Global Market Outlook

Positioning the Pieces

Contents
04 Outlooks
05 Geopolitical Risks Intensify as Inflation
Angst Recedes
11 Bonds Take Center Stage
15 Caution Warranted in Equities: Be Selective

19 Special Topic
20 Emerging Markets:
A Nuanced Approach Matters

Positioning the Pieces 2

Positioning the Pieces

Global markets experienced a variety of surprises and

shocks in 2023, including elevated inflation, muted growth,
an abrupt banking crisis, and the continuation of the
sharpest monetary policy tightening in decades. Looking
at 2024, we anticipate uncertainty to persist, with sub-
trend growth projected across the world’s economies.
While the path to a soft landing appears viable, with growth
decelerating but not collapsing, the effects of monetary
policy tightening are still working their way through the
system. In addition, escalating geopolitical tensions and
ongoing macroeconomic headwinds will continue to test
economies. 2024 will likely be a year in flux with many
factors pressuring the path to global recovery.

Positioning the Pieces 3

Outlooks

Geopolitical Risks Disinflationary trends and decelerating

growth support a soft economic landing.
Intensify as Inflation Central banks’ hawkish stance and
Angst Recedes geopolitical conflicts pose viable threats
to that outcome.

Bonds Take Center Stage Given current yield levels, slowing

growth, and continued disinflation, fixed
income moves into the limelight, offering
attractive prospects for investors.

Caution Warranted in Global fragility and heightened

uncertainty are likely to weigh on equities.
Equities: Be Selective In a potentially more volatile landscape,
investors should adopt a selective stance
in their equity allocations.
Macroeconomic
and Geopolitical Geopolitical Risks
Intensify as Inflation
Angst Recedes

Lori Heinel, CFA Global markets experienced a variety of surprises and shocks in 2023, including elevated
Global Chief inflation, muted growth, an abrupt banking crisis, and the continuation of the sharpest monetary
Investment Officer policy tightening in decades. Looking at 2024, we anticipate uncertainty to persist, with sub-trend
growth projected across the world’s economies. While the path to a soft landing appears viable,
Simona M. Mocuta with growth decelerating but not collapsing, the effects of monetary policy tightening are still
Chief Economist working their way through the system. In addition, escalating geopolitical tensions and ongoing
macroeconomic headwinds will continue to test economies. 2024 will likely be a year in flux with
Elliot Hentov, Ph.D. many factors pressuring the path to global recovery.
Head of Macro Policy
Research We expect 2024 to be a time of “Positioning the Pieces” as we weigh multiple factors within
the macroeconomic environment to assess how they converge in order to refine our outlook
and portfolio views. We see fixed income as a bright spot for investors in 2024 given current
yield levels, slowing growth, and continued disinflation. Amid heightened volatility and global
fragility, we remain cautious on risk assets and favor quality stocks in equity markets. We believe
emerging markets will remain vulnerable given the global landscape, but do see pockets of
opportunity within emerging market debt and select emerging market equities.

In such challenging markets, it is critical to strike the appropriate balance, get portfolio
implementation right, and retain flexibility to respond as clearer signals develop. We explore
these themes and more in our latest Global Market Outlook.

2024 Global Over the course of 2023, global economies have exhibited surprising resilience in the face of the
Economic Outlook sharpest tightening cycle experienced in decades. Despite this impressive degree of strength
in the global economy, and in the United States in particular, growth is nonetheless slowing (see
Figure 1). Resilience has largely exhausted itself. Global trade volumes are outright contracting, and
global industrial production is essentially flat on a year-over-year basis (see Figure 2). Services
demand has held up much better as post-pandemic pent-up demand was satisfied with a lag, but
there are signs of plateauing. Resilience does not equal immunity, especially when it is derived from
unsustainable fiscal spending.

Positioning the Pieces 5

 8 Percent
Figure 1
US Resilience Aside, 6
Global Growth Is
Slowing 4

 World, Real GDP Growth 2

(WEO)
 World, Real GDP SSGA
Forecast 0
 Long-Term Average Growth
(3.5%) -2

-4
1970 1976 1982 1988 1994 2000 2006 2012 2018 2024

Source: Macrobond, International Monetary Fund, State Street Global Advisors Economics. Data as of October 23, 2023.
The above forecast is an estimate based on certain assumptions and analysis made by the State Street Global Advisors
Economics team and Oxford Economics. There is no guarantee that the estimates will be achieved.

25 Change YoY (%)

Figure 2
World Trade, Industrial 15
Production Struggling 20

10
 World, Industrial Production
excl. Construction, SA 5
 World, CPB World Trade 0
Monitor, Total, Volume, SA
5

-10

-15

-20
1994 1997 2000 2003 2006 2009 2012 2015 2018 2021 Aug
2023

Source: Macrobond, State Street Global Advisors, CPB, Economic Policy Uncertainty, S&P Global. Data as of
October 23, 2023.

Disinflation Endures Disinflation has been our highest conviction view over the past year and the incoming data bears
witness to it being fulfilled. Despite intense anxiety over stubborn inflation, disinflation actually
deepened and broadened over the course of 2023. Recent updates, for instance, have shown an
impressive retreat in eurozone inflation. In the United Kingdom, inflation levels that inched lower
a few months ago have declined more meaningfully. Disinflation will not run forever, but it is not
over yet. Supply chain normalization and moderating demand speak to further price moderation
in spite of the recent volatility in energy costs. There is a risk that a much larger spike could ensue
either because hostilities in the Middle East widen or due to sabotage or other unforeseen events.
In our view, unless oil prices stay above $110 for an extended period of time (i.e. three months or
more), the disinflationary forces already in motion should overwhelm their inflationary impulse.

Positioning the Pieces 6

 Remarkably, the disinflation over the past year has come without much visible damage to the
labor market. The outcome reflects the unusually strong starting point for labor markets across
most developed economies. What was a hope a year ago has turned into reality: Central banks,
in their rate-hiking anti-inflation fight, have managed to restrict increased job openings without
eradicating any jobs. That said, the ground becomes shakier from here. Job openings have
indeed been declining and the “margin of safety” is rapidly thinning. The time has now come for
central banks to end the tightening cycle and allow prior hikes to filter through the economy. In
the United States specifically, where the disinflation process is more advanced and where shelter
inflation is bound to meaningfully moderate in coming months, we believe the Federal Reserve
Board (Fed) should deliver not just the 50 basis points worth of 2024 rate cuts envisioned in the
September dot plot, but at least double that figure. Absent such a calibration lower, there is a high
likelihood that the soft landing morphs into something harder.

While we are confident about our assessment of the economic trajectory, making forecasts
about the future is always challenging. This is particularly the case when the geopolitical outlook
becomes more turbulent, with the recent spike in oil prices reflective of that. And as we face
2024, increasingly volatile geopolitical conditions will warrant investors’ attention.

Geopolitical Outlook: Coming into 2023, we held a relatively sanguine outlook in terms of geopolitics. We did not
Caution, 2024 Coming! anticipate large market impacts following the Russian invasion of Ukraine in 2022 and an
escalation in US-Chinese sanctions. Looking ahead into 2024, however, we consider that the
coming year is fraught with potential fracture points, particularly around territorial conflicts and
geopolitically critical elections. In total, we consider they pose enough risk to be more inflationary,
thereby derailing the disinflation trajectory and disrupting terms of trade for large economies. In
short, geopolitical events could deliver smaller stagflationary impulses.

Armed conflicts and violence are rising rapidly. Disturbingly, this trend also applies to the sheer
number of global conflicts, and they are becoming deadlier — Figure 3 confirms conflicts hovering
near all-time highs. The breakdown also shows the recent rise in internationalized intrastate
conflicts — i.e., how civil wars are increasingly fought as proxy wars, such as in Syria or Yemen.
This reflects an increasingly multipolar, unstable world, which suggests that interstate warfare is
easier to imagine than in the past. Harder to capture is that these conflicts have gradually moved
from the periphery toward the center of the global economy. Most notably, Russia’s war in Ukraine
delivered a global macroeconomic shock via the commodity supply channel.

60 No. of Conflicts
Figure 3
Global Armed Conflicts 50
Escalating (1946–2022)
40
 Intrastate (Internationalized)
 Intrastate (Non-Internationalized) 30
 Extra Systemic
 Interstate 20

10

0
1946 1961 1976 1991 2006 2022

Source: State Street Global Advisors Macro Policy; UCDP via Our World in Data as of September 21, 2023.

Positioning the Pieces 7

Geopolitical Fracturing Focusing on possible outbreaks of war underestimates the risks to energy markets. The
and Energy Markets geopolitical fracturing of the global system means that all large energy producers have oil
policy interwoven with other foreign policy objectives. In other words, there are more variables
factoring into oil prices than in the past, and therefore also more sources of risk premia. In
practice, this dynamic has made OPEC+1 supply less elastic than pre-2020. That US energy
production has also become more inelastic — even if for different reasons — suggests that
energy prices are asymmetrically tilted upwards.

The United States has ceased being a net consumer and has emerged as a net energy exporter.
This shift has flipped the historically modest negative correlation between the US dollar and oil
(see Figure 4). The US dollar and oil correlation makes it worse for all importers (and better for
exporters) as each boom/bust cycle is exacerbated. Relying on more recent data, the positive
correlation is even more pronounced. This relationship has geopolitical implications, as it further
increases the incentives for swing oil producers (namely key Gulf Cooperation Council (GCC)
states) to underpin tight supply. The US’s relationship with the Gulf states has had implications
in global oil supply. The marginal supply is in fewer places that are less likely to deliver it, thus
resulting in an asymmetric risk for prices to spike if demand holds up. Lower oil prices, therefore,
require more pronounced demand drops, particularly in the two largest consumer economies,
the US and China.

120 USD Real Effective Exchange Rate Index

Figure 4
Correlation Between 110
US Dollar and Oil Prices
(1986–2023) 100

 Jan 1986–Aug 2019 90

Observations
 Sep 2019–Jun 2023
Observations 80

70

60
0 20 40 60 80 100 120 140
Oil Price ($/bbl)

Source: State Street Corporation, Thiagarajan and Im, 2023.

A Riskier Horizon The United States and China are also the two main geopolitical poles where the 2023 détente
Ahead? could give way to more market-impactful tensions. The wars in Europe and the Middle East
show how much tighter the respective geopolitical blocs are operating, namely G7 unity on
extensive Russia sanctions, and Russia-China-Iran message coordination during the Israel-
Hamas war. Hence, global fracturing in any remote place now has a transmission mechanism to
global politics, in an echo of the Cold War. In this respect, we can identify several events on the
horizon that pose risks to the status quo and could provoke disruption. Firstly, the war in Ukraine
could engender the beginnings of a diplomatic process. While this holds promise for stabilizing
the conflict, it also carries risks for further friction. In particular, EU-China relations are highly
sensitive to Beijing’s role in any potential peace process.

Positioning the Pieces 8

 Secondly, the election calendar across the globe in 2024 is unfriendly. January’s presidential
election in Taiwan only carries downside risk. A variety of triggers could lead to deterioration
in the status quo (e.g., big shifts in Taiwanese public opinion, miscommunication by any new
administration, etc.). Taiwan’s centrality in the global economy as the dominant producer of
semiconductors means changes in perceptions of regional security alone could impact global
risk positioning in financial markets. And lastly, the US elections in November offer another
canvas for geopolitical turmoil. Highly polarized electorates like in the US mean that external
powers could have outsized influence on election outcomes. This can invite foreign policy
adventurism in the hope of tilting the election in one direction.

The above is a non-exhaustive list, but the financial expression should be higher average cross-
asset volatility over the coming year. In particular, the past summer lulls in foreign exchange (FX),
equity, and oil price volatility are not likely to return (see Figure 5). Meanwhile, bond volatility
trends lower on reduced inflation uncertainty and safe haven buying due to geopolitical concerns.

26.5 VIX Index OVX Index 60

Figure 5a
Comparative 24.5 55
Volatility Metrics* 50
22.5

 VIX (L.H.S.) 45
20.5
 VIX Average (10/1/2020– 40
10/1/2023) (L.H.S)
18.5
 OVX (R.H.S.) 35
16.5
30

14.5 25

12.5 20
Dec Feb Apr May Jul Aug Oct
2022 2023 2023 2023 2023 2023 2023

* Metrics: Chicago Board Options Exchanges’ CBOE Volatility Index (VIX), Crude Oil Volatility Index (OVX).
Source: Macrobond, as of October 19, 2023. Past performance is not a reliable indicator of future performance.

Figure 5b 225 MOVE Index

Bond Volatility in 2023

 MOVE 200
 MOVE Average
(10/1/2020–10/1/2023)

150

100

75
Dec Feb Apr May Jul Aug Oct
2022 2023 2023 2023 2023 2023 2023

Source: Macrobond, as of October 19, 2023. Past performance is not a reliable indicator of future performance. ICE BofAML
MOVE (Merrill Lynch Option Volatility Estimate) Index.

Positioning the Pieces 9

The Bottom Line Investors plotting a path through the coming year must do so amid sub-trend economic growth,
a volatile geopolitical backdrop, and worries about the ability of central banks to manage the
transition from a monetary policy built to bring down inflation to one that limits the recession
risks. Our base case is that central banks will move more quickly to lower policy rates than
markets are anticipating, particularly in the United States, but downside risks remain. The shifting
geopolitical landscape also warrants close monitoring given the uncertainty around international/
trade relations, the potential for violent conflicts to begin and/or escalate, and the ability of
elections to reshape political rhetoric.

Positioning the Pieces 10

Fixed Income
Bonds Take Center Stage

Matthew Nest, CFA As we look towards 2024 and the prospect of a significant slowdown in economic activity,
Global Head of Active we believe sovereign fixed income — and US Treasuries in particular — offers investors an
Fixed Income increasingly attractive proposition over the medium term. As with several other asset classes,
we expect recent choppiness to continue. The seemingly unrelenting strength of the US labor
Desmond Lawrence market and its implications for Federal Reserve Board (Fed) policy has been, and may well
Senior Investment Strategist continue to be, a source of angst. Meanwhile, favorable tailwinds are coalescing as the slowdown
and the anchor of long-term demographics start to take hold.

Sovereigns in Most major central banks have ratcheted up policy rates at the most aggressive pace in decades.
the Spotlight The transmission of such an aggressive policy response, however, is notoriously long and
variable in nature. We can therefore expect that the most recent rate hikes have yet to take their
toll on an economy already facing an inevitable slowdown. Concurrent with this is a disinflation
dynamic that still has a bit further to run. This policy-driven cycle favors an overweight duration
position in sovereign debt, as lower rates and a bullish steepening are ultimately priced in. We
believe that the US Treasury market offers the cleanest way of capturing this move in market
pricing. In addition to the cyclical element, the longer-term demographic trend is also supportive
of our bullishness on bonds. Muted labor force and productivity growth, as reflected in the US
experience in Figure 6, underscore the fundamental long-term value in real yields across major
sovereign debt markets.

6 Percent
Figure 6
US Structural 5
Trends Provide an
Anchor for Yields 4

 Productivity Growth 3
(10Y Annualized) 2.23

 Labor Force Growth

(10Y Annualized) 2 1.47
 US Trend Growth
1 0.76

0
1975 1981 1987 1993 1999 2005 2011 2017 2023

Source: State Street Global Advisors, Bloomberg Finance L.P. Data is quarterly from March 1975 to September 2023. Trend
Growth of 2.23% = Productivity Growth of 1.47% plus Labor Force Growth of 0.76% (both 10-year annualized).

Positioning the Pieces 11

 Outside the United States, this may play out slightly differently. For example, across the major
markets in Europe, core inflation remains high or has shown signs of being sticky; there is the
added headache of higher energy costs likely feeding through into headline inflation. A stronger
US dollar further compounds the issue. While the market may move to discount rate cuts sooner
than currently implied and perhaps more aggressively than central bank rhetoric might suggest,
there is still a risk that inflation becomes more entrenched and that eurozone and other European
sovereign debt investors remain on the sidelines until they can envisage a more decisive move in
the disinflation dynamic.

The other side of the aggressive monetary policy response is that European investors have a
compelling alternative if they remain cautious on duration in the near term. The dramatic rise in
short-dated bond yields suggests that the risk-reward profile (yield per year of duration) across
several European markets is at its most attractive level in a decade or more (see Figure 7).

4.0 Yield/Modified Duration

Figure 7
Short-Dated Bonds Still 3.5

Compelling 3.0

2.5
 1–3-yr Euro Government
Bonds 2.0
 Euro Government Bonds 1.5
 1–3-yr UK Gilts
1.0
 UK Gilts
 1–3-yr US Treasuries 0.5

 US Treasuries 0.0

-0.5
Oct Sep Sep Sep Sep Oct
2003 2007 2011 2015 2019 2023

Source: Bloomberg Finance L.P. Data as of September 30, 2023. Past performance is not a reliable indicator of future
performance.

Credit Waits in Although investment grade corporate credit has benefited from relatively solid fundamentals,
the Wings we expect them to soften in the coming quarters as revenue growth fades in a slowing economy
and margin pressures challenge bottom-line growth. Against that background, spreads — slightly
below the average level seen over the past 20 years — do not look inviting. A further point of
caution arises in relation to the declining quality of the overall investment universe in US dollar,
sterling, and euro corporate credit. A selective approach is persuasive, but at current spread
levels, we feel investors can afford to wait for better entry levels.

Absolute yields (broad benchmark level) for sub-investment-grade debt have risen substantially
in recent quarters in line with the trend across debt markets in general. This pattern is not an
immediate problem given the modest near-term refinancing needs, but it does raise the specter
of borrowers having to issue debt at significantly higher coupons if yields are still elevated at the
point of refinancing. Euro-denominated debt, in particular, faces substantial refinancing needs
two to three years out. Consequently, the longer yields stay at these relatively high levels, the
greater the risk of meaningfully higher refinancing costs for issuers.

Positioning the Pieces 12

 Similar to its investment grade counterpart, high yield debt has been trading at relatively
compressed spreads. Default rates are currently quite modest but can only rise as our predicted
slowdown bites in 2024. In that environment, we anticipate a rise in distress ratios and in average
index-level spreads. Consequently, we do not consider high yield debt a compelling proposition
at current spreads.

Emerging Market Debt Against a backdrop of heightened volatility and uncertainty, hard currency emerging market
Commands Attention sovereign debt currently looks attractive in light of the spreads on offer. With spreads in the high
yield subsegment trading well above their long-term average, markets have already priced in
most credit events (see Figure 8). Credit quality has shifted as the credit rating composition of
indexes has changed. In high yield, the proportion of the lowest-rated credits has increased as
countries have defaulted, restructured their debt, and been downgraded. In investment grade,
in contrast, the proportion of the highest-rated credits has grown largely due to the addition of
highly-rated Gulf countries that have been large issuers of debt, resulting in a quality upgrade.
Moreover, in the absence of a US recession, spreads have the potential to tighten further. There is
also additional upside possible from a rally in Treasuries when the data does turn and the market
starts to price in a dovish Fed pivot.

1,400 Basis Points

Figure 8
Priced In: High Yield 1,200
Emerging Market
Debt Drives Sovereign 1,000

Spread Widening
800

 EMBIGD Spread 600

 EMBIGD IG Spread
400
 EMBIGD HY Spread

200

0
2006 2008 2010 2012 2014 2016 2018 2020 2022 Oct
2023

Source: State Street Global Advisors, Bloomberg Finance L.P., J.P. Morgan as of September 29, 2023. Past performance is
not a reliable indicator of future performance. EMBIGD = Emerging Market Bond Index Global Diversified.

On the other hand, the picture for emerging market local currency debt (EMD LC) has become a
lot more complex. Firstly, emerging market monetary policy has decoupled from the Fed, so the
differential between the yield on EMD LC and US Treasuries is around the lowest it has been in
15 years. Next, the strong US dollar is clouding the short-term outlook — not only because of its
direct impact on emerging market currency returns, but also indirectly because of its impact on
emerging market inflation. However, real yields have now turned positive for some of the largest
constituents in the broader EMD LC Index,2 and even though this is still below US Treasuries, it
offers a pick-up versus the euro area.

Positioning the Pieces 13

The Bottom Line As the impressive resilience of the US economy fades in 2024, we believe that sovereign fixed
income offers investors a rewarding prospect. The US Treasury market is probably best placed
to capture this opportunity. The short end of several sovereign debt markets also presents a
compelling yield-duration profile for those investors unwilling to embrace duration more fully. A
slowing economy and advancing credit cycle will present challenges to corporate income and
balance sheets. Therefore, we expect that there will be more rewarding entry levels for credit
investors in the coming quarters. There are attractive spread opportunities in hard currency
emerging market debt, assuming a hard landing is avoided. The picture for local currency emerging
market debt is more nuanced but still offers attractive pick-up potential for eurozone investors.

Positioning the Pieces 14

Equity
Caution Warranted in
Equities: Be Selective

Altaf Kassam, CFA Against a backdrop of tightening monetary policy, stubborn inflation, and mixed economic
EMEA Head of Investment data, equity markets fared better through much of 2023 than had been anticipated. However, a
Strategy & Research continuation of that advance might be more challenging to achieve in 2024.

Dane Smith Given the diminished equity risk premium and the high bond yields that have resulted from the
Head of North gradual removal of liquidity, investors are under less pressure to reach for “riskier” returns that
American Investment had until recently been considered necessary to meet portfolio objectives.
Strategy & Research

Clouding Equity From a big picture perspective, the consumer will be less of a growth driver as excess savings and
Prospects financial stimulus fade and households feel the strain of high interest rates. In the US, for example,
auto and housing have held up well but the more acute pain is likely ahead — the symptoms
are already there. US household interest payments as a percentage of interest income are the
highest since 1959; credit card delinquency rates at small US banks are the highest since 1992;
and personal savings are in decline. And this deterioration is occurring with an unemployment
rate close to 50-year lows.

A more cautious and price-conscious consumer has implications for corporate earnings.
Impacted sales revenue puts further pressure on equities as profit margins shrink. Discretionary
goods and services that are aligned with more cyclical market segments appear at risk — we have
recently seen substantial downward revisions to 2024 earnings growth estimates.

Think Quality Companies with more resilient earnings streams and stronger balance sheets are better
positioned to withstand the pressures of still-tight monetary policy, rising debt, and a
deterioration of consumer spending. In short, we favor Quality stocks, namely those assets
which display these compelling characteristics.

The Quality style allows participation in upside growth, while also offering downside protection.
The general definition of Quality is consistency of earnings, elevated profitability, and low debt
levels — all easily quantifiable metrics. But there are qualitative considerations too, such as the
trustworthiness of the management team, company culture, brand strength, competitive moat,
strength of a business model, and catalysts that may unlock value or disrupt an incumbent.

Positioning the Pieces 15

 14 % Annualized Excess Return
Figure 9
12
Quality Generates
10
Excess Price Returns*
8

 MSCI World Quality 6

5 Year Excess Returns
vs. MSCI World Index 4
2
0
-2
-4
-6
1993 1998 2003 2008 2013 2018 2023

*Quality as represented by MSCI World Quality Index. Price returns shown on a five-year rolling basis.
Source: State Street Global Advisors, MSCI. Data as of September 29, 2023. Past performance is not a reliable indicator of
future performance. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in
an index.

US Large Caps The US Large Cap segment contains an outsized portion of sectors and companies that exhibit
Quality characteristics. In the US, many of the companies that exhibit Quality characteristics
were heavily “re-priced” in 2022–2023 in response to aggressive interest rate hikes. Owning
Quality in 2024 should come with a caveat though, given the potential for renewed market
volatility: Be selective. To avoid the more severe drawdowns, investors should consider avoiding
the cheap cyclical end of the market (for now at least), while also steering clear of those narrower
pockets where valuations have become stretched.

By sector, information technology, industrials, and materials are major beneficiaries of

recent US legislation that provides large fiscal incentives for clean technologies and new
infrastructure investment (e.g. Inflation Reduction Act, Bipartisan Infrastructure Law, and
CHIPS Act). International companies with US operations as well as US companies are also
eligible for these incentives.

European Stocks Monetary policy tightening has impacted the broader European economy quicker than in the
Less Compelling US due to a comparatively less supportive fiscal backdrop. Even so, the European Central Bank
(ECB) appears less likely to cut rates in 2024 in the same manner we expect from the Fed. The
ECB’s apparent preference is to let current rates work through the system. However, the threat
of recession is rising — something the European Commission’s latest forecasts acknowledged.
It noted that “high and still increasing consumer prices for most goods and services are taking a
heavier toll than expected.” The provision of bank credit has slowed and the Commission sees
“continued weakness in industry and fading momentum in services.”3

Although the eurozone household savings rate is still relatively strong, deterioration is evident
in other areas, including domestic fixed investment. As consumers adjust spending habits,
company earnings will inevitably be impacted. While profit margins have been sustained at high
levels, MSCI Europe margins have typically been correlated to inflation — lower margins have
often followed a peak in inflation (see Figure 10).

Positioning the Pieces 16

 12 Percent Percent 16
Figure 10
Margins Correlated 10 14
With Inflation
8
12
 Eurozone — Harmonized
CPI, All-items HICP (YoY%) 6
(L.H.S.) 10
 MSCI Europe (SR) (EUR) — 4
Operating Margin — LTM 8
(R.H.S.) 2

0 6

-2 4
1998 2003 2008 2013 2018 2023

FactSet. Data as of October 13, 2023. *HICP refers to the Harmonized Index of Consumer Prices and is a measure of inflation
in the eurozone and the European Union.

Japan’s Continued The pick-up in Japanese inflation has given companies who have struggled to lift prices an
Momentum? opportunity to now do so, potentially boosting revenue and earnings. With the “shunto”
negotiations in 2024 expected to deliver higher wages (a key factor for inflation), consumers
may be encouraged to spend. Alongside government spending and export growth hopes, the
case for Japanese equities has improved.

Another potential driver of growth is the Tokyo Stock Exchange’s call for companies to improve
corporate governance and capital efficiency, or face delisting. This could help to create higher-
quality, more profitable companies and help push the market towards more sustainable growth.
The benefits from this campaign have been evident in increased share buyback announcements.

Higher risk appetite amid rising Japanese yields could also support inflows into the stock
market, while corporations, which sit on a large amount of cash, could look to reinvest in growth
opportunities in order to keep pace with inflation.

Challenges Persist for Emerging market equities tend to outperform in “best case” environments of stable-to-rising
Emerging Market and global growth and global trade, adequate or abundant global liquidity (stable-to-declining
US/global yields and inflation, stable-to-declining US dollar), and stable commodity prices.
China Equities
A soft landing for the US and developed markets may erase “worst case” fears, though it will
not guarantee the best-case scenario either.

China’s equity market is likely bottoming, setting up a potential near-term recovery. Meanwhile,
policymakers seem to be taking time to create a stimulus plan that protects the economy without
exacerbating structural problems. The longer-term growth outlook remains clouded by a heavy
debt burden, limited fiscal policy space, property market overhang, worsening demographics and
heightened geopolitical tensions. Real GDP growth is expected to slow from near 5% in 2023 to
3% over the next few years.

Positioning the Pieces 17

The Bottom Line Tight monetary policy and slower economic growth dampen the outlook for equities in 2024.
Amid heightened volatility, we favor selectively owning aspects of the market that exhibit
characteristics of Quality investing. The US market is preferred due to its sector composition
and the competitive advantage of its companies. For various structural reasons, we believe
Japan should maintain its momentum of positive performance into the new year. However,
investors looking for outperformance from Europe, broad emerging markets, and China will face
headwinds due to the cyclical nature of their economies and deteriorating economic conditions.

Positioning the Pieces 18

Special Topic

Emerging Markets: Emerging markets remain vulnerable

given the global backdrop, yet pockets
A Nuanced of opportunity exist, particularly in hard
Approach Matters currency debt and select emerging
market equities.
Emerging
Markets Emerging Markets:
A Nuanced
Approach Matters
Chris Carpentier, CFA, FRM The optimism surrounding emerging market assets diminished as 2023 progressed. Part of
Investment Strategist the initial enthusiasm was built on expectations of a reenergized China economy as it emerged
from its zero-COVID policy, a weaker US dollar, and lower expected terminal rates. When this
Lyubka Dushanova scenario did not materialize as envisioned, returns stumbled. As US yields hit new multi-year
Portfolio Strategist — highs, the dollar restrengthened and China’s recovery disappointed, investors’ appetite for
Emerging Market Debt emerging markets assets diminished, with equity and bond performance both impacted, albeit
to varying degrees.

The tendency to view emerging markets (EM) as a singular bloc is misguided given the numerous
idiosyncrasies among the countries that populate the EM universe. While there are undoubtedly
shared risks across the EM spectrum, such as the countries’ sensitivity to continued heightened
geopolitical risks along with broad risk-taking appetite, it is important for investors to recognize
where the variations lie. Key differences among countries include whether an emerging market
country is an energy exporter or an energy importer, and whether the country is a manufacturing-
based economy or a services-based economy. These important distinctions between nations
highlight the heterogeneity of the grouping. Moreover, within the different indexes — namely
MSCI Emerging Markets Index for equities and emerging market debt indexes for both hard
and local currency — there are divergent performance drivers, making it difficult to have one
conversation to represent them all. For example, Chinese equities account for about 30% of the
benchmark emerging markets equity index, while weighing 4.7% of the EM hard currency debt
index and 10% of the local currency market. The arguments for investing in Chinese equities or
bonds can be quite different.

Emerging Market From an investment case perspective, we are generally cautious about emerging markets. While
Equity vs. Debt we do not see much value in emerging market equities in aggregate, there are still opportunities.
A higher-for-longer interest rate environment has been priced into emerging market equities. As
a result, we have witnessed EM risk assets underperform, EM currencies sell off, and earnings
expectations come down. Overall, we have a relatively more favorable outlook on emerging
market bonds, with an emphasis on hard currency debt. We are now in a familiar place where
a data-driven Fed has become again the dominant driver of EM debt returns. Hard currency
sovereign debt looks attractive as EM spreads still offer value and, in the absence of a US
recession, have the potential to tighten further.

Positioning the Pieces 20

Emerging Market Despite China’s continued challenges, we believe a relative opportunity exists. Active managers
Equity Outlook can focus their efforts on structural growth areas of the economy that have a government policy
tailwind — such as technology independence, electrification, and other “new economy” areas.
We also believe separating China from the rest of an emerging markets allocation warrants
consideration, given the country’s high weighting of roughly 30% in the benchmark emerging
markets index, low correlations, and global importance. Beyond its sizable concentration,
slippage in China’s performance often leads to headwinds for other emerging markets,
multiplying China’s impact on EM index performance. For example, weakness in the technology
cycle impacted EM manufacturing, while softer demand for international goods led to lower
orders for EM countries to fill. However, the opposite is also true when the Chinese economy
is performing strongly. A stand-alone China exposure allows investors the ability to dial their
overall China allocation up or down as necessary. Figure 11 illustrates the diverging performance
of China from the EM ex-China universe. Such an approach also adds flexibility around the type
of exposures an investor may choose, whether it is the index/active split, investment styles,
thematic, or small-cap tilts.

75 Percent
Figure 11
Isolating the China 49.18
Return Differential 50

 Rolling 1 Year Return 25

Difference — MSCI China vs.
MSCI EM ex-China
0

-25

-46.29
-50
2014 2015 2016 2017 2018 2019 2020 2021 2023

Source: State Street Global Advisors, MSCI, FactSet. Data as of September 29, 2023. Rolling 1 Year Return Difference —
MSCI China vs. MSCI EM ex-China. Past performance is not a reliable indicator of future performance. Performance of an
index is not illustrative of any particular investment. It is not possible to invest directly in an index.

Outside of China, emerging markets tend to be heavy on cyclical companies and industries,
making them especially sensitive to global economic activity. We expect sub-trend growth for
the global economy in 2024, creating a headwind for emerging markets’ prospects. Outside of
China, allocators also need to be aware that concentration risks remain within the emerging
market universe. India, South Korea, and Taiwan make up over 60% of the EM ex-China index.
Furthermore, both Taiwan and South Korea have a single security that accounts for more than
30% of the countries’ respective index weight.

India’s ascent presents an interesting opportunity. With a young and growing population
along with healthy economic growth (see Figure 12), the country has appealing investment
characteristics. Its sector composition is well diversified and not reliant on any one particular
industry; between them, financials, technology and energy sectors make up about half of the
benchmark India equity index.

Positioning the Pieces 21

 7 Percent
Figure 12
India: Real GDP Growth 6
Advantage
5

 India-China
4
India-United States
3

0
2021 2023 2025 2027 2029 2031 2033 2035 2037 2040

Source: Macrobond, State Street Global Advisors, Oxford Economics. Data as of October 17, 2023. The above forecast is
an estimate based on certain assumptions and analysis made by the State Street Global Advisors Economics team, Oxford
Economics. There is no guarantee that the estimates will be achieved

Emerging Market Debt To understand the outlook for emerging market debt, it is important to distinguish between local
Outlook and hard currency and to understand the key performance drivers of each. Local currency debt
performance is driven by emerging market rates and currencies, while hard currency debt returns
are driven by US Treasury and emerging market spreads. The resilience of the US economy
has seen markets adjust their expectations, with the resulting sell-off in US Treasuries and
strengthening in the US dollar having a negative impact on both hard currency and local currency
debt performance and reversing gains achieved earlier in the year.

Hard Currency Debt Given an evolving backdrop of heightened volatility and uncertainty, hard currency sovereign
debt looks relatively more attractive because emerging market spreads, particularly high yield
spreads, still offer value and, in the absence of a US recession, could tighten further (see Figure
13). The geopolitical landscape has become more unstable, but if the Israel-Hamas war does not
develop into a broader regional conflict, the spread widening that it brought about, which remains
limited, could represent a good entry opportunity into the asset class. A concern about hard
currency debt is that it can be expensive in a climate where the US dollar is strengthening. If the
US dollar weakens, then a more supportive environment would be found for hard currency debt.
Moreover, while US Treasury volatility presents a short-term risk to the asset class, a potential
rally in Treasuries once the US economy does turn presents added upside potential for hard
currency debt.

Positioning the Pieces 22

Figure 13
Emerging Market 589
EMBIG HY Sub-Index
Spreads Offer Value, 788
Particularly in High Yield
207
 15Y Average Spread EMBIG IG Sub-Index
 Current Spread 132
(September 29, 2023)

370
EMBIG Spread
430

0 100 200 300 400 500 600 700 800

Source: State Street Global Advisors, J.P. Morgan, Bloomberg. Data as of September 29, 2023.

Local Currency Debt After outperforming through the first half of 2023, the outlook for local currency debt has
become more complex. It is noteworthy, and unusual, that emerging market monetary policy has
decoupled from the Fed in recent years. Emerging market central banks had responded quicker
to inflation than developed peers in raising rates, and since emerging market inflation peaked
late in 2022, the banks have been primed to start cutting rates earlier than their developed
counterparts (see Figure 14). However, the outlook for emerging market inflation is clouded by
a spike in oil prices and a stronger US dollar, which could drive inflation by way of the foreign
exchange channel. Therefore, in addition to the negative impact that a strong US dollar has on
emerging market currencies, a key question to consider for local currency debt is: How long can
emerging market central banks diverge from the Fed?

Figure 14 10 Percent Percent 8

Emerging Market 9 7.42 7
Inflation* vs. Average 8
Emerging Market 7
6
Policy Rate 5.68 5
6

 EM Inflation (L.H.S.) 5 4

 Average EM Policy Rate 4 3

(R.H.S.)
3
2
2
1 1

0 0
Jan Dec Nov Oct Sep Aug Aug
2018 2018 2019 2020 2021 2022 2023

*EM inflation = weighted average inflation of countries in the JPM GBI-EM Global Diversified Index. Average Policy Rate =
weighted average policy rate of countries in the JPM GBI-EM Global Diversified Index. Source: State Street Global Advisors,
J.P. Morgan, Bloomberg. Data as of August 31, 2023.

Positioning the Pieces 23

 An important recent development in the local currency space was the decision to include India in
the flagship JPM GBI-EM Global Diversified Index from the second half of 2024, which will enable
it to reach the index weighting cap of 10% once it is fully phased in. India’s inclusion brings much-
needed diversification to the local currency index, while also allowing investors to participate in
the growth potential of this large, investment-grade-rated country.

The Bottom Line Even though emerging markets are affected by broader market volatility, we believe that there
are still opportunities across this broad investment universe, notably in emerging market debt.
Within equities, an active approach that focuses on structurally growing parts of the market is
preferred. Overall, both emerging market debt and equities offer exposure to countries with
superior economic growth and lower leverage compared to developed market economies,
delivering diversification benefits as part of broader portfolios.

Endnotes 1 OPEC+ refers to the Organization of the Petroleum 3 https://ec.europa.eu/commission/presscorner/detail/en/

Exporting Countries plus 10 non-members (including ip_23_4408.
Russia).

2 J.P. Morgan Global Bond Index Emerging Market Global

Diversified (GBI-EM GD).

Positioning the Pieces 24

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Positioning the Pieces 25