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April 13, 2017

The Market Sentimentalist: Developing Markets – Too Good To Be True?

by Amareos.

Please note this article was written prior to the US-led airstrikes against Syria. 

It has been a strong start to the year for developing market equities. Robust capital inflows in the first quarter helped propel the MSCI EM index higher by 11+% – approximately double the return seen in developed markets over the same time frame [1]. It is not just the numbers that makes this an impressive performance. It has occurred at a time when the Fed upped the pace of monetary policy accommodation withdrawal from one 25bp hike per year to one 25bp hike per quarter [2].

As demonstrated by 2013’s “Taper tantrum”, and the wobble in late 2015 when investors finally became convinced that the Fed would deliver its long-promised “Liftoff”, emerging markets can be rather sensitive to US monetary policy changes. This sensitivity is well-documented and hardly needs much elaboration. Starved of yield in their home markets for the best part of a decade, investors in advanced economies sought more attractive returns in other parts of the globe, helping to fuel a USD 9tr increase in debt (mainly private) in developing countries [3].

In a scenario of rising US interest rates, the worry of many investors and shared by supra-national bodies like the IMF, was that these capital inflows were vulnerable to reversal, and combined with the effects of a strengthening USD, could trigger a painful credit crunch precipitating a larger economic crisis.

Despite the compelling logic of this bearish scenario, these negative effects have so far failed to materialize. In our judgment, this resilience is attributable to several factors, including high official FX reserves which could be deployed to mitigate temporary liquidity squeezes, more attractive valuations (relative to advanced equity markets) and recent earnings upgrades. Another, often underappreciated factor, is the nature of the Fed tightening cycle.

“Gradual” remains the watchword and US central bankers have been diligent in pre-emptively signalling policy stance changes well ahead of time, something which has served to reduce investor uncertainty regarding the future trajectory of US short-term interest rates [4].

The absence of monetary policy surprises is, of course, entirely consistent with the Fed’s adoption of a forward rate guidance framework – a key component of the unorthodox monetary policy toolkit developed in response to hitting the zero lower bound (ZLB) during the Great Recession. However, even before forward rate guidance was formally adopted, the Fed had form in ensuring investors were not surprised during a rate hiking cycle. The latter years of the Greenspan Fed being a great example – not one of the rate hikes in the 2004 – 2006 period (425bp from start to finish) was unexpected – even by economists!

Back then the motivation for adopting this “surprise-free” monetary policy approach [5] was the desire to gradually cool a housing market which had overheated in response to the stimulus injected to mitigate the hangover from the earlier bursting of the dotcom bubble [6]. This time around it is a desire not to jeopardize the recovery – an outcome that could materialize if, by surprising investors, Fed hikes (or balance sheet normalization which the FOMC agrees should be “gradual and predictable”) trigger significant upward revisions to underlying discount rate assumptions negatively impacting US asset prices [7].

Aside from the rather obvious reasons for wishing to avoid such an outcome, the Fed is also highly cognizant of the fact that it would be put in a very awkward political position. The scope for providing additional monetary policy stimulus via conventional means in the event of a significant economic downturn is practically non-existent (75bp in effect).  Although the Fed considers the unconventional methods deployed during the Great Recession as viable policy options, the present inhabitant of the Oval Office is a well-known objector.

As a result, even though for predominantly domestic (ie. US) reasons, all investors, including those focused on developing equity markets, hear is that the Fed tightening cycle is being conducted in a market-friendly manner. Of course, a market correction could always happen by accident but it would not be by design. (NB: We do not view the comment in the FOMC minutes about equity prices being high relative to standard valuation measures as an attempt to talk down the market, but rather a statement of the obvious as even a cursory glance at Shiller’s CAPE ratio shows.)

One thing that could disturb things is if the Fed unexpectedly found itself behind the curve, such that it was forced to accelerate further the pace of interest rate increases. With hard macro data in the US still pointing to relatively modest economic growth and inflation pressures, the most likely source for such a jolt would come from a de-anchoring of US inflation expectations, which the Fed would view as a loss of policy credibility.

Much has been made of the reflationary bias and rising animal spirits following Trump’s victory. Indeed, we illustrated the sea-change in public attitudes with our crowd-sourced sentiment indicators at the time [8]. That said, as we noted in an earlier Market Insight [9], an audible hiss in the US reflation theme developed in late January. As can be seen in the exhibit below, this reversal in crowd sentiment towards future inflation trends has continued, suggesting minimal risk of the Fed falling behind the curve; good news for developing market equities.

Exhibit 1: Crowd-sourced Inflation Sentiment – US

Source: www.amareos.com

Unfortunately, while this macro risk recedes it is being replaced by another looming on the horizon, namely Donald Trump’s pre-election protectionist rhetoric transforming from words into deeds. The early signs are not encouraging. At the US administration’s insistence, the anti-protectionist pledge was dropped from G20 finance ministers statement published last month and the issue will surely be high on the agenda of the first meeting between President Trump and Chinese President Xi scheduled for this week.

In addition to global macro and policy risks, investors in developing markets also need to keep a close eye on idiosyncratic, country-specific, political risks as these are part and parcel of the investment landscape [10].

One country where political risks are rising is Turkey – the subject of last week’s Market Insight – see: (Market Insight – Turkey’s Referendum: Win Or Lose?). Another is South Africa. President Zuma late last week announced a cabinet reshuffle that, most importantly for investors, resulted in the sacking of the respected finance minister Gordhan [11].

This decision may have been politically expeditious for Zuma [12], who is due to step down in a couple of years (possibly sooner) and has succession plans on his mind, but economically it has been damaging. Gordhan has a reputation for fiscal prudence and is a stalwart opponent of corruption and his importance in government was firmly underlined by S&P’s decision this week to downgrade the country’s sovereign rating to junk (negative outlook) because…

“[C]hanges in the executive leadership, including the finance minister, have put policy continuity at risk”.

Even though public perceptions towards South Africa have been negative for several months, potentially suggesting a certain resilience to “new” bad news, looking specifically at the currency it is clear that even prior to Gordhan’s sacking, the crowd was already having a major rethink about its previously constructive view.

Exhibit 2: Crowd-sourced Sentiment – ZAR

Source: www.amareos.com

Indeed, as can be seen in the following exhibit, since the start of the year the ZAR has seen the greatest negative change in crowd sentiment of all developing market currencies. Such strong downward momentum suggests there is clearly considerable scope for further pessimism towards the ZAR, highlighting its ongoing vulnerability.

Exhibit 3: Sentiment Layers – Developing FX

Source: www.amareos.com

By contrast, the developing market currency where crowd sentiment momentum is most positive is the MXN – the financial market “whipping boy” of the Trump election campaign. Note however, unlike the ZAR where sentiment is currently neutral, the rise in positivity towards the Mexican currency has pushed sentiment to rather elevated levels. The same is also true of last year’s best performing currency and second best to the MXN in Q1, the RUB. Such strong sentiment skews [13], suggest that future gains will be harder to come by, especially as and when sentiment momentum fades, something yet to be seen in the MXN but already apparent in the RUB.

Exhibit 4: Crowd-Sourced Sentiment – MXN & RUB

Source: www.amareos.com

FOOTNOTES:

[1] In terms of individual countries, one of the strongest performances came from South Korea as we suggested might be the case in early December – see: https://amareos.com/blog/political-kill/

[2] We are referring to actual trajectory of the Fed funds target rate not the trajectory predicted by members of the FOMC, predictions that have – until recently – proved to be wide of the mark – see: https://amareos.com/blog/the-market-sentimentalist-shoulda-coulda-woulda/

[3] The IMF published a working paper last December examining the impact of US and global financial conditions on corporate leverage in developing markets – see: https://www.imf.org/external/pubs/ft/wp/2016/wp16243.pdf.

[4] A point noted by former Fed official Don Kohn – see: https://www.brookings.edu/wp-content/uploads/2016/11/kohn_central-bankers.pdf

[5] Bear in mind that the prevailing theory about monetary policy at the time was that it was unanticipated rather than anticipated policy changes that had the more powerful economic impact. This notion has been challenged by central bank research departments keen to beef-up the intellectual underpinnings of the forward rate guidance framework (not to mention the other unorthodox policy tools used, such as QE, which former Fed Chair Bernanke famously quipped “works in practice, but doesn’t work in theory”).

[6] As the subsequent bursting of the US housing bubble clearly demonstrated this cautious, almost risk management style, approach to monetary tightening was not overly successful. (Minksy anyone?) For more details on this approach – see: https://www.brookings.edu/bpea-articles/risk-management-for-monetary-policy-near-the-zero-lower-bound/

[7] The portfolio balance channel effect in reverse.

[8] See our daily tweet (@Amareos_info) on January 6.

[9]See: https://amareos.com/blog/the-fear-factor/

[10]Such risks were considered to be less pertinent in advanced economies. Emphasis on were as events over the past year have only too clearly illustrated.

[11] According to media reports, Fuzile, Head of the South African Treasury informed Gordhan the day before he was sacked of his intention to not to serve out his full term, meaning the loss of another respected technocrat from the Zuma administration.

[12] Although perhaps not that much, as the cabinet reshuffle has prompted calls for a no confidence vote in Zuma to be tabled.

[13] We discussed the significance of skews in crowd sentiment in an earlier Market Insight – see: https://amareos.com/blog/outsmarting-the-crowd/

 

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