Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

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Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

Flash-Gordon-flash-gordon-23432257-1014-1600

Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.

China

The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-

Demand_Growth_in_Asia

Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.

India_moving_to_centre

Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.

A_new_chapter_in_Chinas_growth_story

Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”

A_new_balancing_item_in_the_oil_market

Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.

Power_is_leading_the_transformation

Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.

Technology

“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.

US_Index_-_5_yr_Marketwatch

Source: Marketwatch

Is the ascension of the RMB to the SDR basket more than merely symbolic?

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Macro Letter – Supplemental – No 2 – 11-12-2015

Is the ascension of the RMB to the SDR basket more than merely symbolic?

  • Chinese rebalancing towards domestic consumption changes the balance of trade
  • China’s largest trading partner remains the EU, making a US$ peg sub-optimal
  • SDR currencies offer the best liquidity for intervention or speculation
  • International investment will be dramatically enhanced by full convertibility

I’ve changed my view of the importance of the RMBs inclusion in the SDR. Initially I thought this a purely symbolic action but, having discussed the issue with several economists and ex-Central Bankers (including one from the PBoC) I believe this a logical move towards free convertibility of the RMB.

For many years the RMB has been pegged to the US$. During the early part of this century it rose relative to its neighbours. This was not such a great imposition on the economy since annual GDP growth was still in double figures.

After the great financial recession of 2008 things changed. New economic policies focused on increasing domestic consumption. At the same time the Chinese economy began to slow dramatically as a result of over-investment, especially in primary industries, meanwhile, the benefits of cheap labour, which had driven China’s mercantilist expansion during the past 25 years, showed signs of fatigue.

After 2008, the US embarked on aggressive quantitative easing which eventually began to foster new domestic employment opportunities – in turn leading to a recovery of the fortunes of the US$. Earlier this year the PBoC devalued the RMB albeit to a small degree.

If you were the PBoC what would you do?

China is rebalancing towards domestic consumption at a pace which would be almost inconceivable in any other country. The implications of this shift include an increase in imports and a structural adjustment in the momentum of the trade surplus. China is moving on from simply being the world’s manufacturer to become a trading nation. A freely convertible currency would reduce frictions in trade and encourage foreign direct investment. The downside to this regime change is the volatility of the exchange rate.

At $3.5trln the PBoC has the largest foreign reserves of any Central Bank. This has primarily been a function of their peg against the US$, although they have actively sought to diversify in to EUR and even the “barbarous relic” gold. During the last 18 months the bank has drawn down on some of those reserves (they peaked at $3.9trln in May 2014) as it managed a devaluation versus the US$ which has fallen from RMBUSD 6.05 in January 2014 to RMBUSD 6.49 today (8-12-2015).

Has the benefit of the US$ peg now run its course? During the period of strong – export led – growth, China was under significant international political pressure to allow the RMB to rise against the US$. The perception is that they resisted international interference, but over the last 20 years the RMB has risen by around 30%. Nonetheless, market commentators immediately seized on the devaluation – especially since August – as a sign that the Chinese were engineering an export led recovery at the expense of the US. This 2013 paper from the Bundesbank – China‘s role in global inflation dynamics suggests there may be some substance to these concerns:-

The overall share of international inflation explained by Chinese shocks is notable (about 5 percent on average over all countries but not more than 13 percent in each region). This suggests that monetary policy makers should take macroeconomic developments in China into account when stabilizing domestic inflation rates; (ii) Direct channels (via import and export prices) and indirect channels (via greater exposure to foreign competition and commodity prices) both seem to matter; (iii) Differences in trade (overall and with China) and in commodity exposure help explaining cross-country differences in price responses.

Nonetheless, the authors note that, between 2002 and 2011, the “supply shock” from cheap Chinese goods explained only 1% of changes in consumer prices outside China, whilst the “demand shock”, from rapid Chinese, growth accounted for 3.6% of changes in global consumer prices. 95% of the variation in global inflation were due to non-Chinese factors.

As the Trans Pacific Partnership comes into effect, China needs to embark on a series of bilateral trade agreements. After the US, its largest trading partners are Japan, South Korea, Taiwan, Germany, Australia and Malaysia, however, as a currency trading block the Euro Area is preeminent.

There are two alternatives to a US$ peg, the first is to manage the RMB effective exchange rate, but this would be expensive due to the multiple currencies involved, the second option is to peg the RMB to the SDR basket. Both politically and economically this acknowledges China’s position as the second largest economy. It also heralds another incremental change in perception about the pre-eminence of the US$ as a reserve currency.

The RMB will be included in the SDR from October 2016. As the Chinese administration moves towards free-convertibility it is likely that they will start by widening the degree to which the currency can fluctuate. By managing the RMB versus the other SDR currencies they can take advantage of the liquidity these currencies provide and the lower volatility that the SDR basket has relative to its constituents. This will also allow the PBoC to intervene to stem the largest speculative currency flows. Table below shows the annual level of trade by region (2011):-

Region Exports Imports Total trade Trade balance
 European Union 356 211.2 567.2 144.8
 United States 324.5 122.2 446.7 202.3
 Hong Kong 268 15.5 283.5 252.5
 ASEAN 170.1 192.8 362.9 -22.7
 Japan 148.3 194.6 342.9 -46.3

 

Source: China National Statistics Bureau

Capital Flows

Trade is one aspect of China’s development, the other is capital; the Kansas City Federal Reserve Macro Bulletin – Global Capital Flows from China – takes up the story:-

In 2014-15, China experienced five consecutive quarters of capital outflows for the first time since 2000, and the annual volume of outflows is at a record level. If growth expectations continue to soften, this trend may continue in the near future.

China has been an active investor in Africa and other resource-rich regions, but, as its competitive advantages from labour dissipate, external investment will become far more important. Another reason to allow full convertibility.

Technical issues and challenges

The two requirements for joining the SDR are; being a larger exporter – which is no issue for China -and having a freely accessible currency. They still have some way to go on the latter, but China now has more than two dozen swap lines with foreign central banks, has promoted offshore trading and abolished quotas for foreign central banks and sovereign wealth funds investing in mainland bonds. 

RMB fixing – the PBoC as a participating SDR central bank, must provide the IMF with a daily fix. Currently there is a gap between domestic and the offshore RMB rate, closing that gap will be an operational challenge.

SDR currencies are weighted based on trade and reserve status – Marc Chandler – China And The Pull Of The SDR – elaborates:-

Given China’s export prowess, it suggests the yuan should be a major currency in the SDR. However, as a reserve asset, it is very small. The IMF estimates the yuan’s share of reserves at a minuscule 1.1%.

For more on the technical aspects of the SDR this paper from Europacifica – The RMB in the SDR and why Australia should care offers more insights.

In October China issued its first Treasury bill on the international market. Here is how it was reported by the FT – China completes first London debt sale:-

Spencer Lake, global head of capital financing at HSBC, one of the banks that arranged the sale, called the transaction a milestone in the internationalisation of the renminbi, noting that it was the first debt offering in any currency from the PBoC outside China.

“This strategic move demonstrates the clear commitment by the Chinese authorities to grow the offshore bond market and the confidence in the City of London as a leading renminbi hub for future activities,” he said.

“The PBoC bond will give a genuine boost to liquidity, market confidence and provide investors with the quality that they demand.”

Who will buy the non-performing loans?

Another reason China may want to move towards free convertibility is to encourage foreign investment. An article from Zero-Hedge – One Analyst Says China’s Banking Sector Is Sitting On A $3 Trillion Neutron Bomb explains:-

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion. 

That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven’t done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall. 

Conclusion

I believe the inclusion of the RMB in the SDR is more than simply symbolic. It will allow the PBoC to move away from a US$ peg, widen it trading bands and balance its currency more effectively relative to its main trading partners. PBoC Intervention can be generally confined to SDR currencies which, due to their high liquidity, will be the cross-currency pairs of choice for speculators.

What are the prospects for UK financial markets in 2016?

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Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU, there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.

Should we buy Turkey for Thanksgiving?

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Macro Letter – No 46 – 20-11-2015

Should we buy Turkey for Thanksgiving?

  • Erdogan’s AKP won an unexpected majority in this month’s election
  • The Turkish Lira (TRY) has fallen by 60% against the USD since 2008
  • Turkish stocks look inexpensive by several measures
  • Economic reform appears unlikely

Back in June the AKP failed to achieve a majority in this year’s first general election. Second time around they achieved a resounding victory – though not the “supermajority” required for constitutional reform. The main reason for the loss of confidence earlier in the year was the state of the Turkish economy. Now the AKP has an opportunity to embark on economic reform – this may be easier said than done.

They need to deal with rising unemployment which, having dipped to 9.3% in May, is on the rise again – August 10.1%. Labour participation has been steadily rising – from 43.6 in 2006 to 51.2 today, however it is still low by international standards and female participation is a rather dismal 29%. Youth unemployment has fallen from 28% in 2009 to 18.3% in August, but this does not bode well for their relatively young nation. Of the 77mln population, 67% are notionally working age – 15 to 64. Only 6% are over 64 years. Turks make up 75% of the population whilst Kurds already account for 18%; as this 2012 article from the IB Times – A Kurdish Majority In Turkey Within One Generation? makes clear, substantial cultural challenges lie ahead.

High unemployment has impacted consumer confidence which plunged to 58.52 in September – its lowest level since the global recession of 2009. October saw a rebound to 62.78.

Core inflation remains stubbornly high despite the fall in oil prices. During the summer it dipped below 8% but by October it was 9.3%. The chart below shows the core inflation rate over the last decade:-

turkey-core-inflation-rate

Source: Tradingeconomics and Eurostat

High inflation is primarily due to the weakness of the TRY; the next chart shows USDTRY, but the BIS Effective exchange rate also declined from 100 in 2010 to 70.6 at the end of 2014. The last big TRY devaluation occurred between February and October 2001, the move since 2008 has been of a similar magnitude, albeit with less precipitous haste:-

turkey-currency

Source: Tradingeconomics

Inflation might have been even higher had imports not fallen:-

turkey-imports

Source: Tradingeconomics and Turk Stat

The decline in imports, principally from Russia (10.4%) China (10.3%) and Germany (9.2%) helped reduce the current account deficit to some extent but at -6% of GDP it remains, unhealthy:-

turkey-current-account-to-gdp

Source: Tradingeconomics and Central Bank of Turkey

Turkey is a big energy importer – for a more detailed discussion on energy security for Turkey (and the EU) this working paper from Bruegel – Designing a new Eu-Turkey Gas Partnership is worth perusal.

The current account deficit is matched by the government budget balance, this has remained negative for most of the decade, although the debt to GDP ratio is an undemanding 33%:-

turkey-government-budget

Source: Tradingeconomics and Turkish Ministry of Economics

Meanwhile Turkey’s external debt continues to grow, it now equates to more than half of GDP:-

turkey-external-debt

Source: Tradingeconomics and Turkish Treasury

Much of the external borrowing has been short-term and the private sector accounts for more than two thirds of the total. Since 2002 GDP has increased from $233bln to $800bln – during the same period external debt has tripled. Short-term debt to central bank reserves have doubled. The table below investigates this and other aspects of Turkey’s external debt:-

Turkish Debt

Source: Central Bank of Turkey and Turk Stat

In 2013 Morgan Stanley dubbed Turkey one of the “fragile five”, the others being Brazil, India, Indonesia and South Africa. These countries had high external debt, twin deficits, structurally high inflation and slowing growth. Turkish GDP has been recovering somewhat this year – 3.8% in Q2 2015 – but it remains below its 2002-2011 average of 5.2%:-

turkey-gdp-growth-annual

Source: Tradingeconomics and Turk Stat

Given the weakness of the currency it is surprising that economic recovery has not been more pronounced. This may be due to the parlous state in Turkey’s principal export markets, Germany (9.6%) has seen slow growth and Iraq (6.9%) has been in recession:-

turkey-exports

Source: Tradingeconomics and Turk Stat

In March Morgan Stanley announced that India and Indonesia had made sufficient reforms to be removed from the “Fragile” category. Turkey remains, unreformed, especially in terms of its labour laws – a focal point if they are to reduce structural unemployment.

Turkey has demographic trends on its side but its productivity has been stagnant since the financial crisis. The OECD estimated GDP per hour for 2014 at 29.3 hours – in 2007 it was 28.9 hours.

Financial Markets

Short-term interest rates, which touched 10% last year, have fallen to 7.5%, despite inflation and TRY weakness, but the independence of the central bank has been questioned since Erdogan openly criticised their interest rate policy in March – with the AKP majority restored the problem of inflation may be deferred:-

turkey-interest-rate

Source: Tradingeconomics and Central Bank of Turkey

Reflecting market sentiment better, 10yr Turkish Government bonds, reached 10.78% in October, although they have recovered, in the wake of the election, to yield 9.72% today (Wednesday 18th) here is a five year chart:-

turkey-government-bond-yield 5yr

Source: Tradingeconomics and Turkish Treasury

From a technical perspective bond yields appear to have backed away from the 2014 highs, but considered in conjunction with the continued trend of the TRY, I lack the confidence to buy ahead of real economic reform package. Meanwhile, the US Federal Reserve look set to raise interest rates next month, putting further downward pressure on the TRY and driving short-term US$ financing costs higher.

The Turkish XU100 stock index rallied from 77,776 to 83,692 after the election – today (Wednesday 18th) it stands at 81,274. It has been buoyed by currency weakness:-

turkey-stock-market

Source: Tradingeconomics and Istanbul Stock Exchange

The market valuation is relatively undemanding. A CAPE of 10.3 is higher than its emerging European neighbours, but on a straight PE basis (11 times) and dividend yield (3.4%) it is comparable. On a price to cost, price to book or price to sales basis, however, it is more expensive than Emerging Europe.

The largest stocks in the index are:-

Company Ticker Sector
Garanti Bankası GARAN Banking
Akbank AKBNK Banking
Turkcell TCELL Telecommunications
Koç Holding KCHOL Conglomerate
Türkiye İş Bankası ISATR Banking
Türk Telekom TTKOM Telecommunications
Enka İnşaat ENKAI Construction
Sabancı Holding SAHOL Conglomerate
Halk Bankası HALKB Banking
Efes Beverage Group AEFES Beverage
Vakıfbank VAKBN Banking
Turkish Airlines THYAO Transportation

Source: Istanbul Stock Exchange

Whilst the economy is 25% Agriculture, 26% Industry and 49% Services, the stock market is dominated by banks. At the end of 2013 the weights for the XU100 were 36% Banks, 17% Beverages and 8% Conglomerates – although the fragmented (30 companies) cement industry should be mentioned. It is the largest in Europe and fifth largest globally. Rising bond yields, even though they have fallen since the election, and the weakness of the TRY increase the risk of bank losses. Technically, one should remain long, but I’m not inclined to add aggressively at this stage.

An additional concern is Turkey’s political relations with the EU. According to a 3rd September article from Brookings – Why 100,000s of Syrian refugees are fleeing to Europe:-

Turkey’s is being deeply affected too, in spite of having the largest economy in the region and a strong state tradition. Its resources and public patience are wearing thin. The Syrian refugee issue certainly plays a role in the current political instability in the country. According to UNHCR, Turkey became the world’s largest recipient of refugees (total, including those from Iraq) in 2014. 

The EU’s inability to act on concert to address the migrant crisis, along with the imminent collapse of the Schengen Agreement, is likely to further strain relations. It may not stop existing trade but it is likely to slow new business developments.

Security remains a major issue for the new Turkish government as CFR – What Turkey’s Election Surprise Says About the Troubled Country explains:-

…Turkey now confronts simultaneous conflicts with the PKK and the Islamic State. After a year of intensive American diplomacy, Ankara’s decision last July to provide the United States and coalition forces access to air bases close to the Islamic State’s territory has made Turkey a target.

On a more positive note. The new government is likely to make good on its election promises by increasing fiscal stimulus. That 33% debt to GDP ratio must be burning a hole in Erdogan’s pocket. Stimulus is expected to be directed at infrastructure – the “three R’s”, roads, railways and real-estate. “Grand projects” include a third Airport and a mountaintop mosque for Istanbul, a third bridge and a tunnel across the Bosporus, a canal linking the Black Sea to the Sea of Marmara and a gigantic presidential palace in Ankara.

Conclusion – the currency is key

On balance I think it is too soon to buy Turkish bonds or stocks. The new government seems reluctant to embrace the economic reforms needed to drive productivity growth. External debt will have to be repaid, inflation, subdued and jobs created. Turkish stocks look relatively inexpensive and her bonds may be tempting to the carry trader, but an appreciating TRY is key – should the currency recover, stocks and bonds will follow.

Have technological advances offset the reduction in capital allocated to financial markets trading?

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Macro Letter – No 45 – 06-11-2015

Have technological advances offset the reduction in capital allocated to financial markets trading?

  • Increases in capital requirements have curtailed financial institutions trading
  • Improved execution, clearing and settlement has reduced frictions in transactions
  • Faster real-time risk management systems have enhanced the efficiency of capital
  • On-line services have democratized market access

Liquidity in financial markets means different things to different participants. A sharp increase in trading volume is no guarantee that liquidity will persist. Before buying (or selling) any financial instrument the first thing one should ask is “how easy will it be to liquidate my exposure?” This question was at the heart of a recent paper by the UK Government – The future of computer trading in financial markets – 2012here are some of the highlights:-

…The Project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects. However, it is believed that policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets.

There will be increasing availability of substantially cheaper computing power, particularly through cloud computing: those who embrace this technology will benefit from faster and more intelligent trading systems in particular.

Special purpose silicon chips will gain ground from conventional computers: the increased speed will provide an important competitive edge through better and faster simulation and analysis, and within transaction systems.

Computer-designed and computer-optimised robot traders could become more prevalent: in time, they could replace algorithms designed and refined by people, posing new challenges for understanding their effects on financial markets and for their regulation.

Opportunities will continue to open up for small and medium-sized firms offering ‘middleware’ technology components, driving further changes in market structure: such components can be purchased and plugged together to form trading systems which were previously the preserve of much larger institutions.

The extent to which different markets embrace new technology will critically affect their competitiveness and therefore their position globally: The new technologies mean that major trading systems can exist almost anywhere. Emerging economies may come to challenge the long-established historical dominance of major European and US cities as global hubs for financial markets if the former capitalise faster on the technologies and the opportunities presented.

The new technologies will continue to have profound implications for the workforce required to service markets, both in terms of numbers employed in specific jobs, and the skills required: Machines can increasingly undertake a range of jobs for less cost, with fewer errors and at much greater speed. As a result, for example, the number of traders engaged in on-the-spot execution of orders has fallen sharply in recent years, and is likely to continue to fall further in the future. However, the mix of human and robot traders is likely to continue for some time, although this will be affected by other important factors, such as future regulation.

Markets are already ‘socio-technical’ systems, combining human and robot participants. Understanding and managing these systems to prevent undesirable behaviour in both humans and robots will be key to ensuring effective regulation…

While the effect of CBT (Computer Based Trading) on market quality is controversial, the evidence available to this Project suggests that CBT has several beneficial effects on markets, notably:

liquidity, as measured by bid-ask spreads and other metrics, has improved;

transaction costs have fallen for both retail and institutional traders, mostly due to changes in trading market structure, which are related closely to the development of HFT in particular;

market prices have become more efficient, consistent with the hypothesis that CBT links markets and thereby facilitates price discovery.

While overall liquidity has improved, there appears to be greater potential for periodic illiquidity: The nature of market making has changed, with high frequency traders now providing the bulk of such activity in both futures and equities. However, unlike designated specialists, high frequency traders typically operate with little capital, hold small inventory positions and have no obligations to provide liquidity during periods of market stress. These factors, together with the ultra-fast speed of trading, create the potential for periodic illiquidity. The US Flash Crash and other more recent smaller events illustrate this increased potential for illiquidity.

…Three main mechanisms that may lead to instabilities and which involve CBT are:

nonlinear sensitivities to change, where small changes can have very large effects, not least through feedback loops;

incomplete information in CBT environments where some agents in the market have more, or more accurate, knowledge than others and where few events are common knowledge;

internal ‘endogenous’ risks based on feedback loops within the system.

The crux of the issue is whether market-makers have been replaced by traders. This trend is not new. On the LSE the transition occurred at “Big Bang” in October 1986. The LSE was catching up with the US deregulation which prompted the formation of NASDAQ in 1971.

Electronic trading, once permitted, soon eclipsed the open-outcry of futures pits and traditional practices of stock exchange floors. Transactions became cheaper, audit trails, more accurate and error incidence declined. Commission rates fell, bid/offer spreads narrowed, volumes increased, in an, almost, entirely virtuous circle.

The final development which was needed to insure liquidity, was the evolution of an efficient repurchase market for securities – sadly this market-place remains remarkably opaque. Nonetheless, the perceived need for designated market-makers, with an obligation to make a two-way price, has diminished. It has been replaced by proprietary trading firms, which forgo the privileges of the market-maker – principally lower fees or preferential access to supply – for the flexibility to abstain from providing liquidity at their own discretion.

In the late 1990’s I remember a conversation with a partner at NYSE Specialist – Foster, Marks & Natoli – he had joined the firm in 1953 and sold his business to Spear, Leeds Kellogg in 1994. He told me that during his career he estimated the amount of capital relative to size of the trading portfolio had declined by a factor of five times.

Since the mid-1990’s stock market volumes have increased dramatically as the chart below shows:-

NYSEvolume

Source: NYSE

The recommendations of the UK Government report include:-

European authorities, working together, and with financial practitioners and academics, should assess (using evidence-based analysis) and introduce mechanisms for managing and modifying the potential adverse side-effects of CBT and HFT.

Coordination of regulatory measures between markets is important and needs to take place at two levels: Regulatory constraints involving CBT in particular need to be introduced in a coordinated manner across all markets where there are strong linkages.

Regulatory measures for market control must also be undertaken in a systematic global fashion to achieve in full the objectives they are directed at. A joint initiative from a European Office of Financial Research and the US Office of Financial Research (OFR), with the involvement of other international markets, could be one option for delivering such global coordination.

Legislators and regulators need to encourage good practice and behaviour in the finance and software engineering industries. This clearly involves the need to discourage behaviour in which increasingly risky situations are regarded as acceptable, particularly when failure does not appear as an immediate result.

Standards should play a larger role. Legislators and regulators should consider implementing accurate, high resolution, synchronised timestamps because this could act as a key enabling tool for analysis of financial markets. Clearly it could be useful to determine the extent to which common gateway technology standards could enable regulators and customers to connect to multiple markets more easily, making more effective market surveillance a possibility.

In the longer term, there is a strong case to learn lessons from other safety-critical industries, and to use these to inform the effective management of systemic risk in financial systems. For example, high-integrity engineering practices developed in the aerospace industry could be adopted to help create safer automated financial systems.

Making surveillance of financial markets easier…The development of software for automated forensic analysis of adverse/extreme market events would provide valuable assistance for regulators engaged in surveillance of markets. This would help to address the increasing difficulty that people have in investigating events

At no point do they suggest that all market participants – especially those with principal or spread risk – be required to increase their capital. This will always remain an option. An alternative solution, the reinstatement of designated market-makers with obligations and privileges, is also absent from the report – this may prove to be a mistake.

An example of technological emancipation

In this paper, Review of Development Finance – The impact of technological improvements on developing financial markets: The case of the Johannesburg Stock Exchange – Q3 – 2013 – the authors investigate how the adoption of the SETS trading platform transformed the volume traded on the JSE:-

The adoption of the SETS trading platform was supposed to represent a watershed moment in the history of the Johannesburg Stock Exchange. The JSE is more liquid after SETS. The JSE has nearly doubled its trading activity (volume), trading is cheaper, and there are more trades at JSE after SETS.

Overall, average daily returns are higher. We posit that this is mainly because the returns are increased to the levels demanded for the associated risk. With the new trading platform, it would also be expected that there would be improvements in market efficiency. Higher numbers of investors, more listed companies, faster trading and more trade (evidenced with trading activity and liquidity), all would imply more market efficiency. Contrary to our expectations, however, market-wide and individual-level stock returns are still somewhat predictable; this is a clear violation of market efficiency.

If market participants had been required to increase their capital in line with the increased volume, the transformation would have been far less dramatic. This is not to say that increased trading volume equates to increased risk. Technology has improved access, traders are able to liquidate positions more easily, most of the time, due to improved technology. At any point in the trading day they may hold the same open position size, but by turning over their positions more frequently they may be able to increase their return on capital (and risk) employed.

Federal Reserve concern

The Federal Reserve Bank of New York – Introduction to a series on Liquidity published eleven articles on different aspects of liquidity during the last three months, here are some of the highlights:-

Has U.S. Treasury Market Liquidity Deteriorated? …it might be that liquidity concerns reflect anxiety about future liquidity conditions, with a possible imbalance between liquidity supply and demand. On the demand side, the share of Treasuries owned by mutual funds, which may demand daily liquidity, has increased. On the supply side, the primary dealers have pared their financing activities sharply since the crisis and shown no growth in their gross positions despite the sharp increase in Treasury debt outstanding.

This seems to ignore the effect of QE on the “free-float” of T-Bonds. The chart below shows the growth of the Federal Reserve holdings during the last decade:-

T-Bonds at the Fed - St Louis Fed

Source: St Louis Federal Reserve

Liquidity during Flash Events…all three events exhibited strained liquidity conditions during periods of extreme price volatility but the Treasury market event arguably exhibited a greater degree of price continuity, consistent with descriptions of the flash rally as “slow-moving.”

Unlike the FX and equity market, the US government still appoint primary dealers who have privileged access to the issuer. This probably explains much of the improved price continuity.

High-Frequency Cross-Market Trading in U.S. Treasury Markets. Cross-market trading by now accounts for a significant portion of trading in Treasury instruments in both the cash and futures markets. This reflects improvements in trading technology that allow for high-frequency trading within and across platforms. In particular, nearly simultaneous trading between the cash and futures platforms now accounts for up to 20 percent of cash market activity on many days. Market participants often presume that price discovery happens in Treasury futures. However, our findings show that this is not always the case: Although futures usually lead cash, the reverse is also often true. Therefore, from a price discovery point of view, the two markets can effectively be seen as one.

For many years the T-Bond future was regarded as the most liquid market and was therefore the preferred means of liquidation in times of stress. The most extreme example I have witnessed was in the German bond market during re-unification (1988). The Bund future was the most liquid market in which to lay off risk. As a result, Bund futures traded more than 10 bps cheap to cash and cash Bunds offered a yield premium of 13bps to bank Schuldschein – unsecured promissory notes.

The introduction of electronic trading in T-Bond cash markets has created competing pools of liquidity which should be additive in times of stress. The increasing use of Central Counter Party (CCP) clearing has allowed new market participants to operate with a smaller capital base.

This evolution has also been sweeping through the Interest Rate Swap market, reducing pressure on the T-Bond futures market further still.

The Evolution of Workups in the U.S. Treasury Securities Market. The workup is a unique feature of the interdealer cash Treasury market. Over time, the details of the workup have changed in response to changing market conditions, with the abandonment of the private phase and the shortening of the default duration to 3 seconds. While some market participants may consider it an anachronism, given the increased trading activity in benchmark Treasuries and the tight link to the extremely liquid Treasury futures market, the workup has not only remained an important feature of the interdealer market; it has actually grown in importance, now accounting for almost two-thirds of trading volume in the benchmark ten-year Treasury note.

On the Frankfurt stock exchange each Bund issue is “fixed” at around 13:00 daily. This process creates a liquidity concentration. A similar “clearing” process occurs at the end of LME rings. For spread traders, the ability to “lean” against a relatively un-volatile market – such as during a workup – whilst making an aggressive market in the correspondingly more volatile companion, represents an enhanced trading opportunity. One side of the potential spread price is provided “risk-free”.

What’s Driving Dealer Balance Sheet Stagnation? …The growing role of electronic trading has likely narrowed bid-ask spreads and reduced dealers’ profits from intermediating customer order flow, causing dealers to step back from making markets and reducing their need for large balance sheets. The changing competitive landscape of market making, as manifested by the entry of nondealer firms since the early 2000s, may therefore also play a role in the post-crisis dealer balance sheet dynamics.  …The picture that emerges is that post-crisis dealer asset growth represents the confluence of several issues. Our findings suggest that business-cycle factors (the hangover from the housing boom and bust and subsequent risk aversion) and secular trends (electronification and competitive entry) should be considered alongside tighter regulation in explaining stagnating dealer balance sheets. 

I refer back to my conversation with Mr Foster, the NYSE Specialist; in asset markets – equities and to a lesser extent bonds – as volume increases during a bull-market, the number of market participants increases. In this environment “liquidity providers” trade more frequently with the same capital base. Subsequently, as volatility declines – provided trading volume is maintained – these liquidity providers increase their trading size in order to maintain the same return on capital. When the bear-market arrives, the new participants, who arrived during the bull-market, liquidate. The remaining “liquidity providers” – those that haven’t exited the gene pool – are left passing the parcel among themselves as the return on capital declines precipitously (the chart, some way below, shows this evolution quite clearly).

Has U.S. Corporate Bond Market Liquidity Deteriorated? …price-based liquidity measures—bid-ask spreads and price impact—are very low by historical standards, indicating ample liquidity in corporate bond markets. This is a remarkable finding, given that dealer ownership of corporate bonds has declined markedly as dealers have shifted from a “principal” to an “agency” model of trading. These findings suggest a shift in market structure, in which liquidity provision is not exclusively provided by dealers but also by other market participants, including hedge funds and high-frequency-trading firms.

Given the “quest for yield” and the reduction in T-Bond supply due to QE, this shift in market structure is unsurprising, however the relatively illiquid nature of the Corporate bond repo market means much of the activity is based around “carry” returns. Participants are cognizant of the dangers of swift reversals of sentiment in carry trading.

Has Liquidity Risk in the Corporate Bond Market Increased? …We measure market liquidity risk by counting the frequency of large day-to-day increases in illiquidity and price volatility, where “large” is defined relative to measures of recent liquidity and volatility changes (details are described here). We refer to the illiquidity jumps as “liquidity risk” and to the volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window shows that liquidity risk and vol-of-vol have declined substantially from crisis levels…

…Current metrics indicate ample levels of liquidity in the corporate bond market, and liquidity risk in the corporate bond market seems to have actually declined in recent years. This is in contrast to liquidity risk in equity and Treasury markets…

The Fed methodology is contained in a four page paper A Note on Measuring Illiquidity Jumps. It may be of interest to those with an interest in exotic option pricing. I’m not convinced that I agree with their conclusions about Liquidity Risk – it is difficult to measure that which is unseen.

Has Liquidity Risk in the Treasury and Equity Markets Increased? …While current levels of liquidity appear similar to those observed before the crisis, sudden spikes in illiquidity—like the equity market flash crash of 2010, the recent equity market volatility on August 24, and the flash rally in Treasury yields on October 15, 2014—seem to have become more common. Such spikes in illiquidity tend to coincide with spikes in option-implied volatility, in both equity and Treasury markets…

…we refer to these liquidity jumps as “liquidity risk” and volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window reveals a recent uptick in liquidity risk and vol-of-vol, and confirms the link between them… The evidence that liquidity risk in equities and Treasuries is elevated contrasts with our earlier post, which found no such increase for corporate bonds.

Our findings suggest a trade-off between liquidity levels and liquidity risk: while equity and Treasury markets have been highly liquid in recent years, liquidity risk appears elevated. This change has gone hand in hand with an apparent increase in the vol-of-vol of asset prices, so that illiquidity spikes seem to coincide with volatility spikes. Our findings further suggest that the increase in liquidity risk is more likely attributable to changes in market structure and competition than dealer balance sheet regulations, since the latter would also have caused corporate bond liquidity risk to rise. Moreover, evidence from option markets suggests that this seeming rise in liquidity risk is not reflected in the price of volatility.

Market liquidity in a given market is never constant, the trading volume may remain the same but the market participants, wholly different. In the 1980’s Japanese institutions were a significant influence on the US bond market, today it is the Federal Reserve. Changes, such as minimum price increments and exchange trading hours are significant; the list of factors is long and ever changing. The increase in Liquidity Risk has as much to do with the increase in systematic trading and the relative consistency of approach these traders take to risk management. These traders and their methods have become increasingly prevalent. Whilst cognizant of skewness they see the world through a Gaussian lense. They measure strategy success by Sharpe and Sortino ratio, assessing it by the minute or the hour and being “flat” by market close.

Changes in the Returns to Market Making. We show estimated returns to market making to be at historically low levels—a finding that seems inconsistent with market analysts’ argument that higher capital requirements have reduced market liquidity. The picture that emerges from our analysis is of a change in the risk-sharing arrangement among trading institutions. We uncover a compression in expected returns to market making in the corporate bond market, where dealers remain the predominant market makers, as well as the equity market, where dealers are less important. The compression of market making returns may be tied to competitive pressures, with high-frequency trading competition being important in the equity market.

High-Frequency Equity Market-Making Returns and VIX

Source: Reuters, Haver Analytics

The chart above looks at one minute reversals on the Dow. As long ago as 2003, the HFT customers I dealt with were operating on sub-second reversal time horizons. Nonetheless, the pattern of profitability may be broadly similar.

Redemption Risk of Bond Mutual Funds and Dealer Positioning. Mutual funds’ share of corporate bond ownership has increased sharply in recent years, while dealers’ share has declined substantially. Because mutual funds are subject to redemption risk, this shift in ownership patterns raises the concern that redemption risk might have increased. However, we find no evidence that the net flow volatility of bond funds has increased. Likewise, we uncover no evidence of contrarian behavior by dealers relative to bond fund flows. Therefore, even if we do observe large mutual fund redemptions in the future, our evidence does not suggest that reduced dealer positions will exacerbate the effects on corporate bond pricing and liquidity.

Since the Mutual Fund “Late Trading” scandal of 2003, arbitrage operators have maintained a low-profile. The “flight-to-quality” properties of T-Bonds should also mean mass-redemption is a much lower probability – “mass-subscription” is a higher risk.

The Liquidity Mirage. While low-latency cross-market trading has undoubtedly led to more consistent pricing of Treasury securities and derivatives, there is strong evidence that it has also resulted in a more complex and dynamic nature of market liquidity. Under the new market structure, it has arguably become more challenging for large investors to accurately assess available liquidity based on displayed market depth across venues. The striking cross-market patterns in trading and order book changes suggest that quote modifications/cancellations by high-frequency market makers rather than preemptive aggressive trading are an important contributing factor to the liquidity mirage phenomenon.

In the days of open-outcry trading on futures exchanges “local” traders would frequently cancel and replace bids and offers. These participants were visible, their reliability, or otherwise, was known to the market-place. In an electronic order book there is less transparency. Algorithmic trading solutions have developed, over the last twenty years, to enable efficient execution in this more opaque environment.

“Cost plus” pricing for equity and futures execution is still quite rare outside the HFT world but it has had a dramatic influence on stock market micro-structure and liquidity since the 1990’s.

In a recent speech by Minouche Shafik of the Bank of England – Dealing with change: Liquidity in evolving market structuressuggested that the changes in liquidity are a natural process:-

The reduction in the relative size of dealer balance sheets may also be a natural process of evolution as the market-making industry matures and emphasis is placed on using its warehousing capacity efficiently rather holding lots of inventory. Market making wouldn’t be the first industry to go through such a change: Just In Time management swept through manufacturing in the 70s and 80s with its focus on minimising waste, eliminating inventories, and quickly responding to changing market demand. More recently, supermarkets have reversed their once relentless expansion of retail space, and started moving away from inventory-intensive hypermarkets toward smaller retail units.

Indeed, moving toward smaller in-store inventories is not the only parallel between retailing and market making: both have also been dramatically changed by innovation. Just as the rise of internet shopping has given consumers access to a broader choice of shops and much easier means of price comparison, so has electronic trading facilitated new ways of matching buyers and sellers in financial markets, and added to the data generally available for price discovery.

The Deputy Governor goes on to remind us that the BoE acted as Market-Maker of Last Resort during the last crisis and would do so again.

Conclusion – Financial markets – for the benefit of whom

Financial markets evolve to allow investors to provide capital in exchange for a financial reward. Technology has increased the speed and reliability of market access whilst reducing the cost, however these benefits change the underlying structure of markets, be it co-location of servers in the last decade or block-chain technology in the next.

Politicians seek to encourage long-term investment; high frequency trading is a very short-term investment strategy indeed, but without short-term investors – shall we call them speculators – the ability to transfer of capital is severely impaired. Even the most jaundiced politician will admit, speculators are a necessary evil.

Innovation has democratized financial markets, it has enabled individual investors to create complex portfolios and implement strategies which were once the preserve of hedge funds and investment banks, however the experience has not been an unmitigated success, in the process it purportedly enabled one man from Hounslow to wipe $750bln off the value of the US stock market in May 2010. That this was possible defies credulity for many; I believe it indicates how technology has more than offset the decline in capital allocated to financial market trading, nonetheless, when it comes to financial market liquidity, I concur with Deputy Governor Shakif – “caveat emptor”.

What’s right with the Trans-Pacific Partnership?

400dpiLogo

Macro Letter – No 44 – 23-10-2015

What’s right with the Trans-Pacific Partnership?

  • The TPP may boost real-incomes by $285bln by 2025
  • US Congress should approve the TPP to avoid international political embarrassment
  • The TPP may be expanded to include South Korea, Taiwan and maybe even China
  • Many companies involved in auto, pharma, IT and agricultural should benefit

For Asia-Pacific, the Trans-Pacific Partnership (TPP) is the most substantial trade agreement in history. In this video Cato Institute – Putting the TPP in Perspective: 150 Years of U.S. Trade Policy in Less than 4 Minutes – remind us that this is a “Managed Trade Agreement” rather than a “Free Trade Agreement” (FTA).

The 12 TPP participating countries – Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, USA and Vietnam – represent almost 40% of output and 25% of exports of goods and services globally. This makes it the largest regional trade agreement in history.

After five years of “horse-trading” and “turf-wars” the agreement was finally signed on 5th October, yet, with US Congressional enactment still awaited in December, much media commentary has focussed on the weaknesses of the agreement. These include:-

  • Agriculture – Japanese resistance to the elimination of tariffs on agricultural imports, including rice, beef, pork, dairy, wheat, barley, and sugar. Japan’s average most-favoured nation (MFN) tariff for agricultural products is 16.6% – although some tariffs are as high as 700%. The US accounts for 25% of agricultural imports to Japan.
  • Intellectual property rights – Whilst all TPP members agree on high IP standards, the devil is in the detail. The period of data exclusivity for drug tests, protection of trade secrets, and liability of ISPs for transmitting illegal/pirated material all remain contentious.
  • State-owned enterprises – TPP members are committed to levelling the playing field in respect of preferential access to finance or new markets. Problems arise over the length of the transition period before the new rules must be adopted, standardisation of accounting practices, board governance and unbiased procurement processes.
  • Labour – Issues remain around the adoption of ILO Fundamental Principles, prohibiting workplace discrimination and upholding consistent child labour practices.
  • Investor-State Dispute Settlement – Investor-State Dispute Settlement provisions allow international investors to use dispute settlement proceedings against host governments if they believe their property has been expropriated without compensation or regulated in a discriminatory manner. TPP members disagree about the extent of carve-outs from Investor-State Dispute Settlements for health, safety, and environmental regulations.

According to the Independent – TPP trade agreement text won’t be made public for four years – so in the interim here is the USTR Summary.

The Guardian – Wikileaks release of TPP deal text stokes ‘freedom of expression’ fears – provides more details about Chapter 12, covering IP, yet it is not clear whether this is the final version of the document or not.

In attempting to assess the initial deal The Economist – Every silver lining has a cloud – said:-

First, there is the fact that the agreement has been so hard to sell in America. It took months, and several legislative setbacks, before Barack Obama won the authority to fast-track a congressional vote on TPP. The deal may still be voted down, in America or elsewhere. Those who would succeed Mr Obama as president know that TPP holds few votes. This week Hillary Clinton, the Democratic front-runner and once a promoter of TPP, came out against it. The beneficiaries of TPP—consumers, as well as exporters—are numerous, but their potential gains diffuse. By contrast, inefficient firms and farms, about to be exposed to greater foreign competition, are obvious and vocal. Canada, for example, limited the threat to its dairy farmers and doled out a big new subsidy. The saga is a reminder of how hard free trade is to champion.

Second, the TPP deal underscores the shift away from global agreements. The World Trade Organisation, which is responsible for global deals, has been trying, and largely failing, to negotiate one since 2001. Reaching agreement among its 161 members, especially now that average tariffs around the world are relatively low and talks are focused on more contentious obstacles to trade, has proved almost impossible. Regional deals are the next best thing, but, by definition, they exclude some countries, and so may steer custom away from the most efficient producer. In the case of TPP, the glaring outcast is China, the linchpin of most global supply chains.

Third, good news on TPP stands in contrast to bad news elsewhere. Cross-border trade today is as much about the exchange of data as it is the flow of goods and services: this week saw the annulment by a European court of a deal that had enabled American firms to transfer customer data across the Atlantic. Conventional trade faces even stronger headwinds. The volume of goods shipped in the first half of this year was just 1.9% higher than in the same period of 2014, far below its long-term average growth of 5%. This reflects not only China’s soggy demand for imports—a threat to the developing economies that supply it—but also the accumulation of minor measures that silt up global trade.

Deals like TPP are the most effective way to reverse this sorry trend, by reducing tariffs and other obstacles to trade. Optimists hope it can now be expanded, to include China and others. Sadly, experience suggests that will be hard.

Looked at from a more positive perspective, the TPP tops the US trade policy agenda, incorporating President Obama’s “Asia Pivot”. Signatory countries account for 36% of US trade in goods and services. US ratification of this agreement will upgrade a range of existing FTAs stretching back to NAFTA (1994).

With some exceptions – mostly in agriculture – the TPP aims to remove tariff barriers for goods and services. It will also address some “access” issues in areas such as competition policy, direct investment, labour and environmental standards.

Japan and the US will be the principal beneficiaries of the TPP (64% of GDP gains) but it has been estimated that the agreement could boost real incomes of member countries by $285bln by 2025, with exports increasing by $440 billion (+7%) assuming full-adoption.

The TPP could achieve even more since is allows for the future accession of new members. South Korea, possibly regretting its decision not to take part in the initial negotiations, has announced its interest, while Indonesia, the Philippines, Thailand, and Taiwan are evaluating the benefits. It might even form the framework for a bilateral FTA between the US and China. The chart below shows the potential benefit in GDP terms:-

20150725_FNC164

Source: Economist and Peterson Institute

A brief history of free-trade

Richard_Cobden

Source: Mises.org

The liberal idea of free trade sprang from the earliest discoveries in the field of economics. It is the embodiment of the spirit of “comparative advantage” – David Riccardo’s observation that specialisation makes economic sense and that those agents with a natural economic advantage should specialise and trade, rather than attempting to produce all goods to meet their own needs.

There are difficulties in achieving genuine free trade. Consumer organisations are relatively weak in comparison with trade organisations: this iniquity is the flaw at the heart of so many FTAs. Consumers, if consulted, would vote unanimously in favour of cheaper goods. Inflation targeting might prove difficult for central banks but people’s standard of living would improve, all other things equal. This is the benign face of deflation; it is also the reason why productivity growth is critical to economic progress.

Since the time of Sumer, empire building has involved conquest, assimilation and trade. Artefacts of North African and Middle-Eastern origin uncovered at Roman archaeological sites in Britain, bears testament to the wide-spread distribution of goods throughout the Roman Empire.

The Spanish theologian, philosopher and jurist Francisco de Vitoria (1483 – 1546) developed the first ideas about freedom of commerce and freedom of the seas. A forerunner to FTAs, were the “most favoured nation” (MFN) clauses attached to international treaties during the European colonial era – many of these MFN clauses are still in use today – but it was the philosopher Adam Smith, along with Ricardo, who articulated what we would recognise as free-trade theory today.

William Huskisson (1770 – 1830) was appointed President of the Board of Trade and Treasurer of the Navy in 1823. He was part of the Canningite faction of the Tory party, led by George Canning, which formed a brief coalition government in 1827. Perhaps Huskisson’s greatest contribution to free-trade was his reform the Navigation Acts. This allowed other nations full equality and reciprocity of shipping duties, it repealed the labour laws, introduced a new sinking fund, reduced duties on manufactures and foreign imports, and repealed quarantine duties.

Huskisson had also been a member of the committee appointed to inquire into the causes of the agricultural distress of 1821 – this committee proposed a relaxation of the Corn Laws chiefly due to his strenuous advocacy. Sadly it was the potato famine in Ireland that eventually saw their repeal in 1846. It was the campaign to repeal the Corn Laws which eventually led to the next great clarion for free trade, the Cobden-Chevalier Treaty of 1860. The treaty reduced French duties on most British manufactured goods to around 30% and reduced British duties on French wines and brandy. During the next decade the value of British exports to France more than doubled whilst French wine imports increased by 100%.

Richard Cobden (1804 – 1865) had founded the Anti-Corn Law league in 1838. That the current TPP has taken just five years is therefore encouraging. Cobden is a giant in the annals of free-trade, to find out more about this extraordinary man and the relevance of his ideas today please visit The Cobden Centre. A recent post – No more “Free-Trade” treaties: it’s time for genuine free trade – is an excellent example of their important work:-

Murray Rothbard opposed NAFTA and showed that what the Orwellians were calling a “free trade” agreement was in reality a means to cartelize and increase government control over the economy. Several clues lead us to the conclusion that protectionist policies often hide behind free trade agreements, for as Rothbard said, “genuine free trade doesn’t require a treaty.”

The Cobden-Chevalier Treaty spawned a cascade of bilateral FTAs across Europe. By some estimates these agreements reduced tariffs in Europe by 50%. Sadly as the world economy entered a recession in 1873 the enthusiasm for free trade began to wane. The First World War saw the situation deteriorate further, whilst the great depression of the 1930’s heralded an increase in nationalism which went hand in hand with protectionism.

According to the World Trade Organisation (WTO) – established in 1995 in the wake of the NAFTA agreement of 1994 – the General Agreement on Tariffs and Trade (GATT) of 1947 was the starting point for multilateral FTAs, although it was originally agreed between just 23 countries. This followed in the wake of the 1944 Bretton Woods Agreement which had established the IMF, World Bank and Bank for Reconstruction and Development. By 1951 the European Coal and Steel Community had been founded – later to become the EEC (1957).

Many other bilateral and multilateral agreements followed. For a more detailed investigation of the history of free trade, this WTO – Historical background and current trends 2011 – article is worth investigating. One point the WTO make in conclusion is:-

…despite the explosion of PTAs in recent years, 84 per cent of world merchandise trade still takes place on an MFN (Most Favoured Nation) basis (70 per cent if intra-EU trade is included).

Viewed from this perspective, the ideal of “Free Trade” still has far to go.

Other perspectives on the TPP

In this recent article Bruegal – Trans-Pacific Partnership: Should the key losers – China and Europe – join forces? the authors anticipate a Chinese response which could benefit the EU-

The winners are obvious: Obama and Shinzo Abe, arguably also the US and Japanese economies. Obama can leave office with a strong demonstration of the US pivot to Asia, and Abe can finally argue that the third arrow of his Abenomics program is not empty.

The losers are also obvious: China and Europe. China not only has been left out of the deal, but it has been left out on purpose. If anybody had any doubt (at some point China was invited into the negotiations and some still expect China to continue discussing membership in the future), Obama’s official statement on TPP yesterday makes it very clear: “when more than 95 percent of our potential customers live outside our borders, we can’t let countries like China write the rules of the global economy”. For China the issue is not only losing access to the US market but also the fact that its most important trading partners are in the deal, with the notable exception of Europe.

The fact that TPP has not yet being ratified by national parliaments still offers room for doubt as to TPP’s actual economic significance (exemptions from its coverage could spring out in every jurisdiction) but there is no doubt that it will be economically relevant. TPP covers 40 per cent of global trade and spans 800 million people. Not only will trade barriers be reduced to the minimum in virtually every sector (including generally protected ones such as agriculture) but also common standards will need to be used by all participants, be it for investment, environment or labour. In this regard, the primacy of the protection of brand names over the protection of geographical indications of agricultural products, or the priority of the protection of trade secrets over press freedom are cornerstones of the US success in its negotiations with TPP partners, which also shows the price that a country like Japan are willing to pay for US-led security. In the same vein, the high price to pay (in terms of US supremacy on the negotiation table) makes it all the more unlikely for China to seriously consider joining the bloc in the near future: the treatment of state-owned enterprises and data protection are two stumbling blocks. The latter is also a key deterrent for Europe’s TTIP negotiations.

They see a window of opportunity to the EU to negotiate a deal with China.

From a geo-political standpoint Chatham House – For the West, the Trans-Pacific Partnership Must Not Falter – see the TPP providing benefits which go well beyond economics:-

But the economic benefits are only one upside of the deal. While it is by no means assured, there could also be a significant geostrategic impact. The TPP was not the only Asian trade agreement of choice. China, for example, had been supporting an alternative Regional Comprehensive Economic Partnership. But the 12 TPP participants – the US, Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam –  sent a clear message regarding the kind of standards and rules they believe are best placed to provide the greatest benefit to their populations – from greater transparency and anticorruption to more free and open markets.

Western leadership

The TPP now sets the bar. If successful, in time other states will hopefully join including, most significantly, India, China and South Korea. But this will take time and the TPP has to prove itself first. Prospective member states will have to make extremely tough political choices in order to join and they and their populations will need to see meaningful tangible benefits first. But the door has been left open and if the TPP turns out to realize some of its potential, others could come knocking on the door.

This podcast from CFR – Trans-Pacific Partnership Trade Deal – gives a good global overview from both an economic and political perspective:-

…If you look at the U.S. negotiations with Europe—the Transatlantic Trade and Investment Partnership—if those come to fruition—and they’re on a somewhat slower track—you’re going to reach a position for the United States where two-thirds of its trade is covered under free trade arrangements of some sort of another.

…you’ve had a stalemate in the Doha Round for more than a decade now between the advanced economies—primarily the United States, Europe, Japan to some extent—and the big emerging economies—China, India, and Brazil. And they’re just at loggerheads over a whole series of issues, from, you know, farm subsidies in the U.S. and Europe to the pace of opening up manufacturing markets in the developing countries.

…The Europeans are always very conscious about not losing their relative trade advantages, and the possibility of Japan, and then if Korea docks on to the TPP as well—the possibility of those countries having better access to the U.S. market than European companies would enjoy, I think that will be a spur to action at the—at the U.N.

…Peterson Institute, for example, thinks that Japan is going to gain upwards of $119 billion in absolute gains from TPP.

…TPP is an instrument of Abenomics, the broader structural reorganization inside Japan, and it leverages for Abe all kinds of transformations that would be difficult to accomplish by a Japanese government on its own.

…There’s some loud minority voices of criticism. But overall, the opinion polling in Japan has really embraced this notion of TPP participation.

…The LDP has long been the protector and party that has advocated on behalf of Japan’s farmers. It is now leading this agricultural reform, largely because Japan’s farmers are aging. They’re getting older. And there’s a demand from within the agricultural sector for these reforms and a more competitive-oriented agricultural policy.

Nonetheless, in some parts of Japan Abe’s party still is seen as betraying some of the core interests of its postwar conservative protections, and so he’ll have to tread a little bit carefully to make sure that he can pay off or make sure that the farmers will not be mistreated.

…Initially the rhetoric out of the Chinese government was reasonably hostile to TPP. That has softened in recent months. But clearly, to make the sorts of reforms that would be necessary to join the TPP would be a very big lift for China.

…if Congress rejects the TPP, that’s a slap in the face to 11 other countries, including close allies like Mexico, Canada, Japan, Australia, and New Zealand that have made difficult decisions domestically in order to be able to conclude the deal. So the thinking has always been, at the end of the day, Congress is going to be very reluctant to do that.

Countering the enthusiasm of Chatham House, The Diplomat – Could the TPP Actually Divide Asia? – cautions that there are geopolitical risks that the TPP will increase tensions in the region.

Firstly, South Korea:-

U.S.-Korea free trade agreement (KORUS) came into effect in March 2012. South Korea is undoubtedly a strong candidate to join the group, given that KORUS is seen as a gold standard for free trade deals. Nevertheless, the U.S.-Korea free trade pact largely exempted the politically sensitive Korean rice market. That alone will undoubtedly be a major political issue for all member countries should Korea negotiate entry into the pact, and it will certainly be a source of contention with Japan, a founding member of the TPP that was forced to make concessions on its equally politically sensitive rice market. 

Then, Taiwan:-

The Taiwanese government has made clear that it hopes to be one of the first entrants to the TPP, not only to further its position as a global exporter, but also to encourage domestic reform that is critical if Taiwan is to remain competitive. Given its experience in joining the World Trade Organization, whereby it had to wait until China was ready for accession in 2001 so that it could join at the same time, there is growing concern that Taipei would have to wait again for Beijing to be ready. The frustration of being unable to join a group that is seen as key to Taiwan’s growth will undoubtedly strain cross-Strait relations.

And finally, the undermining of existing agreements:-

The Regional Comprehensive Economic Partnership (RCEP) includes not only all 10 ASEAN countries, but also China, Japan, South Korea, India, Australia, and New Zealand. Critics of the RCEP have been quick to dismiss the pact as aiming at lower standards compared to the TPP, and as focused too heavily on relatively unambitious tariff barrier reductions. Moreover, it is seen as a Chinese-led initiative that does not include the United States. Yet the fact that RCEP brings hitherto unlikely partners such as Burma and Cambodia into the fold of regional trade agreements in itself should be heralded as a significant development that has already achieved what is one of the major longer-term goals of TPP, namely to encourage nations to adopt internationally developed rules and standards. 

To round off the arguments for and against here is Mish Shedlock – Hillary Clinton, Dead Rats, Toilet Paper Politics – he’s definitively unimpressed:-

Every country is a firm believer in free trade for exports, but no country wants free trade for imports. Obviously, that cannot work mathematically, which is precisely why the deal had to be negotiated in secret and has taken five years to produce questionable results. …The New York Times reports “Trans-Pacific Partnership Seen as Door for Foreign Suits Against U.S.“. WikiLeaks analysis explains that this lets firms “sue” governments to obtain taxpayer compensation for loss of “expected future profits.” This agreement is a lawyer’s fantasyland dream come true. Corporations will be suing governments left and right over “expected future profits.” For example, Australia would not sign the deal unless it obtained a waiver for health warnings on cigarette packages that are more stringent than elsewhere. Apparently, all other lawsuits are fair game. And it will be taxpayers who pay the bill. Imagine the lawsuits over GMOs (genetically modified organisms). Monsanto will be suing every country that blocks its GMO products.

…I propose TPP will create a nightmare of worldwide lawsuits at taxpayer expense, while doing nothing that will genuinely advance free trade. Mish Free Trade Proposal As I have stated numerous times, I am in favor of free trade. An excellent free trade agreement would consist of precisely one line of text: “All tariffs and all government subsidies on all goods and services will be eliminated effective immediately”. I maintain that the first country that does that will be the beneficiary, regardless of what any other country does!

Conclusions and investment opportunities

The TPP has 30 chapters to be analysed. It will probably under-deliver as Shedlock indicates, however, perception that large scale, multilateral free-trade negotiation is back on the agenda, after such a long absence – NAFTA was back in 1994 – is likely to be supportive for markets

Country level benefit to financial markets

  • Japan will benefit from the external assistance it lends to the policies of Abenomics. Japanese agriculture will be negatively affected but internal subsidies will mitigate its impact. The TPP should have a strong positive influence on the Nikkei. This will help support JGB yields but is unlikely to cause a significant increase in the JPY if the BoJ continues with its QQE policy..
  • Singapore should benefit, providing goods and services to its Asian neighbours. The Straits Times Index should be supported and the SGD is likely to appreciate.

Sectoral stock market effects

  • US, Canadian, Australian and New Zealand agricultural businesses should reap significant benefits over time – especially Australian sugar refineries – whilst agro-business in Japan will be impaired.
  • Vietnam’s apparel manufactures should have improved terms of trade, as will Malaysian Palm Oil producers.
  • Companies in the Japanese and US auto-industry will benefit.
  • US pharmaceutical companies will benefit.
  • IT companies, especially from the US but also Japan, will benefit.

In the long run, other countries, including South Korea, Taiwan and perhaps even China, may join the TPP. Uncertainty still revolves around final approval of the treaty by the US, but, as more information begins to emerge, investment flows will start to influence equity prices across certain sectors and, more broadly, on a country specific basis.

Brazil – Good buy or Goodbye?

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Macro Letter – No 43 – 09-10-2015

Brazil – Good buy or Goodbye?

  • The Bovespa is down 35% in US$ terms this year
  • Government bond yields are back to levels last seen during the crisis of 2009
  • The BRL has declined by 45% against the US$ during 2015
  • Bond agency downgrades and government inaction exacerbate the sense of crisis

When I last gave a speech about the Brazilian economy and stock market prospects, back in March 2014, I was optimistic. During the summer of that year the Bovespa rallied, USDBRL improved and Brazilian government bond yields declined, but by early September these nascent trends had lost momentum. The table lower shows the evolution:-

Market 28-Mar 29-Aug 28-Dec 05-Oct
Bovespa 50415 61288 48512 47033
10yr Bond 12.8 11.21 12.33 15.23
USDBRL 2.27 2.23 2.69 3.92

Source: Investing.com

The charts below show these markets over the last 10 years:-

brazil-stock-market 10 yr - Trading Economics

Source: Trading Economics

brazil-government-bond-yield 10yr - Trading Economics

Source: Trading Economics

brazil-currency 10yr - Trading Economics

Source: Trading Economics

For good measure, and since Brazil’s economy is sensitive to the price of commodities here is the Goldman Sachs Commodity Index over the same period:-

GSCI 10 yr

Source:Barchart.com

It is worth remembering that, despite the importance of commodities – and Coffee made fresh lows for the year in September – the largest contributor to Brazilian GDP is services (67%).

During the second half of 2014, inflation remained broadly stable at around 6.75%, but, as the BRL weakened, inflation picked up sharply forcing the Bank of Brazil to raise interest rates, meanwhile the government primary budget surplus evaporated:-

Brazil Budget Balance Inflation and Policy Rate - Economist

Source: Economist

This 2nd September Economist article – Brazilian waxing and waning – sums up the range of negative forces besetting the Brazilian economy:-

In the past few years Brazil’s economy has disappointed. It grew by 2.2% a year, on average, during President Dilma Rousseff’s first term in office in 2011-­14, a slower rate of growth than in most of its neighbours, let alone in places like China or India. Last year GDP barely grew at all. It contracted by 1.6% in the first quarter, compared to the same period last year, and is expected to shrink by as much as 2% in 2015. Household consumption registered the first drop, year-on-year, since Ms Rousseff’s left-wing Workers’ Party (PT) came to power in 2003. At the same time, public spending has surged. In 2014, as Ms Rousseff sought re-­election, the budget deficit doubled to 6.75% of GDP. For the first time since 1997 the government failed to set aside any money to pay back creditors. Its planned primary surplus, which excludes interest owed on debt, of 1.8% of GDP ended up being a 0.6% deficit. Brazil’s gross government debt of 62% may look piffling compared to Greece’s 175% or Japan’s 227%. But Brazil’s high interest rates of around 13% make borrowing costlier to service.

…As the government loosened fiscal policy, the Central Bank prematurely slashed its benchmark interest rate in 2011-­12. This pushed up inflation, which is now above the bank’s self­-imposed upper limit of 6.5%, and way above its 4.5% target. The interest-rate cut has since been reversed. On June 3rd the Bank’s monetary policy-makers raised the rate once more, boosting it to 13.75%, more than a percentage point higher than before the decision to cut.

…In the past ten years wages in the private sector have grown faster than GDP (public­-sector workers have done even better). That allowed consumers to borrow more, which encouraged still more spending. Now the virtuous circle is turning vicious. Real wages have been falling since March, compared to a year earlier, mainly because Brazilian workers’ productivity never justified the earlier rises.

…unemployment, which has long been falling and dipped below 5% for most of 2014, increased to 6.4% in April. Economists expect it to reach 8% this year.

…the government is cutting spending on unemployment insurance (which had risen even when the jobless rate was falling) and on other benefits. Taxes, including fuel duty, are going up. So, too, are bills for water and electricity.

…Consumer confidence has fallen to its lowest level since Fundação Getulio Vargas, a business school, began tracking it in 2005. The government has no money to boost investment. Petrobras, the state-­controlled oil giant and Brazil’s biggest investor, is in the midst of a corruption scandal that has paralysed spending: the forgone investment may reduce GDP growth this year by one percentage point. It is hard to see where growth will come from. 

Worst of all, Ms Rousseff’s policy levers are jammed. She cannot loosen fiscal policy without precipitating a downgrade of Brazil’s credit rating. In fact, her hawkish finance minister, Joaquim Levy, has slashed 70 billion reais off the discretionary spending planned for this year (on top of the modest welfare reforms). Nor can the Central Bank ease monetary policy. That would once again undermine its credibility—and weaken the currency. A depreciating real, which is oscillating around a 10-year low, pushes up inflation; it also makes Brazil’s $230 billion dollar-denominated debt dearer by the day.

This chart, courtesy of the Peterson Institute, highlights the relative predicament facing Brazil’s government:-

EM debt and tax balance - IMF

Source: IMF

On September 9th – one week after the Economist article was published – S&P cut Brazil’s bond rating to BB+ – this is “Junk Bond” status. It followed Moody’s downgrade to Baa3 on August 11th. There seems little reason to “Buy Brazil”, but it is when markets look most dire that one should pay the most attention.

In May 2015 I wrote about the prospects for Brazil and Russia here – once again, I was anticipating the rebound in commodity prices coming to the aid of these commodity exporters – yet again, I was premature. The economic slowdown in China continues, commodity exporting countries remain under pressure and, from a technical perspective, the GSCI appears to be heading back to test the 2009 lows.

My conclusions about Brazilian Real-Estate have become slightly more negative since May. The recent increase in domestic inflation, combined with a rise in unemployment, makes rental yields – ranging from 4 to 6% – less attractive. Real yields have grown more negative whilst rental arrears and defaults rise.

Government bonds also lack their previous allure; short term rates rose again from 13.75% to 14.25% at the end of July. Back in March 2014 the SELIC rate was 10.75% whilst 10yr government bonds yielded 12.80% – 205bp of positive carry. Today the yield pick-up is worth a mere 48bp. My analysis of value, back in May, was based on the expectation that the currency had weakened sufficiently and commodity markets were forming a bottom – both these expectations proved erroneous. Since the currency has weakened further, corporate bonds are likely to come under additional pressure due to the large outstanding US$ issuance:-

EM Bonds - USD Exposures - Bloomberg

Source: Bloomberg and Strategas Research Partners

The IMF – May 2015 Brazil – selected report 15/122 – suggests that the situation is not quite so dire as the table above suggests, nonetheless, I would expect to see a rise in the number of high-profile defaults over the coming months:-

Petrobras accounts for some 13.5 percent of total NFC FX debt. It hedged 70 percent of its FX exposure through both domestic and global derivative markets despite ample FX income.9

Other exporting companies account for 36 percent of FX debt.

Non-exporting companies with at least 80 percent of their FX debt hedged in domestic derivatives markets account for 17 percent of FX debt.

Non-exporting companies (both foreign-owned and domestic firms) with hedge for less than 80 percent of their exposures account for 33.5 percent of NFC FX debt,10 or about 10 percent of total debt (Financial Stability Report, September 2014).

The solitary ray of hope has been the Bovespa, it is substantially lower than in May though not far from where it ended 2014. The table below looks at the CAPE – Cyclically Adjusted Price Earnings Ratio, PE, PC – Price to Cashflow, PB – Price to Book, PS – Price to Sales and DY – Dividend Yield:-

Country CAPE PE PC PB PS DY
Russia 4.8 8.8 3.7 0.8 0.7 4.30%
Hungary 7.9 23.4 4.1 1 0.5 2.50%
Brazil 8.2 19.4 5.8 1.3 1.1 3.70%
Poland 10.3 14.1 9.5 1.3 0.8 3.40%
Turkey 10.3 11 8 1.4 1 3.40%
Czech 10.7 14.3 6.2 1.4 1.1 6.10%
Korea (South) 12.2 12.9 6.3 1 0.6 1.40%
China 13.8 6.2 4.1 0.9 0.6 4.90%
Malaysia 15.6 16.1 10.8 1.7 1.9 3.40%
Thailand 15.7 17 10 2 0.9 3.20%
Indonesia 17 17.9 12.3 3.1 2.2 2.60%
Israel 17.4 16.5 11.1 1.8 1.4 2.80%
Taiwan 17.8 11.5 7.3 1.7 0.9 4.10%
India 18.5 21.5 13.7 2.6 1.5 1.50%
South Africa 19.2 14.6 8.5 2.2 1.3 3.60%
Mexico 21.2 26.9 11.9 2.6 1.5 1.90%
Philippines 22.3 19.5 12.7 2.4 2 1.90%

Source: Starcapital.de

I’ve ranked these markets by CAPE to look at valuation from a longer-term perspective. Remember, however, the Bovespa index has only a 14% exposure to Energy and 14% to Commodities; domestic consumption will drive growth for many Brazilian companies – the consumer is likely to be in cyclical retreat as wages and benefits fall. Exporters should thrive due to the currency devaluation but for the broader index these effects will take time to manifest themselves in higher stock prices. My longer-term enthusiasm from May remains undimmed, but I was clearly too early calling the bottom. With China still slowing, the headwinds facing Brazil have yet to fully abate.

Emerging markets in general, are under pressure. Back in January 2014 the World Bank Global Economic Prospects stated:-

…if markets react sharply to the continued tapering, then capital flows to developing countries could decrease by as much as 80 percent, destabilizing current account balances, leading to disorderly depreciations of regional currencies, and quite possibly, increasing imported inflation.

They estimated that 60% of all capital flows to emerging markets, since the financial crisis, have been a by-product of QE.

The IMF – WEO – Financial Stability Report – October 2015 – reviews the situation:-

Corporate debt in emerging market economies has risen significantly during the past decade. The corporate debt of nonfinancial firms across major emerging market economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014. The average emerging market corporate debt-to-GDP ratio has also grown by 26 percentage points in the same period, but with notable heterogeneity across countries.

EM Debt to GDP now stands at roughly 70%.

The Institute of International Finance estimate that investors sold $40bln of EM assets during Q3 2015. Brazil topped their list for asset outflows in Q3 – a 27% decline – closely followed by Indonesia and China:-

The marked decline in EM bond and equity in fund allocations amounted to some 80% of the drop seen during the worst of the taper tantrum in Q2 2013. This has left fund allocations to EM bonds and equities nearly 1.5 percentage points below end-June levels–at just 11%, EM allocations are at their lowest since early 2009. The decline in global investors’ appetite for emerging market stocks has been particularly striking, with EM equity funds suffering more than EM bond funds. Large fund outflows, falling asset prices and marked losses in EM currencies against the U.S. dollar have all contributed to lower allocations.

The IIF go on to state that this year EM countries will witness a capital outflow of $541bln for 2015 vs a net inflow of $32bln for 2014. These are the first EM outflows since 1988.

No way out?

In a recent Bloomberg Op-Ed – The Anatomy of Brazil’s Financial Meltdown – Mohamed El-Erian proposes official “Circuit-Breakers” to stop the vicious cycle. Peterson InstituteA Non-Circuit Breaker Agenda for Brazil – disagree:-

What are the options for Brazil? With interest rates at 14.25 percent, there is unfortunately little room for further rate hikes. With short-term domestic rates at these levels and global interest rates at close to zero, one would be hard pressed to argue that remedies used in the 1990s—specifically abrupt interest rate hikes of a high order of magnitude—would make a big impact on reversing capital outflows. If market pressures continue unabated and exchange interventions are ineffective, Brazil might well need to resort to capital controls. A further credit downgrade might follow, and the stage would be set for the type of inevitable crash that many economists imagined they would no longer see. While a crisis cannot be fully avoided—arguably, it is already happening—the government could still take some action to instill confidence. A strong commitment to prudent fiscal management over the medium term might help attenuate market turbulence even if the government’s hands are tied in the short run by political dysfunction. Instituting debt limits as discussed above would be a good start; Poland’s experience is testament to how fiscal credibility can be enhanced through their adoption. In Brazil’s case, debt limits have an additional advantage: They would send the right medium-term signals without being as overtly unpopular as the other measures and reforms the country desperately needs.

“Circuit-Breaker” policy proposals and the spectre of capital controls are unlikely to stem capital flight in the near-term, but with EM exposures already back to 2009 levels, I believe we’re nearer the end than the beginning of the repatriation process.

Conclusions and Investment Opportunities

For investment to return to Brazil, repatriation of existing investment needs to run its course, corporate bond defaults need to peak and begin to improve, unemployment needs to rise and then begin to decline and the government needs to prove it has the resolve to adhere to a policy of real austerity.

Currency

The BRL is the weakest it has been in more than 20 years, it last approached these levels back in October 2002. Foreign Exchange reserves remain high, I would expect the markets to test the central bank’s resolve. Further currency weakness certainly cannot be ruled out.

Bonds

The full impact of recent currency weakness on Brazilian US$ denominated bonds has yet to run its course. Default rates should rise, the Serasa Experian Corporate Default Index rose 13.3% in the period January to August 2015, meanwhile, corporate delinquencies for the month were 16.1% higher than in August 2014.

Stocks

According to Blackrock investors outflows from EM ETFs in September exceeded $3.2bln, albeit, sentiment has improved over the past week. The chart below shows EM stock market performance for the year to 6th October, Brazil has suffered more than every country except Greece:-

EM Stocks in USD - 2015

Source: Reuters

For the contrarian investor this may present an opportunity to buy – personally, I would prefer to see some indication of government resolve to tackle the countries difficult domestic economic issues first. Next year Brazil will host the Olympic Games – this is an opportunity to push through unpopular policies and showcase all the reasons to invest in Brazil. It is always darkest before the light – I shall be watching closely.