In a rather busy news week, the two main markets drivers – Fed rate hikes and the Trade War – have been the focus of traders. First, Fed Chair Jerome Powell made a 180-degree change in his policy outlook discourse. Six weeks ago, the Fed was a long way from reaching the neutral Fed Funds rate, implying a steady path of rate hikes in 2019. This week, in a speech at the Economic Club of New York, Powell now says that Fed Funds is just below the neutral rate. The timing of this new language is circumspect, as Donald Trump had only days before declared that Powell was a bad choice for Chair of the Fed. Washington shenanigans will never cease. The market reaction was unambivalent: +3.2% on the Nasdaq.
The other news event concerning the Trade War will play out over the weekend at the G20. Will Trump and Chinese President Xi finally come to a compromise? As noted in our Daily Update for Friday, most market pundits don’t seem very constructive regarding a positive outcome. Perhaps, this opens the possibility for a strong open Monday should something positive come out of the G20. In any case, we believe it is too late to sell equities on the Trade War risk.
Macroeconomic data this week was highlighted by the final Q3 GDP estimate for the US, coming in at 3.5%. Down from 4.2% in Q2, we believe that this is as good as it gets for U.S. growth. All fiscal and monetary policy bullets have been fired and late-cycle inflation risks will prevent another QE from the Fed should we hit a soft patch. Survey data was mixed, with the Dallas Fed Manufacturing and Richmond Fed Manufacturing Indexes fallings but the Chicago PMI improved. Personal Income and spending data remained firm in October (+0.5 and +0.6%, respectively) and the Fed’s Personal Consumption Expenditures index held at 2.0% y/y in October, below expectations for an acceleration to 2.1% y/y. Perhaps this data motivated, in part, the more dovish statement from Powell this week. Finally, housing data shows no signs of improvement. Pending home sales fell another -2.6% in October and New Home Sales plunged -8.9%. The Case-Shiller 20-City Price Index also slowed to 5.15% y/y from 5.3% y/y for September. It appears that housing prices re-peaked in March of 2018. As we have noted before, housing is a very economically sensitive sector. The weakness in housing offers a strong argument for an impending recession.
The Search For Yield
During the Financial Crisis, major world central banks dropped interest rates to zero percent, then left rates at essentially zero percent (ZIRP, zero interest rate policy) for essentially nine years. The Federal Reserve has slowly lifted rates over the past couple years, but with the Fed Funds rate at only 2.25%, the European Central Bank discount rate at 0%, and the Bank of Japan discount rate at -0.10%, interest rates remain globally at crisis-level rates. As such, the overriding investment theme since the Financial Crisis has been the hunt for yield. Consumer Staples and Utilities, traditionally defensive sectors which out-perform as the economy slides into recession, have enjoyed relatively exceptional bull market gains due to their dividend yield. Bond investors, requiring higher returns, have left the bond space to snap up equities paying a much higher dividend yield compared to paltry bond yields.
We believe that the hunt for yield will remain an overriding investment theme, especially given this week’s news from Fed chair Powell that the Fed Funds rate is now just below the neutral level (and possibly the highest level we will see for this rate tightening cycle). Our problem this cycle is that the defensive sectors, which offer one source of above-average dividend yields, aren’t looking too defensive to us. Below is the Consumer Staples SPDR (XLP). We’re not sure if we want to rotate into Staples when the U.S. economy slides into the next recession.
Nor do Utilities (XLU) look very defensive at these levels.
Indeed, for investors looking to prepare their portfolios for the next recession, there seems to be few assets in the U.S. that look attractive: all stock sectors are in bubbles (with the exception of Energy) while an investment in 10-year T-Notes only returns 3% today (compared to 5% in 2007 and 6.5% in 2000).
We have been writing for some time about major super cycles. In a Commentary written last year, “Looking Into Our Crystal Ball”, we demonstrated that assets who price run-ups end in a bubble (and crash) also suffer major underperformance relative to other risk asset classes during the subsequent cycle. Whatever the reasons or “new paradigms” cited, no asset will out-perform during consecutive super cycles. Clearly the leading asset class this cycle has been U.S. equity indexes. Below is the S&P 500 relative to the MSCI World Ex-US. We highlight global economic expansions with arrows. Note that the S&P 500 does not lead during each cycle (denoted by red arrows). For example, after the raging bull market of the 1990s, that cumulated in the Tech Bubble, the U.S. massively underperformed world equities in the 2002-2007 expansion.
We are not making a prediction here about when the current expansion will end. But we are predicting that both during the next bear market and during the next global economic expansion, you do not want to be in U.S. index equities. As such, we are keen to seek out non-U.S. assets for a long-duration investment.
As yield will be an overriding investment theme with developed nations taking a very long-term approach to ZIRP, we are looking to Emerging Markets for both yield and capital gains.
Seek Higher Yields In Emerging Markets
For most U.S. investors, slipping the word “Emerging” in the sentence typically draws apprehension and fear of risky, volatile investments. However, in this super cycle, EM risk assets have been taken to the woodshed as ample liquidity on U.S. markets and a strong dollar (falling EM currencies) have done little to inspire investors to put money outside the U.S. Looking at the S&P 500 relative to Emerging Markets below, we’ve likely gotten to a point where investors should have more apprehension about investing in the S&P 500.
Before investing in an asset class that has under-performed for nine years, a legitimate question is “why have EM markets does so poorly? And more importantly, are the factors responsible for the underperformance now behind us (or fully priced in)? For us, the number one reason Emerging Market have underperformed during this expansion is simply their massive out-performance in the prior expansion (2001-2007). EM stocks got relatively too expensive relative to U.S. stocks to justify the added risk. The relative valuation argument, after these past nine years, is now back in favour of emerging markets. A second reason for EM underperformance this expansion is the crazy quantitative easing programmes in the U.S., Europe, and Japan. QE has provided a liquidity sugar rush for U.S. and developed market risk assets. It should be apparent to readers that QE has now passed to QT (quantitative tightening) in the U.S, removing a tailwind which has drawn money into U.S. assets. Yet another reason EM assets have done poorly is the strength of the U.S. dollar this cycle. Falling emerging currencies have made EM assets unattractive for international investors. With the Dollar currently 45% above the cycle low of 2008 versus the JP Morgan EMCI Currency Index, the currency headwind for EM markets is now greatly diminished.
In this Commentary, we explain why we are parking lots of cash in Emerging Market bonds today. To recall, there are two classes of Emerging Market bonds, hard-currency (USD-denominated) and local currency debt. We are more interested in local-currency emerging-market bonds. Our bet is that this asset class has further to rebound than hard currency peers after slumping more amid this the EM market turmoil (Turkey, Russia, Argentina).
It’s the Yields, Stupid
Our first reason states the obvious. In a low global interest rate environment, why not go where money is treated best (rates are highest)? Emerging Market central bank policy rates (in white), while historically low, still offer much higher yields for savers than developed market central bank policy rate (in orange).
While most developed nations are still running policy rates close to 0%, short rates are significantly higher in EM nations. The following table shows the policy rates among some major EM central banks.
There was no QE happening in these countries. Even on a risk-adjusted basis, fixed income investors are better off in EM bonds than U.S. Treasurys.
If we are going to park our cash in an investment for a few years, instead of trading in and out, we need to be generating regular income. The Emerging Market bond products available to all investors via index trackers all offer higher yields than most bond or equity within the U.S. Our Ultra Yield Fund, by comparison, which seeks the fundamentally strongest companies paying a high dividend (currently with a preference for non-U.S. companies and beaten down oilers) pays a 6.4% yield. The table below summarizes some of the products that we use, along with their yields.
Rates Ain’t Goin Much Higher
Next, rate tightening cycles are already being priced into EM bond prices. Yet we do not believe tightening cycles in any region – developing or emerging – will last very long given the late-stage expansion in the U.S. and massive debt levels everywhere (that can’t be financed with higher interest rates).
The U.S. Federal Reserve, Bank of Canada, Bank of England and Norges Bank have each hiked rates since April, fueling tighter financial conditions across the globe. EM policy rates are once again tracking these developed markets, with central banks in Brazil, Chile, Peru and Romania expected to tighten more aggressively than peers in 2019. EM monetary policy began to diverge from developed market peers in 2017, as central banks in Brazil, Colombia, India, Indonesia and South Africa continued to slash interest rates, reducing the relative attractiveness of local currency bond yields. Foreign outflows have since accelerated, forcing EM central banks to adopt a more hawkish bias. In sum, the aggressive rate outlook has been a headwind for bond prices this year. If readers believe that the global rate hike cycle will be short-lived, as suggested by Fed Chair Powell himself this week, then EM bonds are getting attractive for investors.
Buy Low, Not Bubble
A third reason that we are buying EM bonds is that we don’t like buying assets at bubble highs. Emerging market sovereign credit fundamentals have been under pressure this year, as rising external-debt ratios leave borrowers less resilient to exogenous macroeconomic shocks. Yet despite the projected slowdown in global growth, EM reserves are adequate and inflation appears benign, offering scope for policy accommodation if financial conditions tighten sharply. While most emerging-nation debt has been rattled the rebounding dollar, rising U.S. rates and trade war jitters, local-denominated bonds have taken an especially big hit given their currency exposure. Many investors expected a rebound after prices stabilized in July, but the Turkish market turmoil and U.S. sanctions on Russia triggered another slide in the second half of this year.
Note that Emerging market sovereign borrowers are less resilient to exogenous shocks, as elevated currency volatility weakens foreign demand for local currency bonds, resulting in greater external debt issuance. Moreover, falling real yields, reflecting a re-pricing of inflation expectations as spread compression between emerging and developed market economies, reduced the relative attractiveness of EM local currency debt this year. Clearly, with EM debt investors will not be buying into a bubble asset at today’s prices.
To better see the difference between hard currency and local currency EM bond performance, we superposed the two charts with dividends reinvested. The real opportunity in EM bonds today is in the local currency version.
Inflation Does Not Appear To Be Headwind
Yet another reason to favour emerging market debt is slower U.S. inflation. This week the Personal Consumption Expenditures Index came in below expectations, +2.0% y/y for October. Maybe the Fed’s tightening is actually reigning in inflation? Slowing inflation is a positive for emerging market local debt, as diminished price pressures allow the Fed to pursue less restrictive monetary policy. After plunging to an all-time low of 40 bps in May, the EM-U.S. inflation gap has reverted to the middle of its historical range, as Fed tightening keeps inflation well contained. U.S. price pressures have historically spilled into EM, forcing central banks to adopt a more hawkish bias. We don’t see this as a risk today.
Currency Returns
A final reason to like Emerging Market local currency bonds is simply for the currency exposure. Emerging market foreign exchange volatility was elevated this year (peaking with the Turkish crisis in August), allowing for further yield compression in 2018. This yield compression has allowed capital flows to rebound. J.P. Morgan EM Local Currency Bond ETF (EMLC) has had six straight weeks of inflows, the longest streak since the beginning of April.
To display graphically the attractiveness of EM local currency bonds, driving these inflows, we created a chart of the basket of currencies in the EMLC tracker (Brazil real, Indonesia rupiah, Mexico peso, Poland zloty, South Africa rand, Thai baht, Russia ruble, Colombia peso, Malaysia ringgit, Turkey lira) versus the U.S. dollar. As dollar-based in investors, we see this as a “fat pitch”. Using our strong dollars to buy these beaten down currencies will result in long-term currency gains, along with the 6% yield.
U.S. quantitative tightening limits the extent to which EM central banks can cushion their economies from slower growth, causing local government bond yields to track the dollar more closely. Following the Financial Crisis, the relationship between EM yields and the broad trade-weighted dollar was virtually non-existent, as the U.S. Federal Reserve increased its balance sheet by more than four-fold to a peak of $4.5 trillion in December 2014. Yet as Fed policy normalization squeezes short-term liquidity, the relationship between EM local currency yields and the dollar has strengthened significantly. That is, if you believe that the dollar is near its high (a reasonable hypothesis given Jerome Powell’s 180 degree turn regarding the Fed tightening cycle), local currency EM bonds should start seeing a strong tailwind.
Conclusion
In a low interest rate environment, investors are forced to hunt out yield. The “yield well” in the U.S. has been tapped after nine years of ZIRP. Emerging bond price appreciation has been relatively subdued compared to U.S. risk assets. Local currency EM bonds will provide nice currency returns, rewarding investors who diversify their currency exposure outside of dollars.
Trade Recommendations
