8th September 2016
Alexis De Mones, Head of Fixed Income at Ashmore, explores the fiscal implications of Dilma Rousseff’s recent impeachment and provides insight on why Friday’s labour market data suggests that a rate hike in September would be too risky, but if it happened, EM would be nowhere near as vulnerable as people fear.
Brazil: Rousseff and Temer
On the political front, last week the President was impeached with 61 votes for (75.3% senate) vs. 20 votes against (24.7%). According to the constitution, in addition to losing office, this also means that Dilma Rousseff is ineligible for any political position for the next eight years. The nuance was a last minute behind the scenes deal orchestrated by the Head of the Senate, Renan Calheiros, which called for a separate voting on whether Dilma should lose political rights. On that ballot, Dilma was absolved as only a simple majority (42 out of 81) of the senators voted for her to lose political rights, short of the required two-thirds majority. This is a clear political manoeuvre which could benefit other politicians removed from their position (like the former leader of Congress Eduardo Cunha). It increases uncertainties at the margin since the Supreme Court is likely to review the unconstitutional decision of slicing the impeachment vote and could demand a re-run of the vote on the Senate. But in practical terms doesn’t change much. At this current juncture, Dilma Rousseff is so unpopular that not even her own political party wants her back as she would be a liability for the municipal elections at the end of October. Last week Michel Temer officially assumed the presidency until December 2018, mentioning the commitment to structural fiscal reforms in his inaugural speech. The President then attended the G-20 meeting in China, rolling out the red carpet for investors.
While the COPOM met and kept policy rates unchanged at 14.25%, the news was in the statement which followed the meeting. The committee dropped the sentence “no room for monetary easing/flexibility” and added three goal posts to start the easing cycle: the approval of the constitutional budget amendment, the softening of the portion of inflation affected by monetary policy (mainly service inflation) and lower inflation expectations for 2017/18. This could open the door for a cut as soon as October depending on the political/ economic environment.
Labour market data: A move in September ahead of a controversial presidential election would be too risky
US non-farm payrolls increased by 151k in August, unemployment was stable at 4.9% and average hourly earnings at 2.4% yoy. The previous month’s data was revised upwards, posting a solid labour market picture in the US. Overall the data should be consistent with the targets of the Fed and justify a September hike after the more hawkish tone in Jackson Hole speeches and interviews. Fed members seem to be increasingly concerned with financial stability risks caused by rising asset prices and want to normalise rates in order to gain room to manoeuvre in a future recession. A move in September, however, just a few months ahead of a controversial presidential election would be too risky, especially given the market reaction after the hike in December 2015 led to a small bounce in the USD and commodity prices sold off which took equity markets to its second 10% correction in less than six months.
If the Fed does raise rates in September, the hike would likely be accompanied by a strong dovish message that another hike in December is all but ruled out in order to keep volatility low. The other problem with an early hike is a likely flattening of the US yield curve when the Fed should actually be targeting a steeper curve via higher inflation expectations, which would improve the incentives for credit creation by the banking sector. The fact that the 5y5y inflation swap has remained below the 2.0% target since mid-June doesn’t support the view of the more hawkish members that all is fine and that the base rate should be at higher levels. Overall, the Fed remains on its self-inflicted cornered position, as it pursues too many conflicting objectives (asset price stability, inflation, growth and financial stability). Fed inaction will eventually lead to excessive risk-taking at expensive levels in some markets (the equity markets are a strong candidate this time), but it’s hard to fight it while it lasts.
Fed hike: EM would be resilient
But what would happen if the Fed hikes? Will Emerging Markets (EM) suffer? We don’t believe EM is anywhere near as vulnerable to a rate hike as some fear.
Firstly, macro conditions in EM are much more resilient. When Bernanke’s “tapering” announcement caused the “taper tantrum” in 2013, the average current account in EM was at a deficit of 2.1% (GBI-EM GD weighted CAD); today external accounts in EM are close to being balanced over the last 12 months, or in a surplus when one annualises the latest figures. This means that coming from a net debtor position three years ago, EM is now becoming a net creditor to the rest of the world. This makes these countries much more resilient to an increased cost of funding in the USD system.
Secondly, as stated above, we believe that the Fed will continue to be biased towards the dovish side. Previous FOMC meetings explicitly mentioned the intention of avoiding another taper tantrum. Hence, the Fed will try to avoid excessive volatility on the long end of the curve since such an event would lead to further weakness on the US housing market, which is far from regaining its pre-crisis levels. Note the long end is also where Emerging Markets borrow, hence subdued long end rates should keep EM bid.
Lastly, the technical position in EM is much more benign today. Contrary to the taper tantrum in 2013 when billions of US dollars chased expensive local currency bonds, positions are extremely clean after almost three years of relentless outflows and valuations remain attractive even after the current year rally. Granted, inflows over the last two months were strong, but we’re just seeing the beginning of a long term rebalancing from expensive momentum assets in developed markets to attractively valued assets in EM, so buying EM in dips should remain the preferred strategy for global investors.