In the wake of the recent financial crisis, central banks across the globe have taken extraordinary measures in an effort to avert financial calamity and spark economic growth. Five years after the collapse of investment bank Lehman Brothers, central banks’ policies continue to play a critical role in the direction of economies around the world. While it is important to consider how a country/region’s monetary policy impacts its home market, looking at their actions in aggregate can have a material impact on investment decisions regarding markets far away.
U.S. and the Federal Reserve
The U.S. economy, while frustratingly sluggish, has continued to grow at a moderate pace. Additionally, the headline unemployment rate has fallen from 7.8% at the beginning of the year to 7.3% in September. With that said, although the Federal Reserve caught the markets off guard in September by deciding not to alter its bond-buying initiative, tapering is inevitable should the data continue at its current pace. From an investment perspective, we feel that it is critical to make the distinction that tapering is not synonymous with tightening of monetary policy. In fact, since the Fed continues to reinvest the proceeds of securities that mature, it will continue to be a large purchaser of government and mortgage debt.
Europe and Japan
Looking abroad, the European economy has shown improvement in recent months but remains very weak relative to that of the U.S. To illustrate, Eurozone GDP rose just 0.1% in the third quarter, unemployment has risen to a record 12.2%, and industrial production contracted 0.5% in September, with the lynchpin German economy seeing a 0.8% contraction in production. At the same time, inflation has fallen well short of the European Central Bank’s (ECB) target rate of 2%. In the twelve months ending in October, Eurozone inflation clocked in at just 0.7%, the lowest reading since October 2009. In response to this data, the ECB recently lowered its target interest rate to 0.25%, essentially exhausting the traditional monetary levers that it can pull to spark a turnaround. Considering this, we feel that it is likely that the ECB will embark on bond purchases akin to the actions of the Federal Reserve. While the German populous has been unhappy with central bank policies that have hurt interest rates on their savings, pressure by the IMF and U.S. Treasury on Germany to spur domestic consumption could finally cause Germany to capitulate. If the ECB were to move to a more-dovish stance, the euro would likely weaken, which would actually benefit Germany’s export-driven economy the most. Moving to Japan, the Bank of Japan’s (BOJ) bold new initiatives to stem deflation, dubbed “Abenomics” after Prime Minister Shinzo Abe, appear to still be on track as Japan’s economic growth has slowed after a strong bounce earlier in the year. As part of this, the BOJ plans to double the country’s monetary base within two years.
Taken together, with the domestic economy improving and Europe and Japan languishing, it is likely that U.S. monetary policy is on a tightening trajectory whereas other major central banks are still in the loosening phase. Although we find these moves positive for such economies, it could also lead to weaker currencies and, consequently, a stronger dollar. This currency factor places a drag on investment performance for domestic investors purchasing international stocks. For instance, while the Nikkei 225 Index, a proxy for the Japanese stock market, is up nearly 50% in yen terms, its return drops to 27% when converted to U.S. dollars. With these considerations, we have been shifting our developed international exposure to ETFs that hedge currency risk. This allows us to gain exposure to the underlying fundamentals, without the drag of currency depreciation.
Fixed Income Implications
Moving to the fixed income universe, the impact of Fed tapering on domestic bonds has been discussed frequently in the media and here at Condor Capital. We have positioned our portfolios for rising interest rates accordingly by focusing on shorter duration debt, high yield bonds, and floating rate instruments. However, it is also important to examine the impact of the U.S.’s monetary policy on foreign bonds – emerging market debt in particular. In general, the emerging market bond category is broken into two groups, local currency debt issued in the country’s own currency, and sovereign bonds issued in a foreign currency, typically the U.S. dollar. Since the impact of the Fed’s tapering will be more pronounced on local currency issues, we will focus on this segment.
One of the easiest methods to gain exposure to this market is through passive, index-based investments, such as exchange-traded funds (ETFs). In this investment universe, indexes tend to be dominated by countries that issue the most debt. These are countries that run large current account deficits and largely rely on foreign capital inflows to finance the shortfall. As U.S. interest rates rise, capital flows out of such nations, putting substantial pressure on their currencies and fiscal balance sheets. India, Indonesia, Turkey, Brazil, and South Africa, or the “Fragile Five” as dubbed by Morgan Stanley, are the countries most exposed to this risk. The JPMorgan GBI EMG Core Index – which measures the performance of local currency bonds issued by emerging market governments – has nearly 33% of its currency exposure attributed to these countries. Historically, emerging market debt has shown a low correlation to U.S. markets. However, given the unprecedented actions taken by central banks, we believe that one cannot solely rely on backward-looking data since the future investment environment will be unlike any that has been experienced before. For instance, the JPMorgan GBI EMG Core Index has had a very low 0.10 correlation to the rate on the 10-year U.S. Treasury over the last decade. So far this year, however, a period which we believe is a more accurate analog for the environment going forward, the correlation has been a statistically significant -0.57, which indicates that as U.S. interest rates moved higher, this Index moved lower. For this reason, we have sought to reduce our clients’ exposure to Index-based local currency emerging market debt.