In 2016 and 2017, global financial markets slowly began the process of unwinding the big quantitative easing trades that had dominated both global capital flows and performance from 2010 to 2015.
QE itself only had a limited direct impact on markets, specifically by driving real yields to zero in developed bond markets. But it had a powerful second-order effect via global asset allocators, who responded by altering their allocation in favour of the QE-sponsored markets.
All of the major QE trades — namely being long US stocks, US dollar, core European government bonds and, most importantly, QE-sponsored markets (developed) versus non-QE sponsored (emerging) markets — made enormous capital gains. Since late-2010 the dollar has rallied 35 per cent in broad terms and 50 per cent against EM currencies, while the total return to US stocks is 430 per cent and German bonds have made more than 80 per cent. Against such enormous capital gains, the mere yield on offer in EMs was insufficient to prevent massive outflows.
Who, then, gets the biggest hangovers when the monetary punchbowl is removed? Those who imbibed the most. The slow process of monetary policy normalisation signalled by the Federal Reserve’s first rate rise in December 2015 started to unwind two of the big four QE trades. The dollar fell in both 2016 and 2017 and EMs rallied strongly as capital flowed back in.
Fast-forward to 2018, and the dollar has once again rallied while EMs have pulled back. But the dynamics at play here are temporary and the unwinding of QE distortions will continue to shape global market flows for years to come. This year has been a period of interruption, not of derailment.
One of the major harbingers of this interruption has been the US dollar rally, which has been driven by a large corporate tax cut, a hawkish Fed and the imposition of import tariffs.
These policy interventions were specifically designed to help Republicans in November’s midterm election, but they are unlikely to have a lasting positive effect. Election-motivated fiscal giveaways typically increase macroeconomic instability, while tariffs reduce rather than enhance productivity. Neither will sustain the 2018 dollar recovery.
At current valuations, the dollar looks to be about 20 per cent overvalued relative to EM currencies. This misalignment is evident in three independent economic relationships. First, a wedge of about 20 per cent to 25 per cent has emerged between real effective exchange rates in the US and EMs. Second, forward-looking growth differentials favour EMs over the US in the next five years to the tune of about 20 per cent. Third, the dollar is about 20 per cent overvalued relative to US productivity growth.
Having said that, the dollar is an extremely volatile currency, and investors should not expect to realise the 20 per cent upside in EM currencies in a straight line. Interruptions, such as the one seen in 2018, will happen again.
But over the medium term, the dollar will also suffer from America’s retreat from global leadership. America’s reward for sponsoring a rules-based system — comprising global conflict resolution, free trade, near-universal access to the US banking and legal systems, and the free movement of capital — was that the rest of the world willingly adopted the dollar as the medium of exchange for cross-country operations. In other words, the dollar became the pre-eminent global reserve currency.
As the US now increasingly replaces rules with discretion, greater riskiness will erode the willingness of other countries to continue to use the dollar. Diversification away from the dollar will initially favour the existing special drawing rights currencies (dollar, euro, renminbi, yen, sterling) but crumbs from the big table will also over time fall on to non-SDR currencies in EMs, especially the larger currencies.
With the midterm elections out of the way and dollar strength looking to subside, expect these reverse QE trades to re-manifest themselves strongly in 2019. In EM bonds, this should translate into strong performance for EM local currency markets due to the dollar’s weakness, and in EM high yield, due to spreads being well wide of historical averages. In EM equities, it should translate across the board as strong fundamentals shine through.
The unwinding of these consensus QE trades will not happen overnight. Central banks will take a long time to offload assets from their balance sheet, and institutional investors will take a long time to realise that this major shift is taking place. It took them five years to put on the QE trades, so it may take another five to unwind them. But it is important to remember that short-term volatility and headwinds can do little to upend this.
Jan Dehn is head of research at Ashmore Group
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