Which parts of the UK economy and which stocks will be the winners from Brexit?


Macro Letter – No 63 – 14-10-2016

Which parts of the UK economy and which stocks will be the winners from Brexit?

  • Sterling has fallen to its lowest since 1985 on fears of a “Hard Brexit”
  • UK stocks, led by the FTSE100, have rallied sharply
  • Sectors such as IT and Pharmaceuticals will benefit long-term
  • Even construction and financial services present investment opportunities

If you are in the habit of reading the mainstream financial press you will see headlines such as:-

The Times – Leak of gloomy Brexit forecast pushes pound to 31-year low – 12th October

The Economist – The pound and the fury – Brexit is making Britons poorer, and meaner – 11th October

Over the last three months, this has been typical of almost all financial media commentary. Sterling, meanwhile, has fallen, on a trade weighted basis, to a low not seen since the effective exchange rate index was recalibrated in 1990. At 73.79 it has even breached its close of December 2008 (73.855):-


Source: Bank of England

The recent weakness in Sterling has been linked to the publication of parts of draft cabinet committee papers, suggesting UK revenues could drop by £66bln. From a technical perspective the “Flash Crash” in Cable (GBPUSD) last week has exacerbated the situation, creating the need for the currency to retest the low of 1.18 during normal market hours – the market reached 1.2086 on 11th – more downside is likely:-


Source: DailyFX.com

As the two charts above reveal, Sterling has weakened by 16% versus the US$ and by 18.5% on a trade-weighted basis.

Here is the chart of GBPUSD since 1953. It reinforces my expectation, from a technical perspective, that we will see further downside:-


Source: fxtop.com

Given the seismic impact of a “Hard Brexit” on the UK economy, it would not be surprising to see a return to the February 1985 low of 1.0440.

I am not alone in my expectation of further weakness, Ashoka Mody – who organised the EU-IMF bailout of Ireland – told the Telegraph this week that Sterling was between 20% and 25% overvalued going into the Brexit vote.


The EU is the UK’s largest trading partner, accounting for 44% of goods and services exports in 2015 – though this was a decline the on previous year. Of greater concern to the neighbours, is the 53% of UK imports which emanate from the EU. In theory Sterling weakness should benefit UK exports; the impact has been minimal, so far:-


Source: Tradingeconomics.com, ONS

Similarly, imports should be falling – they are not:-


Source: Trading Economics, ONS

I discussed the prospects for UK growth and the effect of Sterling weakness on the balance of trade in Macro Letter – No 59 – 15-07-2016 – Uncharted British waters – the risk to growth, the opportunity to reform – quoting in turn from John Ashcroft – The Saturday Economist – The great devaluation myth:-

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary.

…1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

If Sterling weakness will not improve the UK terms of trade, what will happen to growth? Again, in Macro Letter 59  I quote, Open Europe’s worst case scenario – that UK economic growth will be 2.2% less, on an annual basis, than its current trend, by 2030. Trend GDP growth between 1956 and 2015 averaged 2.46%. Is the media gloom justified and…

Are there any winners?

I concluded my July article saying:-

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

The UK stock market has already jumped the gun. The chart below shows the strong upward momentum of the FTSE100, dragging the, less international, FTSE250 in its wake; yet UK property has been hit hard by expectations of a slowdown in foreign demand:-


Source: Daily Telegraph

The obvious winners in the short term are companies with non-Sterling earnings – the constituents of the FTSE100 have an estimated 77% of overseas revenues – 47 of them pay their dividends in US$. The FTSE250 is not far behind, its members have 50% of foreign revenues. This is not dissimilar to the French CAC40 and German DAX. The table below lists the top and bottom ten FTSE350 companies by Sterling revenues:-

10 FTSE 350 companies with lowest sterling revenues
Company Sterling revenues
Vedanta Resources (VED) 0%
Hikma Pharmaceuticals (HIK) 0.20%
BHP Billiton (BLT) 0.30%
Antofagasta (ANT) 0.40%
Mondi (MNDI) 0.40%
Tate & Lyle (TATE) 0.60%
Rio Tinto (RIO) 0.70%
British American Tobacco (BATS) 1%
Laird (LRD) 1.60%
Victrex (VCT) 1.80%
10 FTSE 350 companies with highest sterling revenues
Company Sterling revenues
Saga (SAGAG) 69.80%
Capita (CPI) 70.40%
Wm Morrison (MRW) 70.60%
Booker Group (BOK) 70.80%
Intu Properties (INTU) 71.60%
Home Retail Group (HOME) 72.10%
OneSavings Bank (OSBO) 72.50%
Standard Life (SL) 88.90%
Grainger (GRI) 96.30%

Source: S&P Global Market Intelligence

Some of these companies are not exactly household names. Below is a table of the top 30 stocks in the FTSE100 by market capitalisation as at 28th September. The table also shows the year to date performance by stock as at 12th October:-

Company Ticker Sector Market cap-£mln (28-09) YTD (12-10) >50% Non-£ revenue % of non-£ revenue
Royal Dutch Shell RDSA Oil and gas 149,100 16.33% Yes 85%?
HSBC HSBA Banking 113,455 15.97% Yes
British American Tobacco BATS Tobacco 92,162 28.58% Yes 99%
BP BP Oil and gas 81,196 25.99% Yes 85%?
GlaxoSmithKline GSK Pharmaceuticals 80,629 32.02% Yes 91%
AstraZeneca AZN Pharmaceuticals 64,771 18.72% Yes 93%
Vodafone Group VOD Telecomms 59,259 6.10% Yes
Diageo DGE Beverages 55,931 20.41% Yes
Reckitt Benckiser RB Consumer goods 50,446 20.66% Yes
Unilever ULVR Consumer goods 46,917 32.18% Yes 85%?
Shire plc SHP Pharmaceuticals 45,899 16.56% Yes 96%
National Grid plc NG Energy 41,223 15.14% Yes
Lloyds Banking Group LLOY Banking 39,634 -29.62%
BT Group BT.A Telecomms 38,996 -15.03%
Imperial Brands IMB Tobacco 37,677 13.35% Yes
Prudential plc PRU Finance 35,544 -3.61% Yes 60%
Rio Tinto Group RIO Mining 34,715 6.72% Yes 99%
Glencore GLEN Mining 30,135 94.96% Yes
Barclays BARC Banking 28,089 -34.34% Yes
Compass Group CPG Food 24,528 37.40% Yes
WPP plc WPP Media 23,330 16.44% Yes 87%
BHP Billiton BLT Mining 23,169 5.18% Yes 97%
CRH plc CRH Building materials 21,314 50.45% Yes
Royal Bank of Scotland Group RBS Banking 20,799 -46.12%
Associated British Foods ABF Food 20,481 -27.11%
Standard Chartered STAN Banking 20,403 -9.76% Yes
Aviva AV. Insurance 17,925 -3.27% Yes 60%
BAE Systems BA. Military 16,698 16.87% Yes
RELX Group REL Publishing 15,842 27.83% Yes 85%?
SSE plc SSE Energy 15,548 -1.75%

Source: Stockchallenge.co.uk, Financial Times

The table indicates where non-Sterling revenues exceed 50% and, where I have been able to glean current data, the most recent percentage of international revenues. These 30 names represent 70% of the total market capitalisation of the FTSE100 Index. The positive impact of the fall in Sterling on the performance of the majority of these stocks is unequivocal.

On a sectoral basis this is a continuation of the price action evident in the week following the Brexit vote. The chart below was published by the FT on 29th June:-


Source: Bloomberg, FT

The underperforming sectors are not difficult to explain. Banks and Insurance companies, despite having international revenues, have been hurt by concerns about the loss of access to EU markets after Brexit. Real Estate remains nervous about a collapse in international demand, now the UK is no longer the gateway to Europe. Meanwhile, the retail and household sectors are likely to suffer as UK economic growth slows, consumer spending declines, inflation – driven by higher import prices – squeezes corporate profit margins and the Bank of England is forced to respond to higher consumer prices with monetary tightening.

Yet, looking at the table below, the dividend cover of the consumer sector is robust and the data we have seen since Brexit – retails sales +6.2% in July and 6.3% in August, combined with the rebound in consumer confidence – suggests that the consumer is what might be deemed serene:-


Source: Daily Telegraph, Highcharts

Other UK economic indicators also seem to be rebounding. Manufacturing PMI was 55.4 in September –its highest level since the middle of 2014. Services PMI, at 52.6, is still expanding and Construction PMI, at 52.3, has returned to growth. Rumours of the death of the consumer may be grossly exaggerated. Even consumer credit, which dipped in July, rebounded in August.

The “Sterling Effect” on stock valuation has more to deliver in the near-term, but once the currency stabilises this one-off benefit will diminish.

Who will the longer term winners be?

It is difficult to assess the long run impact of a “Hard Brexit” without reviewing the WTO – Most Favoured Nation – Tariff schedule for the EU. The trade weighted average tariff for 2013 was 3.2%, but on agricultural products it was a much higher 22.3% whilst it was only 2.3% on Non-Agricultural products:-


Source: WTO

A “Hard Brexit” will probably entail a reversion to Most Favoured Nation terms with the EU under WTO rules.

The 18.5% decline in the Sterling Effective Exchange Rate means the cost to the UK of exporting, even agricultural products – excepting dairy – has been priced in. No wonder economists are busy revising their 2016/2017 growth forecasts higher – until Brexit actually happens, UK exports to the EU, and the majority of our other trading partners, will remain incredibly competitive.

Developing beyond this theme, a recent speech – The economic outlook – by Michael Saunders, a Bank of England MPC Member, reminded the Institute of Directors in Manchester:-

…we should not lose sight of the UK economy’s considerable supply-side advantages, with relatively flexible labour and product markets, openness to foreign investment, low-ish tax rates, strength in knowledge-intensive services and hi-tech manufacturing…

And the winners are…

This by no means an exhaustive list – some sectors are an obvious response to the decline in the currency, others are rather less certain.

Tourism – with the UK suddenly an inexpensive destination for tourists from around the world. In 2015, 7.3mln tourists visited the UK, of which 4.6mln were from the EU. Tourism Alliance estimates the UK tourist industry was worth £126.9bln in 2013. The chart below shows the volatile but upward sloping evolution of tourism revenues:-


Source: Trading Economics, ONS

Here is an edited table of the Leisure and Travel constituents of the FTSE350, it excludes bookmakers, travel agents and airlines:-

Ticker Company
CCL Carnival
CINE Cineworld Group
CPG Compass Group
DOM Domino’s Pizza Group
FGP FirstGroup
GNK Greene King
GOG Go-Ahead Group
GVC GVC Holdings
IHG InterContinental Hotels Group
JDW Wetherspoon (J.D.)
MAB Mitchells & Butlers
MARS Marston’s
MERL Merlin Entertainments
MLC Millennium & Copthorne Hotels
NEX National Express Group
RNK Rank Group
RTN Restaurant Group
SGC Stagecoach Group
WTB Whitbread

Source: Shareprices.com

There should also be a positive impact on construction, as many operators, particularly within the unlisted sector, upgrade their facilities to capture the increased demand.

Not all the omens are positive; many of the jobs created by tourism are temporary and seasonal, the impact of a “Hard Brexit” is likely to lead to an increase in average earnings – good for employees, though not necessary for employers:-


Source: Trading Economics, ONS

The trend in wage growth has been steady for several years, but as inflation picks up and UK immigration declines, wages will rise.

Value Added Industries such as IT, Technology, Pharmaceuticals – these are growth industries in which the UK has a comparative advantage. Typically their growth is delivered through productivity enhancing innovation. That they will also benefit, from a structurally lower exchange rate, is an added bonus.

Property and Construction should recover strongly – according to the Nationwide, UK house prices increased again in September. Only in central London, where stamp duty increases on higher value properties has undermined sentiment, have prices eased.

The UK has a shortage of residential property. Whether interest rates remain low or not, this situation will not change until there is genuine planning reform. The three largest housebuilders Barratt Developments (BDEV) Taylor Wimpey (TW) and Persimmon (PSN) are all trading with P/E ratios below 10 times. The only real concern is the difficulty these companies may experience in securing skilled manual labour – Barrett Developments source between 30% and 40% of their current workforce from mainland Europe.

There are other companies in the construction sector such as Balfour Beatty (BBY) Carillion (CLLN) and Kier Group (KIE) which will benefit from increased public investment in infrastructure projects. Monetary policy is nearing the end of its effectiveness – although the central banks still have plenty of stocks they could buy. The next step is to pass the gauntlet back to their respective governments’. I believe fiscal stimulus on a substantial scale will be the next phase.

Banking and Financial Services may seem like the last place to look for performance. The regulators have been tightening the noose since 2008 – as the current crisis at Deutsche Bank highlights, this trend has yet to run its course. However, challenger banks and shadow banking institutions, including hedge funds, are beginning to fill the void. In the days before the financialisation of the economy, banking was the servant of industry. The real-economy still needs banking and credit facilities. The oldest of the Peer to Peer lenders (unlisted) Zopa, announced their first securitisation this summer. After a decade of development their business it is finally coming of age.

The CMA – Making the Banks Work Harder For You – August 9th is certainly supportive for the digital disruptors of traditional banking. Government support is no guarantee of success but it’s easier to have them on your side.

You may argue that the success of companies such as Zopa are based on technological advantages but the recent history of banking has been about harnessing technology to increase trading volumes and reduce the costs of financial transactions. Growth in the profitability of financial services is integrally tied to advances in technology.

A final argument for Banks is the FTSE350 Banks Index:-


Source: Bigcharts.com

The high in 2007 was 11,263, the low in March 2009, 2,782 – a 75% decline. The index nearly doubled in in the next six months, reaching 5,224 in September of the same year. This June the index failed to break to a new low after the Brexit vote. A base is forming – the banking sector may not have seen the last of fines and regulation but I believe the downside is limited.

China – Coal, Steel, Water and Demographics – Which way now?


Macro Letter – No 62 – 30-09-2016

China – Coal, Steel, Water and Demographics – Which way now?

  • The price of coking coal has risen 164% this year, doubling since July
  • The NDRC is still attempting to reduce both coal and steel production this year
  • The April stimulus package has boosted construction and infrastructure demand
  • The pace of Chinese growth has stabilised but at a much reduced level

This year several commodity markets saw significant price increases. I discussed this in Macro Letter – No 51 – 11-3-2016 – How do we square the decline in trade with the rebound in industrial commodities?

The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally.

Over the last six months the US economy has maintaining momentum, albeit at a disappointingly modest pace. Elsewhere the economic headwinds are blowing harder, with Europe and Japan still mired in a “slow-growth/no-growth” environment. Yet during the last few weeks the spot price of premium coking coal – one of the key inputs for steel production – has doubled to more than $200/tonne. Although this is from multi-year lows seen in 2015, coking coal is now the top performing commodity market year to date:-


Source: Steel Index, Amcharts.com

According to CME data, the futures curve for Australian Coking Coal is in steep backwardation out to December 2017 delivery. This suggests a short-term supply shortage rather than a generalised increase in demand.  Mining.com – Stunning coking coal rally wreaks havoc in steel, iron ore explains what has been happening:-

The rise in the price of coking is upending the economics of the iron ore and steel markets with the Australian export benchmark price climbing 164% so far this year.

Metallurgical coal was exchanging hands at $206.40 on Monday according to data provided by Steel Index as it consolidates at higher levels following weeks of panic buying not seen since 2011, when floods in key export region in Queensland sent the price surging to $335 a tonne (albeit not for long).

The rally was triggered by Beijing’s decision to limit coal mines’ operating days to 276 or fewer a year from 330 before as it seeks to restructure the industry. Safety closures and weather related supply curbs in China and Australia only added fuel to the fire.


Source: TSI, Bloomberg, SGX

The price of Iron Ore has also risen by 31% to around $55/tonne, but, as the chart above makes clear, the ratio between the price of iron ore and coking coal is now at its lowest this century.

China’s coking coal output has fallen more than 10% due to the government edict to curtail domestic production. In response import volumes rose 45% in August alone. Goldman Sachs and Macquarie have both increased their price forecasts for 2017 and 2018.

The National Development and Reform Commission (NDRC) – the agency responsible for implementing production cuts – had achieved only 39% of the annual target for reducing coal capacity and 47% of the annual reduction in steel capacity as of the end of July. The Peterson – Institute – State of Play in the Chinese Steel Industry explains the reasons for this policy. Suffice to say, China’s domestic steel production tripled between 2005 and 2015 taking its share of global steel production from 31% to 50%. Under WTO rules it will have Market Economy Status from December 2016 – a wave of anti-dumping laws suits may well follow unless it curtails production.

Despite common knowledge of official policy, commentators have suggested that the recent production cut was intended to deliberately squeeze coal prices, allowing heavily indebted coal producers to repay loans to domestic Chinese banks. After two meetings between the China Iron and Steel Association and the NDRC, coal producers will now be allowed to produce an additional 50 tonne/day from October to alleviate shortages.

The steel industry was under margin pressure even before the rise in coal prices – the government has been forcing an industry wide consolidation. The high price of coal accelerates this “oligopolisation” of the sector. It is part of a broader reform and consolidation of State Owned Enterprises (SOEs). The Peterson Institute – China’s SOE Reform—The Wrong Path takes issue with this policy. It has its attractions in the short-term nonetheless – consolidation reduces competition within industries, the pricing power of these consolidated “oligopolies” should rise, enabling them to increase profitability and reduce their indebtedness. President Xi has called for “Stronger, bigger, better” state-owned enterprises. I fear for the squeezed private sector in this environment.

A more important structural reform was announced last month when the Supreme People’s Court ordered the establishment of more special divisions to handle liquidation and bankruptcy cases in intermediate courts. China has an undeveloped bankruptcy code – defaulting borrowers linger, acting as a drag on the economy. At the G20 summit President Xi said, “China has taken the most robust and solid measures in cutting excess capacity and we will honour our commitment with actions”. An efficient method of “zombie corporation liquidation” would expedite this process.

Another explanation for the government’s decision to reduce the number working days at coal mines is its commitment to reducing pollution. Brookings – The end of coal-fired growth in China looks at the bigger picture:-

China’s coal consumption grew from 1.36 billion tons per year in 2000 to 4.24 billion tons per year in 2013, an annual growth rate of 12 percent. As of 2015, the country accounts for approximately 50 percent of global demand for coal. In other words, China’s economic miracle was fueled primarily by coal.

…China’s coal consumption decreased by 2.9 percent in 2014 and 3.6 percent in 2015, and the economy has maintained a moderate speed of growth. This indicates that there is a decoupling of economic growth from the growth in coal consumption. China’s coal consumption might have in fact already peaked.

Over the past 35 years, coal powered the engine of China’s rapidly developing economy. Coal represented 75 percent of overall energy consumption. This number decreased to 64.4 percent in 2015—the lowest in China’s modern history—as the country’s energy intensity decreased by 65 percent relative to 35 years ago. In fact, though rarely noticed until the recent peak, this has been part of a fundamental shift in the Chinese economy’s relationship with coal.

The authors present three arguments to support their view that China’s reliance on coal is in structural decline. Firstly, a decrease in manufacturing and construction, which have seen over-investment during the last decade or more. Second, policies on climate change and air pollution—especially the Paris Agreement’s, signed this month, which calls for a 20% clean energy target by 2030. Read China-United States Exchange Foundation – After the Paris Climate Agreement, What’s Next? for more details. Finally, China’s adoption of technological innovation in energy, communications, and manufacturing.

In his G20 speech President Xi said “…green mountains and clear water are as good as mountains of gold and silver”. The problem of clean water is probably the single greatest resource challenge facing China today as this article from CEAC – China that once thrived on water, faces water problems today points out:-

The total amount of water resources in China is so huge as to reach 2325.85 billion cubic meters, which is the 4th largest in the world. However, Chinese population is so large that the per capita amount of water resources is only 1730.4 cubic meters. This is extremely small in the world. Moreover, water resources are distributed unevenly by the region. Generally speaking, water is scarce in northern parts of China, including the Northeast, the North, and the Northwest regions. Beijing is in the North region. On the other hand, water is abundant in the South Central, the South, and the Southwest regions. The problem is that water is growing scarcer, while its consumption is rising. Particularly, people in Northwest China suffer from chronic shortage of water.

…It is not the quantity of water that matters critically in China. The quality of water is deteriorating rapidly. According to “The Monthly Report of Ground Water” which was released by the Ministry of Water Resources of China this January, they conducted water quality observation researches of 2,103 wells in the Songliao plain of the Northeast region and the Jianghan plain in an inland area last year, and it turned out that 80% of ground water is too severely contaminated to drink. Ground water pollution is serious, particularly in the regions of water scarcity.

In the shorter-term there has been some increase in demand. Steel usage has risen in response to the mini-stimulus package implemented in April. It was aimed largely at railway and housing construction. Electricity demand picked up again in May +2.1% from April +1.9%, fuelling an increase in demand for thermal coal. Other leading indicators, also suggest that the slowdown in Chinese growth may have run its course. There has been an increase in railway freight volumes and pickup in copper output:-


Source: Market Realist, National Bureau of Statistics

Outside China the picture looks mixed. LME stocks of Copper and Zinc have recovered but Nickle and Aluminium stocks remain depleted. Global demand still appears to be subdued.

Chinese economy is unlikely to return to the double digit growth rates seen prior to the great recession, but, despite its indebtedness, the world’s largest command economy may be able to avoid an imminent banking crisis.

The Debt to GDP ratio continues to rise. A source of grave concern which is noted in the BIS Quarterly Review, September 2016. At the end of July total Chinese debt reached $28trln – greater than the government debt of the US and Japan combined. Corporate debt, which is fortunately denominated primarily in local currency, now stands at 171% of GDP whilst total debt stands at 255%. A favourite BIS measure is the Credit to GDP gap. A figure above 10 is a warning signal that an economy may be approaching a “Minsky Moment” – China scores 30.1, the highest of any large economy.

China has also continued to reduce its vast foreign exchange reserves, although at a more moderate pace than in 2014 and 2015. In July it reduced its holding of US Treasuries by $22bln – the largest one month decline in three years. It also released information about its gold holdings which, as many market participants had predicted, have risen substantially – it last reported this information in 2009. The US Bond sales may, therefore, have been to insure the stability of the RMB versus the US$ ahead of the G20 summit which was hosted by China this month.

Should we be concerned about a Chinese banking crisis? According to Michael PettisChina Financial Markets – Does it matter if China cleans up its banks? banking solvency is not the issue, but the indebtedness of the economy is:-

The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

…If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or

Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

Pettis remains pessimistic about China’s ability to grow its way out of debt. History is certainly on his side in this respect, however, policies such as the One Belt One Road Initiative, which aims to improve cross-border infrastructure in order to reduce transportation costs between China and its trading partners, still makes sense at this stage of China’s development. Comparisons have been made with the US Marshall Plan which helped to regenerate Europe after WWII but with an indicated aim of financing $4trln of new projects, its scale is much larger. Chatham House – Westward ho—the China dream and ‘one belt, one road’: Chinese foreign policy under Xi Jinping reviews the policy in detail, as does Peterson Institute – China’s Belt and Road Initiative.

Meanwhile, the great rebalancing towards domestic consumption continues, at what, in other countries, would be considered break-neck speed. This may, nonetheless, be too slow for China – the mini-stimulus package, in April, was a clear political capitulation. The Kansas City Federal Reserve – Consumer Spending in China: The Past and the Future looks at the success of rebalancing to date and the prospects going forward. They point out that Chinese consumption as a share of GDP declined between 1970 and 2000 largely as a result of demographic forces – low birth rate and aging population – together with urbanisation. Post 2000 rapid house price appreciation accelerated this trend. Since 2010 consumption has begun to rise from a low point of 37% of GDP, this coincides with the peak in household savings at 42% – it is now around 38.5%. The authors predict:-

In a benchmark scenario of relatively stable income growth and a further modest decline in the household saving rate, consumption growth in China remains at around 9 percent per year over the next five years, causing the share of Chinese consumption in GDP to increase by about 5 percentage points to 44 percent by 2020. This scenario has two implications. First, it suggests that strong consumption growth is sustainable in the near future, allowing China to continue transitioning toward a consumption-driven economy. Second, it suggests that strength in near-term Chinese consumption growth will partly rely on a further decline in the household saving rate. As the household saving rate cannot decline indefinitely, consumption growth may need to rely more heavily on household income to be sustainable in the long run.

Parallels have been made with Japan where the savings rate has declined from 40% to 19% of GDP since 1970. If China follows this pattern, savings as a percentage of income will continue to decline. The transition could be relatively smooth provided the residential property market does not collapse in the interim. The FRBKC article concludes:-

The declining saving rate in China reflects both a changing demographic structure—an expected increase in the young dependency ratio after multiple decades of decline—and a changing consumption pattern of young people, who face less pressure to save thanks to financial support from their parents and grandparents.

In the long run, transitioning to a consumption-driven economy may require some policy changes. Specifically, China may need to implement successful supply-side reforms—which are on the government’s agenda but haven’t yet been significantly pushed forward—to enable domestic production to meet rising domestic demand. Although the Chinese household saving rate is declining from a very high level, the downward trend cannot last forever. A truly consumption-driven economy must rely on strong household income growth, which is ultimately driven by improved technology and investment.

In the long run, demographic forces will affect China more than any other factor. According to the Ministry of Human Resources China’s working population hit a record 774.5mln in 2015, however, the UN estimate China will have 212mln fewer workers by 2050. The UN Demographic Profile is found on page 189.

Market impact and investment opportunities

Next week the RMB will be included in the SDR – the Peterson Institute – China’s Renminbi Is about to Break the Financial Glass Ceiling discusses this in more detail. There is widespread speculation that the PBoC will widen the RMB currency bands at any moment. In other respects the PBoC is in a more difficult position. The RMB has already weakened by 5% against the US$ this year. Cutting interest rates would probably cause the currency to weaken further, riling the US voters ahead of the election. They are not impotent, however, and injected a record RMB 310bln into the money market in August – part of an overt policy to support the official banking sector, diminishing the influence of shadow banks.

Domestic investors have favoured bonds over equities for the past couple of months, while the spread between corporate bonds and government bonds has narrowed. Chinese 10yr government bond yields have fallen around 50bp this year, but official policy, encouraging investors to purchase higher yielding bonds and reduce their exposure to leveraged wealth management products and other non-standard assets, is boosting demand for corporate issues.

Retail investors, who were badly burnt in the stock market collapse of 2015, remain obsessed with the property market despite massive over-supply. Equity broker margin balances remain low. Institutional portfolio managers have reduced exposure to stocks from 62% in July to 49% this month. In the post-crash environment IPO issuance has been subdued with only RMB 955bln of capital raised in the seven months to July. This compares to RMB 1.55trln in 2015. The final quarter may see better sentiment. Stocks may get a boost from local government spending in Q3 and Q4 – if only to insure their budgets are not reduced next year. The table below, from Star Capital, ranks forty of the world’s major stock markets. Using their metrics, China is second cheapest and has the lowest PE, Price to Cash flow and Price to Book:-

Country CAPE PE PC PB PS DY Rank
Russia 4.9 7.5 3.6 0.8 0.8 4.10% 1
China 12.4 6.1 3.2 0.8 0.6 4.70% 2
Brazil 8.5 44.1 6.6 1.4 1.1 3.40% 3
South Korea 12.6 11 5.5 1 0.6 1.80% 5
Hungary 9.9 ? 5.1 1.2 0.6 2.80% 6
Czech 8.7 11.8 5.5 1.2 1 7.50% 8
Turkey 9.7 10.8 6.2 1.3 0.9 2.70% 9

Source: Starcapital.de

The Shanghai Composite Index (SHCOMP) is down 8.85% YTD and by 41.84% since its high in June 2015, however it is up 48.25% from June 2014. Russia’s RTS Index by contrast is up 72.81% from its December 2014 low but still 29.68% below its level of June 2014.

Looking outside China, several Australia-centric mining stocks have already risen on the back of the move in coking coal but it seems unlikely that the supply imbalance will prove protracted. Anglo American (AAL) is still looking to sell more of its Australian coal mines – they may well find Chinese buyers.

Outside of China, infrastructure investment across Asia Pacific is on the rise, which is supportive for industrial commodities in general. KPMG – 10 emerging trends in 2016, published in January, takes a very optimistic long term view:-

Ultimately, however, we believe that this may well be the tipping point that ushers in 50 years (or more) of prosperity as capital starts to match up with projects which, in turn, will drive economic growth in the developing world and shore up retirement savings in the mature markets.

Commodity markets tend to exhibit very individual characteristics, however, several industrial and agricultural commodities have formed a longer term base this year. Is this the beginning of the next commodity super-cycle? It’s too soon to call, but without a rise in global demand the prospects for substantial gains are likely to be limited – Indian GDP growth is slowing. The IMF WEO July update revised its India GDP forecast for 2016 to 7.4% from 7.5% – in 2015 it was 7.6%. Its China forecast was revised up 0.1% and its overall Emerging Market and Developing Economy forecast for 2016 and 2017 was unchanged at 4.1% and 4.6%, although, world economic growth was revised 0.1% lower.

China’s stock market remains cheap by many metrics, but the level of indebtedness is an impediment to economic growth. The property market, although over-supplied, continues to attract investment, but this is economically unproductive in the long run. Government policy is attempting to steer the economy towards higher domestic consumption and technologically driven, productivity enhancing, investments. Environmental issues are finally being addressed, yet the challenge of clean water remains substantial.

Near term, debt reduction – and it has yet to begin – will hamper growth, which will, in turn, reduce the attractiveness of Chinese stocks. Reform of the SOEs will involve consolidation into a smaller number of vast enterprises. Private enterprises will suffer. “Zombie” companies will start to be dealt with as bankruptcy procedures become standardised, but, as with all policy in China, a gradualist approach is likely to be implemented. Commodity markets may continue to rise due to supply side factors but I doubt that Chinese demand will rebound even to the level of 2013/2014, let alone the early part of the century.

Is the “flight to quality” effect breaking down?


Macro letter – No 61 – 16-09-2016

Is the “flight to quality” effect breaking down?

  • 54% of government bonds offered negative yields at the end of August
  • Corporate bond spreads did not widen during last week’s decline in government bonds
  • Since July the dividend yield on the S&P500 has been higher than the yield on US 30yr bonds
  • In a ZIRP to NIRP world the “capital” risk of government bonds may be under-estimated

Back in 2010 I switched out of fixed income securities. I was much too early! Fortunately I had other investments which allowed me to benefit from the extraordinary rally in government bonds, driven by the central bank quantitative easing (QE) policies.

In the aftermath of Brexit the total outstanding amount of bonds with negative yields hit $13trln – that still leaves $32trln which offer a positive return. This is alarming nonetheless, according to this 10th July article from ZeroHedge, a 1% rise in yields would equate to a mark-to-market loss of $2.4trln. The chart below shows the capital impact of a 1% yield change for different categories of bonds:-


Source: ZeroHedge

Looked at another way, the table above suggests that the downside risk of holding US Treasuries, in the event of a 1% rise in yields, is 2.8 times greater than holding Investment Grade corporate bonds.

Corporate bonds, even of investment grade, traditionally exhibit less liquidity and greater credit risk, but, in the current, ultra-low interest rate, environment, the “capital” risk associated with government bonds is substantially higher. It can be argued that the “free-float” of government bonds has been reduced by central bank buying. A paper from the IMF – Government Bonds and Their Investors: What Are the Facts and Do They Matter? provides a fascinating insight into government bond holdings by investor type. The central bank with the largest percentage holding is the Bank of England (BoE) 19.7% followed by the Federal Reserve (Fed) 11.5% and the Bank of Japan (BoJ) 8.3% – although the Japanese Post Office, with 29%, must be taken into account as well. The impact of central bank buying on secondary market liquidity may be greater, however, since the central banks have principally been accumulating “on the run” issues.

Since 2008, financial markets in general, and government bond markets in particular, have been driven by central bank policy. Fear about tightening of monetary conditions, therefore, has more impact than ever before. Traditionally, when the stock market falls suddenly, the price of government bonds rises – this is the “flight to quality” effect. It also leads to a widening of the spread between “risk-free” assets and those carrying greater credit and liquidity risk. As the table above indicates, however, today the “capital” risk associated with holding government securities, relative to higher yielding bonds has increased substantially. This is both as a result of low, or negative, yields and reduced liquidity resulting from central bank asset purchases. These factors are offsetting the traditional “flight to quality” effect.

Last Friday, government bond yields increased around the world amid concerns about Fed tightening later this month – or later this year. The table below shows the change in 10yr to 30yrs Gilt yields together with a selection of Sterling denominated corporate bonds. I have chosen to focus on the UK because the BoE announced on August 4th that they intend to purchase £10bln of Investment Grade corporate bonds as part of their Asset Purchase Programme. Spreads between Corporates and Gilts narrowed since early August, although shorter maturities benefitted most.

Issuer Maturity Yield Gilt yield Spread over Gilts Corporate Change 7th to 12th Gilts change 7th to 12th
Barclays Bank Plc 2026 3.52 0.865 2.655 0.19 0.18
A2Dominion 2026 2.938 0.865 2.073 0.03 0.18
Sncf 2027 1.652 0.865 0.787 0.18 0.18
EDF 2027 1.9 0.865 1.035 0.19 0.18
National Grid Co Plc 2028 1.523 0.865 0.658 0.19 0.18
Italy (Republic of) 2028 2.891 0.865 2.026 0.17 0.18
Kreditanstalt fuer Wiederaufbau 2028 1.187 0.865 0.322 0.18 0.18
EIB 2028 1.347 0.865 0.482 0.18 0.18
BT 2028 1.976 0.865 1.111 0.2 0.18
General Elec Cap Corp 2028 1.674 0.865 0.809 0.2 0.18
Severn Trent 2029 1.869 1.248 0.621 0.19 0.18
Tesco Plc 2029 4.476 1.248 3.228 0.2 0.18
Procter & Gamble Co 2030 1.683 1.248 0.435 0.2 0.18
RWE Finance Bv 2030 3.046 1.248 1.798 0.17 0.22
Citigroup Inc 2030 2.367 1.248 1.119 0.2 0.22
Wal-mart Stores 2030 1.825 1.248 0.577 0.2 0.22
EDF 2031 2.459 1.248 1.211 0.22 0.22
GE 2031 1.778 1.248 0.53 0.21 0.22
Enterprise Inns plc 2031 6.382 1.248 5.134 0.03 0.22
Prudential Finance Bv 2031 3.574 1.248 2.326 0.19 0.22
EIB 2032 1.407 1.248 0.159 0.2 0.22
Kreditanstalt fuer Wiederaufbau 2032 1.311 1.248 0.063 0.19 0.22
Vodafone Group PLC 2032 2.887 1.248 1.639 0.24 0.22
Tesco Plc 2033 4.824 1.248 3.576 0.21 0.22
GE 2033 1.88 1.248 0.632 0.21 0.22
Proctor & Gamble 2033 1.786 1.248 0.538 0.2 0.22
HSBC Bank Plc 2033 3.485 1.248 2.237 0.21 0.22
Wessex Water 2033 2.114 1.248 0.866 0.19 0.22
Nestle 2033 0.899 1.248 -0.349 0.16 0.22
Glaxo 2033 1.927 1.248 0.679 0.2 0.22
Segro PLC 2035 2.512 1.401 1.111 0.19 0.22
Walmart 2035 2.028 1.401 0.627 0.2 0.22
Aviva Plc 2036 3.979 1.401 2.578 0.18 0.22
General Electric 2037 2.325 1.401 0.924 0.23 0.22
Lcr Financial Plc 2038 1.762 1.401 0.361 0.2 0.22
EIB 2039 1.64 1.401 0.239 0.2 0.22
Lloyds TSB 2040 2.693 1.495 1.198 0.2 0.22
GE 2040 2.114 1.495 0.619 0.2 0.22
Direct Line 2042 6.738 1.495 5.243 0.06 0.22
Barclays Bank Plc 2049 3.706 1.4 2.306 0.1 0.22

Source: Fixed Income Investor, Investing.com

The spread between international issuers such as Nestle – which, being Swiss, trades at a discount to Gilts – narrowed, however, higher yielding names, such as Direct Line, did likewise.

For comparison the table below – using the issues in bold from the table above – shows the change between the 22nd and 23rd June – pre and post-Brexit:-

Maturity Gilts 22-6 Corporate 22-6 Gilts 23-6 Corporate 23-6 Issuer Spread 22-6 Spread 23-6 Spread change
10y 1.314 4.18 1.396 4.68 Barclays 2.866 3.284 0.418
15y 1.879 3.86 1.96 3.88 Vodafone 1.981 1.92 -0.061
20y 2.065 4.76 2.124 4.78 Aviva 2.695 2.656 -0.039
25y 2.137 3.42 2.195 3.43 Lloyds 1.283 1.235 -0.048
30y 2.149 4.21 2.229 4.23 Barclays 2.061 2.001 -0.06

Source: Fixed Income Investor, Investing.com

Apart from a sharp increase in the yield on the 10yr Barclays issue (the 30yr did not react in the same manner) the spread between Gilts and corporates narrowed over the Brexit debacle too. This might be because bid/offer spreads in the corporate market became excessively wide – Gilts would have become the only realistic means of hedging – but the closing prices of the corporate names should have reflected mid-market yields.

If the “safe-haven” of Gilts has lost its lustre where should one invest? With patience and in higher yielding bonds – is one answer. Here is another from Ben Lord of M&G’s Bond Vigilantes – The BoE and ECB render the US bond market the only game in town:-

…The ultra-long conventional gilt has returned a staggering 52% this year. Since the result of the referendum became clear, the bond’s price has increased by 20%, and in the couple of weeks since Mark Carney announced the Bank of England’s stimulus package, the bond’s price has risen by a further 13%.

…the 2068 index-linked gilt, which has seen its price rise by 57% year-to-date, by 35% since the vote to exit Europe, and by 18% since further quantitative easing was announced by the central bank. Interestingly, too, the superior price action of the index-linked bond has occurred not as a result of rising inflation or expectations of inflation; instead it has been in spite of significantly falling inflation expectations so far this year. The driver of the outperformance is solely due to the much longer duration of the linker. Its duration is 19 years longer than the nominal 2068 gilt, by virtue of its much lower coupon!

When you buy a corporate bond you don’t just buy exposure to government bond yields, you also buy exposure to credit risk, reflected in the credit spread. The sterling investment grade sector has a duration of almost 10 years, so you are taking exposure to the 10 year gilt, which has a yield today of circa 0.5%. If we divide the yield by the bond’s duration, we get a breakeven yield number, or the yield rise that an investor can tolerate before they would be better off in cash. At the moment, as set out above, the yield rise that an investor in a 10 year gilt (with 9 year’s duration) can tolerate is around 6 basis points (0.5% / 9 years duration). Given that gilt yields are at all-time lows, so is the yield rise an investor can take before they would be better off in cash.

We can perform the same analysis on credit spreads: if the average credit spread for sterling investment grade credit is 200 basis points and the average duration of the market is 10 years, then an investor can tolerate spread widening of 20 basis points before they would be better off in cash. When we combine both of these breakeven figures, we have the yield rise, in basis points, that an investor in the average corporate bond or index can take before they should have been in cash.

With very low gilt yields and credit spreads that are being supported by coming central bank buying, accommodative policy and low defaults, and a benign consumption environment, it is no surprise that corporate bond yield breakevens are at the lowest level we have gathered data for. It is for these same reasons that the typical in-built hedge characteristic of a corporate bond or fund is at such low levels. Traditionally, if the economy is strong then credit spreads tighten whilst government bond yields sell off, such as in 2006 and 2007. And if the economy enters recession, then credit spreads widen and risk free government bond yields rally, such as seen in 2008 and 2009.

With the Bank of England buying gilts and soon to start buying corporate bonds, with the aim of loosening financial conditions and providing a stimulus to the economy as we work through the uncertain Brexit process and outcome, low corporate bond breakevens are to be expected. But with Treasury yields at extreme high levels out of gilts, and with the Fed not buying government bonds or corporate bonds at the moment, my focus is firmly on the attractive relative valuation of the US corporate bond market.

The table below shows a small subset of liquid US corporate bonds, showing the yield change between the 7th and 12th September:-

Issuer Issue Yield Maturity Change 7th to 12th Spread Rating
Home Depot HD 2.125 9/15/26 c26 2.388 10y 0.17 0.72 A2
Toronto Dominion TD 3.625 9/15/31 c 3.605 15y 0.04 1.93 A3
Oracle ORCL 4.000 7/15/46 c46 3.927 20y 0.14 1.54 A1
Microsoft MSFT 3.700 8/8/46 c46 3.712 20y 0.13 1.32 Aaa
Southern Company SO 3.950 10/1/46 c46 3.973 20y 0.18 1.58 Baa2
Home Depot HD 3.500 9/15/56 c56 3.705 20y 0.19 1.31 A2
US Treasury US10yr 1.67 10y 0.13 N/A AAA
US Treasury US30y 2.39 30y 0.16 N/A AAA

Source: Market Axess, Investing.com

Except for Canadian issuer Toronto Dominion, yields moved broadly in tandem with the T-Bond market. The spread between US corporates and T-Bonds may well narrow once the Fed gains a mandate to buy corporate securities, but, should Fed negotiations with Congress prove protracted, the cost of FX hedging may negate much of the benefit for UK or European investors.

What is apparent, is that the “flight to quality” effect is diminished even in the more liquid and higher yielding US market.

The total market capitalisation of the UK corporate bond market is relatively small at £285bln, the US market is around $4.5trln and Europe is between the two at Eur1.5trln. The European Central Bank (ECB) began its Corporate Sector Purchase Programme (CSPP) earlier this summer but delegated the responsibility to the individual National Banks.

Between 8th June and 15th July Europe’s central banks purchased Eur10.43bln across 458 issues. The average position was Eur22.8mln but details of actual holdings are undisclosed. They bought 12 issues of Deutsche Bahn (DBHN) 11 of Telefonica (TEF) and 10 issues of BMW (BMW) but total exposures are unknown. However, as the Bond Vigilantes -Which corporate bonds has the ECB been buying? point out, around 36% of all bonds eligible for the CSPP were trading with negative yields. This was in mid-July, since then 10y Bunds have fallen from -012% to, a stellar, +0.3%, whilst Europe’s central banks have acquired a further Eur6.71bln of corporates in August, taking the mark-to-market total to Eur19.92bln. The chart below shows the breakdown of purchases by country and industry sector at the 18th July:-


Source: M&G Investments, ECB, Bloomberg

Here is the BIS data for total outstanding financial and non-financial debt as at the end of 2015:-

Country US$ Blns
France 2053
Spain 1822
Netherlands 1635
Germany 1541
Italy 1023
Luxembourg 858
Denmark 586

Source: BIS

In terms of CSPP holdings, Germany appears over-represented, Spain and the Netherlands under-represented. The “devil”, as they say, is in the “detail” – and a detailed breakdown by issuer, issue and size of holding, has not been published. The limited information is certainly insufficient for traders to draw any clear conclusions about which issues to buy or sell. As Wolfgang Bauer, the author of the M&G article, concludes:-

But as tempting as it may be to draw conclusions regarding over- and underweights and thus to anticipate the ECB’s future buying activity, we have to acknowledge that we are simply lacking data. Trying to “front run” the ECB is therefore a highly difficult, if not impossible task.

 Conclusions and investment opportunities

Back in May the Wall Street Journal published the table below, showing the change in the portfolio mix required to maintain a 7.5% return between 1995 and 2015:-

Source: Wall Street Journal, Callan Associates

The risk metric they employ is volatility, which in turn is derived from the daily mark-to-market price. Private Equity and Real-Estate come out well on this measure but are demonstrably less liquid. However, this table also misses the point made at the beginning of this letter – that “risk-free” assets are encumbered with much higher “capital” risk in a ZIRP to NIRP world. The lower level of volatility associated with bond markets disguises an asymmetric downside risk in the event of yield “normalisation”.


Corporates with strong cash flows and rising earnings are incentivised to issue debt either for investment or to buy back their own stock; thankfully, not all corporates and leveraging their balance sheets. Dividend yields are around the highest they have been this century:-


Source: Multpl.com

Meanwhile US Treasury Bond yields hit their lowest ever in July. Below is a sample of just a few higher yielding S&P500 stocks:-

Stock Ticker Price P/E Beta EPS DPS Payout Ratio Yield
At&t T 39.97 17.3 0.56 2.3 1.92 83 4.72
Target TGT 68.94 12.8 0.35 5.4 2.4 44 3.46
Coca-cola KO 42.28 24.3 0.73 1.7 1.4 80 3.24
Mcdonalds MCD 114.73 22.1 0.61 5.2 3.56 69 3.07
Procter & Gamble PG 87.05 23.6 0.66 3.7 2.68 73 3.03
Kimberly-clark KMB 122.39 22.8 0.61 5.4 3.68 68 2.98
Pepsico PEP 104.59 29.5 0.61 3.6 3.01 85 2.84
Wal-mart Stores WMT 71.46 15.4 0.4 4.6 2 43 2.78
Johnson & Johnson JNJ 117.61 22.1 0.43 5.3 3.2 60 2.69

Source: TopYield.nl

The average beta of the names above is 0.55 – given that the S&P500 has an historic volatility of around 15%, this portfolio would have a volatility of 8.25% and an average dividend yield of 3.2%. This is not a recommendation to buy an equally weighted portfolio of these stocks, merely an observation about the attractiveness of returns from dividends.

Government bonds offer little or no return if held to maturity – it is a traders market. For as long as central banks keep buying, bond prices will be supported, but, since the velocity of the circulation of money keeps falling, central banks are likely to adopt more unconventional policies in an attempt to transmit stimulus to the real economy. If the BoJ, BoE and ECB are any guide, this will lead them (Fed included) to increase purchases of corporate bonds and even common stock.

Bond bear-market?

Predicting the end of the bond bull-market is not my intention, but if central banks should fail in their unconventional attempts at stimulus, or if their mandates are withdrawn, what has gone up the most (government bonds) is likely to fall farthest. At some point, the value of owning “risk-free” assets will reassert itself, but I do not think a 1% rise in yields will be sufficient. High yielding stocks from companies with good dividend cover, low betas and solid cash flows, will weather the coming storm. These stocks may suffer substantial corrections, but their businesses will remain intact. When the bond bubble finally bursts “risky” assets may be safer than conventional wisdom suggests. The breakdown in the “flight to quality” effect is just one more indicator that the rules of engagement are changing.

Drowning in debt


Macro Letter – No 60 – 02-09-2016

Drowning in debt

  • Central Banks are moving from quantitative to qualitative easing
  • The spread between Investment Grade and Government bond yields is narrowing
  • Issuing corporate debt rather than equity has never been so attractive
  • Corporate leverage is rising, share buy-backs continue but investment remains weak

I was always

Far out at sea

And not waving

But drowning

Stevie Smith

During August the financial markets have been relatively quiet, however, the Bank of England (BoE) cut interest rates on 4th and added Investment Grade Corporate bonds to their Asset Purchase Programme. The following day Vodafone (VOD) issued a 40yr bond yielding 3% – a week earlier they had issued a 33yr bond yielding 3.4%.

Meanwhile, at Jackson Hole the Kansas City Federal Reserve Symposium discussed a paper by Professor Jeremy Stein – a member Federal Reserve board member between 2012 and 2014 – and two other Harvard professors entitled The Federal Reserve Balance Sheet as a Financial Stability Tool – in which the authors argue that the Fed should maintain its balance sheet at around $4.5trln but that it “should use its balance sheet to lean against private-sector maturity transformation.” In layman’s terms this is a “call to arms” encouraging the Fed to seek approval from the US government to allow the purchase a much wider range of corporate securities. It would appear that the limits of central bank omnipotence have yet to be reached. The Bank of Japan has already begun to discover the unforeseen effect that negative interest rate policy has on the velocity of the circulation of money – it collapses. Now central bankers, who’s credibility has begun to be questioned in some quarters of late, are considering the wider use of “qualitative” measures.

As Bastiat has taught us, that which is seen from these policies is a reduction in the cost of borrowing for “investment grade” corporations. What is not seen, so clearly, is the incentive corporates have to borrow, not to invest, but to buy back their own stock. Perhaps I am being unfair, but, in a world which is drowning in debt, central bankers seem to think that the over-indebted are not “drowning” but “waving”.

One of the most cherished ideas, promulgated upon an unsuspecting world, is the concept of using fiscal and monetary stimulus to offset cyclical economic downturns. The aim of these “popular” policies is to soften the blow of economic slowdowns – all highly laudable provided the “punch bowl” is withdrawn during the cyclical recovery.

So much for business cycles: but what about the impact these policies may have on structural changes in economic performance relating to supply and demand for factors of production, such as labour, fixed assets or basic materials? I’m thinking here about the impact, especially, of technology and demographics.

Firstly, the cyclical stimulus extended during the downturn is seldom withdrawn during the upturn and secondly, long term structural changes in economies are seldom considered by governments, since these changes evolve over decades or generations, rather than the span of a single parliament. This is an essential weakness in the democratic process which has stifled economic growth for centuries. This excellent paper from Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff – The Journal of Economic Perspectives – Volume 26 – No 3 – Summer 2012 – Public Debt Overhangs: Advanced Economy Episodes Since 1800 makes this weakness abundantly clear.

The authors expand on their earlier research, this time looking at the impact of excessive public debt overhang on economic growth. They take as their “line in the sand” the point where the government debt to nominal GDP ratio remains above 90% for more than five years. They identify 26 episodes, 20 of which lasted more than a decade – the average was 23 years. It is worth noting that more than one third of these episodes occurred without interest rates rising above normal levels.

In 23 of the 26 episodes, over the 211 year sample, the pace of economic growth was lowered from 3.5% to 2.3% – in other words GDP was reduced by roughly one third. The long term secular impact of high debt and lower growth needs to be weighed against the short-term benefits of Keynesian stimulus. A lowering of the GDP growth rate of 1.2% for 23 years is equivalent to a 24.25% reduction in the potential size of the economy at the end of the debt overhang period – a tall price for any economy to pay.

The authors briefly examine the other types of outstanding debt, in order to arrive at what they dub “the quadruple debt overhang problem”, namely, private debt, external debt (and its associated currency risks) and the “actuarial” debt implicit in “unfunded” pension schemes and medical insurance programmes. This data is hard to untangle but the authors state:-

…the overall magnitude of the debt burdens facing the advanced economies as a group is in many dimensions without precedent. The interaction between the different types of debt overhang is extremely complex and poorly understood, but it is surely of great potential importance.

The 22 developed economies in their sample are now burdened with debt to GDP ratios above the levels seen in the aftermath of WWII. Their 48 emerging market counterparts had their epiphany in the debt crisis of the mid 1980’s, since when they have assumed a certain sobriety of character. This shows up even more glaringly in the divergence since 1986 in the public, plus private, external debt. In developed countries it has risen from around 75% of GDP to more than 250% whilst emerging economies external debt has fallen from a broadly similar 75% to less than 50% today. Governments, often bailout private external debt holders in order to protect the stability of their currencies.

Private domestic credit is another measure of total indebtedness which the authors analyse. For the 48 emerging economies this has remained constant at around 40% of GDP since the mid-1980s whilst in the developed 22 it has risen from 50% in the 1950’s to above 150% today. Since the bursting of the technology stock bubble in 2000 this trend has accelerated but the authors point out that these increases are often caused by cross border capital inflows.

The rise in the debt to GDP ratio may come from a slowing in growth rather than an increase in government debt but the correlation between rising debt and slowing GDP rises dramatically as the ratio exceeds 90%.

The authors draw the following conclusions:-

…First, once a public debt overhang has lasted five years, it is likely to last 10 years or much more (unless the debt was caused by a war that ends).

…it is quite possible to have a “no drama” public debt overhang, which doesn’t involve a rise in real interest rates or a financial crisis. Indeed, in 11 of our 26 public debt overhang episodes, real interest rates were on average comparable, or lower, than at other times.

…Another line of reasoning for dismissing concerns about public debt overhangs is the view that causality mostly runs from growth to debt. However, we discussed a body of evidence which argues runs from growth to debt. However, we discussed a body of evidence which argues that causality does indeed run from the public debt overhang to slower growth. There are counterexamples where a public debt overhang was accompanied by rapid growth, like the immediate period after World War II for the United States and United Kingdom, but these exceptions to the typical pattern do not seem to be the most relevant parallels for the modern world economy.

…The pathway to containing and reducing public debt will require a change that is sustained over the middle and the long term. However, the evidence, as we read it, casts doubt on the view that soaring government debt does not matter when markets (and official players, notably central banks) seem willing to absorb it at low interest rates—as is the case for now.

The Methadone of the Markets

The bull market in fixed income securities began in the early 1980’s. The price of “risk free” assets has always had a significant influence on the valuation of equities but, since the advent of quantitative easing, the principle driver of performance has become the level of interest rates. As the yield on fixed income securities has inexorably declined the spread between the dividend and bond yield has returned to positive territory after many years of inversion.

Companies with growing earnings from their operations can finance more cheaply than at any time in history. Provided they can sustain their growth, their bonds should, theoretically, begin to trade at a discount to government bonds. This would probably have happened before now had the central banks not embarked on quantitative easing revolving around the purchase of government bonds at already artificially inflated prices. The rules on capital weighting which favour “risk free” assets and regulations requiring pension funds and other financial institutions to hold minimum levels of “risk free” assets has further distorted the marketplace.

The unfunded government pension schemes of developed nations are at the mercy of the demographic headwind of a smaller working age population supporting a growing legion of retirees. Added to which, breakthroughs in medical science suggest that actuarial expectations of life expectancy may once again be underestimated.

Ways out of debt

There are a number of solutions other than fiscal austerity. For example, increasing the pensionable age steadily towards the average life expectancy. This may sound extreme but in January 1909, when the pension was first introduced in the UK, the pensionable age was 70 years and life expectancy was 50 years for men and 53.5 for women. The latest ONS data shows male life expectancy at 79 years whilst for females it is 82.8 years. The pensionable age for women has now risen to 63 years and will be brought in line with men (65 years) by 2018. There is still a long way to go, by 2030 the NHS estimate the male average will be 85.7 years, with females living an average of 87.6 years. Meanwhile the pensionable age will reach 68 years by 2028. In other words, the current, deeply unpopular, proposed increase in the pensionable age is barely keeping pace with the projected increase in life expectancy.

Another solution which would help to reduce the level of public debt is a structural policy of capping government spending at less than 40% of GDP. This could be relaxed to less than 50% during recessions as a temporary counter-cyclical measure. UK GDP averaged 2.47% since 1953 – if government spending only increased slightly less than 1% per annum we could steadily reduce the public sector debt burden towards a manageable 30% level over the next 40 years, after all, as recently as 2005 the ratio of government debt to GDP was at 38%. The chart below of the Rahn Curve shows the optimal ratio of government debt to GDP. Once government spending exceeds 15% it acts as a drag on the potential growth of an economy:-


Source: The Heritage Foundation, Peter Brimelow

The interest paid on corporate debt and bank loans is tax deductible which creates an incentive to issue debt rather than equity. It is difficult to change this situation but mandating that equity may only be retired from after-tax profits would encourage leverage for investment purposes rather than to artificially enhance the return on equity. The chart below shows the decline in net domestic investment in the US despite historically low interest rates:-

fredgraph (1)

Source: Federal Reserve Bank of St Louis

The next chart shows the level of share buybacks and the performance of the S&P500:-


Source: Dent Research, S&P, Haver Analytics, Barclays Research, Business Insider

Household debt is predominantly in the form of mortgages. In most developed countries a shortage of housing stock, due to planning restrictions, has encouraged individuals to speculate in the real estate market. In fact BoE Chief Economist Andy Haldane was quoted in The Sunday Times – Property is a better bet than pensions, says gold-plated Bank guru stating that pensions were complex and housing was a better investment:-

As long as we continue not to build anything like as many houses in this country as we need to … we will see what we’ve had for the better part of a generation, which is house prices relentlessly heading north.

The solution is planning reform. This will reduce house price inflation but it will not reduce the level of mortgage debt, however, once housing ceases to be a “one way bet” the attraction of leveraged speculation in property will diminish.

Conclusions and Investment Opportunities

The underlying problem which caused the great recession of 2009/2010 was excessive debt. The policy response has been to throw petrol on the fire. The first phase of unconventional monetary policy – reducing official interest rates towards zero – has more or less run its course. The next phase – qualitative easing – is now under way. This will start with corporate bonds and proceed to other securities ending up with common stock. Credit spreads will continue to narrow even if government bond yields rise. There will, of course, be episodes of panic when “safe haven” government bonds outperform but this will be temporary and the spread widening will present a buying opportunity.

The UK Investment Grade bond market is relatively small at £285bln and liquidity is therefore less robust than for Euro or US$ denominated issues but there is a £10bln “put” beneath the market. Other initiatives will be forthcoming from the central banks. Their actions will continue to be the dominant factor influencing asset prices in general.

Uncharted British waters – the risk to growth, the opportunity to reform


Macro Letter – No 59 – 15-07-2016

Uncharted British waters – the risk to growth, the opportunity to reform

  • Uncertainty will delay investment and damage growth near term
  • A swift resolution of Britain’s trade relations with the EU is needed
  • Without an aggressive liberal reform agenda growth will be structurally lower
  • Sterling will remain subdued, Gilts, trade higher and large cap stocks well supported

Look, stranger, on this island now
The leaping light for your delight discovers,
Stand stable here
And silent be,
That through the channels of the ear
May wander like a river
The swaying sound of the sea.

W.H. Auden


Source: Captain Greenvile Collins – Great Britain’s Coasting Pilot – 1693

Captain Greenvile Collins was the Hydrographer in Ordinary – to William and Mary. His coastal pilot was the first, more or less, accurate guide to the coastline of England, Scotland and Wales, prior to this period mariners had relied mainly on Dutch charts. Collins’s charts do not comply with the convention of north being at the top and south at the bottom – the print above, of the Thames estuary, has north to the right. This, and the extract from W. H. Auden with which I began this letter, seem appropriate metaphors for the new way we need to navigate the financial markets of the UK post referendum.

Sterling has borne the brunt of the financial maelstrom, weakening against the currencies of all our major trading partners. Gilts have rallied on expectations of further largesse from the Bank of England (BoE) and a more generalised international flight to quality in “risk-free” government bonds. This saw Swiss Confederation bonds trade at negative yields to maturity out to 48 years.

With interest rates now at historic lows around the developed world and investors desperate for yield, almost regardless of risk, equity markets have remained well supported. Many individual UK companies with international earnings have made new all-time highs. Banks and construction companies have not fared so well.

Now the dust begins to settle, we have the more challenging task of anticipating the longer term implications of the British schism, both for the UK and its European neighbours. In this letter I will focus principally on the UK.

A Return to the Astrolabe?


Source: University of Cambridge

The Greeks invented the astrolabe sometime around 200BCE. The one above of Islamic origin and dates from 1309. Before the invention of the sextant this was the only reliable means of navigation.

Our aids to navigation have been compromised by the maelstrom of Brexit – it’s not quite a return to the Astrolabe but we may have lost the use of GPS and AIS.

This week the OECD was forced to suspend the publication of its monthly Composite Leading Indicators (CLI). Commenting on the decision they said:-

The CLIs cannot…account for significant unforeseen or unexpected events, for example natural disasters, such as the earthquake, and subsequent events that affected Japan in March 2011, and that resulted in a suspension of CLI estimates for Japan in April and May 2011. The outcome of the recent Referendum in the United Kingdom is another such significant unexpected event, which is affecting the underlying expectation and outturn indicators used to construct the CLIs regularly published by the OECD, both for the UK and other OECD countries and emerging economies.

It will be difficult to draw any clear conclusions from the economic data produced by the OECD or other national and international agencies for some while.

Speaking to the BBC prior to the referendum, OECD Secretary General, Angel Gurria had already suggested that UK growth would be damaged:-

It is the equivalent to roughly missing out on about one month’s income within four years but then it carries on to 2030. That tax is going to be continued to be paid by Britons over time.

Back in March Open Europe – What if…? The consequences, challenges and opportunities facing Britain outside the EU put it thus:-

UK GDP could be 2.2% lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU or reverts into protectionism. In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world, whilst pursuing large-scale deregulation at home, Britain could be better off by 1.6% of GDP in 2030. However, a far more realistic range is between a 0.8% permanent loss to GDP in 2030 and a 0.6% permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.

…Based on economic modelling of the trade impacts of Brexit and analysis of the most significant pieces of EU regulation, if Britain left the EU on 1 January 2018, we estimate that in 2030:

In a worst case scenario, where the UK fails to strike a trade deal with the rest of the EU and does not pursue a free trade agenda, Gross Domestic Product (GDP) would be 2.2% lower than if the UK had remained inside the EU.

In a best case scenario, where the UK strikes a Free Trade Agreement (FTA) with the EU, pursues very ambitious deregulation of its economy and opens up almost fully to trade with the rest of the world, UK GDP would be 1.6% higher than if it had stayed within the EU.


Source: Open Europe, Ciuriak Consulting

Given that UK annual GDP growth averaged 2.46% between 1956 and 2016, the range of outcomes is profoundly important. GDP forecasts are always prone to error but the range of outcomes indicated above is exceedingly broad – divination might prove as useful.

Also published prior to the referendum Global Counsel – BREXIT: the impact on the UK and the EU assessed the prospects both for the UK and EU in the event of a UK exit. The table below is an excellent summary, although I don’t entirely agree with all the points nor their impact assessment:-


Source: Global Counsel

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

Curiouser and Curiouser – the myth of devaluation continues. The 1992 experience….

“The UK’s trade performance since the onset of the economic downturn in 2008 has been one of the more curious developments in the UK economy” according to a recent report from the Office for National Statistics. “Explanation beyond exchange rates: trends in UK trade since 2007. 

We would argue, it is only curious for those who choose to ignore history. 

Much reference is made to the period 1990 – 1995 when the last “great depreciation led to an improvement in the balance of payments” – allegedly. Analysing the trade in goods data [BOKI] from the ONS own report demonstrates the failure of depreciation to improve the net trade in goods performance in the period 1990 – 1995.

Despite the fall in sterling, the inexorable structural decline in net trade in goods continued throughout. As we have long argued would be the case, in the most recent episode. Demand co-efficients are powerful, the price co-efficients much weaker and almost inelastic with regard to imports. Check out the slide show below for more information. 

The conclusions from the ONS report do not add up. Curiouser and Curiouser, policy makers just like Alice, sometimes choose to believe in as many as six impossible things before breakfast.

A brief history of devaluation from 1925 onwards…. 

The great devaluation of 1931 – 24%

In 1925, the dollar sterling exchange rate was $4.87. Britain had readopted the gold standard. Unfortunately, the relative high value of the pound placed considerable pressure on the trade and capital account, the balance of payments problem developed into a “run on the pound”. The UK left the gold standard in 1931, the floating pound quickly dropped to $3.69, providing an effective devaluation of 24%. The gain, if such it was, could not be sustained. Over the next two years, confidence in the currency returned, the dollar weakened, sterling rallied in value to a level of $5.00 but…Fears of conflict in Europe placed pressure on the sterling. In 1939, with the outbreak of World War II the rate dropped to $3.99 from $4.61. In March, 1940, the British government pegged the value of the pound to the dollar, at $4.03.

The great devaluation of 1949 – 30%

Post war, Britain was heavily indebted to the USA. Despite a soft loan agreement with repayments over fifty years, the pound remained once again under intense pressure In 1949 Stafford Cripps devalued the pound by over 30%, giving a rate of $2.80. 

The great devaluation of 1967 – 14%

In 1967 another “balance of payments” crisis developed in the British economy with a subsequent “run on the pound. Harold Wilson announced, in November 1967, the pound had been devalued by just over 14%, the dollar sterling exchange rate fell to $2.40. This the famous “pound in your pocket” devaluation. Wilson tried to reassure the country by pointing out that the devaluation would not affect the value of money within Britain. 

In 1971, currencies began to float, depreciation not devaluation became the guideline

In 1977, sterling fell against the dollar with pound plummeting to a low of $1.63 in the autumn 1976. Another sterling crisis and a run on the pound. The British government was forced to borrow from the IMF to bridge the capital gap. The princely sum of £2.3 billion was required to restore confidence in the pound.  

By 1981, the pound was trading back at the $2.40 level but not for long. Parity was the pursuit by 1985 as the pound fell in value to a month low of $1.09 in February 1985.

In the late 1980s, Chancellor Lawson was pegging the pound to the Deutsche Mark to establish some form of stability for the currency. In October of 1990, Chancellor Major persuaded Cabinet to enter the ERM, the European Exchange Rate Mechanism. The DM rate was 2.95 to the pound and $1.9454 against the dollar. 

Less than two years later, Britain left the European experiment. 

The strains of holding the currency within the trading band had pushed interest rates to 12% in September, with some suggestions that rates would have to rise to 20% to maintain the peg. 

In September 1992, Chancellor Lamont announced the withdrawal from the ERM. The Pound fell in value against the dollar from $1.94 to $1.43, an effective depreciation of 26%. According to the wider Bank of England Exchange rate the weighted depreciation was 15%. 

The chart below shows GBPUSD since 1953, it doesn’t capture everything mentioned above but it highlights the volatility and terminal decline of the world’s ex-reserve currency:-

Cable since 1953

Source: FX Top

Reform, reform, reform

The UK needs to renegotiate terms with the EU as quickly as possible in order to minimise the damage to UK and global economic growth. I believe there are four options: –

EEA – the Norwegian Option


  • Maintain access to the Single Market in goods and services and movement of capital.
  • Ability to negotiate own trade deals.
  • Least disruptive alternative to EU membership.


  • Commitment to free movement of people and the provision of welfare benefits to EU citizens.
  • Accept EU regulation but have no influence over them.
  • Must comply with “rules of origin” – which impose controls on the use of products from outside the EU in goods which are subsequently exported within the EU. The cost of determining the origin of products is estimated to be at least 3.0% – the average tariff on goods from the US and Australia is 2.3% under World Trade Organisation (WTO) rules.
  • Comply with EU rules on employment, consumer protection, environmental protection and competition policy.
  • Pay an annual fee to access the Single Market, although less than for full EU membership.

EFTA – the Swiss Option


  • Maintain access to the Single Market in goods.
  • Ability to negotiate own trade deals.
  • Greater independence over the direction of social and employment law.


  • Commitment to free movement of people.
  • Must comply with “rules of origin”.
  • Restricted access to the EU market in services – particularly financial services.

WTO – the Default Option


  • Subject to Most Favoured Nation tariffs under WTO guidelines. In 2013, the EU’s trade-weighted average MFN tariff was 2.3% for non-agricultural products.
  • Ability to negotiate own trade deals.
  • Independence over legislation.


  • Tariffs on agricultural products range from 20% to 30%.
  • Tariffs for automobiles are 10%.
  • Services sector would face higher levels of non-tariff barriers such as domestic laws, regulations and supervision. Services made up 37% of total UK exports to the EU in 2014 – the WTO option will be costly.

Bilateral Free-Trade Agreement – the Canadian Option


  • Negotiate a bilateral trade agreement with the EU – sometimes called the Canada option after the, still unratified, Comprehensive Economic and Trade Agreement (CETA).


  • Must comply with “rules of origin” – if it mirrors the CETA deal.
  • Services are only partially covered.
  • Negotiations may take years.

The quickest solution would be the WTO default option, the least cathartic would be to join the EEA. I suspect we will end up somewhere between these two extremes; The Peterson Institute – Theresa May—More Merkel than Thatcher? Is of a different opinion:-

To survive politically at home, May must deliver Brexit at almost any cost, suggesting that she might well in the end be compelled to accept a “hard Brexit” that puts the UK entirely outside the internal market. Lacking a public mandate in a fractious party that retains only a slim parliamentary majority, May not surprisingly opposes new general elections, which would focus on Brexit and thus easily cost the Conservatives their majority, along with their new prime minister’s job. Unless the UK suffers substantially additional economic hardship in the coming years, the next UK elections may well occur as late as 2020.

For the financial markets there is a certain elegance in the “hard Brexit” WTO option. Uncertainty is removed, unilateral trade negotiations can be undertaken immediately and the other options remain available in the longer term.

Beyond renegotiation with the EU there is a broader reform agenda. Dust off your copy of Hayek’s The Road to Serfdom, this could see a return to the liberal policies, of smaller government and freer trade, which we last witnessed in the 1980’s. The IEA’s Ryan Bourne wrote an article this week for City AM – Forget populist executive pay curbs: Prime Minister May should embrace these six policies to revitalise growth in which he advocated:-

1) Overhaul property taxation: the government should abolish both council tax and stamp duty entirely and replace them with a single tax on the “consumption” of property – i.e. a tax on imputed rent. It is well known among economists that taxes on transactions like stamp duty are highly damaging, and we have already seen the high top rates significantly slow transactions since April.

2) Abolish corporation tax entirely: profit taxes discourage capital investment by lowering returns, which makes workers less productive and results in lower wage growth. In a globalised world, profits taxation also encourages capital to move elsewhere, both because it makes the UK less attractive as a location for “real” economic activity and because it creates incentives for avoidance through complex business structures. Rather than continuing this goose chase, let’s abolish it entirely and tax dividends at an individual level, as Estonia does.

Read more: Ignore Google’s corporation tax bill and scrap the tax altogether

3) Planning liberalisation: if you ask anyone to name the UK’s main economic problems, you’ll probably hear “poor productivity performance”, “a high cost of living” and “entrenched economic difficulties in some areas”. Constraining development through artificial boundaries and regulations is acknowledged to be a key driver of high house price inflation. Less acknowledged is that, for sectors like childcare, social care, restaurants and even many office-based industries, high rents and property prices raise other prices for consumers, with a dynamic strain on our growth prospects brought about by a reduction in competition and innovation. That’s not to mention the impact on labour mobility. Liberalisation of planning, including greenbelt reform – which May has sadly already seemingly ruled out – is probably the closest thing to a silver bullet as far as productivity improvements are concerned.

4) Sensible energy policy: the UK government has gone further than many EU countries on the “green agenda”. But the EU’s framework, with binding targets for renewables, has certainly helped shape policy in the direction of subsidies and subsidy-like obligations and interventions. Even if one accepts the need to reduce carbon emissions, an economist would suggest the implementation of either a straight carbon tax or, less optimally, a cap-and-trade scheme, rather than the current raft of interventions which make energy more expensive than it need be.

5) Agricultural liberalisation: exiting the EU Common Agricultural Policy gives us the opportunity to reassess agricultural policy. The UK should gradually phase out all subsidies, as New Zealand did, opening up the sector to global competition. This improved agricultural productivity in that country significantly. Combined with a policy of unilateral free trade, it would deliver substantially lower food prices for consumers too.

6) Deregulation: in the long term, Britain should extricate itself from the Single Market and May should set up a new Office for Deregulation, tasked with examining all existing EU laws and directives, with the clear aim of removing unnecessary burdens and lowering costs. In particular, this should focus on labour market regulation, financial services, banking and transport

In a departure from my normal focus on the nexus of macroeconomics and financial markets I wrote a reformist article last week for the Cobden Centre – A Plan to Engender Prosperity in Perfidious Albion – from Pariah to Paragon; in it, I made some additional reform proposals:-

Banking Reform: The financialisation of the UK economy has reached a point where productive, long term capital investment is in structural decline. Increasing bank capital requirements by 1% per annum and abolishing a zero weighting for government securities would go a long way to reversing this pernicious trend.

Monetary Reform: The key to long term prosperity is productivity growth. The key to productivity growth is investment in the processes of production. Interest rates (the price of money) in a free market, act as the investment signal. Free banking (a banking system without a lender of last resort) is a concept which all developed countries have rejected. Whilst the adoptions of Free banking is, perhaps, too extreme for credible consideration in the aftermath of Brexit, a move towards the free-market setting of interest rates is desirable to attempt to avert any further malinvestment of capital.

Labour Market Reform: A repeal of the Working Time Directive and the Agency Workers Directive would be a good start but we must resist the temptation to close our borders to immigration. Immigrants, both regional and international, have been essential to the economic prosperity of Britain for centuries. There will always be individual winners and losers from this process, therefore, the strain on public services should be addressed by introducing a contribution-based welfare system that ensures welfare for all – migrants and non-migrants – contingent upon a record of work.

Educational Reform: investment in technology to deliver education more efficiently would yield the greatest productivity gains but a reform of the incentives based on individual choice would also help to improve the quality of provision.

Free Trade Reform: David Ricardo defined the economic law of comparative advantage. In the aftermath of the UK exit from the EU it would be easy for the UK to slide towards introspection, especially if our European trading partners close ranks. We should resist this temptation if at all possible; it will undermine the long term productivity of the economy. We should promote global free trade, unilaterally, through our membership of the World Trade Organisation. In the last 43 years we have lost the art of negotiating trade deals for ourselves. It will take time to reacquire these skills but gradual withdrawal from the EU by way of the EEA/EFTA option would give the UK time to adjust. The EEA might even prove an acceptable longer term solution. I suspect the countries of EFTA will be keen to collaborate with us.

We should apply to rejoin the International Organization for Standardization , the International Electrotechnical Commission , and the International Telecommunication Union (all of which are based in Geneva) and, under the auspices of EFTA, we can rejoin the European Committee for Standardization (CEN), the European Committee for Electrotechnical Standardization (CENELEC), the European Telecommunications Standards Institute (ETSI), and the Institute for Reference Materials and Measurements (IRMM).


Financial markets will remain unsettled for an extended period; domestic capital investment will be delayed, whilst international investment may be cancelled altogether. If growth slows, and I believe it will, further easing of official interest rates and renewed quantitative easing are likely from the BoE. Gilts will trade higher, pension funds and insurance companies will continue to purchase these fixed income assets but the BoE will acquire an ever larger percentage of outstanding issuance. In 2007 Pensions and Insurers held nearly 50%, with Banks and Building Societies accounting for 17% of issuance. By Q3 2014 Pensions and Insurers share had fallen to 29%, Banks and Building Societies to 9%. Over seven years, the BoE had acquired 25% of the entire Gilt issuance.

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.


China – Rebalancing, Debt and the Stock Market


Macro Letter – No 58 – 08-07-2016

China – Rebalancing, Debt and the Stock Market

  • Chinese growth has been slowing since 2007
  • Total debt to GDP has risen from 148% in 2007 to 237% today
  • Oversupply in real-estate is still a concern but lower interest rates are helping
  • Infrastructure spending may help and Chinese stocks are cheap

I was prompted to write this rather longer letter by the recent weakness of the Chinese currency. The chart below tracks the progress of the USDCNY over the last three years, compared with many emerging markets the devaluation is minimal:-

china-currency 2yr

Source: Trading Economics

A longer term chart shows how far the currency has travelled over the last 12 years:-

china-currency 12 yr

Source: Trading Economics

It was at the National People’s Congress of March 2013 that the policy of “rebalancing” was introduced, however, the CNY continued to strengthen. This gradual appreciation against the US$ had created large imbalances within the Chinese economy. The economic-policy adjustment of “rebalancing” had one objective: shifting China from a production-oriented economy to one focused on household consumption. If, in the process, it could alleviate international pressure on the Chinese administration to allow the CNY to float freely, so much the better. Now it looks as if the outcome of allowing the CNY to float freely would see it sink like a stone.

A Review of Rebalancing

A detailed analysis of the rebalancing challenge is contained in this February 2013 paper from the ECB – China’s Economic Growth and Rebalancing it highlights international concerns:-

China’s leadership is well aware of the limitations of the producer-biased and export-led model. Interestingly, there is no major disagreement between the Chinese and the international community about the need for rebalancing policies to ensure China’s smooth transition to a more sustainable model. The disagreement is more about how fast the reform measures should be implemented.

It has been argued that intertwined economic and political interests make China’s rebalancing more difficult and cause the reform process to advance slowly. Political resistance to the reforms stems from various sources. First, in a system where political success at the local level has been historically dependent on quantitative growth, reforms that emphasise the quality of growth are bound to meet some resistance. Second, the current growth model required to keep some strategic sectors of the economy closed and under state control (e.g. financial markets, services, heavy industry). The planned opening up of these sectors to competition does not only meet resistance from SOEs and banks, but is also questioned in government circles owing to worries about exhausting the “privilege” of direct macroeconomic policy management. Not surprisingly, major resistance is observed in the export lobby, which is one of the most influential in China and the one which reforms affect most directly.

Reviewing the policy initiative in June 2014 – shortly after the, once in a decade, handover of power from President Hu Jintao and Premier Wen Jiabao to Xi Jinping and Li Keqiang – McKinsey – China’s great rebalancing: Promise and peril concluded:-

Of course, there is no guarantee that rebalancing will succeed. Part of the problem is that the politics associated with it—boosting the income of Chinese households at the expense of state-owned companies and other large investment-oriented entities—is actually more complicated than the economics. But one thing is certain. China is rapidly reaching the point of diminishing economic and political returns from its investment-driven model, which is headed for change one way or another: either through a proactive rebalancing, with reforms and policy adjustments, or a forced rebalancing precipitated by rising stresses in and beyond the financial system. So far, the signs are encouraging that the new leadership is serious about changing China’s growth model, and this is reason enough for global firms that have benefited from China’s investment boom to rethink their strategies for the years ahead.

Three years on the challenges of rebalancing an $11trln economy of 1.4bln people are becoming evident. McKinsey – China’s Choice – Capturing the $5 Trillion Productivity Opportunity, published last month, makes the case for continued reform based on boosting productivity:-

…Government can do a great deal to improve the odds of success by transforming institutions in six priority areas:

I. Open more sectors up to competition. SOEs still account for 43 percent of service sector fixed-asset investment, compared with 8 percent in manufacturing

.…In telecommunications, for instance, an effort to introduce mobile virtual network operators to target underserved segments has not yet had a substantial impact because the big three players in the sector still have considerable clout in negotiations and strong influence on pricing. In health care, fixing the economics model to make hospitals less dependent on drug sales and encourage more qualified doctors to work at private hospitals could help improve the quality of service.

II. Improve the breadth and quality of capital markets. China would benefit from a financial system where market forces allocate capital efficiently; that means well functioning bond and equity markets that attract a diverse set of investors, including institutional and overseas players. The municipal bond market could lower financing costs for local government while bringing market discipline to managing investment projects. To facilitate this shift, China needs to strengthen the foundations of an effective financial system, such as strong, independent credit-rating agencies, more transparent public data on the economy, and more effective communication about government monetary policy. Inviting new players (such as internet banks) to supply capital and helping banks build capabilities to undertake more lending for underserved segments such as small and medium-sized enterprises and rural consumers will be important.

III. Enable corporate restructuring. Shifting successfully to a productivity-led growth model will mean a sea change—letting inefficient companies fail rather than protecting and propping them up and rationalizing excess capacity.

…enforcing bankruptcy law and improving the bankruptcy process. Strengthening capabilities of asset-management companies tasked with handling restructuring could help to turn around companies in default. China will need to expand the securitization of non-performing loans to be prepared for any larger-scale bad debt situation and to ensure that banks put effective risk management in place.

IV. Invest in talent and enhance labor mobility. China has made great strides in educating its people, but more is needed. Among the measures that the government could now take are providing more funding for education, designing programs that rotate effective teachers to places they are most needed, and engaging the private sector to define job-ready skills, build those into curricula, and establish an education to-employment pipeline. On top of this, the government could enhance labor mobility to optimize employment across different regions of the country. Expansion of unemployment insurance and training can help smooth the transition for displaced workers and help them back into jobs. Ensuring gender equality in opportunities in education and in the labor market, while supporting women as well as men as they develop their careers, can further strengthen China’s talent base.

V. Boost aggregate demand. As inequality grows, the government can revise fiscal and tax policies to give households more spending power. For families in need, it could consider conditional cash transfers. Improving social safety net programs by raising health-care and retirement benefits, for example, can reduce the need for precautionary saving for out-of-pocket medical expenses, facilitate consumption, and reduce income inequality. Broadening affordable-housing programs to include migrant workers, with market-based subsidies on both the supply and demand side, can also help low-income families to consume more.

VI. Improve public-sector effectiveness. Ensuring that government raises its own productivity is an important part of any transition to a productivity-led model. Such an effort can start by using household income and productivity indicators to evaluate officials and departments rather than rewarding them largely for the GDP growth their cities or regions achieve. Digitizing government operations and service delivery is an important part of the mix. Government also needs to develop better conflict-resolution capabilities to mediate between different stakeholders so that restructuring and reforms can proceed.

Another aspect of President Xi’s reform is in foreign policy, it has been dubbed the “One Belt, One Road” (OBOR). Last week the Economist – Our bulldozers, our rules discussed the potential of the initiative:-

…Asia needs new infrastructure—about $770 billion a year of it until 2020, according to the Asian Development Bank. This demand should eventually ease today’s worries about a lack of projects. Bert Hofman, the World Bank’s chief in Beijing, adds that individual countries will benefit more if they align their plans with one another and with China. It does not pay to plan and build separately.

Next, China needs OBOR. At home, its businesses are being squeezed by rising costs and growing demands that they pay more attention to protecting the environment. It makes sense for them to shift some manufacturing overseas—as long as the infrastructure is there.

Lastly, Xi Jinping needs it. He has made OBOR such a central part of his foreign policy and has gone to such lengths to swing the bureaucracy behind the project that it is too late to step back now.

None of this means the new Silk Road will be efficient, nor does it mean China’s plans will always be welcome in countries suspicious of its expanding reach. But the building blocks are in place. The first projects are up and running. OBOR is already beginning to challenge the notion of Europe and Asia existing side by side as different trading blocs.

This is reminiscent of the economic development of Japan during the 1970’s and 1980’s.

Despite these policy initiatives, the Chinese economy has been slowing for the past six years. An excellent overview of the current situation was provided last month by the China-United States Exchange Foundation – China’s Incomplete Growth Strategy, in which they highlighted the policies for and challenges to achieve growth, both in the long and short run. Most of the problems are associated with the oversupply evident in the real-estate market and the economic drag from the debt associated with this over-supply. Their solution, as McKinsey suggested above, is infrastructure development:-

…last November, they officially placed the blame on long-term supply-side shortcomings, which they pledged to address with far-reaching structural reforms.

…the supply-side focus largely ignores the present. China faces two separate challenges: the long-term issue of a declining potential growth rate and the immediate problem of below-potential actual growth.

Among the long-term factors undermining potential growth are diminishing returns to scale, a widening income gap, and a narrowing scope for technological catch-up through imitation. Moreover, even as the country’s demographic dividend dissolves, its carrying capacity (the size of the population the environment can sustain) is being exhausted – a situation that high levels of pollution are certainly not helping. Finally, and most important, the country is suffering from inadequate progress on market-orientated reform.

While some of these factors are irreversible, others can be addressed effectively. And, indeed, the government’s supply-side reform strategy will go a long way toward doing just that, ultimately stabilizing and even raising China’s growth potential. But, contrary to popular belief, they will not boost China’s actual growth rate today.

Why are so many economists convinced that a long-term reform strategy is all China needs? One reason is the widely held notion that today’s overcapacity reflects supply-side problems, not insufficient demand. According to this view, China should implement policies like tax cuts to encourage companies to produce products for which there is genuine demand. That way, the government would not inadvertently sustain “zombie enterprises” that cannot survive without bank loans and support from local governments.

But only some of China’s overcapacity can be attributed to bad investment decisions. A large share has emerged because of a lack of effective demand. And that is, at least partly, a result of the government’s effort to moderate real-estate investment, which has caused the sector’s annual growth to tank, plunging from 38% in 2010 to 1% at the end of 2015.

With real-estate investment still accounting for more than 14% of GDP last year, plummeting growth in the sector has put considerable downward pressure on the economy as a whole, helping to push China into a debt-deflation spiral. As overcapacity drives down the producer price index – which has now been falling for 51 consecutive months – real debt rises. This is undermining corporate profitability, spurring companies to deleverage and reduce investment, and fuelling further declines in PPI.

The enduring importance of real-estate investment to China’s economic growth is reflected in trends from the first quarter of this year. Annual GDP growth of 6.7%, despite being the slowest rate for any quarter in seven years, exceeded market expectations. And it was driven partly by an unforeseen increase in real-estate investment growth, to 6%.

This is not to say that what China needs is more real-estate investment. According to the National Bureau of Statistics, China had 718 million square meters of unsold commercial and residential floor space at the end of 2015; when space under construction is factored in, inventory expands to more than five billion square meters. With an average of only 1.2 billion square meters of housing being sold each year, the best way to reduce this supply glut is clear: limit future construction. One of the most important reasons for the recent investment surge was abundant liquidity driving speculative demand – and that is hardly sustainable.

…Infrastructure investment, in particular, may well be the key to tackling China’s economic woes. After all, such investment, which grew at 19.6% in the first quarter of 2016, has already proved to be a critical driver of economic growth – and, unlike real-estate investment, it has not worsened China’s resource allocation or set the stage for major imbalances.

When there is slack in the economy, the only way to escape the debt-deflation trap is to grow strongly. Given that China is saddled with large local-government and corporate debts, but also enjoys large domestic savings and a strong fiscal position, this message could not be more pertinent. In an ideal world, domestic consumption would serve as the main engine of growth; under current circumstances, infrastructure investment is the most reliable option.

In the short term, when overcapacity and deflation are the main obstacles, infrastructure investment boosts growth through the economy’s demand side. In the long run, it operates through the supply side to boost productivity and thus raise growth potential. China can fund such investment with fiscal deficits, given strong demand for government bonds. And, with China’s major banks still state-owned, and capital controls still in place, the risk of an imminent financial crisis is very low.

Of course, China’s government must uphold its commitment to implement structural reforms. But infrastructure investment is also badly needed, not just to prevent the economy from sliding further, but also to enable China to generate the sustained long-term growth that it requires to achieve developed-country status.

The slowdown in Chinese growth has finally prompted concerns around the world. In their May Economic Letter, the Dallas Fed – Impact of Chinese Slowdown on U.S. No Longer Negligible noted that the knock on effect of slowing Chinese growth had taken 20% off US GDP. The chart below shows Chinese and US annual GDP growth over the last 10 years, China is the left hand scale, the negative impact of Chinese growth on US GDP since 2010 has been roughly 0.4%:-

China vs US GDP 10 yr

Source: Trading Economics

The Problem of Debt

The current environment in China – as it is in much of the rest of the world – is dominated by the incessant increase in debt. In May, in what many observers regard to be a reversal of their opinion on the dangers of China’s debt mountain, the Economist – The coming debt bust attempted to quantify the magnitude of the problem facing the Chinese financial system:-

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

When the debt cycle turns, both asset prices and the real economy will be in for a shock. That won’t be fun for anyone. It is true that China has been fastidious in capping its external liabilities (it is a net creditor). Its dangers are home-made. But the damage from a big Chinese credit blow-up would still be immense. China is the world’s second-biggest economy; its banking sector is the biggest, with assets equivalent to 40% of global GDP. Its stockmarkets, even after last year’s crash, are together worth $6 trillion, second only to America’s. And its bond market, at $7.5 trillion, is the world’s third-biggest and growing fast. A mere 2% devaluation of the yuan last summer sent global stockmarkets crashing; a bigger bust would do far worse. A mild economic slowdown caused trouble for commodity exporters around the world; a hard landing would be painful for all those who benefit from Chinese demand.

Brace, brace

Optimists have drawn comfort from two ideas. First, over three-plus decades of reform, China’s officials have consistently shown that once they identified problems, they had the will and skill to fix them. Second, control of the financial system—the state owns the major banks and most of their biggest debtors—gave them time to clean things up.

Both these sources of comfort are fading away. This is a government not so much guiding events as struggling to keep up with them. In the past year alone, China has spent nearly $200 billion to prop up the stockmarket; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. To help pump up growth, officials have inflated a property bubble. Debt is still expanding twice as fast as the economy.

…“shadow assets” have increased by more than 30% annually over the past three years. In theory, shadow banks diversify sources of credit and spread risk away from the regular banks. In practice, the lines between the shadow and formal banking systems are badly blurred.

That creates two risks. The first is higher-than-expected losses for the banks. Hungry for profits in a slowing economy, plenty of Chinese banks have mis-categorised risky loans as investments to dodge scrutiny and lessen capital requirements. These shadow loans were worth roughly 16% of standard loans in mid-2015, up from just 4% in 2012. The second risk is liquidity. The banks have become ever more reliant on “wealth management products”, whereby they pay higher rates for what are, in effect, short-term deposits and put them into longer-term assets. For years China restricted bank loans to less than 75% of their deposit base, ensuring that they had plenty of cash in reserve. Now the real level is nearing 100%, a threshold where a sudden shortage in funding—the classic precursor to banking crises—is well within the realm of possibility. Midsized banks have been the most active in expanding; they are the place to look for sudden trouble.


The end to China’s debt build-up would not look exactly like past financial blow-ups. China’s shadow-banking system is big, but it has not spawned any products nearly as complex or international in reach as America’s bundles of subprime mortgages in 2008. Its relatively insulated financial system means that parallels with the 1997-98 Asian crisis, in which countries from Thailand to South Korea borrowed too much from abroad, are thin. Some worry that China will look like Japan in the 1990s, slowly grinding towards stagnation. But its financial system is more chaotic, with more pressure for capital outflows, than was Japan’s; a Chinese crisis is likely to be sharper and more sudden than Japan’s chronic malaise.

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

An article in Bruegal – Chinese banks: the way forward, which was published in April, looks in greater detail at the expansion of Chinese bank credit:-

The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase. Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans.

Having said that, China had a bad-loan coverage ratio of 150%, which is considered high for international standards. However, there is rumor that this will be lowered to 120%. In any event, credit risk is rapidly rising in China as the economy slows down and financial conditions are lax enough for corporates to continue to leverage. The question, thus, is how weak are Chinese banks in the current circumstances.

No review of the financial position of China would be complete without a comment from Michael Pettis; last month he wrote Rebalancing, wealth transfers, and the growth of Chinese debt, this is a long research paper so I have only included extracts below:-

There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Pettis then produces a set of scenarios, firstly with growth remaining at current levels:-

Growth remains at 6-7% 2016 -2019 2020-2023
No government transfers







·    Debt growth is steady at 12-14%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing


·    Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

·    Debt growth rises to 15-18%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing


Growth remains at 6-7% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP







·   Debt growth drops to 9-10%

·   Investment growth declines by 2-3 percentage points

·   Consumption growth rises by 2-3 percentage points

·   Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly

·   Minimal rebalancing


·   Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·   Debt growth rises to 11-13%

·   Investment growth declines by another percentage point

·   Consumption growth is steady

·   Growth in household income is steady and household share of GDP rises

·   Gradual rebalancing


Growth remains at 6-7% 2016 -2019 2020-2023    
Annual government transfers of 3-4% of GDP








·    Debt growth drops to 8-10%

·    Investment growth declines by 6-7 percentage points

·    Consumption growth rises by 6-7 percentage points

·    Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

·    Material rebalancing


·    Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·    Debt growth rises to 6-8%

·    Consumption growth declines by 1-2 percentage points

·    Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

·    Material rebalancing



Next, Pettis looks at the same scenarios adjusting growth lower:-

Growth drops to 3-4% 2016 -2019 2020-2023
No government transfers









·    Debt growth drops to 6-8%

·    Investment growth declines by 4-6 percentage points

·    Consumption growth declines by 2-4 percentage points

·    Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

·    Material rebalancing



·    Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·    Debt growth is steady at 6-8%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady at current levels and household share of GDP is materially higher

·    Material rebalancing


Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP










·   Debt growth drops to 5-6%

·   Investment growth declines by 7-9 percentage points

·   Consumption growth is flat

·   Growth in household income is flat and household share of GDP is higher

·   Material rebalancing




·   Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth is steady at 5-6%

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is materially higher

·   Material rebalancing




Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 3-4% of GDP








·   Debt growth drops to close to zero

·   Investment growth is zero

·   Consumption growth rises from current levels

·   Growth in household income rises from current levels and household share of GDP is materially higher

·   Substantial rebalancing


·   Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth drops to well below GDP growth

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is substantially higher

·   Substantial rebalancing


Pettis concludes:-

A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.

Conclusion and Investment Opportunities

China, like many other countries has a problem with debt. The FT recently published an estimate that the Chinese debt to GDP ratio was only 237% (lower than the Economist’s 260%) and government debt to GDP is only 43.9%, whilst household debt to GDP is 39.5%. The Heritage Foundation – Index of Economic Freedom 2016 – estimates China’s government spending to GDP at 29.3%, below that of many developed nations. The Rahn curve below shows how government spending can help to accelerate growth but the diminishing return once it rises above 15% of GDP:-


Source: The Heritage Foundation, Peter Brimelow

Nonetheless, China compares favourably with Japan where government spending is 40.2%.

Stocks, Bonds and the Currency

The Shanghai Composite, shown below, has turned higher since the middle of May. A break above 3,075 could see it retest the highs of 2015 but this is unlikely to be the policy of the Xi administration:-

china-stock-market 10 yr

Source: Trading Economics, Shanghai Stock Exchange


10 year Chinese Government bonds have declined in yield as a result of the international turmoil created by Brexit, but, unlike many of major, international government bonds, they have not made new lows so far:-

china-government-bond-yield 1 yr

Source: Trading Economics, Chinese Ministry of Finance

I believe the recent rally in stocks is a function of the lower yield on bonds. The Chinese government has the whip hand. During the rally and subsequent collapse in the stock market during 2015, the government did not respond in a coordinated manner. Amongst a plethora of initiatives, and I may well have missed some, they relaxed margin requirements, fuelling the speculative bubble,  then, as the shake out gathered momentum, suspended the trading in shares listed on multiple markets. As liquidity conditions became more severe they froze 38 individual trading accounts – including certain algorithmic liquidity providers. The regulators also banned short selling and margin loans enabling investors to sell short on T=) settlement. They forced certain brokers to execute buy orders; one broker was bailed out with a CNY 260bln cash injection.

The rules on insurance companies purchasing stock were relaxed, certain shareholders (specifically SOE’s) were prohibited from selling and, under Announcement 18, senior managers and major shareholder (ones holding a stake of 5 % or more) were threatened with “severe punishment” if they sold shares of any listed company during a period of six months. IPO issuance was also suspended – a recent article from the  FRBSF – China’s IPO Activity and Equity Market Volatility looks at possible reforms of the IPO market. The authorities will not want to make the same mistakes a second time.

Margin lending has, so far, remained subdued. The chart below has data up to March 2016. Chinese investors were wounded last year but 10 year bond yields have fallen 80bp since June 2015:-


Source: Wind Information Co, WSJ

Returning to the first chart, tracing the fortunes of the CNY, China appears to be exporting its way out of trouble at the expense of its trading partners. Its largest export market is the EU, US followed by Japan and South Korea.  Here is the US census bureau data for US-China trade since 2008:-

Month Exports Imports Balance
Jan-16 8212 37146 -28934
Feb-16 8049 36161 -28112
Mar-16 8952 29853 -20901
Apr-16 8667 32973 -24306
May-16 8518 37535 -29017
Month Exports Imports Balance
Jan-15 9482 38588 -29107
Feb-15 8759 31574 -22814
Mar-15 9882 41139 -31257
Apr-15 9307 36116 -26809
May-15 8763 39073 -30310
Jun-15 9622 41455 -31833
Jul-15 9514 41216 -31703
Aug-15 9169 44142 -34973
Sep-15 9424 45718 -36294
Oct-15 11410 44319 -32908
Nov-15 10618 41908 -31290
Dec-15 10122 37996 -27874
2015 116072 483245 -367173
2014 123621 468484 -344863
2013 121746 440430 -318684
2012 110517 425619 -315103
2011 104122 399371 -295250
2010 91911 364953 -273042
2009 69497 296374 -226877
2008 69733 337773 -268040


Source: US Census Bureau

To help stem the decline in Chinese growth the National Bureau of Statistics has revised the way it calculates GDP. Zero Hedge – China To Boost “Economic Growth” By Changing Definition Of GDP quotes Yu Song of Goldman Sachs:-

Under the new method, the size of the economy is larger than previously estimated2015 GDP was revised up by 1.3% to 11tn USD, the Real growth rate was also revised up (rates vary from year to year and averaged 0.06% (6 bps) over the past 5 years). The upward revision is because China’s R&D expenditure growth has been consistently faster than that of overall GDP–though the difference the change makes to the GDP growth rate is small as R&D is a small part of the economy. The NBS announced 1Q real growth was revised up by 0.04% (4bps), but it did not specify whether the growth rate is now 6.8% yoy or remains at 6.7% yoy. We believe the latter case is slightly more likely as an upward revision would have been highlighted. A higher trend level would mean 2Q GDP growth should be higher as well. As a result, we revise our Q2 real GDP growth forecast to 6.7% yoy from 6.6% yoy previously with slight upside risk to our full-year forecast of 6.6% yoy.

Whether the markets are taken in by this sleight of hand remains to be seen, but, when statisticians are making comparisons in a couple of years from now, the higher growth rate will most likely be taken as gospel.

State Owned Enterprises are investing even as the private sector continues to withdraw – Reuters – China needs the private sector to step up. Residential and commercial construction continues to grow despite 718 M2 of vacant floor space. It is worth remembering that 75% of Chinese individual net worth is tied up in Real-Estate – in the US the figure is 28%. Lagarde’s second in command, David Lipton, of the IMF said China had made only “limited progress” in reducing its debt load but government bonds are near historic lows, making non-performing loans easier to extend. Back in the summer of 2014 I wrote about the importance of the housing market – Macro Letter – No 18 – 29-08-2014The second arrow of Likonomics and the Chinese property market, the stock market subsequently rallied but then collapsed. Now the policy of “rebalancing” seems to be taking a breather.

Chinese stocks, meanwhile, are cheap relative to many other markets. As at the end of June the CAPE was 12.4, PE 6.1 – the lowest of any major stock market globally, PC 3.2, PB 0.8, PS 0.6 and the dividend yield was 4.7%. Only the differential between the dividend yield and the 10 year bond yield (1.93%) looks unremarkable.

Chinese Q2 GDP data is released next week, an unnamed official suggested the PBoC might still have room to cut interest rates, although any further loosening of bank reserve requirements appears unlikely. As we head into the summer lull, Chinese stocks, especially those with an exposure to infrastructure, may offer an excellent buying opportunity.

Will Japan be the first to test the limits of quantitative easing?


Macro Letter – No 57 – 24-06-2016

Will Japan be the first to test the limits of quantitative easing?

  • The Bank of Japan made its first provision against losses from QQE
  • As the JPY has strengthened the Nikkei 225 has fallen more than 16% YTD
  • Domestic institutions have been switching from bonds to stocks
  • Japanese share buy backs are on the rise

The Japanese stock market peaked in December 1989, marking the end of a period of economic expansion which briefly saw Japan eclipse the USA to become the world’s largest economy. Since its zenith, Japan has struggled. I wrote about this topic, in relation to the economic reform package dubbed Abenomics, in my first Macro Letter – Japan: the coming rise back in December 2013:-

As the US withdrew from Japan the political landscape became dominated by the LDP who were elected in 1955 and remained in power until 1993; they remain the incumbent and most powerful party in the Diet to this day. Under the LDP a virtuous triangle emerged between the Kieretsu (big business) the bureaucracy and the LDP. Brian Reading (Lombard Street Research) wrote an excellent, and impeccably timed, book entitled Japan: The Coming Collapse in 1989. By this time the virtuous triangle had become, what he coined the “Iron Triangle”.

Nearly twenty five years after the publication of Brian’s book, the” Iron Triangle” is weaker but alas unbroken. However, the election of Shinzo Abe, with his plan for competitive devaluation, fiscal stimulus and structural reform has given the electorate hope. 

In the last two years Abenomics has delivered some transitory benefits but, as this Japan Forum on International Relations – No. 101: Has Abenomics Lost Its Initial Objective? describes, it may have lost its way:-

The key objective of Abenomics is a departure from 20 year deflation. For this purpose, the Bank of Japan supplied a huge amount of base money to cause inflation, and carried out quantitative and qualitative monetary easing so that consumers and businesses have inflationary mindsets. This “first arrow” of Abenomics was successful to boost corporate profits and raising stock prices by devaluing the exchange rate, but falling oil price makes it unlikely to achieve a 2% inflation rate, despite BOJ Governor Haruhiko Kuroda’s dedicated effort. The quantitative and qualitative monetary easing will not accomplish the core objective.

Another reason for such a huge amount of base money supply is to expand export through currency depreciation and to stimulate economic growth, but that has neither boosted export nor contributed to economic growth. We cannot dismiss world economic downturn, notably in China, but actually, Japanese big companies that lead national export, have shifted their business bases overseas during the last era of strong yen. From this point of view, I suspect that the Japanese government overlooked such structural changes that deterred export growth, even if the yen was devalued. The “second arrow” is flexible fiscal expenditure to support the economy, and the result of which has revealed that it is virtually impossible to keep the promise to the global community to achieve the equilibrium of the primary balance in 2020.

In view of the above changes, I would like to lay my hopes on the “third arrow” of economic growth strategy. The growth strategy has been announced three times up to now, in 2013, 2014, and 2015, respectively. The strategy in 2013 launched three action plans, but they were insufficient. The 2014 strategy was highly evaluated internationally, as it actively involved in the reform of basic nature of the Japanese economy, such as capital market reform, agricultural reform, and labor reform. But it takes ten to twenty years for a structural reform like this to work. Meanwhile, it is quite difficult to understand the growth strategy approved by the cabinet in June 2015. Frankly, this is empty and the quality of it has become even poorer. Abenomics was heavily dependent on monetary policy, and did not tackle long term issues so much, such as social security and regional development. However, people increasingly worry about dire prospects of long term problems like 2 population decrease, aging, and so forth, while the administration responds to such trends with mere slogans like “regional revitalization” and “dynamic engagement of all citizens”. But it is quite unlikely that these “policies” will really revitalize the region, or promote dynamic engagement by the people.

The Bank of Japan (BoJ) has held up its side of the bargain but the “Third Arrow” of structural reform seems to be stuck in the quiver. It is prudent, in light of this policy failure, for the BoJ to look ahead to the time when they are required by the government or forced by the markets, to unwind QQE. Last month they began that process.

As this article from the Nikkei Asian Review – BOJ seen preparing for exit from easing with reserves  explains, the BoJ has made a provision of JPY 450bln for the year ending March 2016 against potential capital losses which might be incurred upon liquidation of their JGB holdings. This is the first provision of its kind and substantially reduces the percentage of seigniorage profits remitted to the Japanese government.  The level of remittances has been falling –from JPY 757bln in 2014 to JPY 425bln last year. As at the end of May 2016 the BoJ held JPY 319.5trln of JGBs – 36.6% of outstanding issuance. Japan Macro Advisors estimate this will reach 49.3% by the end of 2017. This year’s provision, whilst prudent, is a drop in the ocean. Under the current Quantitative and Qualitative Easing (QQE) programme they are obligated to purchase JPY 80tln per annum. The Association of Japanese Institutes of Strategic Studies – The Fiscal Costs of Unconventional Monetary Policy put it like this:-

It is quite likely that quantitative easing through high-volume purchases of long-term bonds will cause the Bank of Japan enormous losses over the medium to long term, imposing burdens on taxpayers both directly and indirectly. If the current quantitative easing continues, the Bank of Japan may find itself in the near future unable to cover such losses even using all of its seigniorage profits.

…The BoJ’s seigniorage will be roughly equivalent in present value to the balance of banknotes issued. If the BoJ procures funds by issuing cash at a zero interest rate and purchases JGBs, the present discounted value of the principal and interest earned by the BoJ from its JGBs will equal the balance of banknotes. If interest rates are about 2%, Japan’s demand for banknotes will fall from 19% of GDP at present to less than 10% of GDP, and the BoJ’s aforementioned losses would even exceed the present value of its seigniorage.

Here is an extract from the BoJ’s 16th June Statement on Monetary Policy the emphasis is mine:-

Quantity Dimension: The guideline for money market operations

The Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period:[Note 1]

The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

Quality Dimension: The guidelines for asset purchases

With regard to the asset purchases, the Bank decided, by an 8-1 majority vote, to set the following guidelines:[Note 1]

a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen. With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years.

b) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at annual paces of about 3.3 trillion yen1 and about 90 billion yen, respectively.

c) As for CP and corporate bonds, the Bank will maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

Interest-Rate Dimension: The policy rate

The Bank decided, by a 7-2 majority vote, to continue applying a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.[Note 2]

[Note 1] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. T. Sato, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Kiuchi. Mr. T. Kiuchi proposed that the Bank conduct money market operations and asset purchases so that the monetary base and the amount outstanding of its JGB holdings increase at an annual pace of about 45 trillion yen, respectively. The proposal was defeated by a majority vote.

[Note 2] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Sato and Mr. T. Kiuchi. Mr. T. Sato and Mr. T. Kiuchi dissented considering that an interest rate of 0.1 percent should be applied to current account balances excluding the amount outstanding of the required reserves held by financial institutions at the Bank, because negative interest rates would impair the functioning of financial markets and financial intermediation as well as the stability of the JGB market.

The decision by the BoJ not to increase QQE at its last two meetings has surprised the markets and lead to a further strengthening of the JPY. Governor Kuroda, gave a speech Keio University on June 20thOvercoming Deflation: Theory and Practice in which he described the history of BoJ policy in its attempts to stimulate the Japanese economy:-

As mentioned, the aim of QQE is to overcome the prolonged deflation that has gripped Japan. Even if this deflation has been mild, the fact that it has continued for more than 15 years means that its cumulative costs have been extremely large. Looked at in terms of the price level, an annual inflation rate of minus 0.3 percent over a period of 15 years implies that the price level will fall by around 5 percent, but an annual inflation rate of 2 percent over a period of 15 years means that the price level will rise by around 35 percent.

It is worth noting that the UK and USA was subject to a long period of deflation during the “Great Depression” between 1873 and 1896 (approximately -2% per annum) by this comparison Japan’s experience has been very mild indeed. The BoJ has a 2% inflation target, however, so we should anticipate more QQE. Kuroda-san, who has previously stated that the effect of NIRP will take time to feed through and that NIRP may be increased from -0.1% to -0.5%, gave no indication as to what the BoJ may do next; although he did say that Japan provides an interesting case study for academia.

On June 8th Professor George Selgin delivered the Annual IEA Hayek Memorial Lecture – Price Stability and Financial Stability without Central Banks – lessons from the past for the future in which he discussed good and bad deflation together with “Free Banking” – the concept of financial stability without central banks (if you have 45 minutes and enjoy economic history, the whole speech it is well worthwhile). With regard to the current situation in Japan – and elsewhere – he highlights the different between good deflation which is driven by supply expansion and bad deflation which is the result of demand shrinkage. Selgin also goes on to allude to Hayek’s view that that stability of spending should be the objective of monetary policy rather than the stability of prices – akin to what Market Monetarists dub the stability of monetary velocity.

Japan’s monetary base has expanded by 170% since March 2013 but at the same time the money multiplier – Money Stock/BoJ Monetary Base – has declined from 8.27 times (April 2013) to 3.35 times (March 2016). Lending market growth was at its weakest for three years in March (+2%) principally due to household hoarding.

Bloomberg - Japan Money Mult and Money base

Source: Bloomberg, BoJ

Since the announcement of Negative Interest Rate Policy (NIRP) in January the sale of safes for domestic residences has increased dramatically. Whilst I have not found evidence from Japan, this article from Bloomberg – Cash in Vaults Tested by Munich Re Amid ECB’s Negative Rates reports that MunichRE – the world’s second largest reinsurer – is setting a worrying precedent, it’s one thing when individuals hoard paper money but, when financial institutions follow suit, monetary velocity is liable to plummet. I suspect institutions in Switzerland and Japan are also assessing the merits of stuffing their proverbial mattresses with fiat money.

The chart below reveals that declining monetary velocity is not exclusively a Japanese phenomenon:-

Monetary Velocity - CLSA

Source: CLSA, CEIC

The Yotai Gap – the difference between bank deposits and loans – is another measure of household hoarding. It widened to JPY 207.6trln in March, close to its record high of JPY 209.9trln in May 2015. The unintended consequences of NIRP is an increase in demand for paper money and a reduction of demand for retail loans even as interest rates decline.

Japanese industry looks little better than the household sector, as this excellent article from Alhambra Investment Partners – It’s Not Stupidity, It Is Apathy (For Now) explains:-

Japanese industry has not gained anything for the surrender of Japanese households, with industrial production falling 3.5% in April, the 18th time in the past the 22 months. IP in April 2016 was slightly less than the production level in April 2013 when QQE began. Worse, IP is still 3.4% below April 2012, which further suggests both continued economic decline and a distinct lack of any effect from all the “stimulus.”

Barron’s – Unintended Consequences of NIRP listed the following additional effects:-

1) compress net interest margins and bank profits;
2) damage consumer and business confidence;
3) provide little incentive for business invest in capital rather than buy back stock;
4) hurt savers;
5) makes active management more difficult by dampening dispersion;
6) increase demand for gold and other hard assets; and,
7) likely widen the wealth gap

The BoJ can continue to buy JGBs, Commercial Paper, Corporate Bonds, ETFs and, once these avenues have been exhausted, move on to the purchase of common stocks and commercial loans. It can nationalise the stock market and circumvent the banking system in order to provide liquidity to end users or even consumers. At what point will the markets realise that they have been pushing on a string for decades? I suspect, not yet, but a dénouement, an epiphany, draws near.

Markets since the announcement of NIRP

Since the BoJ NIRP announcement at the end of January, the JPY has strengthened by around 14%. The five year chart below shows the degree to which the hopes for the first arrow of Abenomics have been dashed:-

japan-currency 5yr

Source: Trading Economics

Currency weakness has put pressure on stocks. International investors sold around JPY 5trln during in a 13 week selling binge to the beginning of April:-

japan-stock-market 5yr

Source: Trading Economics

The Government Pension Investment Fund (GPIF) and other domestic institutions took up the slack – the GPIF has moved from 12% to 23% equities since October 2014 – here is the 31st December breakdown of the asset mix for the JPY 140trln fund:-

31-12-15 % Allocation Policy Target Permitted Deviation
Domestic Bonds 37.76 35 10
Domestic Equity 23.35 25 9
International Bonds 13.5 15 4
International Equities 22.82 25 8
Short term assets 2.57

Source: GPIF

In theory the GPIF could buy another JPY 15.5trln of domestic stocks and reduce its holdings of JGBs by nearly JPY 18trln. I expect other Japanese pension funds and Trust Banks to follow the lead of the GPIF. Domestic demand for stocks is likely to continue.

As I mentioned earlier, JGBs are being steadily accumulated by the BoJ even as the GPIF and other institutions switch to equities. This is the five year yield chart for the 10 year maturity:-

japan-government-bond-yield 5yr

Source: Trading Economics

JGBs made new all-time lows earlier this month, with maturities out as far as 15 years turning negative, amid international concerns about the potential impact of Brexit.

Looking more closely at Japanese stocks, non-financial corporations have followed the lead of the eponymous Mrs Watanabe, accumulating an historically high cash pile. Barron’s – Abenomics Watch: Japan’s Corporates Are Hoarding Cash, Too takes up the story:-

During the three years of Abenomics between 2013 and 2015, Japan’s non-financial corporate sector increased its holding of cash and deposits by roughly 30 trillion yen, or 6% of GDP. This amount is equivalent to about 35% of retained earnings, estimates Credit Suisse.

This amount is high by historical standards. During the previous economic upswing between the end of 2002 and the beginning of 2008, Japan’s corporations held only 11.5% of their retained earnings.

So why are Japanese companies hoarding cash?

One explanation is larger intangible assets. It is easy for companies to put up their fixed assets as collateral for loans, but how should banks value intangible assets such as intellectual property? Cash would be a viable collateral option. However, Credit Suisse finds that there is not much correlation between cash and intangible asset positions. The ratio of cash to intangible fixed assets investments has moved broadly between 8.6 years and 11.6 years over the two decades since 1994.

A second explanation is lax corporate governance, which Abe has been trying to fix. Are Japanese companies only paying him lip service?

A third explanation is increasing pension liabilities. As Japanese society ages, companies feel compelled to hoard more cash to pay off employees who are due to retire in the coming years. Encouraging women to enter the labor force is a key component of Abenomics’ Third Arrow. He has not gone very far.

Last, perhaps Japanese companies are feeling uncertain about the future? Toyota Motor, for instance, drastically changed its yen assumption from 120 to 105 in the new fiscal year. Companies hoard more cash when they don’t know what’s going to happen.

According to the latest flow of funds data from the BoJ – corporate cash was estimated to be JPY 246trln in Q1 2016 – the 29th consecutive quarterly increase, whilst household assets rose to JPY 902trln the highest on record and the 36th quarterly increase in a row. A nine year trend.

Another trend which has been evident in Japan – and elsewhere – is an increase in share buybacks. The chart below tells the story since 2012:-

Topix Share buy backs

Source: FT, Goldman Sachs

Compared to the level of share buy backs seen in the US, Japanese activity is minimal, nonetheless the trend is growing and NIRP must assume some responsibility. Perhaps it was the precipitous decline in capital expenditure, which prompted the BoJ to introduce NIRP. The chart below is taken from the December 2015 Tankan report:-


Source: Business Insider Australia, BoJ

In the March 2016 Tankan, the Business Conditions Diffusion Index remained generally positive but the decline of momentum is of concern:-

Dec-15 Mar-16 June-16(F/C)
Manufacturers 12 6 3
Non-Manufacturers 25 22 17
Manufacturers 5 5 -2
Non-Manufacturers 19 17 9

 Source; BoJ

I doubt capital expenditure will rebound while share buy backs appear safer to the executive officers of these companies. The Japanese stock market is also attractive by several valuation metrics. The table below compares the seven most liquid stock markets, as at 31st March, is sorted by the yield premium to 10 year government bonds (DY-10y):-

Country CAPE PE PC PB PS DY 10y DY-10y
Switzerland 20.3 22.5 13.9 2.3 1.8 3.50% -0.33% 3.83%
France 16 20.9 6.5 1.5 0.8 3.50% 0.41% 3.09%
Germany 16.8 19 8 1.6 0.7 2.90% 0.15% 2.75%
United Kingdom 12.7 35.4 12.8 1.8 1.1 4.00% 1.42% 2.58%
Italy 11.1 31.5 5 1.1 0.5 3.50% 1.23% 2.27%
Japan 22.7 15.3 7.9 1.1 0.7 2.20% -0.04% 2.24%
United States 24.6 19.9 11.6 2.8 1.8 2.10% 1.77% 0.33%

Source: StarCapital.de, Investing.com

For international allocators, the strength of the JPY has been a significant cushion this year, but, for the domestic investor, the Nikkei 225 is down 16.2% YTD. Technically the market is consolidating around the support region between 16,300 and 13,900. If it breaks lower we may see a return towards to 10,000 – 11,000 area. If it recovers, a push through 18,000 should see the market retest its highs. I believe the downside is supported by domestic demand for stocks as bond yields turn increasingly negative.

International investors will remain wary of the risks associated with the currency. Further BoJ largesse must be anticipated; that they have made a first provision against losses from the unwinding of QQE is but a warning shot across the bows of the ministry of finance. As I suggested in Macro Letter – No 49 – 12-02-2016 Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous? a currency hedged equity investment is worth considering. Prime Minister Abe, who began campaigning, this week, for the upper house elections on July 10th, has promised to boost the economy if he wins a majority of the 121 seats being contested. The monetary experiment looks set to continue but the BoJ may be the first central bank to discover the limits of largesse.