It was a brutal and at times scary week. There are plenty of unknowns around the radiation risks tied to the Fukushima nuclear plant. But the fact remains that this nuclear crisis after the quake/tsunami shock may not deal the economy too severe a blow. If nothing else, the shock is prompting a policy response that was always lacking in Japan before: hefty fiscal spending is on the way, and the Bank of Japan has injected money into the system like never before, and via all kinds of channels. The BOJ’s response has helped to quickly stabilise funding markets and asset markets as a whole. The G7 is backing up Japan on yen intervention. Foreign institutional investors were cited in the last few days as steady buyers of Japanese equities, seeing this as an opportunity as the price-to-book on the TOPIX once again fell to a meagre 1.0 (for comparison, it is in the company of Serbia, UAE, Lebanon, Italy, Greece and Venezuela – so yes maybe cheap). From a markets point of view – a minor one in this crisis – Japan did an admirable job shoring up the markets after their were gripped by panic. Keep in mind that sharp policy responses to panics linger for a while, usually well into any recovery. Just as the Fed launched QE2 the moment the U.S. economy was picking up a head of steam, Japan may be countering an economic shock that may not be as big as feared. If so, it could be just the jolt the Japanese economy has long needed just as it was gathering momentum. All that said, the radiation risks, factory shutdowns and threat of power outages will add to the doubts about how quickly the economy will bounce back in the next few months.
JGB risks: The chart below says a lot. Over time, gradually, investors are seeing greater risks in JGBs. Not just those supposed speculators in CDS, but even in the mostly domestic market where the yield curve has stayed historically steep for a while now. The risks are now even greater. Does the need for greater borrowing push JGBs closer to a tipping point? The BOJ may step in to help fund some of the reconstruction costs, but it has showed a great reluctance to be seen underwriting the government. Whatever the BOJ does, the JGB outlook is one that keeps slowly deteriorating. Near-term risks include insurer selling and the lack of buyers heading into fiscal year-end. Beyond fiscal-year end is the big question. A lot of liquidity is in the banking system, and households may start boosting savings again. But the risks are building.
As many know in the markets, correlations can kill you. They may form the basis of algo/model trading and are useful for observing how cross-asset relationships are changing, but you have to be cautious on drawing any conclusions. Correlations can only one of the signals you look at. And so with that health warning, here’s some thoughts on the correlations between equities and oil and a chart.
First of all, the 90-day correlation between daily returns (log) in Brent crude futures and the broad Asia regional index of equities, the MSCI Asia-Pacific ex-Japan, is positive and solidly so. That reflects how Asian growth has driven energy demand, and thus oil prices. The relationship has weakened a bit as oil surged during the North Afrida/Middle East unrest, suggesting that equities are reflecting some caution about both margins and economic growth. But at a correlation of 0.30, the correlation is still a decent one. Even more striking is how consistently the correlation has been positive, both since the financial crisis but even since the 2001/2002 U.S. recession. The periodic correlation breakdowns suggest that sudden price run-ups do create uncertainty, but ultimately this has been a growth story. In fact this correlation last year was the strongest its ever been. And over time, periods of a negative correlation — either oil prices jumping as stocks slide, or vice versa — have not been very strong and have typically been brief. The correlation never goes deeply into negative territory. This relationship may yet change, but the 21-year history of this cart gives a good indication of how the oil price story is a demand and growth one, particularly in Asia. The current correlation is near the 10-year and 20-year daily correlations, showing how it has become more strongly positive over time — the 10-year being higher than the 20-year.
There’s a lot of excitement around the sharp outflows seen from emerging markets in the latest figures from EPFR Global. But this story is getting a little overplayed. Asian central banks have heard the message on the need to tighten policy, with Bank Indonesia following the Bank of Korea in surprising with a rate hike in the past few weeks. The positive response to the BI rate increase, with the rupiah rising and local bond yields dropping, show that the central bank showed the inflation-fighting resolve that investors were looking for, even if inflation is being exacerbated by food price run-ups beyond the control of monetary policy.
Higher short-term rates are inevitable, and SE Asian yield curves/swap curves have more room to flatten. Just look at how South Korea’s swap curve has flattened like mad since the Bank of Korea has appeared to become more aggressive than anyone expected (let’s see at this week’s policy meeting). At the same time, stronger currencies will be part of any inflation-fighting response to keep from raising rates too much and attracting more hot money – yes, hot money. If anything the U.S. and euro zone markets have gotten a little too excited about higher rates, while some EM markets – look at the Philippines – still offer chunky real yields, and those real yields are not even close to being as negative as they were during the 2008 commodities freakout. PIMCO’s Bill Gross last week reiterated the biggest bond fund’s support for EM bonds in decrying the “devil’s haircut” of near zero U.S. five-year real yields.
No doubt there’s a lot of worries about inflation seizing investors at the moment. But blaming a lot of this January volatility on inflation fears seems a bit simplistic and more reallocation, if not mere profit-taking. For all the pressure on prices, you have to be careful of easy comparisons with the 2008 spike in food and commodity inflation. Some of this, such as cocoa and even wheat, is supply driven. And some foodstuff inflation is inevitable as big emerging markets push up the economic curve, with higher standards of living increasing demand on a wider variety of commodities. That’s as natural as the need for these very same EM countries to allow greater currency appreciation, and thereby limit the higher costs of these commodities by boosting purchasing power abroad. Keep in mind that in real terms, the commodity spike is not as scary as it seems.
Worrying that these EM central banks, such as Indonesia, will slam on the brakes to address commodity inflation seems a bit overdone. Are these central banks behind the curve? Of course, but that’s almost a different story. Instead targeted supply and subsidy controls will be the first line of defense, and currency appreciation perhaps the second – something that seems underappreciated at the moment. Rates will rise as they must. But we should keep in mind that some of these markets – think Indonesian local bonds – were crowded by foreign investors who had left little breathing room for any inflation pick-up that would erode the real return on those bonds. Indeed the real yield on Indonesian 10-year bonds shrank to a mere 65 basis points in December in a clear sign that something was bound to give. What’s been remarkable about the selloff in Southeast Asian stocks so far this month is the weak volume driving it. Some foreign investors may be pulling out and reallocating to other Asian markets, but this is no rush for the exits. On top of the selling in Southeast Asia, the euro and euro zone peripheral bonds have soared on a vicious short squeeze that has probably dealt a fatal blow to those thinking the euro was your funding currency for carry trades, especially in EM markets. It also suggests that a popular macro play was to go long EM versus the euro zone, and now that’s gone kaput.