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

Growth rebound in the Eurozone about to get started

I think that there is a good case to be made that safe yields – especially for German Bunds - are past their lows for the year and I shift my tactical stance from neutral to moderately bearish/selling on uptics with a horizon of one month while I maintain my bearish view for Bund and UST with a view to year-end.

First, the ECB has now delivered what I expect is the final rate cut. I do not think that another rate cut is upcoming, especially not for the deposit rate. A negative deposit rate is a tool to lower the level of excess liquidity in the financial system (as no one wants to pay for depositing cash with the central bank) and hence usually has been used to prevent further money inflows in a period of a strongly rising exchange rate (i.e. Denmark). However, the ECB does not really want excess liquidity to drop significantly further in the near term, hence, a negative deposit rate would not serve their purpose. More important are steps to kick-start an ABS market for SME loans. As ECB president Draghi stated at the press conference last week, the ECB is working together with the EIB on such a plan and the German daily “Die Welt” reported that the ECB is thinking about implementing a buying programme for such ABS (however, before they are able to buy SME ABS, there needs to be such a market). Increasing issuance of securitised SME loans would help banks to lower financing costs and more importantly should also free up capital. Hence, it would ease the deleveraging process/free up capacity for new loans and thereby should lower rates for SME loans and improve their availability. Clearly, though, such a process takes a long time.

What is more, though, I think the Eurozone economy is about to turn the corner with growth improving markedly from here onwards, thereby surprising reduced expectations.

Unit labour costs (1999=100, left) Trade balance in % of GDP (right)

 

Source: Eurostat

Form a longer-term perspective, an increasing number of peripheral countries have significantly improved their competitiveness. Unit labour costs in Ireland, Spain, Greece & Portugal have come down significantly over the past two years and the trade balances have moved from significant deficit into surplus. Amid improved competitiveness, the positive impact from rising export demand should therefore increase over the next few quarters especially given a generally more favourable global growth backdrop. Additionally, the negative impact provided by the austerity measures should be about to get lower from here onwards. From 2010 to 2012 the cyclically adjusted primary balance in the Eurozone has moved from a deficit of 2.4% to a surplus of 0.3% according to the IMF and is expected to reach 1.4% this year. Hence, fiscal policy acted as a drag on growth to the tune of more than 1% per year. However, the political support for further austerity measures has been weakened and France and Spain is about to receive two more years and the Netherlands one year to fulfil their budget objectives. As the French finance minister has indicated, France is likely to increase privatisation rather than taxes/or cut spending further. Moreover, in the case of Italy, the new government is also unlikely to drive austerity any further (and clearly Italy with a surplus of 2.3% in its primary balance in 2012 does not need to save more). The net result is that the negative effect from fiscal policy is likely to drop significantly from here onwards, helping growth to recover. Furthermore, the rise in oil prices has been a significant drag for the Eurozone economy as well. 2012 net imports of mineral fuels increased by approx. EUR 150bn compared to 2009. This is equal to 1.5% of GDP and hence rising energy prices were a drag on growth of approx. 0.5% per year in 2010, 2011 and 2012.

Eurozone net imports of mineral fuels, lubricants and related materials in EUR bn

Source: Eurostat

However, oil prices in Euro seem to have peaked in the summer of last year and have since lost more than 10% with Brent crude in Euro down 8% over the past three months. Furthermore, agricultural prices also acted as a significant drag on growth, especially in 2010 but also since the summer of last year when they spiked by 30% within a matter of weeks (measured by the S&P Agriculture Index in Euros). By now, however, agricultural prices have given up all of their gains from last summer again. The effect is that the negative drag on growth from high commodity prices which was apparent over the past three years should fade completely over the next few months, barring another sharp spike in prices.

Additionally, bond yields – especially for the higher yielding semi-core and the peripheral issuers – have dropped sharply over the past months. This increases monetary accommodation in the semi-core and reduces monetary restrictiveness in the periphery and should – with the usual lags – also start to have positive growth effects.

Finally, there are also three factors which acted to temporarily restrain growth over the past months but have gone away by now. One was the long and harsh winter which lasted until almost the middle of April. This meant that the usual seasonal spring upswing started later/was weaker during March and early April. However, as winter has finally gone, the spring upswing  should materialize and data referring to late April/May should be positively affected. This should be seen as one factor which held back construction activity in Germany which dropped by 4.5% in March. Additionally, Italian growth should start to surprise positively. The uncertainty ahead of the election and clearly following the election as no government was formed acted to depress economic activity. Now, however, as a government has been formed this should pass again. Furthermore, as already mentioned, Italy does not need to save more and the new government seems to weaken the austerity efforts. As this happens growth should improve as well. Finally, uncertainty with respect to contagion from the deposit levy in Cyprus should have vanished by now.

Hence, I expect Eurozone growth to improve form here onwards over the next few quarters. The adjustment recessions in the periphery should weaken while Italy should move back to a positive growth environment and Germany should move back to slightly above trend growth as domestic demand improves again.

On a different note, the outlook for inflation continues to be very favourable. The high level of excess capacity should continue to exert downward pressure on core inflation while the lower level of commodity prices will also pressure headline inflation towards 1%. Hence, nominal growth should continue to be low for the time being.

For the US I remain very positive concerning the medium & long-term growth outlook. Private sector deleveraging should be almost over, the monetary transmission mechanism has been restored (leading to an easier monetary environment), the housing market has bottomed and oil & gas output is on a structural upward trend. However, data for the next few weeks might still be moderately weak (amid the fiscal easing and seasonal adjustment effects), but should start to surprise positively again from approx. June onwards.

All in all, I see increasing evidence that especially Bund yields have their lows behind them and from a tactic perspective I switch from a neutral to a moderate bearish bias. However, I do not expect significant yield increases already over the next few weeks.. Rather from summer onwards the picture should become more Bund bearish, in line with higher UST yields. Hence, positions should only be set up on uptics and be kept small for the time being. In conditional space 1:2 put spreads with the help of July options on the Bund future look attractive or alternatively selling atm calls and otm puts. I am also of the opinion that outright short positions in inflation linked Bunds are attractive and real yields should be rising over the next few months as growth improves but inflation can drop further. However, carry for inflation linkers during the current month is large before it turns negative thereafter. Hence, slowly entering shorts over the next two weeks seems advisable in order to reduce the impact of carry on performance.

Yield and spread volatility should remain moderate though as systemic risks remain moderate as well. The higher-yielding semi-core markets (i.e. Belgium and France) remain attractive for outright longs, however, a larger share of outright longs should be shifted into spread longs vs. Germany in order to reduce duration. Selling calls on the Bund future vs. long positions in pick-up products is also an attractive way to reduce “safe” duration. Buying on dips in the periphery (i.e. Ireland, Spain, Italy, Greece, Portugal) remains attractive. Here the focus can be kept on outright long positions.

For the fx markets I still remain of the opinion that the Euro has more upside left over the next few weeks vs. a broad basket of currencies (including the USD and JPY). I do think that the commodity currencies have started a secular downtrend. The USD should move on a long-term upward trend from summer onwards.  

What is happening with Germany?

Long-time readers will know that I have held an upbeat view with respect to Germany for a long time due to a number of reasons. One of the reasons has been the easy monetary environment provided by record low real yields (ongoing) as well as by the weak exchange rate. More important for Germany than the level of the trade-weighted Euro is the level of the EURJPY cross rate even though Germany does not have strong direct trade relationships with Japan. However, Germany and Japan are key competitors in the global markets for items such as cars, machines or chemicals. The collapse of EURJPY since the outburst of the financial crisis in 2008 has helped German exporters gain market share, especially in Asian markets, at the expense of their Japanese counterparts. Following the radical easing in monetary policy by the BoJ, EURJPY has shot upwards by approx. 30% within a matter of a few months.

EURJPY and EUR trade-weighted index

Source: Bloomberg 

This has important implications, not only for the German economy but also for the Eurozone overall:
a) The sharp rise in EURJPY constitutes a net tightening the monetary environment for Germany. German exporters are likely to face a more challenging export environment, especially in Asian markets. This will render the current economic upswing softer than would be the case otherwise.
b) The sharp rise in EURJPY does not have significant tightening effects on the other Eurozone economies, most notably France and the periphery. These economies compete to a much lower extent with Japanese exporters in world markets and hence a higher EURJPY is no issue. Rather, the likely flow of capital out of Japan (as the BoJ reduces the amount of JGBs available for private investors and hence cash needs to be invested elsewhere, likely also in Eurozone bond markets) helps to depress the yields of semi-core and peripheral sovereign bonds. Hence, the monetary environment in the periphery/semi-core gets more accommodative.
c) A weaker-than-expected state of the German economy increases the chances of further easing steps by the ECB (repo rate cut, moving into the direction of forward guidance, unconventional steps to promote the flow of credit to SMEs), supporting growth in the periphery via lower yields and a lower Euro (on a trade-weighted basis).

Overall, the German economy should see a growth recovery but a slower one than would have been the case otherwise whereas the support provided by the monetary environment for the periphery has been increasing and will increase further. As a result, growth differences between various Eurozone countries should become less pronounced.

Rising deflation risks in the Eurozone

I argued in November (see: No inflation pressures in the Eurozone) that inflation fears for the Eurozone are unfounded and rather deflationary risks in the periphery are significant. In the meantime headline and core inflation rates have fallen below the 2% target level. However, inflation pressures have continued to ease and inflation rates should be expected to fall markedly further to below 1% during summer.

The chart below shows the development of various inflation measures for the Eurozone. Headline and core inflation are well known. However, I also calculated a core measure ex administered goods and services. The price changes for administered goods & services are to a large extent directed by the sovereigns and amid the massive fiscal tightening in a large number of countries there has been significant upward pressure on the administered goods prices. Furthermore, I try to deduct also the effects of changes of consumption taxes on prices (Eurostat publishes a constant tax rate HICP). The green line shows this adjusted core inflation measure (i.e. a measure of inflation stripped off the effects of energy&food prices as well as the direct impact of fiscal tightening). This inflation measure stood at 0.4% in January. At that time, core inflation was at 1.3%. Hence, two-thirds of core inflation stemmed from higher prices for administered goods & services as well as higher consumption taxes. On a country level Spain is in outright deflation and France is at 0% inflation according to this measure.

Inflation developments in the Eurozone 

Source: Eurostat, ResearchAhead

Looking ahead, price pressures should ease markedly further. First, as headline inflation has been running above the core measures, prices for food & energy continued to exert upward pressure on inflation. However, as the chart below shows, Brent crude oil in Euros has already dropped by approx. 15% since early February and from where they stood a year ago. This is the largest yoy drop in oil prices since 2009 (i.e. at the height of the global financial crisis). Following a spike of approx. 40% last summer, also food prices (measured by the S&P GSCI Agriculture Index in Euros) have now turned negative on a yoy basis. As a result, the inflationary impact of food&energy prices should wane over the next months and headline inflation should fall to (and might even undershoot) the core inflation rate.

Year-over-year %-change of Brent crude oil in Euros

Source: Bloomberg

However, besides easing headline pressures, also core inflation rates should continue to fall further. For one, unused capacity in the Eurozone is at extremely high levels. Moreover, monetary developments remain very weak and M3 grew by only 3.1% yoy in February with the 6m annualised increase only at 2.1%. Within M3, M1 continues to be the main driver for M3 growth, while the broader aggregates continue to shrink. The 6m annualised change in M3-M2 has collapsed to -20% in February! As the chart below shows, growth in M3-M2 is a good leading indicator for core inflation and suggests that inflation pressures have been easing further. On the other side, credit growth remains very weak also, falling by 1.2% yoy in February. In Spain, loans for corporates are collapsing by almost 20% yoy and to households by 5%. But also in Italy, loan growth is negative while in Germany it stands at only 0% for corporates and 1% for households.

Growth in M3-M2 suggests easing core inflation pressures

Source: Eurostat, ResearchAhead

As a result, the combination of weaker energy and food prices on a year-over-year basis as well as very high unused capacity and very weak money and loan growth all suggest that core and headline inflation rates should fall markedly over the next few months. Sub 1% inflation rates during summer are very likely and should raise deflation fears.