Trade wars and geopolitics
As FIFA unites the world in Russia for four weeks of the beautiful game, developments on the geopolitical front have taken a far less harmonious turn. We noted last quarter that those in the White House were raising the stakes on the trade-war front. However, despite increasingly bellicose overtures from the US administration, with President Trump’s increasingly confrontational manner appearing to follow his own playbook (in The Art of the Deal), markets have generally been dismissive of the potential threat posed by rising trade tensions.
The stakes were being raised, it was thought initially, to broker a better trade deal, but, over the course of the second quarter, sabre-rattling turned into what could prove to be the first skirmishes of a much larger trade war. The heaviest blows have been traded between the world’s two largest economies, but a pile of tariffs and counter-tariffs has been growing across the Atlantic and North America. By the end of the first week of July, the value of trade covered by the measures that Trump has enacted was estimated to have passed the $100bn mark.
The blows landed to date are unlikely to upset the global economic apple cart, but the direction of travel is cause for concern. The World Trade Organisation (WTO) estimated that the scale of tariffs implemented as a consequence of Trump’s trade wars could easily surge through the trillion-dollar mark. That would be equivalent to a quarter or more of the US’s $3.9 trillion total trade with the world last year, and would cover at least 6% of global merchandise trade (worth $17.5 trillion in 2017, according to the WTO). This is likely to be of economic consequence, for both the US and the world.
Away from trade, further blows have been struck against international cooperation. While a meeting between President Trump and North Korean leader Kim Jong-un paved the way for a “new future” of peaceful relations between the two leaders’ countries, this was a rare moment of civility on the international stage. In May, Trump unilaterally withdrew the US from the deal between Iran, the UK, France, Germany and Russia, under which Iran had agreed to limit its nuclear programme in exchange for the lifting of certain Western sanctions. Separately, the war of words that accompanied the end of the 44th G7 summit could be considered the mood music for the current state of international diplomacy. Trump refused to allow US officials to endorse a planned joint communiqué after Canadian Prime Minister Trudeau’s comments in a press conference at the close of the event which suggested US tariffs were insulting.
After spending much of 2018 disregarding the risks of political turmoil in Italy, investors have rapidly reassessed that view as the country appeared on the brink of a possible constitutional crisis. When leading populist Italian political parties dropped their bid to form a government following a dramatic decision by Sergio Mattarella, the president, to block the nomination of an avowedly Eurosceptic finance minister, the country’s government borrowing rates spiked higher. After a week of grandstanding, a resolution was found and the Eurosceptic League and Five Star Movement parties formed Italy’s 65th government in 70 years. However, the fractious relationship between Italian politicians and Brussels only serves to remind investors of the obstacles to maintaining the eurozone’s status quo, let alone to trying to bring about further integration, as championed by French President Macron, in a bid to remedy institutional flaws.
Comments from the German EU budget minister, who voiced confidence in the ability of the markets to bring intransigent EU states to heel, did little to help relations. However, developments in German domestic politics pose a new challenge for the European federalists. Since the financial crisis, Germany, under the leadership of Angela Merkel, has been the fulcrum upon which European cohesion has rested. It could be argued that, following domestic challenges to her position, Merkel looks as tired as her national football team, and that, like the equity bull market, the pillar of Europe is crumbling.
Fans celebrating Mexico’s surprise victory over defending champions Germany at the World Cup shook the ground hard enough in Mexico City to set off earthquake detectors with two ‘artificial’ quakes. Unfortunately, there is nothing artificial about the renewed stress to which emerging markets have been subjected over the course of the second quarter.
The boom-bust track record of emerging markets is largely a function of the extent to which financial conditions in emerging markets are determined by the US Federal Reserve (Fed). In 2015, Professor Helene Rey of the London Business School presented a paper to the Kansas City Fed’s annual Jackson Hole symposium. She argued that ‘one of the determinants of the global financial cycle is monetary policy in the centre country, which affects leverage of global banks, capital flows and credit growth in the international financial system’.1
One of the determinants of the global financial cycle is monetary policy in the centre country, which affects leverage of global banks, capital flows and credit growth in the international financial systemProfessor Helene Rey, London Business School
When the Fed (and the European Central Bank (ECB) and the Bank of Japan) run loose monetary policy, financial capital goes in search of higher returns. Since the financial crisis, a combination of near-zero (or even negative) interest rates and extensive asset-purchase programmes has forced investors to go hunting for yield elsewhere in the world. Emerging-market borrowers have inevitably taken advantage of the low rates on offer, leading to significant increase in indebtedness over the last decade.
Sure as night follows day, currency mismatches between revenues and expenses play a role in any emerging-market financial crisis, the result of borrowing in foreign currency. While some emerging-market sovereigns have prudently reduced their issuance of hard-currency debt (debt issued in a non-local currency at a lower interest rate), the same cannot be said so readily of emerging-market companies. Hard-currency corporate debt has become far more widespread in the aftermath of the global financial crisis, with extensive US-dollar lending also taking place through the international banking channel. Turkish corporate debt doubled in ten years (to 70% of GDP), of which around half is in hard currency. If these companies’ revenues are predominantly earned in local currency, and that local currency depreciates versus the US dollar, default risks rise dramatically.
False sense of security?
As recently as the first quarter of this year, many investors argued that emerging markets were increasingly robust. US interest rates were rising, albeit slowly, but emerging markets were not showing any ill effects. Emerging-market assets were in vogue as financial capital went in search of returns, with 2017 seeing 12 consecutive months of positive portfolio inflows into emerging-market equity and debt.
The stability of emerging-market exchange rates served to confirm the encouraging readings offered by the economic gauges: inflation was low, balance of payments deficits were mostly in abeyance, and interest-rate spreads were narrowing. Never mind that, as recently as 2014/15, emerging markets were subject to a sustained bout of financial duress in the face of a rampant US dollar. Thanks to the apparent brevity of financial memory, this seemed to have been neatly consigned to distant and supposedly irrelevant history.
Central to the view that emerging-market fundamentals were in much better shape was the fact that current accounts have not deteriorated. Historically, when the Fed has run loose monetary policy, the capital that has flowed into emerging markets has underpinned an easing of domestic financial conditions, which in turn has inflated both demand and asset prices.
In this scenario, imports grow faster than exports, the trade balance deteriorates, and the economy becomes increasingly dependent on external financing. As such, a rapidly deteriorating current account deficit has been a tell-tale sign of rising financial vulnerability. However, in recent years, with the exception of Argentina and Turkey, balance of payments positions have mostly been benign.
Hanging in the balance
While balance-of-payment positions would appear to endorse the optimism around emerging markets, it would be foolish to give their economies a clean bill of health. Despite ongoing geopolitical spats, we remain in a highly globalized world. The composition of emerging-market economies, alongside their institutional monetary arrangements and existing balance sheets, means that the improved fundamentals upon which the bullish narrative is built are likely to have been driven by external factors.
As we have noted before, the reflation of the global economy and markets since early 2016 is the result of a return to central-bank largesse and the massive stimulus programme implemented by China. In a world dominated by US liquidity and Chinese demand, emerging-market imports and exports can both surprise on the upside, leaving trade balances broadly unchanged. This is precisely what has happened since early 2016. Emerging markets, particularly commodity producers and those in close geographical proximity to China, have broadly seen higher imports, thanks to rising liquidity-driven domestic demand, offset by higher exports thanks to rising Chinese demand.
While emerging markets have not been betraying the usual hallmarks of excess, we think it likely that inflated balance sheets, rapidly rising debt, overvalued asset prices and all the usual symptoms of excess associated with a ‘hunt-for-yield’ funded by easy money have increased vulnerabilities.
The recent declines in emerging-market asset prices are the latest challenge to the bullish consensus that prevailed at the start of the year. The extent to which the improvement in ‘fundamentals’ justified rapid capital inflows and buoyant asset prices, or to which it was largely the result of external factors that flattered the performance of emerging-market economies, cannot be known for certain. But just as the improvement in emerging-market fundamentals has been heavily dependent on external factors, the fortunes of emerging markets seem likely to deteriorate in the face of continued monetary tightening from the Federal Reserve and a further loss of economic momentum in China.
According to the Bank for International Settlements (BIS), the financial cycle in emerging markets has peaked.2 Credit and asset growth has rolled over, and the financial cycle tends to lead the economic cycle, particularly in a late-cycle environment when the trade-off between growth and inflation becomes increasingly challenging. Importantly, the end of the emerging-market financial cycle has very little to do with the quality of emerging-market balance sheets. According to the BIS, it has been the tightening in global financial conditions which has driven this process. To this end, it will be global liquidity conditions which determine if and when emerging markets can rebound. The risk of a sudden exodus of capital from emerging markets as the external environment deteriorates becomes very real, no matter what a country has delivered in terms of domestic economic and financial improvements.
A receding tide lowers all boats?
The course for the emerging-market financial cycle looks set, at least until we see a change of monetary policy tack from the Fed and the ECB.
The second quarter saw a continued tightening of monetary policy by the Fed, with a further 0.25% interest-rate hike and a continued reduction of the central bank’s balance sheet. While many investors have focused on the possible number of Fed rate hikes and the pace at which they will be delivered, the tightening of global liquidity that follows from the Fed’s balance sheet reduction continues. Despite the solvency issues in Turkey and growing emerging-market credit problems elsewhere, Fed Chair Jay Powell stated in a speech in Zurich that this planned liquidation will proceed as scheduled, and that it will have only limited impact on EMs:
“Monetary stimulus by the Fed and other advanced-economy central banks played a relatively limited role in the surge of capital flows to emerging-market economies (EMEs) in recent years. There is good reason to think that the normalisation of monetary policies in advanced economies should continue to prove manageable for EMEs.”3
Monetary stimulus by the Fed and other advanced-economy central banks played a relatively limited role in the surge of capital flows to emerging-market economies (EMEs) in recent years. There is good reason to think that the normalisation of monetary policies in advanced economies should continue to prove manageable for EMEs.Jay Powell, Fed
That ‘good reason’ has been provided by the researchers at the Fed and the International Monetary Fund (IMF) – two institutions imbued with a surfeit of academic economists who tend, we would argue, to have a poor grasp of how the financial system operates. Few of those, if any, who operate in financial markets would agree that record-low interest rates in the US, the eurozone and Japan have played a negligible role in sending capital into emerging markets. Nor does the Governor of the Reserve Bank of India:
“Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet. This is because the Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in government debt issuance. It must do so now…[and]…reduce the pace of its balance-sheet contraction by enough to… [mitigate] the shortage of dollar liquidity caused by higher US government borrowing. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”4
Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet. This is because the Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in government debt issuance. It must do so now…[and]…reduce the pace of its balance-sheet contraction by enough to… [mitigate] the shortage of dollar liquidity caused by higher US government borrowing. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.Governor, Reserve Bank of India
The Fed is not alone in its resolve to tighten policy. The ECB announced that it will end its three-year €2.4 trillion bond-buying programme at the end of the year, with a further tapering of monthly purchases likely before then. Europe has been the main source of financial capital for the rest of the world since early 2016. Reduced asset purchases by the ECB are contributing to the continued tightening of global liquidity. As the economics of the ‘hunt for yield’ deteriorate, financial capital is set to continue to flow out of emerging markets.
This has forced emerging-market central banks to tighten monetary policy in a bid to stem the outflows. But this exerts a monetary squeeze on the domestic economy. Credit growth will slow, cash flow deteriorate, asset prices sag and credit stress rise. The fact that Chinese equities have chalked up a 20% decline from their January peak to their June trough (which constitutes an official bear market) should not be dismissed lightly.
Main street versus wall street
The Fed has scant reason not to press ahead with normalisation of monetary policy. Indeed, it is now delivering on its interpretation of its dual mandate as legislated by the Federal Reserve Act – full employment and stable prices. The US economy shows signs of accelerating following the fiscal splurge of tax cuts. With government spending set to grow over the course of the second half of the year, many Fed governors have voiced concerns about the US overheating. Indeed, Fed Chairman Jay Powell noted in a recent speech that the last two cycles were brought to an end not by inflation but by financial instability. The Fed clearly has concerns that fiscal stimulus will lead to instability. The announcement that every policy-setting meeting will be followed by a press conference, effectively making every meeting potentially ‘live’ for a rate hike, speaks to this new found hawkish disposition
The first half of 2018 has already served up more challenges for investors to grapple with than the whole of 2017. First it was volatility selling, then the widening of LIBOR-OIS spreads,5 then Argentina calling on the IMF, and Turkey’s travails, while more recently it was trade wars and Italian politics. So far, investors have treated each shock as being largely idiosyncratic – unrelated and unforeseeable events that should be dismissed given solid fundamentals.
We would argue that these events are the direct consequence of reduced central-bank liquidity provisions. It is our contention that markets have not reached today’s lofty heights on the back of strong growth, but rather that a wave of cheap money has done the trick.
While the global liquidity taps were turned on, a wave of forced buying supressed volatility and rendered markets unable to price risk. With the world’s marginal price-insensitive buyers in retreat, markets are suddenly faced with the task of rediscovering the concept of fair value and how to price risk. Until the liquidity spigots are turned on again, it is likely that ‘shocks’ are going to take on an increasing systemic hue. We noted last quarter that the poor returns from risk assets over the course of the first quarter were historically consistent with slower economic momentum and tighter liquidity conditions. The second quarter has followed suit.
Economic data over the course of the quarter suggested a further waning of global economic momentum. Increasingly, the extrapolation of 2017’s synchronised global growth at the start of the year by Christine Lagarde, managing director of the IMF, looks set to be another overly optimistic forecast. Far worse is that many investors continue to point to robust global growth as the basis for continued good returns from risk assets. While over the long term, equity market returns do tend to align with nominal output growth, there is no correlation between economic growth and returns over the short term. Indeed, since the financial crisis began, market returns have dwarfed the growth in corporate profits.
Renowned economist Friedrich Hayek noted that, when money expands at a rate faster than real economic output, the excess liquidity inflates assets prices. Since the financial crisis, much of the liquidity created by central banks has directly inflated asset prices. As we have noted, central banks are vacating the stage when it comes to propping up asset prices trading at historically rich valuations. It is noteworthy that 2018’s stellar earnings growth has been unable to return equity markets to their January highs.
According to the latest poll of institutional investors by Bank of America Merrill Lynch, the net number of fund managers expecting earnings growth to improve over the next 12 months has fallen to an 18-month low of just 10 per cent. Despite this, the overall volume of mergers and acquisitions globally had already reached nearly $2 trillion by May. M&A splurges tend to be a classic late-cycle harbinger.We would argue that the worst investments tend to be made when money is cheap, valuations are rich, the economic outlook is optimal, optimism is infectious, and prospective returns are at their lowest. There are times when investors should focus on making money, and there are times when they should seek not to lose too much. Since late last year, we believe that we have been moving from the first situation to the second, and that a cautious approach is warranted. Consequently, we have positioned clients’ portfolios accordingly.
Key investment risks
- Past performance is not a guide to future performance.
- Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
- The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
- This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
- The strategy may use derivatives to generate returns as well as to reduce costs and/or the overall risk of the strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
- Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.
- The strategy holds bonds with a low credit rating that have a greater risk of default. These investments may affect the value of the strategy.
- The strategy may invest in emerging markets. These markets have additional risks due to less developed market practices.
- The strategy may invest in investments that are not traded regularly and are therefore subject to greater fluctuations in price.
2 BIS Annual Report 2017/18: https://www.bis.org/about/areport/areport2018.htm
4 https://economictimes.indiatimes.com/markets/stocks/news/us-federal-reserve-should-go-slow-on-unwinding-balance-sheet-rbi-governor/articleshow/64454170.cms ; https://www.ft.com/content/e193381a-64c1-11e8-bdd1-cc0534df682c
5 The difference between the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. LIBOR is the average interest rate that banks charge each other for short-term, unsecured loans. OIS represents a given country’s central-bank rate over the course of certain periods.
This is a financial promotion. This document is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that portfolio holdings and positioning are subject to change without notice. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority.