Friday, February 27, 2015

A pronounced cyclical Eurozone upswing is in the offing

The structural factors holding back the Eurozone remain substantial, most notably poor demographics, high indebtedness and a lack of reforms in large countries such as France and to a lesser extent Italy. These structural deficiencies are mainly responsible for relatively low trend growth, probably close to around 1.5%. On the other side, cyclical forces are about to provide the strongest aggregate growth support in a long time. As a result, Eurozone growth should increase markedly in the quarters ahead, likely moving to around 2.5% on an annualised basis by year-end.
First, oil prices in Euro have collapsed and are now down by approx. a third since June last year. It is thought that a 10% drop in oil prices reduces the CPI index by approx. 0.2% and might increase GDP by 0.3%. However, the effects on inflation have largely run their course after three months while it takes 3-4 quarters before the effects on growth become visible. Hence, oil prices are only just about to start exerting their growth positive impetus with the support becoming ever stronger as the year progresses.
Second, the Euro has appreciated since the summer of 2012 until reaching a high in between Dec13 and March14 before moving slightly lower during summer and sharply lower from December onwards. Changes in the trade-weighted currency usually take around 6-9 months before they are being reflected in the economy. Hence, so far only the growth negative effects of the previous strong Euro period should have been absorbed. The growth positive effects of the subsequent Euro weakening are just about to begin and should also become stronger as the year progresses.
The collapse of oil prices (in Euro, red) and the fall in the trade-weighted Euro (white) will exert a growth positive effect
Source: Bloomberg
Third, real yields have moved sharply lower. 10y German real yields have already from 2009 started to become growth supportive as they fell from 2% in 2008 to below 1% in 2011 and have traded below 0% for most of the time since 2012. On the other side, peripheral real yields have been at historically high levels during recent years, thereby exerting a growth negative effect on the economy. As an example, 10y BTP real yields increased from approx. 2.5% in 2008 to 7% in late 2011, before starting to fall as the ECB implemented its emergency measures. Still, even at the beginning of last year, 10y Italian real yields hovered around 3%, a substantially restrictive level for a country where trend growth stands around 0.5%. By now, though, real yields have fallen to approx. 0.3% and should thus provide for an increasing growth tailwind. 
10y BTP real yields (left) have become growth supportive
Source: Bloomberg 
Fourth, credit creation has been negative ever since the Eurozone sovereign crisis broke out in 2011. The right-hand chart below shows the yoy growth rate of MFI loans to the private sector. Loan growth peaked in 2011 when the Eurozone debt crisis broke out and moved into negative territory. Negative loan growth became even more pronounced during 2013 as banks prepared for the ECB’s comprehensive assessment (as the end 2013 balance sheets were used for the AQR). However, loan growth has bottomed a year ago and has slowly recovered since. The outstanding level of loans has bottomed in August last year, just ahead of the release of the AQR results. In between September 2011 and August 2014, loans were reduced by a total of EUR 670bn, which also constituted a significant drag on the economy. Looking ahead, though, the banking sector has been largely recapitalised and the new single supervisory mechanism (SSM) is now in place. Banks are thus finally in a position to more actively manage their balance sheets while improving growth coupled with lower loan rates – substantially so in the periphery – suggests that loan demand should pick up again. Hence, credit creation promises to move back into positive territory, thereby also turning from a growth headwind to a tailwind. 
Credit creation has bottomed
Source: Bloomberg 
As a result, monetary policy has finally become accommodative for the periphery for the first time since the Eurozone debt crisis broke out in 2011. Moreover, fiscal policy has been a significant drag on growth in recent years amid large scale austerity measures. According to the IMF, the cyclically adjusted primary balance for the Eurozone has moved from a deficit of 2.5% in 2010 to a surplus of 1.2% in 2014. Hence, fiscal policy has accounted for a drag of approx. 4% of GDP or 1% per year in recent years. However, the austerity drive has weakened during recent quarters and fiscal policy has moved from being very restrictive to becoming only mildly so and thus the growth negative impact should be much smaller as well.
On a country basis, Germany should continue to do well amid growing exports and a supportive backdrop for the domestic economy (low real yields, high employment, rising real wages). More importantly, France and Italy promise to move from below trend to above trend growth by the end of next year. The substantially weaker Euro should be of vital importance for these countries exporters given that they mainly compete via price and less via product complexity/quality such as for example Germany. In the case of Italy, the sharp drop in nominal and real yields should also provide for relatively higher support.  
Summing up, monetary policy as well as oil price and exchange rate developments turn from a significant growth negative factor towards a marked growth positive one while the growth negative impetus of fiscal policy abates. Therefore, Eurozone growth should move from a below trend pace to a markedly above trend one of around 2.5% on an annualised basis towards year-end. As growth improves, so should the long-run trajectories for the debt-GDP ratios across the Eurozone. The structural primary balances have mostly moved into surplus already and fiscal deficits should become significantly lower amid higher growth and lower yields. Markets should increasingly focus on these materially improving Eurozone growth prospects.

Friday, January 16, 2015

Swiss policy mistake

The removal of the EURCHF floor by the SNB is a very large policy mistake. Apparently the inflows into the Swiss franc have been too large for the SNB to continue increasing its balance sheet in order to absorb the inflow and keep the floor intact. Moreover, as the ECB will engage in QE next week, the SNB feared that the inflows would even increase further and given the strength of the USD over recent months (which dampens the appreciation of the CHF on a trade-weighted basis) probably thought that it could get out of the minimum exchange rate floor policy relatively easily.
However, what the SNB has done is tighten monetary policy sharply as well as injecting a heavy dose of policy uncertainty into the Swiss economy.
First, inflation has already fallen into negative territory in December amid the fall in oil prices and should have expected to fall further in the short term. Now, however, the SNB has added another sharp deflationary shock for the Swiss economy. In turn, inflation - on the headline and core measures - will fall significantly further. While it has also lowered the 3m Libor target rate as well as the rate charged for deposits held with the SNB from -0.25% to -0.75%, nominal bond yields and mortgage rates are unlikely to fall to the same extent as inflation. Thus, not only has the currency appreciated sharply within a matter of minutes, but also expected real yields have probably risen (unfortunately this is a guess as there are no CHF inflation swaps). While SNB president Jordan stated that the Swiss exporters have had 3.5y of time to adapt to the higher CHF, the new appreciation is very drastic and has never occurred in such a fast period of time. In turn, exporters have just lost 20% in terms of international cost competitiveness overnight, a development which will cause significant pain. Besides exports, also investments should be negatively affected amid the lower exports, the renewed monetary uncertainty as well as the likely higher real yields. In turn, nominal growth - which has already been muted in recent years - will likely turn negative in the quarters ahead.

Trade-weighted Swiss franc shoots to all-time high
 Source: Bloomberg

Moreover, this step is unlikely to end the inflows into the Swiss currency. For one, Switzerland and thus the Swiss franc has likely seen large capital inflows recently not only due to the Euro's renewed weakness but probably even more so due to capital flight out of Russia. Switzerland's safe-haven status, the fact that several Russian oligarchs already operate out of Switzerland and in addition that Switzerland is only half-heartedly following the EU sanctions against Russia should be responsible. The ongoing Ukraine/Russian crisis suggests that these inflows will remain. Moreover, as QE in the Eurozone just gets going, the downward pressure on the Euro will likely remain, not least due to uncertainty with respect to Greek political developments. As a result - and given that the Swiss current account surplus amounts to approx. 10% of GDP - inflows into the Swiss franc and thus appreciation pressure should remain. The negative 0.75% interest rate on SNB deposits is only a weak form to counteract more safe-haven inflows as most of the deposits are not affected anyhow (due to high allowances) and given that 0.75% per year does not seem a lot for those fearing for their wealth. Hence, in order not to see the Swiss franc appreciating much further, the SNB will still be forced to intervene, however, now at lower EURCHF levels and with a much lower institutional credibility. The only alternative to save the Swiss export sector from even more pain might be some kind of capital controls (which would be done by the government). It seems that the SNB did not gain much as it still needs to intervene in large amounts but clearly damaged its credibility and has just forced nominal GDP growth significantly lower.

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.