As the dollar starts to strengthen, investors unwind their long-held bets on emerging market stocks, currencies and bonds. The spark in the dollar has left developing countries in confusion and the ripple has spread. Hong Kong’s monetary officials took initiative to prop up their weakening currency while Indonesia raised rates for the first time in four years to arrest a drop in its currency. Currencies like the Turkish lira and Brazilian real are at its low against the U.S. dollar. Not only that, but the MSCI Emerging Markets Index and bond index have underperformed. Looking back at historical data, investors have flocked over emerging-market stocks over those in the developed world mainly due to the microeconomic problems in the developed nations.
However, a strengthening U.S. dollar and rising treasury yield has changed the environment and previous trends on emerging-market stocks. This is because a rising dollar makes it difficult for countries to service debt denominated in the US. currency, while rising yields diminish the attractiveness of foreign assets. Senior officials around the world say, “The markets are now realizing they have to pay attention to fundamentals and assessing which countries are the most vulnerable. A continued rise in the dollar and U.S. yield will punish comparatively healthy emerging markets alongside more vulnerable ones. The world tends to be a much happier place when the dollar is not going up.” They are particularly nervous about nations with large current-account deficits and those that rely on foreign investments in finance government spending. Their dependence on the rest of the world for government finances and trade leaves them badly exposed when the dollar rises. On a different note, politicians are also a worry. The Mexican peso has been dogged by concerns over the renegotiation of the North American Free Trade Agreement and a slowly creeping election. It has gotten fairly difficult for new investors to set foot into the market as volatility continues to spread throughout emerging-market assets. More recently, developing countries have largely loosened their currency pegs and built up reserves. Pegs don’t do well in a market that’s volatile because it gets challenged as the market become less stable. On the other hand, the new economic environment has left many emerging economies shielded by robust growth rates.
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Looking back into time, the European Central Bank’s (ECB) monetary policy decisions have been straightforward, but the time following 2020 could lead to some problems as the bank will face a more complex set of challenges in decision-making. The unemployment rate could fall, and economic growth could persist if the ECB tapers its asset purchase program to zero by the end of 2018 followed by a small increase in the deposit facility rate after the tapering. This will set the ECB up in a good position to raise interest rates by the end of 2019. As the current ECB president’s term comes to an end in October 2019, investors should stay tuned for the events leading up to policy changes and Mario Draghi ending his term.
However, leaving his position in a time like 2019 could mean that his successor will face a different set of challenges. One will be analyzing the extent to which the ECB can normalize policy rates before the U.S. and also before the eurozone economics fall into a recession. Another challenge Draghi’s successor will face is calibrating the instruments through which the ECB implements its monetary policy. This is not the end to the problems and challenges as there could be tensions of the U.S. Federal Open Market Committee (FOMC) raising the fed funds rate to 3.4% by the end of 2020. Analysts following macroeconomic trends claim, “We tend to think the market overestimates the extent to which the ECB can normalize policy rates. Gross exports of goods and services made up 47% of eurozone national income in 2017. Europe’s dependence on external demand will limit the extent to which the ECB can raise rates beyond zero once global growth slows down.” The ECB will have to use its balance sheet to counter deflationary pressure when confronted with the next recession since it will have limited scope to cut policy rates. With policy rates nearing zero during the next downturn, one way for the ECB to lower its term structure of interest rates would be to receive interest rate swaps while buying private sector assets. Lowering its term structure will also reduce firms’ borrowing costs, but as long as the eurozone lacks a centralized fiscal capacity, banks and their sovereigns will stay interlinked. With all of this in mind, Europe’s unconventional policies and low levels of interest rates are likely to persist. Investors in the eurozone short-term markets should expect a new phase of unconventional monetary policies in the near future. The stock market tumbled as the 10-year U.S. Treasury yield broke its 3% record in April 2018. This 3% number has spooked a lot of investors as they have been unable to successfully create a game plan for their respective portfolios. The yield has bounced back and forth from a high 2% level to 3%, which is just a readjustment from the market.
Looking at historical patterns, the 10-year treasury rate has stabilized itself at its peak every time. The current federal funds rate has a range of 1.5-%-1.75% with an estimate of an increase by 55 basis points by the end of 2018. There will be no surprise if interest rates are lower than in previous rate-hiking cycles if global rates are also low. Comparing the 10-year treasury yield to the nominal U.S. GDP curve, yields have stayed below the growth curve and will continue to do so because GDP does not seem to grow in the foreseeable future. Not only that, but yield gains in the current cycle are expected to be constrained because the Fed is still holding trillions of dollars in bonds from its quantitative easing efforts. However, recent market data suggests a time of high volatility and incremental rate hikes. Investors should look into redesigning their portfolio keeping in mind the current environment. Perhaps investors should consider buying in on core bonds as yields rise since it presents an attractive opportunity for portfolio diversification. With the current economy, investors should focus their attention on unconstrained strategies, which can alter bond duration and other market exposures without major constraints. Investing in high quality short-term bonds with yields of 2% or more seems like a great investment opportunity for investors looking to make serious profits while taking on some risk. On the other hand, if rates start to rise faster than expected, investors should look into moving away from equities and credit risk as they are known to underperform during rate hikes. It is understandable that with the upcoming market movements, short-term returns might spiral downwards, but investors should focus on the long-run diversification strategies for their portfolios. For all one knows, this could be an ideal time for investors to recalibrate their holdings. |
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October 2018
CategoriesAll Investing Keith Knutsson Real Estate Real Estate Investing |