9 to 15 May: In Uncertain Times

Fund Flow Data last week revealed further outflows from equities. This means the current quarter has now seen the largest decline in allocations since Q4 2008. This doesn’t necessarily point towards global recession, but it does show the effect of increased uncertainty. The FED is data dependent and asset prices are FED dependent, which leaves the US with little clear guidance and biased towards “bad (economic data) news is good news”.

China’s stimulus had some initial success, but a lack of transparency clouds the longer run inference. Japan is suffering from policy failure and, although it is most likely the next step is another round of fiscal stimulus and targeted rate cuts, nobody really knows what comes next. Then there is the UK Brexit vote and persistent oil price volatility.

2 to 8 May: Beggar Thy Neighbour

Part of the recent recovery in markets can be attributed to stability in the Chinese CNY, which can in large part be explained by weakness in the USD. Indeed, by not cutting rates (and instead resorting to QE and credit easing measures) the ECB also played its part in arresting the USD Bull Run.

Last week, the US jobs report showed the first signs of softness in the US labour market, which at a minimum has reduced the probability of a June hike. Given the limits of policy at the lower bound, we think the “beggar thy neighbour” channel of increased competiveness via a weaker currency is important. A more accommodative FED could therefore, perversely, stimulate further rate moves in Europe and Japan.

25 April to 1 May: Noddynomics

After the BOJ left policy unchanged on Wednesday, the Nikkei 225 fell 5.16% in local terms, which would have been worse without a market holiday on Friday. The currency fared little better. The JPY lost almost 5% against the USD and now sits back at September 2014 levels.

We have been, and continue to be, bears on Abenomics. The “three-arrows” of fiscal stimulus, monetary easing and structural reforms have failed individually and collectively, leading to negative GDP growth in 5 out of the last 9 quarters. We summarise our views by answering three questions:

Why has Japan failed?

  • Fiscal Policy:
    • Abenomics started with a fiscal spending package that saw the budget deficit break 11% in 2013. However, burdened with a debt-to-GDP ratio of circa 230%, the government soon lost its nerve, announcing a sequence of consumption tax hikes (next due April 2017).
  • Monetary Policy:
    • The Bank of Japan continue to buy assets at an unprecedented pace (QE is 3x larger than in the US and 2x larger than in Europe). The central bank therefore now owns 35% of all Japanese Government Bonds (projected to reach 50% within 18 months) and, according to Bloomberg, is a top 10 shareholder in 90% of Nikkei 225 companies via equity ETFs. However, this has failed to spark inflation and, in turn, growth.
    • To understand this failure, we must consider the channel by which QE acts on the economy. It is a signalling tool, through which a central bank can commit to generating inflation via increased liquidity. However, that signal needs to be credible; if the accompanying inflation target is too low or “forward guidance” is inconsistent, then investors will expect policy to reverse at the first sign of price increases. This is a problem globally, but nowhere worse than Japan where the bank is unpredictable and changes policy justification on a whim.
  • Structural Reform:
    • The favourite promise of politicians, Japan has so far failed to deliver any material structural measure.


What happens next?

  • It’s old news, but Japanese government debt is unsustainable. Actually, it’s worse than that – the country is insolvent; no amount of stimulus will allow them to “grow” out of the problem. Instead, the government needs to engineer a pseudo-default by embracing inflation. This is a horrible policy, with savers paying the price of debtors’ profligacy, but is the only politically viable option to exit stagnation. Despite the failure, so far, to generate price increases, we think it is easily possible. The first method is a more credible commitment – higher inflation targets, nominal GDP targets and unlimited policy measures taken without blinking. The second is the nuclear option – “helicopter money” whereby the BOJ permanently monetises government debt. The risk here is losing the credibility of the currency; there can’t be a free lunch where governments indefinitely print money to fund themselves.


What are the takeaways for the rest of the world?

  • Currencies have lost faith in QE:
    • We saw it earlier in the year after the ECB failed to cut rates but boosted asset purchases, leading to a sharp rally in the EUR. Now the relentless buying by the BOJ has seen no weakening of the JPY in 21 months. Policy now needs to innovate to keep market belief.
  • Persistent Intervention and Lack of Cohesion breeds Stagnation:
    • Japan is a story of decades of disjointed policy, with imperfectly delivered stimulus creating a monumental influence of government institutions on market prices, but with little benefit. Europe fits a similar mould – the structural failings of the Euro (monetary union without fiscal union) leading to slow and confused policy.

18 to 24 April: Walking the Tightrope

After a shocking start to the year, financial markets rebounded strongly and, for now, the rally continues. A number of factors explain the shift in sentiment. First, data from China, buoyed by stimulus and credit growth, has improved. Second, commodity prices have rebounded. Third, central banks have either eased or backed away from tightening. This has seen USD strength subside and signs of improvement in European credit markets.

The key question is to what extent these effects are transitory or long lasting:

  • With respect to China, a number of analysts argue the recent about-turn in economic numbers is “debt fuelled” and unsustainable. Last week George Soros commented: “There is an eerie resemblance to what’s happening in China to what’s happened here (US) leading up to the financial crisis in 2007-2008 and it is similarly fuelled by credit growth.” Others, instead, consider improved data to be indicative of a successful transition by the Chinese authorities from an investment to a consumption bias.
  • With respect to Commodities, oil last week rallied in spite of a failed agreement on a freeze in oil production. Thus price action is positive but it is harder to make a supportive fundamental argument. Any freeze would be at record output levels, inventories are still sky high and producer nations are playing weak hands; Saudi Arabia is selling off the crown jewels at the bottom of the cycle with the IPO of Aramco.
  • With respect to Monetary Policy, the ECB has focused on the credit channel to re-energise the Eurozone economy. Although early days, there are some signs in the lending data of an improvement. However, the marginal impact is small against the long running, structural issues. In the US, the FED has stepped back from its 4 hike forecast, weakening the USD, but the committee remain more optimistic than consensus and there are divisions emerging.

Although this week is light on data, there are FED and BOJ meetings, which may have a bearing on the market’s delicate equilibrium – particularly the path of the USD. More over the page.

11 to 17 April: Gifts From the East

In the commodities space, last week saw reports that a number of oil producers were to sign up to a production freeze for the first time in 15 years. The draft agreement would pause production at January levels (albeit this was more or less maximum output anyway) and would exclude Iran and Libya. However, at the time of writing talks have collapsed as Saudi Arabia refuses to sign a deal without Iran.

A raft of positive Chinese economic activity data lifted global sentiment this week. Whilst the Q1 GDP growth figure of 6.7% will stick out in the mind, it was the breadth of the strong data (trade, PMI, power, etc.) that was cause for optimism

Also over the weekend, the FT reported corporate defaults have hit USD 50bn so far, the fastest pace since 2009. This comes after Deutsche Bank released their annual default study, which indicated lead indicators of corporate failure are rising.

Finally, on Sunday, Brazil’s lower house voted in favour of impeachment proceedings against President Dilma Rousseff, securing the necessary two-thirds majority.

4 to 10 April: Barrelling Along

Oil price volatility shows little sign of slowing down. After falling 3.2% on Monday, WTI ended the week 8% higher on declining U.S. inventories and renewed hopes for a coordinated supply cut.

Equities were soggy as a lack of any substantive newsflow saw indices drift lower, with China’s increase in foreign reserves in March the only real headline grabber. This week sees the start of US Q1 earnings season as well as retail sales and China GDP figures.