Market Views: Fixed Income
China, oil and the Fed: what they mean for EMD Relative in 2016
James Barrineau gives his take on three of the biggest themes likely to influence the asset class in 2016.
Unstructured Learning Time
- China: not the black hole that some investors believe
- The Federal Reserve: will it be prepared to slow its hiking cycle?
- Oil: price stabilisation in 2016 appears a foregone conclusion
The striking thing for us about China is that, for the first time in living memory, the country needs to learn to speak to markets.
This particular skill does not exist as yet, as ample evidence suggests.
But the sheer size of the country within the global economic web and its integration into global markets makes this a mandatory requirement.
There are some tentative signs that the Chinese have started down the learning curve – the introduction of a centralized bureau for the economy, comments last this week by finance and monetary officials, etc. – but the hurdles are large and self-created. They include:
- Opaque economic data
- Botched equity market interventions
- A significant shift in the currency regime without any supporting policy measures or advance warning
- The lack of a credible spokesperson
– the list could go on.
So, we are downbeat about the country stepping up its game in the near term in this regard, but sanguine about it doing so in the medium term.
This optimism is primarily because there are so few other options – and in EM we have seen any number of extended periods of market volatility exacerbated by policymaker indifference or incompetence.
But eventually the learning curve accelerates and shifts occur.
The unknown factor is always the amount of asset price damage required to force them along this particular learning curve.
In this regard, a bit of perspective suggests that China is unlikely to fall into a black hole without learning to respond adequately to financial market reality.
The final point is that current policy shortcomings need to viewed against the economic background.
Yes growth will slow, but the authorities also still have lots of policy tools available, such as a flexible currency, which is an absolute requirement for full global integration, to say nothing of rational monetary policy.
China also has a very small stock of foreign currency denominated debt, so the depreciation effect of a falling renminbi on company balance sheets should be limited.
State-owned enterprises are being reformed, which should reduce overcapacity, inefficiency, and wasteful spending in the economy.
Room for fiscal stimulus exists, although it is to be hoped that it is not directed towards investment that would only prove more deflationary a few quarters from now.
So the signposts we are watching for are centred around credible policies, intelligently delivered, and well-explained rationales for current policies.
These are not insurmountable hurdles, and we cannot see why China is destined to drag global markets into a recessionary abyss, as some have suggested.
The US Federal Reserve (Fed)
The market now assigns a 30% probability to a US rate hike in March (this probability is probably falling as we write).
It is entirely possible that the Fed has miscalculated the impact on markets of taking away the punchbowl of quantitative easing, which has led to asset prices becoming rich from an extended period of free money.
If that is the case, then falling asset prices will help lead to lower economic growth and truly preclude anything more than one or two rate hikes this year.
Thus far into a particularly bad new year for markets, such comments as there have been from the Fed have had notably little impact.
Should it be prepared to show any recognition of its failures here, we think market sentiment would improve markedly.
If the Fed is bent on a hiking cycle predicated on indicators of full employment while ignoring the feedback from the markets, it’s hard to see EM improving unless our other two drivers improve in tandem.
On this factor we are positively sanguine.
We are currently at price levels that undermine any economic argument that oil producers can continue over-supplying markets over extended periods.
Prices might dip into the $20s, but this will simply make the cash costs of an even larger amount of production uneconomical and speed the supply-demand adjustment.
Volatility in the price of physical oil should begin declining, as the US rig count has declined by 60% from the peak and shale oil production is already down by about 600,000 barrels per day.
Meanwhile, we will begin to learn, probably within days, the scope and pace of Iranian additions to the market, which have presumably already been mostly priced into worst-case scenarios.
Against these industry economics, a price stabilisation at some point this year seems like a foregone conclusion.
For EMs, although half the asset class actually benefits from lower oil, our experience has been that improving overall sentiment will require stable to trending higher oil prices.
We’re going to get there.
Bigger, fatter, buffer, stronger
In sum, we think value has already started to surface in areas of the EM debt market, such as investment grade1 sovereign bonds trading at almost the fullest extent of its historical spreads.
Oil-related names, including quasi-sovereign companies with little default probability, are also trading at valuations rarely if ever seen.
Other parts of the asset class, like currency exposure, remain problematic until we get further resolution of outstanding issues, especially relating to China, given the global FX fallout from its mismanaged depreciation regime.
We certainly won’t try to pick the right time to plunge in or change our own defensive stance, but investors need to recall that the buffer of high yields on dollar EM debt allowed them to achieve a small positive return last year, despite the drumbeat of negative EM headlines.
This year, that buffer has become fatter as the year has begun, so the more progress we see on the core issues we have outlined above, the stronger the market response should be.
1. The highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard& Poor's) or Baa3 (Moody's).↩