How Will US Monetary Policy Impact Emerging-Market Debt?

As US inflation rises and the move in energy and food prices creates a meaningful risk of recession, how will the Federal Reserve respond? And what impact will that have on emerging-market debt?


Recorded on 31 March, 2022.

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Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.


Hello. In today's podcast, we're going to cover some of our thoughts on US monetary policy and how it will impact them, as well as where within evaluations are for both hard and local currency. Now, if we go on to the next slide, the first thing that one needs to understand, to try to figure out what the challenge the Fed is facing is, is that this economy is now at more than full employment.


If one looks at a chart on the left, the blue line shows where real GDP has been between the end of 2019 and the end of 2021. While, the yellow line shows where real GDP in the US would have been, had it grown at 1.8% trend growth. So, the consensus believe is non-inflationary growth for this economy.


If one assumes that at the end of 2019, when the employment rate was close to 3% on core inflation, annualized analysis shown on the right chart was reaching 2% annualized which is the inflation target pursued by the Fed. Then it would also imply that by the end of 2021, the upper gaps have closed. And over the course of 2022, as the economy moves towards what forecast for GDP growth for this year are, we're going to have a positive upper gap where the supply side of the economy is running at full capacity. If we go on to the next slide, we can see here on the left that an employment rate has come back all the way down to a 3% handle. While on the right chart we see that the Employment Cost Index, which is probably the best measure of cost of employment inflation, that we have a low risk, shows that there's been an acceleration that puts employment inflation at levels that are consistent with what we saw back in the early 1990s. In the following slide, we see different measures of inflation. The two charts on the left show mean inflation as measured by the Cleveland Fed, which has accelerated to close to 7% annualized.


While the one at the bottom left shows the three mean inflation index estimated by the Cleveland Fed, where we see that there's a large amount of diffusion of inflation across all the different components of the index. On the right side, we see a couple of additional measures. All of these measures, they coincide in that inflation has essentially jumped into levels of magnitude that we haven't seen since probably the 1980s. Now, moving on to the next slide. This couple of charts are the crux of the issue, as we see currently. The chart on top has a blue line that shows the evolution of the Federal research balance sheet start at the end of 2019.


The yellow line shows evolution of money supply measures the same too. While the red line shows evolution of on credit, all starting at the same base at the end of 2019. Which then hear that the Fed's balance sheet has almost now old in size. Between then and now while a money supply has grown by about 40%. If we translate that into growth rates, which is what we've done in the chart at the bottom, we see that M2, which is a yellow line, is currently growing a close to 9% annualized while a credit growth is running close to 10% annualized and accelerating. So, we're currently in the situation where the Fed has stopped growing its balance sheet, but we still have a growth in money supply because real rates are so low that there's an incentive for the system to borrow and to lend.


And that is creating more and more money in the system, which in the context of an economy that is running at full capacity, it just creates inflation. If the inflation target is 2% and if we're at full employment and 1.8% is the fastest sustainable growth that we can have, then the money supply, everything else equal should now grow faster than 3.8%. If money velocity stays the same, any growth in excess of 3.8% will translate to prices. There's a pretty significant chance, the manual velocities current actually are accelerating which further complicate the inflation problem that affects cost in its hands. And the only way to deal with this problem is for a fair reserve to tighten in financial conditions, and it can only do so by increasing rates and reducing the size of the balance sheet outstanding.


Now, if we move on to the next slide, the way we think about how much the Fed will need to tighten and financial conditions we need to tighten, is why it's thinking about this chart on the left where the light blue line shows the evolution of the Goldman Sachs financial conditions index. When that line is on the lower side of the graph, financial conditions are expansive when it's on the upper side of the graph, financial conditions are restrictive. And we can see that in spite of the fact that there's been an adjustment in equity prices spreads an increase in the rates in the treasury market. If financial conditions are still at a very expansive level, more expansive than the most expansive levels that we saw prior to the 2000 equity sell off are more expansive than the very competitive financial conditions that we had in late 2017, early 2018, before the Fed started tightening. In our view, the Fed would want to bring financial conditions to a level that is going to be in between the horizontal red and white lines. Why do we pick those levels while the horizontal red line starts at the most accommodative stance that we had in 1993 just before the substantial increase in rates implemented by the Greenspan Fed in 1994. The wide line shows the peak restrictive level in periods from 1995 on, that didn't involve going into a very large equity sell off or a recession.


Ideally, once financial conditions get to within those two lines, that's where the Fed will probably consider itself to be in more of a neutral territory and where the need for increases in rates will subside. Now, if one looks at the right chart which sums into what has happened over the last few months, the reality is that, the peak that we reached in March of this year, coincided with the FOMC meeting or the Fed increase rates by 25 basis points. And in theory it sounded quite hawkish. The following week, Chairman Powell came and doubled down on his hawkishness. But in spite of that financial conditions have actually expanded.


And then one close to a quarter of the tightening that we had seen year to that in 2022. Which means that they would probably had to do more rather than less in terms of rate increases. And it will have to deal with the challenge that we highlight in the following slide if we can go there. The light blue line shown in this graph, shows the share of US GDP comprised by spending in energy and food between 1960 and now.


The shaded areas are periods in which the US economy was in recession. The recessions of 1973, 74 of the early eighties, and in 1991 but all related to supply shocks in the oil market where the increase in energy prices grew the share of the economy comprise by spending in energy and food by more than a percentage point of GDP. And in all of those cases, the rest of the economy had to contract to make room for spending in energy and food. And the economy ended up going into a recession. If we look at what has happened between the low energy prices during the 2020 and now, we see that the increase in the share of the economy represented by food and energy, it's already at around 2% points of GDP. With increasing agricultural commodities and energy commodities that we've seen here today, we would expect the share of the economy that has to go to pay for energy and full costs to increase by at least another point of GDP. We didn't have a recession in 2020 or 2021, because there was a period in which there was a massive fiscal expansion.


The December 2020 and February 2021 fiscal packages accounted for 15% of sponsor GDP. But this is going to actually turn into a drag as you go into a second half of the year. And we'll further complicate the inflation problem that the Fed has to deal with because the Fed will be tightening as the economy is going to be experiencing the contraction which happens as a consequence of this increase in present food prices. So we expect the combination of all of these elements are going to make the outlook for the next six months or so more complicated for most risk assets and for EM. And it's important to actually think a little bit about where valuations are, which we start to do on the next slide.


The chart on the right shows a list of emerging market countries that are either investment grade rated or if they are high yield rated, we think they will have no problems paying back its hard currency denominated debt over the next five years. The spread over Libor that one can get by taking exposure to these countries via five year CDS is 87 basis points. That compares to 73 basis points of spread that an investor can get, but taking exposure to investment grade corporate debt in the US market. This spread is among the tightest that we have ever seen. So from this perspective, when one compares apples to apples, it doesn't appear that there's a lot of room in terms of evaluation to actually help underwrite the risks associated to what we're going to see coming from US monetary policy.


It's important also to point out as we do in the chart on the left, which shows in light blue, the sensitivity of emerging markets Dollar-denominated debt, to changes in the credit spread and in yellow, the sensitivity of USIG that to changes in credit spreads that the amount of credit risk held by investors today is close to the all time highs. It's currently five to six times higher than what it was back in 2008. While the ability of banks to provide liquidity in the event that investors have to get out is just a fraction of what it was back then. So when one combines, where we see monetary policy in the US with valuations with this level of crowded position, we do think that we will see better entry points over the next few months at least to the segment of the asset class. And in what respect to emerging market local currencies and rates in the next slide, we show on the line title weighted others.


The weighted others inflation for the emerging markets local bond index, as of mid-March was 6.98% for the last year. The columns on the right show how that annual inflation of cars evolved. A year ago it was 2.3%, six months ago 4.4, three months ago 5.7, a month ago 6.7.


So the important thing here is that inflation in EM has gradually and steadily accelerated over the last year. And currently it's our 24 basis points above what the EM local bond index is with four and a half years in duration. Moreover, if we look at the two columns on the right, which estimate what the average real rate at the overnight rate maturity would be when compared the last year worth of inflation, we see that the acceleration in inflation has more than neutralized the increases in rates implemented by most emerging market countries. And the real rate is now negative 2.9% while six months ago was negative 1.7%. So again, here, we also think that we're going to need one more leg of widening in local yields to make the summit of the asset less enticing, particularly even what we think we're going to see coming from monetary policy in the years, over the next few months. With this, I’ll end here. If you have any questions, please feel free to channel them to your sales representative and we'll get back to you. Thank you.

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