30th September 2015
Jan Dehn, Head of Research at Ashmore, discusses the similarity between Kilimanjaro’s form and the inevitable evolution of currencies subject to quantitative easing (QE).
Enormous, majestic and almost perfectly symmetrical, Kilimanjaro is Africa’s highest mountain and it never fails to impress. The mountain has three distinct sections – a gradually rising western face that gives way to a wide, almost flat snow-capped roof and an eastern slope that tumbles towards the Tanzanian plains interrupted only by a few wobbles before merging into the surrounding savannah.
Kilimanjaro’s iconic shape also happens, quite by accident, to describe the likely evolution of global currencies under quantitative easing (QE). Since the onset of QE, the USD in particular has evolved more or less along this path with strong sustained appreciation for several years followed by a flatter trajectory and eventually a descent in line with the destiny of all QE currencies.
This brief note explains why the driving force behind currencies under QE suggests this pattern, particularly for the USD and what this means for Emerging Markets (EM) currencies now and in the future. The conclusion offers suggestions on how to position portfolios accordingly.
Up the Western face
The US embarked upon its first QE program in 2011. It has since gone on to launch two additional QE programs and a so-called Twist operation, while all the other major Western economies have also launched their own versions of QE. Through these programs, Western central banks have, between them, printed literally trillions of Dollar-equivalent freshly minted bills that have been used exclusively to buy developed markets assets.
Printing money initially led to fears that it would weaken the currencies in question, but it has had the opposite effect. Why? Because: money printing has not, so far, resulted in inflation. This means that every single unit of currency printed has been real value. The purchasing power of each bill still equates to its face value.
EM currencies versus USD
EM currencies have behaved dismally versus the USD over the same period. Why? The answer is more technical than fundamental. Not a single EM central bank has engaged in QE practices and not a single one of the central banks in the developed world has bought EM assets as part of their QE programs. EM assets – and with them, their currencies – have in effect languished in a state of benign neglect. Global asset allocators have been quick to jump on the central bank bandwagon by adding to their already large core allocations to stocks and bonds in the now central bank-sponsored developed economies, sometimes funding their purchases by reducing exposure to EM.
Sentiment continues to mirror the destination of QE flows. This means that EM countries have experienced a slowdown in their share of financial flows – even outflows in some cases. The result has been that financial conditions have tightened in EM – which explains why there is not a single financial asset in EM that is not significantly cheaper today than before 2008/2009, as compared to developed markets assets. The strong USD has also pushed down commodity prices, which has benefitted the majority of EM countries. However, in a market that rarely distinguishes between EM countries and tends to focus on the negative stories, even the lower commodity prices have reinforced the EM scepticism.
It is therefore ironic that EM fundamentals have remained very stable since QE began. EM countries have settled on a 4-5% real GDP growth path after their initial V-shaped bounce-back from 2008/2009. There have been no major balance of payments crises and no major defaults. A small number of EM countries have fallen into disfavour each year, usually for reasons that are entirely self-inflicted, but this is entirely normal and the affected countries tend to take quick remedial action, so the panics typically do not last very long.
In short, the trek up the western face of Kilimanjaro between 2011 and 2015 has been far more of a technical than a fundamental story. It has been a goldilocks period for developed markets and particularly the USD. Until recently there were no signs at all that the good times would come to an end.
Hitting the roof
The illusion that QE – money printing – can support indefinite rallies was brutally shattered towards the end of Q1 2015. In the US, growth seriously undershot expectations in the first quarter (0.6% qoq annualised versus 3.5% qoq annualised expected). Of course, this was not the first time that first quarter growth disappointed in the US, but this time was different. The US real effective exchange rate has gone vertical. Oil prices have tanked, taking down the US shale sector. Productivity has begun to really struggle. Earnings have missed. And the US trade deficit is now a serious concern.
The difference from previous growth disappointments is that the US economy is now suffering from American-style ‘Dutch Disease’, that is, the damaging effects of the enormous USD rally of the past few years. It may not yet feel that way, but this is an important turning point.
Down the Eastern Slope
Fed hikes, no matter when they arrive, are not likely to materially alter the ‘Kilimanjaro path’ for global currencies. The Fed will hike slowly. The uncertainty surrounding the timing of hikes is far more important than the hikes themselves. This means that the commencement of rate hikes should benefit credit, but only at the margin.
The next major turning point in the global currency story – and the start of the USD’s descent from the current dizzy heights it has reached over the past four years – is likely to revolve around the return of inflation in the QE countries.