Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
The big shock for most investors this year has been the weakness of the U.S. dollar. It had become consensus that the U.S. Federal Reserve would begin the process of shrinking its balance sheet and increasing interest rates in a more aggressive fashion in reaction to an expanding economy and aggressive fiscal spending by the Trump administration.
Instead it has used the excuse of low wage growth, political uncertainty and bad weather (hurricanes) to become more accommodative than expected. At the
same time the lack of legislative success by the Trump administration as well as its stated preference for a weaker dollar has combined with uncertainty
about Janet Yellen’s successor and an improving outlook in Europe to create a much more bearish outlook for the U.S currency.
For the Emerging Equity class this has been hugely positive, at least over the short term. Not only has it allowed interest rates to continue to decline in most of our markets, it has supported commodity prices and significantly reduced capital flight. China in particular has benefited from a significant reduction in pressure on the renminbi (helped along by some aggressive administrative measures). Emerging debt spreads have also continued to contract further reducing the cost of capital for emerging market companies.
These factors in combination with positive bottom-up earnings revisions and very strong domestic liquidity have been hugely supportive of asset prices. The question that we now need to ask ourselves is what could go wrong?
The initial response that most investors would give is the risk of a more aggressive U.S. Federal Reserve, leading to a stronger U.S. currency and a reversal of many of the positive factors cited above.
It is a testament to the success of the massive money printing exercise by developed market Central Banks since the global financial crisis, that a smaller percentage would see a return to deflation as a significant near term risk. There seems to be little doubt on the part of investors that the authorities would quickly reverse course should the market react negatively to any attempt to “normalise” interest rates and balance sheets.
One risk that would also be down most lists would be a further weakening of the U.S. currency. It has become consensus that a weaker dollar is good for the emerging market asset class. Very few investors can recall what happened in 1987 when a weaker dollar lead to a backup in U.S. dollar interest rates and a sudden market collapse. We are certainly not predicting this to happen, although if we look at a number of recent events, the risk of this occurring has certainly increased over the past few months.
The recent budget deal that President Trump agreed to with top Congressional Democrats that extends the debt ceiling to early next year showed not only his willingness to deal with his opponents, it also showed to some extent his dissatisfaction with fellow Republicans. We continue to believe that Trump’s economic strategy begins with deregulation, then tax cuts, then infrastructure spending and if none of these work the risk of trade tariffs becomes very real. It also encompasses a belief that a weaker dollar is helpful to the U.S. economy.
If Trump and the Republicans are unable to agree on a tax bill it is most likely that he will return to the Democrats for support. This would most likely result in a significant increase in Federal Government spending, particularly on infrastructure, with a resulting expansion in the budget deficit. Markets, including emerging equities, would probably at first welcome this move to increase economic growth.
The wild card is how the bond market would react to this move. Would it be a similar outcome to what we have seen in Japan where the Central Bank is clearly monetising the Government deficit and buying assets, including stocks, with very little detrimental impact on the currency or interest rates? Or would the combination of continued lax monetary policy, fiscal expansion and a weaker currency finally lead once and for all to the end of the structural decline in interest rates seen over the past thirty five years in the developed markets? This would ultimately be negative for all asset classes, particularly equities.
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