9 May, 2018 John Authers
The geopolitical outlook is, to use a word that has forced its way to the top of the political vocabulary this year, stormy.
But while the storms and risks are evident and appear to blow in different directions, they are in fact beginning to blow in one direction. Numerous pressures are pushing the dollar upwards, and exacerbating a global problem with the shortage of dollars.
The potential for trouble has been illustrated by the stress for Argentina — which has now followed raising interest rates by 10 percentage points in a week by asking for help from the International Monetary Fund — and Turkey. Both are emerging markets with specific and serious local issues, and a growing proportion of their debts denominated in dollars. But the problems could be far more widespread if the advance of the dollar continues, and they would not be limited to emerging markets.
The forces upwards on the dollar include the rise in crude oil prices, which is continuing following the US decision to leave Iranian nuclear agreement; resurgent political risk in Italy, which weakens the euro; higher short-term rates and quantitative tightening from the Federal Reserve that reduces dollar liquidity and increases the appeal of the dollar to foreign investors.
For both two-year and 10-year bonds, the yield differential of US over German bonds reached another high for the euro era on Wednesday. The 10-year Treasury yield took another trip above 3 per cent in Wednesday trade so the risk of a secular upswing remains real in the minds of traders.
The ugly trade negotiations with China, in which the US appears to many to be deliberately provoking a trade war, add to uncertainty and to upward pressure on the dollar.
The combination of dollar strength, tightening US financial conditions and political uncertainty has a well-established corollary: emerging markets weakness. That creates serious problems for the affected markets in the short term, including the risk of crisis if they cannot repay their debts. It also creates opportunities in the slightly longer term as emerging markets investments still tend to be indiscriminate, with flows entering and leaving “EM” as if is one coherent bloc, even though the differences in balance sheet management between different countries are growing ever wider.
Emerging markets government bonds, measured by JPMorgan’s EMBI index, are at their lowest since February 2016, when the world was in a scare over Chinese devaluation. The index has slid by 8.3 per cent since January.
Meanwhile, emerging market foreign exchange, also as measured by JPMorgan, is weaker than it was on election day, and close to its lows from the days after the election when an emerging market crisis appeared a real risk:
Emerging markets’ data have been disappointing of late, after a brief period earlier this year when they seemed to join a co-ordinated global recovery. The Citi emerging markets economic surprise index has turned slightly negative.
But the greatest issue is the stormy weather emanating from the US. As Jorge Mariscal, emerging markets chief investment officer at UBS Global Wealth Management, puts it: “The question is how the markets will interpret this sugar rush of fiscal stimulus that Mr Trump has injected. Will technology offset the inflationary pressure?”
He doubted that this would cause a generalised emerging markets issue, as there has as yet been no sign of contagion in Asia. He added: “Argentina and Turkey are vulnerable because their balance sheets are very exposed to the US dollar. Any sign that global liquidity is tightening is a problem. The bottom line, to quote Warren Buffett, is that when the tide flows back you can see who is swimming naked. The tide is pulling back and it’s revealing the countries with problems that were overlooked when liquidity was abundant.”
Should risk sentiment recover, there should be opportunities to buy emerging markets credits that have sold off unduly — Colm McDonagh, head of emerging market fixed income at Insight Investment, suggests the greatest opportunities are in the Middle East, Latin America and Asia, and also in the growing local currency debt markets.
But it is important to note that a dollar shortage does not merely affect emerging markets. According to the IMF’s latest Global Financial Stability Report, published last month, many non-US banks are reliant on dollar funding, particularly in Japan. Canada is also heavily reliant on US dollar funding. That means, as the IMF put it, that banks could “act as an amplifier of market strains” if they are compelled to sell assets into a turbulent market.
Mr Trump was elected to change the status quo, and he is doing so. The question is whether the stormy weather creates such a dollar shortage that other markets around the world cannot cope.
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