Global Outlook April

Tactical Asset Allocation (TAA)

The Multi-Asset team’s view on bonds, equities, commercial property and other assets affects asset allocation over the coming months. When making these asset-allocation decisions, we first consider the outlook for each asset class (e.g. government bonds), followed by views within that market (e.g. the US versus Europe, or European core economies against peripheral countries).

TAA Model Portfolio - as at April 2019

TAA Model Allocation - As at 18 February 2019

Foreword

Author

Gerry Fowler, Multi-Asset Strategist, Multi-Asset Investing

In recent months, we have seen a sharp reversal in central-banking rhetoric. There has also been an escalation in stimulus measures around the world, both monetary and fiscal. Risk assets, such as equities, have benefited from these changes, with strong returns everywhere so far this year. Against this changing backdrop there is much to consider. In this edition of Global Outlook, five of our investment professionals delve into topics ranging from the outlook for global growth after the Fed pause, to whether the upcoming Indian elections will affect bond investors.

First up, Jeremy Lawson, Chief Economist and Head of the Aberdeen Standard Investments Research Institute, updates our economic outlook for 2019 and beyond. We expect the dramatic reversal of central-banking rhetoric and policies will combine, with the effects of escalating stimulus measures in China. This should enable global growth to pick up moderately through the rest of the year, after bottoming out in the summer. We now predict another mini-economic cycle will emerge and that the end of the current cycle will be postponed.

In Chapter one, we delve into the implications of the upcoming elections in India. Ken Akintewe, Head of Asian Sovereign Debt, explains how the Indian bond market has reacted to Prime Minster Modi’s reform agenda. With recent changes to the leadership of the Reserve Bank of India leading to a rate cut, as well as some fiscal expansion and geo-political drama, there is much to consider. Ken concludes that Indian bonds are still an appealing investment and that shorter-dated maturities and credit have particular appeal.

Foreign investors have supported strong returns across emerging markets so far this year. Johnny Liu discusses his research on flow data. He surmises that the weakness in flows to emerging markets in the last year was more significant than fundamental data warranted. Meanwhile, the return of emerging-market flows could be a leading indicator of a weakening US dollar.

While much of the outlook has improved, we continue to monitor the state of the levered loan markets. Jennifer Mernagh, Investment Strategist, revisits her analysis with further details on the holders of various parts of the loans market. She discusses increasing regulatory scrutiny in Japan and provides a summary of the market’s response to risks during a period of volatility in financial conditions.

Finally, Ken Dickson, Investment Director, FX Research, puts the latest central-banking policies in perspective regarding the outlook for currencies. Many tailwinds for US dollar outperformance have receded, but so too, have the economic environments in other markets. As a result, it is difficult to see significant changes in rate differentials globally. Rate differentials are typically a key driver of currency returns. We see constrained profit opportunities from currency investment at the moment.

 

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Editor

Gerry Fowler

Chart Editor

Tzoulianna Leventi

 

Implications of domestic
politics on the outlook for
the Indian bond market

Chapter 1

Author

Kenneth Akintewe, Head of Asian Sovereign Debt

Prime Minster Modi and his reform policies have impacted the Indian economy significantly. Elections are approaching, and so we assess opportunities and risks in Indian bonds.

India’s upcoming election has important implications domestically and for bond investors.

Since the election of Prime Minister Modi, politics and policy have become central to the investment analysis of Indian assets. A year ago, Modi’s party (the BJP) was seen as very likely to win the upcoming elections. Now, however, we put those chances at perhaps 60%. This fall in support led the BJP to deliver a variety of monetary and fiscal policies aimed at attracting voters.

Indian bonds are appealing for investors because they remain a relatively idiosyncratic trade with low correlation to other global bond markets

We view the current environment for Indian bonds as benign, with yields around fair value. However, we see credit as attractive. Indian bonds are appealing for investors because they remain a relatively idiosyncratic trade with low correlation to other global bond markets.

We are keenly focused on the upcoming election and expect that volatility could provide good buying opportunities.

Chart 1: Indian local-currency bond yields are high in nominal and real terms

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Source: Bloomberg, Aberdeen Standard Investments, (as of December 2018)

Getting up to speed on high-growth India

Despite global growth slowdowns in 2013, 2015 and 2018, Indian local-currency bonds have returned 24% cumulatively over the last six years. This is a return more comparable to dollar-denominated asset classes like emerging sovereign bonds (28%) than to other emerging local-currency bonds (-10%) where currency weakness has been significant.

This performance highlights some of the key attributes of Indian bonds we find appealing. While other major emerging markets were hit badly by the 2014 collapse in oil prices, India benefited from a reduced current account deficit. Early reforms by the BJP had also opened up the economy and improved foreign direct-investment growth. Additionally, the ‘demonetisation’ process in 2016 led to additional liquidity in the banking system that found its way into debt securities. During this time, the real effective exchange rate for the rupee appreciated 20% due to enthusiasm for Modi’s reforms.

2018 proved a more difficult investing environment globally and in this case, India was not immune. Local banks were being encouraged to increase lending to private companies and individuals, inflationary pressures rose (in part driven by temporary factors like civil servant wage hikes) and oil prices bounced back toward $80 per barrel. From mid-2017 through most of 2018 the Rupee weakened – a total of 30% against the US dollar. Currency weakness fed into even higher inflation and the market began to price policy rate hikes - bond investors suffered.

What has changed?

In the third quarter of 2018, geopolitical tensions around oil eased and waivers were granted on purchases from Iran. Oil prices fell nearly 50% in rupee terms. This represented a positive balance of payments shock for India that was nearly as sharp as those in 2008 and 2014.

The depreciation of the rupee brought it back to near fair value and policymakers began to roll out intervention measures to stabilise it. Along with trade and capital-market-opening measures aimed at attracting inflows, we saw some heavy direct intervention, and foreign exchange reserves dropped by $30m. India’s reserves remain a very healthy $400m, with very strong metrics in terms of short-term debt and import coverage. Household debt is less than 15% of income and total external debt is around 20% of GDP – very low by emerging-market standards. Indonesia has external debt of 33% of GDP and Malaysia 62%.

Domestic politics drove significant gains in the Indian rupee and Indian bonds since Modi came to power. In 2018, international conditions caused a reset in expectations for India. We expect the outlook from here will again depend on domestic politics.

Impact of India’s colourful politics

Our view is that the BJP party has a 60% chance of retaining power. This reflects a 20% probability of an outright majority win for the BJP and a 40% probability of a win via its NDA alliance, though with a loss of its majority. The two other scenarios have roughly a 20% probability each. These include a win for a coalition led by the opposition Congress party (the scenario that produces the most uncertainty), or a win by a coalition of regional parties - the so-called third front.

Election risks for the BJP have increased over the last year. This has been driven by a combination of factors. The demonetisation policy in 2016 and implementation of a goods and services tax in 2017 caused major disruptions to households and businesses. Lower food-price inflation has affected rural wages. This was most evident in three state elections in December 2018, where the BJP suffered significant losses. An additional factor is that opposition parties have started to form a more united opposition. Despite this, there remains a lack of consistency in opposition policies, which is creating elevated policy uncertainty as the election draws closer.

There have been numerous consequences as support for the BJP has waned. The BJP has become increasingly unhappy with the central bank’s hawkish stance in an environment where they would want to provide greater support to households and businesses. They complain of mission creep toward a focus on core inflation even though the mandate is for headline-inflation targeting. As a result, even as headline inflation declined in 2017 and 2018, the policy rate was increased and the real policy rate (vs headline CPI) widened to 450 basis points (bps) – a multi-year high. Additionally, the Reserve Bank of India (RBI) has been introducing measures to deal with nonperforming loans. Some banks have been put under prompt corrective action (PCA). The government has felt that the policies of the central bank were offsetting the effects of their reform policies.

Chart 2: Inflation has structurally declined

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Source: CEIC, Aberdeen Standard Investments, (as of December 2018)

Frustrated, the government threatened to invoke Section 7 of the RBI Act in 2018. This authorises them (under certain conditions) to issue directions to the central bank. This has never been used before and ultimately wasn’t invoked. But the pressure led to Governor Urjit Patel resigning and being replaced by Shaktikanta Das, a former bureaucrat who is seen as being closer to the government. Since then, the RBI has already delivered one rate cut and changed its stance from calibrated tightening to neutral. A further rate cut is expected in the next few months – perhaps before the election.

Chart 3: Higher oil prices offset by lower F&B inflation

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Source: Bloomberg, Aberdeen Standard Investments, (as of December 2018)

Importantly, the government has now released its interim budget for the fiscal year to March 2020. Fiscal expansion is proposed with the aim of alleviating rural farm distress. The deficit is now expected to be 3.4% of GDP in 2019 and 2020 (versus the 3.3% and 3.1% initially targeted). This stimulus includes direct-cash transfers to smaller farmers that will cost INR750bn (0.36% of GDP) in the next fiscal year. There is now tax relief for incomes up to INR500,000 (an increase from INR250,000) by providing a full tax rebate. This was an ‘election-year’ budget. The government has, however, committed to its Fiscal Responsibility and Budgetary Management (FRBM) framework, which mandates the government reduce the fiscal deficit by at least 0.1% of GDP every year till the deficit reaches 3% of GDP by FY21.

Election uncertainty may also have played a part in the recent escalation in tensions between India and Pakistan. While there is still some uncertainty around what actually happened, we do know that an attack by a Pakistani group in Indian-administered Kashmir reportedly killed 40 Indian paramilitary personnel, which resulted in India launching airstrikes across Pakistani airspace for the first time since 1971. An air skirmish resulted in an Indian pilot being shot down and captured. The tensions have de-escalated surprisingly quickly, at least for now, with Pakistan returning the pilot and India attempting to turn it into a victory. Arguably, if there wasn’t an upcoming election, India would not have taken the risk of military action, but now would not be the time for PM Modi to appear weak. This highlights the potential risk of rash actions and further escalation in the short term.

As no subsequent polling data is available, we don’t yet know to what extent, if any, the populist budget may have changed voter sentiment and, similarly, what impact, if any, Modi’s response in dealing with Pakistan may have had.

Macroeconomic & market outlook

In our view, the outlook for Indian bonds is good. Headline inflation has steadily fallen from the most recent peak of 5.2% to 2.1% in January 2019. Food inflation is stable and some of the temporary drivers of earlier inflation, such as the effect of civil-servant wage hikes and increases in housing allowances, have faded. Non-food bank credit growth has improved too. The current pressure on Indian banks to clean up their balance sheets will help create a more sustainable growth environment in the future.

Oil prices have drifted higher to $66 since the end of 2018 and constrained the performance of longer-term yields. Shorter maturity yields have been supported by declining inflation and the pricing in of rate cuts. The two-year to 10-year curve has steepened by about 40bps since January and 60bps since September 2018.

Even if base effects on food prices faded and CPI rose back to 4%, the next 25bp rate cut would still leave the real policy rate at 200bp – consistent with (or wider) than a large number of comparable emerging economies, and very appealing compared to developed economies.

We view government-bond valuations as fair at this stage, with expectations appropriately priced. We prefer shorter duration, but increasing credit risk given that credit spreads have widened to over 100bps.

The Indian economy is usually domestically driven and is not overly reliant on exports, which remain weak globally. India will benefit from the growth slowdown limiting how far commodity prices rise, in contrast to most emerging economies.

In summary, investors liked Prime Minister Modi’s reform agenda and the performance of Indian bonds and currency reflected up to 2018. Last year saw significant weakness in the Indian currency as some reforms negatively affected growth at a time when rising oil prices weakened the balance of payments. In addition, investors began to worry more about whether the BJP would win in the upcoming elections. We think it is still likely that the BJP retains power. In that scenario, the currency is no longer overvalued and real yields remain appealing. We think Indian bonds provide good diversification for global investors and even though we see the long term sovereign yield as fairly valued, we believe there is good value in shorter maturities and credit.

 
Indian bonds are appealing for investors because they remain a relatively idiosyncratic trade with low correlation to other global bond markets
 

Spring is coming

Chapter 2

Authors

Jeremy Lawson, Chief Economist and Head of Aberdeen Standard Investments Research Institute

Global economic growth remains subdued. Our suite of short-term activity indicators has deteriorated since our last outlook, and global business sentiment indicators have yet to find a low point. In response, central banks in developed-market economies have put policy tightening on hold, while policymakers in China are adding to stimulus efforts. Some of the political risks that plagued markets in 2018 have become less acute in the short term. The upshot is that we expect global growth to bottom-out by the summer and then pick up moderately through the rest of the year and into 2020.

Economic momentum remains weak

Although we have been forecasting a slowdown in industrial-led growth since last summer, the pace and magnitude of deterioration has been sharper than we originally expected, and global growth has yet to find a low point. In the first few months of 2019, our Nowcast, China Activity and Momentum indicators have all deteriorated further, while the global composite Purchasing Managers’ Index (PMI) declined to a 27-month low.

Growth has decelerated sharply in most of the advanced economies, particularly the Eurozone

At the component level, the slowdown in activity has been most pronounced in the industrial and trade sector. Indeed, global trade volumes are currently growing at their slowest rate since the financial crisis in six-month annualised terms. The growth contribution from investment has also weakened in most major economies, with forward-looking surveys pointing to further moderation over the coming months. For example, the IFO global-investment-intentions survey remains in negative territory, while our summary indicator of corporate credit conditions, aggregated from central-bank credit surveys, has declined markedly in the US, Eurozone, Japan and UK.

In most economies, domestic consumption was a consistent driver of growth in 2017 and 2018. However, more recent partial indicators of consumer health, such as retail sales, have softened in recent months. Consumer confidence has been mixed, but there are signs that the recovery in asset prices through the first few months of the year is boosting sentiment in some economies.

At a regional level, the growth in US activity has moderated from its peaks. But it remains above trend thanks to the fiscal stimulus still working its way through the system. In contrast, growth has decelerated sharply in most of the other advanced economies, particularly the Eurozone. The Eurozone slowdown is closely related to the moderation in Chinese and emerging-markets growth during last year, which has also continued into 2019.

Margins feeling the strain

The nominal side of the global economy is on a softening trend. The immediate global inflation outlook is being driven in large part by commodity prices. In this respect, 2019 is likely to be characterised by negative oil base effects, reflecting the much lower level of oil prices relative to most of last year. This will mechanically drag headline inflation lower almost everywhere, before the effect fades towards the end of 2019.

Further out, our forecasts for inflation are largely driven by underlying core inflation dynamics. Despite the deceleration in many activity indicators, labour markets have remained resilient. Unemployment has continued trending lower in the main economies, employment is rising and, crucially, there are signs of stronger wage growth in most developed economies.

Rising labour costs should put upward pressure on core inflation for an unchanged level of profit margin. However, the sideways trend in Eurozone core inflation, and the drop in UK core inflation since late-2017, implies a lack of pricing power among firms. Margins are therefore under pressure. Our calculations suggest that profit growth is now negative in both the Eurozone and the UK. In the US, profit growth remains positive but it is slowing. Our caution about the outlook for profit margins underpins our consensus noted below and central bank projections in most economies.

Chart 1: Global growth forecast to trough by mid-2019

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Source: Research Institute, Aberdeen Standard Investments, (as of March 2019)

Even populists are sensitive to markets

Crystallising political risks played a prominent role in last year’s growth slowdown. US-China trade tensions escalated significantly and weighed on manufacturing trade and investment growth across many economies and a populist Italian government heightened concerns about fiscal sustainability and the future of the Eurozone, which caused borrowing spreads to widen and the Italian economy to fall into recession. Additionally, the future for Brexit has yet to be resolved, pushing UK growth below trend.

However, at least in the case of the US-China and Italy-EU standoffs, the substantial rise in market stress during the fourth quarter (that resulted, in part, from the crystallisation of these risks) is precisely what has encouraged politicians to take a more constructive stance, at least in the near term.

For the US and China, this has meant an indefinite deferral of the proposed tariff increase from 10% to 25%. This increase would apply to $200bn of Chinese imports, and was originally supposed to go into effect on 1 January (later 1 March). Positive signalling from both Chinese and US negotiators has built optimism in markets, indicating that the trade war will not escalate further and that a reduction in tariffs may even be possible.

That said, our risk framework continues to point to challenges in the US-China relationship that leave us sceptical about the long-term stability in that relationship, even if a near-term trade deal is agreed upon. The US’s goals – reducing the bilateral trade deficit, preventing intellectual property theft and cyberattacks and creating a more level playing field for US firms exporting to or wanting to operate in China – will be difficult to achieve. That said, China is finally taking steps to liberalise its low levels of foreign direct investment, while also cracking down on forced technology transfers.

In Italy, the severe widening of bond spreads was the catalyst for the government scaling back its fiscal ambitions and the EU responding by taking a more conciliatory stance. In addition, as the League’s popularity has risen relative to that of the Five Star Movement, the prospect of the current coalition collapsing and a new centre-right and more business-friendly coalition government emerging from new elections has increased. From a longer-term perspective, Italy remains in a very vulnerable position and a key source of systemic risk in Europe. But the risk of a more severe crisis this year has therefore lessened.

Elsewhere in Europe, politics are also in flux. In Germany, lines of allegiance have been redrawn, both within and across parties. French politics are being dominated by the fallout from the ‘gilets jaunes,’ or ‘yellow-vest’ protests. Spain is headed for the polls yet again. Meanwhile, European parliamentary elections in May look set to bolster the representation of populist parties, though they are unlikely to be able to deliver a coherent alternative agenda. The upshot of all these developments is that meaningful Eurozone reform is highly unlikely before the next major downturn.

Meanwhile, Brexit continues to dominate the political and policy environment in the UK. The fractious nature of the negotiations have exposed deep divisions in both parties on the issue of Brexit. Much to the frustration of European leaders, the debate on the way forward has largely reflected internal debate in the UK. Against this backdrop, we expect further dislocation in the UK political party landscape as Brexit progresses and the challenging realities of negotiating the UK’s exit emerge. May’s approach to negotiations has reflected an effort to balance the intense interests on both sides of her party; some disappointment for MPs on either side of the debate is inevitable. The departure of 12 MPs from both major parties to the Independent Group may be just the first shot across the bow. An additional source of uncertainty amidst the Brexit noise is the implications of the next UK general election. Specifically, investors are fearful of the more leftist policies promoted by Labour party leadership. However, even in the case of a Labour party government with existing leadership, the realities of the governing would likely challenge any truly unorthodox policy change.

Central banks reverse course

Central banks have also proved highly responsive to last year’s tightening in financial conditions, reducing the chances of a policy error that ends the current expansion.

The People’s Bank of China (PBOC) has added further to the easing measures put in place during 2018, cutting Reserve Requirement Ratios (RRRs) again and putting in place a new central-bank swap facility aimed at bolstering banks’ capital adequacy. Together with the monetary and fiscal easing measures already in place, the additional 200 bps of RRR cuts we expect by the summer, and the potential for the trade truce with the US to persist, we are more confident that Chinese financial conditions and the credit impulse are reaching a turning point.

Chart 2: Credit impulse stabilising - growth to follow?

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Source: Haver, Bloomberg, Aberdeen Standard Investments, (as of March 2019)

Even more importantly, the Fed has made an abrupt policy U-turn since the start of the year. Chairman Powell is now signalling that the next move in policy rates is as likely to be down as up. The balance sheet is expected to stop shrinking by the end of the year, amid signs that policy rates may already be at neutral, and with the ongoing absence of inflation pressures.

Indeed, the Fed’s policy climb-down has had a cascading effect through the rest of the developed world, with forward interest rate expectations dropping in all the major economies. For emerging markets, 2019 is now likely to be a year of outright policy easing in most economies – including Brazil, India and Russia.

Another mini-cycle, but not the end of the cycle

The sharper-than-anticipated slowdown in global activity has led us to mark down our forecasts for 2019 growth in most economies. This would leave the global aggregate at 3.2%, the weakest outturn since the financial crisis. However, we have simultaneously revised up our forecasts for 2020 growth by 0.3 percentage points to 3.5%, with the largest upgrades occurring outside of the US, and especially in emerging markets.

As expected, this is predominantly because the risk of monetary policy errors in the US and China has receded as policy stabilisers come into force and as central banks have demonstrated their acute sensitivity to any deterioration in the economic cycle and market conditions. This dovish reaction should bode well in the case of further disappointments. Additionally, some of the political risks that plagued markets in 2018 appear to have become less acute – at least in the short term.

With systemic, global macroeconomic and financial imbalances either not acute at present or unlikely to unwind over our forecast horizon, the moderate easing in monetary and financial conditions should transmit to the real economy – most powerfully, outside the US. Indeed, we expect the trajectory and composition of growth over our forecast horizon to more or less reverse the pattern of US-led growth divergence and industrial-led weakness that dominated 2018.

However, the amplitude of any upswing within the current expansion is likely to be more muted compared with previous mini-cycles. Financial conditions are unlikely to loosen to the same extent as in 2016, as the Chinese authorities seek to keep a leash on shadow banking and the Fed maintains a positive real policy rate. The responsiveness of economies to loosening financial conditions is unlikely to be as strong as in past rebounds, given higher aggregate leverage and less spare capacity. And although near-term political uncertainty has reduced, the risks have not disappeared. This implies a high option value to firms for delaying capital spending plans.

Chart 3: Financial conditions have already begun to loosen

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Source: Research Institute, Aberdeen Standard Investments, (as of March 2019)

While we do not expect 2019 or 2020 to be years of global recession, the fact that data trends have not yet stabilised means we are watching closely for signs that easing financial conditions and political risks are not having the intended or expected effect. The outlook for China is especially important to our forecasts. If sequential Chinese growth does not pick up, the export-driven acceleration we are expecting elsewhere will not take place – particularly in the Eurozone and emerging Asia.

Other indicators to monitor include employment growth, for signs that firms are responding to the pressure on margins by reducing their labour costs, and lending surveys, for signs that banks are reacting to the weaker economic environment by making credit less available. We still think that spring is coming for the global economy, but the risk of a more permanent freeze has not receded entirely.

 
Growth has decelerated sharply in most of the advanced economies, particularly the Eurozone
 

EM flows: surf's Up
 

Chapter 3

Author

Johnny Liu, Global TAA Analyst

Fund flows reveal much about investor sentiment. They also can also provide an early warning signal when flows become persistent or stretched. We assess the signs for emerging markets.

Venturing into the AUM Ocean

Whether it is portfolio balance data, ETF share counts or mutual fund assets, fund flow data can provide valuable information about investors’ positioning and sentiment across asset classes, regions and even sectors. A data surprise to an overcrowded market means pullbacks can be volatile and creates risks as well as opportunities. No one wants to be last to a good party just when everyone else decides to leave. Meanwhile, under-owned markets can be particularly good to buy as long as the fundamental outlook is sound or improving. Fund and ETF investing has continued to grow, with global assets under management expected to double in size to around $150 trillion by 2025. When this money moves en masse, it can matter a great deal.

Under-owned markets can be particularly good to buy as long as the fundamental outlook is sound or improving

Understanding investor sentiment

Our Tactical Asset Allocation (TAA) investment horizon is up to 12 months. Our process begins with scoring the drivers of asset-price returns in four categories: monetary, valuation, macro profits and behavioural. Within the behavioural category, portfolio flows and positioning are a long-standing and readily available source of data to consider. Behavioural indicators can support a momentum or a contrarian mind-set. Sometimes it is advantageous to follow the herd hoping for the trend to continue. At other times it can be a warning of a volatile reversal.

Chicken or egg? Do flows drive returns or do returns attract flows? There is evidence suggesting that aggregated security returns are highly correlated with unexpected fund flows – an unexpected inflow of 1% into equity funds corresponded to a 5.7% increase in the index. However, this question has been analysed for different types of fund flows and for different investment horizons, too. Several studies have led to the “feedback-trader” hypothesis, which suggests flows do not lead returns. Therefore, the lagging nature of flows data means most investors prefer to consider using them as a contrarian signal.

Reading the Tide

The Institute of International Finance (IIF) provides a dataset on emerging-market (EM) non-resident portfolio flows that we follow closely to assess investor sentiment. There are two aspects that we consider when analysing this data.

Firstly, the IIF records fund flows in a country only when there is a foreign investor acting as one of the counterparts – for example, a US resident buying Brazilian shares from a Brazilian resident. However, the transaction will not be recorded if the US resident buys those shares from a European-based investor. Essentially this is a measurement of cross-border flows, which can have an impact on currency markets as well.


1 Warther (“Aggregate Mutual Fund Flows and Security Returns” - 1995)

Secondly, through the years, the IIF has broadened the universe of funds covered and increased the assets under management tracked. Therefore, we must be careful, as sometimes apparently large flows may still be irrelevant as a share of AUM.

Flows data is volatile, so we construct z-scores to normalise them over long time horizons and regions. We pay attention to the persistence of flows, measured in weeks and months. Significant persistence can signal risks of a volatile reversal. Interestingly, the signal from this analysis can vary across asset classes. For example, debt flows tend to be persistent for longer than equity flows. This may be due in part to their inherent ‘carry’, but, more recently, inflows to bond funds have been supported by quantitative easing and ‘lower-for-longer’ yields. Our dataset indicates that debt outflows from emerging markets have occurred only 17% of the time, which highlights the asymmetric nature of the dataset.

Investor segmentation varies across countries. Sometimes a single category of investor can have an outsized impact on flows. In Japan, for example, the Government Pension Investment Fund (GPIF) manages nearly US$1.5 trillion and made significant target allocation changes in 2014. The fund decided to lower its domestic bond allocation from 60% to 35%, while significantly increasing its exposure to domestic and foreign equities. Combined with ‘Abenomics’ policies, these flows were a major driver of USD/JPY and Japanese equities during the period. The GPIF will release its next annual plan in April and we expect this to be watched closely for signs of a more domestic bias.

The behaviour of foreign flows in emerging economies is another example that stands out because the proportion of foreign ownership of emerging assets is often quite high, but can be volatile. Additionally, this fund-flow data can be instructive because international investors often prefer exposure to emerging markets through funds rather than individual stocks and bonds due to market access restrictions, liquidity and trading costs.

Ebbs and flows

Statistical analysis of emerging-market data finds that flows drive differing results between equity and debt performance and currency changes. Firstly, the correlation of emerging market equity flows to equity market performance is quite high, and has been increasing over the years. Meanwhile, emerging market debt flows have a significantly weaker relationship with the performance of the debt markets. Correlation does not imply causation. We find that although emerging-market flows correlate with asset performance, the relationship changes across time and is only an input to broader analysis.

The correlation of emerging-market flows to US dollar currency movements is strong. Net inflows to emerging markets are normally associated with a weakening US dollar, although the reverse is not always true. This suggests that forecasting EM non-residential portfolio flows will be useful in forecasting the future path of the US dollar. Strong and persistent EM flows are headwinds to greenback appreciation.

Chart 1: Flow with the dollar

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Source: Institute of International Finance, Aberdeen Standard Investments, (as of March 2019)

The Rub

Our data shows the change in emerging, market flows was significant in 2018 – from a run rate of $200bn annual inflows to $200bn annual outflows. Based on a broader fundamental analysis, we think the swing was more significant than warranted, and presented an opportunity to buy cheap assets against the prevailing consensus and fund positioning. Since the beginning of the year, inflows have returned to emerging, market assets, supporting strong returns. The tide is coming in. We continue to watch these flows for the right time to exit, but use flows as only a small part of our broader fundamental analysis of opportunities.

 
Under-owned markets can be particularly good to buy as long as the fundamental outlook is sound or improving
 

Revisiting the loan
market as risks evolve

Chapter 4

Author

Jennifer Mernagh, Investment Strategist, Global Strategy

The change in the US Federal Reserve's rate hiking schedule has lifted pressure from the loans market. However, the regulatory environment is recalibrating.

In January, we published an article on private-markets lending. It discussed the outlook for leveraged loans and collatoralised loan obligations (CLOs). Since then, the US economy has slowed, leading the Fed to pause its rate-hiking cycle. This has improved the cashflow pressure on the companies borrowing in the loans market, particularly lower-credit-quality loans, which had looked vulnerable to higher interest rates.

For loan investors, the forecast of fewer interest rate hikes is offsetting the negative impact from deteriorating GDP growth

From an interest-burden perspective, the economic backdrop for loans looks more constructive. However, the regulatory environment appears to be recallibrating. The Japanese Financial Services Agency (FSA) recently reviewed the regulation around bank ownership of CLO tranches. Japanese banks are fundamentally important to the CLO market. This is because they own a concentrated amount of the AAA-rated tranches of CLOs (CLOs are major buyers of loans).

Although the regulation appears favourable, it has sought increased due diligence from the banks and CLO managers to ensure the collateral is sound. It is, as yet, unclear what this will mean in practice. Likewise, what impact this will have on the market. In addition, the Financial Stability Board has announced a review of the loans and CLO markets.

Market and outlook update

Economic scenarios recently outlined by the Research Institute indicate that GDP growth and inflation risks remain to the downside. However, the Fed’s change in rate outlook means the loan market looks healthier in terms of interest coverage. For loan investors, the forecast of fewer interest rate hikes is offsetting the negative impact from deteriorating GDP growth (used as an earnings expectations indicator).

The number and volume of new loans was considerably lower than average in December and January. While the secondary market sold off in December with broader risk appetite, the lack of supply contributed to a snap back in the credit spread of the S&P LSTA Leverage Loan Index, which narrrowed to 3.4%. The average spread of this index, which represents the largest, most liquid loans, is 4.5% over time.

 

Further analysis of the potential for systemic risk

 

To explore the idea of systemic risk further, we can look into the holders of CLOs. It is predominatntly the banks (particularly Japanese banks) and insurance companies that own AAA-rated tranches. Asset managers and insurance companies are the predominant owners of the mezzanine tranches. Equity tranches, meanwhile, are owned by asset managers, hedge funds and structured-credit funds, although insurance companies also feature. The data shown in the chart is from Citi, which mainly services the US market. However, we also obtained data from other banks to get greater insight into the US and European CLO market. The picture looks similar.

Chart 1: Investor base 2018YE

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Source: Citi Research, Aberdeen Standard Investments, (as of March 2019)

The FSA has ruled that banks will not face additional capital charges if they invest in certain CLOs. However, they must prove that full due diligence of the collateral backing the CLO has been performed. They need to also demonstrate that they are confident that the collateral is appropriate.

What this means in practice is currently unclear. However, the vibrancy and liquidity of the loans market may be challenged, given the importance of this buyer base. If the participation of Japanese bank in the market is restricted, others might step in, but possibly at higher spreads. This would be balanced somewhat by lower primary loan issuance, in both volume and credit rating.

In addition, within the loans market there has been a significant amount of 'B' and 'B-' rated issuance. Should these loans be downgraded, there will be pressure on CLO managers to sell the lower-rated loans. This would ensure that interest payments continue to flow back up the structure. In fact, they would become forced sellers.

There are also possible liquidity mismatches in ETF, mutual fund, hedge fund and asset manager holdings. While fund outflows have slowed, they remain a cause for concern.

What to watch

In our last report, we suggested concentrating on higher-quality credits, with a focus on stock picking. We are monitoring the higher-credit-quality loans and CLO tranches to see if they can withstand a period of weakness in the broader market.

It is possible that some companies will struggle to perform in a slowing growth environment. This may mean that certain loans will be subject to downward credit revisions. We will watch how both the proportion of loans trading below 80 cents and the proportion of lower credit quality loans evolve.

We are also closely following the Bank of England's research into market-based lending and leveraged loans. This is in addition to the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements' work on systemic risks. As mentioned in our last report, there are gaps in data, and macroprudential policies continue to evolve. This means that there may be an evolution of clarity on the matter over time.

 
For loan investors, the forecast of fewer interest rate hikes is offsetting the negative impact from deteriorating GDP growth
 

Currency volatility remains low

Chapter 5

Author

Ken Dickson, Investment Director, FX Research

Changes in relative growth and relative interest rates are important drivers for FX. These fundamentals are changing at a glacial pace, creating an unusually languid currency market.

Dollar tailwinds recede more slowly than expected

In March 2018, the US dollar started a year-long phase of appreciation. The Fed’s decision to keep policy rates moving upwards, alongside an economy growing at a rate well-above that of other developed economies, created tailwinds that pushed the US dollar 7% higher over the period. In our last quarterly review, we noted that some of these tailwinds were abating and that the positive US dollar outlook would start to turn. Tailwinds have indeed receded, but less significantly than we might have thought at that time.

Many central banks have become less hawkish or more dovish since the Fed’s exaggerated pause

Changes in relative monetary policies are a key driver of currencies. The US dollar remains the highest-yielding currency in the G10, by 0.5% or more against the Australian dollar and New Zealand dollar, and up to 3.4% versus the Swiss franc. It is worth reflecting for a moment just how unusual this is – there are almost no other occasions since 1988 (at least) where all G10 rates have been below the US. US dollar interest rates are now as appealing as the carry available in some emerging-market (EM) FX markets. However, over the December and January Federal Open Market Committee meetings, the Fed signalled a pause in ratehiking. Initially, the market pencilled in a return to rate convergence across the world, but this trend has slowed in recent weeks as non-US growth downgrades have persisted.

Another key driver of currencies is relative growth differentials. US growth outperformance versus the rest of the world was predicted and evident in growth revision indices throughout 2018 – this contributed to US dollar strength. We had expected that divergence to abate as the US slowed in 2019. However, non-US economies (Europe in particular) have experienced an exceptionally weak past six months and growth divergence has continued through this year, supporting the US dollar.

Over shorter timeframes, the market’s overall appetite for risk is also important for currency moves. In times of elevated market stress, safehaven currencies like the US dollar, as well as the Japanese yen and Swiss franc, tend to outperform. Last year, geopolitical risk remained elevated throughout the year as US-China trade talks, geopolitical uncertainty in North Korea and Brexit remained at the forefront of the market’s mind. Interestingly, volatility tended to remain low overall (albeit with occasional spikes). However, a combination of weaker economic data, the removal of policy stimulus (as quantitative easing was reversed) and these ever-present risks kept cyclical currencies on the back foot.

A rare mix of monetary-policy developments has changed currency-market behaviour

While there was good reason for risk aversion to curtail currency performance last year, there is evidence that the behaviour of higher-risk, higher-interest-rate currencies changed after the financial crisis in 2008. Prior to the crash, a prolonged period of low market volatility allowed FX carry basket outperformance – with higher-yielding EM currencies offering particularly high returns. After 2008, EM carry has only returned 1.3% per annum, while the developed-market carry basket generated virtually no cumulative return, even after a 20% total return during 2009 (see charts below).

Chart 1: Pre-GFC - The 'great moderation' drives low volatility FX carry returns

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Source: Bloomberg, Aberdeen Standard Investments, (as of March 2019)

Chart 2: Post-GFC - Monetary policy volatility weakens FX carry returns

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Source: Bloomberg, Aberdeen Standard Investments, (as of March 2019)

Carry trades perform well in an environment where interest rates are high or rising, combined with a regime where volatility is low and stable. One key difference before and after 2008 is that, while average volatility levels are similar, the pre-2008 period was much more stable. The key driver to the change in investor behaviour (and volatility) appears to be the expected and actual changes in the Fed’s balance sheet, combined with the trend towards an unusually high US interest rates. The performance of riskier currencies deteriorated as the Fed’s balance sheet peaked and even meagre gains started to reverse, as this stimulus was unwound. Developed-market carry-portfolio performance has been particularly weak as the Fed’s rate-hiking cycle gained momentum and has not rebounded since it paused.

Glacial changes in outlook mean muted currency moves

Our Research Institute is looking for economic activity to regain momentum in the second half of this year. Specifically, we focus on the potential for Chinese stimulus to support a stabilisation and recovery in global growth – albeit less so than in previous Chinese recoveries. As more measures emerge, growth divergence will retrace and support non-US dollar currencies. However, the scope for wholesale changes in interest rate differentials appears optimistic for this year. Many central banks have become less hawkish or more dovish since the Fed’s exaggerated pause. The European Central Bank still flags risks to the downside even after sharp cuts in growth and inflation forecasts as far out as 2021. We therefore do not expect interest rate differentials to turn against the US dollar significantly this year.

Tailwinds for the US dollar are abating but the key drivers are changing at a glacial pace. Currencies are rarely static, as even changes in sentiment and positioning can overshoot slow movement in fundamentals. Currently, we see a risk that global growth expectations are too pessimistic and long US dollar positioning is becoming too complacent. A squeeze in short euro positions looks particularly ripe as we look for data to start to surprise market forecasts. Nevertheless, with fundamentals moving slowly, these currency moves are likely to remain limited during 2019.

 
Many central banks have become less hawkish or more dovish since the Fed’s exaggerated pause