CC-BY-SA-2.0, FlickrPhoto: K-ryu . BlackRock Launches the Sustainable Euro Bond Fund
BlackRock has launched the BSF Sustainable Euro Bond Fund. With the launch, BlackRock is responding to the growing demand for investments incorporating environmental, social and governance (ESG) factors.
The BSF Sustainable Euro Bond Fund builds on the European Fixed Income’s team tried and tested investment process. The issuers we include in the fund are positively screened for environmental, social and governance (ESG) considerations using the MSCI’s ESG Ratings for corporate, sovereign and government-related issuers that assess how well the issuer manages ESG risks relative to its industry, or peer group. Investors benefit from the award-winning investment approach of Michael Krautzberger and his team, who manage the BGF Euro Bond Fund, the existing sister strategy on the basis of which Michael and the team won Morningstar European Fixed Income Manager of the Year 2016 award, the only fixed income team to ever win the award twice.
The BSF Sustainable Euro Bond Fund invests in a broad range of sources to add alpha and maximize total return, primarily focusing on euro denominated investment-grade bonds. There is a strong emphasis on diversification and active risk is spread through selection of country, sector, security, duration and yield curve positioning, as well as through flexibly-managed currency exposure.
According to Krautzberger, “sustainable investing is becoming mainstream as investors globally are placing greater emphasis on transparency and seek an ESG approach to their investments. Considering ESG factors is seen as a sign of operational strength, efficiency, and management of long-term financial risks of the companies they invest in. We are looking to incorporate MSCI’s ESG insights in our active positioning, for example underweighting issuers with deteriorating ESG profiles that we expect to be downgraded by MSCI. We also expect to hold a higher proportion of green bonds in this fund than we do in non-ESG strategies.”
Besides the ability to achieve specific ESG investment goals, companies with high ESG scores and in particular those scoring highly on governance, tend to be less prone to negative surprises. “This is an important consideration given the asymmetric impact of unexpected news on bond prices”, says Krautzberger. The fund is managed by Michael Krautzberger and Ronald van Loon who have a combined investment experience of over 37 years. Michael and Ronald are supported by the European Fixed Income team. BlackRock manages over $1.4 trillion in fixed income assets on behalf of global clients, including both active and index strategies.
BlackRock Impact
In February 2015, BlackRock appointed Deborah Winshel to help unify its approach to impact investing through the launch of BlackRock Impact, the Firm’s global platform catering to investors with social or environmental objectives. The development of the BlackRock BSF Sustainable Euro Bond Fund further highlights BlackRock’s commitment within this space and enables investors to access the platform which currently manages $200 billion of assets across impact investing, environmental, social and governance (ESG) portfolios, and screened portfolios.
CC-BY-SA-2.0, FlickrPhoto: Kevin Dooley. Risk-On Sentiment Trumps Brexit Fallout Fears
The feedback loop between financial markets and the real economy has been positive this summer, relegating the status of the June 23 Brexit vote from a global scare to a domestic UK political matter. The current environment remains supportive for risky assets.
The positive feedback loop that has developed between markets and economies may be the best evidence yet that the fallout from the Brexit vote is far less dire than many feared in June. With market and sentiment channels transmitting little or no Brexit-shock into the real economy in the rest of the world, the UK political drama has swiftly morphed into a local problem rather than a global scare. Recent economic data also suggest that mainland Europe, the region most at risk of contagion, has been remarkably resilient post-Brexit.
Economic and earnings data have been a support factor globally. Positive macro data surprises in developed markets reached a 2.5-year high this month. Second-quarter corporate earnings in the US and Europe came in better than expected. The global policy mix is shifting to an easier stance again, with the Bank of England and the Bank of Japan both easing further and remaining biased to do more. The fiscal gears are also starting to turn. Japan’s government announced a large stimulus package and the US and UK governments are hinting at fiscal stimulus measures in the 2017-18 period.
With investor sentiment turning positive for the first time this year and cash levels reaching 15-year highs, the right conditions for some of that money coming into the market are emerging. The flow momentum seems likely to remain a support factor for risky asset classes like equities, real estate and fixed income spread products, at least until technically overbought levels are reached, or until new macro or political shocks occur. With neither of those on the radar at this stage, we keep our risk-on stance tilted to these asset classes.
Jacco de Winter is Senior Financial Editor at NN Investments Partners.
CC-BY-SA-2.0, FlickrCourtesy photo. Paul de Leusse Appointed as CEO of Indosuez Wealth Management
Paul de Leusse has been appointed Chief Executive Officer of Indosuez Wealth Management. Paul has also joined Crédit Agricole S.A.’s Extended Executive Committee.
Paul de Leusse, aged 44, started his career in management consulting, first as a consultant (1997-2004) then as Managing Partner of Mercer Oliver Wyman (2004-2006). He subsequently joined the consultancy firm Bain & Company as Partner (2006-2009).
In 2009, he joined Crédit Agricole Group as Director of Group Strategy. In 2011, he was appointed Chief Financial Officer of Crédit Agricole CIB. He became Deputy Chief Executive Officer of Crédit Agricole CIB in August 2013. His knowledge of the Corporate and Investment Banking businesses, combined with his strategic vision, for the Major Clients business line in particular, will be a key asset for Crédit Agricole Group’s Wealth Management business.
Paul de Leusse is a graduate of École Polytechnique and a civil engineer trained at École Nationale des Ponts et Chaussées.
CC-BY-SA-2.0, FlickrPhoto: hjjanisch
. Kingdon Capital Management Launches a UCITS Fund Using Lyxor AM's Platform
Kingdon Capital Management has launched a UCITS version of its long/short equity fund. According to HFMWeek it has done so using Lyxor AM’s Platform.
The Lyxor/Kingdon Global Long-Short Equity Fund was registered in Ireland on July 22. It is an open-end fund incorporated in Ireland that invests in publicly-traded equity securities and equity derivatives in global Markets. Its objective is to achieve attractive returns, over market cycles with a strong focus on capital preservation through diversification, risk management and stock selection.
Lyxor AM, a subsidiary of Société Générale, has been looking to grow its alternative UCITS offering as Philippe Ferreira told Funds Society (in Spanish piece) some months ago, these type of funds, ” have proved that they are able to offer similar returns as equities with a third of their volatility which explains why investors such as pension funds have grown their interest in them.”
Kingdon Capital Management, founded by Mark Kingdon in 1983, is an employee owned hedge fund sponsor. It invests in the public equity and fixed income markets using long/short strategies to make its investments. It employs fundamental analysis along with combination of bottom-up and top-down approach to create its portfolio and is based in New York, New York.
CC-BY-SA-2.0, FlickrPhoto: BNP Paribas Investment Partners. The Other Key Messages from the Fed at Jackson Hole
At the 25-27 August Jackson Hole Symposium, US Federal Reserve Chair Yellen broke little new ground – beyond confirming that the case for a US rate rise had strengthened – and suggested the policy-setting Federal Open Market Committee was generally satisfied with its strategy for interest-rate normalization, the available monetary policy tools to combat future recessions and the overall policy framework. We find this message somewhat disheartening.
Given the FOMC’s limited space to cut short-term rates, a persistently low equilibrium policy rate and the likely challenges of relying on asset purchases and forward guidance, we had hoped to see some evidence of greater openness to change. Overall, we are left with a sense of ‘business as usual’. If this is indeed the case, it implies a Fed that may be unprepared to counter another recession aggressively should potential growth and equilibrium policy rates remain depressed.
What messages did we glean from Yellen‘s remarks? What can we say about the overall approach to policy normalization, the policy toolkit for supporting growth and inflation in different states of the business cycle, and considerations for the longer-term policy framework?
A US rate rise this year is highly likely
Data has evolved since the surprisingly weak May payrolls report in a manner that is consistent with the Committee’s expectation for moderate growth, the continued strengthening in the labor market and the gradual firming of inflation. In light of this, Yellen believes that “the case for an increase in the federal funds rate has strengthened in recent months.” We had already assigned a 75% probability to a rate increase this year, so Yellen’s remarks were not particularly surprising.
Still, the decision to address the near-term policy outlook at a conference focused on longer-term policy considerations suggests that the Committee has grown more confident in the economy’s performance and is marginally concerned by somewhat complacent market pricing of the path of policy rates. We still see December (45%) as the somewhat more likely timing than September (40%) for a rate increase given below-objective core inflation and the risk management considerations discussed below, but we will revisit these probabilities after the August payrolls report. Another strong number (225 000 private-sector jobs) in combination with firming wages and a decline in the unemployment rate could suffice to tip us into the September camp, though we would caution that the next policy meeting is not until 20-21 September.
Neutral policy rate still targeted when core PCE inflation hits 2%
Overall, we find this disappointing. As discussed in a previous note, we see compelling reasons for the Committee to hold off on raising rates at least until there is more convincing evidence of inflation moving towards mandate-consistent levels. As the July PCE inflation data confirmed, this is just not the case at present (see Exhibit 1).
Exhibit 1: Personal Consumption Expenditures (PCE) excluding food and energy, the Fed’s preferred gauge of US inflation, remains well below the central bank’s two percent (January 2012 – June 2016)
The reasons include constrained policy options at the lower bound, growth risks that are still tilted to the downside, low inflation expectations and uncertainty about the current and future level of the equilibrium policy rate. In practice, the Committee will likely tolerate inflation rising somewhat above two percent. But policy-setting could achieve better outcomes if the current strategy explicitly allowed for (or even sought) inflation above two percent over the medium term, which would reinforce that the Committee treats the inflation objective symmetrically.
Absent such a shift, investors are likely to continue to expect inflation to run below two percent on average over the coming years. Two percent inflation will continue to be viewed as a policy ceiling, implying an actual inflation objective somewhat below this level.
Peak policy rate: perhaps only be about 150bp away
Judging from the Fed’s June Summary of Economic Projections, the Committee on average sees the longer-run policy rate at three percent, or one percent in real terms. However, both in her June press conference and again at Jackson Hole, Yellen suggested that the equilibrium real policy rate might not rise above its current level near zero for many years. Specifically, she noted at Jackson Hole that “the average level of the nominal federal funds rate down the road might turn out to be only two percent”. If this is indeed the case, we are likely to see a continued flattening of the Committee’s median projected interest-rate path in future projections.
Asset purchases and forward guidance are no longer unconventional
With a persistently low equilibrium policy rate and the continued aversion to taking the policy rate into negative territory, the FOMC will have limited scope to ease policy through rate cuts even if it succeeds in raising rates all the way back to a neutral policy setting (from a loose policy now) before the next recession. Asset purchases (possibly including a wider range of financial market instruments) and forward guidance will remain the primary policy tools. One implication is that right-sizing the Fed’s balance sheet – returning to a situation in which the Fed’s assets largely align with currency in circulation – is unlikely to occur for well over a decade.
Cautious optimism on the efficacy of asset purchases and forward guidance
Overall, Yellen struck a tone of optimism on the ability of the Fed to provide future economic stimulus largely through asset purchases and forward guidance, even noting that simulations of various policy options show that these tools can provide better outcomes for employment and inflation than cutting the policy rate deeply into negative territory.
Still, she noted a number of reasons for caution in relying on these tools – model simulations may overstate the effectiveness of asset purchases and forward guidance when rates are already low; these tools may need to be taken to extremes to be fully effective; and such use may increase financial stability risks.
Cautious rate normalization and eventual tolerance of an inflation overshoot
Yellen’s note of caution on relying on asset purchases and forward guidance to fight future recessions has implications for current policy normalization. Even if the Committee’s strategy has not changed, in practice the FOMC will be very careful to avoid unduly restrictive policy-setting to lower the possibility of having to revert to asset purchases and forward guidance.
Any weakening of key economic indicators, tightening of financial conditions or heightened risks to global growth will likely lead the Committee to delay policy normalization, as has been the case for much of this year. If the downside risks rise meaningfully, the Committee will likely remove its tightening bias – and possibly begin cutting rates – more quickly than it traditionally has.
All of this implies that the Committee will be more tolerant of inflation overshoots. Should global disinflationary pressures wane, the ‘new normal’ could be one in which inflation averages above two percent, even if growth hovers around trend.
The longer-run policy framework is unlikely to change
Two weeks ago, President Williams of the Federal Reserve Bank of San Francisco created quite a stir by suggesting possible changes to the FOMC’s policy framework including a higher inflation target and price-level or nominal GDP targeting. Yellen acknowledged these ideas as ‘important subjects for research’, but emphasized the Committee is not actively considering such changes. Thus absent a recession, we see little scope for a meaningful rethink of the policy framework.
We find this disappointing, to say the least. In an environment where the policy rate is still close to the effective lower bound and the neutral rate remains significantly depressed by historical standards, the Committee has a responsibility from a risk management perspective to carefully examine possible changes to their operating framework that could deliver better outcomes for growth and inflation when the next recession inevitably hits.
Column by BNP Paribas Investment Partners written by Steve Friedman.
CC-BY-SA-2.0, FlickrPhoto: Elanaspantry, Flickr, Creative Commons. Morgan Stanley IM Launches Global Balanced and Global Balanced Defensive Funds
Morgan Stanley Investment Management has announced the launch of two new multi-asset funds, the Morgan Stanley Investment Funds (MS INVF) Global Balanced Fund and the MS INVF Global Balanced Defensive Fund.
The underlying investment process for the two funds mirrors that of the existing Global Balanced Risk Control (GBaR) strategy, which is designed to maintain a stable risk profile. The funds are the first in the GBaR suite to incorporate environmental, social and governance (ESG) factors into the process.
The chief difference between the funds is their targeted volatility. The Global Balanced Fund targets a volatility range of 4 to 10%. The Global Balanced Defensive Fund has a lower target volatility range of 2 to 6%.
Both funds will be managed by Andrew Harmstone and Manfred Hui in London. “The new funds will be based on our established GBaR process, which in our view is the most effective way for investors to participate in rising markets whilst providing strong downside protection,” said Mr. Harmstone, managing director and lead portfolio manager. “We expect the integration of ESG considerations into the process to further improve potential returns and enhance risk management.”
“Morgan Stanley Investment Management’s extensive multi-asset capabilities are reinforced by the addition of these two new funds,” said Paul Price, global head of Client Coverage, Morgan Stanley Investment Management. “Clients now have greater choice in the implementation of GBaR’s risk-controlled approach and their preferred level of volatility.”
The MS INVF Global Balanced Fund and the MS INVF Global Balanced Defensive Fund, registered in Luxembourg, are not yet widely available for sale and are awaiting registration in various markets. They are intended for sophisticated and diversified investors or those who take investment advice.
CC-BY-SA-2.0, FlickrPhoto: Lain. China: How Serious is the Debt Issue?
Emerging Markets (EMs) continue to drive global growth, with China still accounting for the lion’s share. However, China’s increasing debt remains a significant concern for global investors. Pioneer Investments’ Economist Qinwei Wang, takes a closer look at China’s debt situation.
After reviewing the recent developments around the debt issue, Pioneer has not changed their view that China can still avoid a systematic crisis in the near term, “as the issue remains largely a domestic problem and in the state sector.”
“Looking into the composition, China’s debt issues are largely within the country, unlike typical cases in EMs. Its external balance sheet still looks relatively resilient as China continues to run current account surpluses. China has also been building up net foreign assets over the last decade, and is one of the largest net lenders in the world and domestic savings remains high enough to fund investments.”
In addition, looking at domestic markets, Pioneer believes the situation still looks manageable. In fact, the borrowers have been largely in the state sector, directly or indirectly, through various government entities or SOEs. The lenders are also mainly state-linked, with banks (state dominant) making loans, holding bonds or channelling a big part of shadow activities.
The People’s Bank of China has prepared plenty of tools to avoid a liquidity squeeze, with capital controls still relatively effective, at least with respect to short-term flows. Ultimately, the government has enough resources to bail out the banking sector or major SOEs if necessary to prevent systemic risks.
The private sector does not appear to present big concerns, at least for now. In particular, on the property side, following the major correction since 2013, the health of the sector looks to be improving, although there is still a long way to go in smaller cities. Households have been leveraging up, but their debt levels are still relatively low with saving rates remaining high.
“We are not too concerned about existing troubled debt, as there are possible solutions to clean it up while avoiding a systemic crisis, and the implementation process has already started. The more challenging issue is how to prevent the generation of new bad debt.” Says Wang.
He believes that a first step in this direction is to improve the efficiency of resource allocation. Ongoing financial reforms, including the liberalization of interest rates, bond markets, IPOs, private banking, a more flexible FX regime as well as the opening of onshore interbank markets over the last couple of years are positive attempts in his view.
Continued efforts to shift towards a more market-driven monetary policy transmission mechanism is also helping. In addition, the anti-corruption campaign has also effectively added relatively better supervision of the state sector. That said, SOE reforms have been relatively slow, with mixed signals, although we see certain positive developments, such as individual defaults allowed and a pledge to remove their public functions.
Preventing new problematic debt levels from rising again in the future will also require strengthened financial regulations. We think a large part of the new forms of finance, or so-called shadow banking activities, are the result of financial liberalization. The current segmented regulation system is unlikely to keep pace with the rapid financial innovation across sectors and products. This will be an issue to monitor going forward.
“From an investment perspective we keep our preference for China’s “new economy” sectors, which could benefit from the move towards a more service-driven economy.” Wang concludes.
CC-BY-SA-2.0, FlickrFoto: Gideon Benari. Los precavidos inversores de renta fija europea podrían estar sacrificando el rendimiento
Tom Ross, Co-Manager of the Henderson Horizon Euro Corporate Bond Fund, and Vicky Browne, Fixed Income Analyst, look at the impact of the European Central Bank’s corporate sector purchase programme (CSPP).
What is the CSPP?
The corporate sector purchase programme (or CSPP as it is commonly known) was established by the European Central Bank (ECB) and began purchasing bonds on 8 June 2016. The CSPP is a form of monetary policy, which aims to help inflation rates return to levels below, but close to, 2% in the medium term and improve the financing conditions of economies within the Eurozone.
Purchases can be made in both the primary and secondary market. By the end of July 2016 – eight weeks into the programme – secondary market purchases formed 94% of purchases with only 6% being made in the primary market according to data from the ECB.
Which bonds are eligible for purchase?
Bonds purchasable under the scheme must be investment-grade euro-denominated bonds issued by non-bank corporations established (or incorporated) in the euro area. In assessing the eligibility of an issuer, the ECB will consider where the issuer is established rather than the ultimate parent. Thus an issuer incorporated in the Euro area, but whose ultimate parent company is not established in the Euro area, such as Unilever, is deemed eligible for purchase.
How have markets responded to CSPP so far?
To date the ECB has bought 478 bonds totalling approximately €11.85bn from 165 issuers (UniCredit as of 27 July 2016). The list of these bonds (but not the quantities purchased) is available on the websites of the national central banks performing the buying. Analysing these holdings would suggest that, on an industry sector basis, considerable CSPP purchasing has occurred in utilities and consumer non-cyclicals.
In June non-financial credit spreads initially responded positively to the CSPP purchases. However, excess credit returns over the month (returns over equivalent government bonds) detracted from total returns as market volatility increased as a result of the UK voting to leave the EU. Concerns surrounding the vote led to a temporary pull-back in demand for credit and this negative headwind overpowered the positive technical effect from CSPP.
July proved to be a stronger month for credit market performance. The European investment grade market – as measured by the BofA Merrill Lynch Euro Corporate Index – delivered a total return of +1.68% in July in euro terms and excess credit returns of +1.61% (source: Bloomberg at 31 July 2016). Undoubtedly, these positive movements have been partly driven by CSPP purchases as illustrated by the graph below. It reveals how spread performance – a declining spread indicates stronger returns – of the iBoxx Euro Corporate Index has been more pronounced in eligible bonds than non-eligible or senior bank assets.
However July’s returns are not just attributable to the technical support provided by the CSPP. An improvement in market sentiment driven by reduced fears about Brexit, together with a rise in flows into bond funds, has helped to increase demand for the asset class at a time when there is a lack of European investment grade supply.
How has the fund benefited from CSPP?
The Henderson Horizon Euro Corporate Bond Fund was positioned long credit and duration risk versus the index throughout June. Although the fund still trades with a long beta bias we have lowered risk levels over the past few weeks by reducing exposure to positions that have benefited from the recent rally in credit markets. Examples of these are euro-denominated bonds from utility companies Centrica and Redexis Gas, and US real estate investment trust WP Carey.
In July, the fund added to positions from CSPP-eligible issuers on a name-specific basis such as Aroundtown Property, Telenor and RELX Group. Exposure has not just been increased in CSPP-eligible issues but also in companies we favour that are not incorporated in the euro area, such as US names AT&T (in EUR) and Comcast and CVS Health (in USD). The CSPP technical has also been apparent in the primary market. The fund benefited in July from participating in a euro- denominated new issue from Deutsche Bahn, which has performed strongly post issuance. Positive fund performance has also come from a new issue from Teva Pharmaceuticals, which has seen solid demand since coming to the market.
While CSPP should help to provide technical support to European investment grade corporates, there exist several uncertainties in the market – such as the October referendum in Italy and instability in commodity prices – that could cause weakness to arise. We therefore continue to look to reduce risk into further strength while seeking to take advantage of any attractive opportunities presented by volatility or weakness.
CC-BY-SA-2.0, FlickrPhoto: Jorge Elías
. Late Summer / Late Cycle
Here in Boston, cooler nights and unwelcome back-to-school advertisements tell us summer is beginning to draw to a close and autumn is approaching. Like seasons, business cycles often signal their coming demise.
One thing that recurs with greater regularity during the last phases of business cycles is a scramble by companies to purchase competitors. Corporate acquisitions have been rising and are now near peaks seen in other cycles. Late in the cycle, companies often see flagging internal rates of growth and seek to boost growth through mergers and acquisitions. Historically, companies often overpay for such acquisitions late in the cycle. We’re seeing that now with widespread takeovers and significantly higher premia in prices paid.
Another signal of changing cycle dynamics is the profit share of the economy. The share of gross domestic product going to the owners of capital in the form of net profits often dips in the final 12 months of a cycle. The United States is now experiencing the third quarter of such profit deterioration as the owners’ share of the expansion starts flowing to other parts of the economy, rather than to profit gathering.
Late in the cycle, companies often seek to add debt to their balance sheets in order to boost profit growth. Frequently, this results in a broad scale deterioration of credit quality, which is subsequently made worse by the onset of recession. US consumers also tend to add debt to their collective balance sheets in the late phases of a cycle. And indeed we see that the borrowing of both corporations and consumers, which has been comparatively subdued in this cycle, is now starting to rise.
Signs not totally aligned
Not all the usual signs of recession are present now in the US. Some typical late-cycle signs have yet to appear, and this should cheer investors. Typically the shape of the yield curve becomes distorted in the late months of a cycle as short-term rates rise above long-term rates, reflecting market expectations of subdued growth ahead. We’ve seen a flattening of the yield curve in this eighth year of the cycle, but not an inversion of yields, as short rates remain slightly lower than long rates.
Another late cycle characteristic is widespread fear of inflation taking hold and accelerating. The US Federal Reserve often acts to forestall inflation pressures by raising short-term rates, which can slow the economy’s momentum. So far, signs of gathering inflation pressures are scant, but worth watching. As our regular readers know, there are currently no signs that the Fed is about to act aggressively to prevent an inflation spiral.
As long-term investors, we know that fundamentals matter most. In this cycle we’ve seen profit margins hit near-record levels. Likewise, operating income compared to revenues and free cash flow compared to market capitalization have been consistently high for over six years. The return on equity of companies in the major US indices has been outstanding.
Fundamental shift
But in the past three quarters, margins and profits of US companies have been pressured, and not just by weak energy prices. Cost pressures in other sectors have appeared as rising general and administrative expenses and weak sales growth combine to trim profits. That environment makes it harder to grow profits than was the case in the first six years of the business cycle. Worryingly, this shift comes at a time when the S&P 500 price/earnings ratio has reached over 18 times expected 12 month forward earnings, a valuation measure which lies on the high side of history.
Despite the arrival of back-to-school ads in early August, and the return of neighborhood youth to US college campuses later in the month, we can choose to shrug off the passing of summer and instead relish the last warm sunny days. But the evening breezes now bring a chill to the air that we didn’t feel in June or July — a chill that should not be ignored. What we find most concerning is that late in the cycle, market behavior often seems to be propelled more by hope than fundamentals. Maybe that is happening today, as market averages for both large and small caps rise while revenues, margins and profits continue to diminish. It may be comforting to look the other way and pretend the days will remain warm and bright. But investors keen to hold on to their wealth should not let the hope of catching the final gains of the cycle keep them hanging on too long.
CC-BY-SA-2.0, FlickrPhoto: Studio Incendo. No Headwind Strong Enough To Derail Emerging Market Performance
Emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Emerging market (EM) equities and bonds continue to perform well, benefiting from the global search for yield and the tentative improvements in EM fundamentals. With regard to fundamentals, it is important to note that the better overall EM capital flow picture and the pick-up in EM growth momentum are largely linked to the benign global liquidity environment of the past quarters. But regardless of the exact explanation, the general state of the emerging world is much better now than it was in the last few years and the beginning of this year.
Emerging markets have to deal with several headwinds
Currently, there is no situation of critical capital outflows that can easily make policy makers panic, EM growth has been picking up somewhat since June and EM exchange rates have adjusted to a more realistic level. This partly explains why EM assets have not been affected by a number of issues that not so long ago could easily have caused investors to take their money elsewhere. First, there is the sharp decline in the oil price since June. Second, the market started to re-price Fed rate hike expectations following the strong US labour market report of July. And third, most recent Chinese economic data were far from convincing. In other words, emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Of course, recent moves by the Bank of England and expectations about the Bank of Japan and the European Central Bank have kept investors confident that easy monetary policy in developed markets will continue for longer. In this environment, some adverse data and news flow are considered manageable. At any case, investors are not intending to throw in the towel on the EM yield theme yet.
Lower oil price not seen as evidence of EM demand problem
What is particularly remarkable is that the sharp decline in the oil price of the last two months has not affected emerging bond and equity markets. Oil-sensitive markets such as Russia and Colombia have underperformed, but emerging markets as a whole have not suffered. This is in sharp contrast with the second half of last year, when the falling oil price created a lot of additional nervousness about the overall EM growth picture and the external and fiscal vulnerabilities of the commodity-exporting economies.
The main explanation of the different market interpretation of the lower oil price lies in the better EM growth picture. Growth momentum is clearly improving throughout the emerging world. This makes it easier to believe that, this time, oil is declining primarily because of oversupply concerns and not because of a worsening EM demand outlook.
No significant impact from repricing of Fed expectations
In our base-case scenario, the Federal Reserve will hike interest rates in December. A December hike was completely priced out a month ago. Now, the probability is almost 50% again. The re-pricing of a Fed rate hike this year has not affected emerging asset markets and we feel that a further re-pricing of a December hike should not be a big problem either. The main reasons are the better EM growth backdrop and reduced external financing requirements in most emerging economies. A crucially important condition for a limited market impact of the re-pricing of Fed tightening is that the market continues to believe that the normalization of US interest rates will remain a very slow process.
Current pace of China slowdown appears manageable
At this stage, we are more concerned about the recent deterioration of Chinese economic data. We still think that the Chinese economy is generating reasonable numbers, but doubts about the growth stabilisation have emerged again. Real estate sales growth seems to have peaked, while private investment growth continues to struggle. The capital flow picture remains a big positive change compared with last year and the beginning of this year. The authorities have been successful in stabilizing flows, which suggests that policy makers are in control again.
We are keeping our view that Chinese growth is in a multi-year slowdown. A sharp deceleration with increasing system pressures was what we feared last year. Recent data still give enough comfort that the current pace of slowdown is manageable. But at the same time, we continue to think that a deterioration in Chinese growth is the single-most important risk to all EM assets. So if we talk about the recent resilience of emerging market assets, we feel that the most remarkable has been that investors have shrugged off the disappointing Chinese data.
EM central banks will continue to ease monetary policy
As long as the global liquidity environment remains benign and inflation in the emerging world continues to decline, central banks in emerging countries will continue to loosen their monetary policy. Our monetary policy stance indicator has been in positive territory since March and has sharply risen since May. It tells us that more monetary easing has been taking place recently. For emerging debt markets this is hugely important. Not only because declining yields push the value of the bonds higher, but also because more easing of financial conditions should help the EM growth recovery to broaden out and strengthen.
Jacco de Winter is Senior Financial Editor at NN Investment Partners.
