Emerging Markets gain from US tax cuts

Mid-Week Bond Update

Emerging Markets gain from US tax cuts

Despite being battered after US president Donald Trump won the election last year - on speculation that he would build up trade barriers - Emerging Markets (EMs) have come out as winners the week in which Trump locked in his biggest political win: the Senate’s passing of his proposed tax bill boosted US and global growth hopes, something which ultimately favours Emerging Markets. EMs were also buoyed...

by internal political developments, including the appointment of market-friendly leaders in Chile and South Africa. The pro-growth mode continued to take equities to records and took the world benchmark US 10-year Treasury yield to almost 2.5%, a level not seen since March. Long-dated Treasuries lost 0.8% over the past five trading days, more than any of the other 33 fixed income asset classes tracked by Mid-Week Bond Update.

Some investors, however, reacted more coldly to the general optimism, as some US Federal Reserve (Fed) officials warned that the recent flattening of the US yield curve could be sending warning signs on the US economy and might limit the central bank’s ability to hike rates in the future. As seen below, market-implied chances that the Fed will hike rates in March fell. The move vindicates Western Asset’s cautious outlook: click here to read Western Asset Chief Investment Officer Ken Leech’s comparison of the US yield curve to Cassandra, the Greek mythology figure whose predictions were always right, yet never believed. As every year, the Legg Mason Mid-Week Bond Update team wishes you a very happy holiday.

 

ON THE RISE

Probability of no rate hike in March – cold blooded bonds: Relative to the optimism surrounding Trump’s proposed tax cuts and the resulting stock market euphoria, the response from some bond investors was far colder: market-implied chances that the Fed will hike rates in March fell from 17.2% to 15.5%, while chances that rates will remain unchanged rose to 84.5%, up from 82.7%. This follows protractedly mixed data, which continues to show growth is still lacking fast-pace traction: while housing data was strong earlier this week, November’s Industrial Production growth came in at 0.2%, below estimates of 0.3%. Investors are also keenly observing the arrival of next Fed chair Jerome Powell, scheduled to replace Janet Yellen in February. It was his nomination that cooled down rate hike expectations in early November, as seen in the sharp drop on the chart below, as he is seen to have a cautious approach similar to Yellen’s. Click here to read more about Yellen's latest hike.

 

Bond investors give tax cuts a cold welcome

Source: Bloomberg as of 20 Dec. 2017. Please see disclaimers for definitions.

 

Australian dollar – up from under: The Aussie dollar gained 1.6% against the US dollar over the past five trading days, the best developed market currency performance. The country central bank’s minutes showed increased confidence will continue to strengthen next year, rising expectations that interest rates could rise for the first time since 2010. The central bank said employment growth could be above average over the next three quarters, something which could accelerate inflation. Australia is trying to kick-start its economy by boosting its Services sector, becoming less dependent on the more volatile commodities – one of economics’ golden rules.

 

ON THE SLIDE

EM interest rate risk – good timing? As central banks around the world aim to withdraw their decade-long monetary stimulus and prepare to hike rates, asset classes offering lower interest rate risk seem to be gaining favour. Emerging Markets, for instance, is on its way to become one of the year’s winners, with the JP Morgan GBI Index of EM local sovereigns up 8.4% in local currency terms, year-to-date, and 13.7% when translated into US dollars – given the positive performance of EM currencies this year. At present, EMs offer less interest rate risk than developed markets – as measured by the JP Morgan GBI’s duration of 4.9 years, relative to the Bloomberg Barclays Global Aggregate’s 7 years. Developed Market bonds’ duration has increased especially since the 2007-2008 financial crisis, as central banks cut rates to record lows, depressing yields. Rather than rescuing debt-loaded banks and reflating dormant economies, EMs focused on batting against inflation – reducing it substantially in leading nations such as Brazil, Russia, Mexico and India. This allowed them to keep the duration of their sovereign debt at relatively stable levels – a bonus for rate-hike weary investors now.

 

EMs keep duration stable as growth comes back, central banks talk of rate hikes

Source: Bloomberg as of 20 Dec. 2017. RHS is Right hand side. Please find definitions in the disclaimer.

 

Eurozone inflation expectations – not there yet: Despite the good momentum enjoyed by the European economy, inflation continues to be the missing piece in the jigsaw. While European Central Bank (ECB) president Mario Draghi had an upbeat speech last week, the monetary authority cut this year’s core inflation expectations to 1.0%, from a previous estimate of 1.1%, and next year’s to 1.1%, from a September estimate of 1.3%. As a result, the 5-year inflation expected in 5 years’ time, the ECB’s favourite inflation measure, fell to 1.70%, down from almost 1.72% before Draghi’s optimistic speech.

 

Source for all data: Bloomberg and Barclays Capital as of 20 Dec. 2017, unless indicated.

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