This year, however, financial conditions have tightened, by about a standard deviation according to our FMCI. A strengthening dollar and tighter money market liquidity, and flat equities have driven overall financial conditions tighter. Until this year, financial conditions were behaving atypically for a Fed hiking cycle, as usually broader financial conditions tighten as the Fed hikes. If we project the typical historical relationship between fed funds and our FMCI forward through this year, we can expect another 0.5 or so standard deviations of tightening given our forecast for three more fed funds hikes, which would leave overall financial conditions at neutral levels over about the last 30 years, but around the tightest they have been in the post-crisis period (see Charts 1 and 2). The previous time we hit those readings, in late 2015, the economy came close to stalling.
We find that activity lags our FMCI by a relatively short period – about two quarters or so – while consumer prices react to our FMCI at relatively longer lags – about seven quarters or so. Roughly, we find that a one standard deviation move in our FMCI relates to about a 2.5x move in year-on-year industrial production growth and about 0.3pp on year-on-year core CPI.
Tighter financial conditions this year, along with less accommodative fiscal policy in 2019 make us think growth next year could come in substantially weaker than in 2018. We project fiscal policy to add around 1.0pp less to overall growth next year compared to this year; this, combined with the already one standard deviation tightening in financial conditions this year suggests a sizable slowdown in output growth in 2019. We see growth slowing from 3.0% q4/q4 this year to 1.4% q4/q4 next.
As financial conditions tighten, a risk-off move could accelerate tightening and possibly exacerbate a future slowdown. A distinct feature of post-crisis financial conditions has been the lowness/narrowness of corporate bond yields/spreads, which have remained more or less continuously accommodative since 2012. Corporates are by some measures historically leveraged, although in terms of debt serviceability, look less vulnerable. Still, profits could be increasingly pressured, especially as labor supply remains tight while growth slows as we expect, which higher borrowing costs could worsen. Such a combination would likely negatively impact investment spending, worsening a slowdown. Fed rhetoric, both from meetings and participants’ communication, has increasingly centered on shifting towards a neutral policy regime. Atlanta Fed President Rafael Bostic recently gave his range for neutral fed funds as 2.25-3.00%. With fed funds currently at 1.75-2.00%, this implies fed funds will be at neutral levels with just another two hikes. Once rates reach neutral levels, we think the Fed will find it difficult to press on if activity data begins to wobble; tighter financial conditions and pressure from the White House would make doing so even more difficult. Thus, we think the Fed will likely be nimble in pausing its hiking cycle in such a scenario. We see the Fed getting in another three hikes, taking fed funds to 2.50-2.75% by March, before it steps off the gas and pauses its hiking cycle.” – source BNP Paribas
The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off:
“The best place to look for trouble is where no-one expects it. The US consumer is the biggest source of demand in the world economy, and real personal spending came in unchanged in May, against a consensus forecast for a 0.2% monthly gain (equivalent to a 2.4% annual rate of increase). There’s a simple explanation for the disappointing consumer report, and that is the rising oil price. Consumer budgets are so stretched that a few cents more per gallon at the pump translates into reduced spending on other items.” – source Asia Times, David P Goldman, 30th of June.
To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets “repricing” accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.
While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income.
On this subject we read with interest CITI’s take from their Emerging Markets Economics Outlook & Strategy entitled “The stagflation risk in EM” from the 22nd of June 2018:
“The ‘stagflation’ risk in EM
The outlook for EM is turning more ‘stagflationary’, in the narrow sense that growth risks have shifted decisively to the downside, while inflation risks are creeping up. This is an idea we mentioned in the essay that introduced last month’s publication and is worth developing further. The basic problem here is capital flows. When capital flows into EM, currencies strengthen, creating disinflationary pressure. This is an idea we emphasized in our March essay, where we argued that the apparently ‘inflationless’ recovery in EM owed a lot to the disinflationary effects of nominal exchange rate appreciation. And equally, periods of capital inflow mean that the availability of external financing tends to support economic activity and confidence about the future. When capital flows go into reverse, the opposite happens: inflationary risks rise as currencies weaken, while growth comes under pressure. But there’s more going on in EM than just that, largely because the investment recovery has been particularly weak, leading to a number of disappointments in economic activity for EM, even before fx volatility started to rise in April. Those disappointments could get substantially weaker if any of three risks materialize: i) trade tensions continue to increase, ii) China’s current effort to loosen policy is ineffective, leading to a more dramatic weakness in China’s data, or iii) China’s capital account becomes destabilized by outflows. Figure 1.
The balance between inflation surprises and economic surprises among commodity exporters seems particularly bad… Figure 2. …while inflation surprises have not picked up among manufacturing exporters in such a hostile way
This ‘stagflation’ phenomenon is particularly a problem for commodity exporters. The quickest way to see this is in Figure 1 and Figure 2, which show a dramatic divergence recently between economic surprises and inflation surprises among commodity exporters (Figure 1) which is not especially evident among manufacturing exporters (Figure 2). This makes sense: it was commodity exporters that had enjoyed the biggest disinflation in 2016 and 2017 – thanks to the strengthening of exchange rates which accompanied the stabilisation of commodity prices after January 2016 – and whose economic recovery had been particularly important in pushing up aggregate growth numbers in EM. Yet the very factors that had proved disinflationary for commodity exporters – rising commodity prices leading to stronger currencies – had the opposite effect for manufacturing exporters. And while that rise in commodity prices created disinflationary pressure, it also supported economic expansion: the rise in commodity prices was the main factor which helped to end recessions in countries like Brazil, Russia, South Africa and Nigeria. All this was highly supportive for EM’s growth performance as a whole: in 2017, for example, Brazil and Russia by themselves added 35 bp to the overall increase in EM GDP growth of 68 bp.
The recovery in commodity-exporting EMs hadn’t been particularly strong, to begin with. Brazil and Russia are especially striking examples. Despite rising commodity prices, increased global (especially Chinese) demand, competitive currencies and the possibility of strong base effects following two years of economic contraction, the 2017 growth rate for these two economies was a mere 40% of their positive-growth 20 year average1. In Brazil, for example, after 5 consecutive quarters of growth since the economy’s trough in Q4 2016, the economy’s GDP has recovered by a mere 2.7 percentage points, well below the average of the previous four post-recession episodes which had seen recoveries of 7.3 percentage points, ie almost three times faster than the current expansion. And thanks now to the effect of the truckers’ strike, we revise growth for this year down to 1.7%, down from the 2.4% we expected at the start of the year. The basic problem in Brazil is investment weakness, driven particularly by a continuing deleveraging process in the corporate sector (Figure 3).
In Russia, investment spending has been in the doldrums since late 2013 and the recovery that started only in 2017 – boosted by large infrastructure projects, like the Power of Siberia and the Crimea Bridge – has been modest. Russian investment spending has been impeded primarily by the uncertainty related to the rising risk premium imparted into investment projects in the country. As Figure 4 shows, credit markets are not the constraint on investment in Russia as they are in Brazil.
The weakness of EM’s recovery in EM had been evident more broadly too. If we exclude year-country combinations where growth was negative from the sample, EM GDP in 2017 and 2018 is about 85% of that of 20-year average growth. This isn’t primarily caused by the structural slowdown in China; the number falls below 80% when China is excluded. Our suspicion is that the problem affecting Brazil and Russia is, to some extent, a problem shared by other countries; namely weak investment. Looking across the whole of EM ex-China, the growth rate of real investment last year was 3.8%, a far cry from the 9% average recorded during the boom years of 2003-2008. Coinciding with this – and perhaps explaining it – is the decline in net inflows of FDI to EM, which was a mere 0.7% of EM GDP last year, compared to 1.8% GDP during the boom years.
Now that external financial conditions are tightening, downside risks to growth should be taken seriously. We have argued that a change in expectations regarding the dollar would tighten financial conditions for many EM as capital becomes scarcer and more expensive and debt service costs increase. This appears to have materialized in recent weeks; increases in spreads and cumulative capital outflows are comparable in magnitude to those during the taper tantrum over the same horizon (Figure 5).
The economic effects of this capital outflow shouldn’t be devastating, however, for the simple reason that EM’s external position has improved considerably since 2013. As Figure 6 shows, the ‘basic balance’ of the ‘Fragile Five’ (Brazil, India, Indonesia, South Africa and Turkey) is considerably stronger than it was five years ago.
This means that – with the exception of Turkey and South Africa – the consequences of a ‘sudden stop’ in capital flows would require less adjustment than it did back then. So, we don’t expect many sharp contractions in economic activity (with the exception of Argentina, where a recession is likely in the middle quarters of 2018), but financing is still set to become scarcer and more expensive, and this should be a tax on growth, other things equal.
Downside risks to growth are also coming through via a trade channel. The prospect of a destabilized global trading order is obviously a risk to trade growth, and such a risk is likely to affect EM disproportionally; the many small, open economies that populate EM tend to have a higher trade to GDP ratios and significant shares of EM trade take place within global value chains. A more bilateral rather than multilateral trade environment could leave smaller economies out in the cold, e.g. if China were to switch from EM to US imports as part of a bilateral understanding with President Trump. And this kind of pressure will be occurring at a time when EM’s trade volume growth is rather precarious in any case. Figure 7 shows that trade volume growth has been declining recently in most of EM, while Figure 8 shows that while the relationship between trade growth and GDP growth has recovered a bit from its collapse between 2012 and 2015, trade growth is still rather weak relative to GDP growth in early 2018.
A fall in this relationship from current levels is likely to depress growth, as it did during the 2012-15 period when global trade growth was effectively in recession. Finally, it is worth reiterating a point we made in last month’s essay: that the risk of a stronger dollar by itself could weigh on global trade and EM exports; as large shares of global trade are priced in dollars, which means that an appreciation of the dollar can make exports (to countries other than the US and those with a dollar peg) less competitive if prices do not adjust instantaneously.
Just as capital outflows restrict the availability of financing and lead to downside risks to growth, so they also create upside risks for inflation. In Emerging Markets Economic Outlook & Strategy: Is EM enjoying an inflationless recovery?, we suggested that country-specific inflation is highly correlated with FX performance, so further exchange rate depreciation should obviously raise inflationary risks. Whether that turns out to be the case relies heavily on what happens to EURUSD (Figure 9), as we’ve repeatedly argued.
For the time being, we still forecast a 2% appreciation in EMFX over a 6-12 month horizon. However, this is a significant change from just two months ago, when we predicted EMFX to stay around or even appreciate from a much stronger level. But we have already seen EM central banks – and ourselves – having to reconsider the balance of inflation risks in response to the currency depreciation that’s occurred in the past two months. Back in April, for example, we did not expect rate hikes in Indonesia until Q2 2019 and not at all (over the forecast horizon) in India. Indonesia has since hiked twice and we expect another 25bp hike this year, resulting in 75bp cumulative hikes in 2018; while India has hiked once by 25bp and we forecast another 25bp hike before year-end. In addition, we have seen strong hikes to stop the free fall of the currency in Argentina and Turkey. Inflation in these countries was already high to start with, but the increase in oil prices and the dollar strengthening rendered a sharp reaction necessary. And finally, there are countries were expected (further) loosening of monetary policy did not occur. The most recent of these cases is Russia, where the central bank kept rates on hold last week amidst rising energy and fuel prices; we still predict cumulative 50bp cuts for the remainder of the year, but the downside risks to our end-year forecasts have significantly risen. Already earlier, the Brazilian central bank had ended its cutting cycle earlier than expected and left rates unchanged in May.
A further source of pressure on inflation comes from commodity prices. Oil prices are up 50% compared to one year ago and our commodities team forecasts further increases by the end of the year to just under $80/bbl in the base case. Moreover, they attach a 30% probability to an upside scenario, in which oil prices rise to over $90/bbl by year end and remain over $80/bbl throughout 2019. Somewhat elevated commodity prices can be favorable for EM; they are positive for the prospects of commodity exporters, increase the recycling of petrodollar surpluses and raise confidence in the asset class. However, commodity prices are only EM positive up to a point. For commodity importers, this is quite straightforward – higher commodity prices increase import bills and production costs. But also commodity exporters do not necessarily benefit from very high prices. Many EM extracts oil in rather conventional, high sunk cost/low variable cost ways. Higher oil prices then mean mostly larger profit margins and state revenues, but not necessarily increases in investment and production. A further risk comes from the rise in food price inflation that we’ve seen recently (Figure 10).
Corn, soybean, and wheat markets are up 10-25% so far this year, and prices are likely to remain elevated through 2018/19 as physical balances tighten and policy pushes, such as Chinese biofuel blending, promote demand growth.
These inflationary pressures are hitting EM at a time when real interest rates are historically low compared to DM, and China remains an important risk. The pressures we’ve tried to describe here – from capital outflows and higher commodity prices – come at a time when the real interest rate differential between EM and DM is historically low (Figure 11).
It goes without saying that higher inflation expectations will push the ex-ante real interest differential even lower. If one considers the real interest differential as indicating how strong the ‘magnet’ is that is sucking capital towards EM, it is easier to see how a hostile external environment and a reduction in risk appetite towards EM does not sit comfortably with a low-and-falling real interest rate differential.
China’s capital account is a puzzle and should be considered the next big risk to watch. In late 2016 and early 2017, China introduced a raft of controls on capital outflows in an effort to prevent further loss of fx reserves, which at that time had fallen by a quarter to $3 trillion. Those controls were highly effective, in the sense that China’s reserves did indeed stabilize. But that stabilization was also strongly supported by the weakness of the dollar in 2017 and early 2018 since the dollar’s weakness helped to push capital towards China in just the same way that it pushed capital towards other emerging economies.
So, one might expect that a period of dollar appreciation would suck capital from China, particularly at a time when economic activity in China has entered a period of undeniable weakness, which has required a loosening of both monetary and fiscal policy. Yet that doesn’t yet seem to be the case: there is no current evidence of unwelcome outflows from China. Indeed, Chinese authorities have recently acted in a way that expressed a high degree of confidence about net capital flows, announcing measures to liberalize outflows as well as inflows. But we think this is worth watching very carefully, if only because an acceleration of capital outflows while the economy is weak would likely weigh further on risk appetite towards EM. Further depreciation of the RMB would almost certainly intensify the ‘stagflationary’ biases that we see in EM.” – source CITI
As a reminder this our macro reverse osmosis thesis we discussed in our conversation “Osmotic pressure” back in August 2013:
“In a normal “macro” osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and “positive asset correlations” in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse “macro” osmosis we think.Positive US real rates therefore lead to a hypertonic surrounding in our “macro” reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment.” – Macronomics, August 2013.
More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike. When capital flows go into reverse, the opposite happens, whereas QE was deflationary and supporting capital inflows into EM, QT is inflationary therefore inflationary risks rise as currencies weaken, while growth comes under pressure hence a potential “stagflationary outcome”. When it comes to China as we wrote back in February 2014 in our conversation “Crosswind“, China has been succeeding so far in the “controlled demolition” of its risky shadow banking:
“Of course the Chinese crosswind is of two folds, on one hand China’s deflating exercise is akin to a “controlled demolition” and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.” – source Macronomics, February 2014
China is still busy reducing credit excesses in its shadow banking. More recently, the Yuan had a much weaker tone in the past month thanks to US-China trade tensions escalating. For China, it is still a very difficult balancing act in the process hence our “controlled demolition analogy used in the past. In the current attrition warfare taking place, liquidity is being slowly drained, indicating that the credit cycle is turning and financial conditions will continue to tighten. We read with interest UBS’s take when it comes to the latest briefing from the PBC monetary policy from their 3rd of July note entitled “Signs of loosening haven’t boosted risk appetite”:
“PBC has signaled easing, but the impact remains to be seen
The briefing statement from the PBC’s Q2 monetary policy committee meeting, held on 28 June, includes a call to maintain “reasonably ample” liquidity, which echoes similar language (“maintain reasonably ample liquidity and financial stability”) at the State Council’s executive committee meeting on 20 June. Against this backdrop, Rmb510bn of reverse repos come due in the first week of July, followed by Rmb188.5bn of MLFs the next week, and this month will see another wave of tax payments. On the other hand, the PBC withdrew a net Rmb370bn from the system through OMO in the last week of June, though net withdrawals for the month were lower, at Rmb210bn. In our view, the net result of all this will depend on PBC operations. Given the internal and external pressure on GDP growth, we think the PBC’s focus on maintaining stable liquidity is unlikely to change.
RMB plunged against USD in June
The PBC lowered the USD/CNY fix by 3.5% in June. While constraints related to RMB bond issuance may have been a short-term trigger, we view this more as a one-off adjustment after rapid appreciation against non-USD currencies, and we note the RMB is still up 0.8% against the basket YTD despite the correction. While the PBC’s stance has shifted, its moves seem mostly targeted in nature. Overall, we think USD price action will be the bigger driver once this one-time adjustment is behind us.
CDR setbacks haven’t restored risk appetite − but inflection point is brewing
Domestic investors see monetary policy as caught in a dilemma between loosening, which could drive rising property prices and RMB depreciation, and tightening, which undermines GDP growth. In the stock market, sentiment has continued to deteriorate alongside widening credit spreads. Looking at stock market liquidity, outstanding margin debt has contracted and northbound investors have trimmed their stakes, with only industry capital investment registering net purchases in the past fortnight. However, an inflection point looks to be on the horizon. CDR offerings − the biggest near-term impediment to onshore stock market liquidity − have run into delays, while A-share valuations have dipped to 1 standard deviation below the five-year mean amid economic risk. Therefore, we think potentially faltering economic data in June/July could drive expectations of looser credit and fiscal policies and hence signal a rebound.” – source UBS
It appears that the potential for the trade war to escalate is on everyone’s radar. As we posited in January 2017, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen. This overall has clearly had an impact on global financial conditions. But, if indeed the current account balance in the US deteriorates, then the US dollar could weaken going forward.
Much pain has been inflicted so far in the Emerging Markets space with significant fund outflows in some instances. Some are starting to wonder if we are due for a rebound.
- Final chart – Emerging Markets pain. Are we done yet?
As we discussed in our June conversation “Mercantilism“, trade war escalation would have a greater impact on EM than on DM given the high beta nature of EM and the macro osmosis thesis discussed prior which explains the significant inflows into EM in recent years and most recent outflows. We continue to think that the second part of the year could prove more and more challenging with the gradual liquidity spigot being turned by central banks. Rising dispersion in terms of asset allocation, in credit or equities, remains the name of the game. Our final chart comes from Deutsche Bank EM and Fixed Income note from the 3rd of July entitled “The trend is not always your friend” and displays their EM Risk Monitor, showing that it could still get worse for EM:
“The EM Risk Monitor – an EM-specific measure of risk sentiment – has also been trending in the risk negative territory for some time now, but it is still far from the levels seen in February this year. This indicates that if external conditions continue to remain unfavourable (e.g. broad dollar strength), there is potential for more negativity in EM sentiment.” – source Deutsche Bank
If the “Attrition warfare” they will be many more casualties in the EM space that’s a given and the stagflationary outcome would materialize itself fairly rapidly we think. We are already seeing signs of growth deceleration (Global Manufacturing PMI at 53, 11 month low). Clearly, this third quarter is not starting on a strong footing as such we have started to slightly add to our long US duration exposure. We continue to view gold favorably in that “warfare” context.
“There is no instance of a nation benefitting from prolonged warfare.” – Sun Tzu