8th July 2014
Last week’s Fed and ECB announcements have given both institutions the opportunity to speculate. Jan Dehn, Head of Research at Ashmore discusses the concept of bubble economics and the challenges this poses to asset allocators below.
The very modest reaction in the US Treasury market last week to what was, after all, one of the strongest sets of employment numbers for some time is more revealing than appears at first sight. US treasury yields ended the week at 2.65%, around 14 basis points higher than a week ago, but more or less unchanged from a month ago.
We believe the far more important reason for the orderly behaviour of the US treasury market was the set of extraordinary signals coming from both the ECB and Fed last week. Collectively, these amounted to a licence to speculate, the official return of Bubble Economics.
Fed Chairwoman Janet Yellen kicked off proceedings by stating that interest rate policy would not be used to stamp out bubbles. This has resolved decisively, it seems, the debate within FOMC about the relative merits of using macro prudential regulation or interest rates to stamp out bubbles.
Shortly afterwards, at the ECB, President Mario Draghi and his officials explained at their press conference that banks will be able to use the recently announced Long-term Refinancing Operations (LTROs) to buy periphery government debt. Given the backdrop of a sick European banking system, LTROs are certainly a useful device pending a political solution to the problem of undercapitalised European banks (unlikely to materialise, in our view).
But the Eurozone debt crisis showed that any threat to Europe is likely to play out via the sovereign bond market. Thus, by allowing banks to use LTRO money to buy European periphery sovereign debt, even at the expense of lending to the real economy, the ECB has in effect bought insurance against a bigger set of risks.
But with Spain and Portugal already trading at bubble levels, the ECB has also given its green light for Bubble Economics. Former ‘conquerors’ Spain and Portugal today trade well inside their former colonies of Mexico and Brazil, despite the fact that the latter have far, far lower debt burdens, hugely greater policy flexibility, higher trend growth rates, stronger external stock balances and a multiple of other advantages.
Note that the Bank of England (which is slightly ahead of the Fed) is also on the same page: they too will use macro prudential measures rather than rate hikes to stamp out bubbles. In other words, this is a coordinated developed market-wide policy declaration.
Bubble Economics is both pretty basic economics and not entirely unfamiliar. The policy adopted by the Fed and ECB last week was staple fare during the Greenspan Fed. No asset allocator worth his or her salt will therefore be able to claim, ex-post, that they did not see the problems coming.
Ignorance is simply not a credible defence so soon after the collapse of the last bubble. US stocks set new highs almost every day. US bond yields are close to all-time lows. Moreover, only last week the Bank of International Settlements issued a strongly worded and widely reported assessment that asset prices are getting dangerously out of line with fundamentals.
The Fed/ECB licence to speculate is massively dovish, coming at a time when bubble risks pose a more immediate danger than wage inflation, even taking into account last week’s strong US labour market data. There is little material risk of near-term rate hikes. And developed market central banks are ultimately likely to lean as heavily towards dismissing conventional inflation as they are now dismissing bubble risks.
Or to put it differently: the biggest risk to the consensus today is not rises in rates, which are widely expected to begin next year. Rather, it is the re-appearance of inflation and the sudden realisation that developed market central banks will not do very much about it. The resulting decline in real rates would fly in the face of consensus expectations of a stronger Dollar and require a complete re-pricing of the US treasury curve in a bear-steepening direction.
We believe this risk is far greater than the market thinks. The market has barely begun to contemplate the possibility of a return to inflation.
True, inflation is far from costless, even in heavily indebted countries. The main cost of inflation has always been that it creates serious uncertainty about the future and thus impedes investment. But with investment rates running at very low levels to start with, the opportunity cost of inflation is presently low. This will gradually change over time, partly because the costs of inflation rise in a non-linear fashion, partly as deleveraging places developed economies in better positions to grow. But at this stage in the cycle, the trade-off strongly favours higher inflation.
Only when inflation has done its important work of reducing the outstanding real debt stock can substantial rate hikes be put in place to crush inflation.
EM countries would not be unaffected by temporary bouts of US treasury volatility. But there are good reasons to believe that a repeat of the severe market reaction of 2013 can be avoided:
The last point should not lull anyone into complacency about EM. There is no such thing as a risk-free investment. Anywhere. Period. In EM, at least 10% of countries experience some kind of economic or political problem at any given time. And the tightening of global conditions, albeit slow, will inevitably create more differentiation between EM countries. Careful attention to risk should however not be confused with bearishness. We believe EM is much safer than developed economies. As central banks in developed economies lead their countries slowly into a world of inflation, devaluation and financial repression in order to buy growth and to rid themselves of their debt problems, the prudent way forward for asset allocators is to think about protecting the purchasing power of their pools of capital. The best way to do this is to allocate to EM, but to do so actively.