The year of 2015 has been rather eventful from a global monetary perspective. We thought we would provide a brief year-end pulse-check on global monetary conditions to set the scene for 2016.
For us, three key dates shaped where we are today: December 16, December 3 and August 11.
On this day, the Federal Reserve increased its target range for the federal funds rate for the first time since 2006. The chart below illustrates what a strange world we have been living in for so long: the Fed has been operating a zero-interest-rate-policy now for nearly seven years.
According to the Fed’s statement, the US economy is improving and that: “Inflation is expected to rise to 2 percent over the medium term”. The Fed did note, however, that: “Inflation has continued to run below the Committee’s 2 percent long-run objective.” After all, a quick check of market-implied inflation rates – even five years out – shows that inflation expectations are well below the 2 percent level, as illustrated below.
So why hike rates if inflation expectations are well below target levels? The argument from the Fed goes something like this: underlying inflation would be materially higher than what the Fed is seeing at the moment, were it not for declining commodity prices and the strong dollar. But these effects are “transitory” and so should wash out over the medium term. When they do, the Fed expects to see much clearer evidence of inflation closer to target levels. (If this inflation does not materialize, do not be surprised to see rates cut fairly promptly).
The Fed’s rate hike on December 16 will go down in history as one of the most well-flagged movements in monetary policy the market has ever seen. Yet it is not without its controversy. You see, there is a pocket of the US credit markets – the high-yield space – which is starting to show signs of dislocation. Yields are blowing out (particularly for energy credits, as illustrated in the chart below) and a number of funds are facing liquidity problems.
In the days leading up to the Fed’s rate hike, high-yield credit funds run by Third Avenue Management and Stone Lion Capital Partners stopped returning clients’ money following significant redemption requests. Lucidus Capital Partners, another high-yield credit fund, announced it had liquidated its entire $900m portfolio and plans to return all money back to its investors.
The issue is one of bond liquidity. We understand that, of the approximately 26,000 publicly registered corporate bonds outstanding in the US, just 1 percent trade daily; 20 percent trade fewer than five days per year; and 11% do not trade at all! So when multiple investors in a fund holding these assets redeem at the same time, the fund needs to sell assets but cannot find buyers. Yet news of these illiquidity issues fuels more redemptions – and creates a “run” on these funds. Many fear, with sensible reasoning, that we may only be at the beginning of some more serious dislocations in this part of the US credit markets.
(Investors should rest assured that the liquidity issues being faced by certain high yield credit funds are not applicable to the Montaka strategy. We intentionally limit our universe of investable stocks to highly-liquid names. If necessary, we could liquidate the entire portfolio in a matter of days with very limited impact on stock prices).
On this day, the Governing Council of the European Central Bank (ECB) decreased interest rates on the ECB’s deposit facility by 10 basis points to -0.30 percent. Furthermore, the ECB extended its quantitative easing program (under which the ECB buys €60 billion bonds in the secondary market per month) for at least another six months, to March 2017.
This is a highly accommodative monetary policy and reflects the risk of deflation in the European economy. According to ECB President, Mario Draghi:
“The latest staff projections incorporate the favourable financial market developments following our last monetary policy meeting. They still indicate continued downside risks to the inflation outlook and slightly weaker inflation dynamics than previously expected. This follows downward revisions in earlier projection exercises. The persistence of low inflation rates reflects sizeable economic slack weighing on domestic price pressures and headwinds from the external environment.”
Thus, as we round out 2015, we have two of the world’s largest economies, the US and the Eurozone, pursuing divergent monetary policies. No one really knows for sure the implications of international repercussions of this growing divergence.
On this day, Chinese policymakers surprised the world with a currency devaluation – its largest one-day devaluation in two decades. We wrote about this currency move at the time, which can be found here.
In short, we believed the surprise devaluation was a move to force the Fed to delay hiking interest rates – as tightening US monetary policy would have negative implications for the Chinese economy. This action was essentially an admission that:
- The Chinese economy is deteriorating – and likely at a rate that is faster than Chinese policymakers ever expected; and
- Chinese policymakers are unwilling to take the necessary steps to rebalance the nation’s economy away from being investment-led to being consumption-led.
We also feared – and continue to do so – that a weakening Chinese currency would drive capital flight out of the country, thereby exacerbating the currency weakness. Capital flight out of emerging markets, in general, would likely be bullish for the US dollar.
Well it is interesting to observe that, since the initial currency devaluation on August 11, the Chinese Renminbi has continued to deteriorate against the US dollar, as illustrated by the chart below. Indeed, four months later to the day on December 11, the People’s Bank of China quietly suggested that it may look to peg the Renminbi to a “basket of currencies”, rather than solely to the US dollar. This is code for further currency weakening and reinforces the views we expressed on the initial currency devaluation in August, described above.
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We live in interesting times for sure. The days of investment managers ignoring the macro dynamics of the world are well and truly behind us. While we are company-specific, bottom-up investors here at Montaka, we absolutely monitor and analyse the macro environment within which each and every one of our portfolio businesses operate. We believe the portfolio is well positioned heading into 2016.