By Jan Dehn
The global backdrop became more supportive for emerging market assets at the end of January and once again it was due to an entirely non-EM central bank event, namely additional easing from the Bank of Japan (BOJ), which embarked on negative interest rates. The BOJ is now following in the footsteps of the Danes, the Swiss and the European Central Bank (ECB).
Moves to negative rates in the UK and the US seem only a question of time. Given the intensifying slump in the US business cycle, negative rates may indeed be closer than markets think. Recent FOMC minutes showed clearly that the Fed is now retreating at a record pace from the optimistic rhetoric that accompanied its 25bps hike in December 2015.
Capital markets’ optimism points to ‘severe myopia’
Capital markets initially greeted the BOJ move and eventually the FOMC minutes with optimism. Sadly, such excitement is prima facie evidence of severe myopia.
The myopia disease that afflicts the finance industry is so severe that investors simply do not appear to recognise that any strategy of economic recovery that relies solely on monetary policy easing merely ends up being a vicious circle. Long-term institutional investors should be cognisant of this vicious circle and how best to avoid getting sucked into its vortex.
The starting point for a defensive investment strategy is to have a clear understanding of why monetary easing-only policies will fail. Countries rely exclusively on monetary policy easing fail to address two particular problems. The first is productivity. Monetary policies do not address supply-side issues. Excessive use of monetary policy eventually impedes productivity by encouraging speculative behaviour over long-term investment. The second problem is debt. Monetary easing is ‘sold’ as a remedy against destructive deflation and a means of temporarily easing debt service burdens, but these benefits accrue only at the expense of savers and future generations. At the same time, easy monetary policies typically encourage even greater borrowing. This is the situation right now in developed countries, where government debt burdens have gone up sharply since 2008/2009.
When monetary policies are used to excess in countries with evident productivity and debt challenges they quickly lead to new problems. The most important of these is that currencies and financial asset prices become heavily distorted relative to fundamentals – i.e. enormous bubbles are created.
The bubbles created by the excessive monetary easing in the QE economies will eventually burst – either through inflation or through the collapse of QE currencies or both – and when they do the economic consequences will be horrible. Not only will asset prices fall but the economic damage – impacting the ability and willingness to pay, that is real risk – will also be material. What makes matters even worse today is that most of the fiscal and monetary ammunition has already been expended in developed countries, so if the worst were to happen there are no remedies.
Buy into the value created in the non-QE markets
So what to do? The best way to avoid the losses implied in current valuations in the QE markets, especially given the weak fundamental backdrop, is to leave those markets and to buy into the value created in the non-QE markets in the past few years.
One excellent reason for switching to EM is that the fundamental picture is improving in both relative and absolute terms. EM has definitely slowed down in recent years (though EM is still growing twice as fast as developed markets) but this slowdown is cyclical in nature. It has been caused by financial tightening and the big shifts in global currencies resulting from outflows from the asset class as institutional investors – jumping on the QE bandwagon – financed additional developed market exposure by selling EM positions. The cyclical adjustment is now well advanced. The clear improvement in EM’s external balances should provide significant encouragement for EM investors.
Investors are understandably also focused on the possibility of more shocks hitting EM. Given the magnitude of the shocks there have been surprising few casualties. Aside from the few countries in EM that screw up every year for various reasons there has only been one sovereign restructuring in Ukraine. Argentina also defaulted, but for technical reasons rather than anything related to global economic conditions. Corporate HY default rates in EM remain below their long-term average and are now lower than HY default rates in the US.
Finally, you get paid. There is not a bubble in EM fixed income markets, where all asset prices – in absolute terms – trade at or lower than when the Fed has interest rates at 5.375%. The last few years of QE euphoria in developed markets has cheapened EM sharply as investors made room to buy more QE assets by reducing their exposure to non-QE markets. Now is the time to reverse this trade. Remember that the purpose of an investment is not just to make money; it is also to protect capital from the losses that are coming due to the vicious circle of excessive use of monetary policies in developed markets. An EM investment today holds out the prospect of achieving both those objectives.
Jan Dehn is head of research at Ashmore
