Looking ahead to the next FOMC meeting in July, the decision on whether or not to raise rates remains far from clear. Whilst US Q2 GDP is tracking around 2.5% (and Q1’s weak print is likely to be revised higher), the labour market which had been solidly improving is now looking mixed. In addition, although inflation has picked up on both headline and core measures, long term inflation expectations continue to weaken, with the University of Michigan survey hitting a record low. Our assessment of the overall health of the US economy leads us to believe that the Fed may be able to raise rates up to two times by the turn of the year but they cannot go too fast or too far. Indeed, the risks to our view are to the downside. “Too fast” may result in a repeat of the financial market stress that greeted us at the start of this year. “Too far” and divergent monetary policy between major central banks will risk a tide of money flowing into the US from the Eurozone and Japan, as well as from EM in general, and China in particular.
So how far can the Fed go? Not very far because growth will be slow and inflation will be low. US trend growth has been falling for a while, due to both lower productivity growth and demographics. The demographic headwinds that we all know about in Japan (where the working population has been shrinking, rather than merely growing more slowly) is beginning to occur in other developed countries too. We put the US’s GDP growth potential no higher than about 1.75%.
Meanwhile the world is also becoming less willing to trade. Outside of recession years, world trade tends to grow, and we believe that stronger global trade tends to go together with stronger global growth. Trade is now shrinking as countries “protect” their own growth by importing less from others. Although the contraction is very recent and still very marginal, the trend is clear:
Let’s now throw in leverage that remains very high in many countries, concerns over global commodities prices, China capital outflow concerns which have eased but not gone away, as well as increasing political risks with US elections this year and Germany’s and France’s next year. Taken together, our view is that the global economic outlook means that the Fed would do well to get Fed Funds up to 2% during this hiking cycle. Indeed we think the risks are that they fall short of this level and this tells us one more thing: real rates, after accounting for inflation, will be at zero or negative.
As you perhaps know, the fixed income common research language is based on fundamental, quantitative valuation, and technical analysis. The beauty of this framework is that it enables comparisons across all sectors of the fixed income universe and the global integration of investment ideas. Often we tend to focus on fundamentals and valuations, as they offer compelling stories that are intuitively understandable to a broad range of investors. However, for some time we have been emphasising the technical part, not because there’s nothing to talk about on EM fundamentals (on the contrary) but because we believe they represent a profound game changer to investing.
As Laurence De Munter highlighted in her blog earlier in June (see Europe – a more negative yielding world, 9 June 2016), 40% of the European government bond market is trading with a negative yield, and the ECB’s recently announced Corporate Sector Purchase Programme (CSPP) is pushing corporate yields in the same direction.
The traditional investment solution would be to either lengthen duration or lower credit quality. However, as the chart below shows, the German 15-year Bund offers a yield of merely 0.14%, which suggests that longer duration is not necessarily a meaningful solution to low yields. Lowering credit quality, such as switching to Belgian or Italian government bonds, would seem a better idea, as the chart shows. But a yield of 1.76% for a 15-year bond seems low by any comparison and in particular if there are higher yielding and higher rated alternatives. In fact, Mexico’s 15-year EUR government bond offers 2.89% at a higher rating than Italy. Mexico is rated A3/BBB+/BBB+ compared to Baa2/BBB-/BBB+ for Italy. This also applies to shorter-dated bonds, which means that thanks to ECB buying, EUR-based investors now have the chance to earn a higher carry on a higher-rated bond without currency risk.
Not surprisingly, both retail and institutional investors continue rotating into emerging markets debt. Our Applied Research Team estimates that Emerging Market Debt funds attracted inflows of more than US dollar 5.6 billion since the beginning of this March. It could be argued that some of these flows are tactical and not necessarily strategic reallocation. However, institutional demand for EM debt strategies has also picked up significantly since the beginning of the year. Indeed, the run-rate of Requests for Proposals (RFP) in the first five months of 2016 suggests the busiest year ahead since 2012 in terms of RFP activity.
We are conscious of the fact that many investors still see emerging markets debt as a niche allocation in a multi-asset portfolio. One of the concerns is that the asset class lacks depth to absorb large-scale demand for bonds from pension funds and insurance companies looking to cover future liabilities. A study by Bank of America Merrill Lynch research estimates the total amount of EM debt outstanding at US dollar 14.8 trillion in 2014.
Not all of the segments shown in the chart above are easily accessible to investors, in particular the corporate bond market in local currency. But the rest are well established markets, some of which go back to the late 1980s, and still offer a total amount of US dollar 8.7 trillion. The government and corporate hard currency markets can be accessed via the JPM EMBI and CEMBI index families and the government local currency market via the GBI-EM index family. However, even the corporate local currency market is increasingly opening up, evidenced by steps such as China’s recently announced measures to ease access for foreign investors.
In sum, on-going central bank buying significantly reduces the investable universe in developed market bonds, especially in the Euro area. This raises the prospect of permanently lower yields which is likely to fuel further strategic re-allocation into emerging market debt, which offers attractive yields at comparable or better credit quality and ample depth to absorb demand.
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