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Is Lula Unstoppable?
Markets are calm. Investors are happy. Who would have thought it was possible. To comeback and win the Presidency of Brazil with a margin of barely 2%.
Despite winning only one out of five regions, with an overall margin of 2%, Luiz Inácio Lula da Silva will become the President of brazil on January 1, 2023. And Interestingly, the first ever to serve three terms (albeit not consecutively).
Replacing the right win Bolsonaro may result in protests and social unrest that could paralyse the country. And reports have today already started emerge. But markets are calm. And investment managers are generally positive on Brazil Equity and Brazil's hard currency and local debt.
Brazil currently has lots of positives. From a governmental and administration perspective, past corruption has resulted in stronger governance. The central bank is independent. Any extreme leftist fiscal policies can be countered by the now right-leaning congress. In fact, inflation is coming down, and the likelihood of rate cuts are more likely in Brazil than in the U.S., Europe, or Asia.
Many initiatives has also been launched on the investment side of the economy. Private Sector Banks are taking more share of the loan book. The all important Petrobras is behaving more like the global listed Oil sector industry - paying large dividends and de-leveraging. And vital infrastructure is receiving the attention is has long needed.
Liquidity Presents A Dichotomy
As liquidity in the financial system is removed, investors preserve cash to be proactive buyers from the inevitable forced sellers. But not all investors.
As central bankers raise rates across the globe in their fight against inflation, institutional investors are turning their attention to liquidity. In this new chapter of global political economy, a world drained of liquidity is a world where assets are no longer priced on fundamentals.
Being short liquidity means sellers of assets will by necessity take what they can get in order to meet their commitments. Or put differently, being long liquidity facilitates the purchase of quality assets at deep discounts to intrinsic value.
This presents a dichotomy for institutional investors:
An ALM driven investor will be guided by a series of strategic asset allocation benchmarks and associated risk budgets. Which empirically provide a confidence level that their assets will generate enough returns to cover their current and future obligations. So the tendency is to sit out the storm.
But there are hard core investors who see the removal of liquidity from the global economic system, as an opportunity to pounce. Their research inside RFPnetworks is crossing all asset classes. Searching each of the 11 feeds for terms such as "cheap", "intrinsic value", "discount", and "distressed".
We see danger ahead. Markets are still too high, and protection is expensive in an increasingly nervous world; common sense suggests one should invest conservatively, and in safe assets. In a world where people find themselves without the ability to pay commitments as they arise, forced selling drives prices. Among risky assets like equities, one of the counter-intuitive things in a liquidity crisis is that securities perceived as safest and most liquid go down sharply, because investors are forced to sell what they can, not what they want to. We therefore regard plentiful liquidity in the portfolio as overwhelmingly attractive; it allows us to make the most of the opportunities that arise in the aftermath of a crisis. But first we have to get through the storm.
From Behind To Off The Curve
Fed Guidance has moved from being behind the curve, to springing off the curve. At least that is the view of many economists inside RFPnetworks.
Students learning about commodity future prices will come across two terms that describe non-normal futures markets. Namely contango and backwardisation.
If the futures price is above the expected spot the market is in contango. And if the futures price is below the expected spot the market is in backwardisation. But how does this relate to Fed guidance?
After Federal Open Market Committee (FOMC) meetings, the Fed releases its Summary of Economic Projections (SEP). This reveals their official forecasts for Inflation, Employment and GDP. But also what the fed fund rate will be in the future and the terminal rate required to eventually bring inflation under control.
While a lot has happened these past two years, the phrase "inflation is transitory" will not have been forgotten. This was the period when the Fed (and the ECB and the BoE) were being accused by economists of being behind the curve. Their interest rate guidance was arguably in backwardisation.
Looking at the SEP reports over the past 3 quarters, it seems the Fed has shifted into Contango as their predictions for the fed fund rate and the terminal rate have shifted higher and higher to reflect the reality. Specifically, the September predictions for the the December fed fund rate is 4.4%. And for the terminal rate 4.6%. Which contrasts significantly from the March predictions of 1.9% and 2.8%, or 250 and 280 basis points lower than the September predictions respectively.
It seems as though Fed Guidance has moved from being behind the curve, to springing off the curve...at least that is the view of many economists in the research feeds inside RFPnetworks.
Inflation Protection Is Trending
Protecting portfolios from inflation is a key objective of every investor. Inflation protection is becoming even more critical as inflation heads higher.
As the official rhetoric has moved from transitory, to permanent, to all-time-highs, the focus on protecting portfolios from inflation is traversing all asset classes. The search query 'Inflation Protection' brings back hundreds of new research results every week. So whilst this topic is at number 10 in terms of clicks, in terms of sheer volume of impressions it would be firmly at number one.
What is happening is lots of institutional scrolling, and headline reading. Institutions seem to be searching for the ultimate solution to inflation protection. It does not exist. But there is always hope. In the meantime, the novel ideas and in-depth analysis of the conundrum by asset managers, is being well received.
The thought that central bankers can do much to change the broad sweep of inflation is, in my view, far-fetched. Lowering interest rates and keeping them down ensured that, in the aftermath of the 2008 crash, the world escaped a dislocative deflationary recession, and experienced instead a reprieve from deflation. Their actions, however, had an inevitable consequence: the onset of a virulent inflation. This was perfectly predictable at the time, and, indeed, we predicted it.
There was, however, no money to be made from the insight that money had lost stability post-2008 – the car would swerve maybe towards deflation, maybe towards inflation, but the final result would certainly be inflationary, because the authorities’ obsession was (and is) to avoid deflation. The game changer was to be rightly prepared for inflation, and for the last ten years, we have been. To call it too early is, in our book, to call it on time.
Clear Objectives. Limited Detail.
The ECB's new Transmission Protection Instrument (TPI) is still light on detail, but the objectives are clear.
The main focus of research in our fixed income feed was the ECB's new Transmission Protection Instrument (TPI). Most research was positive on this anti-fragmentation tool and it's clear objective - an unlimited bond buying backstop to facilitate the transmission of monetary policy across the EU. However, details on how it would work in practice with respect to peripheral countries, and particularly Italy, remain less clear.
Related to this theme was the ECB's decision to raise rates last week by 50 basis points. Almost all managers expected 25 basis points based on the forward guidance. As such, many managers are now questioning the credibility of forward guidance in an inflationary world.
Lots of questions remain.
What Is The Logic
The ECB is raising rates, but many argue not fast enough. The ECB's is counter argument is that they are doing what is necessary, only differently.
The last weeks brought lots of interest rate surprises from Central Banks. Here were the main talking points:
U.S. Federal Reserve (The FED): The U.S. Federal Reserve increased its benchmark federal funds rate by 75 basis points to a range of 1.5% to 1.75%. More notably, this was the largest interest rate hike since 1994.
Bank Of England (The BoE): The Bank of England raised its policy rate by 25 basis points. More notably, this was a a split-decision with three of the nine-member committee arguing for 50 basis points - despite this being the fifth interest rate hike in a row.
Swiss National Bank (The SNB): The Swiss National Bank surprised almost everyone by increasing interest rates by 50 basis points. More notably, this is their first increase in interest rates in 15 years.
European Central Bank (The ECB): And whilst the ECB has signalled that it will increase rates by 25 basis points in its July meeting (and possibly 50 basis points in September), the market feels this is not enough. And more notably, out of line with other core central banks.
Adding to the FED, BOE and SNB interest rate hikes above, the Bank of Canada has already embarked on multiple rate hikes. And the Reserve Bank of Australia surprised markets earlier in June with their own 50 basis point interest rate hike. And further afield in Emerging Markets, Egypt surprised markets with 2x expected 200 basis point rate hike to 11.25%. And in South Africa, the South African Reserve Bank (SARB) increased interest rates by 50 basis points to 4.75%.
The European Central Bank has not followed other Central Banks in their more aggressive path of rate rises, or surprises. Instead, the ECB has surprised the market with the announcement last week of the preparation of a new anti-fragmentation tool, and a more flexible reinvestment policy as part of the Pandemic emergency purchase program (PEPP). In other words, they are tackling bond market tensions and peripheral spread widening differently.
High Yield: The ICE Bank of America High Yield Index broke the 8% yield level for only the 6th time since 2008. Prompting institutional investors in many countries to revisit the asset class research on the topic in the Fixed Income feed within RFPnetworks PRO Site.
Municipal Bonds: The Bloomberg Barclays Municipal Index dropped -2.27% last week. This is interesting as Municipal Bond Research & Outlook papers have been trending for several weeks in the RFPnetworks PRO Site. Given that this is the biggest weekly drop since April 2020, at these levels, we now may start to see some new RFP's for Municipal Bonds.
Investment Grade Credit and MBS: In Corporate Credit, the new issuance backlog has increased as supply hit zero last week for the first time this year. And the risk premium on newly originated mortgages versus treasuries have seen spreads double, to levels not seen since 2012, with the primary mortgage rate at its highest since 2008.
In 2015, when we saw this level of traffic in the RFPnetworks PRO Site Fixed Income Research Feed, a wave of High Yield and Loan RFP's followed. Watch this space.
It Can't Solve Everything
Central Banks may have finally moved into quantitative tightening, but there are aspects of inflation that monetary policy may not be able to solve.
Unlike in Japan, the UK, US and now the EU are in all rates lift-off mode. With reluctance, Central Bankers have implicitly admitted their previous policy error of not raising rates sooner. But was this mistake deliberate? Or unpredictable? Last week, Asset allocators were searching for answers to these two questions in our Multi-Asset feed.
On the one side, strategists and economists at asset management firms have a certain sympathy for central bankers. They could be forgiven for not predicting:
1. A prolongation of the supply chain crisis, induced by COVID and exacerbated by China's zero-policy.
2. The actual arrival of Russian Troops in Ukraine and the resultant food and energy crisis, causing prices to spike.
3. A labour market crisis where vacancies are outstripping the unemployed.
But can Central Bankers be forgiven for:
1. Maintaining the mantra that inflation is transitory, for so long.
2. Accepting inflation as lesser evil than recession.
3. Continuing to believe that the Covid, Ukraine-Russia and Labour market crisis will simply go away soon.
Interestingly, both sell-side and buy-side economists are also suffering from the same delusions of central bankers. You just need to compare their forecasts for the path of rates and inflation to see that consensus is lacking, and hope has taken hold.
The biggest problem with monetary policy is that it cannot solve non-monetary causes of inflation, the likes of which we are seeing today, i.e. the ones the Milton Friedman afficionado's did not experience in the 80's or 90's, 00's, or 10's.
The other problem is that the developed world has been hooked on debt by the same Central Bank pedlars of low interest rates and liquidity, for so long. If these same pedlars now use their monetary tools to control the sources of inflation that they can control, namely consumption and investment, the price is recession or prolonged stagflation. Something which is harder to solve.
In the meantime, central bank errors are reverting too slowly back to the mean of reality, but the electorate is assuaged. One question remains: For how long will this softly softly approach work?
ON INVESTORS MINDS
Economic policy priorities are at a cross-road between price stability and recession. How central banks will manage these priorities is on investors radar.
From the UK to Italy, and beyond, Central Bankers remain divided on the level of pain they are prepared to inflict on the economy as rates are hiked to combat the malicious food and energy driven inflation numbers.
Is there a solution?
Read the latest analysis from economists and strategists inside RFPnetworks.
Usually They Deliver
China GDP growth targets almost always get met. But this year, there are lots of headwinds that may prevent the just-in-time numbers that investors hope.
In an uncanny way, China has a record of delivering on it's stated growth target. Come what may. But is it possible given the exogenous shocks it faces today?
On the one side, the zero-COVID policy currently imposes some level of restriction on 25-35% of the economy. Even beyond Shanghai. And it is unclear how long this will last.
On the other side, credit and public debt growth are gaining ground. And further policy support in terms of infrastructure spending is the data point many strategists are watching closely.
Emerging vs Developed Opportunities
Central Banks in emerging and developed markets are prioritising different targets. Relative value investment opportunities are now everywhere.
Since March 2020, the 10-year Government bond spread between the US and China has collapsed from 2.5% to zero today.
This spread underlines a wider theme of monetary policy divergence and relative value dispersion between developed and emerging markets.
In the developing world, above target inflation fuelled by higher commodity prices, is a key driver of interest rate hike expectations. Whereas in emerging markets, and particularly China, the issue is not necessarily inflation, but growth and currency depreciation.
The result? Divergent Central Bank policies that are creating medium-term relative value opportunities across asset classes, for investors that are prepared to accept short term volatility.
Fast, Faster, Fastest Rates
Only the FED seems to believe that it is not behind the curve. But the latest macroeconomic statistics suggest they should raise rates faster.
With the FED's official objectives of both price stability and maximum employment, the latest round of macro data has economists questioning FED rhetoric.
On the one side, US March 2022 headline inflation came in at 8.5%, whilst unemployment is projected to reach 3% by year end, a level not seen since the 1950's.
So should the FED be raising rates faster? And if so, why aren't they?
ONE TO WATCH
China is overdue an economic boost. Whilst the setbacks from the real estate sector are still evident, the PBOC and the Government may be preparing a boost
At the start of this lunar year, investors were expecting the new term of President Xi Jinping to boost the economy's momentum following the COVID induced challenges.
However, with the overhang of the Real Estate sector troubles still causing headaches, and now the delicate political situation given China's relationship with Russia, investors are losing patience. How will the PBOC and the Chinese Government react?
Read the latest analysis from economists and market strategists inside RFPnetworks.
ON INVESTORS MINDS
Central Banks are starting to accept that they need to take more action given the latest macroeconomic statistics.
As the 1Q22 macro data begins to surface, Central Banks across the globe are slowly accepting what bond markets already suspected.
Read the latest reactions from economists on how Central Banks are reacting to the latest statistics, inside RFPnetworks.
Asset Allocation is Changing
As quantitative tightening begins investors are re-thinking their asset allocation. In a rising rate environment, portfolios may change significantly.
As the realisation sinks in that inflation won't be transitory after all, investors have been struck by quantitative tightening, multiple expected consecutive rate rises in 2022, and now an inverted yield curve.
What does this all mean for asset allocation, and how should investors adapt their portfolios? Read the latest views from strategists inside RFPnetworks.
ON INVESTORS MINDS
Economic forecasting is rooted in assumptions. Sometimes they hold true. But is that the case for interpreting 2 and 10 year spreads today.
Should investors listen to the Yield curve and the 2 and 10 year spreads, or is the noise to deafening?
Read the latest views from economists inside RFPnetworks.
Trusting Central Banks
Are Central Banks playing politics with monetary policy. Many independent economists argue that interest rate rises are coming too late.
Central Banks appear to be tangled in their own knitting. Faced with a backdrop of:
- COVID-induced fiscal and monetary extreme expansion.
- Inflation talked down as transient, but that has now broken levels most have never experienced.
- A global economy and supply chains that open and close as cases of COVID shift both down and then back up.
And now Central Banks are expected to engineer a soft landing in the midst of the Russia-Ukraine crisis which may continue for longer than anyone expected, and negatively impact global growth more than is expected.
The big question on investors minds is whether Central Banks are applying quantitative tightening and/or hiking too late and as the economics deteriorate. Or will they listen to what the bond markets are saying and back track on rate rises and tolerate higher inflation.
The answers to these questions will have major impact on portfolios in 2022.
ONE TO WATCH
Is Russia actually suffering from sanctions? Does economic isolation matter for such a large economy? Will the long-term implications be irreversible?
In the short term, sanctions on Russia have effected economic isolation. The question now is what are the long term implications for the Russian Economy?
Get the latest views from emerging market economists and portfolio managers inside RFPnetworks.
Challenging Times
China's growth targets are facing headwinds that are impacting both Chinese equity, credit and real estate investors. Lockdowns are not helping markets.
With China still targeting 5 to 5.5% year-on-year growth, investors are now questioning whether this is feasible.
The fact remains that the real estate sector continues to struggle, with loans to developers at falling at a faster rate than has been seen in a decade. A drag on economic growth which is compounded by China's zero COVID case lockdown policy.
As things stand today, Asian equites & credit seem to be very challenging headwinds.
Start your search using the latest tools on RFPnetworks.
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