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Investment Insights

Suyash Choudhary

Introduction

 

Over the past month the central bank ‘put’ is firmly back in play, triggering a global rally in risk assets. Thus Fed rate hike expectations have been broadly pushed into the new year, with some even beginning to speculate about incremental easing rather than tightening. The European Central Bank (ECB) has fuelled expectations of additional easing over and above the current program by committing to a relook in December at its existing policy accomodation. Speculation has started that ECB may cut deposit rates further into negative territory and / or make the asset purchase program more explicitly open ended. China has cut deposit, lending and cash reserve rates again after its first sub 7% quarterly GDP reading since 2009. And speculation is strong that the Bank of Japan (BoJ) may add to its own asset buying program sooner rather than later with the Japanese economy flirting with a technical recession.

 

What has to stand out here is that seven years into an unprecedented global monetary policy response led by the Fed, growth and inflation still need more support. Meanwhile the super-conducive global financial conditions of falling rates, rising equity prices, and depreciating developed market (DM) currencies  helped sustain a massive leverage cycle in emerging markets (EMs). The premise always was that either continued easy policy would sustain ad –infinitum (nauseam?) or it would generate growth and inflation that would make future servicing of this debt effortless. As it turned out, both premises have faltered: Although aggregate central bank easing indeed seems to be ad – infinitum, the expected divergence in policy path of the US versus other majors has created massive cross currency volatilities and capital reallocations, which has severely dented debt servicing capabilities (for more on this please refer our note “On Global Macro-Dynamics: The Pressure Valve”, dated 5th October). More fundamentally, the lack of growth and inflation is a serious impediment to sustenance of this leverage cycle as debt servicing ultimately needs revenue growth whether one is a company or a country. An added dimension of this unprecedented easing has been the hit to savers in terms of interest income foregone and the added concern with companies in terms of servicing future pension liabilities.

 

Financial Conditions: Staying Still Is No Longer Enough

 

An additional concern is how major central banks engaged in competitive easing are losing control over their local financial conditions. For the sake of simplicity one can assume that interest rates (including term spreads and corporate spreads), equity prices, and exchange rate are the three pillars that largely determine local financial conditions. Thus financial conditions for a local economy tighten or loosen depending upon directional changes in these variables.  It is also true that incremental changes to these conditions are mostly happening via the exchange rate route. This is because rates are mostly already towards the zero bound (of course central bankers can influence term and credit spreads via expanding their asset purchases but incremental benefits in this regard are not as strong) while equity prices are not directly controllable by central banks. What remains hence is relative currency depreciation via balance sheet expansion; though no central bank will explicitly mention an intent to move its currency even though the drag to growth and inflation from a stronger currency may still be acknowledged. In a world where the global ‘stock of growth’ is no longer rising and productivity expansions are harder to come by, a rough and ready way to allocate someone else’s growth to yourself is to simply price your goods and services cheaper via a cheaper currency. And hopefully, rising import costs (which also come with a weaker currency) will help lift inflation a little and , again hopefully, maybe even inflation expectations over a period of time. It is another matter that the evidence on this so far is that such boosts are at best of a temporary nature.

 

Looked at from this lens of financial conditions, the dilemma faced by the world’s major central bankers is readily visible. The US Fed has basically been standing still for some time, in that it has stopped incrementally expanding its balance sheet via additional asset purchases, stopped cutting rates, and is now looking  to administer modest hikes in its policy rate which will still keep overall monetary policy quite loose. This would make sense ceteris paribus, or keeping all other things unchanged. But the truth of the matter is that all other things are not unchanged. In the time that the Fed has been standing still, ECB and BoJ have embarked upon additional easing. This has caused relative strengthening of the dollar over the past couple of years. Of course the trend has been helped along by some global capital allocations returning to dollars purely because the Fed has stopped the incremental printing press. No doubt the emerging market stress exposed in a commodity downturn has also helped this phenomenon. But the point here is that even as the Fed has stood still and done nothing to incrementally change financial conditions in the US, US financial conditions have nevertheless tightened. For all its ‘bazooka’, for the past six months or so the ECB seems to be running to just stand still if the movement in the euro is any indication. In fact the progression in this ‘musical chairs easing’ (not our words) seems to be thus: Local financial conditions ease on the back of incremental central bank easing led by currency weakening, thereby allowing ‘snatch back’ of some growth and inflation. This very economic data then leads to relative currency appreciation and rise in bond yields  (and hence tightening of financial conditions) which leads the central bank to start all over. The most dominant example of this is potentially the Fed, which started the earliest and in the most aggressive fashion down the path of monetary easing. In contrast the ECB and the BoJ were much more tentative at first, with the former even hiking rates before having to go back on that. So through the first phase of the last seven years post the global financial crisis, the US led global policy easing in an unequivocal fashion. Therefore, it got its rewards earlier as well in terms of growth stabilization. On the back of this relative stabilization, markets started pricing the dollar and US yields higher relative to other major markets. This has caused a progressive tightening of US financial conditions over the past couple of years or so. Arguably, this tightening is now beginning to show in US economic data thereby prompting the Fed to push against this tightening by delaying rate hike expectations. The problem, of course, is that if the ECB and BoJ may ease policy further in the next few months, then relative financial conditions in the US may continue to be tighter unless the Fed does something more explicit. Alternatively, the expectation unwind may be enough to start sending the dollar lower which in turn may eventually invite more aggressive easing by the other two central banks.

 

Conclusion

 

The game of musical chairs of DM policy easing, aptly described so by our own RBI Governor, is unlikely to add to the net ‘stock of global growth’. This is because any stability to near term growth and inflation prospects is being achieved via influencing relative financial condition; which broadly only redistributes the existing stock of growth. Whereas, the underlying problem seems to be more of capital misallocation over a long seven to ten year cycle. Throwing more capital at the same ‘old economy’ is progressively reducing the incremental efficiency of capital with the result that more number of units of capital are now going in to produce one unit of growth. Furthermore, while asset owners have been benefited by quantitative easing, income earners have been hit; and quite severely. This is one probable reason why the consumption stimulus expected courtesy lower oil prices hasn’t been fully forthcoming.

 

The other problem, which tells also to the difficulty that the Fed faces in actually starting to raise rates, is that one’s local financial conditions are not being determined only by local monetary policy but by that being followed by others. So if one were to imagine a central bank as having a ‘financial conditions target’ consisted with its assessment of local growth and inflation prospects, these conditions are continually changing basis what other central banks are doing. EM issues get periodically thrown into the mix via external account, commodity dependencies, or political uncertainties. This further changes financial conditions, thus keeping DM central banks on a perpetual monetary treadmill. And so long as this continues, we are probably only continuing to extend this already long cycle of global capital misallocation.

 

 

Disclaimer:

 

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.

 

The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

 

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Suyash Choudhary

In our view, one of the most instructive ways to look at the global macro dynamic today is via the phenomenon of off shore debt, chiefly private sector, built up across emerging markets over the past few years. This has no doubt been helped along by the era of very cheap and abundant money and predictable developed market central bank policy over much of the past seven years. The build-up has been quite significant whether looked at in value terms or in terms of percentage of GDP. As a consequence, the potential for negative effects is also correspondingly quite high should parts of this leverage build up cycle start to unravel in a less than optimal fashion.
 
The incentive for this build up has been largely two-fold:
 
1. Interest rate differential widening between developed markets (DM) and emerging markets (EM) as a result of the super aggressive monetary policy from DM central banks, initially chiefly the US Fed but followed later by ECB and BoJ.
 
2. Relative depreciation / stability of the dollar versus many EM currencies, again potentially as a direct result of the Fed balance sheet expansion program. This further incentivized off shore leverage build up by EM private sector since the future cost of debt repayment was perceived to be even lower.
 
It must be noted that both the above ‘gains’ to borrowing abroad existed only if such borrowings were made on an un-hedged basis. What is also of relevance is that a significant part of this build up went into financing the commodity sector; which was the ongoing boom at the time. If this was true then it further enhanced the feeling of good times since not only were offshore borrowing costs low and prospects were strong that ultimate repayment value will be even lesser, but the commodity boom ensured that top lines and hence debt service capabilities were only looking stronger and stronger.
 
It can be argued that the directional trends sustaining this build up starting reversing as far back as 2011. This was marked by the following important trends:
 
1. An index of global EM currencies peaked.
 
2. An index of global commodities peaked.
 
Interestingly, Chinese producer price inflation also started rolling over in that year. Since mid – 2014 the above two trends have gathered much more steam. Combined with new growth worries this year largely on the back of a further downturn in global trade, the concerns with respect to this leverage build up have steadily been going up. The trend reversal is indeed alarming since all three feel good factors referred to earlier have started to reverse. Namely,
 
1. As credit spreads have spiked and DM rates become more volatile, the cost of borrowing for EM private sector has been going up.
 
2. With the dollar reversing trend and appreciating versus EM currencies, in many cases spectacularly so, the amount of future repayment due is going up.
 
3. With a collapse in global commodities and attendant risks to growth, top line growth and hence debt servicing capabilities are getting impacted.
 
Two inferences are noteworthy here:
 
1. Although there has been a recent marked escalation in fears surrounding EM leverage, as noted above the headwinds to the trade actually started way back in 2011 and have strengthened significantly over the past year.
 
2. Any ‘maturing’ of the global leverage cycle will fundamentally accentuate the deflationary forces already in play in the global macro-system, and make them self-affirming.

If investors agree with the backdrop described above, then the pressure points in play are readily apparent. Correspondingly, the ‘valves’ to ease some of this pressure also lie here:
 
1. US Dollar: At the start of the QE experiment, probably no one would have envisaged that markets would eventually come to simultaneously fear the first Fed rate hike as well as prospects of a renewed slowdown in global growth. The only way the EM offshore leverage phenomenon could have fructified smoothly is if ultra loose monetary policy succeeded in creating enough global growth and commodity price strength for EM debt to be able to compensate for dollar strength via enhanced servicing ability. However, this hasn’t been the case with consequent potential impact for this leverage. It is readily apparent also that the dollar needs to back down for the leverage to win some temporary relief. It is thus a shade surprising to us how some global commentators have spoken about the recent Fed meeting as a ‘missed window’ for a rate hike. If the rate hike had succeeded in creating further dollar strength then not only would financial conditions in the US have further tightened, but the EM leverage trade would have on the margin been further squeezed. Both these would have been fundamentally deflationary over a period of time. Thus if the Fed were to back off from tightening for longer than the markets envisage, and the latest US payroll report is a data point supporting that direction, thus leading the dollar strengthening consensus trade to unwind, that would ease the pressure for some time.
 
2. Commodities: If commodity prices were to sustainably reverse at least some of their recent collapse (to some extent this could happen if the dollar strength fades), then this would at least temporarily enhance debt service capabilities on the margin and also bring risk spreads down. Conversely, the longer the squeeze continues the larger the probability of something eventually giving way. It is from this perspective most predominantly, that one should look at the Chinese rebalancing, in our view. Thus China is attempting to rebalance from an investment led growth model to a consumption led one. The consequent drop in headline GDP growth is only one aspect of this rebalance. The other, potentially much more relevant for the EM leverage trade, is that according to some observers China is splitting into two sub Chinas: the commodity intensive sectors and regions are actually in deep deflation whereas the others more reliant on services are doing much better.
 
Conclusion
 
We had argued in a recent note (please refer “ The Seven Year Itch…And Investment Implications”, dated 2nd September for details) that we are in the midst of a prolonged macro cycle marked by continuing capital misallocation post the 2008 global financial crisis. The current note delves deeper into what is probably the most relevant channel via which this misallocation is in evidence today. Also importantly, the ‘capacity risk’ emanating from a maturing global investment cycle is interacting with ‘portfolio risk’ explained here. It is also to be noted that the mirror of the portfolio risk as explained here is the investor or fund that is holding the EM debt, and that has been suffering some meaningful size redemptions over the past few quarters.
 
If investors buy the themes presented here and in our recent notes, it is also obvious that the world is not suddenly getting hit by one off shocks. Rather, much of recent global market developments are explainable in terms of this long macro cycle that the world seems to be stuck in. From time to time the pressure valves get eased, as what seems to be currently happening post the latest US jobs report. However, what really matters is whether the ‘ease’ is durable. The framework provided here as well as in the previous note has also been helpful to us in interpreting global events and developments in context of the larger underlying cycle. It is also an input into what we think are investment implications for clients. We had discussed some of these implications from a fixed income stand point in our recent note “Portfolio Implications of This Long Macro Cycle”, dated 9th September. It is also evident to us that if one agrees with the long macro cycle view, then the merit in being an asset allocator basis underlying risk appetite far outweighs that in being tactical basis one-off events.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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