Argument: Unless we obtain higher oil prices later in the year (15%-20% boost), it's unlikely that the higher inflation we saw in recent months will hold. This is likely to keep equilibrium interest rates lower and is bearish for the US dollar (NYSEARCA:UUP)(NYSEARCA:UDN). Considering the high amount of USD-denominated debt in emerging markets (NYSEARCA:EEM), a dollar that appreciates less aggressively is positive for these countries given the debt will remain relatively more affordable.
I expect this to be a tailwind for emerging markets, despite the reality that corporate yields in developing economies (taken collectively) have been bid down too low (i.e., an estimated 205-285 bps too low) relative to long-run default rate expectations.
In the bond market, inflation is an ever-important predictor over where bond yields will go. Most of the world's debt is of the fixed-yield variety. Namely, yields stay constant regardless of where inflation goes. Therefore, if inflation increases, bonds sell off (all else held equal) while investors pack into bonds during deflationary/disinflationary phases as real yields increase.
Some emerging market economies operate in relative isolation and don't always follow global trends based on idiosyncratic factors. However, the health of developed economies often bleeds into emerging markets through trade relationships given the relative openness of the global economy.
US inflation is approximately on a 2% expected run-rate currently. The 1% figure that held through large portions of 2016 represented underperformance while the recent 2.5%+ CPI figure seen in recent months was too high in light of domestic and global headwinds to inflation.
The Role of Oil
Oil (NYSEARCA:USO)(NYSEARCA:OIL) is having trouble holding $50 despite OPEC production cuts. The bull thesis on oil, which generally goes along the lines of "the market is currently suffering from excess supply, but with OPEC production cuts helping to draw down inventories, the market will rebalance later in the year and we should approach $60 (or higher) oil again."
While compliance among member nations appears high, producers in other parts of the world - notably the US - have been happy to siphon off additional share of the market. Permian drilling capacity has increased and new technological developments such as fracking have effectively reduced the breakeven cost of oil for many exploration and production companies.
Overall, US oil drilling rigs have reached a two-year high with most of the gains attributed to the Permian Basin. At the same time, oil prices are slightly higher than they were two years ago. If this is paired with the reality of lower overall break-even prices for drillers - and hence expanded margins - US drilling is only projected to increase from here. All of this negatively impacts the bull thesis even if compliance is as high as it's reported among OPEC members.
Without material increases in the price of oil, and with the many structural barriers to inflation currently in place, it's difficult to foresee inflation increasing in the US and Europe going ahead.
This is positive for US debt and developed market debt more generally. The US 10-year yield is at 2.33%, although I expect that this figure may dip back down to 2.2% in the coming weeks. It had briefly dipped under the 2.2% mark, but yields have since increased slightly as investors have return to "risk-on" mode following the first-round of the French election (i.e., Le Pen will likely lose against Macron) and Trump's plan to make a major announcement on tax reform on Wednesday, April 26. Hence we saw a bit of a rally in US and European equities on Monday and into Tuesday.
At the same time, this is beneficial for emerging market debt as well. A combination of lower inflation will tend to benefit bond yields. More risk-taking in the market is positive for these markets as a whole. Considering emerging-market debt and equities are firmly in the "risk" category, more favorable sentiment will tend to push more funds into these assets.
Where the Fed comes into play
The main concern regarding emerging market debt is that we're already at a point where risk-taking behavior is close to an all-time high. The spread between US Treasuries and emerging-market debt is a historical low.
The following graph compares the spread between US Treasuries and BB-rated or lower emerging-market corporate debt.
(Source: St. Louis Federal Reserve)
The spread is currently at 385 bps, above February's average of 356 bps, though still materially above the all-time low of 222 bps on May 12, 2006. (By contrast, this spread was at an all-time high of 2,580 bps on December 4, 2008.)
But to think that junk-rated emerging-market corporate credit is not even providing an additional 4% in yield over the 10-year Treasury is difficult to feel comfortable with. Based on default/recovery data, one should expect about a 590-670 bp spread between the 10-year and non-investment grade emerging-market corporate debt. But in an era of low yields and high risk-taking, investors have increasingly veered right on the risk spectrum and produced the low spreads we currently observe.
Since the market began recovering from the oil bust in February 2016, this spread has compressed 500 bps and US equities, as measured by the S&P 500 (NYSEARCA:SPY) have rallied 23%.
The Federal Reserve, meanwhile, is stuck in a bit of a quagmire. It has raised rates in two of its past three meetings, but these hikes have done nothing for back-end yields. Since the Fed's 25-bp increase at its December meeting, the spread between the 10-year Treasury and overnight rate has compressed from 213 bps to 130 bps.
A parallel shift in the curve would currently have this spread at 263 bps (213 + 50) and a 10-year at the 3.5% yield mark. Instead, we're at ~2.3% due to growth and inflation expectations that remain muted and a substantial amount of demand for US Treasuries.
The fed funds futures market, which involves betting on movement in the US overnight rate, has priced in a 96% chance of no Fed rate hike at its May 3 meeting.
(Source: CME Group)
However, the chance of one in June is now at 66%. Market-implied chances increased 13% on Monday due to first-round French election results and, to some extent, Trump's Tweet regarding a forthcoming tax reform announcement.
(Source: CME Group)
With inflation expectations having receded 24 bps since January 27 (implied from the difference between the 10-year Treasury constant maturity security and 10-year inflation-protected security) and a flattening yield curve, this makes rate hikes progressively more difficult.
The effect of this is two-fold and beneficial to emerging markets in each case:
1. It would serve to cut down on the rate of appreciation of the US dollar . Fed rate hikes work to increase yields on US assets and encourage capital inflows, thereby raising the value of the currency in conjunction due to greater demand for it.
Many emerging-market economies issue high quantities of USD-denominated debt to increase investor demand for it. When the dollar appreciates relative to their domestic currencies, the debt effectively becomes more difficult to pay back. The prospect of a strong dollar would weigh on the financial durability of countries such as Turkey (NYSEARCA:TUR), South Africa (NYSEARCA:EZA), and Venezuela, which have high levels of USD-denominated debt relative to foreign-exchange reserves.
2. My thoughts are that the US will be able to increase the federal funds rate to somewhere in the vicinity of 2.00%-3.00% this cycle before it'll need to start cutting. If the demand for US debt remains high, especially for medium- and long-term Treasuries, it will have a difficult time getting there.
Holding all else equal, low rates in the US holds rates low in emerging-market economies as well. This decreases corporate capital costs and represents a continued favorable environment for risk assets, including equities.
So while there are vulnerabilities in developing economies currently and the potential spillover effects of higher interest rates keep investors in these markets anxious, there is still a lack of evidence that the party is over.
Inflation expectations are decreasing, not increasing, and have been for about three months now. I wouldn't expect another boost to inflation expectations unless oil makes another leg up. At the time of this writing, WTI is trading at $49-$50 per barrel.
Globally, we have structural impediments to inflation through high levels of government and corporate debt (decreases future spending power), underutilization of productive resources, industrial overcapacity in India and China (where 37% of the world's population resides), China and its balance of payments issue holding down the yuan (resulting in the relative appreciation of other currencies, which is deflationary), and aging demographics in developed economies, which results in higher dependency ratios and a drag on consumption. (I covered this more in depth in an article from January 2.)
On the domestic front, real estate and auto pricing, which collectively make up close to half of US CPI, are facing pricing headwinds. The Trump administration may be able to push through some of its fiscal policy agenda, but US debt totals will continue to rise. Any further increase in rates will be more deflationary than usual. When interest on the debt consumes a greater portion of the budget, this inherently leaves less funding for the government to support other economic initiatives.
Accordingly, unless oil saves the day with a 15%+ increase by the end of the year, it's difficult to foresee another surge in inflation. This will weigh on equilibrium interest rates and limit the buoyancy in US Treasury yields. If the Fed is more cautious in raising rates as a result (i.e., not able to get overnight rates up to 2.00% by year-end 2018 or 2.75% by year-end 2019) this may take some air out of the US dollar.
Lower US interest rates and a flat/weakly bullish dollar is beneficial for emerging markets taken collective. It is especially beneficial to developing economies with higher levels of external US-denominated debt and relatively lower levels of foreign-currency reserves who lack the ability to support the price of their currency.
Countries most at risk from rising rates and a stronger dollar include Turkey, South Africa, and Venezuela. Therefore, investors who believe in the "higher rates, stronger dollar" thesis are best to avoid to these markets. Emerging markets that would best be adapted to this environment include those with higher amounts of forex reserves relative to USD-based debt. Examples include the Philippines (NYSEARCA:EPHE), South Korea (NYSEARCA:EWY), China (NYSEARCA:GXC), and even Russia (NYSEARCA:RBL)(NYSEARCA:RSX).
However, should the "higher rates, stronger dollar" - and "higher inflation" - thesis not pan out, this would expect to contribute positively to emerging markets and risk assets (i.e., stocks, high-yield bonds, real estate) more generally.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.