Developed markets are acting like emerging markets, what now?

The Herald

The world is a crazy place! Policymakers either blatantly lie to members of the global community, or they are hopeful of miracle cures, or they are plainly just delusional.

We are used to emerging markets doing crazy things, but when developed markets follow suit, we better take note and ask the question: “Is this going to be the new norm?”

I borrowed much of the technical information in this article from PSG who I thank.

Why is everyone surprised by the current volatility in developed global equity markets, bond markets and currencies? Given the loose monetary policies adopted by developed countries, high debt levels and to top it off massive fiscal stimulus and wide deficits similar to emerging markets 20 years ago, how could the outcome be any different to what emerging markets have historically experienced?

Emerging markets have experienced at least three major financial crises that were unique to them over and above the “normal crisis” like the Global Financial Crisis (GFC), the tech bubble and others that affected the developed world over the past 40 years. Over the past 40 years + you had to be resilient to invest in emerging markets and there were extended periods of emerging markets underperforming developed markets.

Investors in emerging markets which include South Africa, Brazil and Turkey have learnt to weather high levels of volatility in equity markets, interest rates and currency movements. Given the current global emerging market geo-political environment, messy politics and poor economic policies it is hardly surprising that emerging markets are out of favour.

Welcome to the “new emerging markets!”

Question: Which countries do you think are running large twin deficits (current account and budget deficits), are behind the curve in monetary policy with negative real rates, and battling with inflation? South Africa’s name is one that would more than likely pop up but you would be wrong. Over the past two years, South Africa’s twin deficit averaged 4,3 percent and Brazil’s 9,7 percent. This compares to 12,5 percent for the UK and 15,4 percent for the US.

Since Covid-19, developed market policymakers have overcome their historic reluctance towards fiscal stimulus and they will use it repeatedly in the future in response to any crisis. This is evident by the recent spending programmes in Europe (EUR 376 billion) and the UK (BGP 130 billion) to alleviate the current spike in energy prices.

Inflation rates are currently higher in the UK, US and Germany than in SA and Brazil, a historically rare occurrence. The German consumer price index (CPI) just hit 10 percent, way above the 1974 peak of 7.9%. The German producer price index (PPI) is over 45 percent, the highest level since 1948…

Brazil has completely normalised its monetary policy post-Covid-19 and SA is also a hike or two away from restoring a normal rate environment. The developed world had to start from zero and negative policy rates into crisis management when inflation hit. Developed market central banks are still way behind the curve in their fight against inflation. This is highlighted by current real policy rates, still ranging from (-) 5 percent to (-) 10 percent in the US, UK and Germany.

Policymakers of developed economies denied inflation at the beginning of the year, lied about it, called it transitory, refused to hike rates, hiked below inflation, sent stimulus cheques, seized oil company profits and now blame Russian President Vladimir Putin!

The market denies the reality of developed market inflation because they think of inflation as an emerging market problem – something for Brazil, Turkey and SA, not the US, UK or Europe.

If developed countries start acting like emerging countries, shouldn’t we expect an emerging market outcome for them?

As we have come to learn, when there are concerns in the world there is a flight to the US dollar. This is also the time when the same old players again point out how bad SA is and investors are advised to flee the country at all costs. If people don’t leave, at least their money must leave! Let us take a peek and see how other countries’ currencies have performed against the USD year to date (up to mid-November). Like I have said so many times in the past, it is not only a SA “thing”.

At the end of last year, there was a clear inflection point and a major re-adjustment was brewing. Something had to give. In articles I wrote at the end of last year/beginning of this year I referred to the debt levels within developed markets, the problem with free money as far as handouts as well as no interest is concerned and the risk of serious inflation. We did not know about Putin’s intentions back then…

Since then there have been some dramatic declines in prices. This time it was not just the tech stocks that declined (which we are used to), but developed market government bonds, which generally get held as pockets of safety, also declined to multiple decade lows. For German bunds and UK gilts to have declined in less than a year by (-)31 percent and (-)43 percent respectively is unprecedented. At the same time, equities were not spared. It was almost like coordinated chaos with no place to hide.

Now that we understand the gloomy picture of the developed world, what is really risky?

The true risk for investors comes firstly from a permanent loss of capital and secondly from the inability of investment returns to be greater than inflation.

In emerging markets, we are surprised if we do not regularly experience wide swings in our currency and bond yields. Volatility in our markets is normal. At the moment emerging markets are out of favour, under-owned and cheap by any measure. That is not the case with developed market assets.

For instance, the massive holdings of government bonds at yields that still imply inflation will fall quickly and remain below target levels for the foreseeable future. The dramatic collapse of bonds has systemic implications, most recently seen in UK defined benefit pensions.

Emerging markets are often referred to as the “problem children” but it is the developed world that has a Peronist monetary and fiscal policy, deeply negative real rates, twin deficits, printing and spending.

When viewed through that lens, expensive, over-owned long-duration assets with rapidly deteriorating economic fundamentals are the epitome of risk, irrespective of their price volatility in the decade after the GFC. In contrast, cheap, under-owned old economy and emerging market assets, well suited to today’s economic fundamentals, are attractive holdings with low “true risk” despite higher historic price volatility.

Portfolio construction today is more important than ever. The old ever-popular 60/40 equity/bond allocation in the developed market will just not cut it. I feel sorry for those who adopted that approach this year, they would have experienced a double whammy of note! – Moneyweb


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