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

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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:-

japan-tankan-capex-index-q1-2016

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)
Large
Manufacturers 12 6 3
Non-Manufacturers 25 22 17
 
Medium
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.

 

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Swiss National Bank policy and its implications for currencies, assets and central banking

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Macro Letter – No 29 – 06-02-2015

Swiss National Bank policy and its implications for currencies, assets and central banking

  • The SNB unpegged from the Euro and sustained balance sheet losses, they will survive
  • The Euro has been helped lower but rumours of a new SNB target are rife
  • The long run appreciation of the Swiss Franc (CHF) is structural and accelerating, the Swiss economy will adjust
  • If G7 central bank balance sheets expanded to Swiss levels, relative to GDP, QE would triple

On Thursday 15th January the Swiss National Bank (SNB) finally, and unexpectedly, threw in the towel and ceased their foreign exchange intervention to maintain a pegged rate of EURCHF 1.20. The cap was introduced in September 2011 after a 28% appreciation in the CHF since the beginning of the Great Financial Crisis (GFC) – from 1.68 to 1.20. After plumbing the depths of 0.85 the EURCHF rate settled at 0.99 – around 18% higher in a single day. This is a huge one day move for a G10 currency and has inflicted collateral damage on leveraged traders, their brokers and those who borrowed in CHF to finance asset purchases in other currencies. Citibank estimates that is has also cost the SNB CHF 60bln. Here is a 10 year chart of EURCHF: –

EURCHF_10_yr

Source: Bigcharts.com

The Swiss SMI stock Index declined from 9259 to 8400 (-9.2%) whilst the German DAX Index rose from 9933 to 10,032 (+1.1%). Swiss and German bond yields headed lower. Swiss bonds now exhibit negative nominal yields out to 15 years – the table below is from Wednesday 4th February:-

Maturity Yield
1 week -1.35
1 month -1.65
2 month -1.55
3 month -1.4
6 month -1.38
1 year -1.11
2 year -0.823
3 year -0.768
4 year -0.632
5 year -0.505
6 year -0.419
7 year -0.305
8 year -0.257
9 year -0.181
10 year -0.111
15 year -0.024
20 year 0.196

 

Source: Investing.com

Swiss inflation is running at -0.3% so the real-yields are fractionally better due to the mild deflation seen in the past couple of months. I expect this deflation to deepen and persist.

Thomas Jordan – Chairman of the governing board of the SNB – made the following statement at a press conference which accompanied the SNB decision:-

Discontinuation of the minimum exchange rate

The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it. The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.

Interest rate lowered

At the same time as discontinuing the minimum exchange rate, the SNB will be lowering the interest rate for balances held on sight deposit accounts to –0.75% from 22 January. The exemption thresholds remain unchanged. Further lowering the interest rate makes Swiss-franc investments considerably less attractive and will mitigate the effects of the decision to discontinue the minimum exchange rate. The target range for the three-month Libor is being lowered by 0.5 percentage points to between –1.25% and –0.25%.

Outlook for inflation and the economy

The inflation outlook for Switzerland is low. In December we presented a conditional inflation forecast, which predicts inflation of –0.1% for this year. Since this forecast was published, the oil price has once again fallen significantly, which will further dampen the inflation outlook for a time. However, lower oil prices will stimulate growth globally, and this will influence economic developments in Switzerland positively. Swiss franc exchange rate movements also impact inflation and the economic situation.

The SNB remains committed to its mandate of ensuring medium-term price stability while taking account of economic developments. In concluding, let me emphasise that the SNB will continue to take account of the exchange rate situation in formulating its monetary policy in future. If necessary, it will therefore remain active in the foreign exchange market to influence monetary conditions.

On Tuesday 27th January the CHF fell marginally after SNB Vice President Jean-Pierre Danthine told Swiss newspaper Tages Anzeiger – Die Presse war voller Spekulationen, that the SNB remains ready to intervene in the currency market. One comment worthy of consideration, with apologies for the “google-translate”, is:-

Q. Does the SNB did not develop a new monetary policy? Just as Denmark, which has tied its currency to the euro in 30 years? Or as Singapore, which manages its currency based on a trade-weighted basket of currencies?

A. Denmark is the euro zone financially and politically closer than Switzerland. The binding to Europe is a long standing. Means that this solution is for Switzerland hardly considered. The arrangement of Singapore is worthy of consideration. But what is decisive is the long-term. Apart from Switzerland and other small and open economies such as Sweden and Norway are done well over the years with a flexible exchange rate.

Rumours of a new unofficial corridor of EURCHF 1.05-1.10 are now circulating – strikingly similar to the level reached prior to the September 2011 peg.

Breaking the Bank

Another rumour to have surfaced after the currency move was that the SNB had become concerned about the size of their balance sheet relative to Swiss GDP. The chart below is from 2013 but it shows the relative scale of SNB QE:-

Central Bank Balance-of-percentage-GDP - source SNB

Source: SNB and snbchf.com

Estimates of the loss sustained by the SNB, due to the appreciation of the CHF, vary, but, rather like countries, central banks don’t tend to “go bust”. The Economist – Broke but never Bust takes up the subject (my emphasis in bold):-

…For one thing central banks are far bigger. Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs.

…Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree.

…With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

The Economist goes on to highlight the risk that going “cap in hand” to their finance ministries will weaken central banks’ “independence” and might prove inflationary. In the current environment inflation would be a nice problem for the SNB, or, for that matter, the ECB or BoJ to have. As for the limits of central bank balance sheet expansion, the SNB – at 80% of GDP – have blazed a trail for their larger peers to follow.

Is it the money supply?

A further unofficial explanation of the SNB move concerns the unusually large expansion of Swiss money supply since the GFC. In early January an article from snbchf.comThe Risks on the Rising SNB Money Supply discussed how the SNB might be thinking (my emphasis): –

Since the financial crisis central banks in developed nations increased their balance sheets. The leading one was the American Federal Reserve that increased the monetary base (“narrow money”), followed by the Bank of Japan and recently the ECB. Only partially the extension of narrow money had an effect on banks’ money supply, so called “broad money”. For the Swiss, however, the rising money supply concerns both narrow and broad money. Broad money in Switzerland rises as strong as it did in Spain or Ireland before the financial crisis.

They go on to discuss the global effects of QE:-

…The SNB had the choice between a stronger currency and, secondly, an excessive appreciation of the Swiss assets.  With the introduction of the euro floor, it opted for the second alternative and increased its monetary base massively in order to absorb foreign currency inflows. Implicitly the central bank helped to push up asset prices even further. Hence it was rather foreign demand for Swiss assets that helped to increase the demand for credit and money in the real economy.

…The SNB printed a lot of money especially in the years before and just after the euro introduction until 2003, to weaken the franc and the “presumed slow” Swiss growth. The money increase, however, did not affect credit growth more than it should have: investors preferred other countries to Switzerland to buy assets. Finally the central bank increased interest rates a bit and reduced money supply between 2006 and 2008. Be aware that in 2006/2007 there is a statistical effect with the inclusion of “Raiffeisen” group banks into M3. Since 2009, things have changed M3 is rising with an average of 7.7% per year, while before 2009 it was 3% per year. Banking lending to the private sector is increasing by 3.9% per year while it was 1.7% between 1995 and 2005.

…Since April 2014, money supply M3 has suddenly stopped at around 940 billion CHF. Before it had increased by 80 bln. CHF per year from 626 bln. in each year since 2008.  We explained before that Fed’s QE translated in higher lending in dollars, dollars that found their way into emerging markets. The same thing happens in Switzerland with newly created Swiss francs. Not all of them remained in the Swiss economy, but they were loaned out to clients from Emerging Markets. Hence the second risk does not directly concerns the Swiss economy and the euro, but the relationship between its banks and emerging markets and the risks of a strong franc for banks’ balance sheets.

 

Here is a chart of M3 and bank lending in Switzerland, the annotation is from snbchf.com:-

Swiss-M3-and-Lending-2014-Ireland

Source: SNB and snbchf.com

The SNBs decision to unpeg seems a brutal way to impose discipline on the domestic lending market and an unusual way to test increased bank capital requirements, however, I believe this was the least bad time to escape from the corner into which they had boxed themselves. The recent fall in M3 should put some upward pressure on the CHF – until growth slows and reverses the process.

The SNB said this about money supply and bank lending in their Q4 2014 Quarterly Bulletin (my emphasis):-

Growth in money supply driven by lending

The expansion of the money supply witnessed since the beginning of the financial and economic crisis is mainly attributable to bank lending. An examination of components of the M3 monetary aggregate and its balance sheet counterparts, based on the consolidated balance sheet of the banking sector, shows that approximately 70% of the increase in the M3 monetary aggregate between October 2008 and October 2014 (CHF 311 billion) was attributable to the increase in domestic Swiss franc lending (CHF 216 billion). The remaining 30% of the M3 increase was due in part to households and companies switching their portfolio holdings from securities and foreign exchange into Swiss franc sight deposits.

Stable mortgage lending growth in the third quarter

In the third quarter of 2014 – as in the previous quarter – banks’ mortgage claims, which make up four-fifths of all domestic bank lending, were up 3.8% year-on-year. Mortgage lending growth thus continued to slow, as it has for some time now, despite the fact that mortgage rates have fallen to a historic low. A breakdown by borrower shows that the growth slowdown has taken place in mortgage lending to households as well as companies.

This slower growth in mortgage lending may be attributed to various measures taken since 2012 to restrain the banks’ appetite for risk and strengthen their resilience. These include the banks’ own self-regulation measures, which subject mortgage lending to stricter minimum requirements. Moreover, at the request of the SNB, the Federal Council activated the countercyclical capital buffer in 2013 and increased it this year. This obliges the banks to back their mortgage loans on residential property with additional capital. The SNB’s bank lending survey also indicates that lending standards have been tightened and demand for loans among households and companies has declined.

…Growing ratio of bank lending to GDP

The strong growth in bank lending recorded in recent years is reflected in the ratio of bank loans to nominal GDP. After a sharp rise in the 1980s, this ratio remained largely unchanged until mid-2008. Since the onset of the financial and economic crisis, it has increased again substantially. This increase suggests that banks’ lending activities have supported aggregate demand. However, strong lending growth also entails risks for financial stability. In the past, excessive growth in lending has often been the root cause of later difficulties in the banking industry.

Switzerland’s banking sector is truly multi-national, deposits continue to arrive, despite penal “negative” rates, meanwhile, many CHF bank loans have been made to international clients. The sharp appreciation of the CHF will force the banking sector to make additional provisions for non-performing international loans. Further analysis of the effect of relative money supply growth, between Switzerland and the Eurozone (EZ) on the EURCHF exchange rate, can be found in this post by Frank Shostak – Post Mortem on the Swiss Franc’s Euro-Peg. He makes an interesting “Austrian” case for a weakening of the CHF versus the EUR over-time.

Swiss Francs in the long run

My first ever journey outside the UK was to Switzerland, that was back in 1971 when a pound sterling bought CHF 10.5. The Swiss economy has had to deal with a constantly rising exchange rate ever since. The chart below of the CHF Real Trade-Weighted value shows this most clearly: –

Real_Effective_CHF_Exchange_rate_EURCHF18_01_2013-

Source: Pictet

This chart only goes up to mid-2013, since then the USDCHF has moved from 0.88 and 0.99 by early January – after the unpegging the rate is near to its mid-point at 0.93. According to the Guardian – What a $7.54 Swiss Big Mac tells us about global currencies – the Swiss currency is now 33% overvalued. Exporters will be hit hard and the financial sector is bound to be damaged by commercial bank lending policies associated with pegging the CHF to a declining EUR. On Monday Bank Julius Baer (BAER.VX) announced plans to cut costs by CHF 100mln, domestic job cuts were also indicated – more institutions are sure to follow their lead. Meanwhile, there are bound to be emerging market borrowers which default. The Swiss economy will slow, exacerbating deflationary forces, but lower prices will improve the purchasing power of the domestic population. Switzerland’s trade balance hit a record high in July 2014 and came close to the same level in November:-

switzerland-balance-of-trade

Source: Trading Economics and Swiss Customs

In a recent newsletter – The Swiss Release the Kraken – John Maudlin quoted fellow economist Charles Gave in a tongue in cheek assessment of the SNB’s action:-

They [the SNB] didn’t mind pegging the Swiss franc to the Deutsche mark, but it is becoming more and more obvious that the euro is more a lira than a mark. A clear sign is the decline of the euro against the US dollar.

Mr. Draghi has been trying to talk the euro down for at least a year. This should not come as a surprise. After all, in the old pre-euro days, every time Italy had a problem, the solution was always to devalue.

But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity. The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy, and the need for savings to finance investments. How quaint!

Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers [not!]. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175…in favor of Switzerland.

And for most of that time Switzerland ran a current account surplus, a balanced budget, and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or central banker, since they have such limited power? And that all these marvelous results come from that one simple fact: their lack of power.)

The last time I looked, the Swiss population had the highest standard of living in the world – another disastrous long-term consequence of not having properly trained economists of the true faith.

Swiss unemployment has been trending higher recently (3.4% in December) and this figure may rise as sectors such as banking and tourism adjust to the new environment, however, this level of unemployment is still enviable by comparison with other developed countries.

The following charts give an excellent insight into the nature of trade in the Swiss economy. Firstly, exports:-

Swiss_ExportsByCountry

Source: snbchf.com

The importance of the EZ is evident (46.4% excluding UK) however the next chart shows a rather different perspective:-

Swiss_TradeBalanceByCountry

Source: snbchf.com

The relative importance of the USA is striking – 11% of exports but nearly half of the trade surplus – so too, is the magnitude of the deficit with Germany, in fact, within Europe, only Spain and the UK are export surplus markets.

A closer look at the break-down of Imports and Exports by sector provides an additional dimension:-

Swiss-Imports-Exports-by-Type

Source: snbchf.com

The SNB already highlighted the import of energy as a significant factor – Switzerland’s energy bill is now much lower than it was in July 2014. The export of pharmaceuticals has always been of major importance – many of these products are inherently price inelastic, the rise in the currency will have less impact on Switzerland than it might do on other developed economies.

Conclusion and investment opportunities

“The reports of my death are greatly exaggerated.” Mark Twain

Contrary to what several commentators have been suggesting, I do not believe the SNB capitulation marks the beginning of the end of central bank omnipotence – they were never that omnipotent in the first place. The size of the SNB balance sheet is also testament to the limits of QE – if the other G7 central banks expand to 80% of GDP the total QE would more than triple from $10.5 trln to $33.6 trln – and what is to say that 80% of GDP is the limit?

Swiss Markets

Switzerland will benefit from a floating currency in the longer term, although the recent abrupt appreciation may lead to a recession – which in turn should reduce upward pressure on the CHF. Criticism of the SNB for creating greater volatility within the Swiss economy is only partially justified, the excessive rise of the CHF effective exchange rate was due to external factors and the SNB felt it needed to be managed, the subsequent rise in the US$ has brought the CHF back to a more realistic level but the current environment of zero interest rate policy adopted by several major central banks has parallels with the conditions seen after the collapse of Bretton Woods.

I believe the SNB anticipates an acceleration in the long term trend rate of appreciation of the CHF. Swiss exports, even to the US, will be impaired but German imports will be cheaper – with a record trade surplus, this is a good time to start the adjustment of market expectations about the value of the CHF going forward. Swiss companies are used to planning within a framework which incorporates a steadily rising value of their currency – now they must anticipate an acceleration in that trend.

The money and bond markets will remain distorted and, in the event of another EZ crisis, the SNB may increase the penalties for access to the “safe-haven” Switzerland represents: and, as indicated, they may intervene again if the capital flows become excessive. 20 year, or longer, Confederation Bonds, alone, offer positive carry, buying call spreads on shorter maturities is a strategy worth considering.

The SMI Index is likely to lag the broader European market, but negative bond yields offer little alternative to stocks and domestic investors will exhibit a renewed cognizance of the risk of foreign currency investments. The SMI Index, at around 8550, is only 7.6% below the level it was trading prior to the SNB announcement. Swiss stocks will undoubtedly benefit from any export led European economic recovery. Meanwhile, the relative strength of the US economy appears in tact – the Philadelphia Fed Leading Indexes for December – released earlier this week – suggest economic expansion in 49 states over the next six months.

Eurozone Markets

The EZ has already been aided by the departure of its strongest “shadow” member; combined with the ECB’s Expanded Asset Purchase Programme (EAPP) this should drive the EUR lower. European stocks have already taken heart, fuelled by the new liquidity and international competitiveness.

European bond spreads continue to compress. Fears of peripheral countries exiting the single currency area will provide volatility but for the major countries – France, Italy and Spain – any weakness is still a buying opportunity, but at these, often negative real-yields, they should be viewed as a “trading” rather than an “investment” asset.

European Markets and Unification

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Macro Letter – No 3 – 17 -01-2014

European Markets and Unification

During 2013 developed market equities were the top performing major asset class. The US and UK had justification for rising since the effects of quantitative easing appear to have stimulated some economic activity. Europe, however, has less reason for strength since ECB policies have been less accommodative. The performance of the German mid-cap index aside, European equity market performance in 2013 was largely due to receding fears of the break-up of European currency union. This has been a major contributor to the decline in peripheral bond yields as the chart below shows.

European Bond Yields - 2005 - 2014 - Bloomberg.

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Source: Bloomberg

Banking Union and the ECB

In 2014 the focus will be on deepening unification, commencing with a European Banking Union. Der Spiegel reports: –

Not Fit for the Next Crisis: Europe’s Brittle Banking Union – 19th December 2013

http://www.spiegel.de/international/business/weak-eu-banking-union-could-have-dangerous-side-effects-a-940065.html

When German Finance Minister Wolfgang Schäuble, a trained lawyer, announced an agreement on Wednesday night in Brussels on the long negotiated EU banking union, observers might have been left thinking that he is precisely this type of lawyer.

On paper, Schäuble and his negotiators are right about very many points. They succeeded in ensuring that in 2016, the Single Resolution Mechanism will go into effect alongside the European Union banking supervisory authority. The provision will mean that failing banks inside the euro zone can be liquidated in the future without requiring German taxpayers to cover the costs of mountains of debt built up by Italian or Spanish institutes.

They also backed the European Commission, which wanted to become the top decision-maker when it comes to liquidating banks. The Commission will now be allowed to make formal decisions, but only in close coordination with national ministers from the member states.

But it goes even farther. Negotiators from Berlin have also created an intergovernmental treaty, to be negotiated by the start of 2014, that they believe will protect Germany from any challenges at its Constitutional Court that might arise out of the banking union.

They also established a very strict “liability cascade” that will require bank shareholders, bond holders and depositors with assets of over €100,000 ($137,000) to cover the costs of a bank’s liquidation before any other aid kicks in. The banks are also required to pay around €55 billion into an emergency fund over the next 10 years. Until that fund has been filled, in addition to national safeguards, the permanent euro bailout fund, the European Stability Mechanism, will also be available for aid. However, any funds would have to be borrowed by a national government on behalf of banks, and that country would also be liable for the loan. This provision is expected to be in place at least until 2026.

The government in Berlin put a strong emphasis on preventing the ESM, with its billions in funding, from being used to recapitalize debt-ridden European banks. Schäuble was alone with this position during negotiations, completely isolating himself from the other 16 finance ministers from euro-zone countries. Brussels insiders report that it was “extremely unusual because normally at least a few countries share Germany’s position.”

The article goes on to highlight some of the weaknesses with this agreement: –

  1. 1.       It’s too complex – The Financial Times stated, “In total, the process could involve nine committees and up to 143 votes cast.”
  2. It’s underfunded – The Single Resolution Mechanism, at Euro 55bln by 2026, is a drop in the ocean.
  3. It’s primarily a domestic affair, the union will be subject to national borders
  4. It will probably take at least five years to establish joint European liability.

Bruegel – Ending uncertainty: recapitalisation under European Central Bank Supervision – takes up the subject:-

http://www.bruegel.org/publications/publication-detail/publication/806-ending-uncertainty-recapitalisation-under-european-central-bank-supervision/

• Estimates of the recapitalisation needs of the euro-area banking system vary between €50 and €600 billion. The range shows the considerable uncertainty about the quality of banks’ balance sheets and about the parameters of the forthcoming European Central Bank stress tests, including the treatment of sovereign debt and systemic risk. Uncertainty also prevails about the rules and discretion that will apply to bank recapitalisation, bank restructuring and bank resolution in 2014 and beyond.

• The ECB should communicate the relevant parameters of its exercise early and in detail to give time to the private sector to find solutions. The ECB should establish itself as a tough supervisor and force non-viable banks into restructuring. This could lead to short-term financial volatility, but it should be weighed against the cost of a durably weak banking system and the credibility risk to the ECB. The ECB may need to provide large amounts of liquidity to the financial system.

• Governments should support the ECB, accept cross-border bank mergers and substantial creditor involvement under clear bail-in rules and should be prepared to recapitalise banks. Governments should agree on the eventual creation of a single resolution mechanism with efficient and fast decision-making procedures, and which can exercise discretion where necessary. A resolution fund, even when fully built-up, needs to have a common fiscal backstop to be credible.

The initial Asset Quality Review (AQR) of European Banks carried out in 2011 by the European Banking Authority proved to be a political embarrassment since almost every bank was found to be in relatively rude financial health: shortly before bailouts were required.

Breaking Views – Still time to undo EU bank stress test fiasco – November 2011 – sums up the problems with the previous stress tests eloquently: –

http://www.breakingviews.com/still-time-to-undo-eu-bank-test-fiasco/1616988.article

The test, which was blessed by last month’s ill-fated European summit, had two problems. First, it wasn’t stringent enough: the European Banking Authority concluded that Europe’s lenders needed an additional 106 billion euros, when the International Monetary Fund thought about twice as much was needed. The test has done little to restore confidence in the blighted sector. Banks are still unable to issue long-term unsecured debt, and have been increasingly thrown back on short-term support from the European Central Bank.

Second, the test encouraged deleveraging by expressing the capital requirement as a ratio and giving lenders eight months to get there. Given depressed share prices, many banks are anxious to avoid issuing equity. Instead they are trying to boost capital ratios by shrinking their balance sheets. This will almost certainly have the unfortunate side-effect of further suffocating the European economy, which is already on the edge of recession.

The current iteration of the AQR will, undoubtedly, have more “teeth” but these are shark infested waters where an ECB “health warning” might precipitate an ugly banking crisis.

The Peterson Institute – The European Central Banks Big Moment – December 2013 –  elaborates:-

http://www.piie.com/publications/opeds/oped.cfm?ResearchID=2527

Europe’s banking union project has had many doubters since it started to be widely discussed in the spring of 2012. What is not in doubt, however, is its transformative nature. In June 2012, EU leaders chose—in a galloping hurry, as usual—to move towards the centralization of bank supervision across euro area countries, with this authority entrusted to the European Central Bank (ECB). The consequences have only gradually become apparent to most and represent both an opportunity and a risk.

The opportunity is to reestablish trust in European banks, reboot the pan-European interbank market, end dysfunctional credit allocation, and start reversing the vicious circle between bank and sovereign credit. In an optimistic scenario, the ECB’s 12-month process of “comprehensive assessment,” including an asset quality review (AQR) and stress tests of about 130 credit institutions covering 85 percent of the euro area’s banking assets, will trigger the triage, recapitalization, and restructuring that history suggests is a prerequisite for systemic crisis resolution.

The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy—and the perception of Europe’s ability to get anything done—could be affected. After all, this exercise is unprecedented in scale and scope, which means the ECB has little prior experience. At the same time, the political fallout is potentially poisonous to most of the states concerned.

Thus, much is at stake in the balance sheet review, and the scene is set for an escalating confrontation between the ECB and member states in the months ahead. The ECB has pointedly made clear that it will form an independent judgment on the capital strength of the banks examined, without necessarily following the views of national supervisors.

A successful AQR and establishment of the Single Supervisory Mechanism (SSM)—EU jargon for the handover of supervisory authority to the ECB—would have structural consequences. Europe’s national and local governments often use their leverage over the publicly-regulated banking industry for industrial policy purposes or to facilitate their own financing, a dynamic known to economists as financial repression.

Bruegel – Supervisory transparency in the European banking union – January 2014  – looks, in more detail, at the issues surrounding European bank regulation by the  ECB, they acknowledge the need for greater transparency and highlight the dangers of a half-baked approach to a banking union: –

http://www.bruegel.org/publications/publication-detail/publication/807-supervisory-transparency-in-the-european-banking-union/

• Bank supervisors should provide publicly accessible, timely and consistent data on the banks under their jurisdiction. Such transparency increases democratic accountability and leads to greater market efficiency.

• There is greater supervisory transparency in the United States compared to the member states of the European Union. The US supervisors publish data quarterly and update fairly detailed information on bank balance sheets within a week. By contrast, based on an attempt to locate similar data in every EU country, in only 11 member states is this data at least partially available from supervisors, and in no member state is the level of transparency as high as in the US.

• Current and planned European Union requirements on bank transparency are either insufficient or could be easily sidestepped by supervisors. A banking union in Europe needs to include requirements for greater supervisory transparency.

I always find Bruegel comments useful , not only in terms of what should be done to move the “European Project” forward, but also as a guide to what the institutional response is likely to be should an EU proposal fail to be adopted. They conclude: –

Finding agreement on an EU legal change that requires the ECB and member-state supervisors to open their books to greater scrutiny will surely be a difficult task given the current diversity of practices and interests – eg banks, national supervisors – that benefit from this diversity.

But greater supervisory transparency will facilitate more efficient distribution of capital and increase market discipline. It will increase the legitimacy of actions that the regulator takes against banks. The European Union receives justified flak that there is a great distance between European citizens and the institutions that make decisions on their behalf. There is real suspicion of the financial sector and distrust that public money goes only to help out political friends. Transparency in terms of the data the supervisors themselves use to make decisions would allow the public, and more realistically the various interest groups one finds in civil society, to judge whether regulators did choose actions consistent with protecting the public interest. Such ‘fire alarms’ therefore represent one small step towards addressing the democratic deficit that most citizens think exists in Europe.

If such transparency is not possible, for purposes of increasing ‘output legitimacy’ more work should be done to strengthen the role of parliaments. For the European Parliament, the autumn 2013 interinstitutional agreement with the European Central Bank represents a good start. Under all current proposals, national regulators will continue to play an important role especially for any bank resolution. As discussed earlier, the German Bundestag gains the ability in 2014 to investigate specific banks as part of the national implementation of Basel III. Such parliamentary powers should become standard in all European Union member states. Moreover, such a procedure should be not only a theoretical power, but also one that is used.

Nationalist Backlash

In a more recent post this month – Peterson Institute – Calm Seas in Europe in 2014? – Jacob Funk Kirkegaard predicts that whilst 2013 was a year of relative calm for the Eurozone, 2014 may be a very different matter. As usual the driving force behind any change in sentiment will be political: –

http://www.piie.com/blogs/realtime/?p=4195

No major EU elections are scheduled in 2014. In Italy, a new electoral law is unlikely to be agreed upon before it takes over the rotating EU presidency in the second half of 2014. By tradition, countries in that position refrain from holding national elections. Rather, European Parliament elections in May will be the political highlight of 2014. As discussed earlier, there is a risk that angry voters will turn out and elect some colorful non-mainstream members to that body. Still, there seems little risk that the European Parliament will become a “Weimar Parliament” with a majority of anti-EU members. Instead the established European parties seem likely to prevail with a smaller majority, ensuring that Europe remains governable.

With their increased representation, the question of what the anti-EU parties want (aside from their daily parliamentary allowances) will arise. Much has been written about the alliance between Marine Le Pen, leader of the French National Front, and the leader of the Dutch Freedom Party Geert Wilders. But theirs is little more than a photo-op coalition, posing limited political risks. There are inherent limitations on the ability of nationalist parties to collaborate across borders.

The European Parliament elections, though, may also indirectly influence the choice of the next president of the European Commission. In an attempt to broaden the democratic appeal of the European Union, the European political parties have suggested that they each propose a pan-European spitzen-kandidat for the post and then let the European voters decide. Of course, this is a naked—if well-intended—power grab by the European Parliament, as the right to select the Commission president resides with the EU member states according to the EU Treaty. And they are unlikely to surrender this right. At the same time, it will be very difficult for the EU member states to ignore the winning side in the European Parliament election. The heads of states will hence likely be compelled to at least choose a new European President from the side of the political aisle that won the most votes in the election. Their selection power will thus be constrained…

Economically, the biggest event in 2014 will be the rollout of the ECB’s asset quality review (AQR) and stress tests of the euro area banking system, representing the opportunity to finally restore the soundness of Europe’s bank balance sheet. Failure to carry out a convincing review will threaten the region with Japanese-style prolonged stagnation and undermine the credibility of the ECB. The AQR/stress test is more important than the hotly debated single resolution mechanism (SRM) designed to close down or consolidate failing banks, finally agreed by the EU finance ministers in late December [pdf]. Only a successful AQR/stress test can avert the continuing fragmentation of credit markets and reduce the high interest spreads between the core and periphery. Assuming that the SRM can fix financial fragmentation is erroneous, and much of the related criticism of the complex SRM compromise is misplaced. Even an optimally designed SRM would not make euro area banks suddenly lend to each other again.

A more pertinent question is whether the SRM compromise makes it more or less likely that the AQR succeeds in 2014. For sure the envisioned SRM is far from perfect. It has an excessively complex structure, including a 10-year phase-in, and a multistage resolution process involving a resolution board, the European Commission, and the EU finance ministers in the ECOFIN (finance ministers’) Council. Parts of it are grounded in EU law and parts are to be embodied by a new intergovernmental treaty. Hopefully some of these kinks will be corrected in the ongoing final reconciliation negotiations on the SRM between the member states and the European Parliament. But writing off the SRM as unworkable just because it is complex is a mistake. The European Union of 28 member states works every day, despite breathtaking complexity. Moreover, in emergencies the European bureaucracy can be circumvented and a decision forced through in 24 hours.

The European political landscape may become more polarised in 2014 with right wing parties gaining ground in the European parliament.

The Economist – Europe’s Tea Parties – 4th January 2014 – looks at the rise of nationalist parties in Europe, making comparison with the US Tea Party Republican group, there are some similarities but the differences are more pronounced: –

There are big differences between the Tea Party and the European insurgents. Whereas the Tea Party’s factions operate within one of America’s mainstream parties, and have roots in a venerable tradition of small-government conservatism, their counterparts in Europe are small, rebellious outfits, some from the far right. The Europeans are even more diverse than the Americans. Norway’s Progress Party is a world away from Hungary’s thuggish Jobbik. Nigel Farage and the saloon-bar bores of the United Kingdom Independence Party (UKIP) look askance at Marine Le Pen and her Front National (FN) across the Channel. But there are common threads linking the European insurgents and the Tea Party. They are angry people, harking back to simpler times. They worry about immigration. They spring from the squeezed middle—people who feel that the elite at the top and the scroungers at the bottom are prospering at the expense of ordinary working people. And they believe the centre of power—Washington or Brussels—is bulging with bureaucrats hatching schemes to run people’s lives.

The minority parties might seem largely irrelevant but voter apathy towards voting at European Elections gives European “Tea Parties” an opportunity to punch above their weight: –

Ultimately, though, the choice falls to voters themselves. The Tea Party thrived in America partly because a small minority of voters dominate primary races especially for gerrymandered seats. In elections to the European Parliament many voters simply do not bother to take part. That is a gift to the insurgents. If Europeans do not want them to triumph, they need to get out to the polls.

For an historical perspective on how the Eurozone might move towards closer unification the New York Fed – The Mississippi Bubble of 1720 and the European Debt Crisis – 10th January 2014 – offers some interesting observations. This is part of a series of articles called the “Crisis Chronicles” from Liberty Street Economics: –

http://libertystreeteconomics.newyorkfed.org/2014/01/crisis-chronicles-the-mississippi-bubble-of-1720-and-the-european-debt-crisis.html

Austerity and Debt Restructuring

From summer 2012 through 2013 European equities performed well, with peripheral markets such as Greece and Ireland benefitting from the reduced risk of a Greek exit and single currency area breakup. Bond markets exhibited a similar response with higher yielding peripheral markets outperforming the core – see first chart above.  2014 may see these convergence patterns reverse as this article from the Council for Foreign Relations – Beware of Greeks Bearing Primary Budget Surpluses – points out: –

http://blogs.cfr.org/geographics/2013/12/04/greeksurpluses

Sovereign Debt Default and Primary Balances - Source IMF.

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Source: IMF

Things are looking up in Greece – that’s what Greek ministers have been telling the world of late, pointing to the substantial and rapidly improving primary budget surplus the country is generating.  Yet the country’s creditors should beware of Greeks bearing surpluses.

A primary budget surplus is a surplus of revenue over expenditure which ignores interest payments due on outstanding debt.  Its relevance is that the government can fund the country’s ongoing expenditure without needing to borrow more money; the need for borrowing arises only from the need to pay interest to holders of existing debt.  But the Greek government (as we have pointed out in previous posts) has far less incentive to pay, and far more negotiating leverage with, its creditors once it no longer needs to borrow from them to keep the country running.

This makes it more likely, rather than less, that Greece will default sometime next year.  As today’s Geo-Graphic shows, countries that have been in similar positions have done precisely this – defaulted just as their primary balance turned positive.

The upshot is that 2014 is shaping up to be a contentious one for Greece and its official-sector lenders, who are now Greece’s primary creditors.  If so, yields on other stressed Eurozone country bonds (Portugal, Cyprus, Spain, and Italy) will bear the brunt of the collateral damage.

European debt restructuring meanwhile still has far to go but many EZ countries seem to think that being “developed” precludes the need to restructure and reform. Carmen Reinhart and Kenneth Rogoff produced a working paper for the IMF –  Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten – December 2013 – which takes a global look at this subject in detail: –

http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf

Here’s the abstract: –

Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging market counterparts. The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression. As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.

The paper follows on from research they have undertaken over the last couple of years including their seminal work – Growth in a time debt – NBER – January 2010 – which achieved considerable notoriety when an economics student discovered statistical errors in the paper – a short version is available here: –

http://www.nber.org/digest/apr10/w15639.html

Their new paper concludes: –

Of course, if policymakers are fortunate, economic growth will provide a soft exit, reducing or eliminating the need for painful restructuring, repression, or inflation. But the evidence on debt overhangs is not heartening. Looking just at the public debt overhang, and not taking into account old-age support programs, the picture is not encouraging. Reinhart, Reinhart, and Rogoff (2012) consider 26 episodes in which advanced country debt exceeded 90 percent of GDP, encompassing most or all of the episodes since World War II. (They tabulate the small number of cases in which the debt overhang lasted less than five years, but do not include these in their overhang calculations.) They find that debt overhang episodes averaged 1.2 percent lower growth than individual country averages for non-overhang periods. Moreover, the average duration of the overhang episodes is 23 years. Of course, there are many other factors that determine longer-term GDP growth, including especially the rate of productivity growth. But given that official public debt is only one piece of the larger debt overhang issue, it is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today’s advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago.

Germany’s slowing growth and potential banking crisis

Meanwhile, Germany, which has benefitted economically from the painful Hartz reforms of the early 2000’s may be losing momentum.

Peterson Institute –  Making Labor Market Reforms Work for Everyone: Lessons from Germany – sets the scene, highlighting how labour reform in Germany has given the country a significant competitive edge: –

http://www.piie.com/publications/pb/pb14-1.pdf

…First, Germany has the best functioning labor market among large economies in Europe and the United States. Second, German wage restraint is of a relatively limited magnitude compared with most euro area countries and hence fails to explain the uniformly large intra–euro area unit labor cost divergences between Germany and other members after 1999. Third, total German labor costs per worker continue to exceed costs in other major EU countries and the United States. Fourth, Germany’s recent labor market revival has not come about through the expansion of predominantly low wage jobs. Fifth, the expansion of mini-jobs in Germany since 2003 has overwhelmingly taken place as second jobs. And sixth, the successful reliance on kurzarbeit programs in 2009 was not an innovation but rather another instance of labor input adjustment in favor of “insider workers” in Germany.

I’m indebted to Quartz.com for the table below which shows German exports and imports by region. Within the Eurozone the two components are fairly balanced but this disguises country specific imbalances, for example, for the first 10 months of 2013, Germany ran a surplus with France of Euro 30bln but a deficit with the Netherlands of Euro 15bln.

German exports and imports by region - source Quartz.

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Source: Quartz.com

The Economist – Die grosse stagnation – 30th November 2013 – paints a rather different picture of the risks ahead for Germany – once again these risks are political in nature, but their principal concern is that the recent coalition deal looks set to reverse a number of these successful reforms: –

http://www.economist.com/news/leaders/21590903-germanys-proposed-new-government-set-turn-motor-europe-slowcoach-die-grosse

…That is because Germany’s economy has been living off past glory—especially “Agenda 2010”, a series of reforms launched in 2003 by Gerhard Schröder, Mrs Merkel’s predecessor. But it is running out of puff. Labour productivity has grown less than half as fast as Spain’s over the past ten years; and its overall rate of public and private investment, at 17% of GDP, has fallen by more than a fifth since the euro was introduced. No European country has carried out fewer reforms than Germany since the euro crisis began.

… The coalition’s 185-page “treaty” was a chance to launch a new reform agenda. Instead, its proposals are a mixture of the irrelevant—charging foreigners to use German motorways—and the harmful.

…The coalition’s pension policy seems even more retrogressive. These days, most advanced economies are expecting longer-living people to be longer-working, too. But the coalition wants the pension age, raised to 67 in the previous grand coalition, to be moved back down again for specific groups, in some cases to 63. France’s president, François Hollande, was rightly mocked, not least by Mrs Merkel, for a similar ploy. Now the woman who has lectured the rest of Europe about the unsustainability of its welfare spending will follow down the same spendthrift road.

…The impact on this coalition on the rest of Europe would not be all bad. One bonus is that, for all its primitive economic policies, the SPD seems keener to support some basic reforms such as the creation of a banking union. But that will count for little if Germany, the motor of Europe’s economy, stalls. And, in the light of the coalition agreement, that is a real danger.

After a strong performance by European Equities and peripheral government bonds in 2013, the prospects for 2014 may be less sanguine, though I’m not bearish at this stage. The principal market risk is likely to emanate from the European banking sector. One example of this, concerns shipping. The chart below shows the Baltic Dry Freight Index month end values from 1985 to end December 2013 – it’s worth noting that the BDI has plummeted this month leading many commentators to predict a global economic downturn.

Baltic Dry index 29 yrs.

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Source: Bloomberg

Over the past ten years the price of “Dry” cargoes has soared and plummeted. During this cycle European banks, German ones in particular – abetted by favourable German government tax treatment – moved aggressively into the shipping finance sector; it is estimated that German banks are currently the financiers behind more than 40% of the world container shipping fleet. These shipping loans were often repackaged and sold on to high net worth investors but, rumour has it, the majority of these investments carried a “principal guarantee”. The ships, meanwhile, are no longer competitive due to improvements in fuel efficiency since the mid 2000’s. The banks are effectively left long “scrap metal”.

Moody’s gave an estimate last month for German banks impairment due to shipping loans of US$22bln for 2014, they went on to state: –

Germany’s eight major ship financiers have lent a total of 105 billion euros to the sector, a fifth of which are categorized as non-performing…

We expect the extended downward shipping cycle to cause rising problem loans in the shipping sector during 2013-14, requiring German banks to increase their loan-loss provisions. This will challenge their earnings power.

Here is the Reuters article for further detail: –

http://www.reuters.com/article/2013/12/10/moodys-shippingbanks-idUSL6N0JP2CV20131210

I wonder whether the ECB’s AQR will uncover the extent of this problem. Last Autumn S&P estimated European banks had a funding gap of Euro 1.3trln as at the end of 2012. My guess is that this is understated: shipping is just one sector, the “quest for yield” is industry wide.

EZ Money supply growth and rising peripheral debt

Another headwind facing Europe is the weakness in money supply growth. In 2012 EZ M3 was growing at above 3%, it dipped below 3% in H1 2013 and below 2% in H2 2013.

Eurozone M3 - ECB.

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Source: ECB

The ECB CPI target of 2% is roughly consistent with M3 growth of 4-6%.

The Telegraph – Eurozone M3 plunge flashes deflation alert – Novemebr 28th 2013

takes up the theme of potential deflation:-

http://www.telegraph.co.uk/finance/economics/10481773/Eurozone-M3-money-plunge-flashes-deflation-alert-for-2014.html

The European Central Bank said M3 money growth fell to 1.4pc from a year earlier, lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel.

A rather more extreme view is expressed by Andrew Cullen – Europeans Looking To Inflate Their Debts Away – Mises Institute – 12th November 2013

http://mises.org/daily/6581/Europeans-Looking-To-Inflate-Their-Debts-Away

How does a reduction in consumer price inflation become “deflation”? How does a minor improvement in the purchasing power of consumers become a problem for liquidity in the financial markets? Austrian-economic thinking, which understands that new money is never neutral in its effects, offers insight:

[T]he crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money …[4]

European politicians and central bank policy-makers are concerned not about consumer price reductions but about real reductions in the money supply as such reductions would force governments to abandon permanent budget deficit monetization. That is why they maintain a monopoly over the power to create money and they like to control where money enters the economy. Politicians use these advantages in two ways.

First, they are all, with the sole exception of the Bundesbank, “inflationists” when it comes to monetary policy. Inflation (that is, an increase in the money supply) steadily reduces the purchasing power of a fiat money and, in parallel, eases the burden of debt repayments over time as nominal sums become progressively of less relative value.

Such price inflation benefits debtors at the expense of creditors. Hence, for highly indebted Eurozone governments, price inflation is the perceived “get out of jail” card, permitting them to meet their debt obligations with a falling share of government expenditures.

Second, at least amongst the political elites in the “PIIGS” (Portugal, Italy, Ireland, Greece, Spain) and in France, they espouse “reflation” plans using the ECB’s money-creation powers which would ratchet up to another degree inflation of the money supply, monetization of government debt, and increases in total government debts; and thereby protect and enhance the economic power and privileges of governments and the state.[5]

Yet growth of PIIGS governments’ debts as a proportion of GDP (Table 1) have now crossed above the critical 90 percent ratio advised by Rogoff and Reinhart as being the threshold above which growth rates irrevocably decline.[6]

Table 1. Gross Government Debt as Per cent of GDP 2008-14 for the Eurozone and selected member countries (Adapted from: IMF Fiscal Monitor: Taxing Times, p16. October 2013)

                                2008       2010       2012       2014 (forecast)

Eurozone                70.3        85.7        93.0        96.1

Spain                      40.2        61.7        85.9        99.1

Italy                        106.1      119.1      127.0      133.1

Portugal                 71.7        94.0        123.8      125.3

Ireland                    44.2        91.2        117.4      121.0

There is another potential problem: European commercial banks may be too fragile to fulfil their allotted role. ECB President Mario Draghi himself has initiated another round of stress testing of European banks’ balance sheets against external shocks, a sign that the ECB itself has doubts about systemic stability in the banking sector. But this testing has hardly begun. Here are four risk factors in play:

First, there has been large-scale flight of deposits from banks operating within the PIIGS’ toward banks of other Eurozone countries,[7] as well as outside the Eurozone entirely. This phenomenon is caused by elevated risk of seizures, consequent upon the forced losses on bondholders at Greek banks and the recent “bail-in” of depositors at the Bank of Cyprus.

Second, many PIIGS’ domestic banks still hold on their books bad loans arising from the boom years (2000-2007). Failure to deleverage and liquidate losses is prolonging the banks’ adjustment process.

Third, they already hold huge quantities of sovereign debt (treasury bonds) from Eurozone governments from previous rounds of buying. Banks have had to increase their risk weightings on such debt holdings as Ratings Agencies have downgraded these investments to comply with Basel II. This constrains their forward capacity for lending to these governments.

Fourth, there is concern for rising interest rates. Since the famous “Draghi put” in July 2012, real rates remain low and yields on PIIGS’ sovereign bonds fell back closer to German bunds. But this summer yields on US Treasury bonds with long maturities started to rise on Fed taper talk.[8] Negative surprises knock confidence in the international bond markets. The risk of massive losses should bond prices drop is one that the European-based banks cannot afford given their still low capital reserves and boom phase legacy of over-leveraging.

Implementation impediments aside, a new phase of aggressive easy money policy from the ECB is both probable and imminent.

[4] J.G. Hülsmann, Deflation & Liberty (2008), p. 27.

You might also enjoy Andrew’s blogsite where he also speculates about large scale asset purchases from the ECB: –

http://www.thecantillonobserver.com

European equity and bond market prospects for 2014

This brings me neatly to what you may consider a rather contrarian view of European equities and bonds. So far this article has focussed on the negative headwinds which many commentators expect to undermine confidence in financial markets, however, I’m reminded of some sage words from the “Sage of Omaha” – the quote below comes from an interview/speech which Warren Buffet gave in July 2000 at the Allen & Co, Sun Valley corporate gathering, reported here by Fortune/CNN: –

http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/

In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.

So here’s the record on interest rates at key dates in our 34-year span. They moved dramatically up–that was bad for investors–in the first half of that period and dramatically down–a boon for investors–in the second half.

Since short term rates are close to zero and central bank buying of government bonds has flattened yield curves in most major markets, surely the risk has to be that government bond yields have an asymmetric upside risk? Well, yes, but only if investors lose all confidence in those “risk-free” government obligations. Added to which – what is the correct size for a central bank balance sheet – $4trln or $400trln? When measured in balance sheet expansion terms the ECB is far behind the curve; they have availed themselves of the aggressive quantitative easing of other central banks to exert internal pressure on profligate EZ countries, cajoling them to structurally reform. I believe this austerity has largely run its course, but, as the AQR, is likely to show, it has left the EZ financial system in a weak position.

European bond convergence between the core and periphery continues as the table below (15/1/2014) from Bloomberg shows : –

Europe Yield

1 Day

1 Month

1 Year

Germany 1.82% +1 -1 +24
Britain 2.86% +3 -4 +84
France 2.47% +1 +4 +34
Italy 3.88% +1 -21 -33
Spain 3.82% +1 -28 -120
Netherlands 2.13% +1 -1 +43
Portugal 5.25% 0 -77 -104
Greece 7.67% 0 -95 -388
Switzerland 1.18% +1 +22 +56

European stock markets are making new highs – although EuroStoxx 50 is still some way below its 2008 peak, unlike the S&P. EUR/USD continues to regain composure after the fears of an EZ break-up in the summer of 2012. In this environment I see no reason to liquidate long positions in European equities and higher yielding peripheral bond markets. If US Equities turn bearish and US bond yields rise abruptly, as they did in 2013, then I would expect the ECB to provide their long overdue support. However, a precipitous decline in EUR/USD is cause for concern as this may herald the beginning of another Eurozone crisis – whilst I anticipate some of the above issues will surface during 2014, the “Draghi put” still offers significant protection, whilst the Peterson Institute – Why the European Central Bank Will Likely Shrink from Quantitive Easing – January 15th 2014 – makes a strong case for the ECBs hands being tied: –

http://blogs.piie.com/realtime/?p=4208

I still believe European markets represent a “hedged” exposure to the continued bullish trends in major market equities and higher yielding bonds – the market always prefers to travel than to arrive.

Commodity super-cycles in a fiat currency world

400dpiLogo.

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Macro Letter – No 2 – 16-12-2013  

Commodity super-cycles in a fiat currency world

Notwithstanding weakness in the last six weeks, stock markets have witnessed significant gains during 2013, but commodities – with a few exceptions – have failed to follow suit.

For global investors the advent of investible commodity indices has simplified the commodity allocation process but I have always encouraged my readers to view each commodity on its own merits.

The Goldman Sachs – GSCI Index is constructed on a production weighted basis; the table below is courtesy of Reuters: –

                       2013       2012    Change Vs 2012

 WTI Crude           30.96%     24.71%           6.25%

 Kansas Wheat         0.88%      0.68%           0.20%

 Live Cattle          2.71%      2.62%           0.09%

 Sugar                1.90%      1.85%           0.05%

 Cotton               1.12%      1.07%           0.05%

 Gold                 3.05%      3.00%           0.05%

 Soybeans             2.63%      2.62%           0.01%

 Coffee               0.83%      0.82%           0.01%

 Natural Gas          2.03%      2.02%           0.01%

 Zinc                 0.52%      0.51%           0.01%

 Cocoa                0.23%      0.23%           0.00%

 Nickel               0.58%      0.58%           0.00%

 Silver               0.49%      0.49%           0.00%

 Aluminum             2.12%      2.13%          -0.01%

 Lead                 0.38%      0.40%          -0.02%

 Corn                 4.66%      4.69%          -0.03%

 Feeder Cattle        0.49%      0.52%          -0.03%

 LME Copper           3.24%      3.28%          -0.04%

 Lean Hogs            1.52%      1.58%          -0.06%

 Chicago Wheat        3.04%      3.22%          -0.18%

 Gas Oil              8.11%      8.56%          -0.45%

 RBOB Gasoline        5.02%      5.90%          -0.88%

 Heating Oil          5.13%      6.17%          -1.04%

 Brent Crude         18.35%     22.34%          -3.99%

This highlights the increasing production of WTI Crude (West Texas Intermediate) relative to Brent Crude. It also highlights the substantial index weighting to Energy followed by Metals and then Grains. In this letter I will keep these weightings in mind.

The table below, from barchart.com, shows the year to date performance of the major US futures markets. The price divergence is not atypical.

US Futures YTD - barchart

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Source: barchart.com

As an “asset class” commodities offer among the most uncorrelated returns, but, unlike more traditional assets, they generally have a negative real expected long-term return. In other words, due to human ingenuity, the cost of production falls over time.

Back in 2006 I used the chart below from the Economist as part of a presentation about the dangers of “long-only” investment in commodities. The Economist first published its Industrial Commodity-price index in 1864 due to demand for information on commodity markets resulting from the strong price appreciation during the preceding two decades. The commodity price appreciation was driven primarily by US demand as the country industrialised and then entered into a bloody civil war. Historic data was collected to create a starting level of 100 in 1845. When the raw data is deflated using the US GDP deflator you will observe that the current index is rebounding from a cyclical low of 20.

The Economist industrial commodity-price index

Economist Commodity Price Index - deflated - 1845 - 2005.

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Source: Economist

Today, in a world of fiat currencies, it is more difficult to examine the cause and effect of changes in supply and demand for commodities because their measurement – generally in US$ – is itself a “moving target” rather than a “store of value”. However, given the vagaries of Gold leasing and the plethora of conspiracy theories surrounding the price of Gold, the “gently declining” US$ seems like the most familiar measure of value. This “Dollar Value” is practical in the short-term but in the Long Run the entire commodity cycle may be as much a reflection of monetary policy as supply and demand for the underlying commodities.

The collapse of Bretton Woods in 1971 heralded in a period of inflation, the appointment of Paul Volcker as governor of the Federal Reserve finally reversed this process as he attempted to control the supply of money. The bursting of the “Tech Bubble” and a policy of low interest rates created the conditions for the next “Super-cycle”.

One of the vexing issues with commodity super-cycles is their variability of duration. This paper from the United Nations Department of Economic and Social Affairs – Super-cycles of commodity prices since the mid-nineteenth century – is a useful guide to the difficulties of prediction: –

http://www.un.org/esa/desa/papers/2012/wp110_2012.pdf

Here is the abstract:-

Decomposition of real commodity prices suggests four super-cycles during 1865-2009 ranging be­tween 30-40 years with amplitudes 20-40 percent higher or lower than the long-run trend. Non-oil price super-cycles follow world GDP, indicating they are essentially demand-determined; causality runs in the opposite direction for oil prices. The mean of each super-cycle of non-oil commodities is generally lower than for the previous cycle, supporting the Prebisch-Singer hypothesis. Tropical agriculture experienced the strongest and steepest long-term downward trend through the twentieth century, followed by non-tropical agriculture and metals, while real oil prices experienced a long-term upward trend, interrupted temporarily during the twentieth century.

The paper goes on to point out that these cycles can last between 20 and 70 years. The UN, however, focus on developing country demand, seeing it as the main driver of the cycles; they don’t consider the “money” side of this phenomenon.

The origin of modern economic studies of cycles is thought to have commenced with Nicolai Kondratiev, it was then taken up by economists of the Austrian School, most notably Joseph Schumpter. At this time – 1930’s – other price cycle theories were being developed independently by Ralph Elliott, among others. Elliott’s ideas were published in his book – The Wave Principle – in 1938. Among his influences were the Italian 10th Century mathematician Leonardo of Pisa – otherwise known as Fibonacci.

I believe there is another long-term factor which drives these cycles, beyond economic growth and currency debasement, and that is geopolitical tension. In developing my thoughts on this subject I am indebted to two authors; Marc Widdowson – The Coming Dark Age – The Phoenix Principle – which I must admit I am still reading, you may download it here: –

http://www.scribd.com/doc/63914376/The-Coming-Dark-Age

The other author is David Murrin – Breaking the Code of History – David looks at the history of empires using a wave principle derived from Elliott and the Polish-American mathematician Benoit Mandelbrot’s theories of fractal geometry, here is his website:-

www.davidmurrin.co.uk

In simple terms, David’s observation is that the majority of wars, throughout history, have been driven by resource scarcity. Looking back at the Economist Commodity Price Index you can identify the great conflicts of recent history. However, during the tumults, more often than not, payment in specie was suspended and inflation ensued. Any countries return to the “Gold Standard”, or its equivalent, was likely to precipitate an inevitable period of deflation; as happened to the UK and US after the first world war.

Returning to the factor of debasement, during the “Great Deformation”, as David Stockman describes the post Bretton Woods era (1971 onwards) governments have been operating in an elastic “quasi-war finance” environment. When ever a crisis arrives, governments lean on their respective central banks to backstop the markets with abundant liquidity. As the worlds’ “reserve currency” is the US$, the US government has an advantage – what De Gaulle referred to as the “exorbitant privilege” during the period of the gold exchange standard, remains a  boon today – but other countries have succeeded to a lesser degree by allowing their currencies to decline relative to the UD$.

The prospects for commodities

Looking ahead to 2014 there are a plethora of factors to consider. I will focus on just a few: –

Commodity – Demand

On the demand side of the equation are China followed by other emerging market countries where strong economic growth is expected. Below is the OECD GDP forecast from 20th November 2013: –

Real   gross domestic product – forecasts
‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Australia

2.4

 

1.5

 

2.6

 

2.4

 

3.7

 

2.5

 

2.6

 

3.1

 

Austria

0.9

 

-3.5

 

1.9

 

2.9

 

0.6

 

0.4

 

1.7

 

2.2

 

Belgium

1.0

 

-2.8

 

2.4

 

1.9

 

-0.3

 

0.1

 

1.1

 

1.5

 

Canada

1.2

 

-2.7

 

3.4

 

2.5

 

1.7

 

1.7

 

2.3

 

2.6

 

Chile

3.2

 

-0.9

 

5.7

 

5.8

 

5.6

 

4.2

 

4.5

 

4.9

 

Czech   Republic

3.1

 

-4.5

 

2.5

 

1.8

 

-1.0

 

-1.5

 

1.1

 

2.3

 

Denmark

-0.8

 

-5.7

 

1.4

 

1.1

 

-0.4

 

0.3

 

1.6

 

1.9

 

Estonia

-4.2

 

-14.1

 

2.6

 

9.6

 

3.9

 

1.0

 

2.4

 

4.0

 

Finland

0.3

 

-8.5

 

3.4

 

2.7

 

-0.8

 

-1.0

 

1.3

 

1.9

 

France

-0.2

 

-3.1

 

1.6

 

2.0

 

0.0

 

0.2

 

1.0

 

1.6

 

Germany

0.8

 

-5.1

 

3.9

 

3.4

 

0.9

 

0.5

 

1.7

 

2.0

 

Greece

-0.2

 

-3.1

 

-4.9

 

-7.1

 

-6.4

 

-3.5

 

-0.4

 

1.8

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Hungary

0.9

 

-6.8

 

1.1

 

1.6

 

-1.7

 

1.2

 

2.0

 

1.7

 

Iceland

1.2

 

-6.6

 

-4.1

 

2.7

 

1.4

 

1.8

 

2.7

 

2.8

 

Ireland

-2.2

 

-6.4

 

-1.1

 

2.2

 

0.1

 

0.1

 

1.9

 

2.2

 

Israel 1

4.5

 

1.2

 

5.7

 

4.6

 

3.4

 

3.7

 

3.4

 

3.5

 

Italy

-1.2

 

-5.5

 

1.7

 

0.6

 

-2.6

 

-1.9

 

0.6

 

1.4

 

Japan

-1.0

 

-5.5

 

4.7

 

-0.6

 

1.9

 

1.8

 

1.5

 

1.0

 

Korea

2.3

 

0.3

 

6.3

 

3.7

 

2.0

 

2.7

 

3.8

 

4.0

 

Luxembourg

-0.7

 

-5.6

 

3.1

 

1.9

 

-0.2

 

1.8

 

2.3

 

2.3

 

Mexico

1.2

 

-4.5

 

5.1

 

4.0

 

3.6

 

1.2

 

3.8

 

4.2

 

Netherlands

1.8

 

-3.7

 

1.5

 

0.9

 

-1.2

 

-1.1

 

-0.1

 

0.9

 

New   Zealand

-0.6

 

0.3

 

0.9

 

1.3

 

3.2

 

2.3

 

3.3

 

2.9

 

Norway

0.1

 

-1.6

 

0.5

 

1.2

 

3.1

 

1.2

 

2.8

 

3.1

 

Poland

5.0

 

1.6

 

3.9

 

4.5

 

2.1

 

1.4

 

2.7

 

3.3

 

Portugal

0.0

 

-2.9

 

1.9

 

-1.3

 

-3.2

 

-1.7

 

0.4

 

1.1

 

Slovak   Republic

5.8

 

-4.9

 

4.4

 

3.0

 

1.8

 

0.8

 

1.9

 

2.9

 

Slovenia

3.4

 

-7.9

 

1.3

 

0.7

 

-2.5

 

-2.3

 

-0.9

 

0.6

 

Spain

0.9 

-3.8

 

-0.2

 

0.1

 

-1.6

 

-1.3

 

0.5

 

1.0

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Sweden

-0.8

 

-5.0

 

6.3

 

3.0

 

1.3

 

0.7

 

2.3

 

3.0

 

Switzerland

2.2

 

-1.9

 

3.0

 

1.8

 

1.0

 

1.9

 

2.2

 

2.7

 

Turkey

0.7

 

-4.8

 

9.2

 

8.8

 

2.2

 

3.6

 

3.8

 

4.1

 

United   Kingdom

-0.8

 

-5.2

 

1.7

 

1.1

 

0.1

 

1.4

 

2.4

 

2.5

 

United   States

-0.3

 

-2.8

 

2.5

 

1.8

 

2.8

 

1.7

 

2.9

 

3.4

 

Euro   area (15 countries)

0.2

 

-4.4

 

1.9

 

1.6

 

-0.6

 

-0.4

 

1.0

 

1.6

 

OECD-Total

0.2

 

-3.5

 

3.0

 

1.9

 

1.6

 

1.2

 

2.3

 

2.7

 

Brazil

5.2

 

-0.3

 

7.5

 

2.7

 

0.9

 

2.5

 

2.2

 

2.5

 

China

9.6

 

9.2

 

10.4

 

9.3

 

7.7

 

7.7

 

8.2

 

7.5

 

India

6.2

 

5.0

 

11.2

 

7.7

 

3.8

 

3.0

 

4.7

 

5.7

 

Indonesia

6.0

 

4.6

 

6.2

 

6.5

 

6.2

 

5.2

 

5.6

 

5.7

 

Russian   Federation

5.2

 

-7.8

 

4.5

 

4.3

 

3.4

 

1.5

 

2.3

 

2.9

 

South   Africa

3.6

 

-1.5

 

3.1

 

3.5

 

2.5

 

2.1

 

3.0

 

3.7

 

Source: OECD

Resource security has influenced China’s foreign policy for several years. Their increasing presence in Africa is but one example of this approach. Chinese trade negotiations at a bilateral and multilateral level continue apace. China’s latest economic policies are discussed by Jamestown Foundation – Economic Reform in the Third Plenum: Balancing State and Market –  

http://www.jamestown.org/programs/chinabrief/single/?tx_ttnews%5Btt_news%5D=41667&tx_ttnews%5BbackPid%5D=25&cHash=9fc3fb92316d1e463d72d5505fc20884#.UqrHhJRFDMx

The new “market-centric” policy suggests more, rather than less, uncertainty for commodity prices: –

The plenum report calls for the market to play a “decisive role” (juedingxing zuoyong) in the allocation of resources in the economy. This represents an elevation from previous party documents, which assigned the market a “fundamental role” (jichuxing zuoyong) in resource allocation. This change in language reflects a step forward in the continued reduction in the number of official price controls. Areas that are specifically targeted in the report include the prices of water, oil, natural gas, electricity, transportation and information technology.

As the private sector gains traction and State Owned Enterprises (SOEs) diminish, better inventory controls are bound to be implemented. Chinese stockpiles of commodities have been a function of SOEs ability to purchase well into the future. The more cash-flow constrained private sector will need to operate more efficiently and with lower stock levels. During the transition I anticipate some reduction in demand. In the past year a moderate slow-down in Chinese growth, combined with a backing-up of US Treasury yields in anticipation of the tapering of QE has put significant downward pressure on a broad array of industrial commodities. With stronger growth forecast for next year demand may lead to an increase in prices but the structural rebalancing towards the private sector is a strong counter-factor.

Energy – supply

On the supply side, starting with Oil, Gas and Coal are the OPEC members, Russia and USA – though it is worth noting that China is the fifth largest Oil producer. Recent price action in Crude Oil has been puzzling in that the price rallied following the recent Iranian peace deal. The European Council for Foreign Relations – The Gulf and sectarianism – give some insight into the increased risk that the recent agreement has created, however, it goes on to look at Shiite/Sunni tensions throughout the whole middle eastern region: –

No single country is considered to do more to propagate sectarianism than Saudi Arabia. As Andrew Hammond writes in his essay in this issue of Gulf Analysis, the Saudi royal family sees itself as the rightful inheritor and guardian of Islamic orthodoxy. Saudi Arabia’s formal interpretation of Islam is ideologically sectarian, condemning all other traditional schools of Islamic thought and religious communities as heresy. The state and private citizens put millions every year into evangelism (known in Arabic as da’wa), the establishment of schools and mosques worldwide and financial support to print and broadcast media that promote its interpretation of Islam.

As Shiite communities inside Saudi Arabia and around it constitute the largest and most organised group of such “heretics”, it deliberately subjects them to particularly stringent criticism and discrimination. Even before the Arab Awakening, the rise of an Islamist, Shiite Iran, and then a Shiite Iraq had already posed a serious threat to a Saudi and Wahhabi influence over the region.

The full article can be found here: –

http://ecfr.eu/page/-/ECFR91_GULF_ANALYSIS_AW.pdf

The oil price appears to be trapped in a virtuous/vicious circle: a collapse in the oil price will exacerbate sectarian tensions prompting a rise in the price of oil. Only a significant slowdown in global demand is likely to change this dynamic.

Of course, there are other geopolitical flashpoints; Russia – as they approach the winter Olympics – the South China Sea (as discussed last week) but the disruption to energy supplies created by a new Middle Eastern conflict would probably cause the largest immediate damage to global growth.  Returning to the UN paper, the “Oil Cycle” tends to be “contra” to other commodities; rising oil prices are often referred to as a tax on consumption. It may also go some way to explaining the relatively strong performance of oil in 2013 despite significant increases in fracking production and continuous improvement in drilling techniques. The chart below shows the relative strength of oil since the Great Recession began.

WTI - 5 yr chart - infomine

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Source: infomine.com

Natural Gas in the US is a “local” market due to US restrictions on the issue of export licenses and the significant cost of gas liquefaction. In Europe, Russia is the dominant player. Russian gas prices have been relatively stable this year, although they have rebounded more strongly than US Natural Gas since 2008.

The recent surge in US gas prices is a response to regional weather conditions. It’s worth noting that US Natural Gas prices tend to be either non or negatively correlated to the price of WTI. Overall supply is increasing and as the government issues more LNG licenses – longer-term I expect prices to remain subdued.

US Natural Gas - 5 yr chart - infomine US Natural Gas - 6 month chart - source infomine

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Source: infomine.com

Coal has remained subdued in the US and elsewhere during 2013. China is the largest producer followed by the US, India, Australia and Russia. Thermal Coal has rallied recently in response to the spike in Natural Gas but, barring a significant increase in global demand, I don’t envisage a marked increase in prices in 2014.

US Thermal Coal CAPP - 2001 to 2013 - Source Infomine

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Source: infomine.com

Industrial metals – Supply

Among the industrial metals I will focus on Iron Ore/Steel and Copper. These form the basis for a large swathe of industrial activity. The largest producers of Iron Ore are China, Australia, Brazil, India and Russia. By contrast global copper production is dominated by Chile which produces around 5 mln tons (USA is next with just over 1 mln tons).

Iron Ore - 5yr chart - source infomine Copper - 24 yr chart - source infomine

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Source: infomine.com

Iron Ore has reflected the moribund state of global demand since the start of the great recession. Copper has recovered from its 2009 lows but further upside impetus is lacking. This may have been due to the high levels of stock, however, during the last six months these stock levels have started to decline. A small increase in demand could lead to a significant re-rating.

Copper LME warehouse levels - 5 yr - source infomine

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Source: infomine.com

 

Precious Metals – supply

The precious metals complex is dominated by Gold and 2013 has been a difficult year for the “Gold-bugs” as central banks continue adding liquidity but gold prices fail to respond. So much has been written about this subject that I feel I can add little to the debate except to note that the disparity between paper gold (ETFs and Certificate) appear to be at an unusually large discount to physical gold – especially in India and China. For more insights into the arcana of the gold leasing market, I refer you to an excellent article by Gold Money’s Alasdair Macleod – There’s too little gold in the West –  published by the Cobden Centre: –

http://www.cobdencentre.org/?s=There+is+too+little+gold+in+the+West+

Here is his typically bullish dénouement: –

Bearing in mind Veneroso’s conclusion in 2002 that there must be 10,000-15,000 tonnes out on lease and loan from the central banks at that time, one could imagine that this figure has increased significantly. Officially, the signatories of the Central Bank Gold Agreement, plus the U.S. and U.K. own 20,393 tonnes. A number of other central banks are likely to have been persuaded to “invest” their gold, but this is bound to exclude Russia, China, the Central Asian states, Iran, and Venezuela. Taking these holders out (amounting to about 3,000 tonnes) leaves a balance of 8,401 tonnes for all the rest. If we further assume that half of that has been deposited in London, New York, or Zurich and leased out, that means the total gold leased and available for leasing since 2002 is about 12,000 tonnes. And once that has gone, there is no monetary gold left for the purpose of price suppression.

Could this have disappeared since 2002 at an average rate of 1,000 tonnes per annum? Quite possibly, in which case, the central banks are very close to losing all control over the gold price.

Meanwhile the trend continues lower.

Gold

Gold - 2yr chart.

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Source: Tradingcharts.com

Agricultural commodities – supply

With the agricultural sector demand is broadly constant although secular trends such as China’s increasing consumption of meat are structurally important. Within the agricultural sector I will review Wheat, Corn and Soybeans. No pork bellies, frozen concentrated orange juice and none of the softs – not because these markets don’t matter but in the interests of brevity.

In June 2013 the Food and Agriculture Organisation (FAO) published their long-term forecast for agricultural production.  Here is their press release: –

Global agricultural production is expected to grow 1.5% a year on average over the coming decade, compared with annual growth of 2.1% between 2003 and 2012, according to a new report published by the OECD and FAO today.

Limited expansion of agricultural land, rising production costs, growing resource constraints and increasing environmental pressures are the main factors behind the trend. But the report argues that farm commodity supply should keep pace with global demand.

The OECD-FAO Agricultural Outlook 2013-2022 expects prices to remain above historical averages over the medium term for both crop and livestock products due to a combination of slower production growth and stronger demand, including for biofuels,

The report says agriculture has been turned into an increasingly market-driven sector, as opposed to policy-driven as it was in the past, thus offering developing countries important investment opportunities and economic benefits, given their growing food demand, potential for production expansion and comparative advantages in many global markets.

However, production shortfalls, price volatility and trade disruption remain a threat to global food security. The OECD/FAO Outlook warns: “As long as food stocks in major producing and consuming countries remain low, the risk of price volatility is amplified. A wide-spread drought such as the one experienced in 2012, on top of low food stocks, could raise world prices by 15-40 percent.”

China, with one-fifth of the world’s population, high income growth and a rapidly expanding agri-food sector, will have a major influence on world markets, and is the special focus of the report. China is projected to remain self-sufficient in the main food crops, although output is anticipated to slow in the next decade due to land, water and rural labour constraints. 

Presenting the joint report in Beijing, OECD Secretary-General Angel Gurría said:  “The outlook for global agriculture is relatively bright with strong demand, expanding trade and high prices. But this picture assumes continuing economic recovery. If we fail to turn the global economy around, investment and growth in agriculture will suffer and food security may be compromised. (Read Mr. Gurría’s speech)”

“Governments need to create the right enabling environment for growth and trade,” he added. “Agricultural reforms have played a key role in China’s remarkable progress in expanding production and improving domestic food security.”

FAO Director-General Jose Graziano da Silva said: “High food prices are an incentive to increase production and we need to do our best to ensure that poor farmers benefit from them.  Let’s not forget that 70 percent of the world’s food insecure population lives in rural areas of developing countries and that many of them are small-scale and subsistence farmers themselves.”

He added:  “China’s agricultural production has been tremendously successful. Since 1978, the volume of agricultural production has grown almost five fold and the country has made significant progress towards food security. China is on track to achieving the first millennium development goal of hunger reduction.

While China’s production has expanded and food security has improved, resource and environmental issues need more attention. Growth in livestock production could also face a number of challenges. We are happy to work with China to find viable and lasting solutions.” 

Developing countries to gain

Driven by growing populations, higher incomes, urbanization and changing diets, consumption of the main agricultural commodities will increase most rapidly in Eastern Europe and Central Asia, followed by Latin America and other Asian economies.

The share of global production from developing countries will continue to increase as investment in their agricultural sectors narrows the productivity gap with advanced economies. Developing countries, for example, are expected to account for 80 percent of the growth in global meat production and capture much of the trade growth over the next 10 years. They will account for the majority of world exports of coarse grains, rice, oilseeds, vegetable oil, sugar, beef, poultry and fish by 2022.

To capture a share of these economic benefits, governments will need to invest in their agricultural sectors to encourage innovation, increase productivity and improve integration in global value chains, FAO and OECD stressed.

Agricultural policies need to address the inherent volatility of commodity markets with improved tools for risk management while ensuring the sustainable use of land and water resources and reducing food loss and waste.

Specifically in the US, droughts and extreme weather conditions have been the principal factors influencing supply. Water remains a scare and undervalued resource but improvements in technology and farming methods are ongoing. Nonetheless, prices for irrigated farm land have been making new highs during the year. Below are a series of Ten Year monthly charts of Wheat, Corn and Soybeans. The price spike of 2008 is evident in each case and the subsequent rally of Corn and Soybeans to make new highs in 2012. However, during 2013, despite another year of droughts, prices have remained subdued. Nonetheless, prices appear to be near to the base of their long-term up-trends.

Wheat

Wheat - 10yr chart

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Source:Tradingcharts.com

Corn

Corn - 10yr chart

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Source: Tradingcharts.com

 

Soybeans

Soybeans - 10yr chart

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Source: tradingcharts.com

The latest USDA reports (December 2013) can be found here: –

Wheat

http://www.ers.usda.gov/publications/whs-wheat-outlook/whs-13l.aspx

Projected 2013/14 supplies are raised 10 million bushels this month to 3,008 million bushels. Production and carryin stocks are unchanged, but imports are raised to 10 million bushels to 160 million bushels with expected higher hard red spring (HRS) and soft red winter (SRW) imports from Canada, up 5 million bushels each.

Corn

http://www.ers.usda.gov/publications/fds-feed-outlook/fds-13l.aspx

Projected 2013/14 corn use is increased 100 million bushels this month, split evenly between fuel ethanol and exports. Margins have been very favorable for ethanol mills, with higher ethanol and distillers’ dried grains (DDG) prices on the revenue side combined with lower corn prices on the input side. Exports have benefitted from lower corn prices and increased global consumption. Increases in use are offset slightly by a 5-million-bushel increase in projected imports. Production and feed and residual are unchanged. Projected carryout is tighter by 95 million bushels, at 1.8 billion bushels, but still double last season’s estimate of 824 million. The 2013/14 season-average farm price for corn is projected 10 cents lower at the midpoint of $4.40 per bushel, with the range narrowed to $4.05 to $4.75 based on prices reported to date.

World coarse grain production for 2013/14 is projected higher this month led by increases for Canadian corn and barley, Australian barley, and Ukrainian corn. Global coarse grain use prospects increase slightly more than production increases, trimming expected global ending stocks.

Soybeans

http://www.ers.usda.gov/publications/ocs-oil-crops-outlook/ocs-13l.aspx

USDA raised its 2013/14 forecast of U.S. soybean exports this month by 25 million bushels to 1.475 billion. Similarly, 2013/14 exports of soybean meal were forecast 250,000 tons higher to 10.5 million short tons, which prompted an expected increase in the domestic soybean crush by 5 million bushels to 1.69 billion. An improved demand outlook lowered the forecast of season-ending soybean stocks by 20 million bushels this month to 150 million. USDA raised its forecast range for the season-average farm price by 35 cents this month to $11.50-$13.50 per bushel.

For Argentina, area reductions for corn and sunflowerseed led USDA to raise its 2013/14 soybean area estimate by 300,000 hectares this month to 20 million. As a result, Argentine soybean production is forecast 1 million tons higher to 54.5 million metric tons. Additional output of Argentine soybean meal may push exports of the commodity in 2013/14 to a record 29.4 million tons. Yet, Argentine soybean stocks could be higher by next September to 28.5 million tons.

None of these forecasts looks excessively constrained and the proximity to trend-line support makes me cautious in the near-term, a breakdown through the ten year up trend could see a retracement of the entire cycle.

A longer term factor which may yet change this dynamic dramatically is the effect of the “Eddy Minimum”.

For some general background on sunspots and climate, this Princeton University website is a useful resource: –

http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Maunder_Minimum.html

The argument in favour of a cooling of global temperature is not new but for the latest comments on this subject the following website is informative: –

http://wattsupwiththat.com/2013/07/24/newsbytes-sunspot-enigma-will-inactive-sun-cause-global-cooling/

Conclusion

Throughout 2013 I waited for a resumption of the commodity bull-trend, expecting that the pick-up in economic activity, combined with the provision of central bank liquidity, would fuel the next leg of the super-cycle. It never materialised. Global growth remained subdued, China switched to a policy of “quality not quantity” and “taper terror” in the US, increased deflation expectations: and revealed weaknesses in a number of emerging markets. Even in the agricultural sector, weather related stress failed to materially reverse the downward pressure on prices.

Looking ahead to 2014 I can see little reason, thus far, to be broadly long commodities – as mentioned at the beginning I encourage all investors to view each market on its own particular merits. However, just like 2013, I am waiting for bearish sentiment to turn. To misquote St Augustine’s teenage prayer “Give me commodities Lord, but not yet!”

I’ll be back in mid January. With best wishes for the festive season and New Year. Col