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Central banks ready & waiting

Slowing global growth means QE at the ready, but hard currency EM assets remain well supported.

It was a positive week for markets as the prior weekend’s G7 meeting gave some hope around further US/China trade negotiations amidst a relatively quiet week on the data front.

Global equities traded up by more than 2%, although tellingly, the US Treasury curve continued to rally with the 2s 10s curve still on the point of inversion, signalling all is not well with the growth outlook.

In emerging markets (EM), in what has been a recurring theme for August, it was local markets that remained under pressure via the FX channel as US data continues to hold up better than global data. This sparked fears that the Fed will not cut pre-emptively to get ahead of the curve.

Credit markets were mixed with the shock Argentine PASO result still weighing on sentiment.

However, there was an increasing degree of differentiation this week and there was an element of bottom fishing in some of the more beaten-up high yield credits, which were sold in the August de-risking move rather than because of fundamental concerns.

Market review

  • In Argentina, opposition candidate Fernandez further inflamed an already tense situation in markets by making incendiary remarks around the IMF programme, significantly jeopardising the next disbursement, which was due in mid-September and which is crucial to the sovereign’s short-term liquidity needs.
  • Argentine assets subsequently made new lows this week as a failed auction on the country’s short-term maturities prompted the government to announce that institutional investors would be forced to roll these instruments in what basically amounted to a selective default. They also announced a reprofiling of both local and external bonds maturing in the next 10 years, with some exclusions.
  • Given the immense uncertainty, Argentina was forced to resort to capital controls at the weekend to stem the drain on FX reserves. The measures are designed to prevent the drain on net reserves, but deposit outflows will still mean that gross reserves will fall. We believe the measures are likely to be successful in stabilising net reserves in the short term and have also led to some stability in the external bond curve in the 35-40 cash price range.
  • When thinking about the outlook for Argentina, it is important to remember that it is not in anyone’s interest for Argentina to experience a disorderly default. The current period is extremely challenging because of the political vacuum created by a lame-duck president and a challenger who lacks the political incentive to calm markets ahead of the elections. With prices in the 35-40 range on hard currency bonds and a flat CDS curve trading at around 62 points upfront, valuations now seem attractive enough, in our view, for a meaningful exchange of risk to start taking place. With capital controls likely to stabilise the net reserves, there is some hope that the situation can stabilise enough for Macri to be able to see out his term and to buy enough time for a new president to be able to outline his policies to the market once elected – rather than being faced immediately with a hard-default scenario.
  • It was relatively quiet in terms of newsflow across the rest of EM last week. The main theme remains one of further easing in the monetary policy stance of the major EM central banks as growth continues to slow.

Market outlook

In a global context, it is clear in our view that growth is slowing. It is equally clear that central banks are ready and waiting with accommodative policy. The nuance remains that the US growth outlook is better than elsewhere, and this is leading to US dollar strength which, if it gathers pace, could ultimately lead to a sell-off in risk assets.

The key debate remains whether the Fed is prepared to get ahead of the curve and pre-emptively ease before it sees a meaningful slowdown in the US data. In that regard, yesterday’s ISM print may help give the Fed a nudge, as at 49.1 it was the weakest reading since January 2016.

On the trade war, it is becoming clearer to us that the Chinese are prepared to play the long game in the hope that they may get a new president to negotiate with in late 2020.

Although trade talks will continue this month, the likelihood of a meaningful deal remains very low, with perhaps the only hope lying in Trump’s unpredictability, particularly heading into an election year.

For EM, we expect hard currency credit to remain well supported, particularly the investment-grade space, given the strength in core rates.

High yield has suffered on the back of Argentina-related weakness and certainly screens as ‘cheap’ – but here the trade-off is between what looks like a relatively benign default environment set against a weak growth backdrop.

In local markets, rates remain well supported but it is the lack of synchronised growth that seemingly remains the key concern for FX, i.e. the US remains stronger than the global economy.

In both high yield and FX, we would expect some mean reversion (outperformance) given the extent of the underperformance last month, but for this to become a trend we will require a more pro-active reaction function from the Fed.