Market Recap

Posted on August 31, 2018 by Gemmer Asset

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First Turkey, Now Argentina


The emerging markets (EM) haven’t been in the news for what, a couple weeks? Dire headlines about Turkey’s problems were all the rage for a while. This week the spotlight, or more accurately the bulls-eye, shifted to Argentina.


By way of background, Argentina has a colorful history when it comes to debt repayments. Specifically, they have a history of not paying. Since independence Argentina has managed to default on its debt no less than eight times. The last default was in 2014. This puts them in the premier league for debt defaulters, as you can see below.



But despite this, in 2017 Argentina was able to sell bonds maturing in 100-years. There really is something to the saying of ‘fool me once, shame on you, fool me eight times, shame on me.” But I digress. Over the last couple years President Mauricio Macri has tried to pursue reforms, but he has been ineffective in tackling a well-entrenched inflation problem.



Macri didn’t help matters when he asked the International Monetary Fund to accelerate the disbursement of its $50bn bailout package. For some reason this was broadcast over YouTube, and investors scrambled for the exits because no convincing reason was given for the request.


As you would expect, the Argentinian peso plummeted, falling roughly 15% on Thursday after a 7% decline on Wednesday.



To try and stem the currency decline, the central bank hiked interest rates by 15 percentage points to 60%.



Ouch!! This clearly will hit the economy hard, and the currency weakness could stoke a whole new round of inflation. And as we talked about a couple weeks ago, the real weak link is the amount of debt Argentina needs to refinance over the short-term. Some analysts think they could possibly need to raise roughly $20bn next year to fund operations, and no one is clear where the money will come from (hence the request to the IMF).


Argentina Highlights a Broader Problem


It’s not just the Argentinian finance minister who’s wondering where the cash will come from to keep the lights on. The chart below shows external funding needs against reserves for six key countries. This is basically a measure of how ‘reliant on the kindness of strangers’ these countries are. In the case of Turkey, Argentina, South Africa, and Indonesia, the answer is uncomfortably so.



Looking through this lens it is easy to understand why the South African rand fell back to the lows of recent weeks, as you can see below.



Brazil was also in the cross-hairs. The Brazilian real closed in on record lows this week (the rising line below signals a stronger dollar and a weaker real).



And if you want to see who is most exposed to the EM problems in the developed world, look no further than European banks – Spanish in particular. The chart below is of Spanish lender Banco Bilbao Vizcaya Argentaria, S.A. The stock is poised to drop below 2008 lows. Now that is saying something!!



Global Liquidity to Blame


It looked like EM received a reprieve last Friday after Federal Reserve Chairman Jerome Powell spoke at Jackson Hole. His comments were greeted as being ‘dovish’ – or in favor of easier monetary policy. EM stocks in particular rallied and the dollar slid after Powell reassured markets that the central bank sees no reason to speed up interest rate hikes. Some even took this to mean that the Fed might not hike at all next year.


This appears overly optimistic.


His message, as well as those of other Fed officials and the central bank’s recently released meeting minutes are really all saying the same thing – that the Fed is going to continue with gradual rate hikes to get the fed funds rate to neutral or higher. Of course, no one can be sure where neutral is, but there is a good case to be made we aren’t there yet.


Despite the problems in the emerging world, U.S. growth is moving along just fine. Second quarter growth was revised modestly higher this week and economists in general think growth could clock in at a little over 3% this quarter. The Atlanta Fed thinks it could be over 4%.



And the inflation indicators the Fed pays attention to are still drifting higher. This week the Personal Consumption Expenditures Price Index (PCE) increased to 2.3% in July from 2.2% the previous month. The core PCE moved up to 2% from 1.9% in June.



Back to Powell’s speech. It is probably a mistake think he is going soft on rate hikes. Towards the end of the speech he singled out a new Federal Reserve study – titled “Some Implications of Uncertainty and Misperception for Monetary Policy.”


The key tidbit from this report is as follows:


“The combination of inflation recently being persistently below the [Federal Open Market Committee’s] 2% target, despite low rates of unemployment, highlights important uncertainties policymakers face about inflation dynamics on the one hand, and the natural rate of unemployment, on the other. In light of the fact that empirical evidence cannot meaningfully reduce these uncertainties, this paper has shown how these two aspects of model uncertainty affect the choice of strategies for monetary policy.


Uncertainties about natural rate of unemployment have led many researchers to conclude that policymakers would be well advised to ignore potentially mismeasured labor market slack and focus almost exclusively on stabilizing inflation.


This paper has shown that because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”


Ok, what does this mean?


Basically, it argues the Fed shouldn’t slow or halt its tightening cycle simply because inflation is currently tame. Rather, the authors found that today’s record-low unemployment – combined with the Fed’s unprecedented stimulus over the past 10 years – could cause inflation to quickly surge above the bank’s 2% target without warning. And if the Fed waits until that happens to respond, it could be too late to rein it back in without triggering a severe recession.


Bottom line: more hikes are on the way, and these hikes will come at the same time central bank balance sheets contract, essentially draining liquidity from the system. The chart below shows the size of central bank balance sheets for the Fed, the Bank of Japan, and the European Central Bank. It is clear the Fed’s balance sheet is contracting for the first time since the financial crisis, and the other two are not making up the difference.



So far this isn’t a problem for the U.S. economy, and probably won’t be until rates move into restrictive territory. However, this is going to be a continuing headache for countries in the emerging world who need to roll over short-term debt in a tight liquidity environment. At some point these problems will be priced in. The swoon in Argentinian assets gets us one step closer to this point.


Have a good weekend.






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