The Fed's policy may just drive a recession

On 16 March, the US Federal Reserve (Fed) hiked its policy interest rate by 25 basis points and started the process of monetary policy tightening after slashing rates to 0% during COVID. This move along with its plans to hike at each of the subsequent six meetings this year was expected by the market. What surprised market participants was the Fed’s terminal policy rate expectation (the highest policy rate it expects out of this rate-hiking cycle) at 2.75% by 2023 versus the estimated long-run neutral rate (the rate supporting full employment while keeping inflation constant) of 2.35%. The Fed also plans to start shrinking its balance sheet earlier than expected and as soon as in May.

What prompted this degree of hawkishness? For one, US inflation at 7.9% in February is the highest since 1982! Second, the US labour market is pretty tight with the unemployment rate at 3.8% in February, close to the pre-pandemic rate. Additionally, job gains have been widespread across leisure and hospitality, professional services, healthcare and construction.

The Fed published its revised economic forecasts for 2022–24 after the policy meeting. It was striking to see the downward revision to its US growth forecast at 2.8% in 2022 compared to its December forecast of 4.0%. The significant increase in commodity prices and economic uncertainty are expected to drive this slowdown. Simultaneously, it projected personal consumption expenditure growth at 4.3% vs 2.6% in December. The epic level of policy stimulus undertaken during COVID both from the fiscal and monetary sides had driven inflation higher throughout 2021 in the US. 2022 added the extra layer of commodity price shock arising out of the Russia-Ukraine conflict.

Following the announcement, the 10Y-5Y US Treasury (UST) spread turned negative, in other words, the yield curve inverted, signaling that the market has started pricing in an economic recession. This was driven by expectations around a global growth slowdown from elevated commodity prices and the degree of monetary policy tightening projected by the most important central bank. Thanks to the 0% interest rate in the US over the last two years, corporate America issued copious amounts of debt to stay afloat. Non-financial corporate debt rose by USD 1.2 trillion during the pandemic. Corporates will now face higher interest rates and some are bound to go bankrupt in trying to meet their debt obligation. Although the Fed did not amend its unemployment forecast for 2023 (at 3.5%), I would assume job losses starting this year as corporates restructure to raise cash and service their debt.

Despite the degree of interest rate hikes forecasted, the Fed does not expect a recession. In fact, Fed chair Jerome Powell cited three historical instances in 1965, 1984 and 1994, where the Fed was successful in cooling the economy through interest rate hikes without causing a recession. The market disagrees and between you and me, the market usually pre-empts and forces the Fed’s actions.

In this stagflation scenario — with growth slowing and inflation remaining persistently high — how should an investor think about portfolio construction? Consumer staples are an obvious beneficiary as higher prices force buyers to cut back on discretionary spending. Utilities and healthcare are other defensive sectors that could protect the portfolio. Loading up on blue-chip names is another good move. You may have come across the argument that ESG investment is inflationary as it penalizes investment in fossil fuel and metals and thereby creates an uneven supply for important commodities. I would take this prompt and add green metals that are needed for renewable energy generation to my portfolio. These include lithium and cobalt (used in batteries), copper (wind, solar PV) and zinc (wind, solar, hydro, energy storage) among others.

Some regions such as Asia have relatively dovish monetary policies compared to the West as inflation is not out of control. Here, ASEAN stocks continue to benefit from their disproportionate exposure to financials, real estate, materials and construction sectors that outperform during inflation. Please check my piece on ASEAN as an inflation hedge for this topic.

Central banks globally are struggling to juggle high inflation and easing growth. At the moment, containing inflation appears to be the number one priority. However, as monetary policy tightening weakens growth, central banks may disappoint the market’s rate hike expectations in order to protect the economy. This would create a good environment for bond investments to thrive, particularly next year.

Conclusion:

The Fed’s aggressive interest rate projections coupled with elevated commodity prices suggest the rising probability of a recession in the US and global economy.

Portfolio construction during stagflation periods should tilt towards defensive sectors such as consumer staples, healthcare and utilities.

Green metals that are used in renewable energy generation and select sectors that benefit from inflation are a good fit in the current environment.

Please consider contributing to humanitarian efforts in Ukraine. Refer to this or this website for organizations undertaking humanitarian efforts.

Reforming corporate Korea out of stagnation

 

South Korea is the tenth largest economy by gross domestic product and has a per capita income of USD 31,360 (2020), qualifying it as an advanced economy. Korea was given the title of the ‘Miracle on the Han River’ for its spectacular rise from an agrarian economy in the 50s to an industrial power house in the latter half of the 20th century.

Despite its notable economic achievements, the Korean equity and currency markets are hindered by governance challenges and investment hurdles. These have kept Korea in the emerging market (EM) bucket by equity index provider MSCI since 1992. Weak corporate governance in large conglomerates, restricted access to the currency market and onerous onboarding hurdles for foreign investors among other factors, have prevented Korea’s upgrade to developed market (DM) status.

Why is corporate governance a big issue in Korea?

Korea’s benchmark Composite Stock Price Index (KOSPI) is dominated by family-run conglomerates called Chaebols (wealth clique in Korean) such as Samsung, LG, SK Hynix and Lotte among others. Chaebols constitute over 50% of the KOSPI’s market cap and the top 10 own over 27% of all business assets in the country. Chaebol families were praised for their role in industrializing Korea during the 60s and 70s and turning the nation into a manufacturing powerhouse from an agrarian economy. Today, Korea’s economy is the 10th largest in size, in a large part thanks to Chaebols.

Notwithstanding their massive contribution to the economy, Chaebols are notorious for their opaque corporate governance policies to retain power with founding family members. These conglomerates have often used circular shareholding structures, made decisions to favour family members and generally disregarded minority shareholder returns. To provide context — the gap in the dividend payout ratio of MSCI World (comprising developed market stocks) and MSCI Korea stood at 21.72 ppt in 2000, 28.01 in 2010 and 29.85 in 2020. The persistent weakness in dividend payout — as Chaebol managements prefer to hoard cash rather than invest — drive Korean stocks’ valuation discount to peer indices as well.

Activist hedge funds are trying to force policy changes

An activist hedge fund invests in companies and plays an active role in changing policies and / or management to unlock business improvement and value. Several activist funds have endeavoured to implement governance reforms in Korean corporates. Local fund KCGI attempted to remove Korean Air / Hanjin Group CEO and establish an independent board of directors to improve decision-making. Samsung’s Lee family is notorious for retaining power with family members. In 2015, activist hedge fund Elliott Management failed to prevent the merger of Samsung C&T and Cheil Industries as the Korean government intervened and backed the Chaebol. This was despite Samsung heir Lee Jae-yong’s blatant attempt to consolidate power in the corporation. These examples highlight the difficulties faced by minority shareholders to unlock value from the biggest Korean firms.

Korean stocks have stagnated over the past decade

Aside from corporate governance challenges, Korean stock prices are held back by the cyclical nature of businesses. For instance, the KOSPI is dominated by cyclical stocks such as semiconductors (Samsung, SK Hynix), shipbuilding (Hyundai), construction (Hyundai Engineering and Construction) and steel (Hyundai Steel, POSCO) that are sensitive to the economic cycle. Korea is an important producer of memory chips that go into manufacturing electronics. The memory chip sector is highly cyclical and correlated to global economic cycle and firm inventory. The KOSPI is often vulnerable to shifting sentiments of the memory chip sector. This generates earnings volatility for corporates and prevents steady flow of capital from foreign investors.

An upgrade to developed market status to the rescue?

If Korea were to achieve an upgrade from emerging to developed market (DM), its stocks would be added to the MSCI World indices which have greater capital invested in them. Against the USD 960 billion tracking MSCI EM, MSCI World Indices benefit from approximately USD 3.6 trillion in assets under management. Research houses estimate USD 20–50 billion capital inflow into Korean stocks upon inclusion into MSCI World indices. These flows may finally help the KOSPI reach the aspired 4000 level and exit the prolonged period of stagnation.

Public officials may be keen for reforms

Korea elected conservative People Power Party’s Yoon Seok-youl as its next president on 9 March. As a former high-profile prosecutor general, Yoon took corrective action against large corporations, suggesting the potential for corporate governance improvements under his leadership.

Democratic Party (DP)’s candidate Lee Jae-myung called for reforms to facilitate Korea’s upgrade to DM during his election rally. In response to MSCI’s wish list, the Korean finance minister spoke about implementing currency reforms this year. It is too early to tell, but these developments paint an optimistic picture for Korean stocks.

Conclusion

Given the stagnation in Korean stock prices and the very low expectation of an upgrade to DM (following numerous failed attempts), the realization of an upgrade and entry into MSCI World indices could be very positive for Korean stocks. From an investor’s perspective, any seriousness from policymakers and Chaebols for corporate reforms is positive. In recent years, Korea’s Fair Trade Commission (FTC) banned new circular shareholdings in 2013, facilitating a reduction in business owners holding key board posts. Companies with independent audit committees rose and the KOSPI’s dividend payout ratio has been inching higher. This momentum needs to continue to see any evident impact on share prices.

Please consider contributing towards humanitarian efforts in Ukraine. Refer to this or this website for organizations that are assisting Ukraine.

ASEAN as an inflation hedge

The epic proportion of fiscal stimulus in advanced economies, pent-up demand post COVID and supply-chain shortages had together raised inflation in the global economy since 2021. As the pandemic subsided in 2022, the expectation of many had been for raw material shortages to ebb and inflation worries to gradually subside.

Enter Russia’s invasion of Ukraine and its grave implication on the commodity market. Russia is an important exporter of crude oil, natural gas, aluminium, palladium and wheat among other commodities. As Western governments slap sanctions against Russia, commodity prices including Brent Crude have rallied. Higher commodity prices are likely to elevate inflation, particularly in net oil and commodity importing nations.

ASEAN stocks thrive during inflation:

Investors can prepare themselves for the equity-market volatility by investing in stocks and sectors that benefit from higher inflation. In an earlier post, I had identified sectors such as banks, insurance, energy and real estate, where companies see higher revenue during inflationary periods.

One way to play the inflation theme is by investing in ASEAN equities. If we take a look at the MSCI ASEAN index — financials constitute 38% of the index, followed by consumer staples at 8.31%, real estate at 8.19%, materials at 6.04% and energy at 4.49%. Over 60% of the index contains stocks that thrive during inflation!

Extracted from MSCI ASEAN Factsheet, January 2022

How certain sectors react to inflation:

• Financial stocks thrive during rising inflation as central banks hike their policy rate to manage price pressures. This increase in the policy rate allows banks to charge higher interest on their loans.
• Consumer staples are products that are essential for daily living such as food, clothing and personal products. Rising prices drive consumers to cut back on discretionary spending (on new gadgets, vehicles) and concentrate spending on essential items.
• Real estate benefits from higher rent and property investment to hedge against falling purchasing power of currency.
• The materials’ sector comprises companies producing chemicals, construction materials, containers and packaging goods and metals and mining products. You may have been reading about the rally in gold, silver, aluminium and copper among other metals since 2021, given the economic reopening, surge in demand and constrained supply in these items.

MSCI ASEAN constitutes countries rated investment grade:

By country, the MSCI ASEAN index is dominated by Singapore, a AAA rated credit (highest credit rating) by S&P, Moody’s and Fitch ratings. Thailand, Indonesia, Malaysia and Philippines, the other countries in the index, are all rated investment grade by the agencies. While ASEAN countries are mostly classified as emerging markets, consider them to be better quality EMs given their historical growth profile, government indebtedness, central bank policymaking and business environment.

The top 10 constituents of the index are all large cap stocks (where market capitalization exceeds USD 10 billion), indicating that the index benefits from quality companies that offer stability during periods of geopolitical unrest and risk-off.

ASEAN’s macro outlook is likely to improve in 2022:

Barring Singapore which profited from 7.6% y/y growth in 2021, all other ASEAN economies underperformed growth expectation set at the start of last year. This was led by the spread of the highly infectious Delta variant, low vaccination rates and intermittent imposition of movement restrictions in these nations. This suggests the scope for strong recovery in 2022, led by better vaccine coverage, milder impact of the Omicron variant and with pent-up demand being unleashed.

As per the IMF, the average growth rate of Thailand, Indonesia, Malaysia and Philippines is forecasted at 5.67% y/y in 2022 compared to 2.72% in 2021. This improvement in growth, led by consumer spending and business revival is likely to support companies and stocks. Consumer price inflation is also forecasted to maintain steadiness at 2.29% in 2022 compared to 2.3% in 2021, much higher than the 0.67% seen in 2020. Higher inflation will support the MSCI ASEAN index.

Good growth outlook, attracts foreign capital. The capital flow tracker prepared by the Institute of International Finance (IIF) corroborates this statement for the ASEAN region. The graph below shows foreign capital returning to EM ASEAN countries in late 2021.

Data extracted from The Institute of International Finance (IIF) capital flow tracker

Note: Please click on the chart to zoom in

Conclusion:

• Inflation pressures are likely to persist in 2022 given geopolitical developments and economic recovery.
• Investors should modify their portfolio by adding stocks that benefit from higher inflation.
• One solution is by investing in the MSCI ASEAN index. Over 70% of the index is composed of sectors that thrive during inflation.
• MSCI ASEAN’s country exposure is dominated by Singapore, a country rated AAA by the rating agencies. The index is exposed to quality large cap names that are likely to protect the portfolio from equity market volatility.

 

Using macro signals for equity investing

Investing in the equity market can seem daunting, particularly to those of us who are risk averse and worried over a lack of finance knowledge. However, history tells us that market performance can be anticipated by following macroeconomic signals and paying attention to the political and geopolitical changes in the economy.

Following the financial crisis in 2007-08, the global economy witnessed a recession where growth collapsed, interest rates were slashed and inflation was subdued. Despite the gloomy atmosphere, some stocks performed better than others given their defensive quality. Think discount stores and medical services providers that benefit from demand inelasticity. You need these goods, recession or not. Or recall India between 2010-11, when consumer price inflation rose to double digits. With input prices shooting up and hurting profit margins, commodity, industrial and bank stocks did reasonably well. These examples suggest that you can (and should) pick stocks or themes based on the macro environment.

Hard core finance professionals rely on bottom-up company analysis to select companies with good balance sheets, cash flow and rising profitability. However, bottom-up stock analysis is time consuming and arcane for individuals outside the field of finance. On the other hand, keeping track of economic changes through the news and the power of observation is more relatable. Macroeconomics can help you pick and choose investment themes and the companies that fit them. Exchange Traded Funds (ETFs) are widely available in the market and investors can access the companies within the ETF index, its investment style and historical performance. Finding the right ETF suitable to the current economic environment is relatively simple given the information available today at your fingertips.

In addition to macroeconomics, geopolitical and regulatory changes also influence stock prices. Think US-China trade war that disproportionately hurt US automakers, chip makers and electronics manufacturers. Or the regulatory crackdown in China in 2021 which hammered Chinese tech companies. Following these developments and their impact could have guided you on where NOT to invest!

Let's take a look at the different macroeconomic scenarios and the sectors that outperform and underperform in them, to assist you in your investment journey.

High growth: Periods of economic boom are ripe for equity investing given strong consumer spending, corporate optimism and credit disbursal to fund unique business ideas. In order to select the sector or company that can generate high returns, turn to the details of GDP growth in that country. What is driving growth? Is it the consumption boom? If so, what are consumers spending on? Is it corporate investment into R&D, machinery or factories? Export boom led by specific products? Think semiconductors in Korea and Taiwan, electronics in Singapore and automobiles in Japan. The details help spot the growth generating sectors and investment themes that could give you your next big investment.

A study conducted by Morgan Stanley Capital International (MSCI, provider of equity indices such as MSCI World, MSCI Emerging Markets among others) showed that industrials, consumer discretionary, financials and informational technology are the most cyclical sectors. This implies that companies within these sectors closely follow the business cycle. On the other hand, consumer staples, healthcare and utilities are the most defensive i.e., least correlated with growth and the economy.

High inflation: MSCI's research shows that high inflation lowers future growth and adversely impacts small cap companies in the medium term. Higher inflation could also take away from sectors that depend on stable cash flow over the long term such as utilities. On the other hand, sectors that act as effective inflation hedges including energy (through rising commodity prices), financials (through higher central bank policy rates that lift banks' interest income) and real estate investment trusts (REITs own real estate assets which benefit from rising rent and property prices during periods of inflation), outperform.

Emerging market equities have historically performed well during inflationary periods given the dominance of the commodity sector in their economies and / or export baskets. Examples include oil and gas in the Middle East, soybean, crude oil in Brazil, copper in Peru, petroleum, coal and coffee in Colombia and oil and gas in Indonesia.

MSCI Emerging Market Index (MXEF) vs Commodity Research Bureau Index (CRB RIND)

Extracted from 'Emerging market equities in an inflationary environment', Man Institute, August 2021

High interest rates: A high interest rate environment usually arises during periods of growth and / or inflation boom, when the central bank tightens liquidity conditions to prevent excesses. The central bank hikes the policy rate, thereby raising borrowing cost and in the process slowing economic activity. This is the environment we find ourselves in today with global central banks raising rates and tightening liquidity conditions.

Financial stocks thrive in a rising rates environment as banks and brokerage firms can charge higher interest on loans and earn higher income. Insurance firms' profit margin improves in this environment as insurers reinvest premium in long-term instruments like bonds, which earn higher interest income when rates are hiked. An analysis conducted by CI Global Asset Management showed that Canadian and US life insurers generated on average 19.36% and 27.27% return respectively during periods of interest rate hikes over the past twenty years.

Rising rates have also benefited real estate stocks such as REITs as interest rate hikes are led by robust growth and inflation which are positive for real estate prices. An analysis conducted by S&P Dow Jones research concluded that between 1970 and 2006, there were six periods with rising bond yields in the US, of which four saw US REITs produce positive total return. In two instances, REITs outperformed the S&P 500 index.

In 2021, several emerging market central banks including Bank of Russia, Banco Central do Brasil and the Hungarian National Bank among others raised their policy rate to combat inflation. Latin American central banks were among the most aggressive last year. Amidst rising rates, the LATAM sectors that produced positive returns on average were communication services, consumer staples, energy and materials. Communication services firms such as telecom as well as materials firms benefit from growth boom.

Political uncertainty: Numerous examples come to mind when contemplating the impact of political developments on equities. Taking a current example - the military standoff between Russia and Ukraine sent stocks crashing in Europe and US while also elevating commodity prices. Back in 2018, diminishing confidence in Spanish Prime Minister Mariano Rajoy's government sent Spanish and Italian stocks tumbling.

Amidst ever changing political dynamics, investors should pay attention to the sectors tied to these economic and political developments. Particularly during election period, having a quick read through candidates' election manifestos is a great tool to anticipate stock market winners and losers.

Catalyzed by the potential sanctions against Russia, oil, wheat, aluminium and palladium (key Russian exports) prices rallied. Markets fear a hit to the supply of these commodities if Western economies slap sanctions on Russia. Blue chip stocks, US treasuries, Japanese Yen (JPY) and Swiss Franc (CHF) tend to perform better in such scenarios, as they are considered safe haven, whereas companies and /or assets linked to sanctions or sanctioned entities underperform. Given the adverse supply shock on Russian natural gas, Dutch natural gas stocks rallied.

During the political uncertainty in Spain, market sentiments were tied to Spain's relations with the EU. Strong relations would signal policy continuity and boost investor sentiment. When PM Pedro Sanchez formed the government, the market rallied and bond yields fell given his commitment to standing by the Euro as well as follow sound government policies. In this case, the persona of the potential prime minister, signalled by his/her comments and election mandate determined market reaction.

Stock market investing can seem daunting. However, simple tools such as tracking the economic changes, reading through government budget documents and election manifestos go a long way in determining equity market winners and losers. You don't need a finance degree to grow your money. Just some good observation and daily reading.

Economics for bond investment

Good investors understand the importance of diversifying their portfolio by balancing risky and safe investments. Government bonds are generally considered to be among the safest investment assets as governments are less prone to default than corporates. Given the lower risk profile, government bonds offer lower interest payments compared to corporate bonds. However, adding government bonds to one's portfolio is a good hedge against investment volatility.

In this note, I will discuss the various macroeconomic variables to assess when considering investment into government bonds. One formula to familiarize yourself with is the opposite relationship between bond yields and prices. When bond yields go up, bond prices go down and vice versa. Rising bond yields therefore, lower the investment return of bonds.

Are we in a high growth and high inflation phase?

Periods of strong economic growth are generally driven by consumer spending, corporate investment, government spending and/or strong trade performance. Strong economic activity may generate inflationary pressures that force the central bank to hike interest rates and raise bond yields. Moreover, during economic boom, equity investments tend to outperform bond investments as investors are generally optimistic about the business outlook.

As economies are emerging out of the COVID-induced lockdowns, economic growth and inflation have been rising since late 2020. In such an environment, investors would wait until interest rates have peaked (and bond prices have troughed) before re-entering the debt market.

Debt market capital flows in Asia turned negative earlier this year as bond yields and inflation rose. In several economies such as India and Philippines, negative real yields (nominal yields less inflation) dimmed the attractiveness of government bonds.

Quarterly growth and monthly inflation data can be accessed through local statistics agency websites, central bank websites or the International Monetary Fund (IMF).

How is the fiscal profile likely to evolve?

A country's fiscal profile refers to the government's debt and budget deficit to GDP. A highly indebted government may face difficulties in servicing its debt as investors require higher interest payments to hold that debt. A poor fiscal profile deteriorates a country's sovereign credit rating and raises the investment risk of holding government bonds. During the pandemic, India, Malaysia and Philippines among other Asian countries found their sovereign credit rating or outlook downgraded by the rating agencies. This raised concerns among investors and weakened capital inflows into their debt markets.

Having said that, bond investors should concentrate on the trend of fiscal profile rather than absolute levels. For instance, several governments announced medium term fiscal consolidation plans post COVID, to bring their debt under control. Examples include India, Indonesia and Malaysia, where ministries of finance announced medium-term debt and deficit targets to soothe concerns. Fiscal improvements, ceteris paribus, lead to lower yields and better bond returns over the medium term.

Investors should also study the average debt maturity and currency denomination of government debt. Longer maturity profiles reduce the exigency of debt repayments and give governments the time to bring finances in order.

Foreign currency denominated debt is more vulnerable to exchange rate volatility during crisis periods. Indonesia and Philippines have higher proportion of foreign currency denominated debt. During periods of risk-off, these markets are more vulnerable to capital outflow driven by exchange rate depreciation. In this regard, although India's debt and deficit levels are generally higher than Asian peers, long average debt maturity (exceeding 10 years) and largely local currency denominated debt provides important cushion to investors.

Data on fiscal metrics is available on the websites of the ministry of finance, budget office and the IMF.

What are the demand and supply dynamics?

In Econ 101 we learnt that the price of a good is a function of its demand and supply. Similarly, bond prices depend on demand and supply. If demand for bonds is higher than supply, bond price would increase and improve the investment return.

I admit that gaining this information is slightly tedious, but not impossible. You simply need to know where to look.

Bond supply is easier to determine as the budget office or ministry of finance provides this data while promulgating the annual budget. Governments often discuss budget financing through surplus cash reserves and/or additional bond issuance.

Bond demand is onerous to determine as each country differs in its bond holders. Common sources of demand include 1) local insurance firms, 2) local pension funds, 3) local banks, 4) foreigners and 5) the central bank. For instance, in South Korea, the local pension fund called National Pension Service (NPS) is an important investor in Korea Treasury Bonds (KTBs). NPS often discusses its allocation into KTBs and its medium-term plans, which can be accessed on its website. In recent years, NPS announced its intention to raise overseas allocation in search of higher yields. With the Korean population rapidly ageing, NPS has been seeking more lucrative investment opportunities for its depositors. Greater allocation overseas implies lower allocation towards domestic assets such as KTBs. This is long term negative for KTB returns.

Similarly, the Employees Provident Fund (EPF) in Malaysia is a key sources of demand for Malaysian Government Securities (MGS). Amidst the COVID pandemic, the Malaysian government allowed citizens facing economic hardships to withdraw their EPF contributions. These withdrawals reduced EPF's assets under management and affected its MGS investment.

As the pandemic shuttered businesses across nations, banks became risk averse to lending. Rather, they preferred increasing their allocations towards the safety of government bonds. This created additional demand for government bonds and boosted prices. Banks provide data on their government bond investments during quarterly results filing.

For information into government bond holders, I would also recommend going through central bank publications. Central banks often produce deep dives on country bond markets and major bond holders.

Is the central bank assisting the bond market through QE?

Prior to COVID, quantitative easing or QE as a policy tool was used mostly in developed economies facing prolonged periods of low growth and inflation. For further information on QE please refer to this article. The Bank of Japan (BoJ) and European Central Bank (ECB) implemented QE measures to revive growth and inflation amidst demographic decline. Post the global financial crisis in 2008, the US Federal Reserve (Fed) performed QE to stimulate the economy and bank lending.

QE opens up an additional source of demand for bonds in the form of central bank bond purchases. The COVID pandemic forced several developing economy central banks to implement QE measures. These were aimed at 1) easing liquidity conditions for consumers and businesses affected by the pandemic and 2) financing governments' stimulus measures by lowering bond yields.

Several Asian central banks undertook QE measures including the Reserve Bank of India, Bank Indonesia, Bangko Sentral ng Pilipinas and Bank of Thailand among others. Central banks publish data on asset purchases on their websites.

As fiscal stimulus deteriorated government' fiscal profile, central banks mollified bond investors by purchasing government bonds and assisting government finances.

How is the currency outlook?

In a previous post, I touched upon the importance of currency return in the overall return of an asset. Foreign investors must incorporate the currency outlook when investing overseas. Suppose you are a US based investor and have invested in Indian government bonds. Over a period of time, the investment returned 15% through capital gains. However, over the same period, the Indian Rupee depreciated 10% against the US Dollar. In that case, your total return would be 15-10 = 5% from this investment.

Therefore, having some idea about where the currency is headed will add to the thoroughness of your investment analysis. Please refer to this post for case studies on currencies.

Conclusion

Government bonds are safe investment bets and considered to be good portfolio diversifiers. In order to assess the pros and cons of investing in this asset class, you can examine readily available economic variables. These include

1) Economic growth and inflation - higher growth and inflation raise government bond yields and lower bond prices.

2) The country's fiscal policy - improving fiscal outlook through lower fiscal deficit and debt over the medium term, ceteris paribus lower government bond yields.

3) Demand and supply dynamics - knowing the major holders of government bonds by country is a great first step in comparing demand and supply for bonds. Information on bond demand and supply can be found on central bank or ministry of finance websites.

4) Central bank asset purchases or QE - Another source of bond demand is the country's central bank. In Japan, the BoJ holds over 40% of outstanding Japanese Government Bonds (JGBs). This policy is aimed at lowering interest rates to boost bank lending, growth and inflation.

5) Currency outlook - investors should incorporate currency views into their investment analysis when investing overseas. Refer to my previous posts on currency discussions.

RBI’s communication – Like Chinese Arithmetic

Monetary policymaking is not only about analyzing economic conditions and devising appropriate responses. It is equally if not more important for the central banker to correctly communicate the policies and their rationale in order to build investor confidence. Market participants closely watch and listen to monetary policy makers. They pay attention to the central bankers’ confidence or lack thereof while communicating. They try to unearth the hidden messages under each sentence spoken and what they imply for the market. The market’s verdict is immediate and most often it is unforgiving of gaffes and missteps.

In December 1996, then Federal Reserve Chair Alan Greenspan asked a seemingly innocuous question during a banquet about irrational exuberance, escalating asset prices and appropriate policy action. Over the next few days, stock indices across Japan, Europe and US sold off. Or let’s recall a more recent incident involving ECB President Christine Lagarde. In March 2020 and in response to a journalist’s question, Lagarde rashly stated that “we are not here to close (sovereign debt) spreads”. Bond yields across European economies rose in reaction to this alarming statement.

Emerging market central banks are under even greater scrutiny given the lack of equivalent confidence in their institutions compared to developed markets. In this context, it is interesting to examine the Reserve Bank of India (RBI)’s communication with the market in recent years.

India entered the Covid-19 crisis on a relatively weak footing, with an elevated fiscal deficit, government debt and inflation. Foreign portfolio debt inflows had been declining since 2015 on the back of market concerns around deteriorating fiscal finances. With the government restricted in its actions, the RBI was responsible for much of the heavy lifting to steer the economy and market through this crisis. And while it did a good job of boosting systemic liquidity, offering credit guarantees to small businesses and suppressing bond yields, its communication was somewhat lacking.

This or that?

The RBI’s mandate is price stability while keeping in mind the objective of growth. In certain instances, the market was unsure about the RBI’s priority. For instance, in December 2019, the RBI decided to maintain the policy rate given high inflation. Simultaneously, it revised down its growth forecast to the lowest in over a decade. The market had been expecting further easing from the RBI, taking cues from its tone in the past meetings. Throughout 2019, the RBI had expressed concern over weakening industrial activity, service sector output and investment. Additionally, it had cut the policy rate by 135 basis points that year to support growth. The sudden switch to inflation control surprised the market as investor confidence building necessitates consistency of messaging.

The RBI is under a similar dilemma this year. CPI inflation exceeded its 2-6% target band in May and there are signs of further price pressures. RBI Governor Das brushed aside inflationary pressures in June by arguing that demand pull inflation is lacking. He reiterated the RBI’s accommodative monetary policy stance to revive and sustain growth. However, market participants continue to remain wary of the RBI’s next move. The money market is already pricing in 99 bp hike to the policy rate over the next year, indicating that the market does not buy the RBI’s commitment. The other aspect to note here is the lack of clarity over what the RBI is prioritizing. Is it growth or CPI inflation? This or that?

To be fair to the RBI, the Philippines central bank, Bangko Sentral ng Pilipinas, is facing a similar quandary this year. Like the RBI, the BSP’s primary mandate is to maintain low and stable inflation within the 2-4% target range. Year to date, headline CPI inflation in the Philippines has averaged 4.5% y/y. Even though Q1 GDP contraction was worse than consensus expectation, the BSP maintained the policy rate. This rate hold was in line with market expectations given previous comments by BSP Governor on the appropriateness of policy setting and growth optimism. The messaging was consistent throughout.

The list of priorities is growing.

Since 2020, India has received massive foreign direct investment flows which boosted the capital account balance and strengthened the currency (please refer to my previous blog post on the relationship between capital account balance and currency). The RBI absorbed these capital inflows by building its FX reserves buffer and in the process controlled the Indian Rupee (INR)’s appreciation.

The RBI’s arguments were that currency appreciation hurts exports and lumpy capital inflows are vulnerable to reversal. It wanted to build a war chest of reserves to prevent currency weakness during periods of external risk-off. And again, to be fair to the RBI, it is haunted by the developments during the 2013 Taper Tantrum and 2018 Fed rate hike, when the INR sold off massively.

But there are flaws in the RBI’s logic and communication style. Currency weakness brings with it imported inflation, which an inflation targeting central bank is well aware of. Additionally, since 2019, Indian inflation has exceeded the RBI’s inflation targeting band.

Secondly, the RBI has not been clear about what magnitude of reserves are considered sufficient. India’s FX reserves have risen to a historical high of over USD 600 billion, the fifth largest globally. They are enough to cover anticipated capital outflows as well as almost 12 months of imports. Despite this robust cover, the RBI recently opined that reserves were insufficient in covering imports compared to Switzerland, Russia and China. Should the RBI be competing with other central banks or considering domestic needs? And like other good communicators, should it not clarify the parameters it is considering?

Finally, currency control appears to be an added priority on top of inflation targeting and growth support. This exacerbates the earlier point on the market’s confusion over RBI’s policy goals.

Will you be there when I need you the most?

The Covid-19 induced fiscal relief packages have weakened the Indian government’s fiscal profile. The government’s debt is estimated at 90% of GDP and it needs the RBI to control bond yields. The RBI stepped in nicely by buying government bonds in the secondary market and executing operation twist (buy long dated and sell short dated bonds to flatten the yield curve and ameliorate the government’s debt servicing needs).

For the most part, the RBI has been successful in suppressing yields. Moreover, its liquidity enhancing policies have massively cushioned the blow to the economy, particularly given the government's limited fiscal space. These have included credit lines and easier loan terms to consumers and SMEs, much needed financing to the struggling shadow banks and loan restructuring schemes to stressed segments.

What it has been less successful at is winning bond investors’ trust. At several points throughout 2020 and 2021, bond investors were unsure about whether the RBI will step in to keep yields low. Indian CPI inflation has been stubbornly high due to food prices and several rating agencies cut India’s sovereign rating and outlook. These factors necessitated higher bond yields and raised valid questions from bond investors.

The RBI has tended to step in when yields crossed a certain threshold, making its intervention reactive rather than proactive. Look at it this way, Mario Draghi’s comment “we will do whatever it takes to save the Euro”, singlehandedly calmed the market and prevented a sovereign debt crisis. This is the power of words and good communication personified.

The RBI has also been forced to cancel several bond auctions because the market was unwilling to accept low yields. The fundamentals were unsupportive and without the RBI’s explicit support, Indian bonds were not a comforting bet. Drawing parallels with other central banks, Bank Indonesia and BSP were more forthright in their government debt purchases. The BSP announced an arrangement with the Bureau of Treasury and secondary market purchase of government securities. The Indonesian government announced legal changes to allow primary market government debt purchase by BI and a burden sharing agreement as well. These were bold, unprecedented measures which were needed during unprecedented times. Although the market was concerned about institutional autonomy and exit strategy, it had the necessary information to forecast future policy actions. This was a major difference to the RBI.

All these arguments are not to belittle the quality of monetary policy in India or its makers. Rather, it is to point out the areas that still need improvement. Particularly since the adoption of inflation targeting, the investor community has been impressed with central banking in emerging Asia and the RBI is no exception. The RBI's efforts to clean up the non-performing debt in the banking system and its financial stability reports are well regarded and widely read by the investor community and policy analysts. Not to forget, the hugely important role that the RBI has played in steering the economy through this crisis.

It is precisely why the market has formed an expectation about the RBI’s monetary policy making. That it is good and well though out (most times). And when expectations are high, it doesn’t take much to lower them.

Currency case studies

This post is a follow-up to my previous article, which laid out the economic framework to forecast currency performance. In that note, I had emphasized on the importance of currency evaluation in the investment decision making process. Currency returns need to be accounted for in the overall investment return and simple economic variables can be utilized to make an assessment about a currency’s direction over the investment horizon.

We identified 7 economic and policy variables to guide the currency outlook. In this note, we will apply the variables to forecast actual currencies. These case studies will assist you in building your thought process around currencies, when to buy and sell them and how to apply economic variables to understand the market. Please note that currency forecasting based on economic fundamentals is appropriate for medium to long term forecasting and identifying currency cycles.

The US Dollar is likely to weaken:

The USD is the most traded currency in the global economy. In 2019, the USD was involved in 88% of all FX transactions. Additionally, as the global reserve currency, the dollar is held by almost all central banks and institutional investment firms. Given the importance of the USD in the global FX market, we start applying our economic framework to forecast its direction.

1. US trade balance is likely to worsen: The United States has historically seen trade deficits (where imports > exports) since 1992. It is a consumption-based economy, relying on imports to fulfill domestic demand. As the US economy is exiting the pandemic, pent up consumer demand is likely to boost imports and worsen the trade deficit. This should weaken the USD.

2. US capital account balance is likely to worsen: The United States is the largest source of private sector capital in the world economy. As a response to the economic shock from COVID-19, the US Federal Reserve (Fed) slashed policy interest rates to 0% in 2020. With domestic interest rates at record low, US based investment firms have the incentive to allocate capital overseas in search of higher yields. This is likely to worsen US’ capital account balance and weaken the USD.

3. The Fed will allow inflation to run high: In August 2020, Fed Chair Jerome Powell announced an important shift in the Fed’s monetary policy. Since 2012, the Fed had been targeting 2% inflation. In August 2020, Chair Powell tweaked the Fed’s inflation targeting mandate from long-term inflation targeting to average long-term inflation targeting at 2%. Quoting Chair Powell – “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”.

This shift in monetary policy is important because it suggests that the Fed will let inflation exceed 2% in some time periods, as long as inflation averages 2% over the long term. With pent up demand in the US coming back, higher US inflation is likely to weaken the USD.

4. US money supply growth is at a historic high: In response to the COVID-19-induced economic shock, the US government and central bank unveiled massive stimulus programs. These were aimed at boosting consumer spending and private investment. At the same time, the stimulus measures pushed M2 money supply growth to a historic high of 24.8% y/y in December 2020!! To provide you some context, M2 money supply during GFC peaked at 10% y/y in March 2012. Such high money supply growth is likely to weaken the USD.

As per our framework, the USD is likely to weaken.

In the subsequent case study, we will assess the currency’s direction relative to the USD.

Korean Won’s fundamentals have been improving.

1. Korea’s trade balance is improving: Semiconductors comprise ~20% of Korean exports. Semiconductor prices are cyclical in nature, with each cycle generally lasting 2 years. The last cycle bottomed out in August 2020 and the pandemic has simultaneously boosted demand for electronic products made using semis. This suggests that semiconductor prices are likely to rise over the next 1-2 years and boost Korean exports. This will strengthen the KRW.

2. Korean inflation is below US inflation:

Ageing demographics is an important driver of lower Korean CPI. In 2020, Korea's fertility rate fell to 0.84, the lowest globally. This compares against 1.73 in the US and 1.42 in Japan. Korea's population fell for the first time in 2020, suggesting a downtrend in consumption and inflationary pressure in the economy over the coming years.

Relative to the US where the Fed may let inflation run high, Korean CPI is likely to be weak due to structural factors. This will weaken the USD against KRW.

3. US money supply exceeds Korean money supply: Against 18% y/y M2 money supply growth in the US (after peaking at 25% last year), Korean money supply peaked at 11% y/y. Lower Korean money supply is likely to strengthen the KRW against the USD.

4. The Bank of Korea is likely to hike the policy rate soon: To provide you some context here, the BoK is a conservative central bank. By conservative, I mean that it has hawkish tendencies and is averse to extra loose monetary policy conditions. Such conditions lead to macro prudential risks such as asset bubbles. The BoK is especially concerned about rising house prices in Korea and household debt being over 100% to GDP. With the economy reverting to normal post the 2020 crisis, the BoK sounded hawkish at its last policy meeting. An eventual policy rate hike will strengthen the KRW.

Currency forecasting is simpler than we think it is. Sure currencies are volatile and prone to swings due to everyday events. But economic fundamentals can guide the medium to long term currency outlook and help look through the daily, weekly or even monthly volatility. Moreover, economic analysis can help enhance the investment decision making process for trading FX and other asset classes across economies.

Key takeaways:

1. Our analysis of the US Dollar (USD) based on the economic variables indicates that the USD should weaken in the medium term.

2. On the other hand, the same variables suggest Korean Won (KRW) appreciation.

3. Similar analysis on currencies can be utilized to identify attractive currency pairs where one currency has strong fundamentals and one weak. FX traders often use such analysis to go long (buy) and short (sell) currencies to make gains.