The health of the global economy and swings in risky asset prices are intricately linked, and it is unlikely higher real rates will bode well for risky assets.
The relationship between real interest rates and risky asset prices is complicated. When an economy is doing well, like that of the United States, the return on capital rises, allowing real interest rates to rise and risky assets to perform well at the same time. But if the real rate rises because of global developments or an overeager central bank, then the rise in the real interest rate harms risky asset prices. A strong U.S. economy has allowed equity markets to do well and rates to rise. But to the rest of the world, especially emerging markets, the rise in the domestic cost of dollar liquidity is an exogenous shock that has harmed risky assets.
Some of the weakness in emerging markets can be explained by a few idiosyncratic developments, especially in Turkey, Argentina, and South Africa. These countries were vulnerable to a stronger dollar, the shift in global financing, and higher U.S. rates in the first half of 2018. The yield on the benchmark 10-year Treasury rose above 3.0% in May 2018 from 2.4% in early January. The dollar has increased between 6% and 8% during the same period, representing a tightening of dollar liquidity for economies dependent on global funding.
Can the current trends continue?
The question is whether this configuration of economic developments and risky asset performance can continue. We think it is highly unlikely, frankly. Still, the more difficult question is how convergence is likely to occur. Will emerging markets recover, or will the better-performing risky assets weaken? We discuss several channels in this context, and we will be following these issues over the coming weeks.
The most obvious channel of contagion is the financials sector. As Turkey’s difficulties mounted, there were questions about European banks’ exposures to local assets, including Turkish banks. When the European Central Bank (ECB) expressed some concern about European banks, the macro markets responded. None of this lasted very long.
The rise in the domestic cost of dollar liquidity is an exogenous shock that has harmed risky assets.
Global trade and tariffs
A second channel is through trade. Emerging markets as whole are weakening, but their weight in world GDP is small. China is the elephant in the room here; it matters for global growth, and a large number of global corporations derive a lot of their revenue from China. China is slowing, but only a little, and policymakers have responded. We don’t expect stresses in emerging markets to cause a material global slowdown.
Within trade, we have the trade conflicts, which keep moving backward and forward. The theory that Trump on trade is all sound and fury and that the headlines are all that matter to him gained some credibility when the U.S. and Mexico announced their NAFTA breakthrough. We are also monitoring negotiations with Canada. There is clearly a risk that the whole thing will fall apart, but the plain fact is that the “new NAFTA” is pretty much the old NAFTA.
The role of central banks
Global central banks, including the Federal Reserve and ECB, also play a role in this configuration of rates and risky assets. Fed Chairman Jerome Powell defended the bank’s policy of gradually raising the policy rate. He was a little dovish relative to his earlier comments about the “great” state of the U.S. economy. Meanwhile, the leading doves on the Federal Open Market Committee, James Bullard and Neel Kashkari, called for caution in tightening monetary policy. Overall, the Fed is looking to increases rates and seems to attach little, if any, importance to the stresses in emerging markets. The market expects rates to rise gradually.
As we discussed previously, there is risk the Fed will tighten more than warranted. The Fed’s June increase — the second this year — pushed the funds rate target to a range of 1.75% to 2.00%, and policymakers signaled they are on track to raise short-term rates at least twice more in 2018. The ECB also plays a part. Core eurozone inflation is expected to accelerate quite materially in the near future, and it’s quite likely that the markets will price in an earlier move by the ECB. Finally, there is the channel of the U.S. economy itself. The economy had a good first half, supported by fiscal expansion and a modest recovery in private investment. We continue to monitor recession risk, which remains low.
Risks seem asymmetric
Our central scenario remains broadly unchanged. Decent growth may continue, but the degree of U.S. outperformance is likely to drop. We could manage to avoid a dramatic worsening in trade tensions. And even though the conflict between China and the United States could possibly get somewhat worse, it is unlikely to erupt into something deeply damaging. Under this scenario, global bonds yields will edge a little higher and emerging markets should be able to recover.
Decent growth may continue, but the degree of U.S. outperformance is likely to drop.
But the risks still seem asymmetric. There is a good possibility the trade conflict will worsen more than we expect. And there is a chance that markets, or the ECB, will overreact to the increase in inflation that we forecast in the eurozone. The upside risk of the U.S. gathering strength and pulling up returns globally is certainly not impossible, but it does not seem very likely to us.