Q3 2023 CIO Review and Outlook

The end of the quarter was rather disappointing. Markets just about everywhere started to sell off. Many individual stocks that I would regard as both high quality and not expensive suffered; often they were among the worst affected. As always at counterintuitive times like this, the question is: “What don’t we know that the market does? Or thinks it does….”

Because, you see, I thought recent inflation data for the U.S. had been very good. We are getting closer to the accepted 2% target and still with no real weakness in the economy and the labor markets. That seemed to hold out the possibility that the Federal Reserve had over the last couple of years achieved the seemingly impossible and brought inflation back down without causing a recession. In addition, it suggested supply chain issues had all but normalized, and despite the best efforts of global politicians to drive each other crazy (and eight billion people along with them), the global economy was getting back on its feet. Ah, but not so fast. Something is happening in bond land and it appears to be affecting all our markets. Long-term yields are rising.

Trouble in bond land

The 10-year breakeven inflation rate—a barometer of what inflation may do in the future—is now at 2.3% and the five-year breakeven inflation rate is at 2.5%, the highest point since April last year when we were in the thick of battle against inflation.¹ So whatever the current inflation data seems to suggest, the bond market isn’t believing it. What’s even more disappointing is that the long-term 10-year real interest rate (interest rate adjusted to remove the effects of inflation) has jumped from close to 1% to nearly 1.75%. ²

So what is happening? There are a number of theories but for me this is a self-inflicted condition perpetuated by the monetary authorities. What the bond market seems to be believing is the ‘higher for longer’ mantra of the Fed, and the big problem is that every central bank in the world seems to be promoting the idea. They seem signed up to it because conventional economics tells them that to cure inflation you need a recession. It probably misses the point that there has been nothing conventional about the economy post-COVID. But if central banks are united in the belief that a recession is required then a recession is likely what we will have. In my opinion, it’s just a question of when.

“Everywhere I look I see people afraid of a beast that has already been tamed, in my view.” CIO Robert Horrocks, PhD

And there’s no point looking anywhere else for help. The fiscal budgets of many countries are stretched in most places after their COVID stimulus payments and if we look all the way across the other side of the world—in geographical and political terms—we have China. It seems to believe that the best way to avoid a future slowdown (from overstimulation of an economy that then requires jamming on the brakes) is to let the economy trundle on at sub-potential rates of growth for the foreseeable future, until…. well until what exactly? So far, this approach has just had the effect of stressing out the property sector.

Shackled growth

Higher rates for longer and a sub-par China aren’t generally good for emerging markets. Add in geopolitics. As well as U.S.-China tensions and the Ukraine War, there’s the reignition of the Israel-Palestine conflict which has erupted in such a way that it’s likely to cause instability for many months and perhaps years to come.

The natural response to all these developments is for people to continue to focus their investments at home and increasingly so in fixed income not equity. The underperformers over the past quarter in our major markets have ranged from those vulnerable to cyclical economic pressures–Mexico, Brazil, Thailand–to those where interest rate changes and economic slowdown create liquidity squeezes. Hong Kong is probably the poster child for this. Only India seemed to march on unnerved by the economic and political climate.

Where does it leave us as we look ahead? For the now, the only positive news for emerging markets in my view is valuations. Dividend yield, the most mean-reverting of index valuation metrics in my opinion, reached a level of 2.4% for emerging markets and 2.3% for Asia in the quarter.³ These are levels which have been typically indicative of long-term value and shorter-run rallies.

On the corporate side, as I look at aggregate earnings quality measures across our markets, I’m not yet seeing signs of distress from elevated rates outside of markets like Turkey and Argentina. Incrementally, there are some signs of deteriorating earnings quality, however, again, these tend to be in peripheral markets. Our main markets of China, India and Japan seem quite stable from this point of view. So, it’s perhaps reasonable to think that when global rates do start to come down, emerging markets in the main will be robustly positioned for decent long-term growth.     

Waiting on a few words

For now, the 10-year real interest rate in the U.S. is the highest since the period before the Global Financial Crisis (GFC). Perhaps more sobering is the fact that real interest rates in China and in India are significantly higher than in the U.S. None of this suggests that central banks across the world are doing anything more than running a tight ship.

My fear then is not that inflation will surge again, but that the monetary authorities will do too much. Everywhere I look, I see people afraid of a beast that has already been tamed, in my view. It’s concerning but there is a silver lining. This current atmosphere is not about anything fundamentally wrong with our economies. It’s more about policy and this policy can be reversed or ameliorated with just a few words or a change of tone. Not only would that be, in my view, the correct economic decision but it would also be favorable for markets.

Thus, the world finds itself in a state of cautious pessimism–pessimistic on the one hand that growth is slowing and earnings will disappoint. But holding onto that pessimism lightly in the knowledge that a few words of optimism from normally crusty central bankers could make everyone smile.


Robert Horrocks, PhD
Chief Investment Officer
Matthews Asia

¹ Federal Reserve Bank of St. Louis, as of Oct. 6, 2023

² St. Louis Fed as of Sept. 13, 2023

³ Factset as of Oct. 10, 2023.