2018: The end of the (QE) affair
There has been much excitement in recent months about the robust and broad-based nature of global economic growth. However, this is not to gloss over the risks that remain
TEN years after the global financial crisis began, we have reached a place where synchronized global economic growth is more than just a pipe dream and the prospect of central banks moving away from their extraordinary ultra-loose monetary policy stances of the last decade is finally a reality.
There has been much excitement in recent months about the robust and broad-based nature of global economic growth. However, this is not to gloss over the risks that remain. Chief among these is inflation. With the notable exception of the UK, where sterling post-Brexit referendum weakness has pushed the Consumer Prices Index as high as 3% in recent months, there have been more column inches devoted to softening than hardening inflation trends.
The world’s fourth-largest economy, Japan, is currently experiencing its second-longest economic expansion since World War II, having grown for seven successive quarters. As in Europe, the Bank of Japan is pursuing ultra-easy monetary policy and has committed to overshooting its 2% inflation target. As a result, it is unlikely that the Bank will alter its current stance of setting the short-term interest rate at –0.1% and 10-year Japanese government bonds at around 0%.
In China, the People’s Bank of China (PBoC) will look to mitigate systemic risks, suggesting a monetary policy tightening bias in 2018. The emphasis at 2017’s Party Congress on the quality of economic growth means continued policy efforts on leverage controls and tightening in the housing sector, which could weigh on public and housing investment. That said, growth looks to be becoming more self-sustaining, with robust consumption and external demand. I expect that China will continue to contribute meaningfully to both global as well as emerging market economic growth in 2018.
Emerging markets: resilience and relative value
After a nervous start to 2017, President Trump-related concerns for emerging market (EM) investors have broadly eased – the difficulties of getting things done domestically has constrained the president’s ability to do as much internationally as he may have initially hinted at. And in the event, sentiment towards the emerging bond markets has held up well in 2017. Optimism over improving (and synchronized) global economic growth has played a part here, as have firmer trends in commodity prices and China’s better-than-expected performance.
In addition, some topical risks started being ‘priced out’ of the emerging bond markets as the year progressed, including developed market political risks and worst-case scenarios in US/China relations (the US has not named China as a currency manipulator or embarked on a trade war).
Emerging market fundamentals and valuations still look selectively attractive versus developed markets. Growth rates in many emerging economies exceed those in the developed world, for instance, while many also boast far lower debt-to-GDP ratios. Yields on both local and hard currency emerging market sovereign debt comfortably outstrip those on developed market government bonds.
As the Figure below shows, high real yields underline the appeal in regions such as Latin America, where inflation is expected to fall in several larger markets, including Brazil and Mexico. However, we do remain concerned about the scale of China’s debt and, although a ‘hard landing’ is unlikely, we believe that tight spreads in the country’s bond market do not properly compensate for the risks.
Most EM countries still have an elevated real yield
More generally, the implications of higher US interest rates still need close attention. However, for many EM economies, the higher US rate environment is less challenging than in previous cycles, due to improvements in their current accounts, and lower overall levels of US dollar-denominated debt. That said, US rate increases could pose a headwind for certain emerging economies, particularly those more dependent on US dollar funding.
Absent the Fed falling behind the curve, EM debt markets can withstand slow and gradual US monetary tightening. Their high real yields should provide something of a cushion against further US hikes. A strengthening global economic outlook, meanwhile, also has favourable implications for the credit quality of EM bond issuers, as EM credit ratings actions typically correlate with growth rates.
Jim Leaviss is head of retail fixed interest for M&G’s mutual fund range.
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11 Jan 2018