Market report September 2020
I decided to start my September report by taking a closer look at emerging markets (EM) – the characteristics, the current situation and the related investment opportunities.
Emerging Markets and Quantitative Easing Programs
The pandemic led to a panic among investors in March 2020. Emerging markets saw an unprecedented outflow of net capital (-$ 84 billion excluding China), which in turn caused dramatic jumps in government bond yields. Against this backdrop, 16 Emerging Markets central banks announced their willingness to engage in the purchase of government bonds if needed. Thirteen of them started the process of quantitative easing (QE) instead of cutting interest rates, most of them above the effective floor. As a result of these bond purchase programs, long-term government bond yields in the surveyed sample of emerging markets fell by an average of -48 bp until the end of April compared to the end of March (against an average increase of + 69 bp between the end of March and the end of 2019).
Chart: Point based index changes due to monetary impulses*, EM Markets
Source: National Statistics, RCieSolution Research
* Monetary impulse indicators are constructed as the second derivative of the 1-year change in money supply M2, as a share in nominal GDP. They are similar to credit impulse indicators, but analyzing changes in the M2 money supply facilitates comparisons between economies.
At this point, it is worth mentioning some important issues:
- The lack of a clear framework for the size and duration of ongoing and planned emerging market ‘QE’ programs may raise concerns – while central banks of 16 emerging markets analyzed have set reasonable targets (mainly ensuring liquidity and the smooth functioning of domestic government bond markets) for their programs of bond purchases, most have not announced the maximum amount they intend to buy or the final timeframe for their programs. Consequently, there is a risk that the QE programs will not be reduced after the targets are permanently achieved.
- Analyzes show that Brazil, Costa Rica, India, Colombia and Croatia carry the highest debt risk – Brazil ranks last in our assessment of debt sustainability risk due to very high public and government debt at the central bank. At the same time, the low level of government effectiveness indicates that fiscal reforms are unlikely to improve the situation. Costa Rica ranks second after Brazil for risk, due to a heavy interest burden and the highest increase in the bond spread since the start of the year (+ 357bps). However, purchases of Costa Rica bonds, as well as Colombia and India, have so far been relatively modest.
- Notwithstanding the short-term benefits, these “quantitative easing” programs in emerging markets, if used intensively, can cause serious problems in the medium to long term, such as inflation overshoots and debt service problems. Systematic long-term purchases of bonds by the central bank could open the door to debt monetization and jeopardize the credibility of monetary policy (if measures similar to quantitative easing go far beyond accommodative monetary policy, there will be a risk that expansionary fiscal policy will be financed by money printing. From the history of emerging markets we know that many emerging market central banks financed government spending up to the turn of the century, mostly with severe consequences such as hyperinflation and sovereign debt default).
- Debt sustainability and inflation are interrelated as debt monetization increases the burden on public debt and increases the risk of inflation. Looking at the combined risks, our analysis identifies Turkey, Hungary, Romania, and India as the riskiest emerging countries to have implemented QE-style programs in the wake of the pandemic and the Covid-19 crisis.
Chart: Assessment of debt stability and EM inflation risk
Source: National Statistics, IMF, Bloomberg, IHS Markit
The COVID-19 pandemic caused huge dislocations in the global economy in a very short time. The wave of political support released in response stabilized activity, but also affected the already sizable debt overhang. Governments now face tough choices. Public sector indebtedness in advanced economies was at record highs before the pandemic. The huge amounts of fiscal spending we have seen so far can increase it by as much as 20% or more of Gross Domestic Product (GDP) in many countries.
Chart: Public debt in global terms, G7, as a percentage of GDP
Historical analysis does not guarantee future results. Until June 30, 2020
Source: Haver Analytics. International Monetary Fund (IMF), Jordi-Schulanck-Taylor Macrohistory Database
Some argue that rising government debt is simply a natural byproduct of global stagnation. Consequently, if the private sector does not maintain the required level of spending – the COVID19 situation is likely to worsen – the government must spend money to avoid depression. Others, more in line with my view, believe that the debt-based economic model of the last few decades has stopped working and that the world is trapped in a debt trap. Currently, the readiness for fiscal adjustment is very low. If you look at the current economic situation as an inflationary environment of ultra-low interest rates devoid of sustained economic growth, in the context of current populism and deglobalizing tendencies, the most likely combination of a policy of financial repression (in which the government will try to pay off public debt using private sector money – savings, at the expense of growth) and inflation.
FED – average inflation target
It is also worth noting the recent shift of the FED towards the average inflation target and the expected next step towards a credible commitment to raise inflation expectations. In the United States, this could spell the end of the FED’s inflation-oriented regime.
At the last meeting of the FED ahead of the US presidential election on September 16, the US Federal Reserve reaffirmed our expectations that it would keep interest rates at 0% until 2023 and inflation to be above 2% for an extended period of time. In particular, the statement by the FED read:
“The Committee aims to achieve maximum employment and inflation of 2% in the long term. With inflation remaining below this long-term target, the Committee will aim for inflation moderately above 2% over a period of time, so that inflation remains on average at 2% and long-term inflation expectations remain firmly anchored at 2%. The Committee expects the accommodative monetary policy stance to be maintained until these results are achieved. The Committee has decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it to be appropriate to maintain this target range until labor market conditions reach levels in line with the Committee’s estimates for maximum employment and inflation rises to 2 percent, being on track to slightly exceed the 2 percent level for a period of time ”.
The modified version of the FED’s reaction function indicates a rate hike only in the third or fourth quarter of 2023. The new Taylor rule for the Fed gives the economy two years respite until the first rate hike by the Fed. Adopting an average inflation target will keep official interest rates at a lower level for longer.
Where are the rising prices in global stock markets coming from?
Central banks have taken unprecedented measures to provide liquidity to the financial system over the past six months. Since developed markets began the economy’s lock-down process to control the virus pandemic, central banks have lowered interest rates to historically low levels and introduced quantitative mitigation measures, such as using their balance sheets to buy corporate and government debt. We have never seen anything like this, even at the height of the global financial crisis.
Chart: Powerful monetary stimulus as a stimulus for markets, G4 – bond purchase program
Historical analysis does not guarantee future results. Based on the latest available central bank data as of June 30, 2020
Source: Haver Analytics, RCieSolution Research
The key question is how this whole enormous stimulus was used. Not in capital investments, except for some beneficiaries like Amazon and government healthcare spending. Instead, much went into increased savings, some of which went on the stock markets.
In late August, the world’s central bankers decided to keep interest rates “low for an extended period”. In particular, the FED has moved to an average inflation target of 2%. This means that instead of raising interest rates when inflation hits the current 2% target, the FED will allow a period of inflation above 2% to rise to an average of 2%. And since inflation has been below the 2% threshold for some time, the rate of inflation may remain above 2% for several years before any rate hike is likely.
Typically, as inflation rises, bond yields rise to reflect Investors’ expectations of a higher return to mitigate inflation risk. However, in the current environment, I expect central banks to use their balance sheets to keep the yields on longer-maturity bonds down, which will lower the yield curve. In an environment of easy money, substantial financial incentives and yield curve management, we believe it is rational to continue to favor stocks that offer greater return potential. Moreover, low interest rates lower the discount rates that equity investors use to price their stock, which raises the valuation of the stock.
Global stock markets
The table shows rates of return in Pounds Sterling (GBP), Local Currency (Loc.) And Relative Currency (Rel.) As of 29/09/2020.
Source: RCieSolution Research
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The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.