Global capital has sought refuge in the US since early 2018. But having enjoyed almost two years as the global beacon for capital, it has eventually ‘caught down’ with the rest of the world as the strong dollar damaged earnings from abroad for US companies, stock markets fell in late 2018 and higher rates hurt interest-rate sensitive parts of the economy.
The key to reversing this low-growth, high-US dollar debt trap are three conditions: a more dovish US Federal reserve (Fed); an improving geopolitical and trade environment; and an end to deleveraging pressures in China. All three variables continue to play out, sowing the seeds for a reversal in the trades that have worked so well since late 2018.
The Fed has cut interest rates quickly and, just as importantly, halted quantitative tightening and expanded the balance sheet via T-Bill purchases – this makes it less likely that the large deficit-funding issuance crowds out other investment and leads to further incidents in the repo market. The Fed will be buying T-Bills for longer than it thinks; otherwise it will risk losing control of front-end rates again. While the government is running large deficits, we don’t believe that the Fed will be able to control the size of its balances sheet and front-end rates simultaneously.
Emerging market (EM) central banks haven’t been able to respond to the slowdown in trade while Fed policy was tight, as an easing would have led to capital outflows into those 2.5% US T-bills, and lowering interest rates could actually have ended up tightening policy. But a weaker US dollar and lower US interest rates has given the green light for EM central banks to ease, and we would expect a pick-up in domestic demand – this is very significant when you consider EMs now comprise 60% of global GDP.
Trade tensions peaking
The geopolitical environment has also improved considerably, although we acknowledge it’s a fragile peace. From the US side, the electoral cycle is coming to the rescue. President Donald Trump has prided himself on a strong economy and stock market, while key swing states sell a lot of agricultural products to China. As the US economy starts to look more vulnerable to recession, there is a greater incentive to come to some form of agreement with China.
From China’s side, growth has slowed but many of the reforms it’s been asked to undertake look to be in its long-term interests. As the current account falls into negative territory via the trade channel, China needs to attract capital inflows unless it is prepared to devalue again (very unlikely). We therefore think the conditions are in place for a truce and some removal of tariffs. And while a comprehensive agreement seems unlikely until after the election; there is a reasonable chance we have seen the peak of the trade war.
China loosens its grip
Despite the lack of headlines, China may be starting to gradually loosen its monetary policy. It lowered its Marginal Lending Rate by 5bps to 3.25% in early November, and this is now linked to the rate at which the People’s Bank of China lends to banks –the reference rate for the economy. This will be nowhere near as aggressive as previous easing cycles in 2009 and 2016 but could signal a shift towards looser policy as renminbi strength makes outflows less likely.
The conditions are there for a reversal in the market dynamic that has dominated price action and capital flows since Trump’s election. The capital that flowed into global bonds, US equities and US money markets will head for the higher returns elsewhere if the geopolitical environment improves and the Fed keeps rates at a lower level. With core bonds at expensive levels and the market underweight emerging market local debt, we will look to re-allocate risk as events unfold.