Global reflation has been the predominant investment theme driving markets the last couple of quarters. While tentative signs of reflation were evident prior to November’s US election, Trump’s election victory injected extra impetus. The prospect of large fiscal stimulus, deregulation and a host of other growth supportive measures has awakened animal spirits, providing a renewed sense of vigour to credit and equity markets in the process. The same can’t be said for duration however. Reflation usually implies not only stronger growth but also a return to trend inflation and, by implication, to higher interest rates – a combination typically not so duration supportive. Unsurprisingly, US 10 year bond yields have since repriced upward, pushing past 2.50%. Reflation of sorts also appears to be taking hold in Europe, albeit without the “Trumpian” push. Eurozone headline inflation tracked 2% YoY in February, while composite PMIs display expansionary trends across both core and peripheral European economies. German bunds have emerged from their negative yielding slumber as a result, and the 10 year yield stands within a hair’s breadth of 0.50%.
Although rates are under pressure in the US and Eurozone, there are several examples of emerging market economies that are at a fundamentally different stage in the monetary cycle and where the outlook for duration is very favourable. Brazil, Russia and Colombia are three such examples. These are economies that have experienced domestic crises of one sort or another in recent years, but are now well advanced in their adjustment.
Let’s take a look at these three examples in more detail:
Brazil has spent the past two years in deep recession. The economy was badly affected by the sharp decline in global commodity prices and an internal political crisis connected to the Petrobras corruption scandal. It also continues to reel from the effects of former President Dilma Rousseff’s fiscal profligacy, where extravagant and unwise expenditure on higher pensions and unproductive tax breaks drove the budget deficit in excess of 10% of GDP. Inflation surged to a peak of 11% on the back of currency depreciation pass-through, as well as the imposition of some overdue hikes on regulated prices. Despite the deep recession, Banco Central do Brasil (BCB) acted decisively and credibly throughout the crisis, steadfastly retaining a hawkish stance in order to rein in inflation back toward its target range. Their prudence has been rewarded. Inflation has declined rapidly over the past number of months, with February’s 4.76% IPCA inflation print within touching distance of the 4.50% central bank target. The political situation has also seen some stabilisation, with Dilma Rousseff’s impeachment paving the way for the incumbent Temer administration to push ahead with much needed fiscal reforms. The combination of strong disinflationary trends and positive fiscal momentum has been crucial for providing the BCB with the space necessary to embark on an aggressive easing cycle. Brazilian local currency bonds continue to perform strongly as a result.
Russia’s economy has also been in the grip of a recession for much of the past two years. Plummeting oil prices in 2014/2015 coincided with the imposition of international economic sanctions on Russia following its military intervention in Ukraine and subsequent annexation of Crimea. The crisis precipitated sharp declines in both economic output and the ruble, while inflation peaked close to 17%. These developments forced the Central Bank of Russia (CBR) to dramatically increase its key policy rate from 10.5% to 17.0% in a bid to shore up the currency and curtail inflationary pressures, in spite of the tenuous growth backdrop. While the CBR has since cut the policy rate, at current levels of 10% it remains elevated. The CBR’s proactive policy response has been instrumental in tempering inflation however. Inflation has declined sharply, and at 4.6% is at the lowest level since the end of the Soviet era. With real rates so high, the CBR has the scope to implement further rate cuts credibly. On the fiscal side, a policy response package of expenditure cuts in real terms, bank recapitalisation and tapping of the Reserve Fund, has facilitated the economy’s adjustment to lower oil prices and economic sanctions.
Colombia, another major oil exporter, also stood exposed to the sharp decline in oil prices. Inflation soared from 2013’s low of 1.7% to a peak of 9.0% by mid-2016, as the peso tumbled and the resultant pass-through effects lifted consumer prices. Compounding the inflation woes, adverse El Niño weather conditions combined with a national truck drivers’ strike placed additional upward pressure on food prices. Banco de la República (BanRep) responded with 11 consecutive rate hikes totaling 325bp, pushing the policy rate to 7.75%. Tighter monetary conditions, a reversal of the temporary supply shocks on inflation, and peso appreciation on the back of oil stabilisation have seen inflation reverse back toward BanRep’s 2-4% target range allowing the central bank to credibly initiate a cutting cycle. Developments have also been positive on the fiscal front with Congress passing a package of ambitious tax reforms last December in a move to shore up public finances hard hit by the drop in oil revenues. These efforts have been recognized by credit rating agencies. Last week, Fitch affirmed Colombia’s BBB sovereign rating and revised the outlook to stable from negative citing ‘the reduction in macroeconomic imbalances…diminished uncertainties surrounding Colombia’s fiscal consolidation path…and the expectation that inflation converges towards the central bank’s target.’
In all three cases above there is a consistent theme: a policy mix of tighter fiscal management combined with monetary easing from a tight stance. The three central banks are still in a relatively early stage of their cutting cycle, meaning that the bonds should remain supported in the quarters to come. These conditions create the perfect environment for duration to perform.
What about the currency risk? Easier monetary policy does not necessarily require you to hedge out the FX risk. In all three examples above, the FX proposition is also attractive. Essentially, inflation has been decelerating faster than the central banks have been easing monetary conditions. The result has been that real policy rates are at historical highs, thanks to the cautious and credible action by the respective central banks. There are also some green shoots of growth emerging, albeit from a low base; and from the external perspective, current accounts are in good shape or on the right path – Russia’s remains in surplus, whilst Brazil’s and Colombia’s is improving.
Investors have been attracted by the real rates on offer, so much so that both the BCB and CBR have been intervening in various forms to slow down currency appreciation. That’s hardly surprising when real policy rates in Brazil, Russia and Colombia are currently 7.3%, 5.0% and 2.8% respectively versus negative in the US and Germany. The combination of high real rates, external adjustment and bottoming growth – and not forgetting global reflation’s positive impact on EM growth – is a supportive mix for the currencies.
Global reflation need not be a challenge for all duration.