Big Fish, Small Pond?
It’s the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem — the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.
But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.
These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets. In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.
But change is on its way. MS surveys show most classes of global institutional investors intend to boost allocations to emerging markets, including the more conservative investor groups – Japan’s $1.3 trillion government pension insurance fund, for instance, plans to start buying emerging equities later this year. MS analysts calculate allocations to emerging markets could rise 3.5% over the next five years.
That may not sound like much until one realises the true scale of the global pool of investable institutional assets and compares them with current market cap values in developing countries . These assets currently exceed $212 trillion, meaning a 3.5 % allocation increase will bring over $2 trillion into emerging markets. That’s over half the capitalisation of EM equity market, more than 80% of bond markets and a third of the combined market cap of both sectors.
Take a look at some more numbers:
– Based on current market values, a 1% increase in allocation to EM by pension and insurance funds represents a $524 billion flow to EM assets.
Hungary can seek IMF aid now. But can it cut rates?
The European Union has given Budapest the green light to seek aid from the IMF. (see here) In fact, the breakthrough after five months of dispute does not let Hungary completely off the hook — to get its hands on the money, Viktor Orban’s government will have to backtack on some controversial recent legislation, starting with its efforts to curb the central bank’s independence. It remains to be seen if Orban will actually cave in.
But markets are reacting as if the IMF money is in Hungary’s pocket already. There have been sharp rallies in Hungarian dollar bonds, CDS and currency markets (see graphic below from Capital Economics). The Budapest stock market has posted its best one-day gain since last November while the yield on local 10-year bonds have collapsed almost 100 bps. Hungarian officials are (a bit prematurely) talking of issuing bonds on world markets.
What investors are hoping for now is a cut to the 7 percent interest rate. Hungary’s central bank jacked up rates by 100 bps in recent months to defend the forint as cash fled the country. Now there is a chance those rate rises can be reeled back in. After all, the moribund economy could really use a dash of monetary easing. Thanasis Petronikolos, head of emerging debt at Baring Asset Management has been overweight Hungary and recalls that after 2008 crisis, the central bank was able to quickly take back its 300 bps of currency-defensive rate hikes.
In the aftermath of this, the central bank may be prompted to cut short term interest rates. If the risk premium comes down a lot, the central bank may feel that 7 percent interest rates are not justified. I’m expecting them to at least take this 100 bps back assuming they can reach an agreement with the IMF.
Hungary’s FRAs (forward rate agreement), are still pricing slightly higher short-term interest rates and have not yet reacted to the shifting picture. Many urge caution however on the rate cut expectations, noting that Orban and the IMF may struggle to reach common ground and the central bank will want to see money on the table before it actually acts.
Petronikolos is right in that the economy is moribund, credit growth has slumped and there is a big output gap. But headline inflation is running at 5.5 percent, well above the central bank’s 3 percent target, due to an increase in sales tax. Sandor Jobbagy, at CIB Bank in Budapest is one analyst who says inflation risks have forced him to push back the date of likely interest rate cuts.
The “least worst” option?
Western governments saddled with mountainous debts will “repress” creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called “From Depression to repression”.
Building on the work of U.S. economist Carmen Reinhardt and others, King’s focus on the history of heavily indebted governments applying “financial repression” to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that “Golden Age” – and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a “sideshow”, he reckons. To show t
Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be “persistently lower growth”, whatever your conclusion about the desirability of state or the market allocation of resources.
And, in the absence of an obvious alternative, repression may also be the “least worst” option, King argues.
Renihart is exactly right. But there is a darker theory yet: that Fed policy is just part of a government-wide strategy of practicing “financial repression” to escape from the consequences of the debt explosion. The leading expert on financial repression is Carmen Reinhart of the Peterson Institute. She defines it as a situation in which “governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere.”
Low or negative real interest rates are among the oldest examples. Call this monetary repression. Reinhart points out that it was practiced on a large scale by governments after World War II. She asserts that it accomplished by stealth the effective cancelation of government debt without resort to orthodox spending and tax policies for which governments knew then and now that they cannot get the electorate’s consent.
A similar debt predicament today implies that monetary and other forms of repression are again on the cards, especially in the United States. Wainwright has attempted to measure it, but estimates of real interest rates and monetary repression are fuzzy and contentious, especially because the government as¬serts control over the method by which inflation is measured.
Nevertheless, the company’s research, estimates that the Fed’s interest-rate policy in 2007-11 has cut the real interest rate from a normal 2 or 3 percent to an aver¬age of minus 7 or 8 percent. That’s a diversion of about ten percentage points a year to the Treasury and other borrowers—just about enough to fund the current budget deficit. Genius…
Luis de Agustin
Ukraine’s $58 billion problem
Ukrainian officials were at pains to reassure investors last week that no debt default was in the offing. But people familiar with the numbers will find it hard to believe them.
The government must find over $5.3 billion this year to repay maturing external debt, including $3 billion to the IMF and $2 billion to Russian state bank VTB. Bad enough but there is worse: Ukrainian companies and banks too have hefty debt maturities this year. Total external financing needs– corporate and sovereign – amount to $58 billion, analysts at Capital Economics calculate. That’s a third of Ukraine’s GDP and makes a default of some kind very likely. The following graphic is from Capital Economics.
In normal circumstances Ukraine — and Ukrainian companies — could have gone to market and borrowed the money. Quite a few developing countries such as Lithuania recently tapped markets, others including Jamaica plan to do so. Ukraine’s problem is its refusal to toe the IMF line. Agreeing to the IMF’s main demand to lift crippling gas subsidies would unlock a $15 billion loan programme, giving access to the loan cash as well as to global bond markets. But removing subsidies would be political suicide ahead of elections in October. And with the sovereign frozen out of bond markets, Ukrainian companies too will find it hard to raise cash.
So what options does Ukraine have? It could yet sell bonds on global markets. Or it could, as the finance minister sugggested last week, borrow at home in hard currency. But its tiny, illiquid local debt markets are unlikely to attract too many foreign investors. And yields will be ruinous. Ukraine’s 2015 dollar bond is trading with a yield of 9 percent and Ukrainian sovereign dollar debt carries a hefty 870 basis-point premium to U.S. Treasuries, among the highest in emerging markets. Analysts at Capital Economics write:
Issuing debt at interest rates of 8-10% is unsustainable for a country that even on the IMF’s optimistic projections is likely to record average nominal GDP growth (in US$) of only 4.5% a year over the next three years.
The government could also dip into the central bank’s $30 billion reserves. But this would be a temporary fix. Also, reserves are already down $7 billion since last August and spending more of this could leave the hryvnia seriously exposed in coming months.
Hard times for EM in QE-less world of higher US yields
Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what’s next for emerging markets? Most observers put this year’s stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That’s kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.
Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that’s an environement in which EM assets tend to underperform.
For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve, pushing the spread between 2-year/10-year Treasuries almost 100 bps wider. Flows to emerging markets dipped sharply, the following graph shows:
Money did continue to flow into emerging local bonds and equities in this period, albeit at a slower pace. But from local bonds the return was negative, HSBC notes. That could be an indication of what’s to come:
The carry trade is not dead yet but the change in tone by the Fed suggests it may have passed its best days.
Headwinds for emerging markets may in fact be greater now than 18 months ago. U.S. growth expectations haven’t budged much HSBC says: the bank expects U.S. growth under 2 percent this year and in 2013. On the other hand emerging market output gaps are much tighter than they were 18 months back and oil prices are higher. That makes the outlook for emerging local currency bonds more challenging, especially as a stronger dollar will give EM currencies less room to rise.
Should ongoing improvements in U.S. data result in further hawkish moves from the Fed and if such changes see U.S. yields rise further, we would expect this to be positive for the dollar vs EM . The combination of a potentially more inflationary backbone and a more challenging backdrop for EM FX might become a headwind for local rates.
Japanization of euro zone bonds?
Fear of many years of stagnation in the major western economies has everyone fretting about a repeat of the “lost decades” that Japan suffered after its banking and real estate bubble burst in the early 1990s. Indeed HSBC economists were recently keen to point out that U.S. per capita growth over the noughties was already actually weaker than either of Japan’s lost decades.
But in a detailed presentation on the impact of two years of soveriegn debt crisis on euro zone government bond holdings, Barclays economist Laurent Fransolet asks whether that market too is turning into the Japanese government bond market — where years of slow growth, zero interest rates, current account surpluses and captive local buyers have depressed borrowing rates for years and turned JGBs into an increasingly domestic market dominated by local banks, pension funds and insurers. Non-residents hold less than 10 percent of JGBs, compared to more than 50 percent for the EGB as a whole, and Japanese banks hold up to 35 percent of their own government bond market.
But is the euro government market heading in that direction after successive crises have seen foreign investors flee many of the peripheral markets of Greece, Portugal, Ireland and even Italy and Spain? Fransolet argues that the seniority of substantial European Central Bank holdings built up in the interim (now about 15 percent of each of the five peripheral markets) may be one reason why these foreign investors will be wary of returning. Meantime, euro zone banks, who have traditionally held a high 20-25 percentage point share of euro government markets, withdrew sharply late last year amid balance sheet repair pressures but have rebuilt holdings again sharply in early 2012 after the ECB’s liquidity injections — particularly in Italy and Spain.
In answer to the longer-term question of whether euro bonds will turn into a more insular market dominated less by interest rate signals than liquidity, regulatory and balance sheet issues, Fransolet is equivocal. On one level they are still very different — state-sector holdings of euro debt are still far from Japan’s, the euro market has clearly fragmented and net new issuance of euro debt is also still way below Japan.
However, the trend is clearly toward a more domestically driven market in the periphery of euro bloc in particular and local banks are becoming bigger players. And, crucially, although foreign investors may not return en masse soon, their impact on those markets via futures and CDS markets and index weightings may still be high.
Yield-hungry tilt to equity from credit
For income-focused investors, the choice between stocks and corporate bonds has been a no-brainer in recent years. In a volatile world, corporate debt tends to be less sensitive to market gyrations and also has offered better yields – last year non-financial European corporate bonds provided a yield pickup of 73 basis points above stocks, Morgan Stanley calculates.
But, long a fan of credit over equity, MS reckons the picture may now be changing and points out that European equities are offering better yields than credit for the first time in over a decade. (The graphic below compares dividend yields on non-financial euro STOXX index with the IBOXX European non-financial corporate bond index. The former narrowly wins.)
The extra yield available on equities, coupled with perceptions of a more stable macro backdrop, may encourage income-oriented investors back into stocks.
The bank has put together a 10-stock basket with an average 2012 yield of 5.1 pct (vs MSCI Europe’s 3.9 pct). That is around 250 bps higher than corresponding bonds. Check out Britain’s Vodafone – its shares offer a whopping 8.3 percent yield. That’s 600 bps above its 5-year implied credit yield.
That sounds tempting. But there are caveats. The best yield pickup is available in sectors where investors remain underweight — utilities and telecoms. And a positive yield gap is not always a bullish signal for stocks, Morgan Stanley warns. Japanese dividend yields have been above bond yields since 2008.
Hungary’s plan to get some cash in the bank
Hungary says it might borrow money from global bond markets before it lands a long-awaited aid deal with the International Monetary Fund. That pretty much seems to suggest Budapest has given up hope of getting the IMF cash any time soon. Given the fund has already said it won’t visit Hungary in April, that view would seem correct.
There is some logic to the plan.
Hungary desperately needs the cash — it must find over 4 billion euros just to repay external debt this year.
It is also an attractive time to sell debt. Appetite for emerging market debt remains strong. Emerging bond yield premiums over U.S. Treasuries have contracted sharply this year and stand near seven-month lows. Moreover, U.S. Treasury yields may rise, potentially making debt issuance more costly in coming months.
For Hungary’s government , the idea of a successful bond sale is particularly attractive as this will at a stroke improve its bargaining position with the IMF. That’s bad news, says Tim Ash, RBS head of emerging European research:
The problem is that getting cash in the bank may actually reduce the likelihood of the government actually finally cutting a deal with the IMF, so arguably increases market risk over the slightly longer term.
He concedes however:
Oil prices — Geopolitics or growth?
It’s the economy, stupid. Or isn’t it?
Brent crude has risen 15 percent since the end of last year, focusing people’s minds on the potential this has to choke off the recovery in world growth. But some reckon it is the recovery that’s at least partly responsible for the surging oil prices — economic data from United States and Germany has been strong of late. There are hopes that France and the United Kingdom may escape recession after all. And growth in the developing world has been robust.
Geopolitics of course is playing a role as an increasing number of countries boycott Iranian oil and fret over a possible military strike by Israel on Iran’s nuclear installations. But Deutsche Bank analysts point out that world equity markets, an efficient real-time gauge of growth sentiment, have risen along with oil prices.
Their graphic (below) shows a remarkably close relationship between oil prices and the S&P 500. Click to enlarge
Deutsche says:
We find it hard to believe that a genuine concern about a real risk of war would have accompanied a 4.7 percent gain in the S&P 500 index during February to a post-Lehman high.
Emerging beats developed in 2012
Robust growth from the emerging market basket in January was always going to be tough to beat, but research from February’s gains show just how strong these markets are performing against developed ones, and not just from the traditional BRICs either, research from S&P Indices shows.
Egypt has been a prime example. Following a bout of political unrest and subsequent removal of Hosni Mubarak after nearly 30 years in power, Egypt’s market returns have rocketed, climbing 15.3 percent in February on top of January’s 44.3 percent take-off.
Thailand, Chile, Turkey and Colombia are also on the to-watch list as these emerging lights have all flashed double-digit returns in the first two months of this year, while all twenty emerging markets included in the S&P data were up, gaining an average of 6.62 percent, making gains in the year-to-date a mouth-watering 18.95 percent.
Compare that with developed market returns of 4.6 percent in February, led by Nordic countries in particular Norway with (13.8 percent) in February, Denmark (13.5 percent) and Sweden (10.2 percent). Yet returns in developed markets were dragged down by Israel (-1.9 percent) and Greece (-2 percent). Overall developed markets grew 10.3 percent in the first two months of the year.
So taken together – equity markets have gained $1.6 trillion in February, which when added to January’s bullish run, clawing back all $3 trillion worth of losses in 2011 leading to the best start the S&P 500 has had since 1987.
Optimism should be checked, however. High oil prices supported by geopolitical pressure at the prospect of an Israeli strike on Iran’s nuclear facilities and subsequent knock-out of a 3.5 million barrel per day production of crude oil could start to have a negative effect on markets, while Europe still faces high levels of debt and the challenge of reducing deficits, which could create a drag on the growth of emerging economies.
S&P says:
