EUROPEAN CENTRAL BANK
At Thursday’s meeting, the European Central Bank (ECB) decided it would keep interest rates unchanged and carry on with the current Quantitative Easing (QE) programme until the path for inflation is established, adding that the size and duration of the programme may increase if the outlook suddenly deteriorates.
A key factor for adjusting QE is inflation expectations, which have been suppressed by the recent appreciation of the euro (up 14.6% against the US dollar year-to-date). A stronger euro makes goods and services cheaper to import and therefore reduces inflation. This makes it difficult for the ECB to begin tapering bond purchasing (slowing down the rate at which they buy bonds) and reversing QE.
Now, the ECB faces a dilemma. Is it better to cut its QE programme, which will put further pressure on inflation, keeping it below its 2% target for longer, or should it continue QE until inflation maintains its 2% target? For the time being the ECB has concluded that a “very substantial degree of monetary accommodation is still needed”.
Inflation, measured by the Harmonised Index of Consumer Prices (HICP), is currently 1.5%, but the ECB’s economic growth forecast has been revised up to 2.2% for this year. This is its highest level since 2007 and higher than most economists’ expectations.
Source: European Central Bank, September 2017
The strength of the euro is a source of concern for the ECB. Although the euro exchange rate is not a policy target for the ECB, it affects economic growth. The key point of distinction highlighted by Mario Draghi, ECB President, is how much of the euro’s strength is due to improvements in business confidence across Europe and how much it is due to exogenous factors shaping ECB policy decisions which in turn cause the Euro to strengthen. The ECB have forecast the euro to reach $1.13 by the end of the year, a 6.1% drop from current levels.
Draghi has made reference to the fact that the ECB is looking at different scenarios of duration and volume of QE. However, talks are “very preliminary” with “the bulk of decisions to be taken in October”.
Before the European Central Bank’s meeting on Thursday, economists surveyed by Bloomberg pushed back their expectation for a tapering of the bond purchasing programme, also known as QE to start at the end of October. Markets prior to the ECB meeting began pricing in this expectation in the morning – sending bonds yields lower and prices up. German 10-year bund yields are now 0.32% and Italian and Spanish bond yields are 1.97% and 1.55% respectively. The euro strengthened 0.5% against the dollar on the day.
EMERGING MARKET ECONOMIES
Academic studies have shown that there is no direct correlation between economic growth and market performance in the short term. In the medium to long term however, economic trends do matter.
Growth from the world’s second largest economy – China, has surpassed many predictions, with higher factory output and Gross Domestic Product outpacing forecasts. It has defied those who expected the Chinese economy to begin to cool due to rising borrowing costs and measures to implement the withdrawal of liquidity.
It is worth recalling that back in January 2016, global markets went briefly into freefall on worries about China’s faltering growth. China has since stabilised; with a much-improved property market. New home prices rose 9.7% year-on-year in July helping to boost construction and push economic growth higher. Furthermore, China’s State-Owned Enterprises (SOE) have seen large improvements in profits in the past year, with government data in July showing a 42% increase in year-on-year profits for industrial SOE’s – an impressive figure given that last year saw only a 3% increase and a 21% reduction in profits in 2015.
Emerging market (EM) countries are heavily influenced by the state of China’s economy with their recent strength not only helping EM economies but stock markets too.
A component helping to drive improved corporate performance, which feeds positively into business confidence and improved economic activity, is the weak dollar which has fallen 15.4% against a basket of leading global currencies so far this year.
US Dollar vs Basket of Leading Currencies
Source: Bloomberg, September 2017
A weaker dollar means it’s cheaper for Emerging Market (EM) companies to service their debt which is largely dollar denominated (it is easier to find lenders willing to lend in dollars than in pesos). Several emerging market economies also rely heavily on purchasing commodities like iron ore and oil which are generally dollar denominated. A weaker dollar makes these purchases cheaper and thus lowers input costs across the value chain.
With this generally healthier economic backdrop, emerging market equities and bond markets have outperformed developed markets. EM bonds have also provided healthy returns, delivering 8.5% year-to-date in local currency, with investors assured by the supportive economic backdrop and attracted by yields higher than in developed markets.
The MSCI Emerging Markets Index (a composite of 24 countries which represents 10% of world market capitalisation) year-to- date has returned 28.1% in local currency and 21.2% in sterling terms. To put this into context, the FTSE 100 and the S&P 500 have returned 6.2% and 5.7% in sterling respectively.
Before we delve into the factors behind the returns in emerging markets, it may be useful to see which of the 24 countries have been key contributors. A well-known acronym in economics is BRIC. These are four countries (Brazil, Russia, India and China) that are all considered to be at a similar stage of economic development and have their own index. The MSCI BRIC index has returned 25.0% in sterling and 32.2% in local currency so far this year. These four countries account for a significant part of emerging market returns this year – see chart below.
1 Year cumulative market returns
Source: Bloomberg, 2017