Who Will Be The Next Fed Chair? Doesn’t Really Matter, Says Ashmore
Fed policy will take advantage of short bursts of optimism in the market, says Jan Dehn.
Too much attention is being paid to who will be the next chairperson of the U.S. Federal Reserve, said Jan Dehn, head of research at asset manager Ashmore Investment Management. As long as the policy direction is clear, personalities won’t matter much, he told BloombergQuint in an interview.
According to him, the U.S. central bank will opportunistically raise rates, as and when the market prices in such hikes. Compared to the European Central Bank, the Fed has more leeway to raise rates, he added.
Here are edited excerpts from the interview.
What do you make of the ECB’s plan to cut, but extend its bond-buying program at 30 billion a month euro a month till the next September? How are you reading this number?
This was dovish relative to expectations. Particularly, the decision to leave open-ended the negative interest rate policy. So, he was basically quite explosive by saying that they are not going to raise interest rates as long as QE is being scaled back, and he is going to protect a number of supportive factors in the market, particularly the corporate bond purchases.
This was dovish relative to expectations and should keep monetary policy in Europe very easy even as the European economy is doing quite well right now. So, this is quite bullish for European stocks and for the European economy.
How would you peg someone like Janet Yellen as against one or two people who are in contention right now for Fed chairman?
There is a little bit too much of attention being paid to who is going to be the next Federal Reserve chairman. At the end of the day, it does not make a great difference. The policy direction is quite clear. They are going to be scaling back quantitative easing over the next several years. And in that environment, given how heavy positioning is particularly in the U.S. stock market and in the U.S. dollar, they have to go very gently on interest rates. I don’t think that personality matters much. It will have a short-term effect on market sentiment but when the rubber meets the roads their ability to raise rates ahead of what market is expecting is extremely limited.
The Fed policy is going to take advantage of a short burst of optimism in the market where the market proceeds to price in the rate hike and then the Fed will say ‘thank you very much. I will take that rate if it is priced in.’
Because if it is priced in, there is no risk associated with it. It’s important to understand the backdrop here. That we have a few rate hikes on the books. And if we have a recession, historically, in recessions the Fed has cut as much as 5 percent on interest rates and we simply don’t have enough rates on the books yet to be able to cope up with a recession.
So, until the economy has recovered significantly more and has therefore been able to cope with pricing and more rate hikes, whoever is going to be Fed chairperson is not going to be able to hike rates materially ahead of what is expected in the market.
Do you see the diversion between the way the ECB is proceeding and the way the Fed is progressing?
There is one fundamental difference. The Fed is quite happy to opportunistically raise rates when these rate hikes are priced in, whereas the ECB, on that particular point, is quite clear that they have no intention whatsoever of touching rates. Ultimately, this boils down to a difference in the health of the banking system in the U.S. compared to Europe. Europe never recapitalised its banks. There may be a whole bunch of weird things sitting on the balance sheets of European banks as a result of that. Europe has also rather weak and heavily indebted periphery whereas the U.S. doesn’t. So, these two fundamental differences.
The weak European periphery and healthier American banks mean that the Fed has a marginally higher degree of freedom to raise rates which it will do if the market prices in a rate hike. Whereas in Europe, we are not going to get that. Otherwise, the two central banks are quite similar.
The overall priority is going to be to gradually reverse quantitative easing and that is really in a bid to try to allow the biggest bubbles we have in global financial systems today, namely, the U.S. equity bubble and the European fixed income bubble to gradually be deflated while the economy is picking up, so that when it does become necessary to hike rates as inflation goes up, then it is possible to do so without in the U.S. creating an equity market crash and in Europe creating a bond market crash.
So, the whole focus really is, let’s hope that inflation doesn’t show up and lets gradually scale back quantitative easing. Then some point in the future when asset prices in the real economy are more closely in line with each other then it is okay for the inflation to show up because we can raise rates and will have no more business cycle dynamic.
In the entire interplay between a new Fed chairperson, Donald Trump wanting to have a say and the rising probability of an interest hike in the U.S. in December, what does it mean for U.S. bond yields?
U.S. bond yields are going to be moving up. The primary driver of this is actually the economy. We are getting decent earnings and growth numbers. Some of the economic indicators are healthy. There is the prospect in the nearer term of some kind of tax cut which will stimulate the U.S. economy. That bullish expectation for U.S. growth is enabling the stock market to go higher, and then people are selling U.S. Treasury bonds and pushing up yields. As these yields go up, then the next Fed hike gets priced into the market and then the Fed says, ‘we are going to hike’.
It’s important though to take into consideration that this tax cut is not going to be a tax reform, it is going to provide a short-term stimulus, but it will probably have to be financed by increasing amounts of debt. Unfortunately, there is a very close relationship between the amount of debt the government issues relative to the amount of debt in the private economy and productivity growth. Basically, the bigger the fiscal deficit, the more money is taken from the private sector and spent by the government. Because the government spending is so much less efficient than private sector spending, this is a key reason for the decline in productivity. Because of the decline in productivity, the long-term interest rates target, the interest rate that the Fed hopes to achieve over the long term, that actually declines if you increase the amount of government debt which is going to be the outcome of this tax reform.
The bottom line is that these factors that are driving U.S. Treasury yields higher and the dollar higher are likely to be relatively temporary. I don’t think they could be game changers for the U.S. economy. We are not going to wake up tomorrow and find that the U.S. has 4-5 percent productivity growth and so on. This is an important opportunity for investors to take some profits in the Treasury market, to take some profits at these higher levels for the dollar and use this period of relative dollar and dollar strength and Treasury weakness to begin to put some money into other parts of the global economy where there are better value propositions on offer than in the U.S.
Should we see a correction in the U.S., what could it be that could burst this bubble?
There is no doubt that the U.S. equity market is expensive. It is extremely expensive relative to valuations that are on offer in many other parts of the world. This is really a consequence of the fact that the way the global financial markets chose to trade quantitative easing, which is the single largest government intervention ever in financial markets – and it particularly benefitted the U.S. – the way the market traded QE was essentially to buy U.S. stocks and the U.S. dollar. The dollar went up 40 percent against most of the currencies in the world and the U.S. equity markets tripled in value. But all those inflows led to a feel good feeling. But actually, there has been very little reform. U.S. government debt has gone up, the dollar is overvalued and U.S. stock markets are rather expensive. And the real concern here is that as quantitative easing – which has ultimately been the primary driver that has caused so much money to flow into the equity market – as that’s scaled back, people are going to ask themselves, ‘I have made a lot of money in the past five years trading this quantitative easing wave, but what is the outlook for the next five years? Am I going to make as much money as quantitative easing is scaled back, as monetary tightening is taking hold in the U.S.’
That’s an important potential source of risk because I would expect that the equity market would make incrementally smaller and smaller gains as the intervention from central banks is diminished over time. The other factor that worries me is that you are seeing a big divergence between the performance of a smaller number of tech companies, such as Amazon, whose business models are working out well and then the rest of the equity market which is not doing really as well. So we are seeing that it is not so much a broad-based acceleration anymore, it is beginning to look like a single sector is driving everything. That’s not such a healthy development.
For example, once the tax cut has been fully priced in, once we have a rate hike and once we’ve had some profit taking in then the rest of the world after a reasonably good yield in Europe and emerging markets, we should see profit taking now and that means money going into the U.S. But that looks more like a dynamic that plays up for the rest of the year. Once we get into next year and people say what has really changed and what is now being priced in, then I think the U.S. equity market will start looking extremely expensive and there will be strong incentives for the investors to start pulling money into other parts of the world and that could lead to a pullback in the equity market.
Have emerging markets priced in this central bank unwinding or are we likely to see more volatility as we head closer to December?
The unwinding of quantitative easing will be extremely bullish for emerging markets. There was a perception early on, when quantitative easing began, that because this would drive down bond yields in the developed markets, there could be a surge for spread and yield and that could lead to money flowing into EMs. But as we have seen in the period from 2013 through 2015, we had three years of extraordinarily large outflows. The reason why quantitative easing had this, perhaps counter-intuitive effect, is because investors chose not really to look at yield differentials in developed markets and EMs, which is what the original thought was, but rather people looked at the capital gains. Capital gains in the QE-sponsored markets were absolutely enormous. U.S. equities tripled in value, the dollar was up 40 percent and in German 30-year bond people made more than 17 percent returns. In light of this enormous capital gains, investors were saying, ‘Why should I have my money in 7 percent government bond yields in India or in 9 percent government bond yields in Ecuador?’ It was not really about yields, it was about capital gains.
The interesting thing is, now that we are beginning to see the scaling back of quantitative easing in the developed market, both in bonds and equities, people will then ask themselves, ‘Am I going to make capital gains anymore?’ And the answer is no. You are not going to make nearly as much capital gains as before. And meanwhile valuations are so high that you are not going to get any carry either. There are only two ways of making money – capital gain or yield. If you don’t get any yield or any capital gains, then the question is where are you going to get any returns at all. Meanwhile, there is so much money that left emerging markets, that pushed up bond yields and led to capital losses. We are now in a position that we can offer both capital gains and high yield within emerging market.
The unwinding of quantitative easing is going to be positive for emerging markets. We will see more flows coming back into the non-QE sponsored world because it has a much more attractive value proposition.
Where does India stand in terms of attractiveness versus emerging market peers?
India is in a complex situation because the market is quite expensive. We are looking at a 12-month forward price-earnings ratio in Indian equities of about 18. The earnings per share priced in for the fiscal year 2019 is 22-23 percent. It is almost as expensive as the U.S. equity market. It is expensive compared to the MSCI EM in general and frontier markets in the EM. So, India looks expensive. In addition, there are some near term issues, particularly the prospect of more expansionary fiscal policy. The government has announced significant amounts of infrastructure investment. We had the very important announcement of the public sector banks’ recapitalisation. In addition to that we have some near-term implementation problems with GST.
The market is likely to look at these short-term events and say, ‘If we going to have a lot more supply of government bonds, then yields may go a little bit higher in the bond market and given where valuations are, that’s a negative in the short term.’ However, I would argue that you should look through these short-term effects. Clearly, more infrastructure spending in India is an excellent idea. India does need more infrastructure investment.
The whole idea of recapitalising public sector banks is an extremely good piece of news. One of the reasons that economy has not reacted even more strongly to the reforms that have been done in India is because a large part of the banking system is sitting on non-performing loans and it is a big drag on the economy.
And finally with GST, there are teething problems, but government is clearly showing that it is responding to these teething problems and I think these effects will fade. We have this situation where there is an improving and strengthening medium-term outlook for India against the backdrop of very expensive stocks. So how do you handle that combination? I would suggest that you go back to basics and you go to value.
I like industrials, infrastructure. I would take a closer look at the PSU banks, particularly as we start seeing how much the government will start influencing the management of these banks. I will keep away from stocks which are very expensive now like financials and consumer stocks.
We think that the Indian outlook is getting better, but we have a little hurdle to get over. The best way to do is look at the transport, construction, industrials. That’s where the real value lies and that’s where you have the biggest gains. If I am right, then over the next year, we will begin to see the benefits coming through from the longer-term reforms that the government is doing.
Do you think that foreign investors are in wait-and-watch mode before they move in and put in the money? And in that case, can we not rule out a correction because of it?
We can’t rule off the correction. I would be surprised if we don’t see one. In fact we are already seeing one as far as emerging markets are concerned. We have had 18 months of strong performance. EM equities are up 40 percent in dollar terms in the last 18 months. Local currency bonds in EMs are up 20 percent in dollar terms in the last 18 months. Against such a strong performance, you are seeing a pullback now. Investors are taking profits. We are going into the fourth quarter. People often don’t want to take on risk in the final quarter of the year. But in terms of the pullback from the international investors in India, that’s an India-specific event. It’s because investors have historically been conditioned to look at fiscal spending as the big danger signal in India. Under the Congress administration, the fiscal policy got out of control both at the central government level and the quasi fiscal deficits through public sector banks. That has been improved.
I don’t think it is right for people to be worried about the fiscal picture in India because we know what the fiscal spending is going on. It is going into infrastructure and bank recapitalisation and both are very good for India in the long term. Because India is expensive, and investors have this habitual way of looking at fiscal spending, they are pulling a bit of money out of India.
In the rest of EMs, third quarter saw very strong inflows. There are very good reasons to expect significant increases in foreign flows into emerging markets including India, particularly as we go into next year. There is curious lag behavior between when the market begins to turn decisively and when big institutional investors respond. If you take U.S. pension funds, they will be advised by consultants. Once there has been a big turning point in the markets, which as far as EMs are concerned, was at the end of the first quarter of 2016, it will take about a year for consultants to gain sufficient conviction to think there is a turning point in the market. They will then advise pension funds to allocate. The pension funds then have to go through a sequence of steps including board approval, searching for managers and writing contract before they can allocate. This delay is typically in the region of 18 months between when the market turns and when the institutional flows come in. That’s exactly what we saw.
In the third quarter OF 2017, we saw very material institutional inflows into EMs. So far, only one third of the money that left has come back but nevertheless the flows have begun. I think those flows will take a pause in the fourth quarter for the reasons that we are familiar with. We like to take profits in the fourth quarter and so on. But as we get into next year, we are going to do so with very solid double-digit returns in local currency bonds and local currency equities in emerging markets. Investors are, generally speaking, extremely light and the outlook in those markets are materially better than the outlook in developed markets in the next few years with quantitative easing being scaled back.
Do you think reforms will take a backseat for this current government as they move towards elections in 219?
Yes. I was surprised at the announcement of recapitalisation of public sector banks. I had not expected it ahead of an election season. But it is a very good piece of news. This will be the last major reform that we will see before the election season. I was very positively surprised. It has two important implications. First, if you can sort out the banking sector mess, that is, recapitalise public sector banks, then you will see a much brighter outlook for credit growth, particularly for households and corporates. Given the reforms that have already taken place in India, we should see a significant response from the banking sector and a growth in spending both at corporate and household level in response to stronger banks. That’s not entirely unhelpful as we go into an election. We start seeing some of the benefits of the reforms.
The second aspect is that the insolvency of a number of public sector banks has been one of the primary arguments for not opening up the bond market in India to foreign investors. When you have very weak banks which have to be market makers and then you have foreign investors coming in, then that becomes a very vulnerable part of the banking system. With stronger banks one of the last arguments for still maintaining quotas and capital controls for foreign investments in the bond market in India really goes away. Then we are just down to a lobby group that doesn’t want competition from foreign investors.
That’s why we like the PSU bank recapitalisation. It opens the possibility that it happens. Other than that, I don’t expect any major reforms from India before the elections. Let’s be fair that Modi has done a lot more than any other governments have done in such a short period. So, building blocks are in place for a sustained strong growth performance in India over many years to come.
What have you done with your Indian portfolio holdings? Have you found opportunities to add to the Indian portfolio or have you reduced your exposure?
We have changed our allocation. We have now gone for the deep value stuff in the industrial sector, transportation, construction, beaten-up pharma, some midcap IT companies where we see deep value now. We have scaled back our exposure to the cyclicals, large-cap IT, consumer stocks and financials. For the cyclically dynamic sectors, we have reduced our exposure and gone to the deep value on the industrial side of the stock market. That reflects that we have this problem with very high valuations and a little bit of headwinds as these good policy initiatives like infrastructure, bank recapitalisation and GST get implemented. While you have that transition period until the fruits of reforms begin to manifest themselves, it’s a good time to take some profits in some of the cyclically sensitive shares and then go into the deep value stuff in the real economy which ultimately offers the best value as we start realising the medium term bullish prospects in the Indian economy.
Is the Indian monetary cycle is reaching its end or are we a long time away from that?
I think we are drawing to a close here. RBI is focused on this dilemma of a big fiscal policy stimulus and how it might impact interest rate hikes and how it might impact the currency and foreign investor sentiment vis-à-vis the likely long-term benefits. The RBI will have to be much more mindful of the short-term effects. We have seen inflation creep up a little bit and current account deficit widen a little bit because of high oil prices. There are some signs that the RBI is absorbing and it’s therefore holding back on cutting rates and that’s the right policy. We always want the RBI to err on the side of caution. There is enough opportunity in the Indian economy that we don’t have to fuel markets purely with rate cuts, especially if there are risks.