Mid-year EMD outlook: Back to Basics - Fade the tightening scare

Mid-year EMD outlook: Back to Basics - Fade the Tightening Scare

Mid-year EMD Outlook – in a Nutshell

Late-cycle, but Fade the Tightening Scare

• MACRO: The toppish teflon cycle

I.Growth: It’s back to basics as geopolitical risks have normalized. The Teflon cycle is gearing down as the key growth drivers identified in previous EMD outlooks lose steam (fiscal impulse, lagged impact of past monetary easing and the AI-driven capex cycle). Iran-induced inventory build-up fades. On the other hand, oil is back at pre-war levels. EM-US growth gap to move in EM’s favour (upper chart), mainly due to cooling US growth & oil’s roundtrip – this is not prices, yet (lower chart).

II.Inflation: Disinflation in H2, particularly in the US as the energy impulse reverses and tariff boost fades, while US unit labour cost < 2%. Global inflation to remain above most central banks targets.

III.Policy: Fiscal stimulus fading but don’t fear the Fed. Monetary conditions tighten moderately, but outright Fed hikes should be avoided, preventing a late cycle to morph into an end-cycle stage.

IV.The single biggest (two-sided) risk: AI innovation cycle - euphoria extended or reality check looming?

• MARKETS: Looks like Goldilocks, smells like Goldilocks – but isn’t quite Goldilocks

• Review: Shifting from a defensive to a constructive stance in Q2 proved correct as EMD rebounded & geopolitical tensions faded. Local EMD slightly outperformed hard currency EMD, as expected.

• Tactically cautiously constructive, not greedy: Risk-reward less appealing due to valuation and cracks in the AI euphoria wall. A dovish repricing of the Fed keeps a floor under risk appetite. Moderately overweight local EMD amid stretched USD positioning. EMFX is the cleanest dirty shirt wrt. valuation.

• Strategic horizon: We continue to expect solid returns driven by carry & duration as inflation risks subside. The US - RoW growth gap is moving in EM’s favour, supporting EMFX. Overweight local currency EMD. A late cycle set-up keeps VOL elevated, arguing for a tactical approach to markets.

Mid-year EMD Outlook - Macro Playbook

Growth: Toppish Teflon Cycle

• Teflon cycle: During the past year, the global economy has shrugged off the energy supply shock and the tariff shock.

• Gearing down: Forward-looking indicators point towards growth moderation in H2 (LHS).

• Heading into H2, key growth drivers are losing steam. On top, consumption & the inventory cycle is set to slow.

  • Monetary conditions are tightening and the credit cycle slowing (RHS)  - real rates higher & USD stronger

  • Fiscal support is fading in the US. The fiscal impulse in Germany is picking up, but China remains lackluster.

  • The AI capex cycle is still running hot, but we’re seeing the first signs of peak momentum.

Mid-year EMD Outlook - Macro Playbook

Business Cycle Context: Late Cycle set-up

• Bellwethers of a late-cycle environment: Monetary tightening in broader sense, yield curve flattening, deteriorating credit cycle (LHS), tight but cooling labour markets. Very low forecast dispersion suggests a bit of “macro complacency” (RHS).

• The speed of the late-cycle moves are key: Indicators point towards a gradual rise in unemployment (NFIB, Conf.Board), slow deterioration in credit metrics.

• Crucially, we do not expect a resumption of Fed’s tightening cycle, preventing an end-cycle showdown.

Mid-year EMD Outlook - Macro Playbook

Don’t Fear the Fed → No End-cycle Showdown

• Inflation risks peaking in H1: Inflationary impact from energy and tariffs is fading. US inflation model (LHS) reached a post-pandemic low (LHS). The mother of all central bank fears not materializing: Wage gauges still trended lower.

• Past peak hawkishness at June FOMC meeting: No Fed hikes in 2026 expected. US inflation likely to end the year below Fed’s own 2026 estimate, trending down (Warsh: Trends matter more than datapoints). Cut possible in early 2027.

• Monetary conditions are tightening in a typical late-cycle fashion but at a moderate pace, keeping the business cycle intact (RHS). Especially less forward guidance should imply more market volatility around FOMC events & data releases

Mid-year EMD Outlook – Market Expectations

Constructive, not Greedy as vol Remains High

• A slowing but resilient business cycle supports solid EMD returns on a 12M horizon in high single digit/low double digit territory.

• Carry-driven returns expected: Amid historically tight spread levels and cooling global growth, tightening potential is limited (LHS).

• Cautiously constructive, not greedy: Sentiment hasn’t corrected meaningfully lower (RHS), pointing towards elevated vol and a tactical market environment.

• While not punitively tight, monetary conditions are much tighter than last year, challenging the overall beta environment.

Mid-year EMD Outlook – Market Expectations

Local FX EMD: Laggard in H1, Tailwinds in H2

• Positioning has turned massively in favour of DXY, suggesting depreciation in the coming months (LHS)

• Cleanest dirty shirt on valution: EURUSD close to short-term fair-value fo the first time in a while, DXY expensive on long-term valuation and fundamental EMFX valuation less stretched than e.g. Credit.

• Reversal of the oil price shock capping the EM hiking cycle, supporting GBI duration (RHS).

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