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.

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.

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.