Emerging Markets

The prospects for Emerging and Frontier Markets in the post-Covid environment
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The prospects for Emerging and Frontier Markets in the post-Covid environment

Macro Letter – No 133 – 06-11-2020

The prospects for Emerging and Frontier Markets in the post-Covid environment

  • The Covid pandemic has accelerated several economic trends
  • Technology industries will benefit
  • Less developed countries will suffer
  • This crisis could see ‘The African Century’ postponed

During the past six months the global economy has been assailed by a multitude of vicissitudes. But on closer inspection, the pandemic has served to accelerate a number of economic and political trends which were in train long before the outbreak in Q1 of this year.

Back in February, when the crisis was largely confined on China and financial markets were still in denial, I wrote in – When the facts change: –

Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs.

Then came the panic of March. Stocks collapsed, developed market government bonds rallied, the VIX Index quadrupled: and central banks and government Treasuries intervened to an unprecedented degree in order to right the ship. Our leaders triumphed, stock markets recovered, bond yields moderated, short-term interest rates in several emerging market economies were slashed and the policy of quantitative easing spread, from the ‘developed’ core, to countries which could barely have contemplated such asset purchases during previous global crisies. Here are few of the actions taken by EM central banks: –

Source: VoxEU CEPR, Hartley and Rebucci

To some degree, masked by the gyrations of the stock market, certain longer-term economic trends have simply accelerated. Technology companies have taken centre-stage, with digital transformation changing the working practices of, perhaps, half the global labour-force. In the US it is estimated that the percentage of people now able to work remotely has risen from 41% to 59%, but whereas prior to the pandemic, remote work amounted to the occasional day, here or there, remote working has now become the new normal.

There has been a seismic shift in the real-estate market. Demand for commercial office space has declined, demand for larger residential units and for houses (with outdoor space) rather than apartments. This is an entirely predictable response to these changes in the nature of work.

Other technological trends have also accelerated. The robotics revolution is replacing humans in a wide array of industries in the way it transformed the car assembly line some decades ago. Add in advances in the digitisation of logistics and the era of ‘just in time production’ can much more effectively offset the higher cost of domestic manufacture. Global supply chains have been shortening since the great financial crisis. Since the spring these trends have gained additional momentum.

In March, in an article for AIER I asked – Is this the End of Globalization?Among the topics I discussed was the impact these supply chain trends may have on Emerging and Frontier markets: –

In his July 2019 essay for Project Syndicate, In Praise of Demographic Decline, Adair Turner observes:

Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. That’s good news for most of the world, but not for Africa.

The author goes on to suggest that for countries in demographic decline, automation of manufacturing processes is an economic boon, whereas for countries with rising fertility it is an impediment to improvements in their per capita standard of living. 

As with many trends among developed countries, Japan, where deaths outnumber births by an average of 1,000 people per day, is in the vanguard in embracing technology to counter the demographic deficit. The shortening of GVC’s will simply hasten their innovation in automation.

I went on to look at the rising use of robots: –

Source: IMF, International Federation of Robotics

The infographic above comes from a June 2018 IMF publication entitled, Land of the Rising Robotsin which the authors’ conclude: –

…the wave of change is clearly coming and will affect virtually all professions in one way or another. Japan is a relatively unique case. Given the population and labor force dynamics, the net benefits from increased automation have been high and could be even higher, and such technology may offer a partial solution to the challenge of supporting long-term productivity and economic growth.

Last year, the McKinsey Global Institute looked at the job security of different occupations in the face of automation in the US. Countries with lower average earnings will be slower to adopt automation but their comparative advantage is likely to be eroded, especially if the worlds’ trade policies grow more protectionist: –

Source: Mckinsey Global Institute

In labour-force terms, most of the roles which can be automated are unskilled. As long as EM and Frontier countries can maintain a comparative advantage in labour input costs, their unemployment rates will remain low. The threat of developed nation automation, however, imposes a ceiling on wages in all countries and developing nations will feel the effect most directly.

Returning to Lord Turner’s article for Project Syndicate – In Praise of Demographic Decline– the author quotes from the UN 2019 population projection which indicates that Asia, Europe and the Americas have almost achieved population stability. The problem of automation on employment prospects is therefore lower in these countries. It is poorer countries whose populations are young and still growing which are most at risk . This is especially true of Africa where the UN projects the population will soar from 1.34bln to 4.28bln by the end of the century.

Turner tentatively suggests there may be a universal rule of human behaviour; that rich, successful societies choose to adopt fertility rates which lead to gradual population decline. He also challenges the concept of the ‘working age’ population (15 to 64 years) questioning why, if longevity is increasing, that upper bound should still apply, going on to surmise: –

…in a world of rapidly expanding automation potential, demographic shrinkage is largely a boon, not a threat. Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. Conversely, automation makes it impossible to achieve full employment in countries still facing rapid population growth.

The author compares India, where the population continues to expand, with China, which has been aggressively embracing automation as its population ages and the effect of its ‘one child’ policies has caused its population to plateau – growing old before they grow rich.

If the greatest demographic challenges face countries with rapid population growth, then Africa may find its route to middle income status impeded, especially if developed nation manufacturing can be almost entirely automated.

As Turner concludes: –

Automation has turned conventional economic wisdom on its head: there is greater prosperity in fewer numbers.

The Covid-19 pandemic has caused other weaknesses of emerging economies to be laid bare. The IMF – How COVID-19 Will Increase Inequality in Emerging Markets and Developing Economies – published earlier this month, observes that, several years prior to the crisis, EM income inequality had begun to rise, along with worryingly high levels youth inactivity. They also note increasing educational inequality and an absence of economic opportunities for woman. All these trends have accelerated during the past nine months, to such an extent that the improvements of the last decade have been swept aside: –

Source: IMF

In their 2nd May briefing on EM bonds, The Economist took up this theme asking – Which emerging markets are in most in peril?The authors listed several EM bond issuers who had defaulted even before the current crisis had begun: –

Argentina has missed a $500m payment on its foreign bonds. If it cannot persuade creditors to swap their securities for less generous ones by May 22nd, it will be in default for the ninth time in its history… Ecuador, which has postponed $800m of bond payments for four months to help it cope with the pandemic; Lebanon, which defaulted on a $1.2bn bond in March; and Venezuela, which owes barrelfuls of cash (and crude oil) to its bondholders, bankers and geopolitical benefactors in China and Russia… Zambia, which is seeking to hire advisers for a “liability-management exercise”, an agreement to pay creditors somewhat less, somewhat later than it promised.

Anticipating trouble ahead they also produced this most informative table: –

Source: The Economist

The Economist notes that the 66 countries listed need to find $4trln to service their existing debt this year – which drops to $2.9trln once China is excluded. With luck this refinancing will be manageable. Global capital markets have matured and deepened greatly since the Asian crisis of 1997. The table below shows the percentage of local currency bonds issued by various EM borrowers today: –

Source: Institute of International Finance

On average 79% of these issuers tapped their local currency markets, rendering them relatively immune to speculative abuse on the foreign exchanges. By contrast, those countries which were obliged to tap the international market, raising capital primarily in US$, were forced to pay a substantial credit premium for the privilege.

The IMF, concerned by the rapidity of the capital flight from EM bond markets at the start of the pandemic, focussed their research on the risks of a sudden stop in credit markets and the policy actions which should be undertaken to avert disaster. The next chart shows the initial divergence and subsequent re-convergence of global government bond markets since Q1: –

Source: IMF

Surprisingly, international investor exposure to EM bonds has remained fairly static over the last five years, as the chart below reveals: –

Source: Institute of International Finance

As developed nation central banks have lowered interest rates and increased QE so the quest for yield has risen. Given the attractive yields offered by EM issuers one might have expected a significant increase in international exposure. It seems the risks of EM sovereign default has leant investors some degree of sobriety.

Of course the BIS has been keen to observe the synchronicity between this years’ EM bond rebound and the advent of EM central bank QE. Perhaps this new approach will strengthen the resolve of yield hungry investors: –

Source: EPFR, JP Morgan, BIS

Conclusions and Investment Opportunities

As a watcher (and trader) of the European government bond markets over more than three decades, I have observed the convergence and divergence of yield spreads between the periphery and the core. When looking beyond the Eurozone, one has to account for currency, as well as interest rate and duration risk. In the past EM bonds lacked of local currency liquidity which meant the credit risk could be taken through a spread between the US$ sovereign issuer and US Treasuries. Today the EM capital markets have matured, nonetheless, local currency bonds need to be hedged against adverse currency movement. Meanwhile, those issuers, forced to raise capital in the US$ markets are likely to be less liquid and, in many cases, less credit worthy.

The new paradigm for EM bond traders is the introduction of EM central bank QE. This is a ‘whatever it takes’ moment for many emerging nations. If they can successfully defend their currencies and their bond markets from speculative capital flight they will foster increased liquidity and with it increased capital raising capacity for the governments. We stand upon the threshold of a brave new world where an EM country, with a flexible exchange rate regime and well-anchored inflation expectations, can suspend disbelief and print its way out of a credit crisis. A recent BIS paper – Inflation at risk in advanced and emerging market economies– found that EM countries success in taming inflation, together with their adoption of inflation targeting frameworks, has greatly reduced upside inflation risks.

For the developed nation central banks, for whom the Bank of Japan has been the leader of innovation, for almost two decades, the efforts of EM central banks to wield QE, will be watched with bated breath. It still remains unclear how far a central bank can expand its balance sheet before the currency market calls it to task. Given that the Bank of Japan has yet to do so, it falls to an EM country will discover those limits. Until then, the widening of EM credit spreads will (selectively) provide an excellent buying opportunity.

In the longer term the demographic dividend of a young population may no longer be the panacea it once was hoped. Technology, and especially the automation of manufacturing means that countries which might have adopted a mercantilist, export driven approach to raise themselves out of poverty will find the road is longer and less rapid. Emerging economies will bifurcate into those that can afford to automate and those that need to support their unskilled youth. This will determine their economic growth trajectory, their government finances and the success of their domestic businesses. For emerging, and particularly Frontier economies, their youth, without education, is no longer unalloyed stuff of economic prosperity.

Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?
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Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?

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Macro Letter – No 107 – 04-01-2019

Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?

  • Emerging market currencies have suffered from US interest rate increases
  • The Dallas Fed proposes reserve/GDP ratio as a simple indicator of stress
  • If tightening is nearly complete their may be buying opportunities in EM stocks

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I speculated on whether US tightening of monetary policy and the reversal of QE was causing more difficulty for emerging markets – and even perhaps Europe – than it was for the domestic US economy. I was therefore delighted to receive an update on 9th December from the Federal Reserve Bank of Dallas, entitled, Reserve Adequacy Explains Emerging-Market Sensitivity to U.S. Monetary Policy. The authors, J. Scott Davis, Dan Crowley and Michael Morris, remind readers that Past-Chairman Greenspan made the following observations after the Asian crisis of 1997/98: –

In a 1999 speech to the World Bank, Greenspan summarized the rule stating “that countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year.

Personally I find the choice of one year to be a conveniently arbitrary time period, but the remark was probably more concerned with prudence, after the event, than an attempt to model the sudden-stop over time. It also ties in with the generally agreed definition of a country’s short-term debt, that which has to be repaid or rolled over within a year.

The authors go on to discuss reserve balances: –

Reserves are a safety net to guard against currency instability when major advanced economy central banks tighten policy.

The burning question is, what level of reserves is necessary to insure the stability of one’s currency? The authors suggest that this should be the following equation: –

FX reserves – Short-term foreign-currency denominated external debt + current account deficit

Their solution is to observe daily changes in the interest rate spread between the Corporate Emerging Market Bond Index (CEMBI) and 12 month Fed Fund Futures. To relate this to the level of central bank reserves an ‘interaction term’ is constructed which describes to relationship between reserve levels and credit spreads. An iterative process arrives at a level of reserves relative to a countries GDP. One may argue about the flaws in this simple model, however, it arrives at the conclusion that a 7.1% central bank currency reserve adequacy to GDP ratio is the inflection point: –

To that end, a range of possible threshold values is tested—from reserve adequacy of -10 percent of GDP to 20 percent of GDP. The threshold value most supported is 7.1 percent of GDP. When reserve adequacy is less than that, the sensitivity of the CEMBI spread to changes in fed funds futures is proportional to a country’s reserve adequacy, with the CEMBI spread becoming more sensitive as reserve adequacy declines. Reserve adequacy above 7.1 percent doesn’t much affect CEMBI sensitivity to expectations of U.S. monetary policy— sensitivity is similar whether reserve adequacy is 9 percent or 29 percent.

The chart below shows the level of reserves for selected EM countries since 2010, the colour coding shows in red those countries with reserves less than 7.1% of GDP and in blue those above the threshold: –

heat map of reserve to gdp ratio

Sources: International Monetary Fund; Bank for International Settlements; World Bank; Haver Analytics

China has maintained extremely high reserves despite maintaining fairly tight currency controls. The table above shows PBoC reserves gently declining but they remain well above the 7.1% inflection point.

Observations and recommendations

The Fed model is elegantly simple, it would be interesting to investigate its applicability to smaller developed economies; I imagine a similar pattern may be observed, although the reserve requirement inflection point might be lower, a reflection of the depth of their domestic capital markets. I also wonder about the effect of the absolute level of interest rates and the interest rate differential between one country and its reserve currency comparator – not all emerging markets peg themselves to the US$.

This study could also be applied to frontier economies although it may not necessarily be so effective in measuring risk when the statistical basis of GDP and other statistical measurements is suspect – consider the recent upward revisions of the economic size of countries such as Nigeria and Ghana. This paper from World Economics – Measuring GDP in Africa – March 2016 – has more detail.

As part of an initial screening of EM markets for potential risk, the central bank reserve to GDP ratio is easy to calculate. It will not reveal the exact timing of a currency depreciation but it is an excellent sanity check when one is tempted, for other reasons, to invest.

Last year Turkey and Argentina both saw a sudden depreciation, but, with the Federal Reserve now indicating that its tightening phase may have run its course, now is the time to look for value even among the casualties of the Fed. India is, of course, my long-term EM of choice, but as a shorter-term, speculative, recovery trade Turkish or Argentine bonds are worthy of consideration. With inverted curves, shorter duration bonds are their own reward. Argentine 4yr bonds spiked to yield 36% in November and currently offer a 33% yield. Turkish 1yr bonds are even more beguiling, they spiked to a yield of 32% in October but still offer a 22% return. Momentum still favours a short exposure so there is time to take advantage of these elevated returns.

A global slowdown in 2019 – is it already in the price?
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A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

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Canary in the coal-mine – Emerging market contagion

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Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

  • Emerging market currencies, bonds and stocks have weakened
  • Fears about the impact of US tariffs have been felt here most clearly
  • The risk to Europe and Japan is significant
  • Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.

 

 

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Where in the world? Hunting for value in the bond market

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Macro Letter – No 99 – 22-06-2018

Where in the world? Hunting for value in the bond market

  • Few government bond markets offer a positive real return
  • Those that do tend to have high associated currency risk
  • Active management of fixed income portfolios is the only real solution
  • Italy is the only G7 country offering a real-yield greater than 1.5%

In my last Macro Letter – Italy and the repricing of European government debt – I said: –

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets.

Suffice to say, I received a barrage of advice from some of my good friends who have worked in the fixed income markets for the majority of their careers. I felt I had perhaps been flippant in dismissing an entire asset class without so much as a qualm. In this letter I distil an analysis of more than one hundred markets around the world into a short list of markets which may be worthy of further analysis.

To begin with I organised countries by their most recent inflation rate, then I added their short term interest rate and finally, where I was able to find reliable information, a 10 year yield for the government bond of each country. I then calculated the real interest rate, real yield and shape of the yield curve.

At this point I applied three criteria, firstly that the real yield should be greater than 1.5%, second, that the real interest rate should also exceed that level: and finally, that the yield curve should be more than 2% positive. These measures are not entirely arbitrary. A real return of 1.5% is below the long-run average (1.7%) for fixed income securities in the US since 1900, though not by much. For an analysis of the data, this article from Observations and Notes is informative – U.S. 10-Year Treasury Note Real Return History: –

As you might have expected, the real returns earned were consistently below the initial coupon rate. The only exceptions occur around the time of the Great Depression. During this period, because of deflation, the value of some or all of the yearly interest payments was often higher than the original coupon rate, increasing the yield. (For more on this important period see The 1929 Stock Market Crash Revisited)

While the average coupon rate/nominal return was 4.9%, the average real return was only1.7%. Not surprisingly, the 3.2% difference between the two is the average inflation experienced for the century.

As an investor I require a positive expected real return with the minimum of risk, therefore if short term interest rates offer a real return of more than 1.5% I will incline to favour a floating rate rather than a fixed rate investment. Students of von Mises and Rothbard may beg to differ perhaps; for those of you who are unfamiliar with the Austrian view of the shape of the yield curve in an unhampered market, this article by Frank Shostak – How to Interpret the Shape of the Yield Curve provides an excellent primer. Markets are not unhampered and Central Banks, at the behest of their respective governments, have, since the dawn of the modern state, had an incentive to artificially lower short-term interest rates: and, latterly, rates across the entire maturity spectrum. For more on this subject (6,000 words) I refer you to my essay for the Cobden Centre – A History of Fractional Reserve Banking – the link will take you to part one, click here for part two.

Back to this week’s analysis. I am only interested in buying 10yr government bonds of credit worthy countries, where I can obtain a real yield on 10yr maturity which exceeds 1.5%, but I also require a positive yield curve of 2%. As you may observe in the table below, my original list of 100 countries diminishes rapidly: –

Real Bond yields 1.5 and 2 percent curve

Source: Investing.com, Trading Economics, WorldBondMarkets.com

Five members of this list have negative real interest rates – Italy (the only G7 country) included. Despite the recent prolonged period of negative rates, this situation is not normal. Once rates eventually normalise, either the yield curve will flatten or 10yr yields will rise. Setting aside geopolitical risks, as a non-domicile investor, do I really want to hold the obligations of nations whose short-term real interest rates are less than 1.5%? Probably not.

Thus, I arrive at my final cut. Those markets where short-term real interest rates exceed 1.5% and the yield curve is 2% positive. Only nine countries make it onto the table and, perhaps a testament to their governments ability to raise finance, not a single developed economy makes the grade: –

REal Bond yields 1.5 and 2 pecent curve and 1.5 real IR

Source: Investing.com, Trading Economics, WorldBondMarkets.com

There are a couple of caveats. The Ukrainian 10yr yield is derived, I therefore doubt its accuracy. 3yr Ukrainian bonds yield 16.83% and the yield curve is mildly inverted relative to official short-term rates. Brazilian bonds might look tempting, but it is important to remember that its currency, the Real, has declined by 14% against the US$ since January. The Indonesian Rupiah has been more stable, losing less than 3% this year, but, seen in the context of the move since 2012, during which time the currency has lost 35% of its purchasing power, Indonesian bonds cannot but considered ‘risk-free’. I could go on – each of these markets has lesser or greater currency risk.

I recant. For the long term investor there are bond markets which are worth consideration, but, setting aside access, liquidity and the uncertainty of exchange controls, they all require active currency management, which will inevitably reduce the expected return, due to factors such as the negative carry entailed in hedging.

Conclusions and investment opportunities

Investing in bond markets should be approached from a fundamental or technical perspective using strategies such as value or momentum. Since February 2012 Greek 10yr yields have fallen from a high of 41.77% to a low of 3.63%, although from the July 2014 low of 5.47% they rose to 19.44% in July 2015, before falling to recent lows in January of this year. For a trend following strategy, this move has presented abundant opportunity – it increases further if the strategy allows the investor to be short as well as long. Compare Greek bonds with Japanese 10yr JGBs which, over the same period, have fallen in yield from 1.02 in January 2012 to a low of -0.29% in July 2016. That is still a clear trend, although the current BoJ policy of yield curve control have created a roughly 10bp straight-jacket beyond which the central bank is committed to intervene. The value investor can still buy at zero and sell at 10bp – if you trust the resolve of the BoJ – it is likely to be profitable.

The idea of buying bonds and holding them to maturity may be profitable on occasion, but active management is the only logical approach in the current global environment, especially if one hopes to achieve acceptable real returns.

Is there any value in the government bond markets?
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Is there any value in the government bond markets?

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Macro Letter – Supplemental – No 4 – 12-5-2017

Is there any value in the government bond markets?

  • Since 2008 US 10yr T-bond yields have fallen from more than 5% to less than 2%
  • German 10yr Bunds yields have fallen even further from 4.5% to less than zero
  • With Central Bank inflation targets of 2% many bond markets offer little or no real return
  • In developed markets the inverse yield gap between dividend and bond has disappeared

Since the end of the great financial recession, bond yields in developed countries have fallen to historic lows. The bull market in stocks which began in March 2009, has been driven, more than any other factor, by the fall in the yield of government bonds.

With the Federal Reserve now increasing interest rates, investors are faced with a dilemma. If they own bonds already, should they continue to remain invested? Inflation is reasonable subdued and commodity prices have weakened recently as economic growth expectations have moderated once more. If investors own stocks they need to be watching the progress of the bond market: bonds drove stocks up, it is likely they will drive them back down as well.

The table below looks at the relative valuation between stocks and bonds in the major equity markets. The table (second item below) is ranked by the final column, DY-BY – Dividend Yield – Bond Yield, sometimes referred to as the yield gap. During most of the last fifty years the yield gap has been inverse, in other words dividend yields have been lower than bond yields, the chart directly below shows the pattern for the S&P500 and US 10yr government bonds going back to 1900:-

Chart-2-the-reverse-yield-gap-in-a-longer-term-con

Source: Newton Investment Management

Bonds_versus_Equities

Source: StarCapital, Investing.com, Trading Economics

The CAPE – Cyclically Adjusted Price Earnings Ratio and Dividend Yield Data is from the end of March, bond yields were taken on Monday morning 8th May, so these are not direct comparisons. The first thing to notice is that an inverse yield gap tends to be associated with countries which have higher inflation. This is logical, an equity investment ought to offer the investor an inflation hedge, a fixed income investor, by contrast, is naturally hedged against deflation.

Looking at the table in more detail, Turkey tops the list, with an excess return, for owning bonds rather than stocks, of more than 7%, yet with inflation running at a higher rate than the bond yield, the case for investment (based simple on this data) is not compelling – Turkish bonds offer a negative real yield. Brazil offers a more interesting prospect. The real bond yield is close to 6% whilst the Bovespa real dividend yield is negative.

Some weeks ago in Low cost manufacturing in Asia – The Mighty Five – MITI V – I looked more closely at India and Indonesia. For the international bond investor it is important to remember currency risk:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

If past performance is any guide to future returns, and all investment advisors disclaim this, then you should factor in between 2% and 4% per annum for a decline in the value of the capital invested in Indian and Indonesian bonds over the long run. This is not to suggest that there is no value in Indian or Indonesian bonds, merely that an investor must first decide about the currency risk. A 7% yield over ten years may appear attractive but if the value of the asset falls by a third, as has been the case in India during the past decade, this may not necessarily suffice.

Looking at the first table again, the relationship between bond yields in the Eurozone has been distorted by the actions of the ECB, nonetheless the real dividend yield for Finnish stocks at 3.2% is noteworthy, whilst Finnish bonds are not. Greek 10yr bonds are testing their lowest levels since August 2014 this week (5.61%) which is a long way from their highs of 2012 when yields briefly breached 40% during the Eurozone crisis. Emmanuel Macron’s election as France’s new President certainly helped but the German’s continue to baulk at issuing Eurobonds to bail out their profligate neighbours.

Conclusion and Investment Opportunity

Returning to the investor’s dilemma. Stocks and bonds are both historically expensive. They have been driven higher by a combination of monetary and quantitative easing by Central Banks and subdued inflation. For long-term investors such as pension funds, which need to invest in fixed income securities to match liabilities, the task is Herculean, precious few developed markets offer a real yield at all and none offer sufficient yield to match those pension liabilities.

During the bull-market these long-term investors actively increased the duration of their portfolios whilst at the same time the coupons on new issues fell steadily: new issues have a longer duration as well. It would seem sensible to shorten portfolio duration until one remembers that the Federal Reserve are scheduled to increase short term interest rates again in June. Short rates, in this scenario will rise faster than long-term rates. Where can the fixed income portfolio manager seek shelter?

Emerging market bonds offer limited liquidity since their markets are much smaller than those of the US and Europe. They offer the investor higher returns, but expose them to heady cocktail of currency risk, credit risk and the kind of geopolitical risk that ultra-long dated developed country bonds do not.

A workable solution is to consider credit and geopolitical risk at the outset and then actively manage the currency risk, or sub-contract this to an overlay manager. Sell long duration, low yielding developed country bonds and buy a diversified basket of emerging market bonds offering acceptable real return and, given that in many emerging markets corporate bonds offer lower credit risk than their respective government bond market, buy a carefully considered selection of liquid corporate names too. Sadly, many pension fund managers will not be permitted to make this type of investment for fiduciary reasons.

In answer to the original question in my title? Yes, I do believe there is still value in the government bond markets, but, given the absence of liquidity in many of the less developed markets – which are the ones offering identifiable value – the portfolio manager must be prepared to actively hedge using liquid markets to avoid a forced liquidation – currency hedging is one aspect of the strategy but the judicious use of interest rate swaps and options is a further refinement managers should consider.

This strategy shortens the duration of the bond portfolio because, not only purchase bonds with a shorter maturity, but also ones with a higher coupon. Actively managing currency risk (or delegating this role to a specialist currency overlay operator) whilst not entirely mitigating foreign exchange exposures, substantially reduces them.

Emerging market equities may well offer the best long run return, but a portfolio of emerging market bonds, with positive rather than negative real-yields, is far more compelling than continuously extending duration among the obligations of the governments of the developed world.

Will technology change the prospects for emerging market growth?
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Will technology change the prospects for emerging market growth?

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Macro Letter – No 75 – 21-04-2017

Will technology change the prospects for emerging market growth?

  • The challenge to low-cost manufacturing in emerging markets is from technology
  • Some industries will benefit but many jobs will be displaced globally
  • The mercantilist model of emerging market growth will need to adapt
  • Technology will solve some of the demographic challenges of the developed world

In July 2016 the International Labor Organisation (ILO) released a report entitled – ASEAN in Transformation – in the preface it relates the apocryphal story of a 1950’s conversation between Henry Ford, Chairman of Ford Motor Company, and Walter Reuther, Leader of the United Automobile Workers Union.

Ford asked, “Walter, how are you going to get those robots to pay your union dues?” to which Reuther responded, “Henry, how are you going to get them to buy your cars?” It reminds us that disruptive technology is not new. As the latest wave of innovation begins to disrupt employment globally, it makes sense to reassess the prospects for some of the world’s fastest growing economies.

The ILO report goes on to focus on the impact of technology on ASEAN countries, a region with 632mln people. This is an under-researched topic. They highlight the industries which are most likely to be affected and suggest ways countries can adapt to minimise the impact of automation on employment. This is their conclusion:-

Considerable opportunities for growth exist within ASEAN. Importantly, the local domestic market is expanding, and ASEAN’s middle class is expected to grow to 125 million by 2025. This represents a massive and emerging regional market.

However, threats remain, and in some cases, are intensifying. In particular, a range of labour-intensive sectors in a number of less developed countries are susceptible to major technological disruption, leading to potential large-scale job displacement. The consequences for these countries could be profoundly negative if they are unprepared to adapt.

We are witnessing the emergence of new markets, the potential relocation of production, the rise of new hiring trends and the displacement of lower skilled jobs. Supplying workers with the appropriate skills and competencies remains a major challenge. Overall, concerted efforts are required from all ASEAN stakeholders. They should act now to build a future of innovation and growth shaped with better employment opportunities.

The World Bank Development Report 2016 – Digital Dividends provides a global perspective. Here are a couple of graphs which illuminate the challenging landscape:-

World_Bank_-_Impact_of_Automation_on_employment_20

Source: World Bank

If the unadjusted percentages indicated in the graph above are realised the social and political stability of many countries maybe undermined, however, the next graph shows which occupations are likely to be most at risk. It also shows which occupations can be expected to benefit from the productivity enhancing impact of new technology:-

World_Bank_-_probability_of_being_computerised_and

Source: World Bank

Educational challenge

Be an expensive complement (stats knowhow) to something that’s getting cheaper (data).

—Hal Varian, Chief Economist, Google, 2014

Going back to the ILO report, the key to creating workers with the correct skills is designing appropriate education. According to Asian Nation:-

50.5% Asians, age 25 and older, who have a bachelor’s degree or higher level of education. Asians have the highest proportion of college graduates of any race or ethnic group in the country and this compares with 28 percent for all Americans 25 and older.

This graph shows the educational attainment across ASEAN:-

ASEAN_Student_Survey_-_ILO

Source: ILO

Singapore scores highly but so does Cambodia, however, it is the low skilled worker who will suffer; the retraining challenges, for Asia and elsewhere, will be substantial. More than 60% of salaried workers in Indonesia and 73% in Thailand are at risk from automation. The highest risk group are employed in Textiles, Clothing and Footware.  More than 9mln people are employed in this sector across ASEAN and the ILO estimate that 64% are at risk in Indonesia, 86% in Vietnam whilst in Cambodia that figure rises to 88%.

Business Process Outsourcing (BPO) is another industry which is ripe for automation. There is a heavy concentration of BPO in the Philippines where more than 1mln salaried working are employed. The ILO estimate that 89% are at risk from automation.

Earlier this year I discussed the demise of China as a low-cost manufacturing hub in – Low cost manufacturing in Asia – The Mighty Five – MITI V – Malaysia, India, Thailand, Indonesia and Vietnam. I concluded:-

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Over the next few years I remain confident about these economies but the headwinds of technology will blow through these markets, nonetheless. Low cost manufacturing has to be set alongside, efficient inventory management and transit costs. In the apparel industry, where trends change in a rapid and unpredictable fashion, the advantage of fast design to production lead times makes the benefits of robotic production, geographically close to the consumer, much more alluring.

In a fascinating post on LinkedIn – Robots Take Over – The Apparel Production – Susanna Koelblin – discusses the decision by Adidas to transfer a part of the production of their sports shoes back to Germany for the first time in more than 20 years. Another “Speed factory” will open in the US later this year. Here are some of her observations:-

It took 50 years for the world to install the first million industrial robots. The next million will take only eight. Importantly, much of the recent growth happened in particular in China, which has an aging population and where wages have risen…

German robot maker Kuka, acquired last year by China’s Midea, estimates a typical industrial robot costs about 5 euros an hour. Manufacturers spend 50 euros an hour to employ someone in Germany and about 10 euros an hour in China. Rather than seek out an even cheaper source of labor elsewhere – in another emerging Asian economy, say – Chinese manufacturers are choosing to install more robots, especially for more complex tasks. China isn’t getting rid of the work, just the workers…

It is in fact China which is leading the world in terms of the installation of industrial robots, but relative to the size of its workforce these concentrations are still relatively low. China boasts 4.9 robots/1,000 workers while Germany tops the world ranking at 30.1/1,000. That is almost twice the concentration of the US and four times that of the UK.

The current level of earnings in manufacturing still favours the work force of the MITI V but as the cost of automation continues to fall and average earnings in, lower cost Asia, rises, an inflection point will be reached:-

Wage_costs_-_inflation_and_currency_MITI_V_-_Tradi

Source: Trading Economics

Manufacturing wage inflation has been high in Indonesia partly in response to earlier currency depreciations – over 10 years the Rupiah has declined by 46% against the US$ whilst manufacturing wages have increased by 164%. All these emerging economies maintain a manufacturing cost advantage relative to robotic automation, however, for countries like Malaysia, which has seen its currency decline by 46.7% over the last five years, whilst manufacturing wages have only risen by 37.6%, the competitive advantage versus robotic automation is narrowing. Malaysia now has a manufacturing wage cost which is slightly higher than China’s.

Interestingly, India has seen a real-terms improvement in export competitiveness. Its currency has fallen 21.4% over five years but manufacturing wages have only risen by 14.6%. Vietnam and Thailand have seen export competitiveness decline, yet in both cases they have had considerable room for manoeuvre.

I am in agreement with Dr. Jing Bing Zhang, Research Director of IDC Worldwide Robotics, we should not be worried about automation derailing the emerging market growth model over the next decade. This is what he said in a recent interview with the Diplomat:-

There are different schools of thought…  From my research, I don’t see it. Maybe we will be less dependent on human labor. But there is no way this will eliminate the need for people in the next 15-20 years. We are entering high speed growth for robotics but in 2014 global density for robotics was still very low at 66 per 10,000 employees, 36 in China, 57 in Thailand, and close to none in India.

The uptake of robots does not appear to have damaged employment in Germany where unemployment recently dipped below 4%, the lowest level since 1981. One can argue that demographic forces are at work here but Germany has the highest concentration of robots relative to workers globally.

Chatham House – Robots and pensioners to the rescue – examines a different aspect of automation and demographics, focussing on Japan:-

Bleak demographics saddle Japan with a potential growth rate of less than 1 per cent, economists say, unless there are aggressive moves to accept more immigrants, boost the role of women in the workforce and overhaul workplace inefficiencies to increase productivity.

Yet despite its real and chronic problems, Japan may arguably be faring better than the image often projected of a country on the brink of an abyss. Japan still feels safe, prosperous and dazzlingly futuristic. While the overall economy has stagnated, GDP per head has outperformed most of the developed world, including Germany and France, according to World Bank figures − partly a consequence of the population crunch…

Most importantly, a shrinking population fosters innovation to boost productivity. Writing in the Financial Times, Michael Lind, a senior fellow at New America, a Washington think-tank, argued that a labour shortage can be a blessing rather than a curse: ‘Where labour is scarce and expensive, businesses have an incentive to invest in labour-saving technology,’ he wrote, ‘which boosts productivity growth by enabling fewer workers to produce more.’

That is precisely what is happening in today’s Japan, with investment pouring into robotics, industrial automation and artificial intelligence. Furuta notes that a similar phenomenon took place in 18th-century Japan, under the Tokugawa shoguns, when sharp population declines due to famine and natural disaster spurred an age of innovation in science, the arts and agriculture. Such thinking has prompted Prime Minister Abe to embrace the idea that Japan’s population crunch may have a silver lining: ‘Japan may be losing its population. But these are incentives,’ Abe said in a speech last year. ‘Japan’s demography, paradoxically, is not an onus, but a bonus.’

In my previous Macro Letter – No 72 – Low cost manufacturing in Asia – The Mighty Five – MITI V – I reproduced the latest Deloitte Global Manufacturing Competitiveness Index, here it is again:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deloitte

The MITI V are all expected to rise up the competitiveness ranking over the next three years – with the exception of Thailand which remains unchanged in 14th place.

I remain optimistic about emerging market growth, but keep in mind the industries which will benefit from technology and those which will be harmed. For example, the software developers of India look well placed to thrive; the garment workers of China may not.