Global FX and Emerging Markets Rally

Yesterday’s release of the third consecutive decline in quarterly US productivity – the worst run sinceat least 1980 – does not bode well for the prospects for USD. 2Q productivity declined by 0.5%, coming in way below consensus expectations of +0.4%, suggesting that the growth potential of the US economy may have declined substantially. Importantly, unit labour costs (ULC) rose by only 2% while 1Q ULC was revised from a 4.5% gain to a 0.2% decline. Productivity growth determines the real wageand corporate profitability growth outlook. Real wages have been stagnant for many years, while the post-Lehman US corporate profitability advance peaked in 2014 and is now in decline. Most of the post-Lehman profitability advance had been supported by cost-cutting and replacing equity with debt, with the result of US corporates now running debt/asset ratios near historical peaks.
The previous Fed President Bernanke has put low productivity gains into the context of undershooting inflation rates, supporting our view that the Fed will allow inflation expectations to lead to a potential rebound of nominal yields. In other words, the Fed will try to keep real yields at subdued levels and not allow a pre-emptive rise in nominal yields, leading to unwanted high real yields. The Fed should operate deliberately behind the curve, and yesterday’s poor productivity reading supports this view.

While the Fed no longer adds to its balance sheet, there seems to be an excess of USD in the system. Asia’s FX reserves ex China have reached a record high. Meanwhile, the BoJ, ECB, SNB and BoE have filled the gap left by the Fed, pumping liquidity into the system. This additional liquidity either finds its way into economic investment and is absorbed by economic expansion, or leads to financial investments, or in the worst case scenario results in a decline in monetary velocity, leading to a liquidity trap. The release of the dismal US productivity report not only signifies the poor US growth outlook but also the weak growth potential of DM in aggregate. Most DM economies are challenged by a mix of weak productivity growth rates, subsequently low investment returns and slow economic growth.

DM central banks pump liquidity into the system for good reason. Their overleveraged and overcapacity-running economies have failed to stabilize their inflation outlook. Instead, inflation expectations keep falling. By adding liquidity into the system, central banks try to ease balance sheet pressures. Economies sacrificing consumption and favouring savings are deflationary. Central bank liquidity adds may slow the consumption cutback, but as long as investment returns remain poor, this additional central bank liquidity should not find its way into local (real sector) investment. With about US$11.5 trillion of DM bonds providing negative yield, the excess DM savings will be looking for yield. This is why the EM rally is primarily a flow of funds story and not a story built on solid EM fundamentals.

The marginal widening of the DM-EM growth differential and global risk factors turning from EM to DM have redirected funds. The wall of worry is high, which is understandable, given the many structural shortcomings still found in EM. However, this wall of worry suggests too that markets are not yet fully positioned, suggesting that the EM rally has further legs to go, with wide real and nominal yield differentials to DM providing the incentive to invest in EM. This is a fixed income-driven rally. When Mexico’s July CPI came in at 2.65%Y, undershooting the 2.73%Y expected, MXN received another shot into the arm, with more flows piling into Bonos. US presidential candidate Trump falling behind his rival Clinton has helped too. More gains in MXN and LatAm are likely, in our view.