The Return of Deflation Raises Caution in Emerging Markets

All signs point to an imminent recession in the U.S. and the return of deflationary forces. The markets are pricing this in, forecasting that the Fed will begin to cut interest rates this summer. The debate is now between the soft-landing and hard-landing camps and on the length of the coming downturn, and on whether Jeremy Powel has the stomach for austerity or whether he will happily return to ZIRP and money printing.

In this environment, safety will trump risk. The recent surge in the infallible FAANG stocks — the current preferred safe haven for global investors — and the poor returns for value, small cap and cyclical stocks shows that we are in the very late stage of the business cycle or already in recession. Emerging market assets are not likely to do well at this time.

Commodity prices are leading the way in this deflationary push. As the chart below shows, oil and lumber, which are the two most significant economic indicators in the U.S. are down sharply relative to inflation (CPI). Oil is down 37% over the past year and natural gas is down 74%.  Lumber prices have fallen 50% more than the CPI. Even copper, which is supported by tight supplies and rising demand from “climate change” policies, is  still down 13% and supporting the deflationary push.

 

We also see broad deflationary forces in the broad commodity indices. forces. The S&P GSCI Commodity Index (GTX) and the S&P GSCI Industrial Metals Index are down 18% and 15%, respectively, over the past year, while the CPI has risen 6%.

The Industrial metals index is most significant for emerging markets because historically it has led the way for EM stocks. We can see this below.

Investors should keep their powder dry for the beginning of a new cycle in 2024.