“As I see it the principal risk is this: no sovereign in the 21st century, whether developed or emerging market, borrows money in the expectation that they will have to repay the money.”
– Lee Buchheit, IMF 2019 Spring Meetings
We are back from the IMF Spring meetings in Washington with a sense that policymakers have had a sigh of relief. Growth is stabilising in China, the US is working on a trade agreement, softening its stance towards Russia and Turkey, and central bankers have pledged to keep policy supportive for the foreseeable future.
There are, however, two major worries among policymakers and investors.
The first concern is that should economic growth falter over the coming years, the policy instruments available to tackle a debt crisis may be insufficient.
The second is that political forces may abuse monetary instruments to keep growth going into election cycles, rather than implementing reforms and enhance productivity. In a rare break of political silence, ECB President Draghi expressed concerns about central bank independence in his IMF interview, with a specific reference to the Federal Reserve.
We share with policymakers both long-term concerns about the economy’s fragility.
With a large programme already in play in Argentina and other countries potentially needing to apply for help in a downturn – Venezuela, Turkey, South Africa, to cite some – the IMF’s balance sheet may soon look stretched. In addition, the capital structure of emerging market sovereigns, with new bilateral loans from China and Russia as well as collateralised contracts, looks much more complex than in the past. This will likely make debt restructurings more complex and onerous for bondholders, going forward.
In the Eurozone, where the ESM may play a similar role to the IMF in the future, countries like Italy may be in a similar situation, having lagged on reforms and productivity. Debt overhangs have also grown across corporates, particularly in the U.S., while leverage has remained more in check across firms and banks in Europe, constrained by regulation.
Policymakers know these economic fragilities have increased and as a result, the use of easy monetary policy to kick the economic-can continues. As we expected the Fed, the ECB and the PBoC turned dovish earlier this year, with major central banks in developed and emerging markets following suit, including the RBA, RBNZ, RBI, Banxico, CBR and BSRI.
The long-term question remains open: how much dry powder will central banks be able to deploy to tackle future crises? And if they continue to use loose policy, which collateral effects will this generate?
These collateral effects may include a debasement of currencies against growing bubbles in hard assets and positional goods in particular – education, central urban housing, healthcare. Persistent low interest rates can also favour larger over smaller firms, encouraging M&A consolidation and increasing barriers to entry. Most U.S. industries have become monopolies or oligopolies as a result – from toothpaste to airlines to microprocessors – as explained by J. Tepper’s The Myth of Capitalism. In turn, corporate and social winner-takes-all effects are compounded by inefficient tax systems, which are regressive and do not redistribute wealth and opportunity – the UK being a case in point. The result of rising inequality, as we have seen over the past few years, is an implosion of the political centre and the emergence of extreme politics.
However, against the structural risks from persistent debt overhangs, the over-use of monetary policy and the resulting political extremism, we see unexpected positives over the coming months, from trade policy and geopolitical developments.
We remain positive on the outlook for risk assets for the rest of the year. Firstly, while recession risks are being priced out by the market, growth-upside from a China led stimulus is yet to be priced in. Secondly, as we have discussed earlier, many investors shocked by last year’s moves have missed the upside in markets and are looking to catch up. As BlackRock’s Larry Fink pointed out recently, there is perhaps a higher risk of a melt-up in markets rather than a melt-down. The largest consensus underweights are Europe and the UK, according to the latest Merrill Lynch fund manager survey. Therefore, we still see a substantial gain available to investors from beta and several alpha opportunities in Europe as well as some EMs including Mexico, Russia, Ukraine and Indonesia.
On the China-US trade war, we believe we may be close to a deal, as China adopts a more market-oriented economy, curbing internal subsidies, lifting entrance restrictions for foreign firms and increasing purchases of U.S. goods. Trump-administration officials have repeatedly discussed the upcoming US-China trade agreement, which we think will turn into a compliance framework between the two countries.
In addition, the U.S. approach to trade sanctions is showing an interesting turn towards negotiations: Russian aluminium producer Rusal, formerly owned by Oleg Deripaska, saw its sanctions lifted this week as it announced a $200m investment to buy a mill in Kentucky. At the Turkey-US relations conference in Washington, Turkish and U.S. officials toned down the debate on sanctions against the delivery of the Russian S-400 missile defence system, exploring a set of alternatives including storage of the S-400 until NATO patriot batteries are delivered.
The underlying theme here is that the U.S. has shifted from a hard line negotiation to a softer approach, where trade policy has become a tool to promote U.S. business and jobs – particularly in states where Mr Trump’s voter base is most active. This is good news for the U.S. economy, but also for countries which have been threatened with destructive sanctions – like restrictions on sovereign debt.
The next sanctions target could be the Eurozone, where the U.S. has been discussing the possibility of raising sanctions on cars and other exports. We expect the EU’s reaction to be a tit-for-tat, though the risk is trade tensions escalate faster than they did between the US and China: the EU could adopt a tougher stance than China when retaliating, as we have already seen in a sequence of U.S. regulatory fines to European banks vs anti-trust and tax avoidance fines from EU regulators to large U.S. firms. One advantage for Europe may be that U.S. public opinion may be less understanding of a prolonged trade war with historical allies, while a stronger strategic case can be made for negotiations with Russia and China.
Besides more U.S. imports, the silver lining of a trade war with Europe could be a wake-up call for common fiscal policy and perhaps, after European elections, a common response in the form of fiscal stimulus from core European countries, particularly on security defence spending.
In a kick-the-can economy, rates remain low for a prolonged period, companies and governments can sustain a relatively large amount of leverage – albeit the worst ones may have to restructure – banks are forced to gradually deleverage and replenish capital. The endgame is either an increase in productivity and growth, or a loss of value for developed market currencies against hard assets.
This is why we believe there is still substantial value in assets which can gain from the pricing out of recession fears – like credit as well as selective rates and volatility sectors of emerging markets.
We maintain long positions in European high yield corporate and financial credit and in emerging market debt in hard and local currency in Mexico, Russia, Ukraine and Indonesia.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by portfolio managers/ macro analysts Aditya Aney and Pablo Morenes.
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