Race to the Bottom
Central banks have shifted decisively towards easing this year. The Fed set the ball rolling in January, with its pivot away from rate hikes and balance sheet reduction. Since then, several central banks in emerging (China, India) and developed (Australia, New Zealand) economies have delivered easier policy. Last week saw important dovish interventions from both the Fed and the ECB, setting the scene for both to ease in Q3.
There are two major drivers behind this shift. One is inflation. Inflation has been low for many years, for a variety of reasons discussed by my colleague Jason Davis in this blog a few weeks ago. Inflation expectations are adaptive – low inflation in the past creates expectations of low inflation in the future. This year, we reached a tipping point where inflation expectations had fallen too far, and had chipped away too much at central bank credibility.
This happened first in Japan, where low inflation slowly became entrenched over two decades. Next came the Eurozone, where inflation has stagnated around 1% for several years, and, as a result, market expectations of medium-term Eurozone inflation have tumbled this year to barely above 1%.
And even in the US, where inflation has been somewhat higher, the Fed has consistently failed to meet its 2% inflation target, and inflation expectations have drifted steadily downwards. The Fed has seen low inflation become entrenched in Japan, and starting to become entrenched in the Eurozone, and is determined to stop that happening in the US.
Low inflation and low inflation expectations created a very dovish backdrop, making central banks ready to ease on any slowdown in growth. That growth catalyst duly arrived with the weakening in trade, manufacturing and investment, associated with the trade war, which has pushed the global growth outlook below trend.
We expect the Fed to cut its policy rate by 75 basis points this year, reversing most of last year’s hikes, with further easing likely to come next year. We also expect the ECB to lower its policy rate even further into negative territory this year, and to restart its bond purchase programme. Other central banks are likely to follow suit. This underpins our positive view on government bonds.
There are some respects in which easing by many central banks is mutually reinforcing. Yet in one important respect, central banks are competing. Capital flows away from currencies with lower interest rates, and a lower exchange rate is an important channel through which easier monetary policy boosts growth and inflation, especially for open economies. But as Reserve Bank of Australia Governor Philip Lowe put it succinctly this week “if everyone is easing, there is no exchange rate channel”. That could encourage central banks to ease more, to at least prevent appreciation of their currencies, in something of a race to the bottom.
In this cycle, the trade war adds a new dimension to the currency channel. President Trump was quick to criticise Mario Draghi’s dovish speech last week, and it is quite possible that ECB easing could ratchet trade tensions with the US higher, undoing some of this impact of the easing, and perversely leaving the Eurozone in need of further stimulus.
One way out of this race to the bottom is for easing to come as much from fiscal policy as from monetary policy. Indeed, without the explicit coordination envisaged by Modern Monetary Theory and the like, monetary policy has been very supportive of fiscal policy, by reducing government financing costs. Especially in Japan and the Eurozone, this has had a big impact on fiscal deficits, and has created the fiscal space for governments to ease (see chart).
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EMD: High quality income in a low yielding world (again)
In our January blog post titled “Emerging Markets Debt: Can we earn that carry?” we defended the possibility of a continued recovery of the asset class after the strong start of the year. Our optimism has been rewarded: Through June, EM sovereign is up by 11.2%, leaving the losses of 2018 behind.
Such a strong first half of the year again begs the question: what comes next? We think there are three main reasons that emerging markets debt (EMD) will remain in demand as a source of quality carry: 1) the resurgence of a low yielding environment boosts the search for income 2) emerging markets debt offers an income pick up with solid credit quality 3) default rates in EMD remain low.
Technical tailwind from the search-for-income flows
Dovish shifts from global central banks this year have pushed a quarter of developed markets bond yields to negative territory again1. For EUR based investors in particular, less than half of Global Aggregate Bonds stock is yielding positively now. Emerging market debt has historically been a beneficiary of income-seeking flows under such a backdrop.
Better average quality behind the carry
EMD issuers, both sovereigns and corporates, have enhanced their balance sheets over the past years. EM sovereign index (EMBI Global Diversified) has returned to investment grade average rating after losing it in 2014. EM corporate net leverage is now at the lowest since 2013.
Comparable default and rating transition rates
As a result of the balance sheet improvement, we see EM in a better shape preparing for external shocks. The default rate for EM high yield corporate is estimated at 2.6% for 2019, which is below long term average. Moreover, despite the risk premium from having emerging market post codes, credit rating transition rates in EMD are actually similar with developed market counterparts (chart 4).
Conclusion
In the current low yielding environment, we believe investors’ search for yield will resume, resulting in demand for quality income solutions. With better average quality and lower leverage, we believe EMD should continue to stay on top of asset allocators’ mind for the foreseeable future.
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- Bloomberg Barclays Global Aggregate Bond Index, local currency, as of June 2019.
FOMC Statement & Potential Impact on Fixed Income
Investing in Uncertain Times: November 2016 to Present and Beyond
Credit Convexity: Are you being paid for the risk?
Treasury STRIPS: State of the Market
