Warnings and Winners From the IMF Meetings

Simon Waever: Welcome to Thoughts on the Market. I'm Simon Waever, Morgan Stanley's Global Head of Emerging Markets Sovereign Credit and LatAm Fixed Income Strategy.

Seth Carpenter: And I'm Seth Carpenter, Global Chief Economist and Head of Macro Research.

Simon Waever: Today: The key takeaways for investors from the International Monetary Fund spring meetings in Washington, D.C.

It’s Tuesday, April 21st at 10am in New York.

Every six months, the IMF meetings in D.C. bring policy makers and investors together to take stock of the global economy, and we were both there as part of our IMF policy pulse conference.

This time, continuing a pattern of recent years, the backdrop was a bit more complicated. Investors are weighing the economic fallout from the Iran conflict, potentially more persistent inflation pressures, and, as always, rising concerns around global debt and fiscal sustainability. So, the key question coming out of Washington is how do these risks reshape the outlook, and what should investors be paying attention to now with the growth outlook.

Seth, when you think about the Iran conflict, what's the single's biggest channel through which it could hit global growth? And is that risk underpriced by markets today?

Seth Carpenter: I think it really is underpriced, and not just by markets. I would say I had conversations with investors, but also with policy makers down in Washington. And I would say relative to my views on things, both markets and policy makers are under appreciating how much of a hit to growth this could be. Where is it going to happen? What's the channel?

Well, that actually – that differs depending on which economy that you're looking at. I would say here in the U.S., it's primarily the middle- and lower-end of the income distribution. Higher energy prices, gasoline prices going up, taking away discretionary income, especially in what we've been calling this K-shaped economy where the bottom half is already struggling. So, a bit of a hit primarily to consumption spending.

I'd say in other parts of the world, it's broader. Asia – we are already starting to see rationing being imposed for production, for public transportation in lots of ways – that really are going to crimp spending both by households and businesses. And then of course Europe.

Well, they're still in some ways reeling and adapting from the energy price shock. When Russia invaded Ukraine, natural gas prices went up a lot more then. But I think there's still an adjustment process going on.

So, I think the potential hit to growth is real. I think it has spread across economies around the world, but each different economy, each different country has its own sort of nuance and flavor to it.

Simon Waever: And what about the central banks? I know you met with quite a few of them as well. Are they at risk of being behind the curve on inflation or is actually the bigger mistake now look like over-tightening?

Seth Carpenter: Yeah, I really think the over-tightening is the bigger risk here. It's funny, being behind the curve. That's a phrase that I did hear a lot, especially among some of the European policy makers. And people are feeling scarred, I guess you could say, from the surge in inflation that we got coming out of COVID.

But history suggests that these sorts of surges in energy prices tend to be:  one, more focused in headline inflation rather than core; and second, they do tend to revert on time and go away, over time.

And I would say the bigger the hit to growth, the more likely it is that the inflationary impulse will start to fade on its own. And so, I do think there's too much reliance maybe on the inflation side of things, maybe not quite enough on the growth. And so, at the end of the day when I weigh the pros and cons, I would say the risk is probably too much tightening rather than not enough.

But you know, Simon, I tend to spend more of my time in Washington talking to policymakers and investors who are focused on the developed market economy, EME. So, I talked to people about the Fed, talked to people about the ECB.

Morgan Stanley's real strong suit, when we do these conferences of the meeting though, is our EM focus. And I know you and the rest of the team have really over the years ramped up our engagement. So, when you think about the conversations that you had with investors and with officials, what do you think has, sort of, shifted most in recent months. And maybe what's shifted over the past week because the news flow has been going back and forth. What's going on in emerging markets that investors need to know about?

Simon Waever: Right. I would say the first, and by far the biggest focus throughout the week was the disconnect between the very positive market sentiment versus actual developments in the Iran conflict. I think many participants believe the mood would be much worse and that the decision coming out of the meetings would be whether to buy into a challenging backdrop or just stay away.

But instead, I think they came away thinking that the mood was actually fairly upbeat. But also that markets are pricing in a substantial probability of a resolution already. And that brings me to my second takeaways, and that's around EM resilience. EM’s faced multiple macro shocks in recent years, and I think it's fair to say that EM policymakers, including central banks, have built up their credibility when it comes to responding to such events and the volatility they bring.

Several of the EM central banks we met were positively surprised by the resilience of FX markets but also noted that they would still err on the side of caution. EM fundamentals also help in this aspect, which has seen contained external imbalances versus the past and mechanisms to deal with the energy price shock.

Of course, with everything else impacted by the war, duration matters – especially as fiscal buffers are not equal across EM. But I would say in general it reaffirms our view that EM is in a good place to absorb and deal with the uncertainty. And that would actually be my third and final point. That the year as a whole should be good for EM assets, assuming that trajectory remains one of deescalation.

And I think that does extend to FX as well, where the market may quickly return to trading U.S. dollar weakness, particularly if the market's priced more of the Fed cuts that you expect.

Seth Carpenter: Got it. So, you did say, assuming we return to a theme of deescalation, and I guess we have that built into our forecast. The last four or five, six days has seen lots of back and forth. But if we do assume we end up deescalating the current crisis in the Middle East, looking across EM [be]cause it really is a differentiated, subtly nuanced, broad part of the world. If I had to push you a little bit and say, where do you see the clearest winners? What would you point at?

Simon Waever: Sure. I mean, to me, LatAm remains a key winner. We've had this call since the start of the year, but if anything, the Iran conflict and my discussions at the IMF only reinforce this. The region is obviously physically removed from the Middle East, but there are also many large commodity exporters, and a lot of the discussions were around the political realignment with the U.S. and there are several examples.

Just to give a few: Argentina as usual, was a key part of the discussions. And compared to the meeting six months ago, they were much more positive given what's been accomplished since, both in terms of the structural reforms and the FX purchases here to date. And I have to mention Venezuela given it was during the meetings last week that the IMF resumed dealing with them, which had been a key positive catalyst that we've been looking for. Brazil is obviously the biggest economy, and I would say sentiment was pretty positive. But also there's an acknowledgement that the elections in October are just too close to call. And that is likely to bring some uncertainty closer to the time.

Seth Carpenter: Yeah, those are all super compelling examples [be]cause they mix the economics, the markets with the politics. Obviously you mentioned the elections coming up in Brazil; and then for Argentina it was this real huge landslide shift in what was going on because of an election there a couple years ago. And we're seeing how that's coming out. Alright, so let's go in the opposite direction. And not everything can be rosy, and even if as a class we're pretty optimistic and pretty constructive on EM… Do you think there are some key vulnerabilities across the space that you cover that maybe could surprise us to the downside? Or maybe that markets really aren't appreciating now and might have to rethink?

Simon Waever: Yeah, I think to start with, we move outside of LatAm and in all those discussions it was much more about the extent of vulnerability to the conflict and in particular the energy exposure.

And I would say in general, an old price of eighties is a sweet spot for EM, sovereign dollar bonds. But differentiation should pick up a lot. I would say the obvious view would be that energy exporters should outperform importers. But what I would highlight is actually more around the differentiation within all the importers [be]cause that's where policy space can differ significantly.

And even just within Central America and Caribbean, I would call out countries like Costa Rica and Guatemala as having more policy space than say, El Salvador or Dominican Republic. And within Africa, it really comes down to the energy balance and whether you have alternative financing sources.

Seth Carpenter: Got it. Got it. That's really helpful. I will say every day, every week, every month we get new headlines about what's going on. I think you and I are both going to have to be glued to our screens to, sort of, follow what's going on and see how it affects markets. But I guess for here today will call it quits. I really learned a lot from my time down in Washington. It sounds like you had some really good engagement too.

Simon Waever: Yep. I agree. Thanks for taking the time to talk.

Seth Carpenter: It's always good to talk to you, Simon.

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