Low EM inflation good for EM bonds
March 8, 2018

Jan Dehn, Head of research at Ashmore Group, explains why EM's low inflation over the past 13 months bodes well for EM bonds. He also explores why US President Trump's initiatives on tariffs are bad news for investors with positions in US dollar-denominated assets.

Emerging market inflation has been extremely benign over the past thirteen months, he writes. CPI inflation, weighted by the JP Morgan GBI EM GD index of local currency bonds, has declined from a year-on-year rate of 4.35 percent in January 2017 to just 3.64 percent as of end of February 2018. This 71bps decline in inflation exceeds the 56bps decline in nominal bond yields over the same period. 2017 was a very good year for local bonds with returns from a duration of 9.52 percent and an FX gain of 5.69 percent, i.e. a total return in Dollar terms of 15.21 percent, but investors can now enter the EM local currency bond market at an even higher real yield than at the start of 2017. Play it again, Sam!

Investors should also be encouraged that EM local currency bonds continue to hold up extremely well in the face of the recent bout of volatility in developed markets. So far this year, EM bonds are up 3.15 percent in Dollar term and EM currencies have outperformed the US dollar by 1.78 percent. We attribute this resilience to a combination of attractive absolute valuations, improving fundamentals and very benign technicals following years of outright institutional selling of EM local currency induced by Quantitative Easing (QE) in developed markets.

EM bonds also look more attractive in a relative sense. Yields are much higher in both nominal and real terms, while policies in the US and some other developed economies appear to be getting worse. Besides, in addition to overvalued financial markets, developed countries suffer from excessive reliance on monetary stimulus, poor fiscal policies, lack of reforms, protectionism, anti-immigration policies and deteriorating inflation and debt dynamics. These problems will get compounded by higher interest rates in the years ahead. Finally, the current political trends in the UK, the US and other developed countries do not offer encouragement that the right kind of solutions will be forthcoming. Death by a thousand cuts seems more likely in developed market bonds.

US tariffs – bad news for investors with positions in US dollar denominated assets

By slapping heavy tariffs on all steel and aluminium imports in the US, the Trump Administration issued a clear signal that US economic policy is becoming even more heterodox and populist than has hitherto been the case.

This is very bad news for investors with positions in US dollar denominated assets, because protectionism causes real exchange rate overvaluation and slows growth. Latin America offers countless lessons about how populist and heterodox economic policies impact economies: basically they exert a destructive influence.

At best, they are policies which provide a modest degree of comfort in the very short term while leaving you worse off in the longer term.

Populists shy away from taking tough decisions and reforming economies, even if such decisions are clearly in a country's long-term interest. Instead, they favour short-term palliative measures, which help them to preserve their popularity, but only by accumulating even bigger problems in the future. The costs of populist policies tend to rise in non-linear fashion as countries approach full employment. This is because the kind of measures typically favoured by populists, including fiscal stimulus, barriers to trade and measures against immigrant labour are exactly the types of interventions, which hurt more in the late stages in the business cycle.

The US economy is, of course, already at, or close to, full employment. The US economy also faces major challenges competing in export markets. Contrary to the rhetoric of the Trump Administration this lack of competitiveness is not due to some sudden surge in protectionist measures abroad. Rather, it is due to declining productivity at home and the over-valued US dollar. Unfortunately, protectionism will only make these problems worse. The tariffs on steel and aluminium may keep alive a small number of very unproductive producers, who really ought to be shut down rather than be protected, but the rest of the economy will suffer due to the resulting higher input costs. In net terms, this undermines the competitiveness of American companies in overseas markets by driving up the real effective exchange rate via higher domestic costs pressures. The US current account balance will worsen, not improve. In the end, American consumers pay too, of course. 

Fiscal stimulus is another example of late cycle populism

The plunge into outright protectionism is disconcerting enough on its own, but the Trump Administration has also recently engaged in another classic example of late cycle populism, namely turning to fiscal stimulus as central banks begin to tighten policy. The recently approved Trump tax cut will cost 8 percent of GDP and it is entirely unfunded. Productivity is unlikely to be impacted at all. The dominant impact of the reform on the private sector will be a massive increase in issuance of US government bonds in the coming years, which will push up both interest rates as well as the overall debt stock, which has already nearly doubled since the 08/09 financial crisis. The combination of loosening fiscal and higher interest rate will also hurt investment by sucking up investable resources and pushing up the cost of capital (also known as ‘crowding out'). The depressing impact on investment is the most worrisome, because lower investment will depress the US growth potential for a long time into the future and according to the perverse logic of populism the government will likely intervene more rather than less as the sluggishness of the private economy intensifies. Investors cannot claim to not have been given fair warning. Economic history is littered with precedents, he concludes.

 





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Jan Dehn, Head of research at Ashmore Group, explains why EM's low inflation over the past 13 months bodes well for EM bonds. He also explores why US President Trump's initiatives on tariffs are bad news for investors with positions in US dollar-denominated assets.

Emerging market inflation has been extremely benign over the past thirteen months, he writes. CPI inflation, weighted by the JP Morgan GBI EM GD index of local currency bonds, has declined from a year-on-year rate of 4.35 percent in January 2017 to just 3.64 percent as of end of February 2018. This 71bps decline in inflation exceeds the 56bps decline in nominal bond yields over the same period. 2017 was a very good year for local bonds with returns from a duration of 9.52 percent and an FX gain of 5.69 percent, i.e. a total return in Dollar terms of 15.21 percent, but investors can now enter the EM local currency bond market at an even higher real yield than at the start of 2017. Play it again, Sam!

Investors should also be encouraged that EM local currency bonds continue to hold up extremely well in the face of the recent bout of volatility in developed markets. So far this year, EM bonds are up 3.15 percent in Dollar term and EM currencies have outperformed the US dollar by 1.78 percent. We attribute this resilience to a combination of attractive absolute valuations, improving fundamentals and very benign technicals following years of outright institutional selling of EM local currency induced by Quantitative Easing (QE) in developed markets.

EM bonds also look more attractive in a relative sense. Yields are much higher in both nominal and real terms, while policies in the US and some other developed economies appear to be getting worse. Besides, in addition to overvalued financial markets, developed countries suffer from excessive reliance on monetary stimulus, poor fiscal policies, lack of reforms, protectionism, anti-immigration policies and deteriorating inflation and debt dynamics. These problems will get compounded by higher interest rates in the years ahead. Finally, the current political trends in the UK, the US and other developed countries do not offer encouragement that the right kind of solutions will be forthcoming. Death by a thousand cuts seems more likely in developed market bonds.

US tariffs – bad news for investors with positions in US dollar denominated assets

By slapping heavy tariffs on all steel and aluminium imports in the US, the Trump Administration issued a clear signal that US economic policy is becoming even more heterodox and populist than has hitherto been the case.

This is very bad news for investors with positions in US dollar denominated assets, because protectionism causes real exchange rate overvaluation and slows growth. Latin America offers countless lessons about how populist and heterodox economic policies impact economies: basically they exert a destructive influence.

At best, they are policies which provide a modest degree of comfort in the very short term while leaving you worse off in the longer term.

Populists shy away from taking tough decisions and reforming economies, even if such decisions are clearly in a country's long-term interest. Instead, they favour short-term palliative measures, which help them to preserve their popularity, but only by accumulating even bigger problems in the future. The costs of populist policies tend to rise in non-linear fashion as countries approach full employment. This is because the kind of measures typically favoured by populists, including fiscal stimulus, barriers to trade and measures against immigrant labour are exactly the types of interventions, which hurt more in the late stages in the business cycle.

The US economy is, of course, already at, or close to, full employment. The US economy also faces major challenges competing in export markets. Contrary to the rhetoric of the Trump Administration this lack of competitiveness is not due to some sudden surge in protectionist measures abroad. Rather, it is due to declining productivity at home and the over-valued US dollar. Unfortunately, protectionism will only make these problems worse. The tariffs on steel and aluminium may keep alive a small number of very unproductive producers, who really ought to be shut down rather than be protected, but the rest of the economy will suffer due to the resulting higher input costs. In net terms, this undermines the competitiveness of American companies in overseas markets by driving up the real effective exchange rate via higher domestic costs pressures. The US current account balance will worsen, not improve. In the end, American consumers pay too, of course. 

Fiscal stimulus is another example of late cycle populism

The plunge into outright protectionism is disconcerting enough on its own, but the Trump Administration has also recently engaged in another classic example of late cycle populism, namely turning to fiscal stimulus as central banks begin to tighten policy. The recently approved Trump tax cut will cost 8 percent of GDP and it is entirely unfunded. Productivity is unlikely to be impacted at all. The dominant impact of the reform on the private sector will be a massive increase in issuance of US government bonds in the coming years, which will push up both interest rates as well as the overall debt stock, which has already nearly doubled since the 08/09 financial crisis. The combination of loosening fiscal and higher interest rate will also hurt investment by sucking up investable resources and pushing up the cost of capital (also known as ‘crowding out'). The depressing impact on investment is the most worrisome, because lower investment will depress the US growth potential for a long time into the future and according to the perverse logic of populism the government will likely intervene more rather than less as the sluggishness of the private economy intensifies. Investors cannot claim to not have been given fair warning. Economic history is littered with precedents, he concludes.

 



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