My Diary 739 --- No Tightening Risks In Asia; Debt Super Cycle and Carry Trade; China: Data, Reform & Shadow Banks; The Carry Trade’s New Toy
Sunday, January 13, 2013
“Bubbling Optimism vs. Bumping Central Banks” --- 2013 has started with bubbling optimism across global risk markets with equities and credit rallying further. Equities are approaching 5yr highs and credit spreads their 5yr lows, while govt bonds are selling off worldwide and BE inflation behave. USD is falling vs most currencies, except JPY given Japan’s full-throated commitment to looser monetary and fiscal policy. Meanwhile I have observed a sudden surge in equity fund inflows, which seem consistent with lukewarm incoming data.
Macro wise, it looks to me that the beginning of 2013 shares some similarities with the past three years, as certain green shoots offer reasons to be optimistic. However, that optimism is more cautious this year in the knowledge that fiscal policy is turning more restrictive. Even as global growth picks up, the legacy of two full years of subpar performance will play a major role influencing macroeconomic performance. Global inflation is expected to retreat modestly this year, settling at a 2.5% yoy pace in 4Q13. This would build on the even larger drop recorded in 2012 and take inflation to the lower end of the range for the past decade, outside of recessions. The decline is expected to be focused in DMs, where core inflation is expected to fall against a backdrop of considerable slack, yet another year of sub-trend growth, and sharply lower import price inflation. The projected tension between low underlying inflation and the constraint posed by the ZIRP bound represents a unique challenge for DM central bankers. Aggressive fiscal tightening in the US and Europe in the face of high UNE represents another. In response, central bank B/S is set to expand further.
Having said so, though the global economy disappointed last year and growth expectations were also dampened for 2013. Consensus estimates of global growth for this year stand about 1.5% yoy lower and each G4 central bank has lowered its sights over this period. Nevertheless, the past year has delivered double-digit returns in global credit and equity markets as weak growth has also been accompanied by a significant reduction in macroeconomic tail risks. In the near-term, the markets face a new set of deadlines in March related to the debt ceiling, the postponed sequestration, and the renewal of the continuing spending resolution. I think this debate will create significant noise but will ultimately signify little with regard to the global outlook.
Looking forward, I think the key driving force for risk markets in the next 12-24 months is whether the economy has regained enough health so that policymakers can remove some of ultra easing policies, while the patients will continue recovering. For its part, the Fed made a significant shift in its reaction function in September in an attempt to augment the perceived diminishing returns of asset purchases. The minutes of the latest meeting also highlight the Fed’s concern about a large open-ended purchase plan with sentiment on the committee pointing to a scaling down of the program later this year. Over the week, Kansas Fed President George said she was uneasy about the continued asset purchases and they complicate the eventual exit strategy. She also noted in her commentary that current policy could be contributing to an asset price bubble and possible inflation. Such worries were shared by her colleagues, including St Louis Fed President Bullard.
In Europe, ECB has reluctantly taken on the role of a sovereign liquidity backstop, and the launch of the OMT program institutes a key risk-sharing mechanism changing the nature of sovereign debt in the region. However, last week Draghi disappointed those hoping for a rate cut in the next few months. Although the ECB's view on the macro was little different to last month, there's little doubt that there was more confidence in the press release. Draghi was also in bullish mood in the Q&A, discussing declining yields and CDS spreads, rising capital inflows, rising deposit bases at periphery banks and the declining usage of the ECB balance sheet and Target2. Draghi summarized this as "positive contagion".
Over to Asia, PM Abe commented that BoJ should follow the Fed's lead and target employment as one of its monetary policy targets. The comments are driving the Nikkei to its 23-month highs, while sent the JPY to new low. Mr. Abe added that he wants the central bank "to have responsibility for the real economy too". According to local newspaper, a joint statement between the govt and BoJ specifying a 2% inflation target is in the process of being drafted. Including local government and private sector spending, the stimulus package is expected to be worth around JPY20trn and will focus on infrastructure building (Bloomberg). Japanese data also added more JPY weakness with CA surplus shrinking to a JPY225.9bn in Nov (vs. Oct's JPY414.1bn surplus). Clearly, the new PM Abe has strong convictions and incentives. But for Japanese reflation to become a true game changer, the policies need to be implemented and to produce results. There seems little doubt about implementation, with Abe co-opting the BoJ to raise its inflation target to 2%, and then replacing the top 3 people at the BoJ at the end of the quarter.
That said, while ECB and BoE have been much more concerned about supply destruction in the wake of the global financial crisis, Fed and BoJ have viewed the GDP shortfall as mostly demand-driven. Based on the estimates of the output gap consistent with each central bank’s thinking, the Euro area and UK have experienced as much as a 6%-10% outright reduction in productive capacity as of 4Q12, relative to pre-crisis potential growth trends. By contrast, the US and Japan have seen a much more modest 2% hit. With output gaps still depressed across the G4, the debate is somewhat moot in the near term as inflation pressures will remain subdued again this year. However, a return to more robust growth would lead to a staggered exit from unprecedented monetary policy support, with the ECB and BoE likely to move first. With the risk markets are so addictive to liquidity, any hints of liquidity withdraw by the major central banks will likely cause market volatility and various degree of price correction in different assets. Thus, in the past few quarters, I have seen a major new initiative under way as central banks experiment with their communication policy --- the signals policymakers send about their objectives and how they will react to changing economic circumstances.
X-asset Markets Thought
On the YTD basis, global equities were up +3.04% with +3.30% in US, +3.86% in EU, +4.60% in Japan and +3.24% in EMs. In Asia, MXASJ and MSCI China closed +1.87% and +2.89%, respectively, while CSI300 dropped -1.57%. Elsewhere, 2yr USTs yield stayed flat at 0.25% and 10yr’s widened 11bps to 1.87%. In Europe, The 10yr Spanish bond yield (-34bp) closed below 5% (4.857%) for the first time since March 9th 2012. Italy's 10yr yield (-36bp) is also at its lowest level in more than 2 years. A good Spanish bond auction was a main driver and some FI strategists are no longer believe that Spain or Italy will need to trigger OMT in 1Q13. Elsewhere, 1MBrent crude went down -1.21% at $110.59/bbl. The USD weakened 1.11% @1.3343EUR and strengthened +2.87% to JPY89.18. CRY index was up 0.56% to 296.66, while Gold price were down 1.11% at $1657.7/oz.
Looking forward, in the coming weeks, investors are concerned that equities have run up too quickly, so that the further rally probably shifts from being valuation driven to earnings driven. In the regional markets, some investors are talking about a 10% plus tactical correction, as MXASJ price-to-book has risen from 1.4X to 1.68X, but this is lower than the 2XPB seen at Jan 2010 and Jan2011. In my views, the main acute event risk remaining is Fiscal Cliff 2 over the next two months. My best guess is that the threat of a non-renewal of the debt ceiling is largely zero as the Republicans will not want to be considered totally irresponsible in causing an outright default by the US government in its interest payments. But the threat to enforce the Budget Control Act and to allow no further delay in automatic spending cuts under sequestration is a lot more serious.
In addition, there are many talks, in particular from the private banking side, that the major x-assets theme in 2013 is the credit-to-equities rotation. In 2012, fund investors poured USD680bn into bond mutual funds and ETFs, while taking some USD23bn out of equity funds. I think this rotation trend will only happen gradually as at this point in the cycle, the normal push factor that drives investors away from bonds should be monetary tightening. In fact, the strengthening of credit quality will make credit spreads very attractive, if government rates remain steady. In addition, we will see continued QE buying in US throughout this year, despite hints in the FOMC minutes last week of an end to QE in 2H13. Meanwhile , BoJ has not made clear how much it will buy this year, but with changed political leadership soon at the BoJ, risk is all on the upside on further BoJ bond buying. Hence, monetary tightening is unlikely to become a push factor against bonds. For equities, the main positive factor that can pull investors out of credit into equities is growth in economies and earnings at this stage. As discussed above, we see the world economy rebounding, but have so far not yet raised projections much and neither has the consensus. For growth to become a true pull-into-equities factor, we would need to see decent upgrades in earnings and growth forecasts.
No Tightening Risks In Asia
Some sell-side economists have lowered 4Q US GDP forecast from 1.5% to 0.8% mainly because of WTE trade data and moderated growth in industrial production in December ahead of the fiscal cliff debate. Moreover, the increase in payroll taxes and higher marginal rates on high-income households is set to depress 1H 13 income growths by roughly 2% yoyo. Although lower inflation will cushion part of this blow, US growth is expected to slow at the start of the year, limiting the lift in overall global growth. Despite concerns over fiscal cliff 2 & HH income growth, the preliminary reading of consumer sentiment in January is likely to show modestly improved confidence. The partial resolution of the fiscal cliff, coupled with the continued momentum in hiring, is supportive, as is the strong start to the year by stock markets. In additional, inflation has stayed tame, with softer gasoline price growth offset by continued but modest rises in rent inflation.
In the mid-term, I remain positive to US economy recovery as housing will take a leading role this year. In 2012 household formation began to pick up and inventories of unsold homes declined substantially. The result was a tighter demand/supply balance that spurred the first phase of a recovery in homebuilding and more gradual recovery in house prices. These influences will support further rapid gains in home building in 2013, and some anticipate that real residential investment will grow 22% this year, the fastest since the early 1980s. Moreover, I will look for regional PMIs to show evidence of a rebound in the economy as the clearer fiscal outlook at the beginning of 2013 is positive for business investment.
By contrast, EM Asia will be supported by the turn in global manufacturing as well as continued solid gains in Chinese demand. For EM economies, subpar growth has itself been a force to moderate tail risks. The risk of overheating and excessive credit asset price growth was the main threat to the region during 2010-11. As such the slowdown has provided a welcome respite, which promotes financial stability and removes pressures for policy tightening. To be sure, the sharper-than expected slowdown in China and other large EM countries during 1H12 raised concern that the unwinding of a credit boom would prove disorderly. Signs that EM inflation pressures have abated alongside indications that China is lifting provide important confirmation that the EM expansion can be sustained. More importantly, after slowing through much of 3Q12, EM Asian exports are gaining momentum as final demand begins to lift. In aggregate, sequential trend export growth firmed 14.8% QoQ saar through November, up from a trough of -10.6% in 3Q. Excluding China, exports rose an even firmer 20.5% QoQ saar, reflecting broad-based gains across the region. With the production cycle picking up, the bounce is set to continue into early 2013.
However, unlike the DM peers, the coming months are likely to feature a gradual shift in EM central banks rhetoric featuring an increasing emphasis on the risks of higher inflation and credit growth. But policymakers are unlikely to take concrete action to follow it up. Inflation has been rising recently in China, but I expect policy rates are likely to remain on hold even as inflation rises to near 3.5% during this year’s second half. Indeed, the rise in RMB against USD is likely to be controlled, and the PBoC is still expected to deliver two to three RRR cuts. Elsewhere in the region, Korea, Malaysia, and Taiwan will lead the pack as headline inflation in these economies is forecast to end the year more than 1%-point higher than the rate at which it started. For the most part, Asian inflation is moving up from low levels and the forecasted gains are not expected to trigger central bank tightening.
Debt Super Cycle and Carry Trade
The debt super cycle is a description of the long-term decline in US balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.
In fact, since the 1970s, the upward trajectory in financial obligations has continued virtually unabated. For example, public debt in DM countries has climbed from 30% of GDP to >100%. Total (private and public) debt in US has more than doubled to 380% of GDP over the same period. A similar trend has unfolded in other developed countries. Historically, debt grew in line with GDP, rising faster during booms and falling back during busts. Since the 1970s, however, the quickness of central bankers to unleash stimulus has moderated downturns and kept the corrective phase of the debt cycle from fully playing out. As a result, recoveries have launched from successively higher plateaus of debt. During expansions, central bankers have been slow to withdraw stimulus, accentuating the build-up in borrowing.
Though periodic “cyclical” corrections to the buildup of debt and illiquidity occurred during recessions, these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance sheet excesses become, the more painful the corrective process would be. Now, the super cycle reached an important inflection point in the recent economic and financial meltdown with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead. Once fiscal policy is pushed to the limits of sustainability, the debt super cycle could come to a violent end. However, the fact that the stock market correction in the closing weeks of the fiscal cliff debate in 2012 was not particularly severe suggests that investors have become more tolerant of Washington infighting. Nonetheless, this is far from assured.
We are now in a reflationary period, when the economy is being pumped up by central bankers and other policy-makers. Substantial equity exposure may work during this time, but the concerns is that the expansion will be held back by the combination of ongoing HH deleveraging and fiscal consolidation in DMs. This combination will require monetary policy in DMs to support growth via low rates, potentially for years. Combined with plentiful savings in EMs, the deleveraging backdrop in the DM means that the global savings glut will remain a key feature for some time. Several fixed income asset classes stand out as being potential winners in this environment. Investors will favor income over the potential for capital gains. Spreads could narrow to extremely tight levels as the “search for yield” intensifies, similar to what occurred in Japan. Corporate HYs tend to outperform stocks in a low, but positive growth environment. Corporate credit quality is strong and corporate bonds currently provide a sizable yield advantage relative to competing asset classes, and will benefit in a world where growth is slow enough to keep policy rates low but not slow enough to cause a recession. In short, the environment will also push investors toward carry trades.
China: Data, Reform & Shadow Banks
The latest Chinese dataflow was supportive of risk sentiment. While RMB new loans came in at RMB454bn in Dec (RMB523bn in Nov), TSF accelerated to RMB1.63tn in Dec, up from RMB1.14tn in Nov. As a result, non-bank financing rose to 72% of total social financing in December. Due to the continuation of banks' disintermediation, the amount of RMB new loans is becoming increasingly less relevant to the total financing and the growth outlook of the real economy. In other news we learned that exports grew 14.1% yoy, a surprisingly strong rate compared with the consensus forecast of 5% and November's 3%. By destination, December exports to ASEAN countries rose 28% yoy, while exports to the US increased by 10% and those to EU by only 2.3%. December import growth, at 6% yoy, also beat consensus forecast of 3.5% and was up from zero in November. The pick-up in import growth momentum is consistent with a mild recovery of industrial activity in China. Meanwhile, December CPI inflation rate rose to 2.5% (consensus= 2.3%), compared to 2% in November. After hitting the bottom at 1.7% in October, the inflation is now gradually turning up. Inflation was not a problem in 2012, but it will be a different story for 2013-14 driven by a turnaround in the food price cycle and higher unit labor costs. An expected push by the new government on resource price reform will add to the pressure.
On the reform side, China’s new party leadership has clearly elevated the fight against corruption as a high priority. Labeled by party secretary Xi as a risk that may lead to ‘the collapse of the party and the country. Though the senior leadership has promised reforms, and some initial policies have already emerged, I think most of the anti-corruption reforms are likely to take time to introduce, and likely face enforcement challenges. Good news is the development plan for urbanization in China drafted by the NDRC, MoF and CPPCC are held. The plan will cover >20 urban agglomerations, 180 prefecture-level cities, and over 10K towns across China. The government will also raise land acquisition compensation in rural areas and reform land management system to remove urbanization obstacles. Furthermore, China will likely accelerate the household registration reform to make it easier for people to migrate freely in the country. This will help promote reforms on income distribution and boost domestic demand.
In addition, Chinese bears continue to argue that shadow banking activities are a major source of China’s systemic risk, and estimate that the outstanding amount to RMB15-25tn (vs. outstanding bank loans RMB63tn). However, if one looks at the breakdown of these shadow banking activities, the most problematic and fastest growing segment is financing via trust loans. According to the PBOC, in the first 11Mo2012, new trust loans rose 535% yoy and reached RMB1.04tn, accounting for 7.5% of total social financing. According to China Trustee Association, the outstanding amount of trust loans as of end-Sep2012 was RMB2.44tn, equivalent to about 4% of outstanding bank loans. Of the RMB2.44tn in trust loans (outstanding), collective trust products that finance LGFVs and real estate companies (with an estimated outstanding amount of about RMB1tn) are most problematic, as many individual investors are not prepared to face the consequence of a default and may stage public protests when they lose money. At RMB1tn, it is about one-tenth of the problem of LGFV debt two years ago, which was viewed then by many China bears as a risk that could crash the entire economy. As for resolution, we believe the piecemeal approach will likely work and the impact on banks’ NPLs will likely be minimal.…… Lastly valuation wise, MSCI China is now traded at 10.4XPE13 and 11% EG13, CSI300 at 10.5XPE13 and 16.5% EG13, and Hang Seng at 15.8XPE13 and 2.8% EG13, while MXASJ region is traded at 11.8XPE13 and 15.8% EG13.
The Carry Trade’s New Toy
The momentum of recent JPY weakness is showing no signs of a slow-down, with USDJPY going from ~79 to 89.2 – or a whopping 12.3% rally – in just 2 month. The only other time since 2000 that the pair rallied >10% in 40 trading days was from mid-Feb to early-Apr2009. However, keep in mind that this was a sharp bounce immediately after a plummet caused by the Lehman market crash, which makes the current USD/PY rally all the more impressive. Given this recent momentum, I am not too surprising to see USDJPY reach into 90 in coming weeks.
In fact, there are several driving factors, both from political and monetary policies, behind the JPY weakness. Following the LDP’s landslide victory at election, the incoming premier Abe has stepped up pressure on BoJ, threatening to change a law guaranteeing the bank's independence if it did not agree. In fact, BoJ responded almost immediately with an aggressive easing of monetary policy --- 1) BoJ announced that its Asset Purchase Program will be increased by another JPY10trn. 2) The central bank also provided details of its new Stimulating Bank Lending Facility, which aims to provide LT funding directly to financial institutions. The Bog expects to supply a further JPY15trn of liquidity to the banking system through this facility. Taken together, these two policy measures will lead to an additional JPY25trn increase in the BoJ’s B/S, which is now expected to virtually match that of Federal Reserve in 2013. Moreover, further easing by the Japanese central bank may be in the cards next year. This could coincide with a modest increase to its inflation target, from 1% to a range of 1-2%. Also, the BoJ could announce additional asset purchases that extend beyond 2013. This would be similar to the Fed’s recent pledge to conduct unlimited QE.
Looking back, since the eruption of the global financial crisis in 2008, BoJ has been the least aggressive of the G4 central banks in expanding its B/S. The lagging nature of BoJ has been a key factor in supporting JPY. This pillar of support for JOY is no longer in place. At minimum, BoJ will keep pace with the Fed in 2013. And with the ECB and BoE’s asset purchase programs on hold, their B/S is not expanding at the moment.
Given that USDJPY is largely a “competitive devaluation” story, JPY weakness should be much more prevalent on the cross rates, especially against currencies that offer relatively high yields. Given the lagging nature of BoJ, the USD has been the preferred funding currency for “carry trades” since 2008. The JPY will now join the Dollar in this capacity. In addition to the Fed, BoJ will become a significant source of liquidity for the global economy. Made available at near zero cost, this newly created money will search out higher yields and returns. Finally, BoJ’s aggressive actions support our bullish view on gold, despite its recent weakness. It should be clear that most central banks are debasing their currencies through QEs and/or negative real interest rates. Holding paper money will be a losing proposition. Real interest rates in the major developed economies are expected to stay negative to the end of the decade. Investors will continue to turn to gold as an alternative “hard” currency that will preserve wealth and purchasing power.
Good night, my dear friends!
