No 1 rule – Don’t fight Central Banks

Central Bank policies have certainly transformed markets. Following up on the ECB’s pledge to buy up to 3 year bonds (in theory in unlimited size, though for the moment, at least, on a sterilised basis) of countries that subject themselves (at a minimum) to conditions imposed by the EFSF/ESM, the FED last Thursday announced QE3. In effect, the FED has extended it accomodative policy till mid 2015 from late 2014 previously and, in addition, agreed to buy US$40bn per month for an unlimited period of time ,until US unemployment declines substantially. Whilst (on annual basis) US$480bn of purchases of MBS’s is below the US$600bn QE2 programme, the unlimited nature of the programme, lit up markets following the announcement. The FED added that it would consider increasing the programme if the outlook for the labour market did not improve.

In effect, Central Banks are acting given the lack of policy action by politicians in the US and EZ, though for the first time that I can recall, a Central Bank (the ECB) has conditioned its policy on certain action being taken by governments – read Spain. Last Wednesday, the German Constitutional Court (the “Court”) ruled that the President could sign off on the ESM and the fiscal compact, which would, as a result, enable the treaties to come into effect and, importantly, rejected opposition to such programmes as being “fundamentally unfounded”, suggesting that future objections are likely to be dismissed. They did however impose, as expected, certain important conditions which, amazingly, seem to have been ignored by most analysts at present. These include:
Importantly, a prohibition on the ESM to access financing through the ECB. However, I believe there are potential ways to get around this “restriction” (see below), though other restrictions could impact such schemes;
Limiting Germany’s potential maximum liability to E190bn in all circumstances, which could only be increased if approved by the German Parliament, the Bundestag. Furthermore, the approval of the Bundestag must be sought if (a) the size of the ESM is increased, (b) a bail out for a new country is to be granted and (c) the acceptance of an MOU, which would contain the terms and conditions of a prospective bail out. The budget committee of the Bundestag can only decide on non material changes to existing bail outs;
Some argue that there is ambiguity as to whether the Court’s decision prohibits the ECB from buying bonds in the secondary market, aimed at financing of an EZ country’s budget deficit, though I believe that the ECB has argued that such purchases are designed to repair a broken monetary transmission policy (and not to finance governments budget deficits) and I cant see such arguments prevailing. However, the Court is to look at this issue when it issues its final decision.
In theory, the EFSF/ESM can issue bonds which are bought by financial institutions and then used as collateral to gain ECB financing. If, in particular, the haircut on such bonds is minimal, banks will be ready buyers of such instruments, which, as a result, could be used to increase the firepower of the ESM. It is essential that the size of the ESM is enlarged, as the current cap of E500bn is insufficient for its purpose and cannot be increased otherwise, as no EZ country is willing to increase its capital contribution. However, the Court has ruled that Germany’s exposure to the ESM must be capped at E190bn, without prior approval of the Bundestag. What happens if the ESM incurs losses, for example !!!!!

The focus is now on Spain. To date the country has been in denial and the decline in its bond yields, following the ECB’s recent announcement has provided it with some time. However, Spain will require some form of bail out, as the country cannot continue to issue short term debt which benefits from the potential ECB bond buying programme. France, in particular, is urging Spain to accept a bail out fearing contagion consequences, though I believe that the situation in France is critical and worsening and will prove difficult for the country to resolve. In addition, Spain faces a repayment hump in October, suggesting that Spain will request a country bail out around that time, in addition to the funds (E100bn) necessary to bail out its banks. However, does it really make sense to add more debt onto a country’s whose debt situation is worsening dramatically. I don’t think so and, indeed, I believe that Spain will be forced to restructure its debts, as will be the case for Greece and Portugal. Ireland and, possibly Italy, may get away without the need to restructure, though if the stigma is removed, they may well choose to do so as well. There is some hope that the fiscal position of Ireland will be improved, as the EZ badly needs a “success” and Ireland is the most obvious candidate.

Greece will come back into focus – sorry. The Troika is set to issue its report in early October. It is rumoured that the IMF will state that Greece will require a further bail out – politically impossible at present. In theory the EZ countries, together with the ECB can extend the maturity of Greek debt, though there has been vocal opposition (though not as great as another bail out) to such proposals. It is clear that Mrs Merkel wishes to see Greece remain in the EZ, fearing contagion effects if otherwise. However, with the ECB in the market and willing to buy short term debt in unlimited size and the establishment of the ESM, a “safety net” has been created, which I believe will minimise the contagion effects of a Grexit. Indeed, I would argue that Grexit is not negative, but that after an initial reaction, will be viewed positively by markets. As a result, I remain of the view that Grexit is the most likely outcome.

The EZ is gradually heading towards a banking, fiscal and ultimately political union. It will, as usual be two steps forward and one back (sometimes two, or three or…..), but the direction is clear. France, however, remains the big threat. The country is not economically strong enough to impose such a move, though will find the thought that it has to give up sovereignity “difficult” to say the least. In addition, it is clear that Germany, increasingly is taking the key role and is directing policy. There is the possibility of many a slip between cup and lip, but the German goal of an United States Of Europe is on track. This policy/goal is going to be a huge problem for the UK in due course and will inevitably require a referendum, but for the moment the UK will bumble along. The outcome of the general electing in Holland was positive, with the pro EZ Liberal and Labour parties winning sufficient seats to form a coalition between themselves – though another party is likely to be included in the ultimate coalition. However, it must be noted that the Liberal party, in particular, is opposed to a further bail out for Greece. Growth measures need to be introduced, rather than relying on the austerity policies currently being employed and which just make the situation worse. There were major demonstrations in Spain and a general strike has been called in Greece – yes another – shortly.

Developments elsewhere are mixed.

The Japanese economy is declining rapidly and political games (the opposition want elections as soon as possible) suggest that it will be bogged down for a while. The rapid slowdown in Asia and Europe has shut the Japanese materially, now that the bounce following the post tsunami spending has declined. In addition, with massive budget deficits and a fast worsening demographic position, Japan looks as if it will not recover anytime soon. However, the Yen remains powerfully strong – go figure !!!!!

The great mystery remains China. The prospective leader, Mr Xi “disappeared” for nearly two weeks (he has resurfaced today) and with a major change in leadership imminent, the situation remains highly uncertain. The Chinese authorities announced a Yuan 1tr stimulus programme, though it could be argued that around half of that programme represented previous policy initiatives. The Chinese seem to be reverting to fixed asset expenditures, rather than consumption and, in spite of all the talk otherwise, I cant see that changing in the near future. In any event, the size of the programme is much less that the Yuan 4tr programme announced in 2008/9. Policy seems to be stuck, ahead of the impending change in leadership.

Bank lending has risen, but the level of NPL’s in the system continues to rise exponentially and the data reported by the officials seems highly questionable.  In addition, importantly, there is a mood within China itself that all is not well – its the foreigners who remain more bullish !!!!!. Economic growth is declining, quite probably far faster than the official numbers suggest – it certainly looks as if China will struggle to reach the 7.5% GDP growth forecast for the current year. Remember that China needs to grow by 7.0% to 8.0% per year to generate sufficient jobs for its people and thereby avoid social tensions, the Communist Parties number one policy consideration. Personally, I cant see that happening. Indeed, I have never seen a command economy generate that rate of growth consistently for an extended period of time. Yes, the traditional China bulls remain, but I remain deeply sceptical and, indeed, bearish in the medium to longer term, in particular. In my view, China cannot get out of its current mess without a material improvement in the US and European economy – it is not the master of its own destiny.

The new Indian Finance Minister seems to acting – very much needed. First he postponed the anti  avoidance measures, which was resulting in a number of foreign investors exiting the country. Just recently, he has indicated that he would increase prices of diesel, to reduce the subsidy which costs India so dear and a subsidy which the country can ill afford. Finally, there are reports that he may open up the retail industry to competition from foreign multi brand companies  very much needed, if true. The Indian Rupee, which was the worst performing currency in the region, is beginning to pick up and if this policy trajectory continues, foreign investment should flow into the country, particularly portfolio investment, suggesting that the Indian market will rally.

The Russian authorities continue to introduce further measures to curb political dissent, even moving to restrictions on the Internet. It is clear that policy differences between President Putin and his PM, Mr Medvedev exist,  though I do not believe that Mr Medvedev political power either currently or in the future is strong enough for hm to pose a significant threat. The question is being asked increasingly as to whether President Putin will survive his term, quite a change from his previous unassailable position. Vested interests are using the political uncertainty for their own advantage, as supporters of the regime demand more and more goodies for their support. Capital flight will continue, though the increase in the price of oil will avoid difficult decisions for the moment. The Russian market is cheap and is likely to rise, though I remain far from certain as to the durability of the rise.

The authorities in Brazil have been introducing measures to stimulate their economy and, in addition, have reduced interest rates to historic lows. However growth remains anemic and demand for commodities weak. The Brazilian Real has picked up recently, though the authorities are desperately trying to curb its rise. However, inflation is picking up in the country, which will lead to difficult decisions for the Central Bank. Brazil needs a material pick up in the global economy, a situation I do not see at present.

The FED’s announcement last Thursday, sets the scene for a continued pick up in the US economy, which clearly has and will continue to outperform many others. Whilst problems relating to the impending “fiscal cliff” will not be resolved ahead of the impending Presidential elections (with a clear threat that they will not be fully resolved thereafter, given the partisan politics in the US), the US remain the “cleanest dirty shirt in town” as Mr Bill Gross of Pimco would say. Whilst a number of analysts disagree, I continue to believe that the US housing market will continue to improve which, if I’m right, will prove to be a major positive for the economy. Unemployment levels remain stubbornly high, but there is some evidence that US businesses, particularly from the large ones, have shut up shop until they know the outcome of the Presidential elections. Will unemployment decline faster thereafter – who knows, but I believe that there is reasonably good chance that it will.

In the past, the cure for a debt crisis has been for Central banks to ease monetary policy and, in effect, enable inflation levels to rise. Whilst inflation remains relatively high, especially given the severity of the crisis, it should decline in the US and Europe next year. The ECB will, for the moment at least, sterilise any bond purchases, though whether this is practical if the level of bond purchases is significant is debatable. In any event, I believe that the ECB will move to unsterilised QE, as is the case in the US, UK and Japan – it was probably deemed by Draghi as a policy too far for the German’s at present,  but he did, at the previous ECB meeting, suggest that the ECB reserved the right to embark on unsterilised QE.

The prospect of rising inflation has resulted in commodities, particularly gold rising. In addition, the mining sector rose materially on Friday, with a likely follow through next week. Personally, I believe that this sharp rise was unjustified, as I do not believe that, in the short to medium term, that inflation will rise materially. Demand will be far more important a factor and with the economic slowdown in China, accompanied by huge levels of inventories in the country, I cannot but believe that the mining sector is unlikely to outperform in spite of its dramatic under performance recently. I would be more comfortable with the energy sector, rather than the miners, though the current price includes a material geo political risk premium – probably around US$15 for Brent at least. It is unlikely, however, that geo political risks will diminish in the near future. Russell Napier of CLSA has written an excellent piece of research arguing that “2/3rds of global money-supply has come from emerging markets (“EM’s”), where authorities create money automatically as they intervene to contain exchange rates”. He goes on to argue that deflation will prove the more powerful factor. You should read his report – whilst unconventional in thinking, it has significant merits in my view. Not good for you gold bugs out there if he is right.

The financial sector has improved, in particular in Europe. Whilst European banks are still trading below book value (around 0.90, according to CS), it is unlikely that they will trade above book value in the near future. As a result, I believe that the insurance sector, particularly those with large investment portfolios will outperform, in particular if this current rally continues, which I believe will be the case for a while yet. Until very recently, most of the market bounce has been due to short covering, rather than the market being outright long and Hedge Funds, in particular, have under performed materially. They will be forced to go long to avoid under performing materially, especially as we near the year end. In addition, cash levels remain high and private investors have not yet entered the market – though if history repeats itself, when private investors enter markets, analysts suggest that the other investors should consider selling/reducing their positions. However, for the moment, it remains risk on in my humble view.

The Euro has risen to US$1.3120, well above just US$1.22 or so recently. A number suggest that the Euro will rise further to US$1.35/40. Personally, whilst the Euro may pick up a bit more as portfolio inflows help, I continue to believe that the Euro at these and indeed possibly higher levels is significantly overvalued and indeed will be a form of monetary tightening, which clearly is unwelcome in the EZ. However, inflation levels will decline faster if the current strength continues, and I for one will be looking to short the Euro in due course. The A$ has appreciated from its recent lows given the announcements by the ECB and the FED – is that rise sustainable – unlikely in my view.

There is no doubt that the policies by the ECB and the FED have improved market sentiment materially. I don’t see that reversing anytime soon, subject to the known knowns, I say hastily. Essentially, don’t fight Central Banks.

Attended a fantastic conference at Magdalene College Cambridge, courtesy of the polling company You Gov. The results of their tracking data was stupendous and particularly interesting. In addition, they organised a number of fascinating presentations by highly intelligent and articulate speakers.

Back to my daily notes next week, rather than swanning around with the good and the great.

Kiron Sarkar

15th September 2012

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