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Pamela Davenport published in

Economic outlook for 2024

                                                Featured Image

Pavel Muravev, iStock/Getty Images Plus

Key Points

  • Americans are hopeful the Federal Reserve can achieve a so-called soft landing for the U.S. economy in 2024.
  • The Fed projects U.S. GDP growth of 1.5% next year.
  • Inflation is trending steadily lower but will likely remain above 2% in 2024.

The Federal Reserve has made significant progress in bringing down inflation while maintaining growth in the U.S. economy in 2023. However, while inflation has trended lower recently, interest rates are historically high. Economists anticipate the economic fallout from the Fed’s tight monetary policy measures may intensify in 2024.

Investors are hopeful the Fed will be able to navigate a so-called soft landing for the U.S. economy and avoid a severe recession in 2024. Unfortunately, inflation remains well above the Fed’s 2% long-term target, and experts are divided on whether the Federal Reserve may have simply delayed an inevitable recession.

The Federal Reserve itself projects its monetary policy tightening measures will weigh on U.S. economic growth in 2024.

Fortunately, the Fed recently modified its economic projections and no longer anticipates a U.S. recession. While the risk of a severe recession has declined in 2023, economists and analysts anticipate interest rates will remain higher for longer than optimistic Americans had hoped.

Investors looking ahead to 2024 should consider taking a cautious approach to their finances given the potential for a slowdown in gross domestic product growth, sticky inflation and a delayed negative economic impact from the Fed’s aggressive rate hikes.

Economic outlook for 2024

There’s no question the U.S. economic outlook has improved throughout 2023, but that doesn’t necessarily mean the economy is in the clear heading into 2024.

The U.S. recorded 2.2% GDP growth in the first quarter of 2023 and 2.1% growth in the second quarter. As for its latest projections, the Fed expects the economy to roughly maintain that growth pace in the second half of 2023, forecasting full-year GDP growth of 2.1%. The Fed predicts GDP growth will slow to just 1.5% in 2024, a modest but positive pace.

The labor market also remains resilient heading into the end of the year. The unemployment rate has risen to just 3.8%, and the economy has averaged more than 250,000 jobs created per month over the past three months. The Federal Open Market Committee projects the U.S. unemployment rate will average a healthy 4.1% in 2024, still well below its long-term average of around 5.7%.

Unfortunately, some economists are skeptical that the U.S. can maintain economic growth with interest rates so high. The Conference Board predicts U.S. GDP growth of just 0.8% in 2024, including a “shallow recession” in the first half of the year. The nonprofit research group said wage growth is slowing, pandemic savings are declining and U.S. household debt is spiking.

The COVID-19 pause on student loan payments ended in October, placing an additional financial burden on millions of Americans. As a result, The Conference Board projects real U.S. consumer spending will drop 1.1% in the first quarter of 2024 and decline 1% in the second quarter annually. The firm said softening consumption, coupled with rising interest rates, will also weigh on U.S. business investment in early 2024.

The Fed’s inflation target

The FOMC has been aggressively raising interest rates since March 2022 with one goal: controlling inflation. So far, the Fed’s policy measures have worked extremely well, but its job still needs to be finished heading into 2024.

Core inflation

The Federal Reserve’s preferred inflation measure is the core personal consumption expenditures price index, or core PCE. The core PCE measures U.S. shoppers’ prices for goods and services, excluding volatile food and energy prices.

The Fed has a long-term core PCE inflation goal of 2%. But core PCE inflation surged as high as 5.3% in February 2023. As of August 2023, annual core PCE inflation was down to just 3.9%. That said, it remains nearly double the Fed’s 2% target.

Looking ahead to 2024, the FOMC projects core PCE inflation will continue to improve and average just 2.6% next year and 2.3% in 2025.

Soft landing

Inflation is typically a symptom of an overheating economy, so the Fed has been raising interest rates to bring down inflation without cooling the economy so much that it begins to contract.

Brad McMillan, chief investment officer at Commonwealth Financial Network, said the Federal Reserve deserves credit for its performance up to this point.

“With job growth strong and other data supportive, those higher rates seem to be bringing inflation down successfully without tanking the economy,” McMillan said. “This is the elusive soft landing that everyone has been hoping for but which very few thought would really happen. Of course, we are not there yet.”

Alternatively, a hard landing for the economy would likely be bad news for stock prices and U.S. workers.

For example, when the FOMC raised fed fund rates to more than 19% in 1981 to combat inflation, it triggered a severe 16-month recession. Subsequently, that launched a nearly two-year bear market for stocks and sent unemployment up to 10.8%.

Are more rate hikes expected in 2024?

Since March 2022, the FOMC has raised its fed funds interest rate target range by 5.25% to its current level of between 5.25% and 5.5%. Interest rates are now at their highest level in 22 years.

The bond market is pricing in more than a 40% chance of another rate hike by the end of 2023 and a more than 25% chance the Fed will cut interest rates below their current level by May 2024, according to CME Group.

Bill Adams, chief economist for Comerica Bank, said surprising increases in housing prices could fuel further shelter inflation in 2024. But rising long-term U.S. Treasury yields could help make additional Fed rate hikes unnecessary.

“Either way, the path is clearer for the Fed to pivot to rate cuts in mid-2024 with wage growth slowing, core inflation head(ing) lower and gasoline futures prices at year-to-date low(s),” Adams said.

Looking further into the future, the FOMC projects the fed fund rate will fall to an average of 3.9% in 2025 and 2.9% in 2026. But investors shouldn’t rely too heavily on these extremely long-term projections given how much economic circumstances could change between now and then.

Can we expect a recessionary environment in 2024?

While there is no official government definition for an economic recession, economists typically consider at least two consecutive quarters of negative GDP growth to be a recession. The Fed is no longer forecasting a prolonged U.S. recession, and economists from Bank of America agree.

But the ratio of the 10-year yield to the 2-year yield curves in U.S. Treasurys has been inverted since mid-2022, and an inverted yield curve has historically been a strong indicator a recession is likely.

The New York Fed’s recession probability model suggests a 56.12% chance of a U.S. recession by September 2024.

Richard Saperstein, chief investment officer at Treasury Partners, said the positive performance of the stock market in 2023 may have lulled Americans into a false sense of economic security heading into 2024.

“There are elevated expectations for a bullish slowdown where the economy slows enough to bring down inflation but not enough to trigger a recession,” Saperstein said. “Stocks are facing headwinds from higher interest rates and the uncertainty of how higher rates will affect economic growth and earnings.”

Americans concerned about a potential recession in 2024 should continue monitoring the Labor Department’s monthly jobs reports, typically released on the first Friday of each month. As long as the economy continues adding jobs, GDP growth will unlikely drop into negative territory, experts say.

Risks to economic growth in 2024

While a growing number of economists are optimistic about a potential soft landing in 2024, there are plenty of risks to the U.S. economy in the next 12 months.

The most obvious risk is the one the FOMC identified, and it’s made targeting inflation a top priority for nearly two years.

If it becomes clear at any point that inflation is no longer trending lower in 2024, the Federal Reserve will likely have no choice but to respond with even more interest rate hikes. And that would put additional pressure on corporate earnings and economic growth. Higher interest rates increase borrowing costs for consumers and corporations, reducing spending and investment and slowing economic growth.

But even if inflation continues to trend lower, the FOMC will need to time its pivot from rate hikes to rate cuts perfectly to avoid either a rebound in inflation or a sharp drop in economic growth that could lead to a recession. The Fed is attempting to thread the needle and achieve a soft landing. But even one major misstep by the central bank could be enough to send the economy spiraling.

Financial pressures such as student loan repayments, slowing wage growth and rising household debt may negatively impact consumer spending in 2024, especially if Americans completely burn through their pandemic-era savings. Rising credit card debt levels when interest rates are already at multidecade highs could also hurt consumer sentiment and spending.

Finally, geopolitical risks are always a wild card for the economy, especially in a U.S. presidential election year like 2024. The ongoing conflict in Ukraine and the recent outbreak of war between Israel and Hamas in the Middle East could have a significant impact on international financial markets and the global economy.

USA Today

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Pamela Davenport published in

Here’s why 2023 could become a turning point for the energy transition…

2023 could become a turning point for the energy transition, according to a new report from Generation Investment Management.

2023 could become a turning point for the energy transition, according to a new report from Generation Investment Management.

  • 2023 could become a turning point for the energy transition, according to a new report from Generation Investment Management.
  • Ahead of the World Economic Forum’s Sustainable Development Impact Meetings 2023, the report provides an overview of current trends and recommendations for the world’s path to sustainability.
  • While significant progress has been made in many sectors, much remains off-target, not least a fair transition for both the developed and the developing world.

The year 2023 may be remembered as the year when the energy transition finally came into the focus of global politics. This is according to the latest annual Sustainability Trends Report 2023 from Generation Investment Management, a sustainable investor chaired by former US Vice President Al Gore. It’s the result of both a greater societal commitment to tackling the climate crisis and the impact of the energy crisis caused by the war in Ukraine, which made the search for energy independence a top priority for policymakers.

Yet, despite notable progress, the report highlights that we are still some way off-target. Global temperatures have continued to rise and accelerating the energy transition is often a source of controversy.

Chart showing the change in global temperatures relative to the 1961 to 1990 average.

2023 could become a turning point for tackling the climate crisis as the energy transition moves centre stage. Image: Our World in Data

As the World Economic Forum prepares for its Sustainable Development Impact Meetings 2023 in New York from 18-22 September, we look at the trends and recommendations put forward by Generation in more detail.

DISCOVER

How is the World Economic Forum facilitating the transition to clean energy?

With power as one of the main sources of CO2 emissions (34%), moving power generation from fossil fuels to renewable energy sources is one of the crucial objectives of the energy transition. Generation argues that the world is close to the point when emissions from electricity grids will peak and start to drop as renewables like solar and wind as well as other clean energy sources continue to grow and fossil fuels’ share in the energy mix tapers off.

Chart showing the sources of global electricity production.

Clean energy is on an upward trajectory while coal is set to taper off.

However, there continues to be a marked difference between developed and developing countries: while electricity-related emissions in the former have fallen relatively consistently since the turn of the century, the latter has experienced a substantial increase in emissions.

Chart showing the electricity-related emissions in wealthy countries.

Developing and developed countries are substantially diverging in their CO2 emissions. Image: Ember

While solar power was the star performer among renewables in 2022, achieving an installation record, backlogs for connecting to the grid have held up progress for renewable energy developers. At the heart of the issue is a lag in expanding power lines – a bottleneck governments need to address urgently, the report says.

Taking the heat out of buildings

Buildings are directly responsible for only 6% of global CO2 emissions – largely from gas-powered space and water heating – but they still rank among the biggest emitting sectors worldwide. This is because, when considering their indirect emissions from electricity usage, the figure triples.

What is more, the sector has made little progress, with emissions plateauing in the past couple of years.

The issue is not just down to old buildings that require high amounts of energy for heating and cooling. Due to cost, even new buildings are often not as energy-efficient as they could be. The report advocates more stringent construction regulations and enforcement to overcome resistance within the industry. In developing markets, the suggestion is a tie-in with development aid to enforce better construction standards.

That said, Generation acknowledges that where stricter building codes and regulations are being introduced, they have frequently led to controversy. The lengthy debate over abolishing gas boilers in Germany and opposition to wind and solar farms in the US are recent examples of this.

Figure showing the historical emissions shown through 2022. energy transition

Buildings are one of the highest CO2 emitters. Image: IEA/Generation

Decarbonizing industry

Responsible for 24% of global carbon emissions, industry is one of the sectors that struggles the most with weaning itself off fossil fuels. Steel, cement, chemical fertilizers and plastics manufacturing all cause high emissions due to their use of coal and gas for industrial heat and as a feedstock.

Generation’s report states that while little progress has been made to date, governments are starting to put policies in place to support technologies such as clean hydrogen production. Hydrogen burns CO2-free and can be made with low-carbon and carbon-free methods, but these are still high-cost. With clean hydrogen projects mushrooming, the report suggests that favourable policies such as the American climate law and ‘buy clean’ policies could improve those economics.

Graphs showing the emissions per year in different sectors.

Hard-to-abate industries struggle to wean themselves off fossil fuels. Image: WRI

DISCOVER

What is the World Economic Forum doing to help companies reduce carbon emissions?

Transportation is another major culprit when it comes to CO2 emissions. While aviation and shipping contribute to this to some extent, nearly three-quarters of transport emissions in 2022 were from road transport, according to the International Energy Agency (IEA).

Electric vehicles are one answer. But although their share in the global market for new cars has come on in leaps and bounds, their adoption still faces many barriers. These range from a lack of charging infrastructure to a dearth of the critical minerals needed to make batteries and a need for effective battery recycling.

What is more, electrifying cars is only one part of the equation. Road haulage, ships and planes are all in search of alternative power sources, and electrification may only be of limited use to them. Sustainable aviation fuel may become airlines’ best alternative, while shipping may move to ammonia as its fuel of choice, the report suggests.

Alongside, improving public transport, introducing congestion charging in cities, and turning over streets to pedestrians and cyclists will be important to decarbonizing the world’s roads.

Figure illustrating the transport emissions, by sector,

Road transport accounts for nearly three-quarters of sector emissions. Image: IEA

Protecting biodiversity

More than a fifth (22%) of emissions can be attributed to land and food production. Reducing these emissions is closely linked to maintaining and restoring biodiversity. That includes putting a halt to forests and land being given over to food or commodity production, as well as protecting the world’s plants, animals and other organisms.

The EU is among those who have legislated against importing products of deforestation, while ‘forest’ countries such as Brazil – which has a chequered history when it comes to deforestation policies – are increasingly investing in protecting them. Investors and corporates are also starting to put pressure on companies to eliminate suppliers that don’t protect the natural environment.

One major contributor to deforestation is food production, especially red meat and commodities such as chocolate and coffee. Here, the report finds that less progress has been made – not least because demand is continuing to grow.

Figure illustrating the greenhouse implications of dietary choices.

What we eat affects our planet’s future – especially meat consumption. Image: Our World in Data

To avoid a further ‘land grab’ for food production, farmers must produce greater yields from the same size of farmland. This requires fertilizers and other agricultural inputs to be rolled out more widely, but these, in turn, can have a significant carbon footprint. Developing alternative approaches to eliminate this risk is essential and needs to be invested in, Generation says.

Chart showing the historical trends in clean energy investment.

Clean-tech investment needs to reach around $5 trillion a year by 2030. Image: IEA

A $5 trillion investment opportunity

Today, 70% more investment flows into clean energy than into fossil fuels, according to the IEA. But that is far from enough both in terms of volume and where those investments are directed.

Today’s volumes need to triple to approach $5 trillion a year if we are to meet the goals of the Paris accord and the investments need to be spread out more evenly across industries and across the planet. Developing countries in particular must be enabled to leapfrog fossil fuels rather than follow the example of the developed world. Climate-led investments that combine a high climate impact – eg, the removal of emissions at scale – with attractive risk-adjusted returns for investors may be one way of achieving this.

As COP28 in Dubai approaches, the Sustainability Trends Report 2023 concludes that the developed economies hold the key to helping developing countries make the energy transition work.

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Pamela Davenport published in

Can investment-grade credit provide resilience amid uncertainty?

An uncertain economic outlook and high interest rates are generally not viewed as a positive backdrop for investment-grade (IG) corporate bonds (rated BBB/Baa and above). Yet, a confluence of supportive factors is underpinning this asset class. These include relatively good credit quality, high average starting yields above 5.5%, an overall duration of about seven years and stabilization of the banking sector. 
As a result, credit spreads above Treasuries have tightened to slightly less than 120 basis points (bps), which is near their 10-year average of 124 basis points.
In our view, while investment-grade credit could come under selling pressure in an extreme risk-off environment — the duration profile of the sector, credit fundamentals that are better than in prior periods of economic stress, as well as sustained demand from investors — should provide a degree of support, limiting downside risk in most scenarios. 
Overall, we believe investment grade provides a solid middle ground for portfolios. If the U.S. Federal Reserve executes a ”soft landing“ and avoids a recession, investment-grade credit should fare well. And if there’s a ”hard landing“, the drawdown in investment grade should be muted compared to what we would expect to see in equities.
We discuss below each of the factors that are critical to investment-grade credit. 

1. Duration profile is attractive as Fed hiking cycle ends

Recessionary periods and the end of the Fed hiking cycle have historically been associated with declining rates and spread widening. The Bloomberg U.S. Corporate Investment Grade Index has a duration of 7.1 years, compared to 6.3 years for the Bloomberg U.S. Aggregate Index. This could prove beneficial in a scenario where growth is slowing, leading long rates to rally as the Federal Reserve begins to ease policy.

In the past three economic cycles, yields for both short and long-term bonds have declined before spreads widened. Thus, duration of corporate bonds has helped to offset the impact of wider spreads. 
In advance of a potential recession, 10-year Treasury yields could decline 100 basis points to around 3.5% and credit spreads could widen by a similar amount which would leave investors with relatively low capital losses. The income that investors can currently earn from investment grade, with yields above 5%, would continue to support total returns but may potentially move lower as spreads eventually compressed. These periods of market volatility, however, generally present an excellent opportunity for active security selection to contribute to excess returns.

 

Rates have tended to fall before corporate spreads widen

 

Chart shows the spread of the Bloomberg U.S. Corporate Investment Grade Index, the yield for 10-year Treasuries and the federal funds rate from 1999 until September 2023. In the past, when the Federal Reserve instituted large interest rate cuts (such as 2001-2002, 2007-2009 and 2020) corporate bond spreads peaked long after the rate cuts began. In 2002, corporate spreads peaked 22 months after cuts began. In 2009, corporate spreads peaked 15 months after cuts began and in 2020, corporate spreads peaked 9 months after cuts began.

2. Liquidity and a more defensive posture are key amid uncertain economic backdrop

Given an uncertain economic outlook, we continue to emphasize liquidity, partly by allocating to defensive industries that have tended to outperform in challenging economic conditions and focusing on holding on-the-run issues for the credits in our clients’ portfolios. 
For instance, recent mergers and acquisitions (M&A) activity in the pharmaceutical sector has created some attractive investment opportunities where large debt deals have come to market at relatively cheap prices. The sector has also held up solidly in prior downturns.
Valuations also currently look compelling for utilities, as spreads have underperformed the broader Bloomberg U.S. Corporate Investment Grade Index due to robust new debt issuance in the first half of 2023. Utility companies’ stable profitability and defensive, regulated business profile should insulate the sector if the economy weakens. Extreme weather is an increasing risk for the sector — with wildfires and hurricanes occurring more frequently — but this risk can be mitigated by credit investors through issuer and security selection. 
On the other side, avoiding losers can be just as important as identifying winners. Cyclicals, like chemicals, could be challenged because of the economic backdrop in both the U.S. and China, which has dominated cyclical demand in recent years. We are also limiting exposure to traditional automakers, which have been among the worst performers in the last two recessions.

 

Noncyclical spreads have outperformed cyclicals in prior recessions

 

This is a line chart illustrating the difference between spreads for the consumer cyclical and noncyclical sectors within the Bloomberg Investment Grade Corporate Index and the spread for the overall Bloomberg Investment Grade Corporate Index, shown by subtracting the spread for each sector of the index from the spread of the broader index from November 25, 1998, to September 5, 2023. Around prior recessions, noncyclical spreads have outperformed cyclicals and the overall index. In 2002 noncyclical spreads widened by around 115 basis points less than the index. In 2008-2009, noncyclicals widened around 250 basis points less than the overall index, while cyclicals widened nearly 40 basis points more than the index. In 2020, cyclical spreads widened as much as 85 basis points higher than the index while noncyclicals widened around 60 bps less.

3. High level of absolute yields attracts flows 

When yields reach five percent or more on investment-grade corporate bonds, rising inflows into the asset class have tended to create a favorable supply-demand dynamic that puts downward pressure on spreads.
Over the year, there has been consistent demand for U.S. dollar-denominated investment-grade credit from U.S. pension funds and international investors, particularly in Asia. Deals coming to market have been many times oversubscribed, despite overall market weakness. Additionally, lower merger and acquisitions activity has resulted in lighter issuance and constrained supply, which has been supportive of valuations.
Many investors who had been underweight to credit are now rebalancing their portfolios, contributing to the demand. We have also seen some investors moving out of equities and buying bonds, particularly among pension funds executing liability-driven investing (LDI) strategies. We expect this favorable technical backdrop to persist, as long as yields remain elevated.

Assets have been returning to IG credit

 

Chart shows cumulative flows for U.S. investment-grade credit open-ended mutual funds and exchange-traded funds, as tracked by Morningstar. Since August 2022, more than $10 billion in net flows have come into the asset class. Investment-grade credit funds last experienced outflows in September 2022, when they lost around $2.6 billion in net assets.

 

Source: Morningstar. Data as of 7/31/2023. Chart shows cumulative flows for U.S. investment-grade credit open-ended mutual funds and exchange-traded funds.

 

4. Financials present opportunities despite challenging Fed policy

At around a third of the Bloomberg Investment Grade Corporate Index, financials are an important part of the investment-grade debt universe, essentially serving as a proxy for the asset class. Given the ongoing funding needs of financials, they are more sensitive to interest rates. Tighter Fed policy typically creates higher funding costs and puts pressure on deposits, which can be a drag on bank profitability. Banks may also see higher losses in their securities books due to higher Treasury yields. 
Bank bond valuations are starting to look attractive, but over the near-term, spreads could widen more if the economy weakens, as banks have traditionally not tended to fare well in recessions. Yet, even with a broad downgrade of regional banks occurring in August and some potential headwinds, our analysts remain constructive on the credit fundamentals of select issuers with diversified deposit bases, robust business models and strong risk controls. 
The largest global financial institutions are well-capitalized partly as a result of regulations passed in the wake of the Global Financial Crisis (GFC), which provides an underpinning of support. Meanwhile, the failure of Silicon Valley Bank and Signature Bank earlier this year has continued to cast a shadow on the larger U.S. regional banks. These two areas of banking could provide compelling investment opportunities over the longer term.
If the Fed keeps rates high, smaller banks may come under continued earnings pressure and may experience a few more ratings downgrades. However, over the longer term, these risks will likely be offset by more stringent capital and liquidity rules which would strengthen fundamentals.
5. Credit quality looks solid
Overall, credit quality in the asset class remains solid. Interest coverage is deep and overall leverage has come down from its pandemic-era peak. Refinancing risk is also low, as a large number of companies have locked in debt at lower rates for several years.
The percentage of BBB-rated companies (one step above high yield) in the index has risen from around 25% to nearly 50% over the past three decades, which could be cause for concern. Some cyclical businesses may be at risk of falling into high yield in a recession. Yet, counter-intuitively, companies rated BBB could be at lower risk of a downgrade than in the past. 
Incentivized by lower borrowing costs, many single-A companies have been willing to take a downgrade in recent years to fund M&A activity and expand their businesses. But now, sitting at BBB, the management of these companies are incentivized to do everything they can to maintain their investment-grade status as the penalties for falling to high yield are severe. For example, many companies across sectors like pharma, food and beverage, and energy have been focused on reducing debt balances accrued to support acquisitions. In many cases, they would like to maintain the flexibility to do acquisitions in the future which will encourage them to have healthier balance sheets to be able to borrow again in the future at attractive interest rates.
Hence, while some more cyclical businesses may fall into high yield, there are many companies that are steadily improving credits that can continue reducing their debt footprints even in the face of slower economic growth.

Maturity profile for investment grade index indicates low refinancing risk

 

Chart shows the total dollar value of bonds in the Bloomberg U.S. Corporate Investment Grade Index separated by the year they are due to mature from 2024-2033. The total value of bonds set to mature in 2024 is $146 billion, the lowest total of any year represented in the chart. The highest amount of bond maturities is set to occur in 2026, with $523 billion.

 

Source: Bloomberg. Data as of August 15, 2023. Chart shows the total dollar value of bonds in the Bloomberg U.S. Corporate Investment Grade Index separated by the year they are due to mature from 2024-2033.

The bottom line

Even with an uncertain economic backdrop ahead, investors can find compelling opportunities in investment-grade credit. The overall duration profile of the sector is particularly appealing, with the potential for a slowdown in growth and the Fed’s hiking cycle coming to an end. Spreads may widen in a risk-off scenario, but the carry from today’s higher starting yields can provide a significant buffer to limit losses for investors.
Solid credit fundamentals and sustained demand from investors should also limit downside risk. Overall, investment-grade credit can provide a solid middle ground for portfolios in this uncertain environment and should serve investors well across a variety of economic outcomes.

Karen Choi is a fixed income portfolio manager with 24 years of experience (as of 12/31/22). She holds a bachelor’s degree in international relations from Wellesley College.

Scott Sykes is a fixed income portfolio manager with 22 years of experience (as of 12/31/22). He holds an MBA in finance from the University of Pennsylvania, a master’s degree in international economics from the University of Essex, and a bachelor’s degree in both commerce and German from Washington and Lee University.

Greg Garrett is an investment director with 35 years of industry experience (as of 12/31/22). He holds a bachelor’s degree in finance from the University of Arizona.

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Pamela Davenport published in

The Future of Hydrogen Planes Comes with Advantages and Challenges, says MIT…

September 22, 2023 1 By TAMI HOOD

The future of hydrogen planes comes with advantages and challenges, says MIT

Among the hurdles to be overcome include H2 production, general safety, and the logistics of refueling.

The aviation industry has, to a not insignificant degree, been investing in hydrogen planes in than effort to decarbonize as the world battles with the impact and progression of climate change.

 

This includes efforts to develop the aircraft themselves as well as what will be needed on the ground.

After all, making sure that hydrogen planes can safely fly is only a first step. Everything from standards and regulations to ensuring that a supply of fuel will be readily available will also need to be established. This involves a considerable number of companies and researchers, some of which are focused on the air, while others are concentrating on the ground.

A team of researchers from MIT’s International Center for Air Transportation recently examined this complex effort, identifying some of the areas in which it appears highly promising, as well as some of the aspects that will be notably challenging.

“Hydrogen may be a good thing, but you got to look at it from the full system level, right?” asked aeronautics and astronautics MIT professor R. John Hansman from the International Center for Air Transportation, as quoted in a recent Spectrum IEEE report. “Because it won’t work unless you have all the pieces to make it work as an operating system. There’s a lot of technology that would have to be developed.”

Mainstream use of hydrogen planes would require substantial amounts of H2 as fuel.

According to a paper co-authored by Hansman and a number of students from MIT, O’Hare airport in Chicago, alone, would require 719 tons of liquid hydrogen every day in order to meet the demand of H2-powered aircraft.

Hydrogen planes research - MIT building

The team behind the paper presented it in Finland at the University of Vaasa for the IEEE International Conference on Future Energy Solutions.

Massive fuel demands

The researchers had investigated the requirements for supplying enough liquid H2 to meet the demand for 100 airports worldwide serving long-haul flights, assuming their aircraft used that clean fuel.

They determined that to support the long-haul flights from those airports, the energy from over 30 percent of global nuclear electricity production per day would be required to keep hydrogen planes supplied with fuel. For real climate benefits from the use of H2, renewable or nuclear energy would be required for the H2 production, said the paper.

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Pamela Davenport published in

Harnessing GovTech to Tax Smarter and Spend Smarter 

Digitalization, done right, can equip governments to improve revenue collection and spending efficiency.

David Amaglobeli, Ruud de Mooij, Mariano Moszoro

Digitalization is a transformative force as powerful as the advent of the printing press in the 15th century or electricity in the 19th. Yet some governments have been slow to harness the potential of digital technology to improve delivery of public services and strengthen public finance.

A two-pronged policy approach is required—connecting unconnected households to the internet and accelerating and strengthening the adoption of digital solutions in the public sector. We outline strategies for pursuing these policies in a new staff discussion note on government technology, or govtech.

Encouraging digital adoption

Emerging and developing countries have the most potential to leapfrog their development trajectory by adopting digital technologies. These countries lag considerably behind in internet connectivity, a key enabler for adopting and using digital technologies. Globally, about 2.7 billion people still need to be connected. Within countries, a digital divide persists across age and gender. Bridging this divide and benefiting from digitalization takes adequate digital infrastructure.

Our estimates show that $418 billion of investment in digital infrastructure is needed to connect unconnected households. The bulk of these investment needs are in emerging market and low-income developing economies, with the latter’s requirements estimated at 3.5 percent of GDP. Government support can be crucial in achieving universal connectivity by incentivizing or directly investing in building internet infrastructure, especially in regions where profitability remains challenging.

In addition to infrastructure, affordability and digital literacy are crucial. Internet subscription costs remain high in low-income developing countries, where, relative to average incomes, the average cost is nine times the amount citizens in advanced economies spend. To make internet access more affordable, governments can consider offering discounts or vouchers on subscription fees. Additionally, promoting digital literacy programs is essential to overcome reluctance among specific populations, particularly older individuals, to embrace new digital technologies.

The Power of govtech:

Digitalization enables governments to leverage technology to enhance revenue collection, improve efficiency of public spending, strengthen fiscal transparency and accountability, and improve education, health-service delivery, and social outcomes. These can be achieved through better decision-making processes, adoption of international standards and practices, transformation of public financial management processes and systems, and improved taxpayer and trader services to support voluntary compliance and trade facilitation.

Adopting govtech in fiscal operations can strengthen public finance on both revenue and spending sides. IMF staff analysis shows that e-filing, e-invoicing and electronic fiscal devices could lead to a significant increase in tax revenues. For example, the adoption of e-invoicing and electronic fiscal devices could improve revenue mobilization by up to 0.7 percent of GDP. Digitalization’s impact on revenue administration is enhanced by expanding digital connectivity and ensuring sufficient staffing and expertise among tax officials. Similarly, the automation of budget payments using digital technologies is associated with more budget transparency. Our analysis suggests that digitalization is generally associated with an improvement in the efficiency of expenditure.

Digitalization can also improve the effectiveness of social spending and the quality of public service delivery. Digital interventions, such as providing students with equipment and software, can improve education outcomes. In healthcare, govtech can help improve quality of care, increase the coverage of underserved populations, and optimize resource utilization. Electronic health records, telemedicine, and digital platforms for patent licensing, procuring medicine, and monitoring infectious diseases are areas of digital innovation in health care.

Digitalization can also help strengthen social safety nets through better identification, verification of eligibility, and provision of delivery mechanisms. For example, integrating digital ID and creating extensive socio-economic data can enable governments to better target and accurately verify beneficiaries receiving social assistance.

But these benefits from digitalization can materialize only if it is done right. Implementing large digitalization programs is a complex undertaking and requires careful planning, adequate resources, political support, and appropriate change management processes. Digitalization may require changes in regulations and established processes, adequate staffing and expertise among officials, and strong safeguards for data security and privacy to protect sensitive information. Without adequate safeguards, implementing complex digital solutions could even be counterproductive and facilitate corruption.

By adopting an approach to digitalization where citizens’ needs are the primary focus and engaging in close collaboration with stakeholders, govtech can help overcome these challenges and unlock its full potential to enhance public services for society. The IMF stands ready to support countries through its capacity development in implementing govtech solutions for public finance.

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Pamela Davenport published in

Energy Storage Important to Creating Affordable, Reliable, Deeply-Decarbonized Electricity Systems

MIT Energy Initiative report supports energy storage paired with renewable energy to achieve decarbonized electricity systems

TOM MELVILLE       ·    MITEI

In deeply decarbonized energy systems utilizing high penetrations of variable renewable energy (VRE), energy storage is needed to keep the lights on and the electricity flowing when the sun isn’t shining, and the wind isn’t blowing—when generation from these VRE resources is low or demand is high. The MIT Energy Initiative’s Future of Energy Storage study makes clear the need for energy storage and explores pathways using VRE resources and storage to reach decarbonized electricity systems efficiently by 2050.

The Future of Energy Storage, a new multidisciplinary report from the MIT Energy Initiative (MITEI), urges government investment in sophisticated analytical tools for planning, operation, and regulation of electricity systems in order to deploy and use storage efficiently. Because storage technologies will have the ability to substitute for or complement essentially all other elements of a power system, including generation, transmission, and demand response, these tools will be critical to electricity system designers, operators, and regulators in the future. The study also recommends additional support for complementary staffing and upskilling programs at regulatory agencies at the state and federal levels.

The MITEI report shows that energy storage makes deep decarbonization of reliable electric power systems affordable. “Fossil fuel power plant operators have traditionally responded to demand for electricity—in any given moment—by adjusting the supply of electricity flowing into the grid,” says MITEI Director Robert Armstrong, the Chevron Professor of Chemical Engineering and chair of the Future of Energy Storage study. “But VRE resources such as wind and solar depend on daily and seasonal variations as well as weather fluctuations; they aren’t always available to be dispatched to follow electricity demand. Our study finds that energy storage can help VRE-dominated electricity systems balance electricity supply and demand while maintaining reliability in a cost-effective manner—that in turn can support the electrification of many end-use activities beyond the electricity sector.”

The three-year study is designed to help government, industry, and academia chart a path to developing and deploying electrical energy storage technologies as a way of encouraging electrification and decarbonization throughout the economy, while avoiding excessive or inequitable burdens.

Focusing on three distinct regions of the United States, the study shows the need for a varied approach to energy storage and electricity system design in different parts of the country. Using modeling tools to look out to 2050, the study team also focuses beyond the United States, to emerging market and developing economy (EMDE) countries, particularly as represented by India. The findings highlight the powerful role storage can play in EMDE nations. These countries are expected to see massive growth in electricity demand over the next 30 years, due to rapid overall economic expansion and to increasing adoption of electricity-consuming technologies such as air conditioning. In particular, the study calls attention to the pivotal role battery storage can play in decarbonizing grids in EMDE countries that lack access to low-cost gas and currently rely on coal generation.

The authors find that investment in VRE combined with storage is favored over new coal generation over the medium and long term in India, although existing coal plants may linger unless forced out by policy measures such as carbon pricing.

“Developing countries are a crucial part of the global decarbonization challenge,” says Robert Stoner, the deputy director for science and technology at MITEI and one of the report authors. “Our study shows how they can take advantage of the declining costs of renewables and storage in the coming decades to become climate leaders without sacrificing economic development and modernization.”

The study examines four kinds of storage technologies: electrochemical, thermal, chemical, and mechanical. Some of these technologies, such as lithium-ion batteries, pumped storage hydro, and some thermal storage options, are proven and available for commercial deployment. The report recommends that the government focus R&D efforts on other storage technologies, which will require further development to be available by 2050 or sooner—among them, projects to advance alternative electrochemical storage technologies that rely on earth-abundant materials. The report suggests government incentives and mechanisms that reward success but don’t interfere with project management. The report also calls for the federal government to change some of the rules governing technology demonstration projects to enable more projects on storage. Policies that require cost-sharing in exchange for intellectual property rights, the report argues, discourage the dissemination of knowledge. The report advocates for federal requirements for demonstration projects that share information with other U.S. entities.

The report says many existing power plants that are being shut down can be converted to useful energy storage facilities by replacing their fossil fuel boilers with thermal storage and new steam generators. This retrofit can be done using commercially available technologies and may be attractive to plant owners and communities—using assets that would otherwise be abandoned as electricity systems decarbonize.

The study also looks at hydrogen and concludes that its use for storage will likely depend on the extent to which hydrogen is used in the overall economy. That broad use of hydrogen, the report says, will be driven by future costs of hydrogen production, transportation, and storage—and by the pace of innovation in hydrogen end-use applications.

The MITEI study predicts the distribution of hourly wholesale prices, or the hourly marginal value of energy will change in deeply decarbonized power systems—with many more hours of very low prices and more hours of high prices compared to today’s wholesale markets. So, the report recommends systems adopt retail pricing and retail load management options that reward all consumers for shifting electricity use away from times when high wholesale prices indicate scarcity, to times when low wholesale prices signal abundance.

The Future of Energy Storage study is the ninth in MITEI’s “Future of” series, exploring complex and vital issues involving energy and the environment. Previous studies have focused on nuclear power, solar energy, natural gas, geothermal energy, and coal (with capture and sequestration of carbon dioxide emissions), as well as on systems such as the U.S. electric power grid.

 

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Pamela Davenport published in

EM Rate Cuts on the Horizon as Inflation Trends Down

EMERGING MARKETS
August 8, 2023
Brazil’s central bank kicked off a monetary easing cycle on August 2, 2023, more aggressively than expected, reducing its benchmark interest rate by 50 basis points to 13.25% and signaling more of the same in the months ahead due to an improving inflation outlook. It is the third central bank in emerging markets (EM) to cut rates in recent months, preceded by Chile in July and Hungary, which was the first to cut rates in May of this year.
When runaway inflation first began sweeping across the globe, emerging markets central banks were generally ahead of the curve, raising rates much more quickly than their developed market counterparts. For example, Brazil began its monetary tightening cycle in March 2021, ahead of most others, and raised the Selic (the Brazilian federal funds rate) to a six-year high of 13.75% by August 2022. Now that inflation is seemingly coming under control in many markets, it appears that EMs could also be earlier in cutting rates.
The pace of the monetary easing cycle may not be as rapid and will vary by country. After a significant decline in EM headline inflation in the first half of the year, we expect a more visible reduction in core inflation in the second half. A backdrop of slow and steady rate cuts combined with reasonable growth in many EM countries should be positive for local currency debt. More stable market dynamics could likewise benefit select hard currency (U.S. dollar-denominated) sovereign and EM corporate issuers.
EM inflation should continue to slow in the second half of the Year
Emerging markets have historically struggled with inflation and last year was no exception. Higher commodity prices resulting from the Russia/Ukraine conflict (EM countries tend to be more sensitive to commodity prices given the generally higher weight of food and energy in inflation baskets), supply chain issues and weak EM currencies fed inflationary pressures.
This year, the surge in food and energy prices has abated, supply chain bottlenecks have eased, and the U.S. dollar has plateaued or weakened against many currencies. As a result, inflation has slowed both on a month-on-month and year-on-year basis in most EM economies.
Moreover, after surprising to the upside for the past couple of years, inflation surprises have generally now turned negative. This disinflation trend looks set to continue in the second half of the year.
That said, there remains a great deal of regional variation. Inflation is relatively contained in Asia. Whereas in Central/Eastern Europe and Latin America, not only has food inflation been persistent, but there has also been a broadening of price pressures to both core goods and services. Part of this has been due to rising inflation expectations, leading to higher wages. This suggests that inflation may remain above central bank targets/comfort zones for longer than previously thought in both regions, even though it has likely peaked and should trend lower.
Other EM central banks need a few more Catalysts
Given the general improvement in the inflation outlook, we (the EM debt team) expect a number of EM central banks to start cutting interest rates along the lines of Brazil, Chile and Hungary. Many EM central banks are ahead of the developed world in their monetary tightening cycle, having raised interest rates earlier and more aggressively to avoid de-anchoring inflation expectations. Turkey has been the main exception, with its policy of reducing interest rates despite high inflation, although it has now started to reverse this unorthodox policy following recent elections, almost doubling interest rates in June.
But while we believe the easing cycle is imminent, many EM central banks will only take this step when there is more certainty that inflation is on the decline, especially core inflation.

Many EM central banks aggressively hiked policy rates

 

Chart shows the change in policy rates from 31 December 2020 to 3 August 2023 for Hungary (12.4%), Colombia (11.5%), Brazil (11.25%), Chile (9.75%), Peru (7.5%), Mexico (7%), Czech Republic (6.75%), Poland (6.65%), Romania (5.5%), South Africa (4.75%), Philippines (3.75%), South Korea (3%), India (2.5%), Indonesia (2%), Thailand (1.75%), Malaysia (1.25%), Turkey (0.5%) and China (-0.3%).

 

Source: Bloomberg. Data as of August 3, 2023.

Looking ahead, the actions of the U.S. Federal Reserve (Fed) and the real interest rate differential between EM countries and the U.S. will be important factors. While it’s not yet clear whether the Fed is at the end of its hiking cycle or still has further to go, we’re unlikely to see the sharp upward pricing in U.S. rates that we have seen over the past year.

Countries across Latin America have been more aggressive in tackling inflation

 

Chart shows core inflation and the central bank policy rate, respectively, for Latin America (Brazil: 7.25%, 13.25%; Mexico: 7.39%, 11.25%; Chile: 7.9%,10.25%; Colombia: 11.59%, 13.25%; Peru 5.11%, 7.75%), Eastern Europe (Czech Republic: 11.4%, 7%; Hungary: 22.8%, 13%; Poland: 11.5%, 6.75%; Romania: 8.7%, 7%) and Asia (Indonesia: 2.66%, 5.75%; Malaysia: 3.6%, 3%; China 0.6%, 3.55%; Thailand 1.55%, 2.25%).

 

Source: Bloomberg. Inflation rate as of April 2023 for Romania and Malaysia and as of May 2023 for other regions. Policy rate as of August 3, 2023.

Finally, the U.S. dollar will be important to watch as it will be difficult for EM central banks to cut rates in a strong dollar/weak EM currency environment. A strong dollar has often forced EM central banks to raise rates in the past, while a weaker dollar has allowed them to cut rates. U.S. dollar cycles (since the abolition of the Bretton Woods system in the early 1970s) have generally moved in clear bull and bear phases, with the average cycle lasting around nine years. If the most recent cycle ended in the fourth quarter of 2022, then it lasted 11 years from the low in June 2011. Aside from the fact that the U.S. dollar is overvalued on almost all valuation metrics, several factors support the case for a weaker dollar, including the Fed coming to the end of its rate hiking cycle. Although it is not clear that the bull market for the U.S. dollar has turned, the bulk of the broad dollar strengthening is likely behind us.

EM exchange rates could start to contribute to returns
EM exchange rates have been a drag on local currency asset returns over the past decade, but today most EM currencies look significantly undervalued based on our in-house fundamental-based valuation model, along with various other real exchange rate models.
While cheap valuations are never enough of a catalyst in-and-of themselves, the fundamental outlook of many emerging markets looks constructive, which could help support a turnaround in EM currencies versus the dollar. Inflation and cost of living concerns have put pressure on fiscal deficits, which have steadily risen over the last few years. That said, public debt levels are still below those of developed markets and remain manageable. There has been some erosion of foreign exchange reserves, but external balances have generally improved across many EM countries thanks to undervalued exchange rates.
We see the most value in Latin America, but Europe is looking increasingly attractive
A downward trend in policy rates, combined with decent overall fundamentals and relatively attractive nominal rates and positive real rates across much of the EM universe, indicate a reasonably constructive view of EM debt overall. This explains why, after over a decade of relatively muted returns, stronger performance of the asset class (as represented by the J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified and the J.P. Morgan Government Bond Index – Emerging Markets Global Diversified) so far this year could turn into a longer-term trend.
That said, selectivity will be key given the divergence in policy and inflation dynamics across countries, as well as varying relative and absolute valuations across issuers. We see potential value in Latin American local currency bonds given the combination of attractive nominal and positive real rates, moderating inflation and proactive behavior on the part of central banks. Macroeconomic conditions are looking better now than late last year and the tilt towards more positive fundamentals is likely to override political risks in those countries for now. Central and Eastern European countries are still struggling to curb inflation — and real rates remain negative — but the region is beginning to look more attractive.
Opportunities in dollar-denominated debt are more select and Idiosyncratic
Opportunities within the U.S. dollar-denominated sovereign universe tend to be more idiosyncratic. In the higher yielding, lower quality credits, we find the debt of distressed and quasi-distressed issuers to be attractive in cases where many of the challenges they face have already been priced in. Debt restructurings across this segment of the market tend to be more frequent but are likely to be limited to the most vulnerable economies. 
Across the investment-grade (BBB/Baa and above) sovereign bonds space, valuations are less attractive. Nevertheless, the EM debt team sees value in select lower beta credits as a counterbalance to the high-yield positions held in certain portfolios.
Several EM corporate bonds appear reasonably cheap. We favor investing in a variety of these credits across eligible portfolios for both their relative value compared to similarly rated sovereign bonds and the potential diversification benefits they provide.

 

Real yields look attractive across some countries in Latin America

 

Chart shows real yields (represented by 5-year yields minus core inflation) for South Africa (6.1%), Dominican Republic (5.1%), Brazil (3.6%), Indonesia (3.6%), Uruguay (2.6%), China (2.1%), Peru (1.6%), Mexico (1.6%), Thailand (1.1%), Philippines (1%), Malaysia (0.3%), Colombia (-1%), Romania (-2%), Chile (-2.4%), Czech Republic (-3.4%), Poland (-5%), Hungary (-12.1%).

Source: Bloomberg. Data as of June 20, 2023. Real yields are represented by 5-year yields minus core inflation. *Real yield for Hungary is -12.1%.

Bottom line

As inflation slows across a number of emerging markets, central banks are likely to pivot toward rate cuts in the coming months and quarters. With fiscal and current account profiles looking largely benign or manageable for many of these economies, this anticipated shift in monetary policy alongside reasonably attractive valuations and fundamentals could lead to longer term gains for many credits across the asset class.
Capital Group
Kirstie Spence Fixed/ Income Portfolio Manager
Harry Phinney/Fixed Income Investment Director
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How Governments Can Drive a Faster, Bigger and Better Energy Transition

A holistic approach to policy-making by governments is required to bring out the energy transition.
What’s the World Economic Forum doing to accelerate action on Climate Change?
  • The energy transition must be backed by a strong and holistic approach to policy-making by governments.
  • The key to this lies in more specific nationally determined contributions – and the year of COP26 is the year to do it.

The very first automobiles, introduced in the 1880s, were expensive, niche, and used only by the rich. Within 30 years, Ford’s Model T entered mass production. This pushed the number of car-owning households in the US from 8% in 1918 to 60% by 1928, and triggered the spread of electrification, suburbs, cinemas, shopping centers, sophisticated advertising and much more.

That’s not linear growth – it’s exponential. We’ve seen it happen time and again throughout history, whether from horses to cars or valves to transistors, and each time it has fundamentally changed the way we live and operate. Our race to a zero-carbon energy system will be no different.

But in the same way that pro-business policies spurred the American economic boom and innovation like the Model T in the 1920s (which, incidentally, followed the Spanish flu pandemic), the clean energy transition must be backed by holistic government policy.

Key to this is achieving greater specificity in countries’ nationally determined contributions (NDCs) under the Paris Agreement – setting out how and when each sector will reach zero emissions and involving all economic actors and government ministries. The benefits of decarbonizing energy extend well beyond individual sectors to health, jobs, education, equality and nature conservation. But the work behind it does too.

This is the year to do it, ahead of November’s COP26 climate summit in Glasgow, where all countries must raise their NDCs. As a first step, governments must rally their ministers of energy, climate, transport, health and other portfolios around the same goal: zero-carbon energy. Ministers can then align their policies with the NDC targets and begin to implement them.

Energy Transition Statistics

The energy sector is already leading the charge to zero emissions, with breakthroughs and rapid price declines across the auto, power and lighting sectors. Globally, the number of electric vehicles on the road has jumped from 17,000 in 2010 to more than 7.2 million today. The installation of solar power grew from 290 MW in 2001 to nearly 127,000 MW in 2020. The share of LED bulbs in the lighting market has grown from 1% in 2010 to an expected 69% in 2020 and will be nearly 100% by 2025.

The growth is happening even where governments lag behind. But it’s faster if led by policy. China has 420,000 electric buses on the road, driven by Beijing’s war on air pollution. Norway last year became the first country to sell more electric vehicles than petrol, diesel and hybrid, backed by Oslo’s target to end internal combustion engine sales in 2025.

Major economies' emissions since 1990, with energy transition roadmaps to NDCs and net-zero

Major economies’ emissions since 1990, with energy transition roadmaps to NDCs and net-zero Image: Carbon Brief / Climate Watch

All of Society Transformation

These advancements drive all-of-society transformation. They create well-paying jobs, prevent premature deaths through reduced air pollution and introduce affordable energy to rural areas, allowing people to refrigerate produce or medication and enabling children to study by light after sunset.

But reaching the necessary pace and scale requires what UN Secretary-General António Guterres has called “inclusive, networked multilateralism”. The more ambition political leaders demand, the more businesses, investors, cities and regions are challenged to advance. The farther they go, the higher governments can push their targets, and so forth. It’s an ambition loop. Platforms like the Marrakech Partnership’s Climate Action Pathways, the Mission Possible Partnership and the Race to Zero Breakthroughs are enabling this kind of pre-competitive collaboration, reducing the risk of the energy transition.

The energy transition is gaining momentum even in the midst of the COVID-19 health and economic crisis, with high-emitting countries setting net-zero emissions goals: China by 2060, the EU, US, Canada, South Korea, Japan and South Africa by 2050.

The UK’s new NDC is rooted in the plan for a green industrial revolution that will create 250,000 British jobs this decade. In 2030, London intends to have ended the sale of petrol and diesel cars, reached 5 GW of green hydrogen production capacity and quadrupled offshore wind capacity, among other plans.

South Africa’s new goal for net zero by 2050 is backed by a strategy to cut coal-fired power supply from around 90% now to 46% by 2030 and 30% by 2050, while boosting wind, solar and hydro. This falls short of the Paris goals, but the ambition – set against a serious economic battering from high COVID-19 rates – is laudable.

Yet the bigger signs of energy transformation are coming from the private sector. International Airlines Group and Oneworld Alliance are ahead of the International Civil Aviation Organization in setting net-zero targets. General Motors is aiming for net zero by 2040 and calling on the US government to forge a national zero-emissions vehicle program. Nestlé intends to halve its emissions by 2030 by supporting the shift to regenerative agriculture and planting hundreds of millions of trees.

Impact of Policy Making on Energy Transition

Government policy will help to both realize these ambitions and continuously ramp them up at the scale demanded by the Paris agreement. NDCs could drive decarbonization by ending fossil fuel subsidies and pricing carbon, shifting investments from fossil fuels to renewables, ending the sale of petrol and diesel vehicles, and ending deforestation – as the NDC Partnership recommends. And as the Coalition for Urban Transitions states, investing in cities – including low-carbon buildings and mobility, renewable power and green spaces – would also enhance both national COVID-19 recoveries and Paris contributions.

Of course, all these policies must uphold two pillars in the race to a healthy, resilient zero-emissions world: the just transition and nature regeneration.

We know the energy transition will create jobs, but those jobs must be made available in places where workers and communities rely on fossil fuels. The just transition is a local challenge, and political and business leaders should treat it as such.

What’s the World Economic Forum doing about the transition to clean energy?

The world we live in today has been shaped by the breakthroughs of our past – from the Model T assembly line to the spread of mobile phones across previously unconnected rural areas. Such breakthroughs continue to propel us towards a safer future, as long as governments make sure the whole of society comes along for the ride.

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World Economic Forum articles may be republished in accordance with the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Public License, and in accordance with our Terms of Use.

The views expressed in this article are those of the author alone and not the World Economic Forum.
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Pamela Davenport published in

New Reality for Investors: 5 Big Trends Changing Markets

There’s a new reality taking shape in global markets.
Commentators have in the last few months mostly focused on a rotation from growth to value, but I think that view is too simplistic. I see many shifts happening simultaneously that could likely define the next decade in markets around the world.
Many investors are expecting a return to normal after inflation subsides and central banks stop raising rates. But I believe the world is undergoing significant changes and that investors will need to reset their expectations about how a typical investing environment will look. Here are five seismic shifts happening in economies and markets right now, as well as the long-term investment implications of each:

1. From falling rates to rising rates and higher inflation

The market is grappling with a macro environment it hasn’t seen in a long time. Inflation is its highest since the early 1980s. And until recently we’ve had 40 years of declining interest rates. That’s longer than most investment managers’ careers, if not lifetimes. That’s part of the reason we see a market struggling to adjust to this new reality.

Is this the end of a 40-year disinflation cycle?

 

The chart shows U.S. 10-year Treasury yields since 1955. Yields increased from around 3% in 1955 for 26 years to a peak around 15%. For the next 39 years they declined before reaching a trough in 2020.

 

Sources: Capital Group, Refinitiv Datastream. As of 10/26/22.

 

It’s easy to assume these are market dislocations that will quickly reverse — bond markets are currently pricing a return to 2% inflation within two years, for example. But these cycles often last much longer than people anticipate, and there is reason to believe higher inflation is structural and likely to persist.

In this new environment I’m especially cautious of highly levered companies, or those raising new debt. Money isn’t “free” anymore, so a larger slice of earnings will go to service debt. Companies with the ability to fund their own growth as well as those with strong pricing power and dependable cash flows will remain attractive in a high-inflation, higher-cost-of-capital world.
2. From narrow to broader market leadership
I think we’re going to be in a much less narrowly concentrated market going forward. The last decade was dominated by a handful of tech stocks that you basically had to own to keep up with the market. I don’t think that’s going to be the case anymore.
I expect opportunities to arise from a variety of companies, industries and geographies. Well-managed companies beyond the tech sector may have their chance to shine again.
For example, e-commerce companies have gone from being the disruptors to being challenged themselves. They’re often very low margin and expensive to scale with difficult delivery logistics to manage. Very few have done it well. Some traditional retailers that have combined the benefits of brick-and-mortar stores with a compelling online shopping experience are starting to take share from pure e-commerce companies.

Market leaders are becoming less concentrated

 

The line chart shows the ratio of the S&P 500 Equal-Weighted Index to the S&P 500 Index. An upward line indicates market breadth increasing while a declining line indicates market breadth decreasing. From 2015 through 2021, market breadth declined. From 2021 until present market breadth increased, reaching 109.

 

Sources: Capital Group, Refinitiv Datastream, Standard & Poor’s. As of September 30, 2022. Indexed to 100 as of 1/1/05.

 

After the market’s dive in 2020, I expected leadership to broaden, and it has done so. In my view, this is a healthy development and supports why I have been trying to de-concentrate my own portfolios. In theory, it should be a positive backdrop for stock pickers over indexers.

3. From digital to physical assets
The last bull market was dominated by tech companies that made their fortunes on digital assets, such as online marketplaces, streaming platforms, search engines and social media. This overshadowed the fact that you can’t build a new economy without older industries. Not that digital-first companies are going away, but I think investors will start to place greater emphasis on commodities and producers of physical assets.

 

Capital spending super cycle could power a new industrial renaissance

 

The stacked area chart shows capital expenditures across MSCI ACWI sectors on an annual basis from 2007 to 2021. The sectors measured and total capital expenditures in USD billions of each respective sector as of December 31, 2021, are as follows: financials and real estate (66.2), health care (90.0), consumer staples (105.0), materials (177.9), industrials (184.8), energy (225.0), consumer discretionary (238.2), info tech (239.7), communication services (243.7), utilities (252.2).

 

Sources: Capital Group, FactSet, MSCI. In current U.S. dollars. As of December 31, 2021.

 

Some might assume that trends like the shift to renewable energy will squeeze out incumbents in traditional sectors like industrials, materials or energy. On the contrary, there may be winners among businesses that are helping other companies be more energy efficient — whether that’s smart buildings, power management or HVAC systems that reduce gas emissions. Other global trends such as grid modernization, reshoring and energy security may cause a boom in capital investment across industries. These are areas where smartly managed industrial companies might have a real renaissance.

4. From multiple expansion to earnings growth
Many newer investors got comfortable with stocks being very expensive over the last five to 10 years and now assume stocks will return to those levels during the next bull market. When rates were near zero the market could support loftier multiples, but I think those days are over.
An exercise I’m trying to apply when evaluating my portfolio is to ask: “What if stocks don’t return to 25x earnings in 2027? What if they only trade at 15x earnings?” If I can make a stock work at that level, then I can probably limit my downside. Using that lens, I’m trying to find emerging and growth-oriented companies that are not valued as such. I like those that may also offer potential upside to the valuation, but where the investment thesis doesn’t depend on it.
If multiple expansion is limited in the next bull market, stock returns will have to be powered by earnings growth. That means markets aren’t likely to be as patient with unprofitable companies. Stocks whose business models depend on cheap money are going away. Companies that funded losses while trying to scale rapidly even where the economics didn’t work are going away. Markets once paid up heavily for future growth, but now with higher interest rates they are less willing to do so. The market is calling time on business models that don’t work when money is no longer free.
5. From global supply chains to regional supply chains
The globalization of supply chains is another multi-decade trend that is shifting. For a generation, companies moved manufacturing to foreign soil to cut costs and boost margins. But the limitations of placing efficiency over resilience are now clear. Rising geopolitical tension and pandemic-induced disruptions have led companies to consider bringing supply chains closer to home.
While bottlenecks caused by COVID shutdowns have improved, many companies are still being impacted. The auto industry is a prime example. Major automakers have tens of thousands of unfinished cars waiting for final parts, and that missing component is often as minor as an inexpensive semiconductor chip. Now companies are creating supply chain redundancies so that a single disruption doesn’t derail their entire operation.
Even as pandemic-related issues ease, I believe increased geopolitical conflicts are here to stay and will continue to fuel this change. The current environment reminds me of the 1970s, with tension between Russia and the West, more aggressive confrontations with China, the rise of authoritarian leaders around the world and less global cooperation. Since the fall of the Berlin Wall, we’ve had more than 30 generally peaceful and prosperous years. But there are more risks now, and this backdrop suggests lower valuations are warranted and “surprises” should feel less surprising.

Higher global tensions have increased risk of relying on international supply chains

 

The line chart shows the index levels of the Geopolitical Risk Index from 1986 through September 2022. The current level of 152 is the highest during this time period besides immediately after the Persian Gulf War (179) and September 11 attacks (229).

 

Sources: Capital Group; Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194-1225. The Geopolitical Risk Index is a measure of adverse geopolitical events and associated risks based upon the tally of newspaper articles covering geopolitical tensions, using a sample of 10 newspapers going back to 1985. Index level values reflect a 12-month smoothed average of monthly data. As of September 2022.

Consider Taiwan Semiconductor Manufacturing Company (TSMC), the world’s dominant manufacturer of cutting-edge semiconductors. After having concentrated the bulk of its capacity in Taiwan — a focal point of geopolitical concerns — the company is building its first manufacturing hub in the United States. It’s also constructing a new plant in Japan. That regionalization should create a more efficient supply chain for some of its top U.S.-based clients, including automakers and technology companies like Apple, Qualcomm and Broadcom.

A flexible investment approach can help weather the storm
The combination of low rates and rising markets made the last 10 years feel like one long sunny day at the beach. While some rain showers have now driven beachgoers indoors, they’re still looking out the window waiting for the storm to pass. They don’t realize that there’s a new weather system upon us with more clouds, colder temperatures and much stronger winds. The world’s not ending, but it may be a wetter, cloudier and colder place — and life won’t be a day at the beach.

Flexible funds can pivot between sectors as market conditions shift

 

The stacked bar chart shows net change in portfolio weight since 2019 for New Perspective Fund for each equity sector. The consumer discretionary and information technology sectors saw the biggest decreases during this time period. Industrials and health care realized the largest increases.

That may sound like a dark outlook, but I actually see this as a really exciting time to be an investor. As a portfolio manager for New Perspective Fund®, which is not restricted by geographies, sectors or style boxes, my fellow managers and I are able to adjust to this new reality of investing in a variety of ways.

The chart above shows that flexibility in action. Although we didn’t get everything right, we have been shifting from higher growth sectors like consumer discretionary and information technology to health care and industrials over the past few years in anticipation of this new reality. New market environments present new opportunities, and that’s where experience and flexibility can be essential.
Jody Jonsson

Equity Portfolio Manager
Capital Group
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Pamela Davenport published in

Renewable power on course to shatter more records as countries around the world speed up deployment

Global additions of renewable power capacity are expected to jump by a third this year as growing policy momentum, higher fossil fuel prices and energy security concerns drive strong deployment of solar PV and wind power, according to the latest update from the International Energy Agency.

The growth is set to continue next year with the world’s total renewable electricity capacity rising to 4 500 gigawatts (GW), equal to the total power output of China and the United States combined, says the IEA’s new Renewable Energy Market Update, which was published today.

Global renewable capacity additions are set to soar by 107 gigawatts (GW), the largest absolute increase ever, to more than 440 GW in 2023. The dynamic expansion is taking place across the world’s major markets. Renewables are at the forefront of Europe’s response to the energy crisis, accelerating their growth there. New policy measures are also helping drive significant increases in the United States and India over the next two years. China, meanwhile, is consolidating its leading position and is set to account for almost 55% of global additions of renewable power capacity in both 2023 and 2024.

“Solar and wind are leading the rapid expansion of the new global energy economy. This year, the world is set to add a record-breaking amount of renewables to electricity systems – more than the total power capacity of Germany and Spain combined,” said IEA Executive Director Fatih Birol. “The global energy crisis has shown renewables are critical for making energy supplies not just cleaner but also more secure and affordable – and governments are responding with efforts to deploy them faster. But achieving stronger growth means addressing some key challenges. Policies need to adapt to changing market conditions, and we need to upgrade and expand power grids to ensure we can take full advantage of solar and wind’s huge potential.”

Solar PV additions will account for two-thirds of this year’s increase in renewable power capacity and are expected to keep growing in 2024, according to the new report. The expansion of large-scale solar PV plants is being accompanied by the growth of smaller systems. Higher electricity prices are stimulating faster growth of rooftop solar PV, which is empowering consumers to slash their energy bills.

At the same time, manufacturing capacity for all solar PV production segments is expected to more than double to 1 000 GW by 2024, led by China and increasing supply diversification in the United States, India and Europe. Based on those trends, the world will have enough solar PV manufacturing capacity in 2030 to comfortably meet the level of annual demand envisaged in the IEA’s Net Zero Emissions by 2050 Scenario.

Wind power additions are forecast to rebound sharply in 2023 growing by almost 70% year-on-year after a difficult couple of years in which growth was slugging. The faster growth is mainly due to the completion of projects that had been delayed by Covid-19 restrictions in China and by supply chain issues in Europe and the United States. However, further growth in 2024 will depend on whether governments can provide greater policy support to address challenges in terms of permitting and auction design. In contrast to solar PV, wind turbine supply chains are not growing fast enough to match accelerating demand over the medium-term. This is mainly due to rising commodity prices and supply chain challenges, which are reducing the profitability of manufacturers.

The forecast for renewable capacity additions in Europe has been revised upwards by 40% from before Russia’s invasion of Ukraine, which led many countries to boost solar and wind uptake to reduce their reliance on Russian natural gas. The growth is driven by high electricity prices that have made small-scale rooftop solar PV systems more financially attractive and by increased policy support in key European markets, especially in Germany, Italy and the Netherlands.

Newly installed solar PV and wind capacity is estimated to have saved EU electricity consumers EUR 100 billion during 2021-2023 by displacing more expensive fossil fuel generation. Wholesale electricity prices in Europe would have been 8% higher in 2022 without the additional renewable capacity, according to the new IEA report.

While the competitiveness of wind and solar PV has improved since last year, government policies need to adapt to changing market conditions, particularly for renewable energy auctions, which were undersubscribed by a record 16% in 2022. Moreover, policies need to focus on timely planning and investment in grids in order to securely and cost-effectively integrate high shares of variable renewables in power systems. Multiple countries in Europe including Spain, Germany and Ireland will see wind and solar PV’s combined share of their overall annual electricity generation rise above 40% by 2024.

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Pamela Davenport published in

2023 Market Outlook: Cross Currents

Cross currents continue to rock the economic boat, even though we believe a brighter year is on the horizon.

The Federal Reserve’s ongoing commitment to raising interest rates to cool inflation is likely to lead to weak U.S. economic trends in early 2023. However, Fed policymakers have indicated they are looking to an eventual pause in rate hikes, possibly in early to mid-2023, and that it is likely the federal funds rate target will remain at its peak, or “terminal,” rate for a while.1

In other words, there may be more choppiness, given that inflation is still a noticeable (although receding) problem, but the longer-term U.S. economic outlook has improved.

Source: Schwab Center for Financial Research

U.S. stocks and economy: How many more times, Fed?

It wouldn’t surprise to us to learn that a U.S. recession is coming or already in progress. The Conference Board’s Leading Economic Index has had an eight-month change consistent with every recession going back to 1960.

Leading economic indicators are pointing to recession

Chart shows the Conference Board's Leading Economic Index dating back to 1960, with recessionary periods overlaid in gray. The Leading Economic Index has fallen by -3.8% this year, an 8-month change consistent with every recession since 1960.

Source: Charles Schwab, Bloomberg, The Conference Board, as of 10/31/2022.

The Fed is trying to thread the needle between slowing growth enough to curtail inflation while at the same time avoiding a recession—a feat known as achieving a “soft landing”—but that’s a very narrow opening. And frankly, history isn’t on the Fed’s side when it comes to soft landings. We think it is only a matter of time until cracks in the labor market widen and we see a recessionary move up in the unemployment rate. In fact, the Fed is telling us in its own forecast that a recession is expected: The central bank’s latest expectation for 4.4% unemployment in 20232 would be a 0.7% increase from the current rate.

It may seem counterintuitive, but employment weakness would be welcome sooner rather than later, as it would bring the Fed closer to “checking the box” of increasing slack in the labor market—ultimately helping put downward pressure on inflation and allowing the Fed to ease up on the brake it has been applying to the economy. If this occurred alongside a stabilization and/or turn higher in leading indicators, it would set up the economy for better days later in the year.

Global stocks and economy: Risk and recovery

A better year for global investors may lie ahead, but volatility may remain high in early 2023 as a potential global recession lingers, central banks step down rate hikes, and China’s post COVID-19 reopening introduces upside risk to inflation.

Inflation is still stubbornly high. Central banks stepping down the pace of rates hikes is more about responding to weak economies than making strong progress on lowering inflation. Even though third-quarter economic growth was better than expected for many major countries in North America, Europe, and Asia, a global recession likely began sometime during the third quarter.

One important signal of an already-underway recession is the leading indicator for the world economy produced by the Organization for Economic Cooperation and Development. In this index, a drop below 99 tends to happen right around the start of a global recession. It’s a repeating story, and it’s below 99 again, signaling another potential recessionary period.

Global leading indicators point to global recession

Line chart of OECD Global Leading Indicators since 1970, illustrating pattern of recession when the indicators breach the 99 threshold level.
The depth of this potential recession appears to be mild, so far. Some parts of the global economy and some countries are growing, offsetting others that are contracting. For example, while there remains strength in services (seen in travel and leisure), the demand and manufacture of goods has been weakening (evidenced by rising inventories and slowing product sales). The likely recession is rolling through different parts of the global economy at different times, in contrast to the everything-everywhere-all-at-once recessions of 2020 and 2008-09.

China’s authorities are preparing to end the zero-COVID policies that have held back their economy for the past three years. In reaction, the MSCI China Index rose 29% in November, compared to just 5% for the S&P 500 Index. This surge in Chinese stocks has propelled outperformance of emerging-market stocks. Yet—in another example of counterintuitive cross currents—the potential reopening poses upside risk to inflation just as central banks appear to be stepping down their rate hikes. We will be watching developments carefully to assess the balance between the impact of reopening excitement and inflation worries on the stock market.

Fixed income: Bonds are back

It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors. After years of low yields followed by a brutal drop in prices during 2022, returns in the fixed income markets appear poised to rebound.

Our optimism about returns for 2023 is based on three factors:

  • Starting yields are the highest in years—in both nominal and real terms;
  • The bulk of the Fed tightening cycle is over; and
  • Inflation is likely to decline.

After a long drought, the bond market is awash in yields that are attractive relative to other income investments. A portfolio of high-quality bonds—such as Treasuries and other government-backed bonds, and investment-grade corporate bonds—can yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in higher tax brackets. In addition to the relatively attractive yields, higher coupons for newly issued bonds should help dampen volatility.

We expect the Federal Reserve to end its rate hikes in early-to-mid-2023 amid a soft, perhaps recessionary, economy that brings inflation lower. Given that outlook plus the year-end rally in bonds, yields may rebound early in the year. However, the yield curve (the difference between short-term and longer-term Treasury yields) is likely to remain deeply inverted as monetary policy remains tight. Assuming the Fed sticks to its tight policy stance at the expense of economic growth, 10-year Treasury yields could fall as low as 3%. With that backdrop, we favor adding duration to bond portfolios during periods of rising rates, while staying up in credit quality.

Investor takeaway: Focus on quality

We continue to recommend more of a factor-based investment process than a sector- or style-index-based process. At least until the economy begins to stabilize, we suggest that stock-picking-oriented investors focus on quality-based factors, such as balance sheet liquidity, positive earnings revisions, strong free cash flow, and lower volatility.

In global stocks, one way we’ve been defining quality is high-dividend payers—generally a sizeable dividend is a sign of financial strength and good cash flow. High-dividend-paying stocks have outperformed during past recessionary bear markets, and they outperformed again in 2022 across sectors and countries. So did short-duration stocks (that is, stocks of companies with more immediate cash flows, rather than cash flows in the distant future): They outperformed in 2022 both when the market was falling and in the fourth quarter when it rebounded. There can be no guarantees, but investors may be able to navigate 2023 by sticking with what has been working in both up and down markets during 2022.

We’re similarly focused on quality in the fixed income market. Investment-grade bonds are likely to provide attractive yields in 2023 at lower risk than we’ve seen for several years. Current yields on riskier bonds, such as high-yield bonds, don’t provide enough compensation for the extra risk, in our view. Things may change as the year progresses, but for now we recommend staying up in credit quality and increasing duration, keeping the average near your long-term benchmark.

1 The terminal rate is the level of the federal funds rate at which the Federal Reserve is expected to stop raising the rate.

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Pamela Davenport published in

Emerging Markets Outlook 2023

The first half of 2023 will be challenging for emerging markets, but lower inflation and China’s reopening will likely present opportunities for growth in the second half.
The outlook for emerging market economies in 2023 will largely be dictated by inflation. Eastern Europe, Latin America, and much of Africa have faced a more pronounced inflationary cycle over the last year. Higher interest rates amid the spike in cost of living is expected to weaken domestic demand in these regions. However, Middle Eastern and Asian economies are expected to fare better as inflationary pressures have been more benign, and their central banks have been able to keep interest rates relatively low. The war in Ukraine, China ending its zero-tolerance COVID-19 policy, and the growth trajectory for the United States and European Union pose risks to this outlook.

Inflationary pressures will determine the outlook

Pandemic-related supply chain disruptions and changes to consumer preferences caused global inflation to surge in 2021. Eastern Europe, Latin America, and parts of Africa experienced some of the worst inflation in 2022 (figure 1). Chile, Brazil, Poland, Czechia, and Nigeria had all started 2022 with core inflation above 7% on a year-ago basis.1 Then came Russia’s invasion of Ukraine in early 2022, which exacerbated inflation further as the supply of food, energy, and other commodities coming from the region was cut off. In addition, the Fed began hiking interest rates, which weakened emerging market currencies. Many emerging market central banks implemented their own rate hikes to prevent further currency depreciation and restrain inflation.

Although central banks in many emerging market countries responded relatively early to inflationary pressures, price growth continued to accelerate over much of 2022. Fortunately, some of those price pressures have eased more recently, particularly in Brazil, Chile, and Czechia.2 As a result, the central banks in these three countries were able to keep rates on hold in Q4 2022.3 Disinflation in Latin America and Eastern Europe has been a welcome development. However, excessive government spending and a flare-up in the Ukraine war or energy markets could easily exacerbate price pressures again. New government administrations in both Chile4 and Brazil5 have large social-spending ambitions that could reverse progress on inflation. In Eastern Europe, the biggest risk stems from the war in Ukraine and the possibility that energy prices will rise again.

By contrast, emerging Asian economies had faced more limited inflationary pressure last year (figure 1). Each of the ASEAN-6 countries, Vietnam, Indonesia, the Philippines, Singapore, Malaysia, and Thailand, had less than 3% core inflation in January 2022.6 Pandemic-related restrictions endured through much of the year, including in China and Japan, limiting demand-side pressures to inflation. More recently, inflation in the region has picked up a little as demand rebounded and supply-side price shocks—such as higher energy bills—fed through to the prices of other goods and services. Even so, core inflation in Asia has continued to run much lower than in other emerging market countries. For example, the Philippines had the fastest core inflation of the ASEAN-6 countries at 5.9% year over year in December.7 Brazil, Chile, Colombia, and Peru all had higher core inflation over the same period. Core inflation throughout eastern Europe was far higher.

Regardless of the timing of accelerating price pressures, consumers across emerging market countries are either slowing or outright cutting the pace of their spending. Inflation-adjusted retail sales in Chile and Czechia consistently fell during the second half of 2022 on a year-ago basis.8 By Q4 2022, real spending had slowed dramatically across a wide set of countries. Spending declined marginally on a year-ago basis in Thailand in October, while it was up just 0.1% in Indonesia for December.9 The slowdown in consumer spending comes despite the government extending support to households. The governments of Hungary, Czechia, the Philippines, Indonesia, Chile, and Brazil have all implemented policies to alleviate the rise in the cost of living.10

Risk of major default remains muted for now.

As interest rates rise, many governments provide additional support to consumers, and domestic and external demand wanes, concerns over government finances have come to the fore. After all, previous episodes of global monetary tightening have ended poorly for emerging markets. Fixed exchange rates and excessive external debt, especially when denominated in foreign currencies, created a raft of defaults during the Latin American debt crisis in the 1980s and the Asian Financial crisis in the 1990s.11 Today, external debt positions have improved in these countries, and most emerging market currencies have been allowed to float. For example, Thailand’s external debt as a share of GDP is less than half what it was in the late 1990s, and the Thai baht has been a floating currency since the Asian Financial crisis in 1997.12

Despite the general improvement in emerging market finances, a handful of smaller emerging market countries have run into fiscal trouble. For example, Sri Lanka and Ghana have already defaulted.13 The stress in these countries shows up clearly in the interest rates of their government bonds and in their exchange rates. Sri Lanka’s 10-year government bond spread against US treasury bonds averaged around 25 percentage points in December. That is up more than 16 percentage points from its 2019 average. In Ghana, things look even worse, with the spread on 10-year government bonds ballooning to 42 percentage points, more than double the spread in 2019.14

Of the larger emerging market economies, few are facing serious stress. Mexico, India, Taiwan, Thailand, and Vietnam have seen credit spreads narrow since 2019. Even in places where credit spreads have widened, the margin has been relatively slim. Chile, the Philippines, and South Africa have seen their spreads widen less than Germany’s over the same period.15 Colombia and Hungary are two exceptions. Spreads with US treasuries in these countries have widened considerably since the pandemic hit. Both countries have struggled to get their inflation under control and are running current account deficits.

Although 2022 posed a serious challenge for emerging markets looking for financing, 2023 is likely to be considerably better. However, the 2023 outlook will largely depend on what happens with interest rates and inflation in the United States. Investors expect the Fed to begin reducing rates later this year, sensing that inflation is coming down quickly.16 This would ease pressure on emerging market currencies and allow their central banks to also take a more dovish approach. Financial markets appear comfortable with this narrative, funneling money back into emerging market bonds. In just the first two weeks of this year, emerging market countries sold US$39 billion of international bonds, considerably more than the record US$26 billion raised over the same period in 2018.17 However, the Fed’s own messaging has been more hawkish than market expectations, raising the risk that financial pressures could rise again in emerging markets.

China’s abandonment of zero-tolerance COVID-19 protocols, meanwhile, could have implications for sovereign risk. The reopening of China is expected to raise commodity prices. The International Energy Agency’s 2023 forecast shows demand for oil rising faster than supply, which should lift crude oil prices, benefitting OPEC countries.18 After falling in the middle of last year, the prices of other commodities are rising again, which should support government revenue in countries such as Chile, Peru, and South Africa. However, another commodity price cycle will likely challenge government finances in net-importing countries, particularly those in eastern Europe and Asia. It could also force central banks to raise interest rates as inflation rears its ugly head again, applying additional pressure on governments with the need to borrow.

Darkening external environment

After the pandemic hit and the world shifted its demand away from shuttered services and toward spending on goods, emerging market exports soared. As the world shifts back toward services and global economic growth stalls, exports are coming back to earth. Southeast Asian countries have seen some of the strongest deceleration in exports. Malaysia, Singapore, Vietnam, Indonesia, and Thailand, all saw year-over-year export growth slip more than 10 percentage points between Q3 and Q4 of 2022. Plus, Singapore, Indonesia, and Thailand all posted outright year-ago declines in Q4. Weakness in the external environment was not limited to ASEAN countries. India, South Africa, Poland, and Chile all saw year-ago declines in exports in Q4 as well. Although Brazil’s export growth looks like it accelerated strongly in Q4, it was mostly due to base effects. Indeed, December’s exports were the lowest in 11 months.19

Commodity prices had surged in the beginning of 2022 as the war in Ukraine raised concerns over access to the food, metals, and energy that are produced in the region. However, as the world adjusted to the war, commodity prices reversed some of their earlier gains. The decline in commodity prices in the second half of last year contributed to weaker exports, especially for OPEC countries. Exports from Saudi Arabia had already fallen more than 18% between June and October, though the value of exports in October was still far higher than any monthly recording prior to 2022.20 Although China’s reopening could raise the price of oil, it is unlikely that crude will reach the heights seen in the middle of last year. However, such an assessment also depends on how much oil Russia is able to produce amid ongoing sanctions.

China’s reopening should have a larger effect on emerging market exports than just higher commodity prices. Pent-up demand in China should boost demand for exports, particularly in the second half of this year. The sharp rebound in demand should certainly help countries in Asia as China is the largest export market for Malaysia, Singapore, Indonesia, and the Philippines. However, plenty of countries farther afield, such as Brazil, Saudi Arabia, and South Africa, call China their largest export market too.21

Service exports should also rebound as China reopens. With borders virtually closed in China, tourism in Asian countries had taken a huge hit. Before the pandemic, Chinese residents accounted for more than 20% of all tourists in Vietnam, Thailand, and the Philippines, and more than 10% of all tourists in Malaysia and Singapore.22 In 2022, Chinese tourists didn’t account for more than 4% of all tourists in any of those countries, suggesting that the upswing from Chinese tourism could be substantial this year. For an economy like Thailand that relies heavily on tourism, the return of Chinese visitors would dramatically improve its economic output, which remains below its pre-pandemic peak.

The first half of 2023 will continue to present challenges for emerging markets. The risk of recession in the United States and Europe has already contributed to a weaker external environment, while China continues to struggle with the immediate aftermath of loosening COVID-19 restrictions. However, the second half of the year should be brighter. Developed economy central banks may begin to ease or at least no longer tighten monetary policy, providing relief to emerging market currencies and monetary policymakers. Meanwhile, domestic inflation is expected to come down further, which should alleviate some of the cost constraints consumers have faced. The reopening of China, however, could be a double-edged sword. Although it should foster greater demand for emerging market exports, it risks raising commodity prices, thereby exacerbating inflationary pressure just as it was beginning to ease in much of the world.

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