We enter the fourth quarter with a better risk tone to the market following the US Federal Reserve’s (Fed) extension of Operation Twist, their announcement of open-ended Quantitative Easing 3 (QE3) and the European Central Bank’s (ECB) announcement of its bond buying Outright Monetary Transaction (OMT) program. Taken together, these coordinated policy actions have lessened the chances of a negative left tail event within global financial markets.
Even before the Fed’s announcement risk assets performed well through the third quarter, on expectations of policy action following ECB governor Mario Draghi’s July speech where he pledged to ‘do whatever was necessary’ to save the Euro. Sovereign external (hard currency) debt (EMBIG) has been the star performer this year returning more than US equities and US High Yield, followed by EM Corporate (CEMBI Broad) and EM Local Currency Debt (GBI-EM Global).
The key question we debated at our quarterly investment meeting was the potential for policy responses in developed markets to stimulate organically led growth. It is clear that we have not seen a decoupling of developed markets and emerging markets. Our Leading Economic Indicator shows growth expectations have turned down to below trend since the last quarter, but some flattening is in evidence. The Fed’s recent actions should have a positive impact on asset pricing, however it may be short lived, unless we see some further credible response on the fiscal side from the US and further stimulus from the Chinese. Global growth expectations will likely bottom in the fourth quarter and healthier domestic demand in EM countries will help to underpin a growth pick up towards the end of the year. One risk to this view is the potential for a more protracted slow down in China. Necessary further policy stimulus may come only after the political transition has occurred and currently no date has been set for the transition.
It is likely that the first half of the quarter will fall in to our Scenario 2, where the market is ‘risk on’ buoyed by the liquidity injection from the Fed and the ECB’s Draghi ‘put’. In this environment we will have a positive risk bias in the portfolios looking for further spread compression, particularly in high yield sectors, and currency appreciation. Commodities may continue to rally which could be an issue for EM inflation and potentially limit the ability for central banks to ease further. We do not see inflation as an immediate concern this quarter despite the strong rises in wheat, corn and oil prices. Strong base effects are keeping inflation under control and core inflation remains benign.
The second half of the quarter may disappoint with the market slipping back into our Scenario 1, the ‘Muddle through growth scenario’. Policy stimulus in China, Spanish and potentially Italian entry into the ESM and a credible fiscal plan for dealing with the US debt ceiling/fiscal cliff will be required to avert a return to Scenario 1 and move to the more bullish Scenario 4.
We are constructive on all three sectors of EMD during the first half of the fourth quarter. We expect further gains from the high yield sector (both corporate and sovereign) and from local currencies, particularly those with higher interest rates and a link to economic cyclicality. Flows into the asset class remain strong as investors continue to seek yield and diversify away from developed markets. However, we remain cautious about the prospect for a bounce in global economic growth and weary of idiosyncratic political risks in Europe and the US causing a return to risk aversion.