Economic Insights - June 4 - 8, 2018
Taper tantrum 2.0?
From December 2016 until March 2018 emerging market stocks outperformed developed market stocks. Developing country assets benefitted from a weaker dollar and synchronized global expansion. But, now the trend has shifted; emerging markets have underperformed. Emerging market stocks are down around 1% year-to-date. Emerging market currencies are 3% below their recent high as of April 3, 2018. According to Bloomberg, emerging market stock and bond portfolios had their largest monthly outflow since November 2016 in May.
Risks have popped up in Turkey, Argentina, and Brazil. The Turkish central bank raised rates 300 basis points in late May after the currency went into free fall. Argentina has hiked its policy rate to 40% and has an International Monetary Fund (IMF) bailout. The Brazilian real has come under pressure since the government fixed fuel prices to appease striking truck drivers. Investors have started to worry that emerging markets may undergo stress like the taper tantrum period.
Revisiting the taper tantrum:
The taper tantrum occurred in 2013 as investors anticipated the Federal Reserve (Fed) ending its asset purchase program. U.S. rates moved up sharply, the 10-year moved from 1.625% in May 2013 to slightly above 3% at the start of 2014. Emerging market assets were hit hard. Prior to that, very low interest rates in the United States had investors hunting for returns in higher-yielding emerging market assets. But then as U.S. rates rose and investors started to price in Fed policy normalization, emerging market currencies weakened and stocks underperformed. Countries with wide current account deficits were most vulnerable. Countries with big current account deficits have a lot of foreign investment and run into problems when foreign investment leaves the country. The so-called sudden stop was the risk during the taper tantrum.
Today versus taper tantrum:
In general, emerging markets are in better shape than in 2013. Current account deficits have improved. That’s good news, meaning less risk from a sudden stop of capital. According to calculations from Morgan Stanley, the inflation backdrop is much more favorable for a broad range of emerging market countries. Less inflationary pressures mean more breathing room for central banks.
While some macroeconomic fundamentals have improved, other risks remain elevated. Emerging market debt continues to move higher. According to the Financial Times citing data from Renaissance Capital, emerging market debt as a share of GDP has increased from 145% at the end of 2012, to 184% at the end of 2016. They also calculate foreign ownership of emerging market debt up.
Going forward, we don’t expect emerging market assets to outperform. We think as the U.S economic growth continues to pull ahead of the rest of the world, the dollar will continue to move up. That’s likely going to be a drag on emerging markets assets. However, a lot of emerging markets are in much better shape than they were in 2013. So, are we in for taper tantrum 2.0? Not likely, but risks are elevated.
A big week for central banks
There are two key central bank meetings this week: the Federal Reserve meeting ends Wednesday, June 13 and the European Central Bank (ECB) meets on Thursday, June 14. Both have the potential to move markets.
The Fed will almost certainly raise the fed funds rate 25 basis points. So, it’s the details of the press conference, the so-called summary of economic projections, and the policy statement that matter. The market will likely be focused in on whether the Federal Open Market Committee (FOMC) shifts from expecting three rate hikes this year to four. Investors will likely be fixated on the long-term path of rates as well.
The rub is that the Fed’s trajectories for rates in 2019 and 2020 diverge from the market’s expectations. Based on futures data, the market is currently pricing in a 2.25% fed funds rate at the end of 2018 versus the Fed’s median projection 2.125%. But as of the end of 2019, the market expects a fed funds rate of 2.65% versus 2.875% from the FOMC. And by 2020, the market is only calling for about a 2.7% fed funds rate, while the FOMC anticipates 3.375%. The market clearly does not think that the Fed will be able to move up the fed funds rates as much as they think they can.
The market will also be looking for changes to the policy statement. At a May speech, John Williams the current San Francisco Fed President and incoming New York Fed head, raised questions about the need for forward guidance as the Fed moves closer to a normal policy rate. So, the market is wondering whether the Fed changes that statement, “the stance of monetary policy remains accommodative.” Changes to this statement likely mean that a fed funds rate between 1.75% to 2% with more hikes on the way is returning to something like normal.
Going forward, like the market, we think that the Fed will not be able to move as much as their projections suggest. A fed funds rate between 2.5% to 3% will likely start to eat into economic growth. As the fed funds rate approaches 3%, there is real risk that the yield curve inverts, a telltale sign of recession.
The ECB meeting:
The impending announcement of the end of the ECB’s asset purchase program has gotten a lot of attention. After a speech by board member Peter Praet, markets have pulled forward the timing of this announcement to this week’s meeting. Investors largely anticipate that the ECB will start tapering its asset purchase program in September with a firm end date in December. It is just the timing of that announcement, June or July, that is up in the air. According to Cornerstone Macro, if the formal declaration of the quantitative easing end date aligns with market expectations, it should be digested fairly well.
What may be more important are any hints on when the ECB will start raising interest rates. With disappointing economic data and Italian political uncertainty, the market has pushed back rate hike expectations. The futures market is currently pricing in a move above the zero bound well into the second half of 2019.1
For both the Fed and ECB, a lot of attention has been placed on policy action for the rest of the year. For the Fed, it’s all about three versus four rate hikes. For the ECB, it’s the end of the asset purchase program. But, there is more uncertainty about policy actions in 2019 and beyond.
1 As of June 6, 2018. Based on the 1-month eurozone OIS forward swap curve. From Krishna Guha and Ernie Tedeschi of Evercore ISI.