Summary and Conclusions
In our last letter we described the global financial setting as warranting prudence, but also as showing investors´ willingness to keep betting for the continuity of a fragile equilibrium. In this context, it was not surprising to observe declining rates following the first sign of discrepancy at the Fed back in August, nor the subsequent jump pushed by confirmation of central banks de-investment policies and progress in the tax reform agenda of the Trump administration. It was neither shocking to see global equities returning 5% in the last two months, high yield bonds delivering 2%, emerging market bonds another 1%, nor that volatility measures remaining at their minimum. More astonishing, however, was the fact that market players have continued to perceive some fundamental contradiction between a global saving glut and depressed investment on one side, and increasing friction in labor markets, especially in the US and Europe, and central bankers anticipating greater tightening in monetary conditions. Such an apparent dilemma has become even more upsetting as we face a potential change in Fed´s leadership ahead, while we read that the US Senate has just approved an important increase in the fiscal deficit for the next decade. Meanwhile, the global recovery process has re-affirmed its course, and the Fed and the ECB have increasingly signaled their need to continue normalizing monetary policy conditions, not only by hiking rates but also by forestalling a gradual change in their balance sheet management. Worth noting, this policy confirmation was done despite benign inflation behavior in recent months. Abstracting for a fundamental change in the Fed´s board, the US monetary authority is set today to maintain its deleveraging process started earlier this month, hike rates once in December this year, and probably comply with some additional rate hike during 2018 (the official Fed projection calls for 3 more rate hikes in 2018). The Fed´s recent capitulation regarding long term rates has been the most important newness, finally sharing part of the market skepticism regarding much higher terminal rates absent a notable change in general economic conditions, and investment and productivity in particular. In a similar vein, the ECB announced the past Thursday that its quantitative easing program could come to a halt by the end of next year, likely lifting implicit restrictions to introduce its first rate hike during 2019. There has also been some progress in the fiscal front in the US. The US Senate recent approval of a 2018 budget envisaging USD1.5trn deficit increase in the next ten years (approximately 0.75% of GDP by the end of the decade) beckoned a concrete possibility for the long awaited tax reform to pass Congress barrier. The Senate decision will permit the use of the reconciliation process, allowing the official party to progress with just simple majority, although constrained to the new budget parameters. Nevertheless, Congress discussion is likely to remain challenging, as the expected removal of itemized deductions would impact more negatively the large States, like California and New York, both contributing with a critical number of Republican legislators. This notwithstanding, the new fiscal slippage would simply double the widening of the fiscal deficit projected under status-quo, at least as calculated by the Congress Budget Office, all together representing something like 10% of GDP in new public debt during the next decade.
It is fair to assume that a temporary fiscal expansion of the magnitude under discussion is unlikely to modify the level of long term real rates in the US at least. But its impact on inflation and the The Bayesian Staker Argentina: close to an upgrade, yet far from IG 2 debt market might not be negligible. Nevertheless, such a fiscal impulse together with significant deregulation could indeed stimulate a strong investment momentum and accelerate productivity generation, which in turn could certainly modify the long term equilibrium, sustaining stronger growth and real rates consistently higher too. These two possible scenarios, however, could have very different implications for asset markets. The first scenario might be simply characterized by an increase in the risk premium pushing nominal rates higher, affecting negatively risk assets. On the contrary, the second scenario should be positive for equities and credit markets. US President Trump is about to announce a new leadership at the Fed, further complicating the financial perspective in the coming months. The set of principal candidates includes names with very different profiles, some implying a radical change in the policy path. The most probable candidate is Jerome Powell, member of the Fed Board, and a banker without the formal credentials of the current chairman, Janet Yellen, but with a similar policy type and practical experience in monetary policy and regulatory matters. On the contrary, former Undersecretary and Stanford University professor John Taylor represents the major risk of a substantial policy overturn. Taylor, author of the well-known monetary policy rule, embodies the preference for rules against discretion, and theory versus praxis, or basically the opposite nature of the flexible and pragmatic Fed seen in the last few years. The naming of the two, Powell and Taylor, as chairman and vice-chairman respectively, should not be ruled out, with President Trump trying to maintain some balance, but seniority signaling the leading policy preference. Based on the previous discussion, and agnostic about the Trump administration’s ability to push for a strong reflationary process, we remain concerned about asset valuation. We continue to believe that the US economy is recovering but capped by a slow potential growth pace. Likewise, we acknowledge the Fed´s message regarding more tightening ahead, although with an uncertain endgame; even without incorporating the risk of a changing leadership. The pending question is whether these counterbalancing forces could maintain the dominant optimism without demanding higher real rates, or else push towards higher rates consistent with greater economic dynamism or simply a larger risk premium. Notwithstanding the consideration above, we do respect market forces, able to maintain for quite some time even unsustainable returns, constantly testing our conviction. In particular, persistent low inflation in the US is likely to keep risk appetite stout and long term rates bounded. Whether demographic forces are strong enough to keep hampered the labor market-wage-price inflation circuit is up for discussion. But it is reasonable to expect this link to regain some sensitivity as labor markets keep tightening, absent a productivity shock or a sizeable investment push. Therefore, buoyant asset prices despite ongoing uncertainties seem to advocate for a prudent investment approach, searching for diversification and not underestimating protection. This continues to be the time to hold no strong conviction and an active and nimble strategy for risk taking. With the discussion above as a backdrop, Argentina seems to offer a singular prospect nowadays, where a strong idiosyncratic component meaningfully buffers the prevailing global uncertainty. Last Sunday´s electoral result re-confirmed popular support to the ongoing normalization process, reinforcing a constructive outlook for argentine assets. The elections have not only increased the government representation in Congress, but also anticipated a 2019 election without a clear opposition contender. The latter suggests a unique opportunity, insinuating policy stability for at least another 6 years. Likewise, the longer horizon to mature the ongoing process brings higher credibility to the gradual strategy being implemented by the government. For these reasons, while we wait for the government to present a set of structural reforms to Congress in the coming days, we hereby attempt to analyze what Argentina must accomplish in order to achieve sustainability, or at least to start comparing with the regional countries that have reached investment grade status. The preliminary conclusion is that a meaningful increase in investment and saving rates seems a necessary condition for sustainability, while history tells such processes take few years at best. Nonetheless, Argentina has just started to converge, and it is very likely that rating agencies reward recent improvements with the first rating upgrade shortly.