If you ask around about the proximate cause for the turmoil in emerging market assets in 2018, you’ll generally come away believing that while idiosyncratic flareups (e.g., Turkey and Argentina) have certainly played a role in souring sentiment, the controlling factor is the Fed’s tightening cycle.
But you could conceivably argue that because developed market monetary policy is still highly accommodative and, more important, highly predictable, emerging market assets as a group have overreacted this year.
That is, yes, it makes sense that the wobbliest dominos in terms of structural vulnerabilities (e.g., current account deficits and heavy FX borrowing) are starting to tip as the Fed turns the screws. And yes, it makes sense that the chickens are coming home to roost on Turkey now that Erdogan-o-mics is enshrined in monetary policy (last week’s hike notwithstanding). And sure, you should expect some turbulence in the ruble given the risk that the OFZ market gets hit with sanctions. Etc. Etc.
But does it make sense for the bottom to have fallen out to the extent it has YTD on emerging markets as an asset class? And if so, does it make sense to attribute the losses to the fabled global “liquidity crunch”?
Maybe not. Maybe babies are being thrown out with the bathwater. And maybe, just maybe, fears of an acute global liquidity crunch are overdone.
Or at least that’s what Credit Suisse’s Kasper Bartholdy suggests in an EM strategy note dated Wednesday.
Bartholdy starts off with some pretty run-of-the-mill commentary. “We think risk markets, including the markets for EM assets, can live with the Fed balance sheet reduction and rate increases that lie ahead in the remainder of the year, on the condition that the pickup in both US wage growth and term risk premia in the UST market remains slow”, he says. Nothing out of the ordinary there – just your standard “don’t panic unless wage growth accelerates and the term premium rebuilds” line.
But Kasper is lulling you to sleep. Because shortly after that, he launches into a rather extraordinary critique of the prevailing narrative around DM central bank balance sheet rundown and what he pretty clearly believes is a largely spurious narrative with regard to the purported global “liquidity crunch”.
“Many analysts and portfolio managers have argued that this year’s weak performance of EM currencies and financial assets is predominantly explained by tightening global ‘liquidity’,” Bartholdy writes, adopting a palpably skeptical tone, before implicitly reminding you that correlation is not causation:
The sum of G4 central bank assets (measured in US dollars at current exchange rates) peaked in late March of the present year and began to decline significantly in April, nearly exactly at a time when EM currency depreciation against the dollar took off in earnest while EM sovereign credit began to underperform US corporate credit by a wide margin. Some observers see this as evidence that central bank balance sheet shrinkage caused the underperformance of EM assets against comparable US assets.
To be clear, Kasper doesn’t deny that G4 policy tightening and rising U.S. yields pose a threat to EM assets and for risk assets more generally. Rather, what he questions is whether those dynamics are behind recent EM underperformance. To wit:
EM assets have often in the past performed well in periods with US monetary policy tightening and sharp increases in US Treasury yields (Figure 2). That is because UST yield increases have historically often happened in response to credit-positive news, such as upside US growth data surprises or favourable political developments. We do not have to go far back in history to find examples of this. One example is the period from October of last year to the end of January of this year. In that period, EM asset were on fire even as UST yields sky-rocketed and the Fed’s balance sheet was shrinking.
He also notes that despite Fed hikes and balance sheet rundown, 10Y yields have been rangebound right up until this week and further, HY has held up well during the same period. That, Credit Suisse suggests, appears to “counter the notion that the Fed’s balance sheet shrinkage or shrinkage in the dollar-value of G4 central banks’ aggregate balance sheet has led to a major general tightening of financial conditions that would in turn explain the sharp weakness of EM asset prices in the period since April.”
Bartholdy doesn’t stop there – not by a long shot. He goes on to assert that it is “logically inconsistent” to blame G4 central bank balance sheet shrinkage for EM weakness if you can’t explain why it is that U.S. and Japanese stocks have held up fine and/or why it is that balance sheet rundown hasn’t affected USD corporate credit spreads.
Of course you could easily explain the resilience of U.S. equities by reference to fiscal policy that’s catalyzed a buyback binge and bolstered corporate bottom lines, but let’s just let Kasper do his thing.
If you ask Bartholdy, he’s found “only scant – if any – meaningful empirical evidence of a causal relationship (or even of correlation) between the size of G4 central bank balance sheets and the performance of EM assets” and beyond that, he’s not even sure central bank balance sheets are really shrinking at all. Here’s Kasper:
We also question the whole notion that the sum of the G4 central banks’ balance sheets can really meaningfully be said to be falling at this stage. The ECB, the BOJ, and the central bank of China have all continuously been expanding their balance sheet this year. Only the Fed has reduced its balance sheet in local currency terms. If we compute the sum of G4 central bank balance sheets by converting local-currency data for all days into dollars at the set of exchange rates that applied at the end of last year, we find that on that measure there has been no shrinkage in the sum of the G4 central bank balance sheets in recent months. This is clear from Figure 1.
Long story short, Kasper thinks market participants shouldn’t be as laser-focused on the whole “global liquidity” narrative as they (market participants) most assuredly are.
So what should everyone focus on? Well, maybe take it back to the basics. “We think it makes more sense to focus on interest rates across the US Treasury yield curves, especially real yields, than to obsess over monetary aggregates”, he goes on to write, adding that “at least there is a simple and intuitive transmission mechanism directly from yields on US Treasuries into prices for other assets, whereas we see no equivalent obvious direct transmission mechanism from the central bank’s balance sheet to risk asset prices.”
In case that’s in any way unclear, Kasper spells it out in the simplest possible terms in the title of a subsection seven pages deep into the note. I’m just going to go ahead and excerpt several passages from that section:
The road to QE unwind damage runs through rising UST yields
The primary action point of quantitative easing efforts across the G3 central banks has been purchases of both government bonds and close substitutes, such as mortgage bonds. In light of the magnitude of those purchases we find it particularly sensible to assume that yields and prices of government bonds have been affected substantially by QE. Specifically in the US, the ten-year TIPS yield was of the order of 2.3% during most of 2006 (the last full “good year” for the US economy in the pre-2008 cycle), far above their current level of slightly less than 0.9%.
However, the Fed Funds rate is far lower now (about 2%) than it was in 2006 (the Fed raised it to 5.25% in that year). Among the factors that are currently keeping TIPS yields contained and the Fed funds rate low by pre-2008 “strong-economy-standards” is a widely held perception (both within and outside the Fed) that the neutral short-term real interest rate has fallen over time. That rate is, rightly or wrongly, widely perceived to be much lower now than it was in 2006.
Against that background we find it probable that even in the presence of sustained Fed balance sheet reduction in the period ahead, TIPS yields will get back to 2006 levels only if the Fed’s and market participants’ estimates of the neutral Funds rate rises notably, and that will in turn probably require a substantial acceleration in US wage growth or other measures of US inflationary pressure.
In that context, it’s probably worth noting that despite the much ballyhooed rise in 10Y yields this week, 10Y reals were higher in May.
Bartholdy goes on to talk a bit about the stubborn refusal of the term premium to rebuild despite fiscal profligacy in Washington, and on that, he cites the usual factors (e.g., attractiveness of U.S. yields creating demand, low rates vol., still-anchored inflation expectations and demand created by the safe-haven status of the U.S. long end).
The upshot of all this is that in the absence of a sudden acceleration in wage growth, a dramatic repricing higher of the term premium, a sharp reassessment of the neutral rate and ultimately, a steep rise in real yields, risk assets (including EM) should probably be fine in the face of Fed balance sheet rundown.
Here, I’ll just let Kasper tell you about it:
As we stated up-front, our broad view is risk markets, including the markets for EM assets, can live with the Fed balance sheet reduction a rate increases that lie ahead for the remainder of the year on the condition that the pickup in both US wage growth and term risk premia in the UST market remain slow, and the market’s views on the neutral Funds rate is not shaken in a major way. When and if that condition is violated, perhaps in response to a string of very strong US wage data, real yields across the US curve may rise sufficiently to cause a major problem for all risk assets, not least in EM space. However, we see no obvious reason at present to expect sharp US wage acceleration to play out exactly in the months between now and the end of the year.