28th September 2016
Jan Dehn, head of research at Ashmore, suggests that a fear of policy decisions in developed economies is completely rational; the effect of a bad policy decision is heavily exacerbated when made under already bad conditions. He explains how QE economies are poised on a fine knife-edge between recession and inflation, saying that small policy mistakes could easily push them off the edge.
Recession or inflation?
Suppose that a major QE economy, such as the US, plunged into recession. Policy makers would be extremely poorly placed to respond effectively. Most governments in QE economies have already used up their conventional and ‘conventional unconventional’ policy tools, such as rate cuts and trillions of Dollars of asset purchases. In addition, they have accumulated debts averaging 30% of GDP due to fiscal stimulus operations following 2008/2009. These stimulus measures have abjectly failed to spark ‘exit velocity’. In fact, average growth rates in developed economies have declined by an astonishing 42% since the Crisis. Looking forward, the picture is even bleaker. The next generation of stimulatory measures, such as Helicopter Money, protectionism and negative interest rates would have serious negative side effects on currencies, trade and banking systems – and ultimately growth.
Inflation cannot be ruled out either and would pose a similar nightmare. Stagflation impales QE central bankers on the horns of a dilemma as they are forced to choose between protecting measly growth or stamping out inflation. It is not possible to do both after years of declining productivity. Fighting inflation by hiking rates meaningfully would crash stimulus-addicted stock and bond markets and increase debt service costs for over-indebted economies dramatically. Faced with this prospect central banks would likely protect growth, while inflation would rise. Bond markets would immediately object, so bear-steepening of QE yield curves could quickly threaten housing. Regulators and central banks would therefore be forced to step up financial repression significantly to hold down long yields. Japan, of course, has already moved to directly manage of the long-end of its yield curve. Others will follow. Ultimately, QE currencies should decline if yields are forced lower under conditions of rising inflation and domestic savers would face enormous losses in purchasing power terms.
EM economies are rapidly becoming the only ‘normal’ countries left on the planet
There is a profound irony in the fact that the market remains far more preoccupied with the potential effects of QE central bank decisions on EM than on the QE economies themselves. Objectively, EM economies are rapidly becoming the only ‘normal’ countries left on the planet, in the sense that they have regular business cycles, use conventional policies, have reasonable debt burdens, sensible asset price valuations and so forth. Moreover, EM countries have recently demonstrated considerable resilience. They have just come through a hurricane of headwinds – the start of the Fed hike cycle, the USD rally, the Taper Tantrum and falling commodity prices – without a major pickup in defaults.
Indeed, with respect to interest rates, as recently as February of this year the average yield on EM bonds was higher than when the Fed has rates at 5.375% (end of 2006)! EM resilience is rooted in fundamentals that are quite simply much, much stronger than those in developed economies, whether one considers debt levels, FX reserves, growth rates, demographics, the room to ease monetary policies and fiscal room. EM economies are reforming far more than developed economies, especially in the last few years. In short, the conditions of vulnerability that make Fed policy changes such an important risk in developed economies are simply not present in EM. EM asset prices have also become far less correlated with Fed fears. By contrast, sensitivity to Fed hikes in developed market bonds is not only higher, but has been growing steadily since last year.
Remember that EM bonds pay 6.26% yield
This relationship alone ought to be a clincher for those, who still struggle with the Fed hike question. But if that is not enough remember that EM bonds also pay 6.26% yield for the same duration that in the US pays just 1.26% and which in Germany pays -0.51%. Despite its many merits EM bonds remain far from many investors’ radar screens. Global asset allocators have shunned non-QE markets for years, particularly EM as they chased risk in developed economies. Flows have barely begun to return. Investors are scared about return prospects in developed economies. Since they still think of EM investments as risk-plays they are reluctant to allocate. Emotions do matter, but today EM is actually the safer play.
Developed markets are risky
It is not just that valuations have been dangerously stretched; their underlying economies are also vulnerable. It is the combination of vulnerable markets and vulnerable economies, which make QE economies especially sensitive to even modest shocks, such as policy actions by their central bankers. Sooner or later a QE central bank will make a mistake. Sooner or later a QE economy will be pushed into inflation or recession or both. The market currently seems to correctly recognise that the decisions of QE central bankers are important, because they can trigger major market or economic convulsions. However, positioning has not yet responded to these risks, so technicals are also poor in the QE markets. There are very good reasons to believe that EM countries have neither the fundamental nor the market vulnerabilities that characterise developed economies today. Technicals are also strong. For these reasons, it makes sense to allocate out of the QE economies and into EM, the safer alternative.