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Analisi 28.09.2017

Global Market Conditions Are Offsetting Fed’s Balance Sheet Contraction Strategy

Global Market Conditions Are Offsetting Fed’s Balance Sheet Contraction Strategy

From the Desk of a Fund Manager (September): Global Market Conditions Are Offsetting Yellen’s Balance Sheet Contraction Strategy; Asian Economies Remain Prepared.


Fed Chair Janet Yellen delivered on her earlier promise to begin reducing the US central bank’s balance sheet despite concerns that dormant inflation continues to linger in the background. Citing continued growth in nonfarm payroll employment and subsequent declines in the national unemployment rate, Yellen suggested that the underlying strength in the US economy and reducing slack in the labour market would lead towards a pickup in wage growth and consumer prices. The Fed Chair's announcement also reinforced the idea that any interest rate hikes would remain gradual, so ensuring adequate liquidity for the economy.

The opinions outlined by Yellen give support to the investment landscape for emerging markets, especially for Asian equities, at both a quantitative and a qualitative level. As a quantitative approach, the Fed Chair has proposed to call a halt to the reinvestment of assets beginning to mature at an initial rate of about $10bn per month and then slowly build towards a pace of $50bn per month. Hypothetically, at a rate of $50bn per month, which by Fed standards would be too aggressive and ahead of the curve, it would take 70 months (about 6 years) to return the US central balance sheet back to its pre-Global Financial Crisis level.

However, even with this pace and timing, global liquidity would still remain in expansive mode. The European Central bank (ECB) has decelerated its monthly bond-buying programme down to €80bn a month ($50bn), implying that any coordinated central bank tightening has yet to commence as the ECB seems alone in effectively offsetting the Fed. On the fiscal side, the muted response from the US dollar index (DXY) to Yellen’s announcement suggests that dollar movement is more aligned with President Trump's administrative policies such as tax reform rather than US central bank monetary policy. With the DXY losing more than 10% year to date, this is equivalent to an approximate 50 basis point cut to interest rates, paring Yellen’s two 25 basis point cuts this year. This creates a similar impact as the ECB offsets the Fed.

Qualitatively, this supports the view that Yellen is not actually behind the curve, a concern that most held earlier this year. The larger risk surrounds central bank leadership after February 2018 when Yellen’s term as Fed chair concludes. An early reappointment of her in this role would provide a boost to market confidence, lowering the possibility of any policy reversal.

Beyond Yellen’s stated strategy for a likely December hike and three additional ones in 2018, questions also linger around the maturity composition of Fed assets.

Despite a weaker DXY index and a subsequent appreciation of Asian currencies, Asia's trade dynamics have performed relatively well, reflecting tighter supply chain integration and rising demand from China. Were the DXY to rally on Trump policy rollouts, markets would likely question if the weaker Asian currencies give a warning of future negative headwinds. However, the declining USD so far in 2017 did little to benefit the economies of Southeast Asia and India. This is likely to be due to the changing regional debt and composition profile, where more paper is denominated in domestic currencies with longer durations to reduce currency mismatch and rollover risks. This bodes positively for risk appetite as USD influence appears to fade.

There are reasons to hold a positive outlook for Asian economies as regional policies that support growth remain in place. Asian economies continue to maintain orogrammes that strive to support economic reforms, such as addressing credit misallocation in China, chaebol reform in South Korea, or bankruptcy and tax law in India. Despite holding the party majority, Trump’s inability to push through any legislation is unlikely to change, particularly given the high turnover of key cabinet members within his administration. This should provide an attractive backdrop for Asian equities, particularly as foreign exchange reserves and capital adequacy ratios remain at healthy levels and provide sufficient liquidity. This will help to pare back future actions taken by global central banks when they finally commence.

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Christopher Chu
Assistant Fund Manager - Asia

 

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