Three snapshots for Thursday
Fears that Athens is on the brink of crashing out of the euro zone and igniting a renewed financial crisis have rattled global markets and alarmed world leaders, with Greece set to figure high on the agenda at a G8 summit later this week. This chart shows the impact on assets since the Greek election:
Euro zone banks now account for only 8% of total euro zone market value – they were over over 20% of the market in 2007:
Japan’s economy rebounded in January-March from a lull in the previous quarter, shaking off the pain of a strong yen and Europe’s debt crisis on solid consumer spending and rebuilding from last year’s earthquake.
Big Fish, Small Pond?
It’s the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem — the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.
But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.
These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets. In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.
But change is on its way. MS surveys show most classes of global institutional investors intend to boost allocations to emerging markets, including the more conservative investor groups – Japan’s $1.3 trillion government pension insurance fund, for instance, plans to start buying emerging equities later this year. MS analysts calculate allocations to emerging markets could rise 3.5% over the next five years.
That may not sound like much until one realises the true scale of the global pool of investable institutional assets and compares them with current market cap values in developing countries . These assets currently exceed $212 trillion, meaning a 3.5 % allocation increase will bring over $2 trillion into emerging markets. That’s over half the capitalisation of EM equity market, more than 80% of bond markets and a third of the combined market cap of both sectors.
Take a look at some more numbers:
– Based on current market values, a 1% increase in allocation to EM by pension and insurance funds represents a $524 billion flow to EM assets.
The “least worst” option?
Western governments saddled with mountainous debts will “repress” creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called “From Depression to repression”.
Building on the work of U.S. economist Carmen Reinhardt and others, King’s focus on the history of heavily indebted governments applying “financial repression” to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that “Golden Age” – and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a “sideshow”, he reckons. To show t
Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be “persistently lower growth”, whatever your conclusion about the desirability of state or the market allocation of resources.
And, in the absence of an obvious alternative, repression may also be the “least worst” option, King argues.
Renihart is exactly right. But there is a darker theory yet: that Fed policy is just part of a government-wide strategy of practicing “financial repression” to escape from the consequences of the debt explosion. The leading expert on financial repression is Carmen Reinhart of the Peterson Institute. She defines it as a situation in which “governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere.”
Low or negative real interest rates are among the oldest examples. Call this monetary repression. Reinhart points out that it was practiced on a large scale by governments after World War II. She asserts that it accomplished by stealth the effective cancelation of government debt without resort to orthodox spending and tax policies for which governments knew then and now that they cannot get the electorate’s consent.
A similar debt predicament today implies that monetary and other forms of repression are again on the cards, especially in the United States. Wainwright has attempted to measure it, but estimates of real interest rates and monetary repression are fuzzy and contentious, especially because the government as¬serts control over the method by which inflation is measured.
Nevertheless, the company’s research, estimates that the Fed’s interest-rate policy in 2007-11 has cut the real interest rate from a normal 2 or 3 percent to an aver¬age of minus 7 or 8 percent. That’s a diversion of about ten percentage points a year to the Treasury and other borrowers—just about enough to fund the current budget deficit. Genius…
Luis de Agustin
Japanization of euro zone bonds?
Fear of many years of stagnation in the major western economies has everyone fretting about a repeat of the “lost decades” that Japan suffered after its banking and real estate bubble burst in the early 1990s. Indeed HSBC economists were recently keen to point out that U.S. per capita growth over the noughties was already actually weaker than either of Japan’s lost decades.
But in a detailed presentation on the impact of two years of soveriegn debt crisis on euro zone government bond holdings, Barclays economist Laurent Fransolet asks whether that market too is turning into the Japanese government bond market — where years of slow growth, zero interest rates, current account surpluses and captive local buyers have depressed borrowing rates for years and turned JGBs into an increasingly domestic market dominated by local banks, pension funds and insurers. Non-residents hold less than 10 percent of JGBs, compared to more than 50 percent for the EGB as a whole, and Japanese banks hold up to 35 percent of their own government bond market.
But is the euro government market heading in that direction after successive crises have seen foreign investors flee many of the peripheral markets of Greece, Portugal, Ireland and even Italy and Spain? Fransolet argues that the seniority of substantial European Central Bank holdings built up in the interim (now about 15 percent of each of the five peripheral markets) may be one reason why these foreign investors will be wary of returning. Meantime, euro zone banks, who have traditionally held a high 20-25 percentage point share of euro government markets, withdrew sharply late last year amid balance sheet repair pressures but have rebuilt holdings again sharply in early 2012 after the ECB’s liquidity injections — particularly in Italy and Spain.
In answer to the longer-term question of whether euro bonds will turn into a more insular market dominated less by interest rate signals than liquidity, regulatory and balance sheet issues, Fransolet is equivocal. On one level they are still very different — state-sector holdings of euro debt are still far from Japan’s, the euro market has clearly fragmented and net new issuance of euro debt is also still way below Japan.
However, the trend is clearly toward a more domestically driven market in the periphery of euro bloc in particular and local banks are becoming bigger players. And, crucially, although foreign investors may not return en masse soon, their impact on those markets via futures and CDS markets and index weightings may still be high.
Japan… tide finally turning?
Until recently, when you mentioned ”Japan” in the investment context, you could almost hear a collective sigh of disappointment — it was all about recession, deflation and poor investment returns.
However, sentiment does seem to be finally changing, not least because Tokyo stocks have rallied almost 20 percent since the start of the year, outperforming benchmark world and emerging indexes.
The yen has also been on a (rare) declining trend since the start of February, with the selling momentum accelerating since the Bank of Japan set an inflation goal of 1 percent in a surprise move and boosted its asset buying programme by $130 billion on Feb 14.
A closely-watched survey by Bank of America Merrill Lynch showed record optimism on Japan’s growth among fund managers, with a net 91 percent of Japanese fund managers saying they expected the domestic economy to strengthen. That’s up from a net 47 percent two months ago.
Overall, survey partipants worldwide slashed their underweight positions on Japanese equities to a net 4 percent in March from 23 percent last month. This is the smallest underweight position on Japan since August. According to Gary Baker, head of European equity strategy at BofA Merrill:
There’s quite a change in sentiment towards Japan. If you have global growth then Japan… is a big cyclical region to benefit from that. While investment story is the same, what changed there is the yen weakness… it becomes easier to play the story.
Fresh skirmishes in global currency war
Amid all the furious G7 money printing of recent years, Brazil was the first to sound the air raid siren in the “international currency war” back in 2010 and it continues to cry foul over the past week. With its finance ministry issuing fresh warnings last night over hot-money flows being dropped by western economies on its unsuspecting exporters via currency speculation, Brazil’s central bank then set off its own defensive anti aircraft battery with a surprisingly deep interest rate cut late Wednesday. Having tried everything from taxes on hot foreign inflows to currency market intervention, they are braced for a long war and there’s little sign of the flood of cheap money from the United States, Europe and Japan ending anytime soon. So, if you can’t beat them, do you simply join them?
The prospect of a deepening of this currency conflict — essentially beggar-thy-neighbour devaluation policies designed to keep countries’ share of ebbing world growth intact — was a hot topic this week for Societe Generale’s long-standing global markets bear Albert Edwards. Edwards, who represent’s SG’s “Alternative View”, reckons the biggest development in the currency battle this year has been the sharp retreat of Japan’s yen and this could well drag China into the fray if global growth continues to wither later this year. He highlighted the Japan/China standoff with the following graphic of yen and yuan nominal trade-weighted exchange rates.
Edwards goes on to say that this could, in turn, create another explosive FX standoff between China and the United States if Beijing were to consider devaluation — the opposite of what the protectionist U.S. lobby has been screaming for for years.
“We have long stated that if the Chinese economy looks to be hard landing, as we believe it will, the authorities there will actively consider renminbi devaluation, despite the political consequences of such action.”
“Clearly, the US will not respond well if China chooses to devalue. But China might argue that as its reserves are now declining there is clear downward pressure on its currency and that, after all, the US has asked it to allow market forces to have more of an influence!”
Being chic and not saving
Japanese people are generally regarded as saving a lot and not spending much, but in olden times when Tokyo was called Edo (until the mid-19th century), it was considered iki (chic or sophisticated) not to keep one’s earnings overnight.
The latest survey from the Central Council for Financial Services Information (part of the Bank of Japan) may suggest that people are going back to that tradition — although perhaps not for style reasons.
The survey, only available in Japanese so far, showed more than one in four households (consisting of at least two people) said they have no savings, the highest level since the survey started in 1963.
The average level of savings was 11.5 mln yen ($143,232), down 190,000 yen from last year.
More than 40 percent of the respondents said their savings fell from a year ago, double those who said their savings increased.
As Goldman Sachs predicted last year, it may be a matter of time before Japan’s savings rate goes negative.
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.
from MacroScope:
Are Treasuries the new JGBs?
Anemic economic growth in the United States has sparked fears the country was entering a Japan-style “lost decade.” The comparison also has implications for government bond markets. Some traders see the U.S. Treasury market’s new, lower-yielding structure as eerily reminiscent of trading patterns seen in JGBs (Japanese government bonds). Says George Goncalves at Nomura:
There has been much debate since the start of the '08 credit crisis over whether the US is turning into Japan and if so how to trade it. We have spent a fair deal of time over the last two years developing a framework for how US rates investors can leverage these insights to "Trading USTs like JGBs.” […] One thing is clear: momentum trading starts to wane and narrower ranges will become the norm in a low yielding world with the Fed on perma hold meanwhile a lack of alternative fixed income products is still forcing investors to buy USTs.
This does not mean that investors can remain permanently bullish on Treasuries, however, Goncalves warns.
Many accounts have now subscribed to the view that the UST markets are turning Japan-like, but we caution that as with all range-trading periods, buying at the lows in a range that is stretched is still a dangerous proposition. Look at the JGBs experience in 2003 for a warning to those calling for even lower USTs rates from here.
from Funds Hub:
Gerard Fitzpatrick: Positive on global growth
Guest blogger Gerard Fitzpatrick is portfolio manager at Russell Investments, where he runs a $5 billion global bond fund.
The views expressed here are entirely the author's own and do not constitute Reuters point of view.
The global economic outlook is positive overall, currently powered by China and America's twin engines of growth. Questions have been asked about the level to which the Japanese disaster may slow down the world's economic recovery, but in reality, it's expected to have only a small negative effect on global growth this year.
Europe remains constrained by the Euro sovereign crisis, and we expect to see only low levels of European growth. Europe is moving in the right direction, but there are still lingering challenges. Despite Greece and Ireland remaining at risk of default, the economic outlook is moderately positive.
The Portuguese parliament has taken a striking gamble that will be acutely monitored by other European governments and bond investors. If they continue their refusal to accept harsher austerity measures, the outcome for Portugal could simply be binary, where either deeper support from the bailout providers will be made to balance the books or their refusal to accept such harsher austerity could push the already politically stretched bailout providers to breaking point. At an extreme, this could push Portugal into an abyss of confidence with bond investors and rating agencies.
Previously, the best stand-alone defence peripheral European governments held versus an ever increasingly sceptical bond market was a commitment to austerity measures to help stem the rising tide of indebtedness. If you take that defence away, the gambling peripheral country could drown.
The world has only just come out of a recessionary environment, and we expect inflation to remain relatively low in key global bond markets for several reasons.
