Coming out of the Spring 2022 IMF meetings, we are looking to increase low-beta spread duration and decrease some EMFX exposure.
Our Active Emerging Markets Debt team recently attended the Spring 2022 IMF meetings and share their key takeaways.
The bad news of higher rates has been digested, but the bad news of weaker growth has not. Recession risks are rising, with a European recession, oil embargo risks, and China’s zero-Covid uncertainties adding to Fed rate hikes as headwinds. And the Fed is unlikely to change its policy path soon. Recession risks are mounting and unanticipated by the market, we think. This means a complicated market. To simplify them, we come away from meetings looking to increase low-beta spread duration and decrease some EMFX.
Europe risks entering a recession. At the start of the meetings, the IMF downgraded its 2022 German GDP forecast by 1%, more than the 0.8% downgrade for global growth (IMF World Economic Outlook, April 2022). Risks to European growth were a key discussion point at meetings. Inflation pressures are serious and potentially persistent, with commodity prices the key driver. It wasn’t explicitly said, but we believe this presents a scenario in which the ECB is unable to tighten policy (sufficiently) due to growth concerns, leaving inflation not fully addressed. An important macro positive is a more flexible fiscal stance, which could improve growth prospects at some point, though not inflation. Still, an even weaker Euro would be our specific asset-price conclusion. Entrenched inflation expectations will be something to watch in the years ahead. And we haven’t yet mentioned embargo risk.
Embargo risk is real and markets are unprepared. How long will European energy consumers fund Russia’s war on Ukraine? All western discussion on the Russia/Ukraine situation is framed in humanitarian terms. And yet here we are, with Russian exports actually up sharply this year versus last and the ruble fully recovered from its sanctions-triggered collapse. We come away from IMF meetings thinking that risks from the overall Russia/Ukraine situation are still very much escalating (NATO weapons supplies, more sanctions, for example), even if the conflict inside Ukraine could be frozen with Russia simply consolidating territorial gains. And market participants almost unanimously thought (or wished) no embargo is coming and seem unprepared. We think an embargo is only a matter of time and could come from the Russian side as well (technically by requiring ruble payment for gas and oil).
China’s risks are multi-layered and hard for markets to discount. To start, Chinese officials maintain a very low profile at meetings, so all information is indirect. Economically, concerns surround zero-Covid policy and its potential spread to Beijing and wherever Omicron takes them. This is creating downside risks to growth. The IMF only downgraded its 2022 growth forecast for China by 0.4%, less than the global growth downgrade. But we’d note that Asian oil importers, Japan and India, saw their growth forecasts downgraded by 0.9% and 0.8%, respectively. Our concern is that CNY could come under pressure for growth reasons, given the jobs-intensity of the export sector in a political year. Inflation is low, so pass-through of currency weakness into inflation shouldn’t be a constraint. And, real interest rates are not that high by global standards, so even lower interest rates aren’t an obvious policy move to us, making currency weakness all the more attractive as a policy tool. Also discussed were political risks to Xi from zero-Covid. And, the risk of capital flight is always under-rated, in our view. The proximate way this is getting thought about is either direct sanctions on China (for human rights or other pretexts) or “secondary” sanctions for helping Russia evade sanctions. Our view is that tensions are still rising sharply with China and that sanctions talk always end with sanctions, and sanctions never end. It is just a matter of time, in our opinion, and maddening for markets to absorb.
US rate expectations might be pausing; the market for policy rates may be priced as hawkish as it will be this year. Who doesn’t know the Fed is hiking? Fed fund futures price 250bp in hikes for the rest of 2022. A US 10-year around 3% or higher was a popular view. We’re almost there already! The only interesting or under-appreciated elements of the discussion surrounded Quantitative Tightening (QT). We saw market participants still grappling with the (in our view very bearish/hawkish) implications of the Fed’s now-faster QT program. This directly affects mortgage rates (they would be selling MBS) and the long end of the rates curve. In our view, this is how the market will cap rates and where the first signs of stability will appear.
Emerging market central bankers were wide awake at the wheel! Although it was not an explicit takeaway, how could it not be? The broad theme of the meetings is that participants were already bearish on inflation and higher rates and haven’t yet digested weaker growth. Well, EMs have many central banks that hiked policy rates significantly and well before the price shock coming from the Ukraine invasion. And we think many EMs will be positively affected by the multiple underpinnings for commodity prices. In fact, some were predicting a new commodities supercycle. We were glad to see participants note that there’s been no increase in energy sector capex commensurate with prices, something we’ve been harping on. Oh, and it’s not going to change. And it’s good because of the “Green agenda”. That’s almost the way the discussions go. But, now that it’s biting and guiding asset prices, there’s a bit more hard-headedness.
There’s a global food and energy crisis with no collective response ready; this has big implications for social unrest, especially in EM, so be selective. The typical consumption basket in major EMs is about 35% food and energy, or closer to 50% for lower-income countries. Countries with independent central banks and strong external accounts (that can stabilize inflation expectations), and thankfully this describes most EM countries, are likely to keep it under control. But, even Peru, Chile, and to some extent Colombia have experienced social unrest related to inflation, although corruption and loss of trust in the system seem to be the deeper drivers there. In a range of countries, economic, political, and social systems will be tested; to us, this means selectivity and nimbleness in investing. These risks will play out country by country, and you just have to look at each one on its own and be prepared to do something about your conclusions with less reference to tracking error than usual.
Commodity prices are rising, supply will only get more constrained and duplicative, and we don’t believe anything will be done. US Treasury showed no indication of taking a supportive stance toward conventional US energy production. What struck us was how much of the reduction in capex is organic, reflecting the ESG movement and shareholders that are more sensitive to energy production, at least at the micro-level. What this means, to us, is that commodity prices should go much, much higher. The supply needle will not move positively (and in fact, the point of an embargo would be to drown Russia in its oil) in most scenarios that we can see, as a result. We believe it will take more before there is significant investment in production from the majors.
There was very strong support for Ukraine; we don’t believe it will default this year. We see very close cooperation between Ukraine and the US, with close monitoring of Ukraine’s budget and external financing needs in particular. What this means to us, in our opinion, is that Ukraine will only default when it wants to default. If it wants to keep paying, the money and support are there. More practically, we don’t see Ukraine choosing to miss its 2022 (September specifically) external bond payments, making those bonds very attractive. Longer-term, though, the rebuilding costs following the invasion are high and we don’t see how there can’t be an eventual bond restructuring…just not this year.
Emerging markets are so diverse that they stand out as an opportunity in a world focused solely on how horrible higher interest rates and higher commodity prices are. They are not horrible for emerging market bonds whose central banks have already hiked interest rates and which benefit from higher commodity prices. The implications of the meetings for specific emerging markets are as varied as the drivers. To review, we see US long-end rates at risk of stabilizing. This means higher duration for low-beta EM bonds makes sense. We see commodity prices and high real interest rates as supporting some EM local-currency bonds. We come away less constructive on currencies in Asia, due to pressure from a weak China. We come away less constructive on currencies in Europe, due to recession and embargo risks in Europe. Within local currency, this leaves us largely with Latin America, and luckily, we largely see high real interest rates and high commodity price support there. There are still a bunch of cheap, re-pricing reformers among smaller countries.
Crypto normalized. In our view, IMF officials are much more precise in their analysis of digital currencies. In particular, there appears to be an advancement in conceptualizing digital currencies in terms of M0 (think of it as cash) and M1 (think of it as a deposit). Maybe this means the eventual model is a banking one. We don’t know for sure, and luckily VanEck has great crypto experience to navigate this. Our only point is that the IMF continues to view crypto through the lens of banking. As a result, there was great openness to stablecoins as permitting deposits.
Everyone thought sanctions that disappeared Russia’s USD, EUR, and JPY reserves were important and nobody knew how to think about them…we might! We wrote about what we think it means in: How One Bond Manager Values Gold and Bitcoin. It’s a big deal. Anyway, our point is that one should not be a deer in the headlights when history accelerates. Think it through and be as precise as possible. That was the spirit of the analysis – that the weakening of USD, EUR, and JPY’s status as reserve currencies has specific and analyzable implications. The conclusions are supportive of gold as well as selected EMFX that is supported by commodities.
International Monetary Fund (IMF) is an international U.S.-based organization of 190 countries focused on international trade, financial stability and economic growth.
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