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

An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?

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Macro Letter – No 40 – 28-08-2015

An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?

  • The FOMC rate increase may be delayed
  • An equity market correction is technically overdue
  • Long duration bonds offer defensive value
  • The US$ should out-perform after the “risk-off” phase has run its course

It had been a typical summer market until the past fortnight. Major markets had been range bound, pending the widely-anticipated rate increase from the FOMC and the prospect of similar, though less assured, action from the BoE. The ECB, of course, has been preoccupied with the next Greek bailout, whilst EU politicians wrestle with the life and death implications of the migrant crisis.

What seems to have changed market sentiment was the PBoC’s decision to engineer a 3% devaluation in the value of the RMB against the US$. This move acted as a catalyst for global markets, commentators seizing on the news as evidence that the Chinese administration has lost control of its rapidly slowing economy. As to what China should do next, opinion is divided between those who think any conciliatory gesture is a sign of weakness and those who believe the administration must act swiftly and with purpose, to avoid an inexorable and potentially catastrophic deterioration in economic conditions. The PBoC reduced interest rates again on Wednesday by 25bp – 1yr Lending Rate to 4.6% and 1yr Deposit Rate to 1.75% – they also reduced the Reserve Ratio requirement from 18.5% to 18%. This is not exactly dramatic but it leaves them with the flexibility to act again should the situation worsen.

Markets, especially equities, have become more volatile. The largest bond markets have rallied as equities have fallen. This is entirely normal; that the move has occurred during August, when liquidity is low, has, perhaps, conspired to exacerbate the move – technical traders will await confirmation when new lows are seen in equity markets during normal liquidity conditions.

Has anything changed in China?    

The Chinese economy has been rebalancing since 2012 – this article from Michael Pettis – Rebalancing and long term growth – from September 2013 provides an excellent insight. The process still has a number of years to run. Meanwhile, pegging the RMB to the US$ has made China uncompetitive in certain export markets. Other countries have filled the void, Mexico, for example, now appears to have a competitive advantage in terms of labour costs whilst transportation costs are definitely in its favour when meeting demand for goods from the US. This April 2013 article from the Financial Times – Mexican labour: cheaper than China elaborates:-

Mexico_vs_China_-_wages_Merrill_Lynch

Source: BofA Merrill Lynch

China’s economy continues to slow, a lower RMB is not unexpected but how are the major economies faring under these conditions?

US growth and lower oil prices?

I recently wrote about the US economy – US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment? My conclusion was that US stock earnings were improving. The majority of Q2 earnings reports have been released and the improvement is broad-based. This article from Pictet – US and Europe Q2 Earnings Results: positive surprises but no game changer which was published last week, looks at both the US and Europe:-

US earnings: strong profit margins and strong financials

Almost all S&P500 (456) companies published their Q2 results. At the sales level, 46% of companies beat their estimates; meanwhile, the corresponding number was 54% at the net profit level. Companies beat their sales and net profit estimates by 1.2% and 2.2% respectively, thus demonstrating strong cost control. Financials were big contributors as sales and net profit surprises came out at +0.5% and 1.5% respectively excluding this sector. Banks (37% of financials) beat sales estimates by 9% sales surprises and 8.4% at the net profit level. This sector’s hit ratio was especially impressive with 92% of reporting companies ahead of the street estimates. Oil and gas companies, which suffered from very large downgrades in 2015, reported earnings in line with expectations. Sales of material-related sectors (basic resources, chemicals, construction materials) suffered from the decline in global commodity prices, but those companies were able to post better than expected net profits. While positive, these numbers were not sufficient to alter the general US earnings picture. Thus the 2015 expected growth remains anaemic at 1.6% for the whole S&P500 and at 9.1% excluding the oil sector.

Q2 GDP came out at 2.3% vs forecasts of 2.6%, nonetheless, this was robust enough to raise expectations of a September rate increase from the FOMC.

European growth – lower oil a benefit?

The European Q2 reporting season is still in train, however, roughly half the earnings reports have now been published; here’s Pictet’s commentary:-

European earnings: positive surprises, strong banks but no substantial currency impact

A little more than half of Stoxx Europe 600 constituents published their numbers. Sales and net earnings surprises came out at 4% and 4.3% respectively. Excluding financials, the beat was less impressive with 0.8% at the sales level and 2.7% at the net income level. Banks had a strong quarter on the back of a rebound in loan volumes and improvements in some peripheral economies. This sector’s published sales and net income were thus 33% and 11% higher respectively than estimates. One of the key questions going into the earnings season was whether the very weak euro would boost European earnings. Unfortunately, this element failed to impact Q2 earning in a meaningful way. Investors counting on the weaker currency to boost European companies’ profit margins were clearly disappointed as this process remains very gradual. Thus, European corporates’ profit margins remain well below their US counterparts (11% versus 15%).

The weakness of the oil price doesn’t appear to have had a significant impact on European growth. This video from Bruegel – The impact of the oil price on the EU economy from early June, suggests that the benefit of lower energy prices may still feed through to the wider European economy, however they conclude that the weakening of prices for industrial materials supports the view that the driver of lower oil prices is a weakening in the global economy rather than the result of a positive supply shock. The views expressed by Lutz Kilian, Professor of Economics at the University of Michigan, are particularly worth considering – he sees the oil price decline as being a marginal benefit to the global economy at best.

When attempting to gain a sense of how economic conditions are changing, I find it useful to visit a country or region. The UK appears to be in reasonably rude health by this measure, however, mainland Europe has been buffeted by another Greek crisis during the last few months, so my visit to Spain, this summer, provided a useful opportunity for observation. The country seems more prosperous than last year – albeit I visited a different province – despite the lingering problems of excess debt and the overhang of housing stock. The informal economy, always more flexible than its regulated relation, seems to be thriving, but most of the seasonal workers are non-Spanish – mainly of North African descent. This suggests that the economic adjustment process has not yet run its course – unemployment benefits are still sufficiently generous to make menial work unattractive, whilst unemployment remains stubbornly high:-

spain-unemployment- youth unemployment rate

Source: Trading Economics

Euro area youth unemployment remains stubbornly high at 22% – down from 24% in 2013 but well above the average for the period prior to the 2008 financial crisis (15%).

If structural reforms are working, Greece should be leading the adjustment process. Wages should be falling and, as the country regains competitiveness, and employment opportunities should rise:-

greece-german unemployment-rate

Source: Trading Economics

The chart above shows Greek vs German unemployment since the introduction of the Euro in 1999. Germany always had structurally lower unemployment and a much smaller “black economy”. During the early part of the 2000’s it suffered from a lack of competitiveness whilst other Eurozone countries benefitted from the introduction of the Euro. Between 2003 and 2005 Germany introduced the Hartz labour reforms. Whilst average earnings in Germany remained stagnant its economic competitiveness dramatically improved.

During the same period Greek wages increased substantially, the Greek government issued a vast swathe of debt and unemployment fell marginally – until the 2008 crisis. Since 2013 the adjustment process has begun to reduce unemployment, yet, with youth unemployment (see chart below) still above 50% and migrants arriving by the thousands, this summer, it appears as though the economic adjustment process has barely begun:-

greece-german youth-unemployment-rate

Source: Trading Economics

Japan – has Abenomics failed?

Japanese Q2 GDP was -1.6% y/y, Q1 was revised to an annualised +4.5% from 3.9% – itself a revision from 2.4%, so there may be room for some improvement in subsequent revisions. The weakness was blamed on lower exports to the US and China – despite policies designed to depreciate the JYP – and a weather related lack of domestic demand. The IMF – Conference Call from 23rd July urged greater efforts to stimulate growth by means of “third arrow” structural reform:-

In terms of the outlook for growth, we project growth at 0.8 percent in 2015 and 1.2 percent in 2016, and potential growth over the medium term under current policies we estimate to be about 0.6 percent. Although this near-term growth forecast looks modest, we would like to emphasize that it is above potential and, therefore, we think that the output gap will be closing by early 2017.

Still, we need to emphasize that the risks are on the downside, including from external developments, weaker growth in the United States and China, and global financial turbulence that could lead to safe haven appreciation of the yen, which would take the wind out of the recovery to some degree.

The key domestic risks include weaker than expected real wage growth in the short term and weak domestic demand and incomplete fiscal and structural reforms over the medium term. These scenarios could result in stagnation or stagflation and trigger a jump in JGB yields.

 

Conclusions and investment opportunities

I want to start by reviewing the markets; here are three charts comparing equities vs 10yr government bonds – for the Eurozone I’ve used German Bunds as a surrogate:-

Dow - T-Bond 2008-2015

Source: Trading Economics

Eurostoxx - Bunds - 2008-2015

Source: Trading Economics

Nikkei - JGB 2008-2015

Source: Trading Economics

With the exception of the Dow – and its pattern is similar on the S&P500 – the uptrend in stocks hasn’t been broken, nonetheless, a significant stock market correction is overdue. Below is a 10 year monthly chart for the S&P500:-

S&P500 10yr

Source: Barchart.com

US Stocks

Looking at the chart above, a retest of the November 2007 highs (1545) would not be unreasonable – I would certainly view this as a buying opportunity from a shorter term trading perspective. A break of the October 2014 low (1821) may presage a move towards this level, but for the moment I remain neutral. This is a change to my position earlier this year, when I had become more positive on the prospects for US stocks – earnings may have improved, but the recent price action suggests doubts are growing about the ability of US corporates to deliver sufficient multi-year growth to justify the current price-multiples in the face of potential central bank rate increases.

US Bonds

T-Bonds have been a short term beneficiary of “flight to quality” flows. A more gradual move lower in stocks will favour Treasuries but FOMC rate increases will lead to curve-flattening and may completely counter this effect. Should the FOMC relent – and the markets may well test their mettle – it will be a reactive, rather than a proactive move. The market will perceive the rate increases as merely postponed. Longer duration bonds will be less susceptible to the vagaries of the stock market and will offer a more attractive yield by way of recompense when a new tightening cycle begin in earnest.

Europe and Japan – stocks and bonds

Since the recent stock market decline and bond market rally are a reaction to the exogenous impact of China’s economic fortunes, I expect correlation between the major markets to increase – whither the US so goes the world.

The US$ – conundrum

Finally, I feel compelled to mention the recent price action of the US$ Index:-

US Dollar Index

Source: Barchart.com

Having been the beneficiary of significant inflows over the past two years, the US$ has weakened versus its main trading partners since the beginning of 2015, however, the value of the US$ has been artificially reduced over multiple years by the pegging of emerging market currencies to the world’s reserve currency – especially the Chinese RMB. The initial reaction to the RMB devaluation on 12th August was a weakening of the US$ as “risk” trades were unwound. The market correction this week has seen a continuation of this process. Once the deleveraging and risk-off phase has run its course – which may take some weeks – fundamental factors should favour the US$. The FOMC is still more likely to raise rates before other major central banks, whilst concern about the relative fragility of the economies of emerging markets, Japan and Europe all favour a renewed strengthening of the US$.

The US$ as a store of value

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Macro Letter – No 20 – 26-09-2014

The US$ as a store of value

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

US$ Index - 25yr - Barchart.com

 

Source: Barchart.com

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

US$ TWI - 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

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

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

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

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

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

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

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

Here is US GDP over the last twenty years: –

US GDP - 1995-2014 - Trading Economics

Source: Trading Economics

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

US Trade Balance - 1995-2014 - Trading Economics

Source: Trading Economics

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

EU GDP 1995-2014 - Trading Economics

Source: Trading Economics

EU Trade Balance - 1999-2014 - Trading Economics

Source: Trading Economics

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

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

China Trade balance - 1995-2014 - Trading Economics

Source: Trading Economics

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

The US response to the trade deficit

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

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

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

Foreign_Official_and_Private_Investment_Positions_

Source: US Commerce Department

The Congressional Research Service concludes:-

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

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

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

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

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

Gold vs US$

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

Gold - 25 year - Barchart

Source: Barchart.com

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

Leading Indicators

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

Philly_Fed_-_July_2014_Leading_Indicators

Source: Philadelphia Federal Reserve

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

US Leading Indicators 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

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

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

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

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

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

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

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

Where next for the US$

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

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

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

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

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

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