Views From the Floor

Should we sell in May and go away? It certainly looks that way for emerging markets; and the likely delay to any inflation regime change.


The 1940s may provide a blueprint of what to expect in the coming months; and a look at liquidity in the financial markets since the advent of the coronacrisis.
 

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Quote of the Week:

"What we are doing is creating a policy framework that has an inflation bias in it, which is the first time we’ve had that in generations. The policy response is a war-time policy response."

Dario Perkins, chief European economist at TS Lombard and a former UK Treasury official

 

Sell EM in May and Go Away?

In eight of the past 10 years, May has proved a losing month for stocks, currencies and local bonds in emerging markets (‘EM’).1 This is a trend likely to continue in 2020, in our view, for two main reasons.

First, there has been a material accumulation of government debt in emerging markets ahead of the current coronacrisis. The vertical axis in Figure 1 shows the change in government debt-to-GDP ratios between 2007 and 2019, while the horizontal axis shows the change in government expenditure-to GDP ratios over the same time period. In a nutshell, government spending-to-GDP ratios for many emerging markets increased despite deteriorating finances. We believe that in the coming months, these unsustainable debt-to-GDP ratios will worsen significantly as a consequence of the weakening economic activity.

Secondly, emerging markets have no fiscal room to manoeuver as things go from bad to worse. Figures 2-3 show the 7-day rolling total of new Covid-19 cases since reaching 30 per week. Note that in many EM countries, new Covid-19 cases are growing exponentially, well after they had begun to stabilise or even fall in countries that flattened the curve. Indeed, if Brazil, India, Russia, Indonesia, Mexico, and South Africa are a fair representation of Covid dynamics in EM-ex China (equivalent to about 3 billion people), limitations to international movement of people may have to remain in place. In addition, panic reaction and a lack of coordination among policymakers means that EM countries are likely to take even longer to go back to ‘normal’ than their DM counterparts.

We would argue that China is unlikely to come to the rescue, in our view. Indeed, China is not experiencing the V-shaped recovery some observers had initially expected. As of the end of April – when ‘normality’ has returned to China for about three weeks – coal consumption was still down 7% versus 2019, property sales were down 6% and transport congestion down 2%. Additionally, April PMIs have been relatively flat when compared with March, implying similar levels of activity.

Figure 1. Change in Gross Government Debt / GDP and Government Spending / GDP

Change in Gross Government Debt / GDP and Government Spending / GDP

Source: Compustat, Factset, UBS; as of 31 March 2020.

Figure 2. New Covid Cases in BRIC, Italy, US

New Covid Cases in BRIC, Italy, US

Source: Bloomberg, John Hopkins, Man GLG; as of 30 April 2020.
Note: 7-day rolling total on new Covid-19 cases since reaching 30 per week.

Figure 3. New Covid Cases – South Africa, Korea, Mexico, Indonesia, US

New Covid Cases – South Africa, Korea, Mexico, Indonesia, US

Source: Bloomberg, John Hopkins, Man GLG; as of 30 April 2020.
Note: 7-day rolling total on new Covid-19 cases since reaching 30 per week.

Destination: Inflation. Next Stop? Deflation.

In April, we wrote about how the denouement of this crisis might well be a return to a 1940s-style era of financial repression, with policymakers attempting to inflate away the enormous stocks of government debt the conronacrisis has incurred.

But regime changes take time. What happens in the interim?

The relationship between velocity of money and inflation suggests that before we can even begin to think about inflation as the way out, there is a period of severe deflation ahead. As Figure 4 shows, there is a leading relationship between the two – as the velocity of money accelerates, so in turn does inflation, and vice versa. The velocity of M2 money (which along with cash and checking deposits includes savings deposits, money market securities, mutual fund deposits and other time deposits) has plummeted since the crisis began, something replicated during other financial crises. Consequentially, we can expect deflation over the coming months.

Whilst it is reasonable to anticipate regime change as a consequence of financial repression and higher government spending, it is worth looking before we leap. The destination may be inflation, but the next stop is deflation.

Figure 4. US M2 Versus Inflation

US M2 Versus Inflation

Source: Bloomberg; as of 4 May 2020.

With contribution from: Guillermo Osses (Man GLG, Portfolio Manager) and Ed Cole (Man GLG, Managing Director – Equities).

1. Source: Bloomberg; as of 3 May 2020