By Jan Dehn, Ashmore Group
As the Fed prepares to hike rates in 2015, the window of opportunity presented by hyper-easy monetary policies for developed economies to undertake deeper fundamental reforms is rapidly closing.
So far, hardly any progress has been made. President Obama’s tenure has not seen the country’s economic problems solved. US trend growth has halved since the 1960s, while the debt stock has doubled to more than 350 per cent of GDP (not counting the further 300 per cent of GDP in unfunded social care liabilities). Europe and Japan recently re-engaged in QE-type stimuli to defend their fundamentally challenged economies from the effects of higher US rates in the future.
The US dollar rally of the last few months might suggest that the US is staging a self-sustaining recovery. Sadly, this is largely a pleasant fiction. A more accurate description would be that the US is defeating Europe and Japan in an ‘ugly contest’. The US has done particularly well in recapitalising its banks early and cleverly employing its government balance sheet to deleverage households. As negative housing equity declines and labour markets improve, consumer-led inflation can reasonably be expected to return by the second half of 2016.
Herein lies the problem. Since inflation is likely to return long before the economy as a whole has deleveraged or improved its productivity, the Fed will get impaled on the horns of a dilemma: How can it fight inflation and keep a fundamentally challenged economy growing and sustain QE-inflated asset prices to preserve confidence? Until the underlying economy has healed, the Fed will have to choose to protect the recovery over fighting inflation.
It will choose inflation. One of the attractions of being heavily indebted is that inflation becomes your friend. It reduces real rates and erodes debt stock. Additional financial repression may be required to keep long yields in check, but this weakens the Dollar and helps to restore competitiveness to exporters. It is also politically astute for America to inflate – the pain of adjustment is borne by future generations and foreigners. Neither vote in US elections. In short, the US is fortunate to be far better placed to inflate than Europe and Japan. What is good for the US economy turns out to be bad for the US dollar.
A year of reckoning
Concerns about inflation and US dollar weakness may seem premature. After all, meaningful inflation is still more than a year away. But 2015 promises to be a year of reckoning. It is the last year before inflation returns, the last year before markets realise that the US Fed will not seriously fight inflation and the last year before an increasingly stretched US dollar rally begins to unwind and the US yield curve begins to bear steepen.
Ahead of the coming turmoil in rates and foreign exchange markets, investors will probably still be cautious towards emerging markets (EM). This caution creates a wedge between sentiment and fundamentals, but this is not a bad thing. It keeps EM policy-makers on their toes. Healthy carry and spreads preserve attractive valuations and bubble risks are small. Markets will exaggerate differences between perceived good and bad credits, so active management will be rewarded.
EM is generally able to withstand foreign exchange volatility due to healthy reserve balances. Technicals are good after poor price action in 2013 and 2014. Fundamentally, EM withstood a 200bps yield curve re-pricing in 2013 with only minor damage to their economies. Such price action would have sunk many developed economies.
Besides, the world remains riven with serious imbalances. Nearly 90 per cent of all tradable debt has been issued by developed economies. Yet, they only comprise 44 per cent of global GDP, while EM make up the rest and control nearly 80 per cent of the world’s foreign exchange reserves. Since EM’s central bank reserves are almost exclusively invested in debt and foreign exchange from developed economies, the way developed economies choose to fix their debt problems matters greatly to EM.
The most important message for EM is this: The consensus that a strong US dollar and higher real rates in the US will sink EM in a further round of capital flight is unlikely to survive for much longer.
If anything, the Korean won’s recent dramatic appreciation against the Japanese yen is more indicative of the future. EM countries will face serious currency appreciation pressures once the true inflationary intentions in the developed economies become more apparent. At the same time, the purchasing power of savings invested in developed market assets will begin a long path of decline. This makes 2015 a good year to take advantage of very attractive valuations and quietly switch out of US dollars before everyone catches on.
Jan Dehn is head of research at Ashmore Group plc, a fund management company.
This is the sixth in a series of guest posts on the outlook for emerging markets in 2015.