Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
The recent market sell-off was different in two regards. The U.S. dollar was not viewed as a safe haven and Emerging Market equities did not underperform their developed market counterparts.
This was even more surprising as the catalyst for the sell-off was rising U.S. interest rates. Normally, this would be supportive of the U.S. currency due to widening interest rate differentials and the role of the dollar as the world’s reserve currency.
We have written before about the deteriorating debt dynamics in the U.S. and the quandary the authorities will find themselves in should rates need to be increased by any substantial amount. In simple terms the U.S. Federal reserve could at some point find themselves unable to raise rates beyond a certain level without investors questioning the sustainability of U.S. debt levels. At that point outright monetisation could potentially become (as it is in Japan) an unstated government policy.
U.S. Gross Federal Government debt as a percentage of GDP now stands at 105%. Of this approximately 30% is held by other federal agencies, primarily the social security fund. In addition, the U.S. Federal Reserve now owns about 10% of all U.S. Treasuries. Despite these cross holdings by other agencies, the U.S. Government must still pay interest on the total gross debt amount.
Total tax collection in the U.S. for last year was estimated to be approximately 26% of GDP, which would place the U.S. 31st out of 35 OECD countries, just ahead of Turkey and behind South Korea. By comparison the average tax revenues to GDP for the OECD last year was 34.1%. U.S. income tax collection for corporates and individuals as a percentage of GDP is surprising similar to that of the OECD. The major reason for the lower tax receipts by U.S. government entities is the lack of a value added tax.
At the federal level U.S. tax collection is quite a bit lower than the total, averaging only 16.5% over the past ten years. To put this number in context, it has not been above 21% since the end of the Second World War.
With gross U.S. government debt accounting for approximately 105% of GDP it is hard to see how interest rates could rise by any significant amount without consuming an unacceptably large percentage of federal revenues. An average interest rate on U.S. government debt of 4.0% for example would consume almost one quarter of U.S. Federal tax revenues. This we believe would be politically unacceptable as it would begin to crowd out other budget expenditures, many of which are fixed.
The rebuttal to this alarmist view of U.S. debt dynamics is that most of the current debt outstanding is receiving interest rates that are low by historical standards. The current average interest rate on U.S. government debt is only 2.38%. As a result total interest payments as a percentage of GDP are only half the levels seen in the early 1980’s. For the average interest rate to get close to the 4.0% level, there would need to be a fairly substantial increase in interest rates.
The last time U.S. interest rates rose and the U.S. dollar sold off was prior to the 1987 crash. At the time U.S. government debt to GDP was only 60% of GDP, although nominal and real interest rates were much higher than they are today. For example, rates on thirty year bonds increased by over 300 basis points to 10.5% in a little less than two months prior to the crash. At the same time consumer price inflation was accelerating from an annualised rate of only 1.5% in January to 4.5% in October.
The main argument against this scenario repeating itself is the power of the digital economy and globalisation. The internet and global supply chains in lower cost emerging markets (particularly China) have enabled both buyers and sellers to seek out the best prices for goods. It is assumed in this environment that deflation is the norm. At the same time the pricing power of labour has also been diminished by automation and outsourcing. This is certainly the bet that U.S. policy makers are making. Not only are they pursuing a weak dollar policy, massive fiscal stimulus (an estimated one trillion dollar budget deficit forecast for this year) and a still fairly easy monetary policy. A comparison of short rates today with those prevailing in 1987 is quite illustrative- the U.S. Federal Reserve increased the federal funds rate in September of that year to 7.5% with the unemployment rate at 5.7%. Today the federal funds rate is 1.5% and the unemployment rate is 4.1%.
Our conclusion is that the developed markets, and not just the U.S. will continue to err on the side of stimulative, pro-growth macroeconomic policies. Although Japan’s debt dynamics are even worse than those in the U.S., policy makers have the benefit of a Central Bank that seems more than willing to monetise the government’s deficits and a relatively high current account surplus (3.5% of GDP) that helps stabilise the value of the currency.
If the markets begin to believe that the U.S. Federal Reserve is hesitant to increase interest rates when necessary, or if they begin to backtrack on tapering plans due to widening deficits and rising government debt levels then we can expect a significant increase in market volatility.
The issue that investors will then need to grapple with is what is truly a safe haven under this scenario? Could U.S. dollar cash actually be considered a relatively risky asset given its declining value? Or are commodities or even emerging market currencies and equities, where most countries have much lower debt to GDP ratios, a better bet in order to preserve purchasing power?
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