The I's of the Storm: Interest Rates, Inflation & the IMF

Greg Campion: The clouds on the macroeconomic horizon have grown darker in recent days, as investor hopes that inflation might be peaking have seemingly been dashed, at least for now. Does that mean that high inflation further, rate hikes, and impending recession are all on the horizon? The forecast is not so clear.

Ricardo Adrogue: We come to the conclusion that money growth will have come down to minus 5%, and that will be enough to bring inflation, global inflation down to levels that nobody's talking about, which is below 2%.

Greg Campion: That was Dr. Ricardo Adrogue, Head of Global Sovereign Debt and Currencies at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, the darkening macro clouds on the horizon and the strategies for navigating them with smart exposure to sovereign debt, interest rates, and currencies. All right, Ricardo, welcome to the podcast.

Ricardo Adrogue: Thank you, Greg. Great to be here.

Greg Campion: I'm psyched to have you. It's been a while and we've got no shortage of things to talk about. So it's been a tough year, in terms of performance for most risk asset classes, whether you're talking about EM, DM, equity, debt. I look across some of the EM indices and I see double digit down performance numbers, percentage wise, similar to what we're seeing across all risk asset classes. So I guess maybe let's start there with the context of difficult markets as the backdrop. What do you see as the kind of two or three biggest headwinds going forward?

Ricardo Adrogue: So, Greg, I perceive the risks being in three big buckets. Two of them are pretty much on the news. One is obviously the geopolitical risks that we're facing that do not seem to be going away anytime soon. And here we refer, not just to the Russian invasion of Ukraine, but also China- US and China- European issues. We don't know where or how that will get resolved, and China is a very important contributor to global production. That's number one. Number two, the Fed. And specifically, something which is quantitative timing, which is not typically talked on. Everyone is focusing on how much the Fed is hiking, how many more times, what is the pace at which they're hiking, whether that is tightening enough or not, whether the fed is willing to push the economy into a recession. All of which are real concerns but we have focus also on the quantitative timing aspect of it. That's number two. And number three, the IMF. The IMF has increasingly become a case of debt for emerging markets. They have started implementing what is called a common framework, which the idea is to try to bring both bilateral and private sector debt holders to the same level of comparison when you restructure the debt. But effectively, what the IMF is achieving with that is weakening the property rights of bond holders with a definition of debt sustainability that is very questionable and is basically pushing a lot of these emerging markets into a spiral of poverty, I would say. Not realizing that breaking property rights is the sure way of making sure the country stays underdeveloped.

Greg Campion: Okay. So thanks for highlighting all those. A lot to consider there and a lot to dive into. I just wanted to pick up on that inflation point specifically, and I wanted to dive into that in a little more detail. You recently wrote a piece about inflation and got really specific in terms of talking about quantitative tightening and the potential impact that we could see there on inflation. And I personally thought that the piece was quite different from everything else that I'm reading out there in the market, in that it makes a fairly provocative statement. And that is that quantitative tightening could lead to inflation falling below 2% by late 2023. Now, again, that's pretty different than what other people out there are saying, thinking, writing about today. So it'd be great to have you maybe talk us through your thesis there.

Ricardo Adrogue: The basis of the analysis that we did is the money theory, which is at the end of the day, inflation is a monetary phenomenon. Now that's not to say that from the money theory, one can conclude very firmly on where inflation will be at any specific point in time. But over time, money and inflation go together. And it has been with the idea that quantitative tightening is taking place. The Fed announced it in May. The Fed is saying that they will be reducing the balance sheet at a pretty fast clip over the next year. And the Fed has provided no analysis of what the effect of that could be. And there's very, very little in terms of analysis coming from anywhere else. So our analysis is very basic. It's saying how much global money will contract once the Fed reduces the stock of their own reserves, reduces the balance sheet of the Fed. What is the money stock of the world and what happens with that money stock of the world? So what happens with that money stock of the world is it will drop by about five percentage points. And the money stock of the world is the creation of central banks plus commercial banks. The money stock, the way typically is thought of is in money aggregates, which is deposits plus cash in circulation. And so that's called M2. If money goes down by 5% and the world continues to grow, then you need velocity of circulation of money that allows for the goods and services to be bought and sold to stay up too because you need more activity means more transactions, once transactions need money, circulates more rapidly. But under again assumptions of everything else staying the same, the only thing that happens in this world on the next 12 months or the next nine months or next eight months or so is that the Fed reduces the balance sheet by what has been announced, we come to the conclusion that money growth will have come down to minus 5%. And that will be enough to bring inflation, global inflation down to levels that nobody's talking about, which is below 2%. Now, as I said, that is a monetary analysis that over time is true, but is very difficult to call exactly the timing of that. And the reason we wanted to highlight it is that there's pretty much no analysis on quantitative timing, and it could be very meaningful in terms of effect on inflation and effect on the availability of US dollars in the world.

Greg Campion: So to summarize, inflation is a monetary phenomena. Through this quantitative tightening mechanism, you're going to essentially have lower money supply in the system, therefore that should bring inflation down. It's perhaps less about supply demand dynamics in the overall economy?

Ricardo Adrogue: Correct. And I would add, there's very little understanding of what has caused the current inflation and the same analysis done during the time of the pandemic would have given us a pretty good signal that inflation was going to accelerate quite sharply. That doesn't mean that this analysis, because it was right, then it will continue to be right now, but it does mean that at least we have a very clear picture or clearer picture than most in the market of what has caused this spike in inflation.

Greg Campion: Yeah. Okay. And just to be clear, it's not that you're making a call here, so to speak that inflation will fall below 2% by late 2023, but you're highlighting it as a very plausible scenario based on this analysis. I guess, what is the flip side of that coin? So what could cause things to go in the other direction?

Ricardo Adrogue: So the best economies in the world are highlighting all the risk to the upside or the persistence of inflation. And in a nutshell, once inflation gets to level that it is now it's perceived by everyone. And in the context of a very strong labor markets, it's very difficult for any individual corporation to prevent wage increases that are in line with the high inflation, and that causes the perpetuation of the inflation dynamics. So when inflation is 2%, corporations can give wage increases between zero and 4% and nothing really happens. But when inflation is 8%, it makes a difference whether corporation can give wage increase less than 8% or not. And in most cases with very strong labor markets, they won't be able to. And that means that next year's inflation will be supported by this year's wage increase, which is the cost of that past inflation. And so that dynamic is what makes inflation stay sticky at high levels and causes the Fed to have to be very aggressive and risk a potential recession.

Greg Campion: Okay. Okay. All right. So you've got opposing forces. If that scenario plays out that you wrote about in your recent piece, you could potentially make an argument that the Fed is making a policy mistake, continuing to raise rates into an environment where inflation is set to fall and perhaps the economy is already slowing. But the picture is anything but clear because the other scenario that you just painted in terms of wage pressure leading to continued inflation is also a very plausible scenario. I may be getting ahead of myself here, but as a portfolio manager, how do you manage through that type of uncertainty?

Ricardo Adrogue: So the way we do is we take a base case scenario. Our base case is increasingly that inflation may have turnaround, but we do focus on what are some pointers that could give us timely signals on whether we are right or we're not. Specifically, we watch very closely commodity prices. Commodity prices are the supply side, price effect that have pushed food and energy up worldwide. And obviously those are related to geopolitical considerations. It's much more difficult to read their geopolitical direction or when this may get resolved or not resolved or get worse, but one can see on a daily basis where commodity prices are and whether commodity prices are coming down, which they have in the past few months or weeks at least. That is a positive signal that maybe inflation has peaked. Then the other component that we look at is labor disputes to try to assess how much the societies are willing to accept that we have all become poorer. And therefore, we cannot consume the same that we're consuming before. It's not easy to coordinate that because obviously the wage earners will feel that it's the companies that want to get higher profits. At the end of the days, everyone is worse off. It's how to allocate those losses. So that's number two, what the labor disputes looks like. And number three, what policy actions from the fiscal authorities are. The governments. Because again, especially in democratic societies, there is a very strong incentive for governments to tailor to the needs and the will of the people. And in early stages of an inflationary phenomena, people perceive that they are being left behind and so they demand better living conditions by better wages. And it takes a long time for the broader population to realize that we may be on a spiral in which inflation stays high, simply because it was high before, that we need to make an effort to say," Okay, we need to cool things off." So all of those are metrics that we monitor to assess whether we might be right. The last one is we do look at how the market reacts to the different surprises, both on the positive side and the negative side, both on activity and inflation. When we have a positive inflation surprise, meaning higher inflation surprise, and the markets appears to overreact, the move is large. It's clear that there has been enough investors thinking like us and maybe inflation has peaked and it may need to go higher.

Greg Campion: Yeah. So maybe too many people were lined up on the side of trying to call that top of the recent inflation numbers. And then, obviously the recent one that we had really inaudible markets, so that I guess, gives you a signal in terms of what market positioning looked like heading into that. I want to talk a little bit about currencies. So as Head of Sovereign Debt and Currencies here at Barings, you spend a decent amount of time diving into all the different dynamics that are driving the value of currencies. We've seen some pretty dramatic moves. So for the past year, the most notable one being the real strength of the US dollar. I guess, I'm curious to hear your views on that, if you think that's continues. And then I'd also love to just talk, generally speaking about currencies, as you have discussions with clients of Barings, I'm curious how they're thinking about managing currency exposure. If it's something they hedge, or if it's something that is a potential source of alpha, but let's start with the US dollar first.

Ricardo Adrogue: Sure. So the interesting thing about the current environment is that the shocks facing the global economy are not necessarily negative for the US. The US is a very large energy producer. It produces a lot of food. It's a very, to some extent, closed economy. Not great links with the rest of the world. And so slowing China are very big problems from an energy sector in Europe, which are causing big potential downside to growth in Europe. The US has been spared for all of that. So in the bigger context of all these economies in the world, the US looks quite good. So it's a very good reason why the US dollar can be strong. And that also feeds into rate policies by the Fed, which because the US economy is stronger, allows the Fed or forces the Fed to be more aggressive on interest rates than other parts of the world, which in turn makes the dollar even more attractive because you also have positive carry. So on a forward looking basis, we don't think that the US can be completely insular from the rest of the world. And we do see the rest of the world that because of the energy crisis in Europe, because of COVID policies in China, the rest of the world that is slowing down quite dramatically. Whether it is in recession or not in recession is interesting. Numbers are not yet conclusive. And one would've thought that they should have become conclusive several months ago because monetary policies have been in time quite a bit, but the COVID cycle economic cycle has made these economies react very differently. People have savings but also people have felt more comfortable going back to work at different paces. And that have resulted in an economic cycle that have stretched the Fed hike rates, but the employment numbers continued very strong and some of the activity numbers are very strong. And even in Europe, there's some bad numbers, but they're also some very good numbers. So that's when the US dollar. Forward looking, we would expect the dollar to stay strong. It's very difficult to call for the dollar to weaken significantly from here. It's difficult to see the dollar getting a lot stronger from here.

Greg Campion: And then how about just in terms of, again, thinking about some of these emerging market assets, I mean, is that a tough environment for them to perform if you have a strong dollar?

Ricardo Adrogue: So it's interesting because this type of shock has been negative for some and positive for others. And so while the US dollar has strengthened broadly speaking, there's some currencies that have actually been on a very strong path against the US dollar currency. Currencies like the Jamaican dollar or the Costa Rican cologne, or the Dominican peso have been very, very strong. The Angolan currency has been strengthening. So there's not a one brush for emerging market currencies overall. It's more a currency by currency given that this shock has been very specific, has been an energy shock, has been a food price shock, and some countries produce those goods and have been benefiting from it and it's been reflecting in their currencies.

Greg Campion: And then back to the question, just about some of the conversations that you have with our clients around currency exposure, how are they tending to think about it and are their smart ways to manage it?

Ricardo Adrogue: So a lot of our clients, and I think rightly so, have decided not to hedge their positions, especially European clients that have invested in US dollar assets or assets that are potentially correlated to the Euro. And that has actually given them very good returns because in dollar terms, the returns have been very good had they inaudible it than they would've had exposed bad returns. We at Barings do have a strategy that basically takes all of that out of the equation and allows investors over time to benefit from relative value of currencies. As I mentioned, some currencies, even in a very strong dollar market, appreciate against a US dollar. And so picking those currencies and going long, being exposed to those currencies is a great thing and has helped strategies that do that. And then there's a lot of other currencies that is better to be short or being used as funding currencies. Those that have weakened against the US dollar or weakened against those currencies that have appreciated. So Japanese Yen, for example, has weakened lot. The Euro has weakened lot, but some of the other currencies that I mentioned have actually appreciated.

Greg Campion: Okay, so potentially a source of alpha. And then how does that look from a kind of risk management perspective? Are you almost like pairs trading for lack of a better phrase? So you go long one and short another, or how does that work?

Ricardo Adrogue: It's effectively, yeah, one strategy that we currently have, and we have been running for eight years. Basically takes away the directionality of the dollar position. And we do in that strategy, same that we do in every other strategy we focus on, why are the countries that we expect their currencies to be well supported and which are the currencies that we expect to not be as well supported. And so we go long once and we go short the others, or we fund those longs on the other currencies. And that strategy allows for calibrating the risk at the level that any investor may want. The way we have managed it has been basically paid very close to zero. So there's really no market directionality and we basically do currency pairs.

Greg Campion: Got it. Okay. So it's fundamental analysis, country by country, looking at their specific financial accounts, et cetera, and trying to predict directionality around that, but done in a very risk controlled way.

Ricardo Adrogue: Correct.

Greg Campion: Okay. So let's just talk a little bit about some of the opportunities that you're seeing out there today, because it's a challenging backdrop. It's an uncertain backdrop, as we've talked about, there's many different scenarios that could potentially play out. So it's tricky out there. So as you look across sovereign debt markets today, and I know that both emerging market sovereign debt issuers, as well as developed market issuers are kind of within your investible universe. Curious which countries out there, which country's sovereign debt look more attractive, who looks resilient, what are you liking out there that you're seeing today?

Ricardo Adrogue: Sure. From a sovereign perspective, and when we look at the market overall, the only statement that we can perceive as a market is that the world looks difficult going forward and doesn't seem to yet be on the mend. Such that the best quality countries, and a lot of them are developed markets, is potentially is the strategy that looks the most attractive as a strategy. Now, that doesn't mean that there's no individual countries that may not be as high quality but are very good risks. And typically, countries in the double B sector are countries that could withstand severe shocks. We have like Brazil for a very long time, we continue like Brazil. Elections are coming up, that create some risks. But at the same time, the fundamentals of a country like Brazil, a double B credit that is paying over 250 basis points in spread, appears to be a very attractive proposition. And a country like Ghana or a country like Honduras are countries that we perceive to be risks that need to be avoided. And that's on the hard currency sovereign side. And the main reason, and that has become increasingly clear since the pandemic is the approach that these different countries have to debt and how they have been influenced by the IMF rhetoric on the common framework and debt restructuring. It used to be that IMF considered debt from a sustainability perspective alone. Nowadays, it has put more meat around sustainability, not allowing investors to basically look at and come into their own assessment. And specifically, a country like Ghana, who is a country that consistently missed their own targets and always seem to need increasing amounts of financing. Or country like Honduras, where the president that was elected chose a path that questioned the sustainability of the debt, a debt under the metrics that we look at is completely sustainable is a country that we think it should be avoided, the same way that El Salvador, the El Salvador was a country that we avoided. And so increasingly, from a sovereign inaudible currency perspective, the effort is in analyzing which countries are the ones that have the willingness to pay. So the capacity to pay is there or different investors analyze countries differently, but come to conclusions about whether a country may be capable, able to pay back the debt.

Greg Campion: Got it. Okay. You mentioned upfront China as being one of the big potential headwinds out there. And any discussion that relates especially to emerging markets is incomplete without a discussion about China. So tell me just what your overall thought there is. I guess I'm curious on two fronts, one is on the economic growth front and also the geopolitical underpinnings of what's happening there and the implications, but also on the attractiveness or not of China's actual sovereign debt issuance.

Ricardo Adrogue: The situation in China from the lenses that we look at is one in which the political power trumps any economic considerations. The presidency of Xi Jinping consistently have indicated that they're willing to accept economic hardship, China style. It hasn't been recession yet, but hardship nonetheless, for what appears to be political considerations, political goals, political targets. And that have become even clearer when the property sector in China, the real estate market, was allowed to have a pretty big correction towards the end of 2021. The real estate sector is a very, very large sector in the Chinese economy, directly and indirectly adds up to more than a quarter of the growth of the Chinese economy. That is well known. So everyone, not everyone, but at least on our side, we thought that that was a good reason for the Chinese authorities to focus on that sector rapidly and try to find either an alternative sector that would provide the growth that sector wasn't providing or to fix that sector. And we're more than a year out and none of that has really come true, highlighting one more time that the political dynamics take precedence. And the political goal of China, the near term political goal stated by president Xi Jinping himself, is Taiwan. So the combination of the two in China that is not doing well, economically speaking by the government, that doesn't have that to be a priority anymore is a really big headwind for most emerging markets. And potentially is a source of inflation because China produce is a big, big part of the goods that get consumed globally. Now that's China and the effect on emerging market and that's why it's a headwind. Then we have on top of that, whether China is an attractive investment destination, there's not a lot of sovereign Chinese external bonds that one can buy. There is the local bonds. We never participate in the local markets in China. It is part of some of the indices that some of our strategies use as benchmark. It's a very large part, 10%. We never bought local Chinese bonds. And the main reason is that as the world and this geopolitical dynamics take place, investors in the Western side of the world run the risk of being taken over by the Eastern side or the Chinese. So if you're an investor in China, it makes sense to invest in Chinese bonds and potentially you're at risk investing in US bonds. If you're investor in the US, it's potentially not a good idea to invest in Chinese bonds because the same thing that happened to investors in Russia that lost the access to their bonds by investing in Russian bonds could happen to China. And valuation wise, if we wanted to just look at valuation of external bonds so then trade outside of China. Obviously, China is a very good credit quality. It has a lot of reserves. And so it trades a very low spreads. So it's not really an attractive proposition from a evaluation perspective either.

Greg Campion: Okay. Now one interesting point I just want to pick up on there is that you mentioned that China local issuance is as much as 10% in some of the indices that you and the team follow and that you don't invest there. So that's a pretty big underweight relative to the index, if you have zero exposure. Tell me just about your comfort level. This is a bit more philosophical, I guess, but tell me just about your comfort level of having that much divergence from any given index.

Ricardo Adrogue: So as you know, we invest with high conviction and we invest with bottom up analysis, both on the corporates and sovereign side across Barings. That means that we are not benchmark huggers. Now, specifically to China being 10% of the benchmark is large in market value terms, but it's not very large in risk terms. So we are not running a large tracking error against a benchmark for not having China. And the reason is that it is such a controlled domestic market that volatility of those bonds is very low, the price doesn't change that much from day to day, and the yields are very low. So the combination of the two factors, at least today and since China was including the benchmarks, has not been a big contributor to risk. So having no China, no Chinese bonds doesn't mean that we're running large risk.

Greg Campion: Yeah. Yeah. All right. So maybe to finish up, just as you think about everything that we've discussed here, so many moving parts. From interest rates to inflation, to currencies, very, very difficult landscape to navigate right now. But as you take all that into consideration, and then you put yourself into the shoes of an investor, let's say somebody who's coming into this market with a clean slate. Let's imagine zero exposure to sovereign debt, currencies, et cetera. You are in that position today. What looks the most attractive to allocate fresh capital to?

Ricardo Adrogue: As we discussed, the global environment looks quite challenging. And depending on the type of risk appetite that the different potential investors may have, or the type of investors yourself may be, you may choose a strategy that is what you want to inaudible given the environment looks so difficult. And so that's more of a developed market, very high quality emerging market type of investments. And that is the one that traditionally does well in periods of intense distress, global distress.

Greg Campion: So that would be sort of combination of developed market sovereigns and high quality emerging market sovereigns is on your sort of low end of the risk return spectrum.

Ricardo Adrogue: Correct.

Greg Campion: Yeah.

Ricardo Adrogue: And then you have two potential ways in which a good investor can benefit from this environment. One is an investor that invest in a blended strategy that allows for the selection of the best of the best out there. This current environment has created so much dislocation across individual countries and individual corporates on valuation. Being in some cases completely disassociated from fundamentals, that an investor that can review what those are and have good analysis can pick very, very good jewels, on both a sovereign and corporates and currencies. And finally, a potential overlay is a strategy that can work out under most scenarios, but obviously, in this scenario works out well. A currency overlay that allows an investor that doesn't want to devote a lot of capital, but has some risk to devote to a potential revenue generating strategy that does basically the same thing on derivatives market and allows with base capital to put relative value currency positions that over time, if successful, will produce possible returns.

Greg Campion: Well, that's encouraging. I mean, for a conversation where we discussed a lot of headwinds, it's encouraging to me to hear that you and the team are also finding opportunities amidst what sounds like still a really dislocated market when you look across the emerging market debt spectrum, the sovereign debt currency, that entire universe. It seems like there's still a lot of imbalances to your point around the normal economic cycle with a pandemic overlaid on top of it has just led to so many strange imbalances around the world that a team like yours that is focused on really understanding the fundamentals from the bottom up is really poised to take advantage of these types of conditions. So no shortage of things to follow. And we'll look forward to keeping up with everything that you're saying. So please keep writing great pieces like this QT piece, which we'll link to in the show notes of this podcast. But Ricardo, this has been great. I really appreciate your time and hope to have you back soon.

Ricardo Adrogue: Thank you, Greg. Thank you very much.

Greg Campion: Thanks for listening to episode number two of season seven of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple podcasts, Spotify, Google podcasts, and more. We publish a new episode every other week. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.