Why the reflation trade can work for Gulf economies
US Treasury yields have turned positive. The most significant jump was the 10-year Treasury note, which jumped from 0.72 percent in September to 1.375 percent on Monday morning.
The questions to ask are: What is behind the move? What does it mean for equity markets? And what are the implications for emerging markets, especially the Gulf Cooperation Council (GCC)?
The name of the story is reflation, or rather a fear of inflation.
Since last March, central banks have pushed $6.6 trillion of liquidity into their economies and are expected to follow suit with an additional $5.8 trillion later this year, according to Cross Border Capital, a London-based consultancy. This is monetary stimulus alone, which is enhanced by huge fiscal stimuli in the US. Last year’s monetary expansion was the largest in 150 years. On top of that, the fiscal stimulus amounted to $2.9 trillion. It is expected it will be followed by a further potential $1.9 trillion and an infrastructure bill.
During the financial crisis, the various quantitative easing packages did not result in inflation because they went into bolstering the reserves of the undercapitalised banking system.
Things are different this time around, as the money goes directly into people’s bank accounts and to local and state governments. Together with higher commodities prices (WTI at $59.24/barrel and copper at a nine-year high) many economists, including former US Treasury Secretary Larry Summers, warn of inflationary pressures.
The IMF foresees inflation in advanced economies to reach 1.6 percent in 2021, and Citigroup put global inflation this year at 2.3 percent. These forecasts make sense while the US economy is on steroids, economists anticipating 7 percent gross domestic product (GDP) growth and a budget to GDP deficit at 12 percent this year.
When investors fear inflation they tend to sell fixed income assets, which is what happened to US Treasuries - resulting in rising yields, as mentioned above.
In the end the GCC currencies, which are pegged to the dollar, will rise and fall with the fortunes of the US economy and the global pricing of its currency.
In equity markets we have seen a rotation out of growth stocks into cyclicals and energy. Energy stocks have a great track record in times of rising inflation, outperforming the S&P 500 by 14 percent, according to Ned Davis Research, which is good news for oil-dependent GCC economies.
All of the above has a real impact on emerging markets and, with it, on GCC economies as well. Emerging markets currency-denominated bonds had their worst week since December, as dollar-denominated debt saw its worst performance since January.
Irrespective of what happens in the real economy, we can expect US Treasury Secretary Janet Yellen and Fed Chair Jerome Powell to remain dovish, which will have an effect on dollar-denominated debt.
Unlike most other emerging markets, many GCC currencies are pegged to the dollar, which means that its debt yields and currencies will move commensurately.
We have seen the reflation trade take hold in GCC markets with the Tadawul outperforming its peers and bank stocks, which are a classic reflation trade doing particularly well.
Saudi Arabia’s largest bank by market capitalisation, Al Rajhi, has outperformed its peers. Banque Saudi Fransi and Saudi Basic Industries Corporation also rose steadily.
Higher inflation expectations are positive for GCC oil exporting nations, as Brent stayed reliably above $63 for the last week and Goldman Sachs analysts predict Brent to reach $70/barrel within the year.
In the end the GCC currencies, which are pegged to the dollar, will rise and fall with the fortunes of the US economy and the global pricing of its currency. While the rising yield bodes well for the value of the dollar, we have to see this in the context of what happens in China, where the renminbi still holds a considerable interest rate differential to the dollar, leaving it open to appreciation going forward. The renminbi supports Asian currencies in relative terms.
For emerging market currencies not pegged to the dollar, current developments may be more difficult. Who could forget the taper tantrum of 2013, which was bloody in many places?
Again, GCC currencies and debt will ebb and flow in tandem with the US dollar thanks to their pegs – particularly as higher oil prices are bound to do wonders for GCC economies and their budgets.
- Cornelia Meyer is a Ph.D.-level economist with 30 years of experience in investment banking and industry. She is chairperson and CEO of business consultancy Meyer Resources. Twitter: @MeyerResources