Volatility ahead as central banks tighten: Pendal Group
The world cannot handle higher interest rates as central banks around the globe begin to tighten, a Pendal Group expert has said.
Vimal Gor, head of income and fixed interest at Pendal, which recently rebranded from BT Investment Management, said current volatility in emerging-market equities and bonds was resulting in “the sucking sound” of money moving from emerging markets back into US Treasury bonds as the Federal Reserve enacts quantitative tightening (QT).
Gor gave his bearish view of the global economy and high leverage to the Conexus Financial Fiduciary Investors Symposium, held in the Blue Mountains, NSW in May.
“The reason we had synchronised recovery (last year) was all due to China, which drove world growth in 2015-16, and now China growth is slowing and trying to enact reform,” Gor said. “[Purchasing managers’ indices] in Europe have been slowing at their fastest rate since 2008…The entirety of European growth has come from exports to China. It’s not synchronised growth in recovery, it’s a world that’s been pulled along by China and that’s now slowing as they’re tightening fiscal policy.”
While central banks, including the US Federal Reserve, were starting to raise interest rates, the world economy would suffer because of high debt levels, Gor said.
“Since the GFC, total world credit has gone up from 215 per cent to 245 per cent of world GDP,” he said.
Pendal had concerns about US debt, with its deficit expected to grow from $US5 trillion a decade ago to $US30 trillion by 2028, taking interest repayments from 3.5 per cent to 7 per cent of US GDP and coming on the back of the second-longest recovery in US history and in peacetime, Gor said.
He questioned the timing of the Trump administration’s tax cuts and a proposed $US200 billion ($270 billion) infrastructure plan to encourage private and state-based investment.
“The US is adding massive fiscal stimulus, just at the point we’re through full employment and through the output gap,” Gor said. “The multiplier effect will be minimal impact on wages, and inflation will be quite large. This is the last point in the cycle where you want to be adding fiscal stimulus.”
The US still benefits from its reserve currency status but as Treasury bond yields and interest payments go up, that gets called into question.
“As you’re spending more and more of your revenue to service debt, your credit worthiness goes down; therefore, people demand higher bond yields from you…and you go round and round,” Gor explained.
Capital flow from emerging markets back to the US
The “sucking sound” refers to a systemic issue now building was being driven by QT and sales of US Treasury bonds, effectively doubling to $US1.3 trillion in the last year, creating a capital flow from emerging markets back to the US, where three-month Treasury yields, for example, were now more than S&P dividend yields.
“You hear this big sucking sound coming back in to the front end of the US. The risk-free rate is now a valued investment option with T-bond yields at 3-4 per cent more than corporate yield,” Gor said.
That “idiosyncratic” volatility in smaller economies such as Indonesia, Korea and Turkey was resulting in capital returning to the US, he said.
“When this comes to impact markets, we’ll see volatility pick up, risk assets move around a lot, and my best guess is S&P will be unchanged this year but will move in a 20 per cent range,” Gor said. “That impacts credit spreads the most, with equity volatility in emerging markets.”
The suggested defensive strategy for investors was either explicit, through buying volatility, or implicit, through use of cash as an asset class.
Meanwhile, he said, Australian banks would restrain lending in light of findings from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and stress testing of an official rate rise would see borrowers losing capacity to service loans.
This had caused Gor to alter his forecast of two rate rises this year to continued unchanged status.
“There’s a good chance that (RBA governor Philip) Lowe finishes his term without moving rates,” Gor said. “Our base case is that the Australian economy will go sideways. It is lacklustre. Australia is super boring and if it can remain that way, that would be good because all the risk is on the downside.”