By Ajay Shah, on December 27th, 2011
Patrick Chovanec has a fascinating article in Foreign Affairs, titled China’s Real Estate Bubble May Have Just Popped. This is interesting and important from two points of view.
First, bad news for China is bad news for the world economy. We are already in a bleak environment, with difficulties in Europe, Japan, the US, and India. It will not be pretty if China runs into trouble as well. I am reminded of the feeling of carefully watching real
estate in the United States in 2006, with a sense that the future of the world economy was going to turn on how it turned out.
Second, it made me think about real estate in India. As with China, one often sees buyers of real estate in India have the notion that
this is a safe financial asset. This is a questionable proposition. Real estate is perhaps not an asset
class with a positive expected return in the first place; and it is certainly not a convenient asset class with features like liquidity,
transparency, diversification and easy formation of low-volatility diversified portfolios. I find it hard to explain the prominence of
real estate in the portfolios of even educated people in India.
In the article, Chovanec says:
For more than a decade, they have bet on longer-term demand trends by buying up multiple units — often dozens at a time — which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast `ghost’ districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.
This has not happened in India. So in this sense, the situation in India is not as dire. But his second key message seems uncomfortably
close:
As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some
cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.
Part of this looks familiar. There is a lot of leverage in Indian real estate development and speculation. Real estate speculators and
developers are finding themselves in a bit of a scramble hunting for credit. One hears about very high interest rates being paid by
developers. Other sources of financing are also weak. This reminds me of the dark days before the global crisis, when borrowing by real estate companies was the canary in the coal mine.
If business cycle conditions and financial conditions worsen, the problems of borrowing by real estate developers and speculators will get worse. How might this turn out? Perhaps the borrowers will merely get uncomfortable. Or, a few firms could really get into trouble, and start liquidating inventory. That would have substantial repercussions.
Suppose there is a situation where there are many people who have speculative positions in real estate, but significant selling of
inventory has not yet begun. The longs would then be nervously looking at each other, wondering who would be the first one to sell, to take a better price and exit his position. The ones who sell late would get an inferior price. In such a situation, conditions could change sharply in a short time.
On a longer horizon, I would, of course, be delighted if real estate prices are lower. This would help shift the supply function of
labour, reduce the cost of setting up new businesses, etc. But that’s more about the long-term policy changes, which would remove barriers for converting land into built-up housing, while rising vertically into the sky with FSI in Indian cities ranging from 5 to 25.
By Simon Grey, on October 26th, 2011
The United States will likely suffer the loss of its triple-A credit rating from another major rating agency by the end of this year due to concerns over the deficit, Bank of America Merrill Lynch forecasts.
The trigger would be a likely failure by Congress to agree on a credible long-term plan to cut the U.S. deficit, the bank said in a research note published on Friday.
A second downgrade — either from Moody’s or Fitch — would follow Standard & Poor’s downgrade in August on concerns about the government’s budget deficit and rising debt burden. A second loss of the country’s top credit rating would be an additional blow to the sluggish U.S. economy, Merrill said.
I wholly welcome this development for two reasons.
First, the downgrade might help politicians and voters wake up to the fundamental economic reality America faces. I don’t think the odds of this occurring in a timely manner are very good, but there having a ratings agency speak some semblance of the truth about the federal fiscal situation is certainly going to improve the odds.
Second, there is plenty of entertainment to be found in watching politicians and talking heads explain why a downgrade is just, well, wrong. The nihilist in me watches the world burn. The cynic in me enjoys watching the people who are burning explain how fire is a figment of our imagination. So, if nothing else, the inevitable downgrade at least promises to be entertaining. And, these days, you can’t ask for much more than that.
By Claus Vistesen, on October 17th, 2011
It was telling that just as the ECRI and other notable research outfits decided to push recession button on the US economy the data flow became notably more positive. This could be a sign of the times that the cycle is just too volatile for even capable analysts to call or it could simply be a blip to the otherwise fundamental issue that economic weakness is here to stay for now.
Risk asset markets however made no mince of the recent stabilisation of the euro land crisis as well as the better news flow from the US economy. Just take the following headlines from Bloomberg and you know exactly what kind of sentiment I am talking about.
Quote Bloomberg
U.S. stocks advanced, giving the Standard & Poor’s 500 Index its biggest weekly gain since July 2009, as retail sales beat economists’ estimates and the Group of 20 nations began discussions on Europe’s debt crisis.
(…)
U.S. 30-year bonds capped the longest weekly losing streak since January as concern eased that Europe is unable to curb its debt crisis and U.S. retail sales climbed, damping bets the country will fall into a recession.
The question is then whether it signals a decisive and lasting breakout or whether it was simply a rally to the top of a choppy range before we start another descend to test the lows. Recent weeks’ market movement will suggest that you sell the current levels as top of a post crash range and I, for one do not think we are out of the woods yet. It is important to emphasize two issues on the US economy when it comes to the likelihood of a recession.
Firstly, the US housing market has never recovered and inventories remain low. This means that there is not much room for the economy to slump even if it does enter a recession. Any recession is then likely to be relatively short. Secondly, all liquidity gauges we are watching are pointing strongly upwards which is likely to provide strong tailwinds for risky assets 9-12 months out. Excess global liquidity, US broad and narrow measures of money are all shooting up.
In addition, we should consider the slow but sure movements by all four major central banks to increase either the short term liquidity or simply re-starting QE.
The BOE put itself at the front of the pack with the recent addition of another bn 75 GBP worth of QE, but likewise at the ECB it was interesting to see that long term liquidity operations was re-instated together with an expansion of the covered bond purchasing programme. Additionally, the ECB has been and will continue to be more or less forced to support bonds in the periphery, particularly in Spain and Italy, in order to ring fence the periphery from the coming Greek default. In comparison, the Fed’s latest much debated Operation Twist looks almost modest since it is, by the letter of the theory, not quantitative easing but rather qualitative easing [1]. Of course, the market is fully expecting the Fed to act aggressively should the economy falter further with a joint financing programme with the Treasury for long duration mortgage products as the most likely initiative alongside the more technical move in the form of reducing interest rates on excess bank reserves to negative.
I think it is important to realise that the Fed, with its latest actions, have its gaze firmly fixed on stimulating a recovery in the US housing market which is seen as the most important missing leg in an already faltering US recovery.
In Japan, the BOJ’s situation is different in the sense that economic has been distorted by first the devastation of the earthquake and then obviously the technical recovery as supply side disruptions have eased off. I take note of the fact that the BOJ has verbally put a lot of promises on the table in terms of stimulating the economy not least, one would imagine, in relation to the ongoing strength of the JPY. Finally, it is worth pointing out that the BOJ’s balance sheet has actually expanded briskly in the past two months.
The main conclusion to draw here I think is that while it is certainly not over yet, developed market policy makers are starting to open the floodgates. The euro zone crisis will remain a severe drag and like an almost chronic illness will continue to flare up. A disorderly Greek default can still not be ruled out and as the euro zone policy makers seem to take comfort on even a second of calm it seems to me that the market will have to push harder before we get a realistic proposal for a Greek default.
The recovery in the periphery (or obvious lack thereof) is still not working. The internal devaluation in the European periphery is alive and well when it comes to nominal wage increases which is getting a beating but in the context of lingering inflation in core and headline it leads to a squeeze in real wages and further depresses the recovery. The problem is that a sharp reduction in living standards through a decline in real wages to restore competitiveness is needed but if it occurs without any form of nominal currency depreciation not to mention in the context of very sticky core inflation, it just becomes counterproductive. Absent a fiscal union to socialise the risks it is difficult to see how the euro zone policy makers will be able to come with a fudge that will satisfy markets. In that regard I agree with Chris Wood here.
Ultimately, GREED & fear’s view on all of the above remain the same. This is that the only coherent end game for Euroland remains a formal move towards collective fiscal responsibility, which would ultimately address the fundamental cause of the present crisis. This is the financial fault line represented by monetary union without fiscal union. Euroland either has to go down this path or it has to confront all the problems associated with a break up since in GREED & fear’s view there is no “middle way”
One positive development on Greece is that the private sector involvement (PSI) proposal originally envisioned seems to have been abandoned for a much more realistic haircut.
But more challenging issues remain.
It was hardly surprising that the S&P downgraded Spain last week which only serves to underline the issue that while Greece may be the imminent worry the real problem lies in Spain and quite possibly Italy. There is a limit to the amount of Italian and Spanish bonds that the ECB can buy as long as it is evidently clear that growth prospects continue to remain difficult.
In emerging markets and touching on the theme I dealt with in my last installment the recent inflation data from India indicate why I continue to think that investors may hold too high expectations for easing in big emerging markets.
Quote Bloomberg
India’s inflation exceeded 9 percent for a 10th straight month in September, maintaining pressure on the central bank to extend its record interest-rate increases.The benchmark wholesale-price index rose 9.72 percent from a year earlier after a 9.78 percent jump in August, the commerce ministry said in New Delhi today. The median of 21 estimates in a Bloomberg News survey was for a 9.75 percent increase.
Elevated inflation in India and China are crimping room for policy makers to ease monetary policy and support global growth amid Europe’s debt crisis and a faltering U.S. recovery. India’s central bank Governor Duvvuri Subbarao said yesterday that a more than 9 percent inflation is above “comfort level.”
Of course, the picture is not uniform here with notable economies such as Brazil and Indonesia already lowering interest rates but all eyes are currently on China (and secondarily India) and here I think that we will have to see stronger signs of a hard landing or a relapse into a more severe global slowdown we can expect policy makers to actively stimulate.
In summary, I think that we are indeed nearing an inflection point at which money printing in the developed world will once again provide relief to risky asset markets but the problem is that the underlying economic backdrop has not improved much. In particular, the ongoing lack of resolution in the euro zone represents an issue but Eastern Europe as well as a housing bubble in Australia (and perhaps even in Denmark) are also potential sources of uncertainty not to mention the unravelling of credit excess in China. As such, “it” is far from over but a tradable bounce in risky assets which goes beyond the current choppy range may soon represent itself.
–
[1] – The distinction between quantitative and qualitative easing is simple. The former refers to an expansion of the balance sheet through the central bank increasing its liabilities and adding a corresponding amount of assets. The latter refers to changing the composition of the asset side of the central bank’s balance sheet and as I am reading the gist of OT the Fed has committed to keep its balance sheet unchanged by selling short term bonds and buying long term bonds. Try this one for a good recap of what QE is and isn’t.
By Claus Vistesen, on September 26th, 2011
If investors were hoping that the strength of commodities was sign that decoupling, led by Asia and Latam, were running on course to help the global economy expanding, events last week must surely have extinguished such hopes. Indeed, it was always a question of commodities and emerging markets catching up to the ongoing slaughter in Europe.
Indeed, what seems to be main question now is whether the US economy will avoid a recession and, as a consequence, just how bad it has to get before the Fed starts another round of shock and awe QE. In this sense, I also always thought that expectations of emerging market foreign exchange reserves bailing out Europe and/or central banks easing aggressively to support the global economy were pinned on expectations that after all were too high.
(Quote Bloomberg)
The world’s largest emerging economies will not act as a bloc to ease Europe’s financial crisis, Russian Deputy Finance Minister Sergei Storchak said.“It’s impossible, I’m certain of that,” Storchak told reporters today in Washington. “If the BRICS are going to act to overcome the euro zone’s financial problems, then it will be based on the possibilities presented by working through the International Monetary Fund.”Finance ministry and central bank officials from Brazil, Russia, India, China and South Africa met before this week’s IMF annual meeting to discuss coordinating policy as Europe reels from a sovereign debt crisis and growth slows in the U.S. There is a “high” danger that Greece will not fulfill all of its debt obligations, Storchak said.
As for the EM tightening cycle I think that while we may certainly see an easing of pace or perhaps even a full stop of tightening measures I think a reversal is out of the question. This is especially the case as the recent strong correction in commodities and the global slowdown is likely to make inflation a non issue going forward. However, inflation lags the cycle and if the central banks are fixed on this measure it will take some time before the data allows decisive action unless of course the future is suddenly discounted in a radically different way due to rising downside risks.
In India, the tightening cycle is surely near its end with the yield curve already flat as a pancake, but with sticky inflation and fiscal policy continuously loose, there is limited scope to the central banks’ ability to maneuver.
(Quote Bloomberg)
India’s central bank is close to the end of its record series of interest-rate increases as inflation will probably slow next year, Deputy Governor Subir Gokarn said.“You could say that the cycle is nearing its end,” he said, “given the projection that inflation will start coming down and will continue to move down from December onwards.” He declined to specify when the Reserve Bank of India may stop raising rates.
Worryingly, recent news out of China appears that the country may be turning Indian or at least that the expected easing may not come as expected. Especially, it is bad news for the global economy in the near term (but perhaps good in the long run?) that Chinese authorities seem to be engineering a crack down on property developers which will not only lead to an acceptance of lower growth in order to effectively quell off balance sheet lending.
It seems that investors hoping for emerging markets to drive forward the global economy may, for the moment, be guilty of too high expectations.
By Claus Vistesen, on June 10th, 2011
Of all the permutations of growth stories, scares and soft patches investors should remember that when all is said and done, the economy and market can only do three things; move down, up or sideways. Of the three, the last state is often the most interesting and challenging since while in such a state the debate will be centered on two main themes. Firstly, the reasons for said sideways movement that broke and otherwise upward or downward trend and secondly whether the market and economy will eventually will break this sideways movement by launching a new or resuming the old trend.
As far as goes the market’s erratic movement in the first half of 2011 the immediate reason for the abrupt halt to the positive trend was the devastation of the earthquake in Japan and the subsequent (short term) slump of global equity markets. While the SP500 did have a sniff at new highs at the end of April and into May this level could not be held and we have since poodled back down below support levels.
One of the problems in the current environment is that while the immediate macroeconomic outlook is one of a slowdown, the question of whether it will turn into a more lasting double dip is more difficult to determine.
(click on charts for better viewing)
On the face of it, we should now be approaching the point at which the global economy reveals to us just what level of growth that we can expect to be “normal” and crucially; where this growth is supposed to come from.
What might be starting to creep up on investors’ screen is that the answer to the question above might not be what they anticipated.
On the basis of the data I am looking at, the upward momentum of global leading indicators peaked a year ago (in Q4-09) and momentum has since steadily declined to reflect growth returning to “normal” after the sharp recovery following the global financial crisis. The most recent soft patch in the middle of 2010 gave way to a rebound, but the key is whether the recent relative decline in growth momentum is a messenger of a more sustained downturn or simply another so-called mid cycle soft patch. OECD’s leading indicators point to a definite slowdown but also to a rebound towards the end of the year. The main point really is one of divergence between economies.
In Europe it has become almost unbearably painful to watch the charade which surrounds the slowmotion default in Greece and the frantic attempts by policy makers to suggest that all is well and the next loan tranche is coming. Everyone can understand why politicians, of all people, should not give way to short term panic and whims of the market but we are way past the point of no return and we need a credible long term solution to not only Greece but indeed the debt overhang in the entire so-called periphery.
Not surprisingly, the macroeconomic backdrop of the ongoing fiddling while Rome (or was that Athens or Madrid?) burns is deteriorating. Morgan Stanley recently noted then that;
We see increasing evidence that the euro area business cycle has reached a turning-point. This verdict comes very clearly from our Surprise Gap Index, which plunged deep into negative territory in May. Our Surprise Gap Index is our long-standing favourite proprietary indicator to pick out the turning points in the euro area business cycle.
My only quibble would be that some economies in the Eurozone never experienced an upturn in the first place. It must now be clear for everyone that choosing to put faith entirely in a process of internal devaluation with little or no additional help from the ECB (and even interest rate hikes to boot) has put us in a situation which is far more dangerous than the one we set off from.
A sovereign default was always going to be costly and the main channel of transmission to the real economy will the capital shortfall at banks and who essentially should pay to recapitalise them. Yet, the continuing steadfast position that any form of restructuring is out of the question pushed us further towards the point where events overtake policy makers to such an extent as to foster a collapse of sentiment and trust which will ricochet far beyond the growing queues in front of Athens’ banks.
In emerging markets, growth will remain strong but policy makers in key countries such as India and China have grown weary over inflation and especially in the former seems to be content on accepting short and perhaps even medium term slowdowns in order to tackle inflation. There is no risk of a recession in emerging markets (and thus the global economy) at this point but any slowdown in emerging markets will be an important litmus test for the developed world and thus just how dependent we may now be on a continuing expansion in the so-called developing world.
Even in the face of mounting inflation problems as a result of importing low interest rates from the US I remain constructive on emerging markets and especially on China. Quite simply, I am working under the assumption that while authorities may move clamp down on inflation and excess growth in credit the main bias is thoroughly towards letting the boom continue. If I see signs that this assumption may be wrong I will duly change my views, but so far so good.
But the real issue which may decide whether sideways movement in growth and market returns gives way to continued upside or renewed downside is what happens in the US and specifically, whether the Fed is readying a new round of QE3.
Priming the Pumps for a New Round of QE?
Bernanke is famously on record for linking success of QE to the ongoing strength in the stock market and while I have myself given support to this notion on the basis of simple empirical fact that the wealth effect seems to be increasing over time, it is the effect on the real economy we should rather be focusing on. John P. Hussman recently posed the following simple question;
My intent is not to argue strongly that the economy cannot continue to expand as fiscal and monetary stimulus comes off, but instead to at least ask why this should be expected as a foregone conclusion. On the basis of leading indices of economic activity, we observe more indications of economic slowing worldwide than we observe growth. Moreover, strong periods of employment growth have historically been preceded by high, not low, real interest rates. This is far from a perfect relationship, but it is clear that historically, high real interest rates are far more indicative of strong demand for credit, new investment, and new employment than low real interest rates are.
We will never know what kind of independent momentum the economy in the US (or elsewhere) is able to maintain without actually pulling back stimulus, but the question is whether now is the time to take the chance.
The question of further QE would seem to currently be a mute point. Almost all analysts I have been reading and the general message droning in off the wires of Bloomberg and CNBC is that QE3 won’t happen. Recently, I watched a small clip in which chief economist at Goldman O’Neill simply noted that there wouldn’t be QE3 because there was no need for it. In a recent post at his new blog my friend Edward Hugh also parses the entrails of the potentials of QE3 and while some analysts are beginning to pencil in the prospects of another round of QE it seems that it is a much more difficult call this time around.
For example he quotes a recent analysis by BNP Paribas;
“With equities, credit and commodities all continuing to trade in a range disconnected from weaker economic realities being transmitted via surveys, hard data and the interest rate markets, we arrive at the same conclusion as we have over the last month, primarily that financial assets are fully expecting further quantitative easing if the need arises”.
This would seem to be reasonable conclusion and essentially stipulates how the break down of any sideways trend would be contingent on whether the Fed decided to provide a further dose of QE. However, I reiterate that the general sentiment I get is that the current slowdown is different and that no further QE is needed. A lot here obviously depends on how believe inflation and inflation expectations to evolve. Edward quotes analysts noting that since the labour market is improving, core inflation edging up as well as inflation expectations taking off from sub-zero deflation territory QE3 is not needed. Yet, as I say, none of this is clear cut. Here is Edward;
Really I don’t buy these latter two arguments, and I don’t buy them for a number of reasons (I am not sure inflation expectations won’t be coming down, indeed I don’t see why they shouldn’t), but number one among them would be the danger of “event risk” in Europe. Basically it is important to understand the global mechanisms that are at work here, and the global implications of local decisions. If the global economy has been growing reasonably well over the last six months it is because what Nouriel Roubini once called a “wall of liquidity” is seeping out of the United States, where solvent domestic demand for credit is flat and will remain flat due to the private indebtedness problem (remember US “over consumption” (the high proportion of GDP which has been consumption driven) has only been the mirror image of Chinese “over investment” and we that live in a world which badly needs to rebalance).
This argument is interesting to consider in itself in the sense that it suggests how the mechanism by which carry trade flows funded in USD has been the main source of the incipient global recovery. The flipside to this argument obviously is that the continuing ultra loose liquidity adds considerable volatility to commodity prices which, in itself, is detrimental to growth. In addition, strong surges of headline inflation may also lead to stagflation which is evident e.g. in the UK.
The main issue however is that that the data in the US is turning sour and the housing market has not yet made it to the party. This week’s job report was poor and, apart from an improving trade deficit, a faint hue of gloominess is returning to the US economy. But, are we looking at a real recession risk? The data I am looking at and the, after all, still positive momentum of leading indicators suggests no and I am moving in behind a general consensus. Hussman synthesizes the main position in his latest column;
In recent weeks, and particularly in last week’s ISM, employment claims and unemployment reports, we’ve observed a substantial weakening in measures of economic growth. At present, the evidence of economic deterioration is not severe – as I noted in 2000, 2007 and last summer, recession evidence is best obtained from a syndrome of conditions, including the behavior of the yield curve, credit spreads, stock prices, production, and employment growth. While all of these components have weakened, they have not deteriorated to the extent that has (always) accompanied the onset of recessions.
So far, so good then. I would reiterate the point on the ISM indices which have turned decisively down lately with especially the manufacturing ISM shifting down considerably both in terms of the coincident activity index and new orders. The same goes for the non-manufacturing ISM which even eeked out a bright spot in May with an increase in the new orders component.
The latest from Morgan Stanley’s Gerald Minack also suggests that we should be sanguine on the US economy going into the second half of 2011 even if he merely postpones the deflation/growth scare 6 months.
Investors again are worried about the expansion faltering. However, better second-half growth data – notably, in the U.S. – should help risk assets, particularly DM equities. The 2012 outlook remains problematic, however, with growth set to slow in most major blocs, bar the special case of Japan.
All this then seems to indicate that while the Fed certainly will be committed to low interest rates it might be more difficult for investors to genuinely expect a new round of full fledged QE3. This should also be seen in the context of the ongoing debate of whether QE works at all and whether the associated volatility in commodity prices is worth it. In his recent column Hussman puts his thumbs down;
Rather, the policy [QE] has failed because it focused on easing constraints (bank reserves, short-term interest rates) that weren’t binding in the first place. Very simply, neither the Fed’s policy, nor the fiscal policy initiatives to date, address the central challenge that the U.S. economy faces, which is the debt burden on households.
This raises the central question of just what policy tools that should be applied in the context of a (global) balance sheet recession baring the case in which one simply lets the economy spiral into debt deflation and eventual widespread private and sovereign defaults. One obvious solution would be give some form of debt relief on a national scale and then let Fed re-capitalise the financial sector through equity or debt purchases, but just how much would be needed and what would this imply in terms of the Fed becoming an owner of capital rather than a custodian of the Greenback and its value. Besides, this solution has been tried in Ireland where it was merely the government who assumed a guarantee of its bad banks only then to have neatly forgotten the fact that monetary policy (and thus the ability to actually hone up to the guarantee through issuance of liabilities (i.e. currency)) had been ceded to Frankfurt a long time ago. The US naturally would be in a different situation but it would require the Fed to drastically shifts its QE towards private sector securities rather than government bonds.
James Hamilton is also lukewarm regarding the end of QE2 for the same reasons as Hussman. The basic message is that QE2 has only had a modest effect, but also more importantly that the Fed can not be expected to exert much of an effect in the first place. While this may be true Hamilton does point us towards one key point which relates to the fact that although the Fed might not actually be starting off a new round of Treasury purchases, this does not mean that the Fed’s balance sheet will actually shrink.
A more technical issue then is another hotly debated question in relation to who the marginal buyer of treasury bonds will be once the Fed steps back from the fray. The interesting thing about the effect of QE is that while one would expect QE to help keep a lid on yields, the opposite has actually occured as e.g. QE2 has led to an increase in yields (which now looks about to reverse) on the back of the improving economic outlook. Conversely, one should then expect yields to go down (to reflect expectations of lower inflation?) as QE2 tapers off.
According to Morgan Stanley’s David Greenlaw and absent the Fed as a marginal buyer the US Treasury will need, once again, to call upon an old faithful buyer.
Given that Treasury issuance is expected to continue at an extremely elevated clip for the foreseeable future, how will the market adjust to the loss of most Fed buying? In other words, who will be the marginal buyer of Treasuries going forward? Our analysis suggests that heavy buying by the largest foreign holders of Treasuries will be needed to avoid a back-up in yields.
Indeed, on this reading the end of QE2 looks very significant indeed.
I would re-emphasize here that despite Greenlaw’s main argument that there is little scope for further purchases by domestic actors a steadily deteriorating macroeconomic landscape should be bullish for treasuries all things equal, but I concur that without the Fed the market may start to get a little more attached to the supply side story.
On balance it would then seem that the consensus remains weighed towards no QE3 either because it is not needed or because it does not work in the first place. I think it is very simple in the end though. If sideways movement gives way to a new downside in the market below key support levels it will be very easy for the Fed to argue for a new round of QE which I will they will deliver in due time.
By Claus Vistesen, on February 14th, 2011
One of the main investment and trading themes crystallised during Q4-10 was the move out of emerging markets and into developed markets. As all themes, it started as a contrarian misfit moving against the truck loads of capital piling into emerging markets but has now reached its mature state flapping its wings as a beautiful butterfly and the main investment theme du jour. We know this because the Economist devoted a piece to it in their latest print edition;
(quote, the Economist)
One reason to look elsewhere is that Western economies’ prospects look sunnier than they did a few months ago. American consumer confidence has rebounded more quickly than expected, for instance. Much of the money that has come out of emerging economies has gone straight into developed markets, in what Michael Hartnett at Bank of America Merrill Lynch has dubbed the “Great Rotation”. Rich-world stockmarkets may also be the big beneficiaries of reallocation by fixed-income investors who believe that the bull run in bonds is over, says Nick Smithie of UBS.
The obvious question is whether it is too late to join the party now that the story has hit the mainstream press. The trend following crowd would doubtlessly argue for you to jump the bandwagon.
In so far as goes the idea that the relationship between emerging markets and developed markets should be enjoying an equal share of the excess liquidity sloshing around, there is certainly plenty of scope for further out performance of the developed markets. This notion is supported I think by the fact that the overall emerging market index has only recently started to correct downwards (in the aggregate). This is in contrast to the canary in the coal mine in the form of India whose equity markets have been resolutely hammered so far in 2011. This is perfectly predictable since India runs a current account deficit and is largely funded by short term maturity inflows.
I would even venture as far as to call it the revenge of text book economics as the current state of affairs fits very well into the (fairy)tale taught on international finance programs of the benefits of international diversification. A fully diversified international investor would thus currently be sporting a nice gain on any stock holdings in developed markets (in the US in particular). Indeed, if the main story of the post financial crisis world has been that of impaired monetary transmission mechanisms in the US and thus how Bernanke’s free money flowed towards emerging markets, it seems as it has been temporarily restored.
Or has it?
It is precisely this meltup which has emerging market central banks scrambling to cool down their economies and which has currently set a vicious circle in motion for EM risky assets. Higher inflation in itself is detrimental to economic activity and as higher activity leads to higher interest rate/tightening expectations which again leads to lower economic activity. Within this circle the dilemma persists. How do you cool down your economy when raising interest rates runs the risk of attracting even more yield hungry capital? Turkey recently lowered interest rates and while everyone seems to be talking about the Indian central bank being behind the curve I think it is deliberately pursuing this strategy as it knows how raising interest rates may not be consistent with its objectives.
I for one was quite worried to hear Bernanke openly admit that the main criteria of success of QE2 is the fact that the stock market is going up. My view of the Fed policies is that they are trying to put weight against what they see as an inevitable and long process of deleveraging in the domestic economy and that this deleveraging is best dealt with in the face of rising risky assets (which is obviously de facto true in the US with a strong wealth effect from rising stock prices). I believe that the Fed is right to pursue extraordinary policies, but by marrying himself to the stock market Bernanke is playing a game he cannot win.
The main effect of QE2 was always to bid up commodities and risky assets across the board and together with a number of adverse supply shocks in the agricultural sector we are looking at a nasty meltup in 2011. I think that the current goldilocks recovery in the US supported by no imminent threat of interest rate hikes by the Fed (no matter the benevolence of the data!) is bullish for US stocks, but nothing goes up for ever and technically we have been on the brink of a correction for a long time.
If we manage to blow off some steam from the US stock markets, I think it will be a good idea to sling shot your way onto the developed market out performance theme, but for god’s sake do not buy US beta for the long term at these levels!
TMM remind us that even with consensus trades, there is a limit to the degree of love and trend following.
As for DM Equities, we are just soooooo wanting them to fall over, having been on the bull bandwagon for so long, it’s time to switch allegiance and play for a move down… How far? Not sure yet and we’ll play that by ear, but new highs will have us out.
Perhaps spoken of one who would be able to take profit on a long DM position, but also an astute warning to those about to jump in the pool.
In this vein allow me to offer the contrarian perspective on the current consensus trade;
Look to build emerging market exposure in your long term investment portfolios
Chris Wood who pens the indispensable Greed and Fear for CLSA puts it very well;
With so much money invested in markets like India and Indonesia last year, there is clearly the potential for more selling on a flow of funds basis whatever the fundamentals. Still GREED & fear remains of the view that one of the most interesting opportunities provided by the present inflation scare will be for investors to buy the likes of India and Indonesia at significantly lower levels.
If 2011 turns out to be marred in a nasty meltup of headline inflation, emerging markets will suffer much more. Wood notes India and Indonesia where I have my eyes firmly fixed on the former for some stock pickings. But even by buying into beta at good levels, I think you can secure some nice future returns on that pension portfolio. Actually, this is a prime lesson in the difference between trading and investing for the average retail parasite.
What happened last time we saw developed market out peformance?
Looking at the chart above the astute investor will immediately note that the last time we saw significant out performance of the developed market sector, it coincided with a sharp drop in global equity prices (you know, the crisis and all). Now things are obviously different you might plead. We are in a nascent recovery and global equity markets are powering ahead even as emerging markets struggle no doubt much to the pleasure of authors of finance text books.
However, it is quite easy to build the case for a very sinister hoax played on international investors piling into the broad based recovery story. Thus, I don’t think that the global monetary tranmission mechanism has changed. Structurally, we still have to much capital chasing to little yield and while it should favor emerging markets in the long run it adds volatility their business cycle and thus the global business cycle too. The main worry at the moment in this respect is the prospects of a hard landing in China which would have strong global effects. In this sense, if the emerging markets experience a hard landing it stands to reason that it will be a global one too, de-coupling runs two ways!
This then becomes an argument for reducing the blind exposure to the QE2 punt and the goldilocks US recovery.
Remember the Fundamentals
Despite the current surge in headline inflation the main challenge for developed markets which remains fundamentally unsolved is how to generate growth while simultaneously consolidating public finances. The Eurozone periphery is merely a taste of fundamental problems to come. The recent fiscal monitor by the IMF should put a scare into even the most ardent bull;
Despite the improving global outlook, the pace of fiscal consolidation this year is slowing in some key countries. The United States and Japan are adopting new stimulus measures and delaying consolidation relative to the pace envisaged in the November 2010 Fiscal Monitor. The underlying fiscal outlook has also weakened in some emerging markets—among them are several that need to build larger fiscal buffers, particularly in the face of surging capital inflows, overheating, and possible contagion from advanced countries. By contrast, advanced economies in Europe are projected to continue tightening policies amid heightened market scrutiny in several countries. Altogether, sovereign risks remain elevated and in some cases have increased since November, underlining the need for more robust and specific medium-term consolidation plans.
I am not sure the IMF really knows what it is they are saying here, but go to the two charts in the blog post by Carlo Cottarelli and notice that advanced economies are to consolidate less than expected in 2011. Obviously, this is unsustainble but the flip side of this argument (and something I’d wish the wise people at the IMF would push stronger) is that national governments are waking up to the cruel reality that without fiscal stimuli there will be no growth. Indeed, some politicians will have to navigate an environment where the absense of continuing support by fiscal spending (financed by the central bank or domestic savings) is the only source of growth until some form of export apparatus might be put in place if at all. Allow me to repeat myself for the umpteenth time.
What happens once it dawns on investors that the trend growth rate in many OECD economies is negative absent fiscal deficits? Indeed, what happens when everyone realises that the only way to survive is to export and build a strong net foreign asset position?
I believe that this fact as it will reveal itself moving forward will have wide implications for sovereign debt and global growth dynamics. And while the time may not be now, it also implies a wholly different approach to the recent out performance of developed markets even if this particular theme, as a trade, may still have some time to run in 2011.
By Thomas Knapp, on January 18th, 2011
To whom it may concern:
The United States Congress is currently engaged in one of its periodic debates over raising the “debt ceiling” (the total amount of money it “allows” itself to be in debt for).
I’m nearly 100% certain that Congress will “allow” itself to borrow more money.
If you’re thinking about loaning them some of that money, though, you might want to reconsider.
The collateral underlying US government debt is the notion that I’ll pay you back the money they borrowed.
Three words: Ain’t Gonna Happen.
If 435 US Representatives, 100 US Senators and a US President borrow money from you, then so far as I’m concerned they’re the ones who get to pay you back.
Those 536 individuals are already extended to the tune of $14 trillion, or (math in my head time) somewhere in the general neighborhood of $25 billion each.
If you think that those 536 people have, on average, assets worth in excess of $25 billion to collateralize/cover their existing debt, with stuff left over to make you comfortable that they’ll pay back new debt, by all means loan them all the money you’re comfortable loaning them.
If you think I’m going to pick up their check, though, let me repeat myself, just so you can’t claim later that you were unaware of it: Ain’t Gonna Happen. I didn’t borrow the money, they did. I’m not going to pay it back, which means that either they’re going to have to pay it back themselves or that it isn’t going to be paid back (three guesses which one).
So you might want to look into legitimate investment opportunities instead of the US government’s fly-by-night scams. I’m just sayin’ …
By Claus Vistesen, on December 15th, 2010
I did have some plans to do a series of post to give a brief overview of my main macro and trade themes for 2011, but time has, not surprisingly, caught up with me. As such, you will have to make due with a special version of random shots.
Risky Assets to fly in 2011? – This one is a bit too general to answer in full of course, but one interesting discourse that has emerged lately is that as bond vigilantes are feasting on the Eurozone (and even going for an altogether larger prey in the US), investors are being pushed into equities.
Following a well worn cliché in the world of finance, equities is the least ugly alternative.
Now, this may only be a working explanation on the surface since the underlying move into equities is also part of a more structural consequence of QE2 since the Fed is not only trying to move investors around on the yield curve, they are also trying to move them out of the curve altogether and into more risky alternatives. In this sense, what appears to be a melt up in equities might just be a slow but steady excess liquidity driven grind. Surely, Bernanke is in no rush to raise interest rates in 2011 and if the US economy continues to slowly heal, there will be only speed bumps ahead of a general trend upwards. One interesting thing here will be how the market reacts to event the slightest hawkish tone from the Fed or perhaps even a downtoning of the dovish stance. I think; not all too well but precisely because of this assumption (which I think many share with me), the Fed will remain uber dovish as far ahead as the eye can see.
Technically, I think the melt up towards the end year is in for a rude stop in the beginning of the year and I have the SP500 declining to about 1180-1190 in January. This would then provide a potentially tasty entry point for a 2011 rally. Other than a veritable cataclysm in the Eurozone (which appears the main source of systemic risk at the moment) and China suddenly slamming on the breaks in an unduly harsh manner, I see little resistance for risky assets in 2011. This is especially the case as the BOJ and the ECB will likely add their interpretation of “QE2″ to the table to respond to the ongoing sluggishness of their respective economies.
We have already gotten a barrage of 2011 predictions and outlooks from research houses, banks and other financial sages and quite frankly it is quite difficult to get a bearing on it all. I did find the Barclay Macro survey quite interesting though as it shows that about 70% of all investors see risky assets in the form of commodities and equities to outperform in 2011 while US treasuries will underperform. The underlying rationale is again quite simple I think. Given the severity of the crisis, monetary policy will tend to apply the brakes with a considerable lag and if 2010 saw the first signs of the effect of such a lag, 2011 could give us the full force. Again, this is especially important to note as the ECB and the BOJ might just be about to join the party.
On the other hand, “underperforming treasuries” will also present Bernanke with a dilemma in the sense that the extent to which the infamous bond vigilantes fancy more than a pot shot on US bonds he may be forced to apply even more pressure to keep yields low.
Low Growth in the OECD – This one is hardly news and hardly one exclusively for 2011 either. However, I still think there is a lack of recognition of just how low growth in the OECD is likely to come in for the coming years. In this way and just as investors have their focus set on outperformance in Asia and Latin America, I think that the ultimate growth outcome in the OECD will be worse than the market currently expects.
The point I am basically getting at is that we need to think about the fact that the Eurozone periphery essentially are going to be hampered by negative trend growth rates and that the rest of the OECD will be dependent on exports to grow (think mainly Germany, Japan and now also the US). Apart from any productivity miracle or some other exogenous source of growth, the growth engines in the OECD are simply tapped out. Indeed, this is probably the most important structural macro theme for me at the moment.
Now as for 2011, a lot of this will also depend on whether economies really intend to walk the walk in terms of fiscal tightening or whether they are simply talking. Clearly, countries under the spotlight in the form of the Eurozone periphery will see their growth rates severely dented by the need to consolidate public finances. In the US on the other hand, I think the latest estimate for the 2011 budget deficit is 10% of GDP which is hardly tight.
According to the IMF’s latest forecasts “Advanced Economies” will be running a deficit on the structural balance to the tune of 5% in 2011 and the G7 as a whole one of 5.88%.
But all this only goes to accentuate the issue since if there is one thing we have learned by now it is that one cannot borrow ad infinitum and especially not as you are essentially borrowing against a depreciating asset in the form of future growth held down by population ageing. So the big (as in biig!) question is; if you substract the 5% government spending induced deficit from the equation what kind of trend growth rate is left in the OECD as a whole?
Clearly, we know that some economies are now basically saddled with negative trend growth rates, but I think that even the aggregate number in advanced economies would be scary reading. We could call this decoupling in reverse and thus how vulnerable we now are to the continuing growth spurt of Asia and other so called emerging economies. But in the end, it is a basic question of not having any more components of the national identity to lever up as it is obviously clear that governments are only going to find it increasingly difficult to borrow (even in the case of very generous central banks).
Indeed, as we move forward I see this low growth environment for the OECD (and actual negative trend growth in some economies) as one of the main components in my call that we are going to see some spectacular and costly sovereign defaults in the OECD edifice going forward. On this, I think the current mess in the Eurozone is only the beginning.
The Euro and the Eurozone - Actually, I have not followed FX a lot lately so I am a bit of out form here, but I still use my Old Maid metaphor when thinking about big global currency movements and intra G3 movements especially. Interestingly, 2010 saw the JPY as a looser and thus holder of Old Maid in the sense that it appreciated significantly against the USD and Euro. In essence, the USD was being held down by the Fed’s policies and the Euro actually acted as a nice buffer against the crisis in the Eurozone as it fell strongly throughout the spurts of Eurozone tension in turn providing a much needed boost to external competitiveness when it was needed the most.
In principal, these trends do not stop at year end and will continue to dominate at least part of the intra G3 movements in 2011. The main question is what kind of bazooka, if any, the BOJ will pull out to revive the ailing Japanese economy. If it becomes the kind of shock and awe many are expecting we could be into a nasty long squeeze in the JPY. This also goes for the Euro in the context of the ECB being forced, kicking and screaming, into supporting Eurozone bond markets. I hold this to be almost given since the current setup simply does not work.
Today, Trichet called for more bold action on the fiscal front and in terms of capitalising the stability front (didn’t he just tell them to tighten their belts?). This is no doubt part of a futile attempt to preempt any defacto query, to the ECB, by part of the EU on taking an active and open role in the bailout. Trichet and his compadres are not going to like it, but the alternative asking Italy and Greece to pay for the bailout of Spain who in turn helped finance Greece and Ireland is simply hogwash.
As I have noted on several occasions; should the issue turn out to be contained with Greece, Ireland and Portugal the fiscal solution/stability fund would suffice, but evidently we are looking at a much more structurally problematic issue and Spain is surely next in line and even yields on German and Belgium bonds have begun to break loose. As such, it is becoming increasingly clear that the ECB will have to take a more active part beyond “simply” supplying liquidity to the banking system and buying bonds on the drip (or covertly).
I tend to have little opinion on the EUR/USD in general, but I will timidly forward the idea that we can expect the ECB to surprise with some of open support to the periphery, it should provide some pressure on the single currency. Yet, it is also fair to assume that the extent to which risky assets fly in a bath of excess liquidity the USD will depreciate and the Eurozone will gain on carry flows as interest rates are still higher in the Eurozone (especially, if things get so calm that the ECB starts turning hawkish again, but this may be selfdefeating in itself of course).
Emerging Markets – Well, the EM story is important enough to merit its own section even if it is intimately tied to the risky asset story. Yet, there is no need to re-invent the wheel and in this sense I think that Morgan Stanley’s Manoj Pradhan’s recent note on the 2011 EM outlook is pretty much accurate in all the important areas.
Especially his first point is important on structural outperformance by the EM relative to the developed world whereas 2011 should see EM growth cooling and, hopefully, growth in the developed world nudging up. As such, 2011 will see relative outperformance by developed markets. This is a bold, but also astute, call. It is bold because I think the link between the EM and DM is still too strong to see DM growth decouple entirely for a relative slowdown in emerging markets. In this sense, how far and how fast monetary policy in emerging markets are tightened in response to fears of overheating will be key. It is astute because, all things point in the direction of a slowdown in the emerging world after a breakneck 2009 and 2010 and in this sense, on the margin, perhaps the developed world is the place to be in 2011 on a tactical basis.
I also like that he spends some time on the inevitable, but important, process of rebalancing away from a reliance of an overlevered Anglo-Saxon consumer in the OECD (and of course, a now cracked Eurozone periphery). Reverse decoupling and rebalancing towards the emerging markets are two of the main global discourses and real economic drivers at the moment.
Finally, I think it is also important to re-emphazise the basic problems emerging markets face as they try to cool their economies through higher interest rates only to allow more hot money flowing in. The policy mixture is obviously being developed as we move along with some form of capital controls being implemented across the board. In a world of structural excess liquidity this policy dilemma becomes an additional issue on top of the more traditionally discussed trilemma.
As such, I am large cautious on the emerging markets going into 2011 as I think they are overloved, but the long term bull call stands uncontested. In addition, there appears to be general acceptance and expectation that key emerging economies (China most notably) will react strongly to any lingering signs of overheating and just as Bernanke might not care that his low interest rates will fuel asset bubbles far from the shores of the US, so may Chinese policy makers care very little if they have to slam on the brakes to the detriment of global growth and OECD’s recovery.
By Doug Gentry, on December 3rd, 2010
Each year The Economist magazine publishes one of my favorite economic indicators – the Big Mac Index. This year The Economist said,
Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar.
 Here’s the background. First the theory. In a world of freely floating currency exchange rates, those rates will adjust over time so that a commodity costs the same anywhere in the world. This is called purchasing power parity. An example: Imagine that Brazil finds some way to sell sugar on the global market at a much lower price than everyone else. Right away sugar buyers can buy more sugar with their own currency from Brazil than anywhere else in the world. This will substantially increase Brazil’s exports.
Now, we also know that if a country’s exports increase significantly their currency will increase in value on the international currency market. That is because all these purchases of Brazilian sugar will increase demand for the Brazilian real. As the value of the real rises Brazilian sugar becomes more expensive to foreign buyers – their own, local currency can’t buy as many real as before. At the same time other sugar exporters may see a slight decrease in the value of their currencies, as sugar buyers switch to Brazil. Over time international currency exchange rates will adjust so that a sugar buyer will be able to buy the same amount of sugar anywhere in the world. That’s the theory of purchasing power parity. We know that currency rates don’t float perfectly, and in some cases countries seek to influence the value of their currencies. Enter the Big Mac Index.
A number of years ago staffers from The Economist decided to test purchasing power parity (PPP). Rather than using a boring commodity like sugar, they looked at Big Macs, from McDonalds. Big Macs are as close to a commodity at the definition allows – virtually identical everywhere. They recorded the price of Big Macs in scores of countries, converted those prices to dollars and tested the PPP theory. The results showed a wide range of prices for Big Macs.
Now, these results could disprove the PPP theory. Instead, The Economist staffers maintained that PPP was true, and that various countries’ currencies were either over-valued or under-valued. Let’s use China as an example. Earlier this year a Big Mac cost $3.58 in the United States, but only $1.83 in China (after converting yuan to dollars). If PPP is true, then China’s currency is under-valued by almost 50 percent. And, in fact, there is considerable angst in the international community about China’s efforts to artificially lower the value of its own currency in order to protect its huge export market and supporting industries.
Economists love to forecast, and yet have a very mixed record of success with their forecasting. The Big Mac Index can be used as a rough forecasting tool. In the March, 2010 article the Euro was 29% over-valued. Over the last six months the Euro has declined in value against the U.S. – just what the Big Mac Index would predict.
Who says economists don’t have fun?
By Emmanuel Tabones, on November 15th, 2010
There is a scene in Book XXI, Chapter IV, of Sir Thomas Mallory’s Le Morte D’Arthur,” which described how King Arthur waged his final battle with Sir Mordred, concluding with the utter destruction of both their armies, and leaving the latter surviving, alone. Meanwhile, the monarch still had two knights left, Sir Lucan and Sir Bedivere, though they were both “sorely wounded.” Sir Lucan pleaded with the king not to continue the conflict any further, reminding him that he had “won the field” that day. But Arthur would have none of that as he was determined to exact final revenge, at whatever cost. Readers all know what happened next because of his fateful decision.
This all came to mind as I read a recent question posted in the Wall Street Journal’s online “Journal Community” section:
Should the U.S. and other countries risk a trade war with China over the valuation of the yuan?
Alas, it is just another way of saying, should the U.S. and like-minded countries risk mutually assured destruction in order to fix what others refer to as a non-existent problem, or at worst, one that is overblown. We could all simply end up like King Arthur.
As economist Walter E. Williams noted in his excellent article entitled, “Our Trade Deficit (May 25, 2005):” “I buy more from my grocer than he buys from me, and I bet it’s the same with you and your grocer. That means we have a trade deficit with our grocers. Does our perpetual grocer trade deficit portend doom?”
Of course not, I say, but as Dr. Williams had observed, this example illustrates that there is more to the issue than those seemingly frightening deficit figures used by certain “pundits and politicians” to scare the general public, and there are a fair number of such fear mongers these days, both from the political right and left, whether we refer to Pat Buchanan, Lou Dobbs, as well as former congressman Richard Gephardt, current U.S. Senator Sherrod Brown (D-Ohio), and a host of others.
However, judging from the lopsided poll results and angry posts in support of trade war, these respondents and other, similarly outraged individuals, have largely ignored the thoughtful and sensible pronouncements of people like Dr. Williams. Yes, these folks have certainly worked themselves up to a similar, “to hell with the consequences” frenzy, and the U.S. Federal Reserve’s new initiative, known as QE2, is largely influenced by these same views. Fortunately, saner heads seem have to have prevailed at the recent G20 summit, with the general consensus rejecting American efforts to pressure China to relax tight controls on its currency. Yet, that hardly resolved any major issues, leaving the prospect of trade war hanging over everyone’s heads like a dreaded “Sword of Damocles.” More importantly, the United States has simply incurred the opposition of trading partners such as Germany (not to mention China) for this seemingly reckless monetary policy aimed at further bringing down the value of the U.S. currency, all in the name of “stimulating the U.S. economy and creating jobs.”
Gee, if only things were that simple and not fraught with risks, such as the likelihood of causing a dramatic rise in inflation, especially in the price of commodities like petroleum products. With the continued deterioration of the U.S. dollar, we may very well see oil prices again rise north of USD $100 per barrel, perhaps as early as 2011. The Obama administration is probably betting that many Americans (especially those who actively participate as voters) are not savvy enough to know the connection, and unfortunately, that may very well be the case. Maybe people will finally figure it out once oil hits USD $200, with inflation raging at 20 percent.
Meanwhile, I doubt President Obama fooled anyone with his insistence that QE2 was “not meant to deliberately weaken the U.S. dollar,” as reported by Ben Feller of AP and others. It also appeared that the Fed was not fully prepared for international reaction, especially with countries getting ready to, or having imposed additional financial regulations meant to blunt the intended effects of QE2. Nowadays, I am increasingly convinced that Bernanke and his people are losing their grip on economic, global reality.
With this unfortunate and largely misleading political perception that America’s high unemployment rate is directly linked to its massive U.S. trade imbalance, and with increasing demands to impose trade barriers, other nations could likely respond in kind, which could bring us to a SH2 (Smoot-Hawley 2) type scenario and an economic nightmare that could reduce global trade dramatically and bring about massive, worldwide unemployment not seen since the Great Depression. As the philosopher George Santayana was quoted as saying, “Those who do not learn from history, are doomed to repeat it.”
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