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Salman Ahmed

The “Japanisation” of Europe


Emerging Market corporates have feasted on cheap US dollar debt over the last few years. According to a PwC report (Global Economy Watch – May 2015, "Will dollar denominated debt become an emerging economy epidemic?") since the US Federal Reserve introduced the first round of quantitative easing in 2008, dollar denominated debt rose from USD6 trillion to USD9 trillion in 2014. 

In October that year, the Fed's decision to stop QE helped the greenback to strengthen, which it has been doing ever since. Some fear that with global instability, as investors rush to the USD as a safe haven asset in 2016, Emerging Market economies will be struck down but as the PwC report found, many EM governments have comfortable external public debt: GDP levels that should insulate them from the risks associated with a stronger dollar.

Salman Ahmed (pictured), Chief Global Strategist at Lombard Odier Investment Managers (`LOIM'), believes that in addition to improving fundamentals, given the current climate of negative interest rates in major economic regions and sustained low interest rates off the back of global disinflation, "there is a strong yield differential being offered by emerging markets; now in excess of 7 per cent versus Germany and Japan and around 5.5 per cent versus the US. 

"Given these yield differentials, prolonged low global inflation, continued central bank easing and increased valuation support, we believe that the EM asset class deserves a rethink. That said, we strongly believe that harnessing underlying fundamentals is key to building a quality-based, diversified portfolio in order to access this attractive but still quite risky risk premia," explains Ahmed.

There's no doubt that over recent years, the fear of a Fed rate hike has put emerging markets under increased pressure. If the Fed were to adopt a more hawkish stance going forward EM countries with more vulnerable fundamentals such as Turkey, South Africa and Brazil would be most exposed. 

"However, this is not our base case scenario and we believe that Fed policy from here on in, will remain cautious and benign," says Ahmed, who continues: "Despite the sharp pressure and terms of trade shocks we have seen, a number of emerging market economies have improved their current account balances and are now running them at more sustainable levels. In a number of these countries there are strong signs that valuations are diverging from where the nominal exchange rates are, leading to increased indications of undervaluation."

Against this backdrop, Ahmed actually believes that the "emerging market" label is fast becoming irrelevant. He notes that there is now a great deal of differentiation between the constituents. With each country exposed to different growth cycles, their dynamics are moving in different directions like galaxies in an expanding universe. 

This can be perfectly understood when one considers that commodity importers such as India are benefiting far more from the current world of low commodity prices than commodity producers such as Brazil. 

"Furthermore, India is a major beneficiary of the current global shift. It has gone through a reduction in inflation and improved fiscal balance, with recent data even better than expected. Their current account has improved and their public debt levels have reduced. With this in mind, we strongly believe that if we are to consider accessing this risk premia, we need to take each country's fundamentals into account when building portfolios," says Ahmed.

Looking at today's global markets, one could make a strong case for being bearish or bullish depending on one's global macro interpretation. On balance, Lombard Odier Investment Managers' base economic scenario (estimated with 70 per cent likelihood) is the "Japanisation" of Europe and widespread disinflation in the global economy. "This situation implies very low rates for much longer as monetary policy remains the main source of economic stimulus," says Ahmed. 

In Europe, the policy stance will thus be forced to remain highly accommodative. 

"In the US, we expect economic growth and the rate of decoupling from other markets to slow as the labour market reaches full employment territory and the economy feels the drag from a stronger US dollar. The negative external environment will force the Fed to remain committed to a cautious stance. Moreover, we see lower rates in other major economic centres acting like a gravity pull on US interest rate markets, given global competition for capital," adds Ahmed. 

Central banks have faced stern criticism from some market commentators who their meddling in the markets as nothing more than an exercise in Ivory Tower academia. Granted, they may feel they've had no choice but to artificially inflate the markets and keep rates low, but they've created a rod for their back. They will have few tools left when the next global recession hits. Their interventions have structurally altered fixed income markets. 

"The sustained use of quantitative easing (QE) followed by deeper negative interest rates has created a low rate environment which arguably forces investors to look further afield for yield. Furthermore, investors are facing unrewarded risks arising from increased herding and tighter regulation, which is spelling the end of friction-less access to cash," says Ahmed. 

In 2016, LOIM expects sustained volatility, which will force central banks to intervene in order to mitigate the impact on financial conditions. Whilst equities might remain a necessary option for investors, US equities in particular have moved totally out of synch with the global economic reality; they have become a Platonic simulacrum. Global equities could undergo a sharp beta shock, supporting those in the bear camp. 

However, as Ahmed wrote in a January white paper ("Frightened Bulls versus Terrified Bears") what terrifies the bears is a repeat of a Draghi type policy "trick", which either promises to, or actually overwhelms the system with additional free liquidity; enough to numb the focus on underlying realities and work its way towards "order" by pushing investors towards buying risky assets as risk-free asset returns go deeper into negative territory.

"It appears that this bull case is clearest in the European equity space, where the ongoing gradual economic recovery, easing credit conditions, deflation forcing the central bank to deploy more easing and less demanding valuations create a solid case for asset price recovery from here," confirms Ahmed.

Aside from its base case scenario, LOIM has an alternative scenario (15 per cent probability) that envisages a world where QE polices are successful in generating economic growth and inflation and a more normal recovery in risky asset prices is coupled with rising bond yields. 

"This scenario also sees a more synchronised tightening in monetary policy in major economic centres," says Ahmed. 

"Our tail risk scenario (also estimated at 15 per cent likelihood) is based on the potential likelihood of policy errors by key central banks and has significant negative implications for portfolio valuations (both fixed income and equities). 

"In this scenario, it is important to acknowledge the political economy of central banks such as the ECB, where it is well known that not all key members of the governing council (specifically, the Bundesbank) are on board when it comes to the QE program. Indeed, any sign of a public disagreement within the ECB has the potential to create a massive "credibility gap" in the eyes of the market, generating shock waves in risk-free rate markets.  Even in the US, a tail risk could emanate from a potential "QE overdose", whereby the macro liquidity created by the Fed becomes indigestible and undermines financial market stability."

All one can do in this environment is work with probabilities and position portfolios accordingly. 

In the event of a drawdown, "We are focused on stringent drawdown management and prioritise a deep focus on fundamentals to create sturdy portfolios which can withstand what we perceive to be the potential upcoming shocks," concludes Ahmed

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