Thursday, May 15, 2014

Macro-prudential policies & the Great Moderation 2.0

Macro-economic volatility has decreased substantially from the mid 80s onwards in a large number of economies. This period of reduced macro volatility was termed the Great Moderation. However, during the financial crisis GDP growth plummeted and inflation evaporated just to rebound thereafter amid massive fiscal and monetary easing. This lead macro volatility higher and stopped the talk of the Great Moderation. However, as of late volatility in a large number of economic data – most notably growth and inflation – has decreased again. This is shown in the chart below for US real GDP growth. There are a number of reasons for a more stable growth development, most notably that modern economies are far less dependent on the very cyclical and volatile manufacturing sectors but more dependent on less cyclical and less correlated services sectors (for example, education and healthcare). Moreover, inventory management has also been a key factor in determining macro-economic volatility. During good times, manufacturers and retailers increase their inventories, thereby leading to even higher growth. During bad times, though, they want to reduce inventories and as a result, production needs to be decreased by more than demand has fallen, aggravating the downturn. Nowadays, however, more manufacturers use just-in-time management methods and are used to lean inventories. As a result, this also reduces macro-economic volatility (and again services are less volatile as services can not be stored and hence there is no inventory problem). Additionally, the state has a larger role within the economy than during previous periods and tends to act as an economic stabiliser. Finally, the monetary policy enviornment has changed as central banks increasingly focused on providing for a stable enviornment via the adoption of inflation targets. As central banks have become more credible in securing a low inflation environment, inflation expectations and therefore also inflation has become more stable (and inflation tends to be more stable at low levels anyhow).  

US GDP and rolling standard deviation: increased stability after the Financial Crisis 

Source: Bloomberg, ResearchAhead

These factors are all still in existence and hence this should be seen as the main reason why the environment of low macro-economic volatility has re-established itself. What is more though, nowadays there is one additional element at play as a means to prevent another financial crisis: the increased usage of macro-prudential policies. The aim of such policies is to manage systemic risks within the banking sector as well as the broader economy. It thereby should lower the probability of another devastating financial crisis. Mostly, it is expected to do this via preventing the build-up of new excesses in certain regions or sectors. As an example, facing a credit-fuelled house price surge, the macro-prudential regulator would for example demand higher capital buffers or reduce the maximum allowed loan-to-value ratio. This should ease rampant credit growth and should thereby stabilise the housing market. 
For overall economic growth it means that it should be somewhat lower than would otherwise be the case. Furthermore, the central bank does not need to take care of regional or sectoral excesses. Combined with a more subdued growth rebound it can refrain from hiking rates for longer. Or put differently, the central bank does not need to raise rates in order to break the neck of a housing boom (and thereby killing the economy) but can instead focus on the overall economic developments. In this case, it should also take longer for inflationary pressures to materialise amid an overall less pronounced growth recovery. On the other side, if a downturn hits, it should also be milder and shorter as the previous excesses were smaller and there are more instruments available (easier capital rules, lending standards) to counteract the downturn than was the case in earlier business cycles. 
As a result, the introduction of macro-prudential policies should help to lower macro-economic volatility further and serves as a partial substitute for traditional monetary policy. This can be seen with the example of Switzerland. The Swiss National Bank introduced a floor in the EURCHF rate in 2011 in order to prevent a strong currency from driving the economy into a deflationary recession. However, doing so meant giving up implementing an independent monetary policy. Effectively, the SNB can not hike rates for as long as the ECB does not hike rates or it needs to give up on its exchange rate target. The resulting loose monetary policy environment (zero rates and aggressive balance sheet lengthening) provided fuel to an already existing housing market upturn. In order to slow down the housing market, the Swiss government has – on the request from the SNB – increased banks' counter-cyclical capital buffers for mortgages for the second time in January this year. This measure should promote a less loose environment in the mortgage market while at the same time allows the SNB to conduct its easy monetary policy for the broader economy for longer. 

For markets, the lower macro-economic volatility should be mirrored in lower financial market volatility across asset classes. Moreover, the volatility of central bank rates should drop even more as in those currency areas where macro-prudential policies play a more important role, policy rates need to be changed by less. This also means that respective central banks can wait longer before they revert to rate hikes.This all argues in favour of carry and of less liquid products across financial markets as well as for an environment of lower risk premia and flatter curves than at similar stages during previous business cycles.

Thursday, March 20, 2014

EM slowdown should not threaten European and US recovery

Currencies of non-commodity producing developed economies appreciated significantly over the past twelve months. Moreover, growth has been weakening in a large number of emerging markets. Does this threaten the growth recovery underway in Europe and the US? I do not think so as the upward pressure on EUR, GBP and USD results from capital flowing back into these areas, providing for looser monetary conditions which works against the fx-induced monetary tightening. Moreover, while exports going into EMs and commodity producers should be negatively affected, the European economies are mostly dependent on each other and therefore might find themselves in a mutually reinforcing recovery.

During the past decade, emerging markets have grown strongly and a lot of capital has flown into the emerging markets world. Additionally, as EM have a high commodity intensity of growth, the demand for commodities increased significantly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. However, higher commodity prices put upward pressure on European (ex Norway) and US inflation and downward pressure on growth. Thereby, it worsened the debt crisis of recent years and lead to more capital flowing out of Europe/the US into EMs and commodity producers. Last year, however, this process went into reverse. The fundamental environment for a large number of Emerging Markets and commodity producing economies has been deteriorating amid the build up in (private sector) indebtedness, loss of competitiveness, rising current account deficits/falling surpluses and growing political risks. The fundamental supply-demand balance for commodities has deteriorated as well amid higher supply growth on the back of the previous rise in investment and lower demand growth due to weaker growth in the commodity intensive emerging markets. On the other side, systemic risks in the Eurozone have receded, real growth in Europe and the US is slowly rising and QE draws to an end, leading to upward pressure on UST, Gilt and to a lesser extent Bund yields.    
Developed markets and commodities: From a vicious to a virtuous cycle
  Source: ResearchAhead
In turn, capital has started to flow back out of EMs and commodity producers into Europe and the US, leading to strong upward pressure on currencies such as EUR, GBP and USD. Thereby, the previous vicious cycle has given way to a virtuous cycle. Commodity prices have stopped rising/been dropping. This puts downward pressure on inflation but supports real growth. This in turn, eases the debt crisis and helps to improve fiscal budgets. This process has much further to run and the trends of recent quarters where DM assets outperform vs. EM assets - with EUR, GBP, USD appreciation vs. a broad basket of currencies, EM vs. DM spread widening and DM equity market outperformance – can continue. While the appreciation in EUR, GBP and USD acts to tighten monetary conditions, it also props up asset prices and provides for an improvement in financing conditions – especially in the Eurozone periphery – which constitutes a loosening of monetary conditions. Just as EM equity markets dropped significantly in recent months, DM equity markets moved higher. Furthermore, as the chart below shows, sovereign CDS in Europe and the US fell sharply while sovereign CDS in emerging markets rose significantly. 

12m change in 5-year sovereign CDS

Source: Bloomberg
Moreover, the export environment should improve despite the stronger Euro and a more challenging environment for emerging markets and some commodity producers. The table below shows exports in % of GDP for Eurozone countries. The first row shows exports going to other Eurozone countries, the UK, Switzerland, Sweden, Denmark (i.e. Western Europe ex Norway) and the US. The second row contains exports relative to GDP going to Emerging and Developing countries. The final row shows the ratio of the two numbers. Exports to Western Europe and the US far outweigh those going into the EM world. The Euro did not appreciate much vs. these currencies (it even depreciated slightly vs. CHF and GBP). Only in the case of the USD has it appreciated meaningfully over the past year. However, with a rise of approx. 6% this should not be enough to negate rising demand on the back of higher US growth. In turn, export demand for Eurozone countries (and the UK) should improve given that they are mostly dependent on each other, thereby mutually reinforcing their cyclical upswing!  


Friday, December 13, 2013

Economies & Markets in 2014: Welcome to the New Age

This is a shortened version of my macro and markets outlook for 2014.

2013 was marked by a reduction in systemic risks in the Eurozone, falling inflation and gradually improving growth at low levels in Europe and the US. As we move into 2014, systemic risks promise to remain low, real growth is set to increase substantially and inflation should bottom out. While fiscal policy was very restrictive in recent years – thereby forcing monetary policy to adopt an increasingly accommodative stance - it will become much less so in the quarters ahead. This will force some of the major central banks to limit their monetary accommodation. As European and US growth improve and the Fed winds down its asset purchase programmes, the first half of next year promises to see a continuation of recent trends – bear-steepening of US, UK and EUR curves with an outperformance of the Eurozone and an ongoing tightening in Eurozone sovereign bond spreads. However, significant above-trend growth, slowly rising core inflation and wage pressures on the back of falling unemployment will push the US Fed into further action towards the end of the year. In line with the FOMC’s forward guidance, rate hikes will not yet be on the agenda but an outright reduction in USD liquidity will become increasingly likely via the introduction of reverse repo operations. This, however, promises to cause a renewed wave of selling across Emerging Markets and in commodity dependent assets and currencies while also propelling risk aversion and realized volatility higher across developed markets. The upward pressure on EUR, USD and GBP vs. a broad basket of currencies should be maintained in 2014 but as the year progresses, the USD should increasingly become the outperformer within this group. 

  • Short UST, Gilts, Bunds and JGBs. US-EUR and UK-EUR spread wideners.
  • Long break-even wideners.
  • Overweight higher-yielding semi-core and peripheral bonds.
  • Long USD, GBP and EUR vs. a broad basket of EM and DM currencies. Short CAD, NOK, AUD & JPY.
  • The second half is likely to be dominated by increasing prospects of monetary tightening in the US and the UK. 

Wednesday, October 30, 2013

Low, lower, Eurozone inflation

I have been arguing for several years now that medium term inflation pressures in the Eurozone are very low. Furthermore, as written in spring this year (see: Rising deflation risks in the Eurozone dated April 16), I was looking for inflation to drop to 1% and even below. The latest news on the inflation front confirm this assessment. Today, Spanish HICP fell to a level of only 0.1% yoy in October (vs. estimates of a fall from 0.5% to 0.4%). German inflation dropped from 1.6% to 1.3% in October (vs. expectations of a 1.5% reading). Hence, Eurozone HICP is also likely to fall further. In September headline inflation fell to 1.1% and core inflation to 1.0%, materially below the ECB's "below but close to 2%" target.
Over the past years, inflation in the Eurozone was largely driven by higher commodity prices (amplified by a weaker Euro during the sovereign debt crisis) as well as due to significant fiscal tightening (via higher consumption taxes and higher prices for administered goods and services). The chart below shows the development of various inflation measures. The difference between headline inflation (in blue) and core inflation (in black) is down to the swings in commodity prices. As major central banks (Fed, ECB, BoE) slashed rates to 0% and flooded the market with an unprecedented amount of liquidity to counteract the debt crisis and economic weakness, commodity prices shot higher, leading to upward pressure on headline inflation rates. Now, however, the commodity super cycle has ended (see for example my strategy presentation from May) amid a fundamental shift in the supply-demand balance and weaker growth across a large number of emerging market economies. The shift in the commodities market environment has been amplified by the Fed's tapering talk in spring/summer and by improving growth prospects in Europe and the US as this led to a shift of capital out of commodities back into US and European equities.
Eurozone inflation developments
Source: Eurostat, ResearchAhead
What is more, a large part of core inflation during the Eurozone sovereign debt crisis (i.e. since late 2010/the beginning of 2011) was down to fiscal tightening measures. This can be seen in the difference between core inflation and the core measures ex admin prices (in red) and the core HICP constant taxes ex admin prices (in green). These inflation measures try to deduct the impact of higher consumption taxes and higher prices for administered goods and services from the core inflation measure (as these higher prices were due to the fiscal tightening). As can be seen, this adjusted measure has been running below 1% for quite some time and stands currently at 0.7%, i.e. still significantly below core inflation. As additional fiscal tightening measures become less pronounced, this difference should fall further. Moreover, the level of excess capacity in the Eurozone remains at a record high, monetary and credit dynamics are very subdued and the high level of the Euro decreases prices for imported goods & services. 
So far, the record low in Eurozone core inflation was reached at 0.8% in Jan/Feb 2010. However, at that time, the enacted strong monetary and fiscal easing measures lead the Eurozone and the global economy into a fast recovery following the deep recession after the Lehman bankruptcy. The Eurozone composite PMI stood at 53.7 in February, rising to 57.3 in April. Furthermore, commodity prices were rising sharply, leading to rising inflation pressures. Now, however, the composite PMI stands at 51.5, suggesting that Eurozone growth remains below trend for longer and hence excess capacity is unlikely to shrink while commodity prices have been moving sideways (energy) to lower (agriculture). Hence, the low point in Eurozone inflation should not yet have been reached and core inflation is likely to hit a new record low in the months ahead. The ECB will have to take note of these developments. 

Friday, August 23, 2013

Developed markets growth improvement vs. busting EM bubble

I have been looking for higher safe yields in Europe and the US for some time now and also expected a growth improvement of net-commodity consuming developed markets vs. the rest of the world. In early July I concluded (see: H213: Limited systemic risks, low inflation & relative DM vs. EM growth improvement): "Those countries and markets which have been supported heavily by capital flowing out of the US and Europe (i.e. commodities, EMs) are most at risk of a significant underperformance as the combination of weakening fundamentals and the potential for a tighter monetary environment amid capital outflows demand its toll. On the other side, US, Europe and Japan should see a supportive mix of improving growth and an ongoing growth supportive monetary environment. In turn, risky assets and currencies of the EM/commodity producing world should continue to be sold on uptics whereas developed markets’ risky assets as well as US/European fx should be bought on dips. However, safe nominal and real yields have seen their lows and moved back on a rising path, especially in the US. "
This conclusion remains fully valid and the current market movements (higher nominal yields, higher risky asset prices and higher currencies in the Eurozone, UK and the US on the one side, lower currencies and risky asset prices in EM and commodity producing countries on the other) promise to run significantly further.

To escape the US Great Recession and the sovereign debt crisis in Europe, capital has flown into emerging markets and commodity producing countries in previous years. It helped fuel growth, inflation and indebtedness and thereby lead to worsening fundamentals in the capital receiving countries. As systemic Eurozone risks have abated, growth in Europe and the US is improving and real yields are rising, this capital is now flowing back, exposing an environment of worsened fundamentals in the EM/Commodity producing countries.
Even though their currencies are plummeting, the capital outflow constitutes a net monetary tightening in the affected emerging economies as credit availability shrinks and rates are rising. Moreover, several emerging markets face the problem that a lower external value of their currencies translates mainly into higher inflation and not higher external competitiveness. In order to prevent further capital outflows, some countries have already reverted to rate hikes (thereby further tightening monetary conditions) and/or started to buy their own currency with the help of foreign reserves (which, however, tends to reduce liquidity in the domestic financial system). Also the currencies of developed market commodity producers (i.e. NOK, AUD, CAD) continue to be at risk. These countries see a deterioration of their fundamental outlook amid the end of the commodities super cycle. Furthermore, they have been at the receiving end of large sums of capital flowing out of the Eurozone and the US as well which now might increasingly flow back. Finally, they were also beneficiaries as central banks increasingly diversified their reserve currencies over the past years. As reserve accumulation goes into reverse, though, this support evaporates. Hence also in this case fundamentals suggest a deteriorating environment. The difference to emerging markets is that the respective central banks tend to accept the lower external value of the currency and can even react with rate cuts as for example in the case of Australia. As a result, instead of performing pro-cyclical policies into the slowdown as in a number of emerging markets, they have the ability to enact counter-cyclical measures. Nonetheless, as growth is weakening and capital is flowing out, there is more currency weakness in store.
For the Eurozone, the UK and the US the reversal of capital flows constitutes monetary easing and should lead to an improvement in credit availability over the medium term. Therefore it counteracts the growth negative effects from higher yields and higher trade-weighted exchange rates. In turn, the trends of higher yields and stronger currencies promise to run further on a strategic time horizon (i.e. on a 6-9m view to Q1-Q2 2014) and the respective strategic positioning (shorts in safe bonds, longs in EUR,GBP,USD) should be maintained. Spreads of higher-yielding semi-cores and peripheral bonds should see a sideways to tighter trading environment given that higher growth improves their creditworthiness amid a better outlook for the debt-GDP trajectory.
However, the dislocations in emerging financial markets have the potential (via weaker growth and weaker currencies) to lead to lower export demand for the developed markets and might in conjunction with fears surrounding the Fed’s tapering temporarily lead to higher risk aversion. Within fixed income, this could potentially have the largest effects on corporate bonds. For one, a large number of corporates has profited significantly from the booming emerging and commodity producing countries. Furthermore, corporate bonds in general have been in good demand over the past years as a means to escape the sovereign debt crisis. Hence, risks are for a partial reversal of these flows and sovereign bonds should be preferred to corporate bonds.

Friday, July 12, 2013

H213: Limited systemic risks, low inflation & relative DM vs. EM growth improvement

My outlook and asset allocation for H2 2013 remain mostly unchanged (see also my strategy presentation from May Low systemic risks, low inflation and improving real growth): Systemic risks - which emanated mainly from the Eurozone - remain limited, inflation will be low for longer while real growth in developed markets can improve over the next quarters. On the other side, the outlook for several important emerging markets as well as commodity producing economies has been deteriorating.

The US economy has successfully averted the so-called fiscal cliff and following a period of subdued dynamic, growth should reaccelerate into year end. For one, the negative effects of the fiscal tightening enacted earlier this year should slowly fade while the housing market has turned around, the output of oil & gas is on a structural upward trend and the combination of an improving labour market, rising real wages and high pent up demand for consumer durables should support consumption growth. Furthermore, the monetary transmission mechanism in the US has been restored suggesting that the previously enacted monetary easing is increasingly hitting the real economy. As a result, the US Fed will start to taper its asset purchases in October and is likely to start rising rates in Q4 2014.
In the Eurozone, the economy remains mired in a mild recession. However, growth should gradually move into positive territory during the current half of 2013 and improve further going into 2014 even though it will remain below trend. For one, the negative growth effects from rising energy prices should fade while the negative growth effects from a restrictive fiscal policy environment should slowly become lower. On the other side, Spain, Portugal, Ireland and Greece have largely restored cost competitiveness and as a result the positive growth impact from net exports should increase. In line with the ECB’s forward guidance, there is no rate hike on the horizon for a long time and there remains a substantial probability for another cut in the repo rate, albeit a cut in the depo rate into negative territory carries a very low probability only. Furthermore, the ECB is likely to prevent an increase in EONIA levels and should be expected to counteract a further marked fall in excess liquidity.
Just as the growth environment in the US, Europe and also in Japan (amid the massive easing of monetary conditions) improves, it will become more difficult for a number of emerging market and commodity producing economies. China is actively trying to rebalance its economy, moving growth away from a credit-fuelled and resource intensive investment boom towards more consumption/services leading to significantly lower growth in the process. Moreover, a large number of emerging markets have seen a deterioration in their fundamental environment over the past years just as a constant stream of capital flowed from Europe and the US into their economies. Private sector credit growth has been rampant and financing conditions might become increasingly restrictive in an environment where the Fed ends its USD glut. In turn, risks will be rising over the course of 2014 that several EM central banks will have to start selling their foreign currency reserves in order to support its currency and domestic financial markets.
Those countries and markets which have been supported heavily by capital flowing out of the US and Europe (i.e. commodities, EMs) are most at risk of a significant underperformance as the combination of weakening fundamentals and the potential for a tighter monetary environment amid capital outflows demand its toll. On the other side, US, Europe and Japan should see a supportive mix of improving growth and an ongoing growth supportive monetary environment. In turn, risky assets and currencies of the EM/commodity producing world should continue to be sold on uptics whereas developed markets’ risky assets as well as US/European fx should be bought on dips. However, safe nominal and real yields have seen their lows and moved back on a rising path, especially in the US.

Tuesday, May 14, 2013

Strategy presentation: Low systemic risks, low inflation & improving real growth

I have published a new strategy presentation Low systemic risks, low inflation & improving real growth. Here are the key points:

A) Is the commodities super cylce over?
Amid the sharp surge in commodity prices over the past ten years, investment into commodities (commodity production and physical/paper commodity holdings) have surged. Now, physical supply is increasing at a faster rate than before. Moreover, amid the subdued commodity price performance of the past two years and improving prospects for equities, investors have started to shift out of cash and commodities into equities (aka "the Great Rotation"). Moroever, Chinese growth has cooled and the Chinese growth mixed has become more dependent on services growth than before and hence less resource intensive. The result is lower demand growth. The effect for the net-commodity consuming countries (Europe ex Norway, Asia ex Malaysia/Indonesia, US) constitute a positive supply shock, i.e. a reduction in inflation and a support for real growth. On the other side, commodity producers should see slower growth.

B) US economy to move back on a self-sustainable growth path
The longer-term outlook for the US economy has become increasingly more favourable. The structural rise in the output of oil & gas, the sharp reduction in household debt service ratios, the improvement in bank balance sheets, the restoration of the monetary transmission mechanism, the recovery in the housing market, an increasing level of pent up demand (business investment & household durable goods) combined with a slow recovery in the employment market and a slow rise in real earnings render the medium-to-long-term growth outlook very favourable. As growth improves, the fiscal deficit will fall markedly further. Moreover, amid the rise in oil & gas output, the current account deficit can decrease slightly further. The current spring soft patch - caused by fiscal tightening and still wrong seasonal adjustments - will be over soon. Inflation does not pose a significant problem. Core inflation rates can move slowly higher again over the medium term. However, as the Fed will likely start to scale back its asset purchases probably in Q4, the pressure on the USD should be for higher levels but commodities should suffer further. Hence, headline inflation rates should remain relatively subdued.

C) Eurozone growth improvement ahead
Eurozone growth expectations have been lowered further. However, the growth outlook is starting to improve. Austerity measures have reduced growth by more than 1% in 2011 and 2012 but should the negative effects should weaken over the next quarters as austerity policies are weakened (Italy) and stretched out over a longer-term time scale (France, Spain, Netherlands). Furthermore, energy prices have reduced growth by 0.5% each year since 2010 but this effect should vanish completely. Spain, Greece, Ireland & Portugal have made substantial progress in restoring their competitiveness. Hence, export growth should increase and the adjustment recessions should weaken. Amid the substantial reduction in bond yields across the Eurozone, monetary accommodation has been increasing and with the usual lags should become more growth supportive. From a more short term perspective, the long and harsh winter has weakened the usual spring upswing in March and up to mid April. But as winter has finally gone, the spring upswing should gather steam. Finally, with the formation of a government in Italy, the uncertainty has been reduced and should help the Italian economy to recover. As a result, the Eurozone growth can improve slowly and start to surprise positively over the next few months vs. the lowered expectations. Inflation risks in the Eurozone remain low as core inflation is being held back by weak credit growth and a very high level of unused capacitiy while easing commodity prices are exerting downward pressure on headline rates as well.
The ECB will likely not cut rates any further but focus on steps to kick-start an ABS market for SME loans. This would help the banking sector, however, it will be a slow process only.
For the sovereigns, debt sustainability has been increasing amid the sharp reduction in sovereign bond yields and the slow improvement in primary balances. Furthermore, they have been shifting banking sector credit risks back onto banking creditors. Systemic risks remain in the Eurozone remain moderate.

D) Strategic Views & Trades
  • The bull market in “safe” bonds (aka Bunds, UST) has ended. On a 6m horizon, Bund yields should trade back to the upper end of the trading range of the past 12 months, more substantial upside in UST yields. 
  • Previous periods of rising safe yields were driven by additional aggressive central bank easing (QE by the US, LTRO/OMT by the ECB) or expectations of central bank tightening (as at the start of this year where markets priced a significant monetary tightening amid early LTRO pre-payments) the next few months will likely be driven by an improvement in the real growth environment. Real yields should be rising and safe curves should steepen 
  • The environment for carry products in the Eurozone remains favourable as monetary policy remains supportive, the growth improvement improves debt sustainability and the need to generate carry & roll-down remains strong spreads for higher-yielding semi-cores peripherals can narrow further.
  • Short Bunds, short UST, UST-Bund spread wideners, short German and French inflation linkers, Bund and OIS curve steepeners, semi-core Bund spread tighteners, outright longs in peripheral bonds (Italy, Spain, Portugal, Ireland, Greece). Prefer periphery vs. similar yielding financials. 
  • Asset Allocation: overweight equity (from net-commodity consuming countries & long cyclicals); small overweight in bonds (amid overweight in carry products, but underweight in safe assets); underweight commodities & cash; overweight EUR & USD; underweight JPY & commodity fx