Yield Curve Control – the road to infinite QE

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Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

  • The BoJ unveiled their latest unconventional monetary policy on 21st September
  • In order to target 10 year yields QE must be capable of being infinite
  • Infinite Japanese government borrowing at zero cost will eventually prove inflationary
  • The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”.  New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited.  This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds.  Zero-coupon bonds are not a joke – 28th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.  

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

  • Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
  • Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

nikkei-share-buybacks-may-2016-goldman-sachs

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

Is the “flight to quality” effect breaking down?

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Macro letter – No 61 – 16-09-2016

Is the “flight to quality” effect breaking down?

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

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

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

zerohedge_-_100bp_move_in_yields

Source: ZeroHedge

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

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

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

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

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

Source: Fixed Income Investor, Investing.com

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

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

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

Source: Fixed Income Investor, Investing.com

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

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

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

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

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

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

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

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

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

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

Source: Market Axess, Investing.com

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

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

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

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

which-corporate-bonds-ecb3

Source: M&G Investments, ECB, Bloomberg

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

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

Source: BIS

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

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

 Conclusions and investment opportunities

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

Source: Wall Street Journal, Callan Associates

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

Dividends

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

dididend-yld-sandp

Source: Multpl.com

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

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

Source: TopYield.nl

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

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

Bond bear-market?

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

What to do if the Brexit hits the fan? Prepare to Invest

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Macro Letter – Supplemental – No 3 – 17-6-2016

What to do if the Brexit hits the fan? Prepare to Invest

  • Opinion polls suggest that the Brexit camp may win the referendum this month
  • GBPUSD has made new lows on the news
  • UK stocks have fallen to levels last seen in March
  • UK Gilt yields have reached historic lows and credit spreads have widened

Whilst I still think it most likely that we will vote to remain in the EU, if the UK electorate vote to leave the EU on 23rd June, this is what I believe may happen and here is one investment opportunity which might be worth considering:-

Short-term

Sterling will weaken, International capital outflows will hit UK stocks and Gilts. A “technical recession” will ensue.

Medium-term

A weaker currency will cause inflation and exports to rise. Higher yields and a more competitive currency will lead to capital inflows into UK stocks and Gilts. Sterling will recover.

Background

Governor Carney of the Bank of England sees the risk of a “technical recession” should the UK leave the EU. Christine Legarde, MD of the IMF, says she has “not seen anything positive” about Brexit in economic terms, predicting a rebound in growth if the UK remains, but the possibility of a stock and housing market crash if we leave.

Countering these Cassandras’, Iain Mansfield, the director of trade and industry at the British Embassy in Manilla, won the IEA prize for his essay A Blueprint for Britain: Openness not isolation, stating:-

 

The outcome would be to accelerate the shifting pattern of UK’s exports and total trade away from the EU to the emerging markets, where the majority of the world’s growth is located. A more business-friendly regulatory regime and the new security of the City of London from European interference will enhance competitiveness and compensate for the partial loss of access to the European market.

Elsewhere commentators talk of a “Neverendum” even in the event of Brexit.

What to do

The FTSE100 Index is slightly below the middle of its 2,000 point range of the last five years. Despite recent weakness, a Brexit vote will lead to a further weakening of the Sterling Effective Exchange rate. Capital outflows will hit stocks, however, a weaker currency will help the Bank of England to meet its inflation target and exporters will benefit, especially those trading with structurally faster growing economies such as China, India and a number of Commonwealth countries.

Prime Minister Cameron announced the date for the UK referendum on 20th February. The chart below compares the DAX against the FTSE and the S&P500 over the past six months. On the face of it the UK stock market has paid little notice of the vote, although the weakening of Sterling may have been supportive for the more international FTSE companies:-

FTSE SPX DAX 6months

Source: Yahoo Finance

Another interpretation of the price action in financial markets suggests that the markets expect the UK to remain. Similar price action proved more reliable than the opinion polls both during the Scottish Referendum of 2014 and the Quebec Referendum of 1995. Cable (GBPUSD) dipped in March but has since recovered, partly spurred on by initial polls predicting that UK voters would choose to remain, lately it has weakened once more. The charts below are from Wednesday 15th, the Sterling has weakened further since:-

GBPUSD 6 months

Source: Barchart.com

EURGBP has been weakening over the past year:-

EURGBP 1 yr

Source: Tradingview.com

When viewed over the past ten years, however, the nature of the price move appears less remarkable. Eurozone (EZ) growth has been improving after a period of protracted weakness. Could an improvement in sentiment towards the EZ be the catalyst rather than expectations of the demise of Sterling?

EURGBP Monthly since 2007

Source: Tradingview.com

Once the initial turmoil of Brexit subsides, fears about the stability of the Eurozone will return; during the last decade the UK witnessed “safe haven” investment flows from Europe, especially into real estate. Inflows will resume as the European political landscape polarizes further. The UK construction sector will benefit. Reform of planning legislation, more likely once the UK has regained control of its borders, could substantially increase the attractiveness of the building sector. In many ways the housing sector represents an each-way bet. Should the UK electorate vote to remain deferred demand for property is likely to resume.

The UK stock market dividend yield is around 4%: by other metrics, including the Cyclically Adjusted Price Earnings ratio, the market is not overly expensive either. A Brexit decline may provide an excellent buying opportunity. Prepare to invest.

Here comes summer – Did you sell in May?

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Macro Letter – No 56 – 10-06-2016

Here comes summer – Did you sell in May?

  • Are Central Bankers approaching the limit of their power?
  • Individual stock volatility is reaching extremes relative to the indices
  • When dispersion of stock returns is high the risk relative to reward also rises
  • Some hedge fund strategies offer long-term benefits in this environment

This week’s letter is a departure from my normal format. Enclosed is a commentary on the prospects for the financial markets from my friend Allan Rogers whom I have been fortunate enough to know since the early 1990’s. Latterly the CIO of Loews Corporation’s Continental Assurance, Allan was a proprietary trader at Bankers Trust when the bank was in its heyday. Here is the note he kindly sent me on 14th May:-

Summer 2016 features a rising wave of frustration and voter antipathy toward most governing bodies and central banks, with good reason.  Ballot box dynamics threaten numerous incumbent government officials.  Demographic aging phenomena, technological innovation and minimum wage adjustments combine to thwart cyclical labor market improvement.  As post-war economic models fail to anticipate these rapid market adjustments, Central Banks cling desperately to their Milton Friedman monetary theory and Keynesian fiscal assumptions, relying on their imaginations, luck, and prayer to launch wave after wave of novel liquidity infusions.  So far, no good.  In their haste to revive growth after the financial crisis, they have handcuffed the dealer liquidity providers with ill-conceived regulations that endanger the liquidity network plumbing whenever expectations shift abruptly.  We have devolved into a nightmare of ZIRP, NIRP, QE, and God knows what’s next.  But, rather than wring our hands over this dilemma, let’s contemplate sensible portfolio management strategy for a few minutes.

As discussed last year, foreign exchange currency reserves still exceed $14 trillion.  Their potential deployment for economic stimulus remains intact.  Sovereign wealth funds, mostly invested in equity proxies, provide additional support for equity markets.  Central Banks are squeezing private investors as they desperately acquire dominant portions of the most liquid segments of risk-free(?) sovereign debt, corporate debt in Europe, and ETF’s and equities in Asia.  As a result, P/E ratios are elevated and yields bear little relationship to economic fundamentals.  As the political outlook befuddles the experts and aggravates voters, portfolio managers, facing new accountability regulations and third-quarter restrictions on Money Market Funds, need to become even more tactical in their asset allocation until clarity on Trump/Clinton, Brexit, etc. emerges later this year.  Until then, counter-trading the price action makes the most sense.  Even the hedge funds and private equity managers are struggling to perform in this turbulence as previous experience appears to provide useful insights.  The erratic price action reminds me of the late 1970’s when thirty years of fixed rates were followed by the oil price shocks that ushered in the Volcker era. Desperate pension funds and insurance companies might applaud such a development now as their yield assumptions fall 100’s of basis points short of any hope of meeting their forward liabilities.  In a market where the Yen and Euro rally despite explicit efforts to devalue them, one might surmise that their appreciation is only driven by the final unwinding of the massive Yen-carry trade by hedge funds facing redemptions after disappointing performance.

Amid all the chaos, do not expect central banks to abandon their printing presses. Syrian immigration issues in Europe and Trumpian nationalism will retard global trade and risk a replay of more intense competitive devaluation.  When we do reach the point of exhaustion for monetary stimulus, central banks have NO exit strategy. Bond markets will break down abruptly, but until then, US Treasuries should out-perform all other sovereigns. 10 year notes may well flirt with 1% as NIRP experimentation continues. Debates about the number of Fed “tightening” moves are irrelevant. The outlook, going forward, is all about liquidity management.  Although gold has rallied sharply so far this year, I suggest owning some gold, although one should heed the cautious brilliance of Stan Druckenmiller in conceivably buying a more significant percentage.

In this climate, equity markets offer the most promising net returns, IF one is willing to trade them actively.  “Buy and Hold” is a death wish. For over ten years, opportunistic equity traders have encountered volatile, but profitable equity markets. As we sit close to record high prices and valuations, why now? Amid illiquid markets, individual equities experience incredible price volatility despite the tame VIX market. The table below details the price ranges of the Dow Jones Industrials over the previous 52 weeks. If a money manager budgets an annual return of 7-8%, as many pension funds do, then opportunistic trading of these large-cap, blue chips makes achievement of those returns possible. Incremental usage of options and dividends sweeten the results.  But, you must trade these ranges, or, only buy weakness. I know this runs counter to indexing and most notions of prudent investment, but look at the table and draw your own conclusions. Incidentally, these ranges are not atypical, even in years where the averages experience only modest annual changes.

Stock  52 wk low 52 wk high 52 wk range % change
AAPL 89.47 132.97 43 48
AXP 50.27 81.92 31 63
BA 102.1 150.58 48 47
CAT 56.36 89.62 33 59
CSCO 22.46 29.9 7 33
CVX 69.58 109.3 40 57
DD 47.11 75.72 28 61
DIS 86.25 122.08 37 42
GE 19.37 32.05 12 65
GS 139.05 218.77 80 57
HD 97.17 137.82 40 42
IBM 116.9 174.44 57 49
INTC 24.87 35.59 11 43
JNJ 81.79 115 33 41
JPM 50.07 70.61 20 41
KO 36.56 47.13 10 29
MCD 87.5 131.96 44 51
MMM 134 171.27 37 28
MRK 45.69 61.7 16 35
MSFT 39.72 56.85 17 43
NKE 47.25 68.19 21 44
PFE 28.25 36.46 8 29
PG 65.02 83.87 19 29
TRV 95.21 118.28 23 24
UNH 95 135.11 40 42
UTX 83.39 119.66 36 43
V 60 81.73 22 36
VZ 38.06 54.49 16 43
WMT 56.3 79.94 24 42
XOM 66.55 90 23 35
         
Average       43
         
DIA 150.57 183.35 32 22
SPY 181.02 213.78 33 18

 

Source: Yahoo Finance

These data observations, while hardly profound, illustrate the range of possibility for trading profit, even in the largest stocks. Notice that the average price range of individual equities is more than twice the range of the large-cap averages, as reflected in their ETF’s. If you need to earn 8% per annum and the average Dow Industrial offers a 43% annual trading range, you don’t need to channel Jesse Livermore to achieve your objective. These results do not include dividends or option writing benefits.

This series of macro letters is entitled “In the Long Run” so you may, quite reasonably assume that I have “sold out”. I have not, but Allan, highlights the essence of the dilemma facing long-term investors looking ahead. During the past eight years interest rates have fallen in several countries to the lowest levels since records began. Being long government bonds below ones own rate of inflation (and there are few people whose living costs genuinely rise as slowly at RPI, HICP etc.) is irrational, since your real return will be negative – switching to “risker” assets makes sense.

With the Fed expected to tighten, if not this month then very soon, and other central banks contemplating how they may unwind the QE experiment, it seems likely that government yields may rise, credit spreads widen and equities decline.  As Mark Twain once proclaimed, “History doesn’t repeat but it rhymes” the aforementioned scenario occurred in January and February – this spooked central bankers who promptly enacted the secret “Shanghai Accord”. The next round of “risk off” will be different.

Strategies not Asset Classes

It is well documented that the average “long only” portfolio manager underperforms the benchmark over time. Unconstrained investing, either of a “long only” absolute return type or “long/short” makes sense, but make sure your expectations are realistic. Assets such as commodities have a structurally negative real-return, even if they can perform strongly on a cyclical basis. Even “risk free” government bonds can suffer restructuring or be subject to default.

Alternative investments may provide a solution but many liquid alternative strategies (by which I mean Hedge Funds) are highly correlated to equity or fixed income indices, although they offer similar returns with substantially lower volatility. Others, are either negatively or non-correlated. For example, the discipline of the short biased manager is undervalued, given that they actively bet against the long term trend of the stock market. As an addition to a portfolio they can offer a form of active risk management. At the end of April the Barclay Hedge – Equity Short Bias Index was +3.37% YTD whilst the Equity Long Biased Index was still languishing at -1.85%; that is 1.52% of Alpha if the general market is your index.

Two other strategies worth maintaining an exposure to are Global Macro and Managed Futures. Global Macro incorporates the widest array of approaches and exposures – at the index level it is unsurprising that it rarely does well, choose carefully and keep the faith. Managed futures is also diverse but there is still a concentration on systematic momentum and trend following strategies which provide negative correlation during equity bear markets and non-correlation during other periods. It also has the advantage that you can, usually, discover the investment process prior to investment. If style drift should subsequently occur this is your signal to redeem; otherwise you should not need to intervene. It can be a remarkably light touch investment.

I could describe a number of other strategies which have merit in the current market conditions but in the interests of brevity I will close with a recent assessment of the three main risks to financial markets according to Gavekal’s Anatoly Kelestsky:-

  • The June 23 “Brexit” vote in the UK
  • US elections on November 7th
  • German elections in mid-2017

Allan Rogers sees this as a traders market whilst ex-Dallas Fed President – Richard Fisher, speaking at the Mauldin SIC event last month, described his portfolio positioning as “Fetal”. Perhaps this year, more than most, the old adage “Sell in May and go away, return again St Leger’s day” (2nd October) may be apposite.

Quantitative to qualitative – is unelected nationalisation next?

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Macro Letter – No 52 – 08-04-2016

Quantitative to qualitative – is unelected nationalisation next?

  • Negative interest rates are reducing the velocity of circulation
  • Qualitative easing is on the rise
  • Liquidity in government bond markets continues to decline
  • A lack of liquidity in equity markets will be next

Last year, in a paper entitled The Stock Market Crash Really Did Cause the Great Recession – Roger Farmer of UCLA argued that the collapse in the stock market was the cause of the Great Recession:-

In November of 2008 the Federal Reserve more than doubled the monetary base from eight hundred billion dollars in October to more than two trillion dollars in December: And over the course of 2009 the Fed purchased eight hundred billion dollars worth of mortgage backed securities. According to the animal spirits explanation of the recession (Farmer, 2010a, 2012a,b, 2013a), these Federal Reserve interventions in the asset markets were a significant factor in engineering the stock market recovery.

The animal spirits theory provides a causal chain that connects movements in the stock market with subsequent changes in the unemployment rate. If this theory is correct, the path of unemployment depicted in Figure 8 is an accurate forecast of what would have occurred in the absence of Federal Reserve intervention. These results support the claim, in the title of this paper, that the stock market crash of 2008 really did cause the Great Recession.

Central banks (CBs) around the globe appear to concur with his view. Their response to the Great Recession has been the provision of abundant liquidity – via quantitative easing – at ever lower rates of interest. They appear to believe that the recovery has been muted due to the inadequate quantity of accommodation and, as rates drift below zero, its targeting.

The Federal Reserve (Fed) was the first to recognise this problem, buying mortgages as well as Treasuries, perhaps guided by the US Treasury’s implementation of TARP in October 2008. The Fed was fortunate in being unencumbered by the political grid-lock which faced the European Central Bank (ECB). They acted, aggressively and rapidly, hoping to avoid the policy mistakes of the Bank of Japan (BoJ). The US has managed to put the great recession behind it. But at what cost? Only time will tell.

Other major CBs were not so decisive or lucky. In the immediate aftermath of the sub-prime crisis the Swiss Franc (CHF) rose – a typical “safe-haven” reaction. The SNB hung on grimly as the CHF appreciated, especially against the EUR, but eventually succumbed to “the peg” in September 2011 after the Eurozone (EZ) suffered its first summer of discontent. It was almost a year later before ECB President Draghi uttered his famous “Whatever it takes” speech on 26th July 2012.

Since 2012 government bond yields in the EZ, Switzerland, Japan and the UK have fallen further. In the US yields recovered until the end of 2013 but have fallen once more as international institutions seek yield wherever they can.

By 2013 CBs had begun to buy assets other than government bonds as a monetary exercise, in the hope of simulating economic growth. Even common stock became a target, since they were faced with the same dilemma as other investors – the need for yield.

In late April 2013 Bloomberg – Central Banks Load Up on Equities observed:-

Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk-averse investors toward equities.

In a survey of 60 central bankers…23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves.

…The SNB allocated 82 percent of its 438 billion Swiss francs ($463 billion) in reserves to government bonds in the fourth quarter, according to data on its website. Of those securities, 78 percent had the top, AAA credit grade and 17 percent were rated AA.

…The survey of 60 central bankers, overseeing a combined $6.7 trillion, found that low bond returns had prompted almost half to take on more risk. Fourteen said they had already invested in equities or would do so within five years.

…Even so, 70 percent of the central bankers in the survey indicated that equities are “beyond the pale.”

the SNB has allocated about 12 percent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 percent of its $77 billion reserves on U.S. stocks.

…the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 percent of the total, up from 5.4 percent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.

Reserves have increased at a slower pace since 2012, but the top 50 countries still accounted for $11.4trln, according to the latest CIA Factbook estimates. The real growth has been in emerging and developing countries – according to IMF data, since 2000, in the wake of the Asian crisis, their reserves grew from $700bln to above $8trln.

By June 2014 the Financial Times – Beware central banks’ share-buying sprees was sounding the alarm:-

An eye-catching report this week said that “a cluster of central banking investors has become major players on world equity markets”. An important driver was revenues foregone on bond portfolios.

Put together by the Official Monetary and Financial Institutions Forum, which brings together secretive and normally conservative central bankers, the report’s conclusions have authority. Some equity buying was in central banks’ capacity as, in effect, sovereign wealth fund managers. China’s State Administration of Foreign Exchange, which has $3.9tn under management, has become the world’s largest public sector holder of equities.

The boundary, however, with monetary policy making is not always clear. According to the Omfif report, China’s central bank itself “has been buying minority equity stakes in important European companies”.

…Central bank purchases of shares are not new. The Dutch central bank has invested in equities for decades. The benchmark for its €1.4bn portfolio is the MSCI global developed markets index.

The Italian, Swiss and Danish central banks also own equities. Across Europe, central banks face pressures from cash-strapped governments to boost income. As presumably cautious and wise investors, they have also been put in charge of managing sovereign wealth funds – Norway’s, for instance.

…the Hong Kong Monetary Authority launched a large-scale stock market intervention in 1998, splashing out about $15bn – and ended up making a profit. Since the Asian financial crisis of that year, official reserves have expanded massively – far beyond what might be needed in future financial crises or justified by trade flows.

The article goes on to state that CB transparency is needed and that it should be made clear whether the actions are monetary policy or investment activity. Equities are generally more volatile than bonds – losses could lead to political backlash, or worse still, undermine the prudent reputation of the CB itself.

Here is an example of just such an event, from July last year, as described by Zero Hedge – The Swiss National Bank Is Long $94 Billion In Stocks, Reports Record Loss Equal To 7% Of Swiss GDP:-

…17%, or CHF91 ($94 billion) of the foreign currency investments and CHF bond investments assets held on the SNB’s balance sheet are foreign stocks…

In other words, the SNB holds 15% of Switzerland’s GDP in equities!

Zero Hedge goes on to remonstrate against the lack of transparency of other CBs equity investment balances – in particular the Fed.

The ECB, perhaps due to its multitude of masters, appears reluctant to follow the lead of the SNB. In March 2015 it achieved some success by announcing that it would buy Belgian, French, Italian and Spanish bonds, under its QE plan, in addition to those of, higher rated, Finland, Germany, Luxembourg and the Netherlands. EZ Yield compression followed with Italy and Spain benefitting most.

The leading exponent of this “new monetary alchemy” is the BoJ. In an October 2015 report from Bloomberg – Owning Half of Japan’s ETF Market Might Not Be Enough for Kuroda the author states:-

With 3 trillion yen ($25 billion) a year in existing firepower, the BOJ has accumulated an ETF stash that accounted for 52 percent of the entire market at the end of September, figures from Tokyo’s stock exchange show.

…Japan’s central bank began buying ETFs in 2010 to spur more trading and promote “more risk-taking activity in the overall economy.” Governor Haruhiko Kuroda expanded the program in April 2013 and again last October.

BoJ ETF holdings - October 2015 - Bloomberg

Source: Bloomberg, TSE

More ETFs can be created to redress the balance, or the BoJ may embark on the purchase of individual stocks. They announced a small increase in ETF purchases in December, focused on physical and human capital firms – also advising that shares they bought from distressed financial institutions in 2002 will be sold (very gradually) at the rate of JPY 300bln per annum over the next decade. At the end of January the BoJ decided to adopt negative interest rate policy (NIRP) rather than expand ETF and bond purchases – this saw the Nikkei hit its lowest level since October 2014 whilst the JYP shed more than 8% against the US$. I anticipate that they will soon increase their purchases of ETFs or stocks once more. The NIRP decision was half-hearted and BoJ concerns, about corporates and individuals resorting to cash stashed in safes, may prove well founded – So it begins…Negative Interest rates Trickle Down in Japan – Mises.org discusses this matter in greater detail.

In early March the ECB acted with intent, CNBC – ECB pulls out all the stops, cuts rates and expands QE takes up the story:-

…the ECB announced on Thursday that it had cut its main refinancing rate to 0.0 percent and its deposit rate to minus-0.4 percent.

“While very low or even negative inflation rates are unavoidable over the next few months as a result of movement in oil prices, it is crucial to avoid second-round effects,” Draghi said in his regular media conference after the ECB statement.

The bank also extended its monthly asset purchases to 80 billion euros ($87 billion), to take effect in April.

…the ECB will add corporate bonds to the assets it can buy — specifically, investment grade euro-denominated bonds issued by non-bank corporations. These purchases will start towards end of the first half of 2016.

…the bank will launch a new series of four targeted longer-term refinancing operations (TLTROs) with maturities of four years, starting in June.

The Communique from the G20 meeting in Shanghai alluded to the need for increased international cooperation, but it appears that a sub-rosa agreement may have been reached to insure the Chinese did not devalue the RMB – in return for a cessation of monetary tightening by the Fed.

In an unusually transparent move, a report appeared on March 31st on Reuters – China forex regulator buys $4.2 bln in stocks via new platform:-

Buttonwood Investment Platform Ltd, 100 percent owned by the State Administration of Foreign Exchange (SAFE), and Buttonwood’s two fully-owned subsidiaries, have bought shares in a total of 13 listed companies, the newspaper reported, citing top 10 shareholder lists in the companies latest earnings reports.

Shanghai Securities News said the investments are part of SAFE’s strategy to diversify investment channels for the country’s massive foreign exchange reserves.

Recent earnings filings show Buttonwood is among the top 10 shareholders of Bank of China, Bank of Communications , Shanghai Pudong Development Bank , Everbright Securities and Industrial and Commercial Bank of China.

Conclusions and investment opportunities

The major CBs are beginning to embrace the idea of providing capital to corporates via bond or stock purchases. With next to no yield available from government bonds, corporate securities appear attractive, especially when one has the ability to expand ones balance sheet, seemingly, without limit.

The CBs are unlikely to buy when the market is strong but will provide liquidity in distressed markets. Once they have purchased securities the “free-float” will be almost permanently reduced. The lack of, what might be termed, “trading liquidity”, which has been evident in government bond markets, is likely to spill over into those corporate bonds and ETFs where the CBs hold a significant percentage. In the UK, under our takeover code, a 30% holding in a stock would obligate the holder to make an offer for the company – the 52% of outstanding ETFs held by the BoJ already seems excessive.

The ECB has plenty of government, agency and corporate bonds to purchase, before it moves on to provide permanent equity capital. The BoE and the Fed are subject to less deflationary forces; they will be the last guests to arrive at the “closet nationalisation” party. The party, nonetheless, is getting underway. Larger companies will benefit to a much greater extent than smaller listed or unlisted corporations because the CBs want to appear to be “indiscriminate” buyers of stock.

As the pool of available bonds and stocks starts to dry up, trading liquidity will decline – markets will become more erratic and volatile. Of greater concern in economic terms, malinvestment will increase; interest rates no longer provide signals about the value of projects.

For stocks, higher earning multiples are achievable due to the rising demand for equities from desperate investors with no viable “yield” alternative. CBs are unelected stewards on whom elected governments rely with increasing ease. For notionally independent CBs to purchase common stock is de facto nationalisation. The economic cost of an artificially inflated stock market is difficult to measure in conventional terms, but its promotion of wealth inequality through the sustaining of asset bubbles will do further damage to the fabric of society.

Will Nigeria be forced to devalue the naira?

Will Nigeria be forced to devalue the naira?

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Macro Letter – No 50 – 26-02-2016

Will Nigeria be forced to devalue the naira?

  • The Nigerian government met the World Bank to discuss its deficit – loan pending
  • The Bank of Nigeria cut rates in November – bond prices suggest further cuts are imminent
  • Foreign Exchange controls tightened further in December
  • President Buhari states he won’t “kill the naira”

I last wrote about Nigeria back in early June – Nigeria and South Africa – what are their prospects for growth and investment? My favoured investment was long Nigerian bonds – then trading around 13.7%. They rose above 16% as naira exchange controls tightened. Here is a chart showing what happened next:-

nigeria-government-bond-yield

Source: Trading Economics, Central Bank of Nigeria

The catalyst for lower yields was an unexpected interest rate cut by the Central Bank of Nigeria. This is how it was reported by Reuters back on 25th November:-

Nigeria’s central bank cut benchmark interest rate to 11 percent from 13 percent on Tuesday, its first reduction in the cost of borrowing in more than six years.

…The stock market, which has the second-biggest weighting after Kuwait on the MSCI frontier market index , erased seven days of losses to climb to 27,662 points following the rate cut. The index has fallen 20.4 percent so far this year.

“On the back of the reduction in policy rates … investors are reconsidering investment in the equities market to earn higher return,” said Ayodeji Ebo, head of research at Afrinvest. “We anticipate further moderation in bond yields.”

He expected stocks in the industrial sector such as Dangote Cement and Lafarge Africa to gain from the liquidity surge as infrastructure projects boom. Ebo said the rate cut may hurt bank earnings as consumer firms reel from dollar shortages.

Yield on the most liquid 5-year bond fell 264 basis points to a five-year low of 7 percent while the benchmark 20-year bond closed 150 basis points down at 10.8 percent on Wednesday, traders said.

Bond yields had traded above 11 percent across maturities prior to Tuesday’s rate decision, with the 2034 bond trading at 12.30 percent.

The central bank has been injecting cash into the banking system since October in a bid to help the economy. Banking system credit stood at 290 billion naira ($1.5 bln) as of Wednesday, keeping overnight rates as low as 0.5 percent .

…The rate cut also weakened the naira on the unofficial market, which fell 0.8 percent to 242 to the dollar. The currency is pegged at 197 naira on the official market.

Non-deliverable currency forwards, a derivative product used to hedge against future exchange rate moves, indicated markets expected the naira’s exchange rate at 235.56 to the dollar in 12 months’ time – the strongest level in five months – and compared to 245.25 at Tuesday’s close

“Our economists still believe a devaluation will happen in a couple of quarters but I think they have had opportunities,” said Luis Costa, head of CEEMEA debt and FX strategy at Citi.

Here is a chart showing the naira spot and three month forward rate – a good surrogate for the differential between the official and black market rate:-

Naira spot vs forwards

Source: Bloomberg

December saw a further tightening of exchange controls, the FT – Capital controls curtail spending of Nigeria’s jet set elaborates:-

Nigeria’s central bank introduced currency controls last spring as the naira came under pressure after the collapse in the price of oil, the country’s main export and the lifeblood of its economy.

As well as in effect banning imports of goods from rice to steel pipes to protect dwindling foreign exchange reserves, the central bank has also enforced spending limits on foreign currency-denominated Nigerian bank cards, much to the chagrin of Nigeria’s well-heeled travellers. These are needed, it says, to curb black market activity such as “arbitraging”: when a customer turns a quick profit by withdrawing foreign exchange from an overseas ATM to sell on the black market back home.

Another less publicised aim of the controls, according to one senior official, is to limit the flight of billions of dollars suspected to have been fraudulently obtained and then hoarded in cash by business people and officials under the former government of Goodluck Jonathan.

Last month, the central bank extended the policy by banning the use of naira-denominated debit cards altogether for overseas transactions or withdrawals. The central bank has said it will not lift the restrictions until foreign reserves, which have fallen to $29bn from $34.5bn a year ago, are restored.

There is speculation among economists about the true level of foreign exchange reserves – suffice to say $29bln is regarded as an overestimate.

The January Central Bank of Nigeria Communiqué looked back to the rate cut in November but left rates unchanged, here are some of the highlights:-

Output

…Domestic output growth in 2015 remained moderate. According to the National Bureau of Statistics (NBS), real GDP grew by 2.84 per cent in the third quarter of 2015, almost half a percentage point higher than the 2.35 per cent recorded in the second quarter. However, third quarter expansion remained substantially below the 3.96 and 6.23 per cent in the first quarter of 2015 and corresponding period of 2014, respectively. The major impetus to growth continued to come from the non-oil sector which grew by 3.05 per cent compared with the growth of 3.46 per cent posted in the preceding quarter. The major drivers of expansion in the non-oil sector were Services, Agriculture and Trade.

…The economy is expected to continue on its growth path in the first quarter 2016, albeit less robust than in the corresponding period of 2015. This expectation is predicated on the current low global oil price trend which is projected to hold low over the medium-to long term, and with attendant implications for government revenue and foreign exchange earnings. Other downside risks to growth in 2016 include: capital flow reversal, high lending rates, sluggish credit to private sector and bearish trends in the equities market.

Prices

…Core inflation declined for the third consecutive month to 8.70 per cent in November and December from 8.74 per cent in October 2015, while food inflation inched up to 10.32 per cent from 10.13 and 10.2 per cent over the same period.

Monetary, Credit and Financial Markets Developments

Broad money supply (M2) rose by 5.90 per cent in December 2015, over the level at end-December 2014, although below the growth benchmark of 15.24 per cent for 2015. Net domestic credit (NDC) grew by 12.13 per cent in the same period, but remained below the provisional benchmark of 29.30 per cent for 2015. Growth in aggregate credit reflected mainly growth in credit to the Federal Government by 151.56 per cent in December 2015 compared with 145.74 per cent in the corresponding period of 2014. The renewed increase in credit to government may be partly attributable to increased government borrowing to implement the 2015 supplementary budget.

Committee’s Considerations

The Committee observed that the last episode of low oil prices in 2005 lasted for a maximum period of 8 months. However, the current episode of lower oil prices is projected to remain over a very long period.

At the end of January, President Buhari stated that he would not “kill the naira” – this prompted some commentators to question the independence of the central bank. It also suggests that foreign exchange controls will remain in place, despite pressure from the IMF for their removal.

Conclusion and Investment Opportunities

Whilst foreign exchange controls remain in place it is difficult to access the Nigerian markets: stubbornly high inflation remains a concern which these controls will only exacerbate – see chart below:-

nigeria-inflation-cpi

Source: Trading Economics, Nigerian Statistics Bureau

In this, high inflation, environment, it is difficult to envisage much further upside for government bonds. If you have been long I would take profit before the currency comes under renewed pressure. On 21st January Nigeria’s finance minister Kemi Adeosun announced that the government would borrow $5bln from international agencies to plug the shortfall in tax receipts, she has since then been in talks with the AfDB and the World Bank – after all, oil represents 95% of exports and more than two thirds of government revenue.

Stocks have fallen by more than 45% since their July 2014 highs, but further devaluation looks likely. The non-oil sector will outperform in the current environment but should the central bank “throw in the towel” it will be the energy sector which benefits in the short-term. According to Knoema, Nigerian oil production offshore is around $30/bbl whilst the smaller on-shore production is nearer $15/bbl. Other estimates suggest that only 16% of Nigerian oil reserves are worth exploiting at prices below $40/bbl. A 20% to 40% decline in the naira will reduce the break-even immediately. I remain side-lined until the valuation of the naira has been resolved.

As for the naira – a prolonged period of low oil prices will see the three month forward rate return towards NGNUSD 250 – a break towards 280 could represent a capitulation point. I believe this offers value, being 40% above the official rate. Will it happen? Yes, I think so.

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

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Macro Letter – No 48 – 29-01-2016

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

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

Copryright: Universal Pictures

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

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

Freight Rates

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

BDI_-_1985_-_2016 (4)

Source: Zerohedge

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

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

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

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

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

China

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

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

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

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

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

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

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

Dealing with a Different China

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

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

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

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

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

INR vs RMB - Yahoo

Source: Yahoo finance

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

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

Peterson go on to suggest:-

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

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

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

Energy Prices

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

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

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

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

Demand_Growth_in_Asia

Source: IEA

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

India_moving_to_centre

Source: IEA

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

A_new_chapter_in_Chinas_growth_story

Source: IEA

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

A_new_balancing_item_in_the_oil_market

Source: IEA

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

Power_is_leading_the_transformation

Source: IEA

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

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

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

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

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

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

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

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

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

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

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

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

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

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

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

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

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

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

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

Technology

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

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

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

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

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

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

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

LNG Fueled engines

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

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

…Solar & Wind Powered Ships:

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

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

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

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

The central role of the central banks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment opportunities

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

US_Index_-_5_yr_Marketwatch

Source: Marketwatch