Research Radar: “State lite”?
The FOMC’s relatively anodyne conclusions left world markets with little new to chew on Thursday, with some poor European banking results for Q1 probably get more attention. Broadly, world stocks were a touch higher while the dollar and US Treasury yields were slightly lower. European bank stocks fell 2% and dragged down European indices. Euro sovereign yields were slightly higher, with markets eyeing Friday’s Italian bond auction. Volatility gauges were a touch lower and crude oil prices nudged up.
Following is a selection of some of the day’s interesting research snippets:
- Deutsche Bank’s emerging markets strategists John Paul Smith and Mehmet Beceren said they retain their negative bias toward global emerging market equities both in absolute and relative terms, highlighting Argentina’s expropriation of YPF from Repsol as another negative. “We anticipate that so-called state capitalism will continue to be a negative driver, as it has been since mid-2010, since the poor economic backdrop makes the corporate sector a tempting target for governments wishing to boost their popularity or find additional resources to add to the relatively low levels of social protection across most emerging economies.” They added that they remain overweight “state lite” emerging markets such as Taiwan, Mexico and Turkey and underweight Russia, China, Brazil and South Korea.
- Morgan Stanley’s James Lord thinks the rally in Hungary’s markets following Tuesday’s decision by the EU to reopen negotiations on financial assistance is justified but much may now be in the price. He said MS would prefer to wait for some pullback before looking for more bullish trades. On a relative basis, Hungary 5-year CDS is now 60bp wider than Spain’s and MS said that while this gap could close much further it was hard to see how Hungary CDS rates could trade below Spain. “Indeed, if Spain goes into serious financial trouble, it could represent a systemic risk for all Europe, and funding stress would likely increase substantially. Given the strong dependence of Hungary towards the EU, it would be difficult to argue for Hungary to trade through Spain on any sustained basis.”
- Ashmore Investment Management’s Jerome Booth restates his bullish case for emerging markets with 10 points that conclude with the line: “the best way to lose money without really trying is not to invest in emerging markets.” His points include warnings about equating past volatility with risk, passive investing (where he points out that only 12% of emerging debt is represented by available indices) and seeing emerging currency volatility against the dollar as an emerging problem rather than a U.S. one (“It is the dollar which is volatile”.)
- Legal & General Investment Managers’ Ben Bennett argues that central bank money printing will be needed for some time as banks’ bad loans are still way too high for them to be “in a position to drive the money printing presses once again”. Explaining QE as a nationalisation of money printing presses normally operated by the commercial banks, he says the success of either form of money creation can only be judged by the productive nature of use to which that money is put. The pre-crisis lending into the property bubble was negative case in point, and the relative success of QE lending to the banks will be even more complex to judge. “The investment lesson to be learnt is not to follow the money, but to analyse the usefulness of what it is being spent on.”
Research Radar: Very 20th century
Wednesday’s market commentaries are loaded with the buzz around another technical UK recession in Q1 (the first time Britain has suffered what many see as a ‘double-dip’ since the 1970s); guessing about Wednesday’s FOMC outcome; and the European Commission letting Hungary off the hook about its controversial constitutional changes. In aggregate, and probably due to the looming FOMC, markets are fairly stable – world equities, including euro stocks, emerging markets and even Britain’s FTSE are all higher. The US dollar, Treasuries, volatility gauges, gold and even peripheral euro government bond yields are all down a bit.
Following is a selection of some of Wednesday’s interesting research ideas:
- Barclays’ Barry Knapp reckons US and world equities face a dilemma from the endless distortion to multiples and risk premia from monetary intervention and QE that is artifically lowering the risk-free rate akin to the “financial repression” of the 1950s — no one is sure now if equity is cheap or bonds just very expensive. He concludes that best thing for equities in the medium to long term is to avoid further QE but the problem is that stocks will almost certainly suffer in the short run if the Fed takes QE3 off the table. What’s more, Wednesday’s FOMC could be problem for markets initally if the Fed frets about the growth outlook, but a worsening of the economy might bring QE3 sooner than similar bouts in 2010 and 2011.
- ING’s James Knightley says UK GDP numbers mask business survey improvements and better March data and expects the economy to return to growth in Q2 as well as upward revisions to Q1. Flagging up improving business sentiment in the April CBI survey, he says the Bank of England is unlikely to do more QE and reckons any post-GDP rally in gilts or fall in sterling should be short-lived.
- However, Citi’s Michael Saunders is far gloomier in flagging ” the worst recession/recovery cycle opf the last 100 years” and dismisses suggestions that the persistent weakness of the economy since 2008 can be blamed on things like quarterly construction swings. “We expect the economy will continue to underperform, given the headwinds from fiscal drag, high household debts, the EMU crisis and poor credit availability. A less-tight fiscal policy probably would not help significantly, given the likelihood that fiscal slippage would trigger market pressure. A lower pound would help, but the key policy lever is QE and we continue to expect extra QE.”
- Standard Chartered reckons it’s time to book profits on a short EUR/GBP position, as the market looks primed for a correction. “An unexpectedly weak UK GDP report for Q1 has tempered expectations the economy will outperform”
- Societe Generale’s cross-asset team says it remains bullish on crude oil prices due to supply and capacity worries and geopolitical concerns and it targets $135 per barrel for Q3 — a price they say is not priced into futures markets. They say portfolios should be hedged for the possibility that 20-year-high oil/equity correlations will drop sharply and there several ways to gain exposure to rising crude — Brent Sept call option spreads, US 5-year inflation-protected TIPS, long global oil services stocks, long Russia’s rouble and Mexico’s peso and short Thailand’s baht and Korea’s won. Seperately, SG’s Dylan Grice worries about Australia — “What do you call a credit bubble built on a commodity bull market built on a much bigger Chinese credit bubble? Leveraged leverage? A CDO squared? No, it’s Australia.”
from MacroScope:
Central bank balance sheets: Battle of the bulge
Central banks across the industrialized world responded aggressively to the global financial crisis that began in mid-2007 and in many ways remains with us today. Now, faced with sluggish recoveries, policymakers are reticent to embark on further unconventional monetary easing, fearing both internal criticism and political blowback. They are being forced to rely more on verbal guidance than actual stimulus to prevent markets from pricing in higher rates.
How do the world’s most prominent central banks stack up against each other? The Federal Reserve was extremely aggressive, more than tripling the size of its balance sheet from around $700-$800 billion pre-crisis to nearly 3 trillion today. Still, the ECB’s total asset holdings are actually larger than the Fed’s – it started from a higher base.
The Bank of England, for its part, went even deeper into uncharted territory, with its assets as a percentage of GDP surpassing the Fed’s. By the same measure, the ECB has overtaken the Bank of Japan, which has been grappling with deflation for some two decades and started from a much higher level.
Taken together, the expansion in reserves is impressive – and speaks to just how deep the global recession proved to be.
Three snapshots for Wednesday
Markets starting to worry about an end to QE/LTRO liquidity?
Forward looking PMI data is starting to show a divergence between the UK and the euro zone:
German factory orders, which tend to lead GDP growth, fell 6.1% in February from the previous year.
Asian bonds may suffer most if QE on ice
Bonds issued in emerging market currencies have been red-hot favourites with investors this year, garnering returns of 8.3 percent so far in 2012. But for some the happy days are drawing to a close — U.S. Treasury yields are nudging higher as the U.S. recovery gains a foothold and the Fed holds back from more money printing for now at least. That could spell trouble for emerging markets across the board (here’s something I wrote on this subject recently) but, according to JP Morgan, it is Asian bond markets that may bear the brunt.
Their graphic details weekly flows to local bond funds as measured by EPFR Global (in million US$). As on cue, these flows have tended to spike whenever central banks have pumped in cash. (Click the graphic to enlarge.)
Over the past several years, inflows have driven local curves to very flat levels, but current levels of flatness are not sustainable if/when inflows begin to slow, let alone reverse.As there is a clear correlation between the Fed’s “QE periods” and large inflows into Asian markets, we think the next few months will be difficult for Asian bonds markets (JPM writes)
JP Morgan says risks are greatest for Malaysia, Indonesia and Thailand because that’s where foreign ownership ratios are largest – in Indonesia for instance foreigners hold a third of local debt. Deficits in these three countries are also rising meaning debt issuance is rising faster than elsewhere, the bank warned. It advises clients to be underweight Asian local debt (countered by overweights in Latin America and emerging Europe)
Asian currencies face risks too –from China. The yuan is up 30 percent since mid-2005 but ended March with its first quarterly loss since 2009 and many reckon China, fearful of an exports slowdown will not permit any more big rises for now. Asian governments will have to fall into step if they want their own exports to compete. And that, JPM says, is robbing the region’s currencies of a major support anchor.
Time for a slice of vol?
As the global markets consensus shifts toward a “basically bullish, but enough for now” stance — at least before Fed chief Bernanke on Monday was read as rekindling Fed easing hopes — more than a few investment strategists are examining the cost and wisdom of hedging against it all going pear-shaped again. At least two of the main equity hedges, core government bonds and volatility indices, have certainly got cheaper during the first quarter. But volatility (where Wall St’s Vix index has hit its lowest since before the credit crisis blew up in 2007!) looks to many to be the most attractive option. Triple-A bond yields, on the other hand, are also higher but have already backed off recent highs and bond prices remain in the stratosphere historically. And so if Bernanke was slightly “overinterpreted” on Monday — and even optimistic houses such as Barclays reckon the U.S. economy, inflation and risk appetite would have to weaken markedly from here to trigger “QE3″ while further monetary stimuli in the run-up to November’s U.S. election will be politically controversial at least — then there are plenty of investors who may seek some market protection.
Societe Generale’s asset allocation team, for one, highlights the equity volatility hedge instead of bonds for those fearful of a correction to the 20% Wall St equity gains since November.
A remarkable string of positive economic surprises has boosted risky assets and driven macro expectations higher but has also created material scope for disappointment from now on. We recommend hedging risky asset exposure (Equity, Credit and Commodities) by adding Equity Volatility to portfolios.
End of LTRO = end of equity rally 2012?
This year’s global equity rally is unlikely to survive the end of the ECB’s liquidity injections, warns HSBC.
World stocks have jumped 10 percent since the start of 2012, emerging markets are up 15 percent and the index of top European stocks has gained 8 percent. These gains, HSBC says, are almost entirely down to the European Central Bank’s end-December refinancing operation, or LTRO, that injected $500 billion to ease banks’ liquidity worries. The tentative improvement in the U.S. and global growth picture along with beaten-down stock valuations added only limited ammunition to the rally, the bank says.
The findings of HSBC’s analysis? First, past episodes of quantitative easing — Japan in 2001-2004 and the United States, Britain and the euro zone after 2008 – provided a significant fillip to equity markets. U.S. stocks rose an average 6 percent, UK stocks by 8 percent and euro zone markets by 15 percent in the three months following the post-Lehman QE rounds, though in Japan the gains have been short-lived. Second, unexpected changes in monetary policy produced a larger impact on stock prices than the continuation of a previous policy.
And when QE stopped, the effect on stocks was immediately negative. HSBC found:
The periods when the Fed halted QE and allowed its balance sheet to shrink (in August 2009, June to October 2010 and July to October 2011) were all periods of weakness for the stock market.
The ECB is gearing up for another LTRO round in two weeks time. But it will not come as a surprise to markets and there are no plans for more.
HSBC concludes:
Emerging market local bond rally has more legs
Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.
There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.
Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes:
From an EM perspective there is little reason to fight the rising tide of monetary policy support in the near term. Comparisons to the 2009 global carry trade are unavoidable given the scope of G-4 central bank balance sheet expansion.
So far, around 70 percent of the gains posted by the GBI-EM index have been down to currency appreciation (see here). That could change going forward as some central banks may act to slow FX appreciation. That’s already been happening in Brazil. Gains from the duration trade — derived from interest rate cuts — are also more or less done, analysts reckon, because emerging central banks are more likely from here to keep interest rates on hold than to cut. J.P. Morgan adds:
While we look for approximately 7 percent in additional returns in the GBI-EM for the remainder of the year, the majority of this is due to carry (5 percent) while spiot FX returns should be muted at 1.9 percent and duration returns flat.
Interest rates in emerging markets – - harder to cut
Emerging market central banks and economic data are sending a message — interest rates will stay on hold for now. There are exceptions of course.
Indonesia cut rates on Thursday but the move was unexpected and possibly the last for some time. Brazil has also signalled that rate cuts will continue. But South Korea and Poland held rates steady this week and made hawkish noises. Peru and Chile will probably do the same.
The culprit that’s spoiling the party is of course inflation. Expectations that slowing growth will wipe out remaining price pressures have largely failed to materialise, leaving policymakers in a bind. Tensions over Iran could drive oil prices higher. Growth seems to be looking up in the United States.
On top of that, all the major central banks in the developed world are intent on flooding the world economy with cash and some of it will inevitably make its way to emerging nations. So while economies could do with a good dose of policy easing, most central banks cannot afford to let their guard down on inflation.
Take China where January inflation came in well above expectations on Thurday, with food prices up 10.5 percent on the year. Expect no cuts to the policy rate this year, warn analysts at RBC. Over in Seoul, Bank of Korea governor Kim Choong-soo said policymakers needed to be “on alert” for inflation risks and described inflation expectations as “considerably high.” The verdict from Barclays:
Taken together these comments reflect a tilt in concern towards inflation.
Most central banks in emerging Europe never had much room to cut rates anyway, exposed as they are to the euro zone malaise. But as my colleague Emily Kaiser wrote a week back, policy easing bets in Asia are also being trimmed.
Sparring with Central Banks
Just one look at the whoosh higher in global markets in January and you’d be forgiven smug faith in the hoary old market adage of “Don’t fight the Fed” — or to update the phrase less pithily for the modern, globalised marketplace: “Don’t fight the world’s central banks”. (or “Don’t Battle the Banks”, maybe?)
In tandem with this month’s Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that’s a lot of additional central bank support behind the market rebound. So is betting against this firepower a mug’s game? Well, some investors caution against the chance that the Banks are firing duds.
According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What’s more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.
Low interest rates and liquidity schemes can’t solve what ails the developed world. Societies must accept that in order to alter their current perilous course they must undergo great change, moving away from entitlements to which they have become accustomed. The alternative is weak economic growth, a loss of competitiveness and negative external balances — a loss of face and place in the global hierarchy.
As if to reinforce the underlying point that the developed world faces a protracted reform period that tests political, economic and social priorities, credit rating firm Standard & Poors’ — not the most popular company in corridors of power over the past year — warned on Tuesday that it may downgrade the debt of “a number of highly-rated” Group of 20 countries from 2015 if their governments fail to enact reforms to curb rising healthcare spending and other costs related to ageing populations.
For Pimco, the political and social resistance to this sort of change is already showing itself to be significant both in Europe and the United States. People clearly don’t want to see pensions and benefits cut but politicians have already grown government and sovereign indebtedness close to their maximum. Accommodative central banks that helped them get there only ended up fueling credit, consumption and housing bubbles and distorting the balance of the economy away from production and into an increasingly bloated financial sector. That, clearly, ended in tears as finance itself needed bailing out and compounded the sovereign debt burden.
So if harder, longer-term choices and reforms are now needed, central banks ability to continually reflate the world economy by monetary means alone is at best uncertain, Pimco argues. The risk of major upheavals along the way in Europe, for example, has the potential for major market volatility and economic seizures.
