Kiron Sarkar: Summarizing Developments

Summarised below are some of the key events last week.

• Mrs Yellen confirmed her dovish bias during the course of her testimony ahead of her appointment as Chairperson of the FED –  which looks very likely. She stressed that “labour markets and the economy (are) performing short of their potential”, adding that unemployment “was still too high”. Furthermore, she added that  “It’s important not to remove support when the recovery is fragile”. In the Q&A’s she suggested that the true level of unemployment in the US was likely over 10%, as opposed to the 7.3% rate in the Octobers non farm payroll (NFP) report. She added that inflation was below the FED’s threshold of 2.0% and implied that she did not see inflation as a threat at present. In addition, she stated that she did not see any bubbles forming. Essentially, she stuck to the Bernanke script. Her general tone was dovish, especially in the Q&A’s, which suggests that she will be in no hurry to start the tapering process early, preferring to see the US recovery further embedded before the FED tightens monetary policy. The markets took her remarks positively and rose, with the DOW and the S&P closing at record highs. As long as she can persuade her colleagues, I continue to believe that tapering will not start before March of next year – indeed, there is an outside chance that it may be delayed even further. The November NFP report will be scrutinised very carefully.

• Japanese Q3 GDP declined to +1.9% on an annualised basis, down from +3.8% in Q2, mainly due to a widening trade deficit, together with lower capital expenditure. Consumption was also relatively weak – Japanese companies have not increased salaries and wages, which suggests that consumption will weaken further as inflation rises due to the weakening Yen. The value of exports were higher, but in volume terms, marginally lower. The Yen declined to over 100 against the US$ and importantly, over 135 against the Euro. Mr Kuroda defined  the 2.0% inflation target as a “sustainable target”, which suggests that the BoJ may well ramp up its bond buying programme. If inflation rises to 2.0%, how can 10 year Japanese bonds yield just  0.62%, as they do at present. Yes, the majority of Japanese bonds are owned by the Japanese, but will they continue to buy bonds which yield well below prevailing inflation – I doubt it. That suggests that the BoJ will be the only major buyer of government bonds. It is clear that the BoJ is pressing for a weaker Yen, combined with much higher inflation, to reduce the level of accumulated debt. However, the Japanese government has not pursued the structural changes that are necessary to revitalise its economy. As we all know, Japan’s fiscal position is dire. The only conclusion that I can draw is that the BoJ is set to monetise Japanese debt. However, will other countries sit back and watch the Yen depreciate materially. I very much doubt it. Clearly, the Nikkei is responding positively to the weaker Yen, though investors will have to hedge against the currency depreciation. I expect the Yen will weaken further. I have been a sceptic of “Abenomics” and remain so. Furthermore, I believe that a number of countries will begin to criticise the policy to devalue the Yen. The issue of competitive devaluations looks set to return.

• The Chinese official news agency released details of the policy objectives agreed by the Party at their recent meeting. Generally, they included a number of reforms that are welcome and, indeed, necessary to rebalance the Chinese economy by encouraging domestic consumption, whilst relying less on fixed asset expenditure. The 1 child policy is to be loosed somewhat. There was some relaxation of the Hukou system which limits internal migration. SOE’s are to give up more of their profits to build social infrastructure. There was also a reference to property taxes and the ability of the rural community to have more property rights. In addition, the PBoC is to deepen the reforms and open up the financial sector. Currency convertibility was mentioned. The key message was that China would allow markets a more “decisive” role in allocating resources. The main issue, however,  is whether these broad principles will be translated into actual policy, accompanied by the necessary legislation. A number of the proposals will not benefit a number of powerful vested interests and I would expect a tendency to water down such reforms. In addition, the actual policies/legislation will take quite a long time to finalise – it looks as if a 2020 deadline has been set. Interestingly, defence related stocks rose materially following statements that China would increase its military expenditure. Politically, Mr Xi looks as if he will head up a National Security Commission, which is important as the Communist Party relies on the armed forces for its support.

• The EuroZone’s Q3 GDP came in at just +0.1%, lower than the +0.3% in Q2. French Q3 GDP declined by -0.1%, whilst Italy extended its recession. German Q3 GDP came in at +0.3% Q/Q, in line with expectations, though below the +0.7% in Q2. The EU has warned a number of countries that the may well fail the debt and deficit rules, including France and Spain. Recently, a number of countries have not focused as rigidly as is required to meet such rules and I suspect that this trend will continue. Further austerity is going to be a very hard sell. The market largely ignored the poor French data, but I continue to be highly concerned about the country. President Hollande just does not seem to have taken the action necessary and I have no confidence that he will. The disinflationary trends in the EZ appear to be continuing, which will pose a major problem, given the level of debt in a number of EZ countries. Inflation is just +0.7%, with the likelihood that it will decline further in coming months. Indeed, a number of EZ countries are actually suffering from deflation. On a more positive note, Ireland and Spain announced that they would exit the bailout programme. The EZ is bumbling along with very low and/or negative growth. It is hard to see how growth will pick up – the risks are to the downside. The disinflationary forces in the EZ are truly worrying – I suspect that the ECB will be forced to act. Its mandate is to keep inflation below, but close to 2.0%, which suggests to me that it has flexibility if it wants to, especially with a current inflation rate of just +0.7%.

• Negotiations over the establishment of the Single Resolution Mechanism in the EU to deal with undercapitalised banks failed to reach a conclusion. The Germans rejected the idea of using the ESM (in effect they have a veto), as proposed by the a number of countries, including France and Spain. They suggest a fund be set up, which would be financed by levies on the banks and that rules relating to bail ins by creditors and depositors be brought forward. In addition, the Germans do not want the European Commision to be the arbiter of the rules governing the Single Resolution Mechanism – they suggest it should be Council of the European Union, which is made up of representatives of EU countries. The ECB, which takes over EZ financial supervision has stressed that there is a need for a “strong and independent” European resolution mechanism, which clearly must be right. However, will that be the case?. The EU has set a year end deadline to reach an agreement on this matter, which looks unlikely, especially if it is to be meaningful. A number of fudges are already evident. Some 5 years into the financial crisis, the EZ has failed to resolve the problems of a number of its banks. This issue will become much more important in the coming year, especially as the ECB is to conclude its assessment/stress tests of the largest banks by November next year. It is expected  that some banks will fail the stress tests. The big question remains – who will provide the backstop in case the private sector does not come up with the necessary capital to recapitalise those banks which fail the stress tests. You could argue that the ECB’s actions will force the politicians to act, though the relevant banks will have to accept a pretty tough deal. As a result, EZ banks are reducing their balance sheets to try and meet the more stringent ECB capital rules, which will hurt their economies. A number of EZ financials have underperformed, given the current situation, a trend I expect will continue.

• UK inflation, which historically has been higher than a number of EZ countries, declined to +2.2% in October, below the +2.7% in September. The Bank of England’s (BoE) quarterly report also suggested that unemployment was declining faster that had been thought previously. Indeed, the report suggests that there is a 50/50 chance that unemployment will decline to the BoE’s 7.0% threshold by Q4 2014. I have no doubt that if this threshold is met, the BoE will reduce its unemployment threshold to 6.5% or possibly even lower. I cannot see the BoE in any hurry to raise rates and/or to strengthen Sterling.

Mrs Yellens remarks suggest that she will be in no hurry to start tapering, so long as she can persuade her colleagues. As a result, markets continue to drift higher, with the Dow, S&P and Nasdaq set to rise above 16,000, 1,800 and 4,000 respectively, which should physiologically help the markets. EM’s did sell off following the October NFP report, which resulted in fears of an earlier tapering, though the thought of more liquidity following Mrs Yellens comments, has helped these markets. The economic situation in Russia looks as if its deteriorating, with Brazil and South Africa facing weakness as well. The reform plans announced by China are meaningful and will ultimately benefit the economy – the issue is whether they will be implemented as proposed and when. I remain unconvinced as to “Abenomics”, in particular as the Japanese have not pursued the structural and labour reforms that they so desperately need. The policy seems to be to increase inflation and weaken the Yen.

I remain deeply concerned about Europe – the EZ economy looks as if it is stalling or indeed worse. Politically, I just cannot see EZ politicians getting their act together, let alone agreeing on policies to stimulate growth. Germany is still to form a coalition government. The economic situation in France looks dire.

Subject to geopolitical risks, there are some signs that Brent will decline. WTI is declining, given increased US supply. Clearly lower oil prices will benefit the global economy. A deal with Iran looks more likely, though President Obama confirmed that it would not involve the lifting of oil sanctions, at least initially.

Whilst I continue to believe that the liquidity based rally will continue, given the positive momentum and the lack of alternatives, I believe that risk is rising. The global economy seems to be weakening. Cisco suggested weakness in the global economy, though did not affect markets generally. The recent performance of tech IPO’s looks as if investors are buying the relevant equities more in hope rather than on a realistic valuation. It is difficult to time markets and, given the recent performance, shorting markets looks premature. However, investors seem to be becoming complacent, which can be seen from the VIX, which is trading at very low levels – currently around 12. The positive view for equities is that the major central banks are unlikely to tighten monetary policy anytime soon, which I believe will be the case, combined with a lack of alternatives. However, equities are no longer cheap, with sell side analysts stating that they are fairly valued. Next years earnings outlook looks unimpressive. Following the major rally this year, how much more upside is there? Personally, I believe that it is time to start to look at wealth preservation, by buying downside protection and de risking equity portfolios. Markets just appear far too complacent at present.

I continue to believe in a stronger US$, particularly in the medium to longer term. The US$ has appreciated against other currencies, though the Euro has not weakened by as much as I had thought – indeed, in recent days its has rallied from its lows. Most countries, including the US, Japan, UK and even Switzerland have taken measures to devalue their currencies. However, the EZ has not. Can this last, given the disinflationary forces in Europe – I very much doubt it.  I suspect that even German manufacturers are beginning to feel the pain of the Euro strength. It is deemed difficult for the ECB to go for outright QE, but Draghi has proved to be far more market savvy than his predecessor and, whilst the ECB is likely to cut its main refi rate further and announce a further LTRO, these measures will prove to be insufficient. As a result, at some stage, I believe that the ECB may have no choice but to pursue QE – clearly positive for markets. Furthermore, EZ banks have to be fixed. Without that I just can’t see how Europe recovers. All of this suggests to me that volatility will increase.

Kiron Sarkar
17th November 2013

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