How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

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Macro Letter – No 26 – 19-12-2014

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

  • Oil prices have fallen by more than 40% in H2 2014
  • Inflation expectations will be lowered further
  • US Growth should be higher longer-term
  • Near-term, contagion from the “energy bust” is under estimated by the market

 

With the recent collapse in the price of crude oil it seems appropriate to review the forecasts for inflation and growth in the US. Earlier this week, during an interview with CNBC, Bill Gross – ex-CIO of PIMCO – suggested that US growth would be around 2% going forward rather than the 3% to 4% seen in the recent past. The Atlanta Fed – Now GDP forecast for Q4 2014 was revised up to +2.2% from +2.1% on 11th December. This is higher than the Conference Board – Q4 GDP forecast of 2.0% from 10th December, here is their commentary:-

The U.S. growth momentum may pause in the fourth quarter, due to some special circumstances. The outlook for early 2015 shows some upside beyond the 2.5 percent pace. And this is despite continued slow economic growth around the world and a rise in the value of the dollar. The biggest disappointment right now is business spending on equipment which is slowing from an average pace of 11 percent over the past two quarters. But if final demand picks up as expected, business investment might also gain some momentum. One key driver of demand is continued improvement in the labor market. Job growth has been solid for the past year and the signal from the latest reading on The Conference Board Employment Trends Index™ (ETI) is that it will continue at least over the very near term. In fact, continued employment gains are likely to lead to better gains in wages in the first half of 2015. Job and income growth may provide some moderately positive momentum for the housing market. Low gasoline prices will also further support household spending. Finally, very low interest rates, at both the short and long end of the yield spectrum help consumers and businesses. The strengthening of domestic growth is intensifying pressures to increase the base interest rate, but speed and trajectory remain important questions.

There is a brief mention of the fall in gasoline prices and hopes for increased domestic demand driven by a better quality of jobs. Thus far official expectations have failed to shift significantly in response to the fall in oil. If the price remains depressed I expect these forecasts to change. The geographic make-up of US growth is quite skewed. The map below shows the breakdown of GDP growth by state in 2013:-

US GDP by State 2013

Source: Bureau of Economic Analysis

The predominant feature of many high growth states is strength of their energy sector. One state which has been a major engine of US employment growth in absolute terms, since the Great Recession, is Texas. In 2013 Texas jobs growth slowed from 3.3% to 2.5%. In percentage terms, it slipped into third place behind the stellar growth seen in North Dakota and Florida. Florida is an interesting indication of the process by which the drivers of growth are gradually switching away from the energy related impetus seen over the past few years. This article from the Dallas Fed – Texas to Remain a Top State for Job Growth in 2014 looks more closely at some nascent growth trends:-

Oil- and gas-producing states—leaders in the early years of the U.S. recovery—no longer predominated. This reflects the energy sector’s slowing expansion, although two states with the strongest shale activity, Texas and North Dakota, remained near the top. Meanwhile, several Sunbelt states hit hard by the housing crisis—Florida, Georgia and Arizona, for instance—are beginning to bounce back. In these states, employment remains significantly below the prerecession peak; in Texas, it is significantly above.

Texas is vulnerable, as are other energy rich US states, due to the weakness in the price of oil, however, Texas is also reliant on trade with Mexico for more than half of its exports. The down-turn in Mexican growth due to the weaker oil price, is an additional headwind for the “lone star” state.

You might expect this to be cause for some relief on the part of Richard Fisher – President of the Dallas Fed, yet, writing in mid-October in the Dallas Fed – Economic Letter – he remained, consistently hawkish on the prospects for inflation:-

The point is not that wage growth has been worrisomely high (it hasn’t been) or that we’re in imminent danger of a wage-price spiral (we likely aren’t). Rather, there’s nothing in the behavior of wage inflation over the course of the recovery to suggest that the unemploy­ment rate has been sending misleading signals about our progress toward full employment. A secondary point—a cau­tion, really—is that when trying to draw inferences about labor-market slack from the behavior of wages, it’s important to recognize that wage inflation’s response to slack is both nonlinear and delayed.

…Do we keep the accelerator pedal to the floor right up to the point where we reach our destination? Or do we ease up as we near our goal? The answer depends on an assessment of the costs of possibly delaying achievement of our objectives versus the costs of overshoot­ing those objectives. Proponents of a patient approach to removing accom­modation emphasize the risk of having to backtrack on policy, should either real growth or inflation expectations falter. On the other hand, Fed policymakers successfully “tapped the brakes” in the middle of three of our longest economic expansions (in the 1960s, 1980s and 1990s), slowing—but not ending—the unemployment rate’s decline. By com­parison, there are no instances where the Fed has successfully eased the unem­ployment rate upward after having first overshot full employment: When the economy goes into reverse, it has a pro­nounced tendency to lurch backward all the way into recession.

The Federal Reserve Bank of San Francisco – The Risks to the Inflation Outlook – November 17th – has a rather different view of the risks of inflation:-

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

The chart below shows the wide range of PCE forecasts, interestingly the IMF WEO forecast is 1.8% for 2015:-

PCE Inflation projection - FRBSF

Source: FRBSF

The author goes on to conclude:-

Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future.

The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model.

It would appear that even before the recent decline in the price of oil the Fed was not expecting a significant increase in inflationary pressure. What should they do in the current environment where the US$ continues to appreciate against its major trading partners and if the price of oil remains at or below $60/barrel? These are one-off external price shocks which are a boon to the consumer, however they make exports uncompetitive and undermine the longer term attractiveness of investment in the domestic energy sector. IHS Global Insight produced the following forecast for the Wall Street Journal earlier this month:-

US_Pricing_Power_and_Oil_-_IHS_Global_Insight_WSJ

Source: IHS Global Insight and WSJ

My concerns are two-fold; firstly, what if the oil price rebounds? The latest IEA report noted that global demand for oil increased 0.75% between 2013 and 2014 and is running 3.6% above the average level of the last five years (2009 – 2013) this leaves additional supply as the main culprit of the oil price decline. With oil at $60/barrel it is becoming uneconomic to extract oil from many of the new concessions – over-supply may swiftly be reversed. Secondly, the unbridled boon to the wider economy of a lower oil price is likely to be deferred by the process of rebalancing the economy away from an excessive reliance on the energy sector. In an excellent paper in their Power and Growth Initiative series, the Manhattan Institute – Where The Jobs Are: Small Businesses Unleash Energy Employment Boom– February 2014 conclude:-

According to a recent poll from the Washington Post Miller Center, American workers’ anxiety over jobs is at a four-decade record high. Meanwhile, the hydrocarbon sector’s contributions to America’s job picture and the role of its small businesses in keeping the nation out of a long recession are not widely recognized. Another recent survey found that only 16 percent of people know that an oil & gas boom has increased U.S. energy production—collaterally creating jobs both directly and indirectly.

America’s future, of course, is not exclusively associated with hydrocarbons or energy in general. Over the long term, innovation and new technologies across all sectors of the economy will revitalize the nation and create a new cycle of job growth, almost certainly in unexpected ways. But the depth and magnitude of job destruction from the Great Recession means that creating jobs in the near-term is vital. As former chair of the Council of Economic Advisers and Harvard professor Martin Feldstein recently wrote: “The United States certainly needs a new strategy to increase economic growth and employment. The U.S. growth rate has fallen to less than 2%, and total employment is a smaller share of the population now than it was five years ago.”

In a new report evaluating five “game changers” for growth, the McKinsey Global Institute concluded that the hydrocarbon sector has the greatest potential for increasing the U.S. GDP and adding jobs—with an impact twice as great as big data by 2020. McKinsey forecasts that the expanding shale production can add nearly $700 billion to the GDP and almost 2 million jobs over the next six years.

Other analysts looking out over 15 years see 3–4 million more jobs that could come from accelerating domestic hydrocarbon energy production. Even these forecasts underestimate what would be possible in a political environment that embraced growth-centric policies.

In November 2013, President Obama delivered a speech in Ohio on jobs and the benefits from greater domestic energy production. The president highlighted the role of improved energy efficiency and alternative fuels. But as the facts show, no part of the U.S. economy has had as dramatic an impact on short-term job creation as the small businesses at the core of the American oil & gas boom. And much more can be done.

A recent report by Deutsche Bank - Sinking Oil May Push Energy Sector to the Brink – estimated that of $2.8trln annual US private investment, $1.6trln is spent on equipment and software and $700bln on non-residential construction. Of the equipment and software sector, 25-30% is investment in industrial equipment for energy, utilities and agriculture. Non-residential construction is 30% energy related. With oil below $60/barrel much of that private investment will be postponed or cancelled. That could amount to a reduction in private investment of $500bln in 2015. This process is already underway; according to Reuters, new oil permits plummeted 40% in November.

Since 2007 shale producing states have added 1.36mln jobs whilst the non-shale states have shed 424,000 jobs. The table below shows the scale of employment within the energy sector for key states:-

State Hydro-carbon jobs 000’s
Texas 1800
California 780
Oklahoma 350
Louisiana 340
Pennsylvania 330
New York 300
Illinois 290
Florida 280
Ohio 260
Colorado 210
Virginia 190
Michigan 180
Kentucky 170
West Virginia 170
Georgia 160
New Jersey 150

Source: Manhattan Institute

This chart from Zero Hedge shows the evolution of the US jobs market in shale vs non-shale terms since 2008:-

Jobs in shale ve non-shale - Zero Hedge BLS

Source: Zero Hedge and BLS

2015 will see a correction in this trend, not just because investment stalls, but also as a result of defaults in the high-yield bond market.

Junk Bonds and Bank Loans

It is estimated that around 17% of the High-yield bond market in the US is energy related.  The chart below is from Zero Hedge, it shows the evolution of high yield bonds over the last four years. The OAS is the option adjusted spread between High Yield Energy bonds and US Treasury bonds:-

Energy_High_Yield_-_zero_hedge

Source: Zero Hedge and Bloomberg

Deutsche Bank strategists Oleg Melentyev and Daniel Sorid estimate that, with oil at $60/barrel, the default rate on B and CCC rated bonds could be as high as 30%. Whilst this is bad news for investors it is also bad news for banks which have thrived on the securitisation of these bonds. The yield expansion seen in the chart above suggests there is a liquidity short-fall at work here – perhaps the Fed will intervene.

As a result of the growth in the US energy sector, banks have become more actively involved in the energy markets. Here the scale of their derivative exposure may become a systemic risk to the financial sector. When oil was trading at its recent highs back in July the total open speculative futures contracts stood at 4mln: that is four times the number seen back in 2010. The banks will also be exposed to the derivatives market as a result of the loans they have made to commodity trading companies – some of whom may struggle to meet margin calls. Bad loan provisions will reduce the credit available to the rest of the economy. This will dampen growth prospects even as lower energy prices help the consumer.

The US Treasury Bond yield curve has also “twisted” over the past month, with maturities of five years and beyond falling but shorter maturities moving slightly higher:-

Maturity 17-Nov 17-Dec Change
2yr 0.504 0.565 0.061
3yr 0.952 1.005 0.053
5yr 1.607 1.534 -0.073
7yr 2.019 1.863 -0.156
10yr 2.317 2.078 -0.239

Source: Investing.com

On the 15th October, at the depths of the stock market correction, 2yr Notes yielded 0.308% whilst 10yr Notes yielded 2.07%. Since then the 2yr/10yr curve has flattened by 25bp. I believe this price move, in the short end of the market, is being driven by expectations that the Fed will move to “normalise” policy rates in the next 12 months. Governor Yellen’s change of emphasis in this weeks FOMC statement – from “considerable time” to “patient” – has been perceived by market pundits as evidence of more imminent rate increases. An additional factor driving short term interest rates higher is the tightening of credit conditions connected to the falling oil price.

Longer maturity Treasuries, meanwhile, are witnessing a slight “flight to quality” as fixed income portfolio managers switch out of High Yield into US government securities even at slightly negative real yields. According to an article in the Financial Times – Fall in oil price threatens high-yield bonds – 7th December $40bln was withdrawn from US High Yield mutual fund market between May and October. I expect this process to gather pace and breed contagion with other markets where the “carry trade” has been bolstered by leveraged investment flows.

Where next for stocks?

The New York Fed – Business Leaders Survey showed that, despite easing energy costs and benign inflation, business leaders expectations are not particularly robust:-

The Federal Reserve Bank of New York’s December 2014 Business Leaders Survey indicates that activity in the region’s service sector expanded modestly. The survey’s headline business activity index fell ten points to 7.8, indicating a slower pace of growth than in November. The business climate index inched down two points to -7.8, suggesting that on balance, respondents continued to view the business climate as worse than normal. The employment index climbed three points to 16.3, pointing to solid gains in employment, while the wages index drifted down five points to 25.6. After declining sharply last month, the prices paid index climbed four points to 42.2, indicating a slight pickup in the pace of input price increases, while the prices received index fell eight points to its lowest level in two years, at 5.4, pointing to a slowing of selling price increases. The current capital spending index declined ten points to 10.1, while the index for future capital spending rose six points to 25.0. Indexes for the six-month outlook for business activity and employment fell noticeably from last month, suggesting that firms were less optimistic about future conditions.

Set against this rather negative report from the Fed, is this upbeat assessment of the longer-term prospects for US manufacturing from the Peterson Institute – The US Manufacturing Base:

Four Signs of Strength it makes a compelling case for an industrial renaissance in the US. The four signs are:-

  1. US manufacturing output growth
  2. US manufacturing competitive performance relative to other sectors of the US economy
  3. US manufacturing productivity growth relative to other countries
  4. New evidence on outward expansion by US multinational corporations and economic activity by those same firms at home

Another factor supporting the stock market over the last few years has been the steady increase in dividends and share buybacks. According to Birinyi Associates, US corporations bought back $338.3bln of stock in H1 2014 – the most in any six month period since 2007. Here are some of the bigger names; although they account for less than half the H1 total:-

Name Ticker Buyback $blns
Apple APPL 32.9
IBM IBM 19.5
Exxon Mobil XOM 13.2
Pfizer PFE 10.9
Cisco CSCO 9.9
Oracle ORCL 9.8
Home Depot HD 7.6
Wells Fargo WFC 7.5
Microsoft MSFT 7.3
Qualcomm QCOM 6.7
Walt Disney DIS 6.5
Goldman Sachs GS 6.4

Source: Barclays and Wall Street Journal

Share buybacks are running at around twice their long run average and dividends have increased by 12% in the past year. On average, companies spend around 85% of their profits on dividends and share repurchases. This October 6th article from Bloomberg – S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts goes into greater detail, but this particular section caught my eye:-

CEOs have increased the proportion of cash flow allocated to stock buybacks to more than 30 percent, almost double where it was in 2002, data from Barclays show. During the same period, the portion used for capital spending has fallen to about 40 percent from more than 50 percent.

The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

I am cynical about share buybacks. If they are running at twice the average pace this suggests, firstly, that the “C suite” are more interested in their share options than their shareholders and, secondly, that they are still uncomfortable making capital expenditure decisions due to an utter lack of imagination and/or uncertainty about the political and economic outlook. Either way, this behaviour is not a positive long-term phenomenon. I hope it is mainly a response to the unorthodox policies of the Fed: and that there will be a resurgence in investment spending once interest rates normalise. This might also arrive sooner than expected due to a collapse in inflation rather than a rise in official rates.

The US economy will benefit from lower energy prices in the long term but the rebalancing away from the energy sector is likely to take time, during which the stock market will have difficulty moving higher. For the first time since 2008, the risks are on the downside as we head into 2015. Sector rotation is certainly going to feature prominently next year.

Last weeks National Association of Manufacturers – Monday Economic Report – 8th December 2014 shows the optimism of the manufacturing sector:-

Business leaders continue to reflect optimism about the coming months, with 91.2 percent of survey respondents saying they are either somewhat or very positive about their own company’s outlook. Moreover, manufacturers predict growth of 4.5 percent in sales and 2.1 percent in employment over the next 12 months, with both experiencing the strongest pace in at least two years. 

These findings were largely consistent with other indicators released last week. Most notably, the U.S. economy added 321,000 nonfarm payroll employees on net in November. This was well above the consensus estimate, and it was the fastest monthly pace since April 2011. Hiring in the manufacturing sector was also strong, with 28,000 new workers during the month. Since January, manufacturers have hired almost 15,000 workers on average each month, or 740,000 total since the end of 2009. In other news, manufacturing construction spending was also up sharply, increasing 3.4 percent in October and a whopping 23.0 percent year-over-year. 

These reports suggest that accelerating growth in demand and output is beginning to translate into healthier employment and construction figures, with businesses stepping up investments, perhaps as a sign of confidence. This should bode well for manufacturing employment as we move into 2015. In particular, the Institute for Supply Management’s (ISM) manufacturing Purchasing Managers’ Index (PMI) remains strong, despite edging marginally lower in November. For instance, the production index has now been 60 or higher, which indicates robust expansionary levels, for seven straight months. Similarly, the new orders index has been 60 or higher for five consecutive months, and the export measure also noted some improvements for the month. 

Speaking of exports, the U.S. trade deficit changed little in October, edging marginally lower from the month before. Still, growth in goods exports was somewhat better than the headline figure suggested, with the value of petroleum exports declining on lower crude oil costs. The good news is that year-to-date manufactured goods exports have increased to each of our top-five trading partners so far this year.

They go on to temper this rosy scenario, which is why I anticipate the interruption to the smooth course of stock market returns during the next year :-

…growth in manufactured goods exports remains sluggish through the first 11 months of 2014, up just 1.1 percent relative to the same time frame in 2013. Not surprisingly, challenges abroad continue to dampen our ability to grow international sales.  New factory orders have declined for the third straight month, a disappointing figure particularly given the strength seen in other measures. In addition, the NAM/IndustryWeek survey noted that the expected pace of exports decelerated once again, mirroring the slow growth in manufactured goods exports noted above.

This week saw the release of revised Industrial Production and Capacity Utilisation data – this was the commentary from the Federal Reserve:-

Industrial production increased 1.3 percent in November after edging up in October; output is now reported to have risen at a faster pace over the period from June through October than previously published. In November, manufacturing output increased 1.1 percent, with widespread gains among industries. The rise in factory output was well above its average monthly pace of 0.3 percent over the previous five months and was its largest gain since February. In November, the output of utilities jumped 5.1 percent, as weather that was colder than usual for the month boosted demand for heating. The index for mining decreased 0.1 percent. At 106.7 percent of its 2007 average, total industrial production in November was 5.2 percent above its year-earlier level. Capacity utilization for the industrial sector increased 0.8 percentage point in November to 80.1 percent, a rate equal to its long-run (1972–2013) average.

This paints a positive picture but, with Capacity Utilisation only returning to its long-run trend rate, I remain concerned that the weakness of the energy sector will undermine the, still nascent, recovery in the broader economy in the near-term.

Conclusion and investment opportunities

The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.

Where the US stock market leads it is difficult for the rest of the world not to follow. The table below from March 2008 shows the high degree of monthly correlation of a range of stock indices to the Nasdaq Composite. In a QE determined world, I would expect these correlations to have risen over the last six years: -

Ticker Index Country 10 years 5 years 1 year
^IXIC Nasdaq Composite USA 1 1 1
^GSPC S&P 500 USA 0.8 0.86 0.83
^DWC Wilshire 5000 USA N/A 0.9 0.85
^AORD All Ords Australia 0.64 0.6 0.93
^BVSP Bovespa Brazil 0.62 0.53 0.83
^GSPTSE TSX Canada N/A 0.66 0.83
399300.SZ Shanghai Composite China N/A N/A 0.68
^GDAXI DAX Germany N/A 0.73 0.83
^HSI Hang Seng Hong Kong 0.6 0.54 0.79
^BSESN BSE Sensex India 0.44 0.5 0.75
^N225 Nikkei 225 Japan 0.51 0.49 0.87
^MXX IPC Mexico 0.67 0.56 0.33
RTS.RS RTS Russia N/A N/A 0.53
^KS11 Kospi South Korea 0.57 0.59 0.8
^FTSE FTSE100 UK N/A 0.57 0.87

Source: Timingcube.com

A decline in the S&P 500 will impact other developed markets, especially those reliant on the US for exports. 2015 will be a transitional year if oil prices remain depressed at current levels, yet the longer term benefit of lower energy prices will feed through to a recovery in 2016/2017. A crisis could ensue next year, but, with China, Japan and the EU continuing to provide quantitative and qualitative support, I do not believe the world’s “saviour” central banks are “pushing on a string” just yet. Inflation is likely to fall, global growth will be higher, but US stocks will, at best, mark time in 2015.

In bond markets, credit will generally be re-priced to reflect the increased risk of corporate defaults due to mal-investment in the energy sector. Carry trades will be unwound, favouring government bonds to some degree.

Recently heightened expectations of higher short term interest rates will recede. This should be supportive for the Real-Estate market. With a presidential election due in 2016 both the Democrats and the Republicans will be concocting policies to support house prices, jobs, average wages and the value of 401k’s. After three years of deliberation, the introduction of watered down QRM – Qualified Residential Mortgage – rules in October suggests this process is already in train.

Many investors have been waiting to enter the stock market, fearing that the end of QE would herald a substantial correction. 2015 might provide the opportunity but by 2016 I believe this window will have closed.

Will the Nikkei breakout or fail and follow the Yen lower?

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Macro Letter – No 25 – 05-12-2014

Will the Nikkei breakout or fail and follow the Yen lower?

  • The Japanese Yen has declined further against its main trading partners
  • The Nikkei Index has trended higher on hopes of structural reform and QQE
  • JGBs remain supported by BoJ buying

The Nikkei 225 index is making new highs for the year as the JPY trends lower following a further round of aggressive quantitative and qualitative easing (QQE) from the Bank of Japan (BoJ). The Japanese Effective Exchange Rate has fallen further which should help to improve Japan’s export competitiveness whilst import price inflation should help the BoJ achieve its inflation target.

Net Assets

For several decades Japan has been a major international investor, buying US Treasury bonds, German bunds, UK Gilts as well as a plethora of other securities around the globe.  Japan has also been a source of substantial direct investment, especially throughout the Asian region.  May 2014 saw the release of a research paper by the BoJ -Japan’s International Investment Position at Year-End 2013 – the authors observed:-

Direct investment (assets: 117.7 trillion yen; liabilities: 18.0 trillion yen)

Outward direct investment (assets) increased by 27.9 trillion yen or 31.1 percent. Inward direct investment (liabilities) remained more or less unchanged.

Portfolio investment (assets: 359.2 trillion yen; liabilities: 251.9 trillion yen)

Outward portfolio investment (assets) increased by 54.1 trillion yen or 17.7 percent. Inward portfolio investment (liabilities) increased by 71.4 trillion yen or 39.5 percent.

Financial derivatives (assets: 8.2 trillion yen; liabilities: 8.7 trillion yen)

Financial derivatives assets increased by 3.6 trillion yen or 77.5 percent. Financial derivatives liabilities increased by 3.3 trillion yen or 62.5 percent.

Other investment (assets: 178.4 trillion yen; liabilities: 193.6 trillion yen)

Other investment assets increased by 25.5 trillion yen or 16.7 percent. Other investment liabilities increased by 31.6 trillion yen or 19.5 percent.

Reserve assets (assets: 133.5 trillion yen)

Reserve assets increased by 24.1 trillion yen or 22.0 percent.

The chart below shows how Japan continues to accumulate foreign assets despite their balance of payments moving from surplus to deficit:-

Japanese_assets_vs_liabilities_-_IMF_-_BoJ

Source:BoJ

From the mid 1980’s until the aftermath of the bursting of the 1990’s technology bubble, international investment was one of the principle methods by which Japanese firms attempted to remain competitive in the international market whilst the JPY appreciated against its main trading partners.

The Japanese Effective Exchange Rate chart below shows how the JPY has weakened since the initial flight to safety after the bursting of the “Tech Bubble” and again after the flight to quality during the “Great Recession”. This currency weakness was accelerated by the introduction of Prime Minister Abe’s “Three Arrows” economic policy:-

JPY Real Effective Exchange Rate 1970- 2014 BIS

Source: BIS

We are now back to levels last seen before the Plaza Accord of 1985 – after which the JPYUSD rate rose from 250 to 130.

Whilst Japan’s foreign investments returns should remain positive – especially due to the falling value of the JPY – Japanese saving rates continue to decline, just as negative demographic forces are pushing at the door. The stock-market bubble, which burst in 1990, was most excessive in the Real-Estate and Finance sectors. With housing demand expected to decline, for demographic reasons, and financial firms now representing less than 4% of the Nikkei 225 these sectors of the domestic economy are likely to remain moribund. The chart below shows the evolution of Japanese house prices from 1980 to 2008:-

Japanese Home Prices - 1980 - 2008 Market Oracle

Source: Market Oracle

After the slight up-tick between 2005 and 2008 house prices have resumed their downward course despite increasingly lower interest rates.

What Third Arrow?

In order to get the Japanese economy back on track, fiscal stimulus has been the government solution since 1999, if not before.  Shinzo Abe won a second term as Prime Minister with a set of economic policies known as “The Three Arrows” – a cocktail of QQE from the BoJ, JPY devaluation and structural reform. The Third Arrow of “Abenomics” is structural reform. This type of reform is always politically difficult. With this in mind Abe has called an election for the 14th December – perhaps prompted by the release of Q3 GDP data (-1.6%) confirming that, after two consecutive negative numbers, Japan is officially back in recession. He hopes to win a third term and fulfil his mandate to make the sweeping changes he believes are required to turn Japan around.

Energy reform is high on Abe’s agenda. Reopening nuclear reactors is a short term fix but he plans to make the industry more dynamic and spur innovation. In a recent interview with CFR – A Conversation With Shinzo Abethe Prime Minister elaborated on his plan:-

…On the other hand, we wish to be the front-runner in the energy revolution, ahead of others in the world. I would like to implement the hydrogen-based society in Japan.

The development of fuel cells started something like 30 years ago as a national project. Last year, I have reformed the regulations that inhibited the commercialization of the fuel cell vehicle. And at last, a first ever in the world, we have implemented the commercialization of hydrogen station and fuel cell vehicles.

Early next year, in the store windows of automotive dealers, you’ll be able to see the line up of fuel cell cars.

In the power sector, we shall put an end to the local monopoly of power, which continued for 60 years after the war. We will be creating a dynamic and free energy market where innovation blossoms.

He then went on to discuss his ideas for reform of corporate governance:-

Companies will have to change as well. I will create an environment where you will find it easy to invest in Japanese companies. Corporate governance is the top agenda of my reform list. This summer, I have revised the company law on the question of establishment of outside directors. I have introduced the rule called “comply or explain.”

Amongst listed companies in the last one year, the number of companies which opted to have outside directors increased by 12 percent. Now, 74 percent.

Tax reform is another aspect of Abe’s package. In the past year, corporate tax rates have been cut by 2.4%. Another term in office might give Abe time to make a difference, but his ill-conceived decision to increase the sales tax earlier this year had a disastrous impact on GDP – Q2 GDP was -7.1%. A further increase from 5% to 8% was scheduled for October 2015 but has now been postponed until April 2017 – as a palliative to the “deficit hawks” the increase will be from 5% to 10%. Whilst this was a relief for the stock market it led to a further weakening of the JPY. Last week, Moody’s downgraded Japanese debt due to their concerns about the government’s ability to control the size of its deficit.

The Association of Japanese Institutes of Strategic Studies – Tax System Reform Compatible with Fiscal Soundness – makes some interesting suggestions in response to the looming problem of lower tax receipts: -

Given Japan’s challenging fiscal circumstances, broadening the tax base while lowering corporate tax rates seems a realistic compromise to head off a decline in corporate tax revenues. However, simply lowering corporate tax rates on the condition that corporate tax revenues be maintained is of limited effectiveness in stimulating the economy. If the emphasis is to be placed on the benefits of this approach for economic revitalization, then corporate tax rates will need to be drastically lowered and the rates for consumption tax and other taxes raised. Steps will also need to be taken to reform the tax system overall rather than just to secure revenues by increasing consumption taxes. Although the weight of the tax burden will inevitably shift toward consumption tax, the tax base must also be expanded through income tax reform to secure tax revenues. An obvious choice is reconsidering the spousal deduction that gives tax benefits to full-time housewives so that the tax system can be made neutral vis-a-vis the social advancement of women. A major premise in tax increases is ensuring efficiency and fairness in fiscal matters. If the public can be persuaded that tax money is being put to good use, high consumption tax rates such as those in Scandinavia will enjoy public support. A taxpayer number system should be promptly introduced and an efficient and fair tax collection environment put into place.

Japan’s government debt to GPD is currently the highest among developed nations at 227%, however, according to Forbes – Forget Debt As A Percent Of GDP, It’s Really Much Worse – as a percentage of tax revenue debt  is running around 900%, far ahead of any other developed nation.

Labour market reform is high on Abe’s wish list, in particular, the roll-out of incentives to encourage Japanese women to enter the labour market. This would go a long way towards offsetting the demographic impact of an ageing population. It has the added attraction of not relying on immigration; an perennial issue for Japan for cultural and linguistic reasons:-

Japan - Female participation in Labour market OECD

Source: OECD Bruegal

Agricultural reform is also an agenda item. It could significantly improve Japan’s competitiveness and forms a substantial part of the Trans-Pacific Partnership (TPP) negotiations which have been taking place between Japan, USA and 11 other Asian countries during the past two years. Sadly the free-trade agreement has stalled, principally, due to Japanese reluctance to embrace agricultural reform. The Peterson Institute – Will Japan Bet the Farm on Agricultural Protectionism? – takes up the story: -

What is at stake? The gains for Japan from entry into the TPP are substantial, more than what nearly any other member of the agreement would reap. Peter A. Petri, visiting fellow at the Peterson Institute for International Economics, estimates that the agreement would add 2 percent to Japan’s GDP by 2025. More broadly, the TPP represents an opportunity for Japan to reinvigorate its unproductive domestic industries (agriculture included) by permitting greater foreign competition. It would also enable Japan to reassert itself as a leader and a model in the Asia Pacific. Facing an uncertain future with China gaining influence in the region, Japan needs to remain strong and dynamic at home, economically enabling it to leverage its technical and market-size advantages to secure its position in the region. These gains are now in jeopardy largely because of Japan’s agricultural protectionism.

How protectionist is Japan? To be fair, Japan has made progress on lowering support for agriculture since the 1980s. The United States—the primary objector to the protection afforded to Japan’s agricultural sector—also still provides support for its own agriculture sector. However, the magnitudes are starkly different. For every dollar of agriculture production, Japan provides 56 cents of subsidies to farmers. The United States and European Union provide just 7 cents and 20 cents for every dollar, respectively. Additionally, Japan spends nearly 1.25 percent of its GDP on agriculture subsidies (which includes support for producers, as well as consumers). The United States and European Union spend 1 percent and 0.7 percent, respectively. There are also many internal barriers, such as restrictions on the sale and use of farm land and preferential tax structures for farmers, which discourage older generations from leaving or corporate farms from entering the farming sector in many areas.

The political importance of the rural vote may have caused Abe to backtrack on his timetable for reform. This is another example of how important the forthcoming election will be both for the Japanese economy and its stock market.

Kuroda and GPIF to the rescue (again)

On October 31st the BoJ announced an increase in its stimulus package from JPY60trln per month to JPY80trln. On the same day the Government Pension Investment Fund (GPIF) which, with $1.2 trln in assets, is the world’s largest, announced that it planned to reduce its holding of government bonds to 35% from the current 60%, this money will be reallocated equally between domestic and international equity markets. That’s $150bln waiting to be allocated to Japanese equities. The BoJ also announced an increase in their ETF purchase programme, but this pales into insignificance beside the GPIF action.

Writing back in January 2013, Adam Posen of the Peterson Institute – Japan should rethink its stimulus – gave four main reasons why Japan has been able to continue with its expansionary fiscal policy: -

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan’s banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan’s households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders of JGBs (less than 8 percent of the total) and the threat that the Bank of Japan (BoJ) could purchase unwanted bonds. Fourth, the share of taxation and government spending in total Japanese income was low.

Last month saw the release of a working paper from Peterson – Sustainability of Public Debt in the United States and Japanwhich contemplates where current policy in the US and Japan may lead, it concludes:-

The implication of these projections is that even for just a 10-year horizon, somewhat more effort will be required to keep the debt-to-GDP ratio from escalating in the United States, and much more will need to be done in Japan. Using the probability-weighted ratio of net debt to GDP (federal debt held by the public for the United States), holding the ratio flat at its 2013 level would require cutting the 2024 debt ratio by 8 percentage points of GDP for the United States and by 32 percentage points of GDP for Japan. In broad terms achieving this outcome would involve reducing the average primary deficit by about 0.75 percent of GDP from the baseline in the United States and by about 3 percent of GDP in Japan.

The Japanese economy is now entirely addicted to government fiscal stimulus, reducing the primary deficit by 3% and maintaining that discipline for a decade is unrealistic.

I’m indebted to Gavyn Davies of Fulcrum Asset Management for this chart which puts the BoJ current QQE policy in perspective: -

Total CB assets vs GDP - Fulcrum

Source: Fulcrum

Whither the Nikkei 225?

With the JPY continuing to fall in response to QQE and the other government policy decisions of the last two months, the Nikkei has rallied strongly; here is a 10 year chart:-

Nikkei 225 - 10yr - source Nikkei

Source: Nikkei

The long-term chart below, which ends just after the 2009 low, shows a rather different picture:-

nikkei-225 - 1970 - 2009 - The Big Picture - The Chart Store

Source: The Big Picture and The Chart Store

From a technical perspective, recent stock market strength has taken the Nikkei above long-term downtrend. Confirmation will be seen if the market can break above 18,300 – the level last reached in July 2007. A break above 22,750 – the June 1996 high – would suggest a new bull market was commencing. I am doubtful about the ability of the market to sustain this momentum without a recovery in the underlying economy – which I believe can only be achieved by way of government debt reduction. Without real reform this will be another false dawn.

The chart below shows the Real Effective Exchange Rate for a number of economies. The JPY on this basis still looks expensive however the impact of a falling JPY vs KRW or RMB will be felt in rising political tension and potentially a currency war:-

Real_Effective_exchange_rates_-_1980_-_2012_BIS_-_

Source: BIS

Japan can play the “devaluation game” for a while longer, after all, a number of its Asian trading partners devalued last year, but the long-run implications of a weaker JPY will be seen in protectionist policies which undermine the principles of free trade.

Conclusions and investment opportunities

JPYUSD

The Japanese currency will continue to weaken versus the US$. This chart from the St Louis Fed, which only goes up to 2012, shows how far the JPY has appreciated since the breakdown of the Bretton Woods agreement:-

usdjpy1971 - 2010 Federal Reserve

Source: Federal Reserve

I think, in the next two to three years,  JPYUSD 160 is to be expected and maybe even a return to JPYUSD 240.

JGBs

The BoJ currently owns around 24% of outstanding JGBs but this is growing by the month. Assuming government spending remains at its current level the BoJ will hold an additional 7% of outstanding supply by the end of next year. By 2018 they could own more than 50% of the market. In order to encourage longer-term investment – or, perhaps, merely in search of better yields – the BoJ has extended the duration of their purchases out to 40 year maturities. The latest BoJ data is here.

Central bank buying will support the JGB market as the GPIF switch their holdings into domestic and international stocks. . International ownership remains extremely low so adverse currency movements will have little impact on this decidedly domestic market. With 10 year yields around 0.45%, I see little long-term value in holding these bonds when the BoJ inflation target is at 2% – they are strictly for trading.

Nikkei 225

The Nikkei is heavily weighted towards Technology stocks (43%) and on this basis the market still appears relatively cheap, it also looks cheap on the basis of the P/E ratio, the chart below shows the P/E over the past five years:-

Nikkei 225 - PE - Source TSE

Source: TSE and vectorgrader.com

Here for comparison is the Price to Book ratio, this time over 10 years:-

Nikkei 225 Price to Book 10 yr

Source: TSE and vectorgrader.com

Neither metric indicates that the current valuation of the Nikkei is excessive, but, given the frail state of the economy, I suspect Japanese stocks are inherently vulnerable.

Over the next year the Nikkei will probably push higher, helped by buying from the GPIF and international investors, many of whom are still under-weight Japan. A break above 18,300 would suggest a move to test the April 2000 high at 20,833, but a break above the June 1996 high at 22,757 is required to confirm the beginning of a new bull market. In the current economic environment I think this will be difficult to achieve. There are trading opportunities but from a longer-term investment perspective I remain neutral.

Oil and Growth

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Macro Letter – No 24 – 21-11-2014

Oil and Growth

  • The oil price has fallen by 30% since the summer
  • Global inflation expectations are starting to be revised downwards accordingly
  • Global growth, led by energy importers will be revised higher

 

The Oil Price

Since the summer crude oil prices have fallen sharply from above US$105 to below US$75/barrel. This price move has led to discussion of lower demand stemming from a slow-down in global economic activity. Whilst I expect a benign influence on inflation I am not convinced that the price decline is due to a reduction in global demand. Here is a daily chart for Spot West Texas Intermediate crude oil (WTI) since November 2007:-

TWI Spot - November 2007 - November 2014

Source: Barchart.com

The precipitous decline in 2008 was driven by the global recession following the US sub-prime crisis. The liquidity fuelled recovery in the oil price and the world economy was engineered by the largest central banks. During the same period the US$ Index rose and then declined in a broadly inverse manner to Oil though the motivation for the vacillations in the value of the US currency is broader:-

US Dollar Index - November 2007 - November 2014

Source: Barchart.com

Aside from the steady strengthening of the US$ there are a number of factors which have conspired to drive oil prices lower. Firstly there has, and will continue to be, additional supply emanating from the US where improved energy technology has produced significant increase in production over the last five years –from 1.8bln barrels in 2008 to 2.3bln barrels in 2013. In May 2014 it hit a 25 year high of 8.4mln barrels and the Energy Information Administration (EIA) forecast 2015 production will hit the highest level since 1972. The economic impact of cheaper US energy underpins a manufacturing renaissance which is slowly gathering momentum across America.

The next factor is Saudi Arabian production which has not yet been reduced in response to lower prices. Perhaps this, in turn, is a reaction to the secular decline in oil demand from developed countries; though the announcement, last week, of an emissions reduction agreement by China and the USA may add to the downward pressure. Brookings – The U.S. and China’s Great Leap Forward opined thus: -

The world’s two largest emitters of carbon dioxide together pledged deep reductions – well in advance of the pressure they will face in the upcoming UN Climate Change negotiations that begin in Lima later this month, and which are scheduled to conclude a year from now in Paris.  They also did so at a level deeper than many had expected.  While both countries have already begun efforts to cut emissions, the timing of the announcement and the depth of the reductions went beyond what many diplomats, businesses and environmental groups anticipated.

… Internationally, both countries have a range of other issues to address – including working with the poorest nations which lack the resources to make similarly dramatic cuts, but who are deeply affected by a warmer, wetter world. Still, even with all those obstacles ahead, today’s agreement is the beginning of a great leap forward for climate protection.

Additional supply could swiftly come on stream from Libya. Further talks are scheduled between the rival Libyan factions in Khartoum, Sudan, on December 1st.  The chart below shows how swiftly Libyan production has declined:-

Libyan crude_oil_production EIA

Source: EIA

Also hanging over the market is the prospect of Iranian production increases as international sanctions are reduced. Between 2011 and 2013 Iranian oil exports declined from 3mln bpd to less than 1mln bpd. This year they have rebounded strongly, averaging more than 1mbpd. Iranian production has been running at around 3 mbpd but the National Iranian Oil Company expects an increase to 4.3 mbpd next year – though several commentators are doubtful of Iran’s ability to achieve this increase in output. For more detail on the Iranian situation this article – Al Monitor – Iran takes steps to reduce economic risk of falling oil prices may be of interest.

There are some demand factors which may also undermine prices. Chinese growth has been slowing but, more importantly, the Chinese administration has adopted a policy of re-balancing away from production towards domestic consumption. In theory this process should reduce China’s energy demand; off-set, to some degree, by increased export demand from other emerging market countries as they seek to supply China’s consumption needs. I believe lower energy prices will help Chinese exporters to increase margins or export volumes – or both.

The latest IEA Oil Market Report made these observations: -

Oil’s rout gained momentum in October and extended into November, with Brent at a four-year low below $80/bbl. A strong US dollar and rising US light tight oil output outweighed the impact of a Libyan supply disruption. ICE Brent was last trading at $78.50/bbl – down 30% from a June peak. NYMEX WTI was at $75.40/bbl.

Global oil supply inched up by 35 kb/d in October to 94.2 mb/d. Compared with one year ago, total supply was 2.7 mb/d higher as higher OPEC production added to non-OPEC supply growth of 1.8 mb/d. Non-OPEC production growth is forecast to ease to 1.3 mb/d for 2015 from this year’s 1.8 mb/d high.

OPEC output eased by 150 kb/d in October to 30.60 mb/d, remaining well above the group’s official 30 mb/d supply target for a sixth month running. The group’s oil ministers meet on 27 November against the backdrop of a 30% price decline since they last gathered in June.

Global oil demand estimates for 2014 and 2015 are unchanged since last month’sReport, at 92.4 mb/d and 93.6 mb/d, respectively. Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.

OECD industry oil stocks built counter-seasonally by 12.6 mb in September. Their deficit versus average levels, after ballooning earlier this year, fell to its narrowest since April 2013. Preliminary data show that despite a 4.2 mb draw, stocks swung into a surplus to average levels in October for the first time since March 2013.

Global refinery crude demand hit a seasonal low in October amid peak plant maintenance and seasonally weak product demand. The 4Q14 throughput estimate is largely unchanged since last month’s Report, at 77.5 mb/d, as robust Russian and Chinese throughputs offset a steeper-than-expected drop in US runs in October.

Set against these forces, driving the price of oil lower, is the geo-political tension between Russia and NATO, the ISIS insurgency in Iraq and the continued instability of the Middle East emanating from the civil war in Syria. It is difficult to estimate how far the oil price would decline if the civil unrest in Ukraine and Syria ended tomorrow, I suspect, another 20% to 25%% -during the Kuwait War in the month of October 1990 the price of WTI declined from $40 to $27/barrel even before the war was over:-

WTI Spot - July 1990 - March 1991

Source: Barchart.com

From a technical perspective the breakout from the 2011 range to the downside suggests support around $66, $62, $58, with a final capitulation target of $46. There are, however, reasons to be more optimistic about the prospects for oil, even near-term.

A factor, mentioned by the IEA, which may lead to a reduction in supply, is the outcome of the forthcoming OPEC meeting due to take place on 27th November. Qatar has already begun, reducing production from 800,000 bpd to 650,000bpd last month. At the end of November they will reduce production further to 500,000 bpd – in total a 40% cut. They are not the only countries to be reducing production. The tables below are taken from the OPEC Monthly Report November 2014 which included Secondary Sources: -

OPEC-Secondary-Sources  September 2014

Source: OPEC

Whilst oil prices may trend somewhat lower the term structure of the TWI futures market has recently returned from several years of backwardation to contango – Brent Crude has been in contango for some while. This suggests that lower prices are beginning to reduce US domestic over-supply as smaller US operators cease to be able to produce oil profitably. Below $65 the EIA forecast for 2015 will probably need to be revised lower. Prices are likely to be better underpinned at their current levels.

Another encouraging factor is US domestic demand from refiners. US Crack spreads – the price spread between crude oil and its products – has started to widen in recent weeks. Oil demand should increase in response to higher product margins. The cracking margins have risen most dramatically for Gasoline but Heating Oil margins have also improved and may catch up if predictions of an exceptionally cold winter in the Northern hemisphere prove to be correct. NOAA – Winter Outlook from last month is reasonably sanguine – warm in the West and Alaska, cold in South and Rockies – but substantial snowfall in Siberia (the largest in October since 1967) is cause for caution.

Global Growth

This brings me on to the impact of lower oil prices on global growth. Obviously the large crude oil exporting countries will suffer from reduced revenue but the importers of oil – and gas, since many gas contracts are referenced to the price of oil – should be beneficiaries.  This recent article from Brookings – Oil – A Question of Economics – reminds readers of some of the ubiquitous benefits to the global economy of lower energy prices: -

Virtually all businesses will benefit from lower transportation costs by expanding their profit margins or passing the benefit to consumers at lower prices. The lower income groups, who spend a higher proportion of their incomes on transport, will see their disposable incomes rise, benefiting retailers who serve their needs and thereby increasing demand in the economy. Food prices are also likely to fall, as food production, processing and sales distribution are energy intensive activities, thereby benefiting lower income groups further. Increased consumption will stimulate aggregate demand, creating investment opportunities and economic growth. Governments in the west may also have the opportunity to increase fuel taxes to cover the real cost of the negative externalities of carbon emissions, or raise revenue to improve public transportation systems. Furthermore, governments in the Middle East and Asia will reduce spending on their fuel subsidies and may take the opportunity to improve the workings of market forces, which the IMF and Western powers have been seeking for them to do.

The effect of lower oil prices is felt quite rapidly by consumers globally. Oil consumers, at the household level, receive an immediate boost to their real income. This “wind-fall” is then either spent or saved. An explanation of these effects can be found in this Gavyn Davies article in the Financial Times – Large global benefits from the 2014 oil shock (Some of you may need to subscribe to this “limited free service”). He uses IMF data to produce two very interesting charts: -

Oil and GDP - IMF Fulcrum

Source: IMF and Fulcrum

The fall in inflation will be of greater concern to the ECB than the other major central banks. The BoJ has already acted aggressively in response to the economic slowdown in Japan, the Abe government has deferred a scheduled tax increase and announced an early election. The Federal Reserve, having completed its tapering of QE, will be focussed on wage growth. As central bank to the world’s second largest and rising oil producer, the Fed will be concerned about the drag on growth from a slowdown in the energy and utility sectors; market expectations of interest rate increases will be deferred once again. If the ECB act aggressively to head off the chimera of deflation this may be enough to improve global confidence – I believe this makes the blue line prediction more likely. If WTI should plummet towards $60, the improvement in economic growth should be even greater.

As recently as last month the IMF – World Economic Outlook – forecast for Oil prices was $102.76 for 2014 and $99.36 for 2015. They continue to cling to their forecasts based on expectation of increased geo-political tensions. Given that their 2015 forecast is around 30% above current levels if they are mistaken and the oil price remains subdued their global growth forecast could be around 0.6% too low.

Last month The Economist – Cheaper Oil: Winners and Losers – took up the theme of lower oil prices:-

A 10% change in the oil price is associated with around a 0.2% change in global GDP, says Tom Helbling of the IMF. A price fall normally boosts GDP by shifting resources from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. If increased supply is the driving force, the effect is likely to be bigger—as in America, where shale gas drove prices down relative to Europe and, says the IMF, boosted manufactured exports by 6% compared with the rest of the world. But if it reflects weak demand, consumers may save the windfall.

The authors go on to discuss farmers as the main direct beneficiaries of cheaper oil. India especially but other economies with a large agricultural sector as well: -

Energy is the main input into fertilisers, and in many countries farmers use huge amounts of electricity to pump water from aquifers far below, or depleted rivers far away. A dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods, says John Baffes of the World Bank. Farmers benefit from cheaper oil. And since most of the world’s farmers are poor, cheaper oil is, on balance, good for poor countries.

Take India, home to about a third of the world’s population living on under $1.25 a day. Cheaper oil is a threefold boon. First, as in China, imports become cheaper relative to exports. Oil accounts for about a third of India’s imports, but its exports are diverse (everything from food to computing services), so they are not seeing across-the-board price declines. Second, cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment.

Third, cheaper oil cuts India’s budget deficit, now 4.5% of GDP, by reducing fuel and fertiliser subsidies. These are huge: along with food subsidies, the total is 2.5 trillion rupees ($41 billion) in the year ending March 2015—14% of public spending and 2.5% of GDP. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. As in China, cheaper oil should reduce the pain of cutting subsidies—and on October 19th Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

The price move has also prompted a response from the researchers at the Dallas Fed – Oil Prices Fall Despite Global Uncertaintywhilst their concern is broadly domestic they note that it is Non-OECD demand which is driving the increase in oil demand. The largest beneficiaries of lower oil prices will be oil importing emerging market countries: China, India and, to the extent that they are still considered an emerging economy, South Korea. Other candidates include Singapore, Taiwan, Poland, Greece, Indonesia, South Africa, Brazil and Turkey.

Conclusion and Investment Opportunities

Foreign Exchange

The fall in oil prices has been mirrored, inversely, by the rise of the US$. This trend is already well established but I expect it to continue. This is not so much a reflection of the strength of the US economy as the moribund nature of growth expectations in the EU and Japan.

Government Bonds

Lower inflation expectations, combined with central bank inflation targets, should ensure a delay to interest rate tightening even in response to a resurgence of wage growth. Bond prices will continue to be underpinned. At any sign of a slowing of economic growth, yield curves will flatten further. Convergence of EZ bond yields will continue.

Equities

The chart below shows the relative performance of the S&P500 Index vs MSCI Emerging Market ETF (EEM) over the last five years, after an initial rebound from the Great Recession the US stock market began to outperform other stock markets, driven by the economic boon of oil and gas technology, the implementation of TARP  and the highly accommodative policies of the Fed. With the current round of QE at an end, US investors may need to look further afield in search of value :-

EEM vs SandP 5yr

Source: Yahoo Finance

Expectation of “Lower for Longer” interest rates and cheaper oil is supportive for stock markets in general although there will be sector specific winners and losers. Geographically, lower oil prices will favour those economies most reliant on oil imports, especially if their exchange rate is pegged to the US$. Given the under-performance of many emerging market equities over the last few years I believe this offers the best investment opportunity going forward into 2015. Those countries with floating exchange rates such as India have already benefitted from currency devaluation of 2013; however, there is still potential upside for equities, even after the strong performance of 2014. The SENSEX Index (BSE) started the year around 21,000 and is currently making new highs at 28,000, but during the last three months it has tended to track the performance of the S&P 500 Index – despite the fall in oil prices. I anticipate a general re-rating of emerging market equities next year.

An Italian stress-test

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Macro Letter – No 23 – 07-11-2014

An Italian stress-test

240px-Palazzo_Salimbeni_Siena

Palazzo Salimbeni – Siena

  • After the ECB Comprehensive Assessment Italian Banks appear the “weakest link”
  • Italian bank ownership of BTPs is a growing concern if the “carry trade” should unravel
  • Italian stocks have performed better since March but Real-Estate looks better value

Last week I visited Tuscany for the first time in twenty years. Pictured above is of the head office of Banca Monte dei Paschi di Siena. Monte dei Paschi – founded in 1472 – is generally deemed to be the longest established bank in the world. When I visited the city in 1994 their splendid head office, originally the seat of the Salimbeni family, was not open to the public. In the past month in what looks like a “charm offensive” this situation has changed. It is now possible to peruse the bank’s fine collection of art and ponder on the challenges of operating a modern bank in a medieval building.

The change of attitude towards visitors may have been in response to the Banca D’Italia bail-out in January of last year. Monte dei Paschi suffered Eur 2bln in losses in the aftermath of the 2008 financial crisis. Then ,in 2009, they entered into a series of derivative contracts with Deutsche Bank and Nomura which led to further losses in late 2012. The central bank was forced to act since Monte dei Paschi is the third largest banking institution in Italy – though some distance behind Intesa and Unicredit.

AQR Stress

Last week also saw the release of the ECB Comprehensive Assessment. This included the Asset Quality Review (AQR) of the largest 123 financial institutions in Europe. 25 banks failed the test – eight of them were Italian. The tests were performed early this year and of the 25 banks 12 had addressed their capital shortage issues by the time of the publication of the results, however, Monte dei Paschi had the largest shortfall (Eur 2.11bln) and its share price declined by more than 20% on the news. Here is a list of the Italian banks, before and after their capital raising efforts:-

Bank Shortfall Capital Raised Net Shortfall
Monte dei Paschi di Siena 4.25 2.14 2.11
Banca Carige 1.83 1.02 0.81
Veneto Banca 0.71 0.74 0
Banca Popolare di Milano 0.68 0.52 0.17
Banca Popolare di Vicenza 0.68 0.46 0.22
Credito Valtellinese 0.38 0.42 0
Banca Popolare di Sondrio 0.32 0.34 0
Banca Popolare dell’Emilia Romagna 0.13 0.76 0
Italian Bank Total 8.98 6.4 3.31

Source: ECB

The Economist – The ECB’s asset Quality Review : Stressful tests sheds more light on what has changed since the last review of European banks: -

The European Central Bank (ECB) simultaneously to the stress-tests has carried out a comprehensive audit of the value of the stuff on each bank’s balance sheet, the Asset Quality Review (AQR). This was only applied to 123 big banks in the euro zone’s 18 countries, which from next month will be regulated by the ECB instead of national watchdogs. 

The ECB found €136 billion in troubled loans banks had not already confessed to owning, bringing the European total to €879 billion ($1.1 trillion). Italy will have to implement the biggest reclassification of loans (€12 billion), with Greek (€8 billion) and German banks (€7 billion) also challenged. Interpreting the results, even at aggregate level, is complicated by the fact that they are arrived at using data from the end of 2013—and much has happened since then. Notably, many banks that thought they might fail the tests have raised over €45 billion in equity, strengthening them considerably. That explains why only 13 banks will have to unveil plans to raise capital when 25 have apparently failed, including Eurobank in Greece, Monte dei Paschi di Siena in Italy and Portugal’s BCP, the only three with more than €1 billion to raise. They now have to come up with plans to strengthen their balance sheets.

For a different perspective on the ECB Comprehensive Assessment the Peterson Institute – Whither Europe’s Banks after the Stress Test? Makes for interesting reading:-

Beyond the 25 banks that failed the test, other banks face difficulties because the asset quality review forced them to acknowledge their exposure to €135.9 billion in nonperforming loans (NPLs) and write down their assets by €47.5 billion. As mentioned above, only €10.7 billion of this sum was uncovered in banks that failed the comprehensive assessment, leaving around €37 billion of these asset write-downs to be recognized on the books of other euro area banks in the coming quarters. The ECB must now aggressively require banks to recognize these losses.

…International banking authorities have agreed to introduce a new definition of capital for banks to be applicable in 2017. Although this new standard—known as the “fully loaded Common Equity Tier 1 (CET1) ratio” —was not part of the comprehensive assessment, the comprehensive assessment published the data so that financial markets can apply the standard to more fully understand the future state of euro area banks. The CET1 standard is much tougher on banks, as it excludes various lax interim arrangements and accounting standards used by banks before they adopt the new standard. The most notorious of these is the ability of banks to employ what are known as deferred tax assets, which enable the banks to inflate the amount of risk capital they have with what has in many cases been essentially a government fiscal transfer to the banks through the backdoor. The effects of these shenanigans in the comprehensive assessment were to let banks avoid having to add €126.2 billion in new capital to get to the new CET1 standard. Were they to have to add that amount, many more banks would have failed the test. German banks benefitted the most from these issues by €33 billion. Spanish banks get away with not having to add €25 billion in new capital, and Italian banks, €16 billion. The fully loaded CET1 data, which is provided for the adverse scenario for the year 2016, better indicates how banks will fare as the new supervisory rules come into force.

Peterson point out that under the fully-loaded CET1 capital definition a further four Italian banks would have failed the stress tests.

The Brookings Institute – Despite Headlines, it’s Good News on Europe’s Banks, but with Some Risk for the ECB has an altogether more sanguine view: -

European banks are in much better shape than many had feared, if the results announced yesterday for the combined “asset quality review” and “stress tests” are accurate measures of the underlying situation and future prospects for the banks. I know the key people involved and they are highly professional and had a strong incentive not to be too lenient, so I tend to take these results as truly positive. They had political room to produce somewhat more pessimistic results, so I interpret these optimistic findings as their true beliefs. On the downside, the European Central Bank (ECB) now “owns” any major banking problems in Europe and runs real risks if these tests were in fact too optimistic, or even if they were broadly right but new problems develop. Observers generally will not distinguish after the fact between new problems and the playing out of old weaknesses. It is hard to read these results as excessively harsh, which would have been the only protection for the ECB.

What was so good about the results? Only 10 percent or 13 banks out of 130 need to raise any additional capital and the total requirement is a miniscule 10 billion euros compared to 22 trillion euros of assets owned by these banks. This not only says positive things about the current state of the banking system, but also removes the threat of regulatory pressure to deleverage further, which might have inhibited needed lending.

Returning, specifically to the Italian banks Bruegel – Monday blues for Italian banks – suggests that for Italy there is still a long way to go:-

…the Italian banking system is still keeping in place a strong liason dangereuse with the (huge) government debt. This is not at all a special feature of Italian banks (as Figure 1 shows) but with almost 80% of their sovereign long direct gross exposures concentrated on Italy, Italian banks are found in this supervisory exercise to be among the most exposed to the sovereign debt issued by the domestic sovereign. Actually, if one excludes the countries that have been or are under a EU/IMF macroeconomic adjustment programme, Italian banks are the most exposed in the Eurozone.

Domestic Sovereign debt exposure of EU banks

Source: EBA

More interestingly, the exercise shows that this “home bias”, which is deeply at the root of the sovereign-banking vicious circle that characterised the euro crisis, has even worsened over the last three years.

…Sovereign debt accounts by now for around 10% of total assets of Italian banks, on average. The carry trade on these holdings might have kept banks afloat over the last 3 years, but these gains are actually concealing deeper structural issues that Italian banks have – until now – never been forced to face in full.

One such long-known problem of the Italian banking system is profitability, which is (and has been for quite a while now) very low. According to ECB data, average return on equity has been negative over the period 2010-2013 and the comparison with Spanish banks is especially striking. After the huge drop in return on equity during 2012, Spanish banks recovered, whereas Italian banks seemed to have never done it (Figure 2).

Italian vs Spanish Banks ROI

Source: EBA

Bruegel goes on to highlight the lack of restructuring of the Italian banking system and suggest that it is ripe for significant consolidation. Being Italy, this will undoubtedly be a more protracted process due to the complex legal structure of many financial institutions and the length of the judicial process. For a detailed review of the Italian judicial system this IMF – Italy Selected Issues paper may be of interest.

Italian Growth

So what are the prospects for Italy now that the banks have almost got their houses in order? The European Commission – Autumn Forecast – released this week – is less than encouraging. Italy is expected to contract -0.4% in 2014 after a decline of -1.9% last year. 2015 is anticipated to see growth returning but only to +0.4%. The Italian government has attempted to reign in public spending but austerity measures have failed to stem the rising ratio of debt relative to GPD. The chart below, also from Bruegel, compares the situation in Italy with that in the Netherlands:-

Italy and Netherland Government debt to GDP

Source:IMF

The dotted lines show the forecast at each stage. It is some comfort to observe that this is not just an Italian problem but the size of the Italian government debt is, as usual, substantial.

Another important issue to consider when analysing the prospects for Italy is the substantial economic differences between the regions. This Wikipedia map shows the GDP/capita in 2008:-

italian_GDP_per_head_2008

Source: Wikipedia

My sojourn in Tuscany provided an insight into an “average area” consisting of agriculture and mostly light industry. The agricultural sector is a combination of small holdings, mostly in the north, and larger agro-industry around Maremma. Industry is diversified, although metallurgical firms are still prevalent despite the decline in mining. Service, including banking, and tourism are also significant contributors to the economy of the region.

This is neither the industrial heartland of the Northern League nor the administrative metropolis of Roma but it makes an interesting contrast with other parts of Europe and reveals the slow pace of Italian development over the past two decades. The Italian expression “La Bella Figura” (Nice appearance) as mentioned by Silvia Merler of Bruegal captures the essence of the problem. Italy is a little too comfortable.

In a speech in September by Salvatore Rossi – Senior Deputy Governor of the Banca D’Italia – Finance for Growth he reflected on some “home truths” about the state of the Italian economy:-

Italy has long strayed from the path of economic growth. Common sense tells us this is so and the data confirm it.

In the last six years the recession has doubled the rate of unemployment and eroded 11 percentage points from per capita GDP. But our problems go back much further than that: in 2008, on the eve of the financial crisis, the average amount of goods and services produced by Italian workers was basically unchanged from 1995. In the same period other countries, spurred by the technological paradigm shift of ICT, had seen their productivity rates soar.

The strong growth in employment that was nevertheless recorded in Italy in the pre-crisis years, favoured by the introduction of more flexible work contracts, proved insufficient to offset the effect of the stagnation of productivity on households’ disposable income. At the outbreak of the crisis, for the average household this was at the same level as in the mid-1990s and only the progressive reduction of the saving rate had enabled modest growth in consumption.

The diminishing ability to generate income heralds a decline in living standards, both with respect to this country’s past and to the world’s main players. This is all the more worrying when one considers that in forty years’ time the ratio of people of working age (20-69) to elderly retirees will have halved, from 4 to 2. Even just to maintain per capita living standards at their current levels would require an increase in labour productivity of 25 per cent.

Rossi goes on to discuss the need for finance to help the large number of small companies to grow. He observes that in other countries small firms either succeed and expand rapidly or wither and die whilst in Italy they simply limp on. Rossi discusses the need for economic reform. I believe it requires a serious crisis to achieve these goals.

Bonds

As mentioned earlier in this article, Italian banks are significant holders of BTPs. The European convergence trade has been extremely profitable and hopes that the ECB will begin outright monetary purchases (OMT) should the EZ head into a deep recession means the market prices these bonds with an implicit “put option” attached. I believe this is a far from certain. Only last month we saw a brief panic in the Greek bond market – Italian 10 yr yields followed suit rising by more than 25bp. I see little value remaining long 10yr BTPs at current yields – 2.43% – they have come a long way since their November 2011 lows when they touched 7.50%.

Stocks

The chart below shows the FTSE MIB Index vs EuroStoxx 50 ETF. The Italian stock market has been lagging the broader European market for s significant time as Deputy Governor Rossi’s speech about the lack of economic growth prior to the 2008 crisis observes. However, it is worth noting that the MIB has outperformed EuroStoxx since March of this year, perhaps reflecting concerns about slower growth in France and Germany:-

MIB vs Eurostoxx 50 ETF - 10yr

Source: Yahoo Finance

Sadly the ETF data only stretches back to 2005, nonetheless, this clearly demonstrates the profound underperformance of Italian stocks. The MIB may be outperforming this year but I believe the catalyst is an external slowdown rather than expectation of significant internal growth.

Real-Estate

Italian property prices followed the trend seen in many other parts of Europe during the last twenty years but the rise has been muted. This article published in February by Global Property Guide – Italy’s house prices down 6.5% on the year. Will it ever end? Provides some useful background about home ownership and Loan to Value (LTV)rates, it also reflects on the fall in mortgage rate:-

The average interest rate for new housing loans was 2.92% from May 2009 to March 2011, but then rose to a maximum of 4.3% in February 2012. After the ECB rate was reduced from 1% to around 0.75% in July 2012, the average interest rate for house purchases also started declining along with the ECB rate. In November 2013, the interest rate for new housing loans was at 3.54%.

Across the country, Italian house prices have been declining since 2009, however, unlike some other European countries the Italian mortgage market is relatively under developed and LTV rates remain subdued. Whilst debt is a major issue for Italy, mortgage debt acts as less of a fiscal drag on the economy than in the UK or Ireland.

EU Property prices - mdbriefing

Source: MD Briefing

Recent price trends suggest that a recovery is under way. Milanese housing is now forecast to rise by around 4% in 2014 – earlier this year expectations were for continued price declines. The initial resurgence in demand is likely to emanate from the commercial sector. International demand for tourist property will be subdued by the supply overhang in Spain and Portugal but, once the new TASI property tax has worked its way through the system, the broader market will start to clear.

Conclusion and investment opportunities

The correction in Real-Estate prices in Italy has been relatively subdued in comparison with Spain, Portugal or Ireland but, despite additional taxation, the market is showing nascent signs of recovery. This is partly due to the significant reduction in mortgage rates since 2012. Italian property did rise substantially between 2000 and 2008 (around 85%) but this is moderate in comparison with some other EZ countries.

As an investment opportunity Real-Estate is preferable to BTPs or the Italian stock market. Italian REITs have been available since 2006 but recent changes to rules introduced in August may make the market more vibrant; this article from RE Europe -Italy makes REIT regime more competitive internationally, to grow sector by attracting foreign investment provides more detail. Before diving into, what is clearly, a limited market, this article from Bloomberg – Italy seeks to ease REIT rules is also worth reading.

Italy has weaker growth and demographic prospects than some other Europen countries and therefore Real-Estate investment opportunities will be better elsewhere in the EZ, but within Italy I prefer this sector to Bonds or Stocks. After all, at 74.1% Italy is 24th in the world ranking by property ownership (2012 data). After five years of declining prices housing is now more affordable. As the economy recovers from the weakness of 2013 latent demand should emerge. As the picture at the start of this article shows an Italian’s home is his castle.

The Celtic Tiger and the Eurozone periphery

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Macro Letter – No 22 – 24-10-2014

The Celtic Tiger and the Eurozone periphery

  • Ireland has the lowest yield of troubled nations of the Eurozone periphery
  • The Irish stock market has performed well this year
  • Irish Real-Estate has begun to rebound – is this more than a convergence game?

Last week, for the first time in almost a decade, I visited Dublin. Like so many capital cities, Dublin gives one a very different perspective on a country’s economy than the provinces. Seen from this vantage, the Celtic Tiger has re-emerged like a phoenix from the ashes of the Great Recession. At the IMF-World Bank annual meeting on 10th October, Central Bank of Ireland (BCOI) Governor Patrick Honohan, Alternate Governor for Ireland of the IMF gave an interesting up-date on the state of the Irish economy: -

The Irish economy is emerging from the crisis and there are clears signs that economic recovery is underway. GDP growth of 0.2 per cent was recorded last year and data for the first half of this year were very strong and were well ahead of consensus expectations. The increase in economic activity is broadly-based with both domestic sectors and exporting sectors performing strongly. Although below our domestic forecasts, we welcome the WEO’s projection of 3.6 per cent GDP growth in Ireland for 2014.

Labour market recovery is clearly underway. Employment has increased in each of the last seven quarters representing an increase of over 70,000 jobs since the low-point in mid-2012. This reflects recovery of almost a quarter of jobs lost since the crisis. In line with this, the unemployment rate stood at 11.1 per cent in September, down from a peak of 15.1 per cent in early 2012. While this is still unacceptably high, it is certainly moving in the right direction.

Domestic demand has stabilised and is showing encouraging signs of growth. Consumer spending is improving as confidence returns, while firms are investing in plant and machinery once again.

Due to its relatively small domestic market, Ireland’s growth model must be export oriented. Exports are expected to gain ground this year as demand in Ireland’s main export markets, particularly the UK, continues to hold up. In addition, on the basis of the latest trends, the impact of patent expiry in the pharmaceutical sector appears to have passed.

Mr Honohan then went on to discuss the state of Irish public finances:-

Targets to reduce the underlying General Government deficit have been over achieved to date. Reflecting the continued prudent budgetary stance, the General Government deficit for 2014 is now likely to be of the order of 3.5% of GDP down from 8 per cent of GDP in 2012. The size of the consolidation undertaken has been of the order of 18 per cent of GDP since 2008.

Ireland emerged successfully and on schedule from the EU/IMF programme at the end of 2013 and, in 2014, has returned to participating normally in the sovereign debt markets. Our successful exit was based on a number of factors – both domestic and international – including the Government’s steadfast delivery on its programme commitments, the extension of the maturities on the European portion of our programme loans, and the interventions by the ECB to calm the wider euro crisis.

Concerns still remain about the Irish Banking system and October sees the launch of the Strategic Banking Corporation of Ireland (SBCI) which will side-step the traditional and lend to SMEs. Unlike many countries where demand for business loans is anaemic, Ireland has seen a dramatic increase in new businesses this year – according to data from Vision.net 10,700 new enterprises were incorporated in Q1 2014, up 6% on 2013. During the same period insolvencies were down 23%. A slight concern is that new construction company start-ups were up 29%. According to CBOI data house prices nationally are up around 7.5% y/y in May 2014 and within the Dublin area by 15%.

The Central Bank of Ireland – Consultation Paper 87 – highlights measures being taken to avoid another housing bubble by the introduction of macro-prudential policies aimed at limiting excessive leverage in the mortgage market. The proposals are as follows:-

Restrict new lending for principal dwelling houses (PDH) above 80 per cent LTV to no more than 15 per cent of the value of all new PDH loans.

Restrict new lending for PDHs above 3.5 times LTI to no more than 20 per cent of the value of all new PDH loans.

Restrict new lending to buy-to-let above 70 per cent LTV to no more than 10 per cent of the value of all housing loans for investment purposes.

The rise in house prices is almost certainly due to a lack of supply coupled with strong population growth. The 2011 Census – published in June confirmed the significant increase in Irelands population since 2002. The Great Recession may have tempered the pace of growth (the five year inter-censal period showed growth of only 8.2%) but the trend is still positive:-

Ireland - Population - source CSO

Source: CSO

Since 2002 the population in Ireland has grown by 17 per cent, two and a half times the rate of growth in Northern Ireland of 6.9 per cent.

…the median age of the population was 34, the lowest of any EU Member State.

These are attractive demographic trends and the rise in new construction companies is not surprising when viewed from this perspective.

In the Central Bank of Ireland – Macro-Financial Review – a semi-annual report last published in June – the  bank acknowledges their concern about residential property and other potential headwinds, both internal and external, which may knock the Irish recovery off course:-

A number of headwinds will continue to restrain growth, however, including modest external demand growth, high household indebtedness, elevated unemployment numbers, weak prospects for disposable income growth, and the continuing need for fiscal adjustment.

…The key systemic issue for the Irish economy remains the high level of impaired bank loans. Despite some recent reductions, mortgage arrears remain high, while the number of cases of very long-term arrears of over 720 days continues to increase. Loan-servicing arrears among small and medium enterprise (SME) borrowers are also a significant problem. Other challenges facing the SME sector include weak domestic demand conditions, difficulties accessing credit, and high indebtedness among a small proportion of firms. Resolving the loan arrears problem for both households and SMEs is essential for borrowers and lenders and in order to support growth and recovery in the broader economy.

Ireland’s largest export markets are the USA and UK. The relative strength of these economies helps to explain the export-led recovery in Ireland since 2008.

Exports_as_a_percentage_of_GDP_-_OECD

Source: OECD

The relative resilience of the export sector is a testament to the dynamic nature of the underlying economy. Added to this, US investment in Ireland is substantial, as is FDI in general. This March 2012 article from the World Bank – FDI in Ireland: A Reason for Optimism makes interesting reading:-

Over the past 10 years, inflows of FDI into Ireland tend to be substantially higher as a percentage of GDP than inflows into other OECD economies (see Figure 1). In 2009 and 2010, the two years immediately following the banking collapse, Ireland attracted three to four times more FDI proportionately than other OECD economies. These inflows were not just large in relative terms – they were equivalent to 11.7% of GDP in 2009 and 12.9% in 2010. The negative inflows in 2005 and 2008 do indicate that more money was disinvested out of Ireland than newly invested in the economy those years. However, such outflows are mostly loans or dividend payments from foreign-owned firms in Ireland to their affiliates abroad, at least some of which were likely caused by a 2004 change in the US tax rate on foreign profits.

Figure 1: Net inflows of FDI as percentage of GDP, Ireland vs OECD

FDI_Ireland_vs_OECD_Average

Source: UNCTAD and OECD

Ireland has a small, well educated, open economy. Many large multi-national companies have their European operations headquartered in Ireland; especially in the Science, Technology, Pharmaceuticals and Agricultural sectors.

Ireland’s turn-around is in marked contrast to other countries of the Eurozone (EZ) periphery. The chart below shows Real GDP from 1996 to the end of 2010 for seven EZ countries:-

Real GDP_EU_chart7 - 1996-2011

Source: Pordata

Since 2011 Ireland has outperformed further: -

Ireland GDP 2011-2014

Source: Tradingeconomics

Financial Market Performance

How has the Irish economic recovery been reflected in the performance of financial markets? I will look at Stocks, Bonds and Real-Estate.

Stocks

To begin, here is a ten year chart of the Portugese PSI20 vs Irish ISEQ Composite: -

PSI20_vs_ISEQ_2004_-2014 Bigchart.com

Source: Bigcharts.com

Ireland’s difficulties started with the unravelling of the sub-prime mortgage market in the US. The initial down-turn in the ISEQ index was more severe partly due to the heavy weighting of CRH – an international building materials firm – followed by the Irish Banking sector in the index. However unlike Portugal the Irish market had already begun to recover prior to ECB Governor Draghi’s “Whatever it takes” speech in July 2012.

The next chart compares the ISEQ to the Athens Composite:-

ISEQ vs SAGD 2003-2014 yahoo

Source: Yahoo Finance

This shows a similar pattern, however, the strong performance of the Athens Composite in the run up to 2008 was partly due to the heavy weighting of their highly leveraged Banking sector in the index – even today it has a 34% weighting.

A longer term perspective can be seen in the comparison with the Spanish IBEX35 going back to 1995:-

IBEX vs ISEQ 1996 - 2014 yahoo

Source: Yahoo Finance

The broad-based strength of the Celtic Tiger meant that it avoided the worst effects of the bursting of the technology bubble in 2000, despite a significant technology sector. The lower interest rate regime across the EZ then hastened a dramatic housing bubble, which burst spectacularly in 2007. Both Spain and Ireland continue to struggle with high loan delinquency issues, but the accommodative policies of the ECB, as it seeks to soften the effects of a slow-down in economic growth in Germany and France, suggest both peripheral nations have time on their side.

Bonds

Irish 10 yr Gilts currently yield 1.82% down from July 2011 highs of 14.61% but they are off their recent lows of 1.62% seen last month.

Irish 10 yr Gilts 2006 - 2014 Trading Economics

Source: Tradingeconomics

Since early September uncertainty about EZ growth and the adequacy of ECB policy has precipitated an unwinding of yield convergence trades. The table below shows the evolution of 10 year Government bond yields since early September:-

Country Yld 06-9 Sprd vs Bunds Yld 23-10 Sprd vs Bunds Change
Ireland 1.62 0.69 1.82 0.94 0.25
Greece 5.54 4.61 7.46 6.58 1.97
Portugal 2.93 2 3.32 2.44 0.44
Spain 2.02 1.09 2.21 1.33 0.24
Germany 0.93 N/A 0.88 N/A

Source: Investing.com

The flight to quality into German Bunds has been muted by the excessively low absolute interest rate offered by Bunds, however, the difference for Ireland today in comparison with 2011 is significant. At the beginning of July 2011 the 10 yr Irish Gilt spread over Bunds was 8.82% whilst the 10 yr Bonos spread was only 2.4%. It is important to point out that Spanish Bonos yields hit their high a year later than Ireland, in July 2012. At the beginning of July 2012 the spread between 10 yr Bonos and Bunds was 4.74%. By either measure the performance of Irish Gilts, since the depths of their depression, suggests the Irish economy is healing at a faster pace than Spain, Portugal or Greece.

Real-Estate

Irish Real-Estate was at the heart of the economic crisis which slew the Celtic Tiger, it is, therefore, critical to examine to what extent this market has “cleared”:-

Irish_Property_price_index_2005-2014_CSO

Source: CSO and Global Property Guide

This chart shows the evolution of prices up to the end of 2013. Since then prices have improved further with Dublin leading the recovery. According to the Central Statistics office, new Dublin area homes were up 16% in Q1 2014 whilst second hand properties were up 5%. CBOI data to May 2014 shows this trend gaining further momentum. A similar pattern is developing in Spain though the overall correction in prices was far less severe: -

Spain_house_prices_2002_-_2014

Source: TINSA and Global Property Guide

By contrast Greek property prices are still under pressure. The prospects for a recovery were looking better as this Bank of Greece – Monetary Policy update from June explains:-

Prime commercial property prices are expected to stabilise in 2014, while prospects for high-end tourist properties are even more favourable, as a result of a projected substantial growth in tourism. Turning to non-prime commercial properties, prices are expected to drop further in the following quarters, while the real estate market as a whole is projected to start recovering gradually in 2015, provided that the present trend is not reversed by exogenous factors (political factors, international conjuncture, etc.).

The abrupt reversal of yield convergence this month may delay the recovery.

For Portugal the situation is similar to Greece, foreign demand has begun to re-emerge but the financial crisis surrounding Banco Espirito Santo during the summer has undermined confidence.

Ireland has domestic demographic growth on its side, although there is international demand for holiday homes in Ireland’s South West and West. The property market recovery is driven by domestic Dublin area demand connected to the broad-based resurgence in economic growth. The real estate market correction in Ireland has been larger than in Spain. I am also struck by the, almost mercantilist, export led recovery in Irish growth compared to the rising tide of imports into Spain.

Conclusion and investment opportunities

The Celtic Tiger suffered a severe mauling in the aftermath of the US sub-prime crisis. The Irish construction industry was forced to restructure or liquidate. Irish banking was devastated by the global forces of the Great Recession and the government embarked on an aggressive austerity programme to address these issues. The chart below, from the OECD, shows why the Irish government was forced to approach this situation in such a draconian manner: -

Government_surplus_or_deficit_since_2001_piiggs_an

Source: Eurostat and OECD

Unemployment rose from 4.2% in 2007 to 15.1% by early 2012. Between April 2009 and April 2010 a net emigration of 34,500 occurred – the first outward migration since 1989. Since 2012 Employment has risen by 70,000 – approximately a quarter of the jobs lost in the Irish depression – this suggests an output gap still exists. Ireland is a net importer of Oil – its recent decline, despite geo-political tensions, will help to flatter inflation figures.

A turning point in the crisis came in the summer of 2011. To set the scene I will begin in 2010 when Ireland accepted a Eur85bln joint EU-IMF bailout to stabilise its banking system. This quickly bore fruit and by May 2011 the Irish Finance Minister, Michael Noonan, was ruling out the need for a second bailout. Market commentators and economists generally doubted the governments resolve and Irish Gilt yields continued to rise into the summer of 2011. At this point the National Treasury Management Agency (NTMA) clarified the terms of the original EU-IMF bail-out. The bond market suddenly realised that funds which had been earmarked for bank recapitalisation could also be used to fund the fiscal deficit. The Irish government would therefore require minimal new funding until 2013.

Once confidence in government finances had returned, the Irish economy could resume something approaching normality. This brings me finally to the “value question”. Have the financial markets priced in the return of The Celtic Tiger?

Stocks

The Irish stock market has performed strongly this year relative to other peripheral markets but seems to be lagging its own GDP growth. The economy relies heavily on the USA, UK and Europe since these are its principal export markets. On a relative value basis I would remain long of Irish stocks versus other EZ peripheral markets – but not Spain since I am also optimistic about its fortunes. On an outright basis it still offers better value than the rest of the EZ but is likely to experience higher volatility and lower liquidity, especially during times of stress.

Bonds

Irish Gilts (1.82%) by contrast, have been re-priced to reflect a default risk better than Spain (2.21%) and not much worst than France (1.30%). There is, however, a downside risk should the leveraged carry trade be unwound further. Whilst this is true for Spanish Bonos it is less true of French OATs; added to which, the Irish Gilt market has less depth of liquidity than Spanish or French bond markets.

Real-Estate

After its substantial correction, Irish Real-Estate looks like the best value asset class. The macro-prudential policies of the Central bank of Ireland should insure leverage does not become excessive. This will dampen volatility and extend the duration of the appreciation, but I believe it will also favour Dublin over the provinces – cash will be king. My main concern with this prediction is the stubbornly high level of non-performing loans. Yet this also favours Dublin area Real-Estate since negative equity is swiftly being erased.

The Scotian experiment and European fragmentation

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Macro Letter – No 21 – 10-10-2014

The Scotian experiment and European fragmentation

  • Scotland voted to remain part of the Union but the devolution debate doesn’t end there
  • Further European integration risks breaking the European Union
  • Economic growth in the UK and Eurozone will be damaged by long-term uncertainty

The Scottish decision to remain part of the Union, by such a slim margin – 55% to 45% on an 85% turnout – caught me by surprise. On reflection it should not have been unexpected – it was as much about the “hearts” as the “minds” of the Scottish electorate. Now that the dust has settled, I wonder what this vote means for the United Kingdom and for other regions of Europe.

In this month’s issue of The World Today, Chatham House – A result that resolves little Malcolm Chambers – Research Director at the Royal United Services Institute (RUSI) made the following observations: -

The Scottish referendum was supposed to settle the UK’s constitutional uncertainties, but the result has raised more questions than it answers. How Britain addresses the devolution issue and the question mark over its commitment to Europe will shape perceptions of its ability to wield influence and hard power abroad for years to come.

Britain’s 2010 National Security Strategy, published shortly after the coalition government took office, was entitled ‘A Strong Britain in an Age of Uncertainty’. It made no mention of the two existential challenges – the possible secession of Scotland from the United Kingdom, and the risk of a British withdrawal from the European Union. Yet either event would be a fundamental transformation in the very nature of the British state, with profound impact on its foreign and security policy.

The article goes on to discuss the promises made to Scotland by Westminster’s political elite, from all the main parties, which may now create the conditions for eventual independence: -

Devolution max could have a similar effect, making the final step from ‘devo-max’ to ‘indy-light’ appear less traumatic, even as it still allows Westminster to be blamed for any ills that remain. If a further referendum is to be avoided five or ten years from now, it will not be enough to make constitutional changes.

Prime Minister Cameron took the opportunity to raise the issue of Scottish MPs voting on English issues; whilst this was politically expedient, it sows the seeds for regional calls for devolution of power to the poorer areas of Britain: -

Yet growing awareness of the constitutional imbalances created by devolution to Scotland – and, to a lesser extent, to Wales and Northern Ireland – is creating a series of shockwaves that will not dissipate easily. The UK, as a result, could now see a long period of constitutional experimentation and controversy, with profound effects on the governance of the country as a whole.

Chambers then turns to investigate the “European Question”. Here he sees a parallel between the UKs relationship with the EU and the Scottish desire for independence: -

Britain’s relationship with the European Union is similar, in important respects, to Scotland’s position in the United Kingdom. It has a special financial arrangement, involving a rebate of most of its net contribution, that is not available to other member states. It retains its own currency and border controls, and has a permanent exemption from the common currency and passport-free travel to which other states have agreed. As in Scotland, there is strong political pressure for the UK to be allowed special treatment in further areas, such as immigration controls. In both cases, attempts to construct ‘variable geometry’ governance frameworks are made more difficult by the asymmetry in size between the opting-out nation and the political union as a whole.

From the Brussels’ perspective the issue of devolution is not just restricted to the “Sceptred Isle”: -

While the nature of the Britain’s constitutional crises is unique, they are part of a wider crisis of European politics. Over the past five years, the eurozone has faced successive crises as it has sought to find a way to reconcile vast differences in economic interest and viewpoint between its member states. Relations between Germany and the southern states have worsened as the former takes on a more openly hegemonic role.

Without further significant sharing of political sovereignty – for example through a banking union – the risk that one or more member states could leave the eurozone will remain very substantial. Yet further political integration could bring its own challenges, with powerful nationalistic parties in northern Europe already pushing against those who argue that all the answers must come from Brussels. One of the reasons that Britain’s European allies were so worried about the Scotland vote was precisely their concern as to the example that a Yes vote could have sent to separatist movements in Spain, Belgium, Italy or Bosnia. This concern will not have been entirely dissipated, both because of the precedent set by London’s willingness to hold the vote, and by the closeness of the margin.

In conclusion Chambers states: -

It is still far from likely that the United Kingdom will perish, or that it will abandon its commitment to the European Union. But the possibility of one or both of these separations taking place seems set to be a central part of British politics for a decade or more.

The impact on Sterling

Sterling is still some way below its longer-term average on a trade weighted basis as this chart of the Sterling Effective Exchange Rate (ERI) Index shows, however, it’s worth noting that the average between 1994 and 2013 is around 90: -

GBP Effective Exchange rate - BoE

Source: Bank of England

Uncertainty always undermines the stability of ones currency and the Scottish referendum was no different, although its impact proved relatively minor. In a recent speech, Bank of England – The economic impact of sterling’s recent moves: more than a midsummer night’s dream – Kristin Forbes – MPC member, downplayed what could have been a dramatic decline in the value of the GBP:-

There has been some volatility in sterling recently, especially around the time of the Scottish referendum, but sterling is currently only 1% weaker than its recent peak in July 2014.

In her conclusion she points to the appreciation of the GBP since the Great Recession and cautions those who fail to anticipate the negative inflationary consequences of a weaker exchange rate: -

Where sterling’s recent moves may have had the greatest economic impact is on prices and inflation. A “top down” analysis estimating the pass-through from exchange rate movements to prices suggests that the lagged effect of sterling’s appreciation during 2013 and early 2014 may have acted as a powerful dampening effect on inflation. Although model simulations may be overestimating the magnitude of the effect, sterling’s past moves have reduced the risk of inflation increasing sharply, despite the strong growth in employment and the overall economy.

This dampening effect of sterling’s past appreciation, however, will peak at the end of 2014 and then begin to fade. As a result, it is becoming increasingly important to monitor trends in domestically-generated inflation – and especially unit labour costs – so that monetary policy can be adjusted appropriately and also be allowed to work through the economy with its own set of lags. Unfortunately, understanding recent trends in the domestic component of inflation – especially the slow growth in wages – has been challenging. A “bottom up” analysis of inflation that focuses on current measures of domestically-generated inflation (which attempt to minimize the dampening effect of sterling’s moves) show price pressures that are well contained and little evidence of imminent inflationary risks.

These “bottom up” indicators present a very different story then the “top down” estimates of inflation after adjusting for sterling’s recent appreciation. Has sterling’s appreciation had less of a dampening effect on prices than has traditionally occurred – perhaps due to structural changes in the UK or global economy? Or are the measures of domestic inflation understating current inflationary risks – perhaps due to the long lags before timely data is available? To answer these questions, it is critically important to monitor measures of prospective inflation to determine the appropriate path for monetary policy.

If concern about political devolution of power to the regions, at the expense of the power-house of the UK’s South East, and expectation of rising Euro-scepticism, are destined to be the pre-eminent political issues for the next decade, then an appreciation in the value of Sterling is likely to be tempered. Since the UK economy is closely integrated to Europe this persistent undervaluation will be less obvious in the GBP/EUR exchange rate but hopes of the trade weighted value of GBP rising like the USD due to structurally stronger growth will be muted.

In the aftermath of the referendum RUSI – Never the Same Again – What the Referendum Means for the UK and the Worldobserved:-

Having, for the first time, looked at what a ‘yes’ vote might mean for them, private investors and businesses are now more sensitised than ever before to the risks that a further referendum could pose. If some of them were to begin to hedge their bets accordingly, there could be a risk of an extended period of underinvestment in Scotland, with serious consequences for its prosperity.

Better together?

The campaign slogan of the Westminster elite was “Better Together” but, setting aside the rhetoric of power hungry politicians, what are the pros and cons of devolution versus Union? Writing ahead of the referendum Adam Posen of the Peterson Institute – The Huge Costs of Scotland Getting Small made a valiant case for continued integration: -

When is it ever a good idea for a small nation to set up on its own? Leaving aside cases of colonization and outright oppression, there is little good reason ever to shrink on the world scene by leaving a larger unit. The internal politics of democracies always get better deals for regions within them than small sovereigns can elicit from identity-ignoring market forces. The few small nations that did gain in welfare by seceding from transnational entities are those that escaped failed autocratic systems. The Baltic countries escaping the former Soviet Union’s dominance can be seen in this light. But setting out on your own is only beneficial when the system left behind has directly constrained your nation’s human potential. Whatever else, that cannot be said of the current Scottish situation in the United Kingdom.

It is a fact of life in today’s world that a small economy on its own is always buffeted by the forces of the global economy more than a region within a larger union. Even well-run small states like Singapore and Estonia are subject to huge swings in their economy resulting from capricious capital flows in and out. These swings disrupt employment, investment, and competitiveness via real exchange rate fluctuations. More important, small economies are fundamentally undiversified because of their small scale, and they risk their specializations falling out of favor in world markets. Events beyond their control can overwhelm the small nation’s high value-added industries, no matter how good it is at those things, be they oil extraction or banking or whisky distilling. Scottish independence in form will instead mean increased vulnerability in fact, because, inherently, smaller means more exposure when the markets turn—and turn they will.

…The economic debate over independence has tended to focus on the one-time transfer costs: setting up a new government administration, apportioning the accumulated public debt, grabbing as much oil as possible. But these issues are of minimal importance, however one chooses to measure them, compared to the ongoing costs of permanently greater insecurity to households and businesses. Even if an independent Scotland were to start out with the Scottish National Party (SNP) fantasy of relatively low public debt and a relatively high share of remaining oil revenues, it would have to save more, pay higher interest rates, and keep more space in its budget for self-insurance, hampered by a narrow tax base, in order to cope with the vicissitudes of the global economy on its own.

When one looks at the economic austerity foisted on the population of Greece and at the hopeless prospects much of the unemployed youth of Europe I wonder whether there is an alternative to the “integrationist” approach.

Looking for an answer I went back to the forging of the United Kingdom. This is how John Lancaster describes the events which led to the Act of Union in 1707:-

During the 17th century, Scottish investors had noticed with envy the gigantic profits being made in trade with Asia and Africa by the English charter companies, especially the East India Company. They decided that they wanted a piece of the action and in 1694 set up the Company of Scotland, which in 1695 was granted a monopoly of Scottish trade with Africa, Asia and the Americas. The Company then bet its shirt on a new colony in Darien – that’s Panama to us – and lost. The resulting crash is estimated to have wiped out a quarter of the liquid assets in the country, and was a powerful force in impelling Scotland towards the 1707 Act of Union with its larger and better capitalised neighbour to the south. The Act of Union offered compensation to shareholders who had been cleaned out by the collapse of the Company; a body called the Equivalent Society was set up to look after their interests. It was the Equivalent Society, renamed the Equivalent Company, which a couple of decades later decided to move into banking, and was incorporated as the Royal Bank of Scotland. In other words, RBS had its origins in a failed speculation, a bail-out, and a financial crash so big it helped destroy Scotland’s status as a separate nation.”

The above passage, taken from Lancaster’s 2009 book It’s Finished, is quoted near the opening of a recent article by Tim Price – Let’s Stick Together in which he refers to Leopold Kohr – The Breakdown of Nations. The forward by Kirkpatrick Sale describes the problem of size when nation building: -

What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.

Kohr grew up in a small village which may have helped him to recognise one of the intrinsic weaknesses of democracy: that it works best on a small scale.

Taking this theme further and applying it to an independent Scotland, John Butler – From bravery to prosperity: A six-year plan to make Scotland the wealthiest Anglosphere region of all makes the case for a smaller more flexible approach. Here is an abbreviated version of his six point plan:-

Debt Repayment

The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.

Tax Reduction

There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting.

Human Capital

Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.

Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location.

Sound Banking

A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.

As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?)

Self-Reliance

The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.

Scottish Presbyterianism

Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.

To be fair to Adam Posen of the Peterson Institute, none of the arguments for a non-integrated Scotland solve the problems of vulnerability to external shocks. The crux of the issue is whether a larger, more integrated unit, is more effective than a smaller more flexible one.

The Politics of Empires

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton – 1834-1902.

Throughout history successful nations have grown through expansion and integration. The process is cyclical, however, and success sows the seeds of its own demise. Europe emerged from the dark ages to conquer much of the known world. Since then it has imploded during two world wars and may now be embarking on a further wave of integration. Or, perhaps, this is the last attempt to assimilate a multitude of disparate cultures before the “long withdrawing breath” into smaller, more dynamic, self-reliant units.

In the opening chapter of Edward Gibbon’s “Decline and Fall of the Roman Empire” he says:-

…but it was reserved for Augustus (who became Caesar in BC 44) to relinquish the ambitious design of subduing the whole earth and to introduce a spirit of moderation into the public councils.

However, I believe the seeds of destruction, which eventually created the conditions for the establishment of A NEW Europe, stem from Diocletian’s introduction of the Tetrarchy in AD 284. It divided the Roman Empire in four regions.

Diocletian’s son, Constantine attempted to slow this fragmentation by adopting Christianity as the official religion of the empire, however, his decision to move the seat of government from Rome to Byzantium in AD 324 set the stage for the final schism into the Eastern and Western Empires which occurred in AD395 on the demise of Theodosius.

The Western Empire sustained continuous assaults from Vandals, Alans, Suebis and Visigoths leading to the second sack of Rome in AD 410 by Alaric. The Western Empire finally collapsed in AD 476 when the Germanic Roman general Odoacer deposed the last emperor, Romulus . Europe had descended into a “dark age” of constant wars between rival tribes. The sole pan-European administrative organization after the fall of the Western Empire was the Catholic Church, which adopted the remnants of its infrastructure.

The creation of the Europe we recognise today began with the conversion to Christianity of Clovis – King of the Franks – in AD 498, but it was not until the re-uniting of the Frankish kingdoms in AD 751 under Pepin The Short and the subsequent appointment of his son Charlemagne as Holy Roman Emperor in AD 800 that the idea of a Christian “Western Europe” began to emerge. When viewed from this long historical perspective the current development of the EU is still in its infancy.

In the East, Constantinople remained the administrative center of the Byzantine Empire. Under Emperor Justinian in AD 526 the Empire expanded. Challenges from the Lombards in AD 568 saw the loss of Northern Italy, but the rise of Islam after AD 623 proved a more terminal event. Although Byzantium went into decline, due to many assailants – not least the Western Empire – it limped on until 1453 when it to finally succumbed to the Ottoman Turks.

Why the history lesson? The spark of the industrial revolution was kindled in Europe. It developed out of the chaotic collapse of the Western Roman Empire, the warring between a plethora of tribes and the rise of independent city states. It was built on the fragmented polity of petty fiefdoms and the desire to trade despite national borders and political restrictions on the movement of labour and goods. The renaissance began in Italy where the competition between small city states stimulated “animal spirits”. The flowering of art and culture that this democratisation of prosperity set in motion goes some way to support the idea that “small is beautiful”.

During the dark ages the concept of “Nationhood” was fluid, as exemplified by the Dukes of Normandy’s fealty after 1066 to the King of France, but only in respect of their French domains. As nation states began to coalesce international trade developed further. Nations waxed and waned, alliances were made and broken but no single nation succeeded in dominating the whole region. Demographic growth encouraged voyages of discovery. Colonisation followed, and finally the conditions were propitious for the birth of the industrial revolution from which we continue to benefit today.

These processes were gradual, running their course over many generations. I believe Europe is now fragmenting once more; painful for our own time but filled with promise for future generations. Calls for self-government from many regions within the EU will increase. The more Brussels attempts to make its citizens feel European the more its citizens will yearn for self-determination.

This trend will be driven by a number of factors aside from the declining effectiveness of central government. Bruegal – The Economics of big cities articulates one of these economic paradoxes, how globalisation has made the world more local: -

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital.

Human Capital may be defined as “the skills, knowledge, and experience possessed by an individual or population”. In the internet age this resource can be located almost anywhere and need not be isolated due to email, telephone or video conference technology, however, the advantages of physical proximity and social interaction favour cities.

Another, and related, issue is the increasingly disruptive effect of technology on employment. Bruegal – 54% of EU jobs at risk of computerisationhighlights one of the greatest economic challenges to the social fabric of the EU, but this is a global phenomenon: -

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Those authors expect that key technological advances – particular in machine learning, artificial intelligence, and mobile robotics – will impact primarily upon low-wage, low-skill sectors traditionally immune from automation. As such, based on our application it is unsurprising that wealthy, northern EU countries are projected to be less affected than their peripheral neighbours.

European governments are caught between the competing needs of an aging population and a younger generation who have little prospect of finding gainful full-time employment. Meanwhile city workers are paying for the regions where unemployment is highest. The tension between “wealth makers” and “wealth takers” are destined to increase.

Conclusion

Scotland voted to remain part of the Union. The Independence campaign was ill prepared failing to consider such issues as what currency they would use or how they would avoid a run on their banking system. The next time the Scots vote – and there will be a next time – I believe they will leave the Union because these questions will have been addressed. Other regions around the UK and Europe have taken note – the spirit of devolution is abroad. Prosperous regions, such as Catalunya and Northern Italy – Padania as it is sometimes called – crave independence from their poorer neighbours. Poorer regions resent the straight jacket of a single currency – be it the GBP for regions like the North East of England or the EUR for Greece and Portugal. To the poorer regions, the flexibility of a floating exchange rate is beguiling; as the EU stumbles through an era of debt laden low growth devolution pressures will increase.

For the GBP and EUR the Scottish “No” vote will fail to diminish the potential for social and political tension. The value of these currencies will reflect that uncertainty. Longer-term foreign direct investment will be lower. This will place an additional burden on EU budgets. A larger percentage of central government spending will be directed to regions where calls for devolution are highest rather than to economically productive projects in more prosperous areas.

European and UK equities are likely to under-perform in this environment whilst the increased indebtedness of EU governments is likely to increase their real borrowing costs.

Will this happen soon and will it be possible to measure? I think it is already happening but, given the very long-term nature of the fragmentation of nations, it will be difficult to measure except during constitutional crises. The shorter-term business cycles will still exist. Trading and investment opportunities will continue to arise. For the investor, however, it is essential to be aware of the risks and rewards which this fragmentation process will present.

The US$ as a store of value

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Macro Letter – No 20 – 26-09-2014

The US$ as a store of value

  • The US$ Index has broken above July 2013 highs as the US economy strengthens
  • The Trade Weighted Index also reflects this trend
  • But the Trade Balance remains in deficit

US$ Index - 25yr - Barchart.com

 

Source: Barchart.com

As the US economic recovery continues to gather momentum, what are the prospects for the US$ versus its principal trading partners? This is key to determining how swiftly and to what degree the Federal Reserve will tighten monetary conditions. Above is a 25 year monthly chart of the US$ Index and for comparison, below is the US$ Trade Weighted Index (TWI) as calculated by the Philadelphia Federal Reserve. The TWI shows the initial flight to quality during the onset of the Great Recession, the subsequent collapse as the Fed embarked on its increasingly aggressive programme of QE, followed by a more orderly recovery as the US economy began its long, slow rebound. It is still only a modest recovery and I would not be surprised to see a slow grind higher towards the initial post crisis highs around 113 – this is only a 50% retracement of the 2001-2011 range. In the longer term a return to the “strong dollar” policies of the late 1990’s might be conceivable if the current industrial renaissance of the US continues to gather momentum:-

US$ TWI - 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

During the late 1990’s the US$ soared on a combination of strong economic growth, a technology asset bubble and relatively benign inflation due to the disinflationary forces of globalisation, emanating especially from China. During the current decade another technology revolution has been underway as the US becomes self-sufficient in energy production. I am not referring simply to “fracking” as this paper from the Manhattan Institute – New Technology for Old Fuel – April 2013 explains: -

Between 1949 and 2010, thanks to improved technology, oil and gas drillers reduced the number of dry holes drilled from 34 percent to 11 percent.

Global spending on oil and gas exploration dwarfs what is spent on “clean” energy. In 2012 alone, drilling expenditures were about $1.2 trillion, nearly 4.5 times the amount spent on alternative energy projects.

Despite more than a century of claims that the world is running out of oil and gas, estimates of available resources continue rising because of innovation. In 2009, the International Energy Agency more than doubled its prior-year estimate of global gas resources, to some 30,000 trillion cubic feet—enough gas to last for nearly three centuries at current rates of consumption.

In 1980, the world had about 683 billion barrels of proved reserves. Between 1980 and 2011, residents of the planet consumed about 800 billion barrels of oil. Yet in 2011, global proved oil reserves stood at 1.6 trillion barrels, an increase of 130 percent over the level recorded in 1980.

The dramatic increase in oil and gas resources is the result of a century of improvements to older technologies such as drill rigs and drill bits, along with better seismic tools, advances in materials science, better robots, more capable submarines, and, of course, cheaper computing power.

 The productivity gains are substantial within the Oil and Gas industry but the benefits are just beginning to percolate out to the broader economy.

Here is US GDP over the last twenty years: -

US GDP - 1995-2014 - Trading Economics

Source: Trading Economics

Growth since the Great Recession has been relatively anaemic. To understand some of the other influences on the US$ we also need to consider the US Trade Balance: -

US Trade Balance - 1995-2014 - Trading Economics

Source: Trading Economics

The USA continues to be the “consumer of last resort”. Here, by contrast are the EU GDP (1995-2014) and Trade Balance (1999-2014): -

EU GDP 1995-2014 - Trading Economics

Source: Trading Economics

EU Trade Balance - 1999-2014 - Trading Economics

Source: Trading Economics

Europe is also a major export market for Chinese goods but nonetheless appears to rely on trade surpluses to generate sustainable growth. Since the Great Recession the EU has struggled to achieve any lasting GDP growth despite a significant increase in its trade surplus. This is because a large part of the terms of trade improvement has been achieved by reducing imports rather than increasing exports, especially in the Euro Zone (EZ) peripheral countries. The austerity imposed on EZ members by the ECB has encouraged some external trade but the prospect for any sustained recovery in EZ growth is limited.

China has, of course, been a major beneficiary of the US trade deficit, although, since the Great Recession, trade surplus data has become significantly more volatile: -

China Trade balance - 1995-2014 - Trading Economics

Source: Trading Economics

The chart above doesn’t really articulate the colossal increase in Chinese exports – between 2004 and 2009 China’s trade surplus increased ten-fold. Despite the more recent policy of “Rebalancing” towards domestic consumption, the latest data takes this surplus to a new record.

The US response to the trade deficit

The US government is concerned about the structural nature of their trade deficit but this is balanced by capital account surpluses as this report from the Congressional Research Service – Financing the U.S. Trade Deficit – March 2014 explains: -

According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses.

The chart below shows the continued increase in foreign holdings of US assets between 1994 and 2012: -

Foreign_Official_and_Private_Investment_Positions_

Source: US Commerce Department

The Congressional Research Service concludes:-

The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long term rate of growth for the economy. In particular, some observers are concerned that foreigner investors’ portfolios will become saturated with dollar denominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded.

Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital.

Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar’s international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness

In addition, the nation’s net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case.

The author appears to be saying that, so long as foreign private investors are prepared to continue acquiring US assets, the US need not be overly concerned about the deficit. Given that this should be negative for the US, what are the medium-term implications for the US$?

Gold vs US$

Evaluating the US$, in a world where all the major fiat currencies are attempting to competitively devalue, is fraught with difficulty, however, the price of gold gives some indication of market perceptions. It seems to indicate a resurgence of faith in the US currency:-

Gold - 25 year - Barchart

Source: Barchart.com

The substantial appreciation in the price of gold since 2001 is evident in the chart above, however, since the US economy began to recover from the Great Recession and financial markets perceived that QE3 might suffice to avert deflation, gold has lost some of its “safe-haven” shine. 10 yr US Treasuries yield 2.56%, the S&P 500 dividend yield is 1.87% – whilst these are historically low they look attractive compared to 10 yr German Bunds at 0.97% or 10 yr JGBs at 0.54%.

Leading Indicators

The Philadelphia Federal Reserve – Leading Indicators shows the breadth and depth of the prospects for the US economy, below is their latest heat map: -

Philly_Fed_-_July_2014_Leading_Indicators

Source: Philadelphia Federal Reserve

Below is a chart of the evolution of US Leading Indicators since 1995: -

US Leading Indicators 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

The relative strength of the Leading Indicators has not been as evident in the GDP data. This supports arguments such as CEPR – Is US economic growth over? September 2012 by Robert Gordon in which he promulgates his theory of structurally lower productivity growth in the US over the coming decades.

Personally I am not convinced that we have seen the end of productivity growth. I believe the extraordinary improvements in energy technology and productivity will begin to show up in broader data over the next few years.

Which leads me back to pondering on Governor Yellen’s recent comments after the FOMC Press Conference:-

…If we were only to shrink our balance sheet by ceasing reinvestments, it would probably take, to get back to levels of reserve balances that we had before the crisis. I’m not sure we will go that low but we’ve said that we will try to shrink our balance sheet to the lowest levels consistent with the efficient and effective implementation of policy. It could take to the end of the decade to achieve those levels.

This suggests the Federal Reserve may never sell any of the assets they have purchased but simply hold them to maturity. In an oblique way this view is supported by a paper from the Chicago Federal Reserve – Measuring fiscal impetus: The Great Recession in historical context which was published this week. They examine the link between changes in fiscal policy in the immediate wake of the Great Recession and more recently the slow pace of this cyclical recovery. Looking forward they opine: -

Fiscal policy during the Great Recession was more expansionary than in the average post-1960 recession, with declines in taxes, increased in transfers, and higher purchases all contributing to higher than typical fiscalimpetus. This pattern reversed itself following the cyclical trough, with declining purchases, particularly among subnational governments, accounting for most of the shortfall. By mid-2012, cumulative fiscal impetus was below the average level in other post-1960 recessions. Although fiscal restraint is expected to ease somewhat over the coming years, there is no indication that fiscal policy will be a meaningful source of economic growth in the near future.

If fiscal policy is unlikely to be a meaningful source of economic stimulus in the near future then monetary policy will have to do the lion’s share of the heavy lifting.

Where next for the US$

The economic fundamentals of the US economy look solid. Regions like Texas might even be in danger of overheating as this report from the Dallas Federal Reserve – Regional Growth: Full Steam Ahead – makes clear:-

The regional economy is surging, with the Texas Business Outlook Survey (TBOS) production and revenue indexes at multiyear highs and annualized job growth of 3.6 percent year to date. Second-quarter job growth was 4.6 percent annualized, and July job growth was just as fast. Energy production continues to increase, and the rig count has risen since last August in spite of a decline in oil prices. Texas exports rebounded in July.

… All told, the regional economy is growing at an unsustainable pace. Texas employment has grown at more than twice its long-run average rate over the past four months. Declines in unemployment measures have slowed, suggesting Texas is near full employment and slack is being depleted. The rapid growth has led to labor shortages, which can cause bottlenecks in production and hurt productivity. Tight labor and housing markets are leading to mounting wage pressures and increasing prices.

Dallas Federal Reserve President Richard Fisher has been a hawk for as long as I can remember, however, he plans to retire in April of next year. As does his fellow hawk Charles Plosser – President of the Philadelphia Fed, although Jeffrey Lacker – President of the Richmond Fed – will take up the hawkish cause in 2015. Nonetheless this weakens to case for any rapid tightening of policy beyond the tapering of QE.

Given the zero bound interest rate policies of all the major central banks, growth rather than expectations of widening interest rate differentials is more likely to determine the direction of currencies. Therefore, the slower the Federal Reserve act in tightening policy, the stronger the momentum of US GDP growth, the larger the capital inflows and the stronger the support for the US$.

Elsewhere, the prospects for EU growth are much weaker. Further QE is imminent after last week’s disappointing uptake of TLTRO funds – Bruegal – T.L.T.R.O. is Too Low To Resuscitate Optimism has more detail. The BoJ, meanwhile, continues with its policy of QQE yet, without the Third Arrow of the Abenomics – serious structural reform – Japan is unlikely to become an engine of economic growth. China continues its rebalancing but the momentum of growth is downward. In this environment the US looks like a land of opportunity to the optimist and the “least worst” safe-haven in an uncertain world for the pessimist. Either way, barring a substantial escalation in direct geopolitical risk, the US$ is unlikely to weaken. Technically the currency is looks set to appreciate further; in so doing this may create a virtuous circle reducing import price inflation and delaying – or possibly mitigating the need for – tightening by the Federal Reserve.