As part of Western Asset’s Emerging Markets (EM) Team, we attended the spring meetings of the International Monetary Fund (IMF) and World Bank meetings last month in Washington, DC. Our agenda included meetings with policymakers, IMF staff, multilateral development banks, political analysts and US Treasury staff.

Key Takeaways from the Meetings
Once again, we think it’s helpful to consider this year’s spring meetings through the lens of our views when we attended the fall meetings. At the time, we highlighted a challenging outlook for markets, primarily attributed to:

  1. Geopolitics—Irreconcilable differences in Russia; intensification of US/China relations.
  2. Inflation and the Fed—Tight (and tightening) financial conditions in the US, limited global policy space and increased risks of a systemic “crack.”
  3. EM policymakers in a bind—Markets demanded policy orthodoxy, at the expense of growth; countries that couldn’t deliver face bigger challenges ahead.

These factors largely remain headwinds. But the tone of the spring meetings was decidedly more constructive. Investment returns across EM have looked impressive since October. That’s most clearly evident across the major EM economies, where FX performance has been strong (even for the weaker majors, like Colombia), but sovereign spreads have also performed well. US dollar weakness stands out as a key driver of the recent performance.

We see the “weak dollar trade” as a function of expectations for: A sharp pivot by the Fed, ECB policy space staying “higher for longer” and Chinese growth underpinning global growth (ex-US) that’s “good enough.”

US monetary policy stands out as the clearest potential “mispricing” post meetings. Banking sector developments were a major focus of our discussions. The meetings reinforced our view that risks to the US banking system are not systemic. The failures at Silicon Valley Bank and Signature Bank look idiosyncratic in nature, and largely a result of bank-specific asset-liability mismanagement. Unlike 2007/2008, the US financial system is not in the midst of a near-universal asset quality issue. And we now have a crisis-response playbook that’s well-established. In this context, we believe there’s a real chance the market is overestimating potential headwinds to the US economy coming from the financial sector. This could allow the Fed to stay “higher for longer,” pressuring market expectations for US rate cuts in the very near-term, and lending incremental support to the US dollar relative to developed market (DM) peers.

Europe essentially didn’t make the agenda this spring. If we interpret the absence as agreement, then there’s near-consensus on the outlook for “good enough” European inflation and growth, as well as the ability of the ECB to calibrate quantitative tightening (QT), policy rates and liquidity facilities (to respond to fragmentation/financial sector risks) appropriately. In a complicated global environment, we do worry a bit about complacency here. The handling of Credit Suisse by Swiss authorities was viewed as an idiosyncratic, Swiss-specific issue and not necessarily as a precedent for what to expect from Europe more broadly.

China’s abandonment of its zero-Covid policy in November surprised us (and the market), and has paved the way for a front-loaded rebound in specific segments of the Chinese economy. We attribute some of the strength in Europe to a reopened China, and see outperformance (versus the yuan) in key Asian FX pairs (specifically, the Korean won and Thai baht) as indicative of the spillover effects from a stronger Chinese consumer. A quick survey of commodity prices, though, speaks to the limits of the China reopening story. This is clearly not a 2009-style policy response or impulse to global growth. With broad consensus over the short term, Chinese economic developments were discussed almost exclusively in the context of strategic competition with the US and the longer-term implications for exports, investment and potential growth. We also outlined our views on this topic in the fall.

Despite broad consensus on key drivers of the macro outlook, investor surveys showed limited conviction across most trades—with the possible exception of a constructive view on EM local rates—which likely reflects the complex mix of (mostly tail) risks facing the market. It’s a relatively long list of risks, which includes: (1) the (severe) fiscal and financial impact of a debt ceiling showdown, which is, in turn, a function of dysfunction in US politics; (2) a “hike-pause-hike” scenario for the Fed; (3) continued pressure on the US financial system due to asset quality issues in commercial real estate; (4) a rapid deterioration in US/China relations (given the extent of overlapping economic/security interests, there’s plenty of room for an “accident” to precipitate a more pronounced decline in bilateral relations), and (5) further geopolitical fragmentation, which will generally prompt a stagflationary impulse for the global economy, given potential impacts on supply chains and commodity prices.

Debt sustainability and the global sovereign debt “architecture” were also a focus of the meetings. With numerous sovereign restructurings stuck in the mud, the specter of a “lost decade” similar to the 1980s has weighed on the outlook for many EM single B issuers. Working toward a functional debt restructuring mechanism—which makes the duration and severity of these events more predictable, and, as a consequence, minimizes the real economic impact of debt distress—looks like a necessary step toward helping these markets function again. Real progress was made on a number of these issues during the week, even if there’s clearly still more work to be done. We’ve subsequently seen a positive market response in the two bellwether distressed situations (Sri Lanka and Zambia) currently working toward resolution.

“ESG” was a noticeably less prominent theme than in recent years, with investors’ focus turning more narrowly to climate change and building scalable sustainable debt markets. We think this may actually be a healthy development. Sustainable debt markets which emphasize public sector policy, the development of global public goods, and the economic salience of environmental factors can directly contribute to sustainability and impact objectives. We believe this shift in focus represents a step forward for sovereign ESG markets, improving upon an approach that implicitly treats sovereign debt and corporate debt as interchangeable, and which consequently emphasized ESG risk identification and use-of-proceeds bonds as its core building blocks.

Bringing it all together, we think the investment outlook for EM continues to look reasonably constructive. Under a base case in which the US dollar strengthens at the margin relative to DM peers, EM should still benefit from a supportive environment for risk sentiment, given “good enough” growth outcomes across the world’s three main economic engines (China, Europe and the US). Clearly risks abound, though, so even if the base case is constructive, we would also characterize it as fragile. A misreading of the Fed, which leads to an earlier than expected cutting cycle by EM central banks, could undercut some of the currency strength we’ve seen since October. Similarly, we also see risks to the current view for Chinese and European “growth exceptionalism.” A more hawkish Fed outlook, in combination with weaker growth in either region, could kickstart renewed US dollar strength and the resumption of headwinds for both EM policymakers and EM asset prices.

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