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  • 12 Feb 2018 - Martin Shenfield

    The Dull 2018 Consensus

    Equity markets are arguably getting a little frothy short term & some sort of consolidation would be healthy, but we re-iterate that we are not yet in a full scale bubble; although ultimately before the music stops we expect to have fully experienced one!

    Apart from all the obvious longstanding rationales for the equity bull run we would emphasize that the consensus is still too cautious re the sustainability of this global economic cycle. My colleague Dario Perkins highlights again below why there is no ‘macro ‘ reason for this cycle to end by 2018 (which seems to be the consensus?).

    Indeed if he & Charles Dumas are correct about the under-reporting of productivity improvements & the likely acceleration in the latter we may be in for an extended period  of economic growth. The main risks to markets are therefore ‘market’ not macro, even if central banks are unnecessarily stoking an asset bubble with their obsession with chasing an arbitrary 2% inflation rate when the US & EA are already growing significantly above trend. A sharp spike in yields concomitant with a USD surge(very unlikely in the short term) is the most likely end game-so watch the cross currency basis for any sharp widening suggesting a material squeeze in offshore USD funding which would hit EMs, Japanese banks, etc hard & more generally equities.

    The sellside spent December flooding the investment community with long, sometimes tedious analysis about what the global economy and financial markets would do in 2018. Some of these reports – not pointing fingers – are already out of date. Because we are kind and thoughtful at TS Lombard, we have developed a tradition of reading these reports and summarising the ‘consensus’ for our clients – so they don’t have do. While this exercise is rarely something to get excited about, even for an economist, this time it is has been particularly dull. Most of these studies assume 2018 will be exactly like 2017 (was supposed to be), with slightly more inflation and a little bit of extra policy tightening. This is pretty much exactly what the consensus said 12 months ago, or 12 months before that. Worse, several of these studies even adopt the same title: ‘Rational exuberance’. Since this is also the message most central banks are pushing, it suggests the whole macroeconomic community is lacking imagination.   

    It is easy to see how the consensus got into this situation – 2017 was also fairly dull. While investors spent most of the year worrying about the end of the cycle, global growth actually strengthened and risk assets rallied. It became a cliché, but people even started to call this the ‘most hated bull market in history’. And with inflation unexpectedly dipping during the first six months of the year, it was clear that Goldilocks was making an unscheduled return. Since some of this was difficult to explain – particularly the dip in inflation (we blamed structural forces) – perhaps it makes sense for economists to extrapolate recent trends into the future.  You could even argue we did something similar in our own Year Ahead document, which in term of simple growth and inflation projections wasn’t too far off the consensus. But where I think we gain extra points, is in trying to explain why this cycle is unusual and whether the interplay between markets and macroeconomic could cause problems over the next few years. 

    Our most important theme for 2018 is that there is no ‘macro’ reason for this cycle to end. The things that usually prompt recessions – inflation, the perceived threat of inflation, a profits squeeze, monetary tightening and/or overinvestment – are largely absent. In fact, we see several structural forces that could mean this cycle lasts much longer than everyone is expecting, particularly if Germany ‘rebalances’ while new technologies deliver a powerful revival in productivity (assuming the authorities work out how to measure it). As far as I’m aware, no other sellside year ahead report expects anything other than a temporary burst of growth in 2018. We think the main risks for 2018 are ‘market’ not macro. This is where it is important to question what the major central banks are doing. Right now we seem to be in a bizarre situation where the Federal Reserve is reluctant to take on bond markets, convinced that the flat yield curve is telling it something profound about ‘equilibrium interest rates’, while the ECB and BoJ are simultaneously manipulating those same yields through their massive QE programmes (creating an acute shortage of safe assets). This is the perfect environment for bubbles. But since these policies look sure to continue through 2018, any ‘bubbles’ will probably bubblier.  

    In 2019, the outlook gets trickier. Some sellside reports acknowledge this, but don’t devote a great deal of time to it. The consensus can’t seem to decide whether the main problem will be a late-cycle burst of inflation (forcing long-term interest rates higher) or an inverted yield curve.  We think a sharp spike in yields is the main danger, particular when central banks have ended their QE programmes and the shortage of global safe assets begins to unwind. This is also likely to be the trigger for a wider selloff in risk assets and a significant injection of volatility in global markets. What started out as a 2004-06 style ‘conundrum’ could turn into a 1994-style blowout. The good news is that this needn’t herald a turning point in the broader macro cycle, let alone a repeat of what happened in 2008. To the extent there are bubbles, they are unleveraged and most major economies (including the US) are not as sensitive to long-term interest rates as often feared. But, of course, it depends how large these bubbles have become by 2019.  

    A large correction in risk assets would not only be more damaging to the global economy, but it could also undermine the orthodoxy of modern central banks – who will surely be blamed, rightly or wrongly, for their continued obsession will narrow definitions of price stability.

  • 25 Jan 2018 - Martin Shenfield

    Eurodollar Dangers

    Following on from our long standing above consensus optimism about both the sustainability of the synchronised global growth cycle & markets more generally, my colleague Dario Perkins considers below the risks to this rosy scenario of higher real yields (eventually) & in particular the threat of a global ‘dollar shortage’.

    If I had to sum up the TS Lombard global macro view in just a few words, it would be this: the current economic cycle is likely to continue (at least) until there is a significant ri se in real yields. To expand on this, I might also say that a rise in real yields would be a necessary – though not sufficient – trigger for the next global downturn. Until yields rise, we still see significant upside for risk assets including equities, even if this means entering clear bubble territory (the ‘meltup’). But rather than go over this view again, I thought I would use this Daily Note to discuss what is becoming an increasingly popular alternative view among certain investors – the idea that an acute shortage of US dollars could derail global markets in 2018, potentially killing the cycle even without a rise in yields. While this prognosis seems far too gloomy, the underlying analysis highlights some important risks that we will need to keep an eye on in 2018.  

    There has been a lot of talk about a ‘dollar shortage’ over the past couple of years, linked to certain FX and money markets behaving in unusual ways. Attention has focused on the breakdown of ‘covered interest parity’ (CIP), the closest thing we have to a physical law in international finance. When CIP no longer holds, investors are missing out on risk-free returns and market arbitrage has broken down. As we explained in a recent Macro Picture, while these pressures have become particularly noticeable since 2015, the ‘dollar shortage’ is not a new idea – it dates back to the start of the Dollar Standard in the 1940s. Economists realised that the US faced a potential conflict between domestic and international policy objectives (Triffin’s dilemma) and would need to run persistent current account deficits in order to supply the world with sufficient USD liquidity. Some worried that the Dollar Standard would become increasingly unstable, generating a series of boom-bust credit cycles. Those concerns returned in 2008.

    Yet the world’s desire for dollars extends far beyond its reliance on US trade deficits. With the dominance of global capital markets and, in particular, the emergence of the ‘Eurodollar system’ – a ubiquitous term that now covers both offshore dollar deposits and global banks’ wholesale dollar transactions – global finance created an explosion in dollar liquidity between the 1960s and 2007. This ended with the subprime crisis, after which the Eurodollar system has struggled. New regulations, which came into effect in 2015 have compounded these problems, restricting non-US banks’ dollar funding. With the system increasingly reliant on Federal Reserve liquidity, some commentators think the dollar shortage could become more acute in 2018, particularly when the FOMC steps up its Quantitative Tightening programme. There are even some who warn about a repeat of the 2008 crisis, when funding sources suddenly disappeared and global banks scrambled for dollar liquidity. If you have four hours to spare, you might check out this excellent set of podcasts called ‘Eurodollar University’.

    These risks seem overblown, not least since Fed QT (and the end of ECB QE) will supply new forms of collateral to the banking system, easing the safe asset shortage. The Federal Reserve also has much of its post-crisis monetary architecture still in place, including swap lines capable of providing emergency USD liquidity. But we agree it will be important to monitor this situation in 2018-19. Investors should watch the trade-weighted dollar index particularly closely, as the strains in money markets become more intense (cross-border lending dries up) during times of dollar appreciation. The Japanese banks also provide a potential pressure point, having built up considerable USD funding gaps – similar to what European banks were doing in the run-up to the subprime crisis. Could a liquidity problem at Japanese banks turn into a solvency problem? This depends on the quality of the assets they hold. To the extent they have contributed to China’s credit splurge, there are clear risks. But official data suggest the global banking system is not overly exposed to China – suggesting much of the bubble has been funded domestically. 

    The best way to monitor these risks is to follow the ‘cross-currency basis’, a simple guide to how far Covered Interest parity has broken down. While this blew out in the final weeks of 2017, causing concern among investors, it has since rebounded – suggesting ‘year-end’ effects were to blame. A larger, sustained widening in the basis, particularly next autumn when the Fed steps up its QT programme, would be a clearer threat to our view that higher long-term yields are needed before we should worry about the end of the current macro cycle. 

  • 11 Jan 2018 - Martin Shenfield

    Putting China’s Corporate Debt into Perspective

    My colleague Bo Zhuang who has analysed previously in great depth the China debt challenge (cf ‘China: Debt crisis not on the cards’,) including ‘deep data dives’ into the tier 3 & 4 provinces + local courts’ private lending dispute details which reveal an already significant level of unreported private sector defaults, sets out below an alternative take on China’s corporate debt mix.

    Having risen rapidly since the 2008 global financial crisis, China’s total debt level is now one of the highest in the world: 256% of GDP at the end of Q2/17, according to BIS data. The overall debt-to-GDP ratio is similar to that of some developed economies (the US and a number of European countries) but below that of others (Japan, France and Spain).

    A sectoral breakdown shows Chinese corporate debt as the highest among major economies, far exceeding the average in both emerging and developed countries. But household and government debt levels remain lower than in other countries. Total corporate debt fell somewhat from its Q2/16 peak of 167% of GDP to 163% in Q2/17. This was more than offset, however, by the 8% rise in household and government debt over the same period. So, in aggregate, China is still leveraging up, stoking ongoing fears of a looming financial crisis reminiscent of that in the US in 2008. 

    While academic researchers and international organizations posit many theoretical levels, in practice there is no “magic” level at which it can be predicted that a crisis will erupt because of debt. Many countries have experienced crises at levels significantly lower than China’s, often because their debt was financed by foreign sources, because banks provided funding and/or because of duration mismatches. On the other hand, Japan has seen debt levels rise to nearly 370% without any obvious financial-sector distress – despite warnings from analysts for more  than a decade.

    The high corporate debt ratio is distorted by SOEs and local government financing vehicles (LGFVs). While China’s corporate debt-to-GDP ratio of 163% was, indeed, the highest level in the world by far in June 2017, focusing on that ratio alone does not reflect the real situation. This is because Chinese corporate debt is significantly distorted by the borrowings of SOEs and LGFVs, which carry implicit or explicit government guarantees. Experience to date suggests that SOE debt tends to be restructured (prolonged durations, lower interest-rate cuts, new asset injections or even debt-to-equity swaps) rather than written off by banks. Meanwhile, a large amount of LGFV debt is counted as corporate debt, even though it is borrowed largely on behalf of local governments. 

    We adjust the data by splitting corporate debt between private enterprises and SOEs, which provides a different picture from that presented by the BIS. While the total load remains the same, the debtor-mix changes dramatically. There is no official breakdown between SOE and non-SOE debt; but using various valuation metrics, researchers estimate that SOEs hold 60-80% of total non-financial corporate debt. The latest National Institution for Finance & Development numbers suggest SOEs accounted for 60% of all non-financial corporate debt at the end of Q1/17. 

    To arrive at our own estimates, we use Ministry of Finance (MoF) data, which put the total liabilities of SOEs at Rmb94.1 trn in June 2017, of which central SOEs accounted for Rmb49.8 trn and local SOEs Rmb44.3 trn. Assuming 25% of total SOE liabilities compiled by the MoF are either accounts receivable or obligations to non-financial institutions, we estimate SOE debt at 55% of overall corporate debt – or 90% of GDP – at the end of Q2/17. This is close to official data showing that "state-controlled" and "collective control" enterprises together accounted for 55-60% of total bank loans during the period 2013-15. 

    We think of the Communist party-state as a portfolio manager overseeing a clutch of assets comprising the balance sheets of the government, SOEs and banks. When local governments have difficulty continuing to finance loss-making SOEs, these entities become a burden to the regime and weaken the overall portfolio. Small and non-strategic local state enterprises may be allowed to fail. But when it comes to centrally controlled or key provincial SOEs, such an approach would mean weakening the regime’s control of the economy – not a risk that Xi Jinping is going to run, given the emphasis he has put on “socialist strengthening” through a reinforced Party, which is now playing a bigger role in managing the economy. 

    We therefore assume the debts of all centrally controlled SOEs are backed by the government, the state and the Party while local SOEs enjoy the protection of provincial and sub-provincial bodies for 50% of total liabilities. China’s adjusted debt load is relative to other countries. Adjusted total corporate debt leverage was 72% at the end of Q2/17, while the government (or Communist party-state) ratio was 137% and the total and household levels remained unchanged. 

    Looked at from this perspective and assuming that the authorities would intervene in the way we describe above, China’s corporate debt load appears less frightening from a simple default risk perspective. Some SOEs will, no doubt, be allowed to fail if they are deemed politically or systemically unimportant. But, on this adjusted basis, China's high level of government/Communist Party debt would most likely manifest itself in the banking system in the guise of medium- to long-term asset yield and net interest margins rather than an insolvency risk posed by NPLs.

  • 08 Dec 2017 - Martin Shenfield

    More EUR Strength, More FX Diversification

    My colleague Oliver Brennan reconfirms below our positive Euro view for 2018 (with risk of some overshoot). Conversely we remain negative on CHF,CAD & AUD.

    Next year will see the continuation of major market trends which started this year: stronger EUR and weaker USD. The euro area’s broad basic balance of payments (BBBoP: current account, net FDI and net portfolio flow) is returning to surplus, an improvement that is one of the drivers of this year’s EUR rally. This improvement will gather momentum, supporting further EUR strength in 2018.

     Rebalancing by reserve managers will also bolster EUR. According to the IMF’s COFER report, the EUR share of allocated FX reserves fell from 27% in Q1 2010 to 19.9% in Q2 2017. Adjusting for valuation effects, reserve managers are as much as €230bn under-invested in EUR compared to their pre-2010 allocation. The euro crisis was the cause: the drop mostly occurred between 2011 and 2013. But the crisis is now long over. Reallocation has probably been delayed because of the dearth of positive yielding safe assets. As the pace of QE slows, EA growth picks up and government bond yields turn positive, reserve managers will probably start to rebuild the share of EUR in their portfolios.

    By contrast, the dollar has had its day. The 2014-15 USD rally was helped by tighter Fed policy when most other central banks were easing. This made the dollar ‘rich’, underpinned by relatively high domestic yields and big risks elsewhere. But the yield gap between the US and rest of the world is unlikely to increase further – indeed, it should narrow - removing one of the dollar’s supports and exposing its richness.   

    As the dollar gives back most of the 2014-15 gains, the decline will probably be peppered by episodic strength. We expect a hawkish Fed next year (four 25bp hikes in the next 12 months), a stance which will lend some backing to the dollar through rising yields. But any vigour is set to show up near FOMC meetings: it will be tactical rather than fundamental - much like the recent bounce in the dollar. EUR/USD should reach 1.25 next year and could overshoot towards 1.30.

    The worst-performing currency next year? The Swiss franc. Strong, synchronised global growth means that safe havens are no longer in demand. Negative carry in CHF is finally discouraging inflows. But, as other DM central banks begin to think about ending emergency monetary policy (eg the Riksbank), the SNB is sticking doggedly to -0.75% deposit rates. JPY weakness is also a function of central bank policy. But here the BoJ appears less steadfast in maintaining exceptionally easy monetary policy. Any shift next year would be positive for the yen, which is already more than 10% cheaper than its long-term average. JPY’s days as a funding currency are coming to an end. 

    The UK is the country most susceptible to the end of ECB QE, and we remain bearish on GBP. But political volatility cannot be ignored. Nor can the positive feedback loop from the UK’s balance of payments dynamics (as GBP weakens, primary income improves). Sterling will still struggle next year, but political risks will hold down its Sharpe ratio. Elsewhere, we remain bearish on CAD and AUD because we expect commodity currencies to lag as the Chinese economy makes a transition to a new growth paradigm. But we are positive on CNY (against its basket), now that China’s financial account is back in surplus. 

    After a period in which the Fed and ECB were the driving forces of global exchange rates, other, different factors are coming to the fore. This week’s Macro Strategy uses Principal Component Analysis to identify underlying market drivers. FX market variability is at its highest since 2015. This is likely to remain the case and, as idiosyncrasies increase, market volatility is set to rise.

  • 04 Dec 2017 - Martin Shenfield

    When Bubbles Burst

    There has been a lot of market chatter about whether the flattening of the US yield curve( but note real yields have risen since 2014) is typically presaging an imminent recession. We remain adamant that this Is not the case but rather, as my colleague Dario Perkins sets out below, it is aggressive global ‘QE’ which has reduced the supply of long duration assets with positive yields, in turn further exacerbated by asset-liability matching pension & insurance funds. This has distorted the term premium rather than reflecting a deterioration in growth or falling inflation expectations. The problem is further compounded by central banks having effectively outsourced monetary policy to the bond markets! This suggests the bubble could grow larger before either rising inflation or net withdrawal of central bank liquidity (H2 2018?) breaks this feedback loop-but the eventual adjustment could be abrupt.

    When the Federal Reserve started to raise interest rates in 2015, there was a lot of discussion about whether this tightening cycle would most resemble 1994-95 or 2004-07. Both arguably involved policy errors, but in very different directions. In 1994, Alan Greenspan tried to shock ‘somnambulant’ financial markets with aggressive rate hikes and was rewarded with a major selloff in bonds that threatened to spiral out of control. In 2004-07, he took the opposite approach, raising rates extremely gradually and telegraphing every move in advance. This contributed to his famous ‘conundrum’ in which the bond markets largely ignore Fed policy tightening, with every interest rate hike contributing to a flatter yield curve. So far, there is no question about which period we are most closely tracking today – welcome to the Conundrum II.

    In another parallel with the early 2000s, recent curve flattening has sparked a lively debate about whether we should worry about imminent recession. After all, a few more Fed rate hikes and we could see an inverted yield curve in 2018, something that usually proceeds a major slowdown. As in 2006-07, the last time the curve was at flat as is it today, there are opposing views among investors. While the bears are clear about what this means – they’ve been expecting inversion for some time – others argue that the flattening in the curve is actually bullish because it is keeping financial conditions loose. Given that most US lending is tied to longer term rates, the Fed’s failure to raise the cost of borrowing is essentially a failure to tighten monetary policy. As we explained in a recent macro picture, we lean towards this more bullish interpretation, particularly as continued ECB and BoJ QE seems to be distorting the signal from US bond markets, by artificially depressing the term premium.  

    Whatever you call it – ‘safe asset shortage’, ‘global saving glut’ or something else – aggressive central bank buying has reduced the supply of long duration assets with positive yields. The ECB has created new reserves but these are overnight securities with a negative yield, so they have not filled this gap in investor demand. As a result, we have seen massive, unprecedented capital outflows form the euro area into other bond markets, notably US Treasurys. This is something European officials have even started to brag about – they use it to illustrate just how potent their stimulus has become. In a recent speech, Benoît Coeuré showed that spillover beween international bond markets have surged, while confirming our previous analysis that German Bund yields have been driving moves in other markets, ending the dominance of US Treasurys. When you combine this with evidence European insurance companies and pension funds have an upward sloping demand curve – they demand more bonds as yields decline – you have a powerful explanation for what’s going on.  

    The flattening in the US yield curve is much less alarming when you allow for these distortions in the term premium. Real yields have actually risen since 2014 and inflation expectations are only modestly lower, suggesting the market is less concerned about secular stagnation. This means we should regard the flatter yield curve as an easing in financial conditions, not a warning sign about imminent recession. The problem, of course, is that this is exactly what the Federal Reserve concluded in 2006-07. So, are we making the same mistake officials made last time the curve threatened to invert? To answer this we need to address a related question: Must we see higher bond yields before the economy slows and any bubbles burst, or could these things happen by themselves. This is where the current situation looks quite different to what was happening in 2006-07. Back then, the economy had become increasingly dependent on a leveraged housing bubble where the marginal buyer was dangerously exposed to the short-end of the curve. When house prices stopped rising and ‘teaser rates’ adjusted, the bubble burst.  

    We think this current cycle will only end after long-term interest rates have moved significantly higher. In turn, this will require either the return of inflation or the end of ECB/BoJ stimulus (unlikely before late 2018). If we are right that these central banks have been keeping US yields artificially low, then the eventual adjustment could be abrupt. What started out as 2004-07 could end up like 1994. So perhaps the closest parallel is actually what happened in 2000, when the 10-year spiked and the Dotcom bubble burst, before the curve inverted and Greenspan overtightened.

  • 28 Nov 2017 - Martin Shenfield

    UK: Imbalance May Mean a Lower GBP but the Bigger Risk Is for Gilts

    My colleague Oliver Brennan reassesses below the outlook for sterling & gilts. He argues that fundamentally short term sterling might have to drift lower to fund the UK’s current account deficit, even if longer term sterling’s fair equilibrium versus the US dollar might be more in the 1.36 -1.42 range? Also now that the shorts have been squeezed out & the positioning is relatively clean, there are clearly tactical upside risks should a ‘better’ Brexit deal be shortly announced. The greater downside risk we believe is therefore for gilts.

    'Sterling bulls rejoiced at the currency’s sudden strength in September, which was fuelled by a weak dollar and expectations of a BoE rate hike in November and investor short positioning. But the rally was built on weak foundations. The short squeeze is now over, but there is still possible downside after the recent burst of strength due to the need to fund the UK’s current account deficit (CAD) to the tune of £8bn every month – around 5% of GDP.  

    The UK’s primary income balance (the difference between income earned abroad and that paid to foreign owners of UK assets) is sensitive to currency fluctuations because of the UK’s large gross international investment position (IIP). As sterling falls, the net IIP climbs in tandem with the sterling value of UK assets overseas, and so the primary income balance tends to rise too. (The opposite happens when GBP appreciates.) Sterling’s post-Brexit slump thus contributed to a narrowing of the CAD, but the currency’s partial recovery is now increasing the burden on other parts of the balance of payments to fund the remainder of the deficit.

    The UK is also likely to experience portfolio outflows when the ECB winds down its asset purchases. The sharp rise in foreign purchases of Gilts in Q1 2015 suggests that ECB QE crowded out domestic euro area investors, some of them switching into Gilts to capture an 80bp pick-up over Bunds at the time. Portfolio investment tends to be the least sticky component of the financial account - it is easier to sell a bond than a stake in a UK airline - and is the marginal determinant of the sustainability of the UK BoP. This inflow is could reverse in the near future. It will need replacing. 

    UK assets will remain in demand because of the attraction of factors such as the rule of law, protection of property rights and light-touch regulation; there will not be a sudden stop in funding. But the UK is competing with Canada (CAD -2.9%/GDP), New Zealand (-2.8%/GDP) and Australia (-2.1%/GDP). Why not buy their bonds instead and achieve more than double the UK’s risk-free return? To attract the capital it needs the UK must offer higher yields, higher growth or a discount to foreigners. Higher yields are possible (the market already discounts 75bp of hikes over the next two years, see our UK outlook for more details). But a discount to foreigners through GBP depreciation is the most viable option. 

    The UK’s CAD will improve with a weaker currency. The IMF assesses sustainable current account balances and CA / FX elasticity in its annual External Sector Report: the UK’s sustainable CA balance is roughly -2.5%/GDP. In 2015, the CA ‘gap’ was -3%, i.e. the CAD was 5.5%/GDP. The gap shrank thanks to GBP depreciation after the referendum, but following revisions by the Office for National Statistics it remains around 2.5%/GDP too large. From this perspective GBP remains overvalued despite its 5% fall this year. GBP should depreciate further, perhaps by as much as the post referendum fall again (10% on the TWI), to bring the CAD to a sustainable level.

    This assumes that all else remains equal: the final piece of the puzzle is the UK’s political backdrop. We have previously covered the UK’s Brexit plan B (or lack of it) already. The Conservative is government struggling under an ill-equipped leader, and the spectre of Labour coming to power with an unashamedly socialist agenda of nationalisation, redistribution and tax increases could start to discourage foreign investment (although no signs yet) and force GBP to find an even lower equilibrium level.'

  • 23 Nov 2017 - Martin Shenfield

    The Bank of England and the UK’s Economic Outlook

    The house view remains that both sides of the Brexit argument over-egged their cases and that in the long run provided that there is a ‘Plan B’ as set out in detail in our LSR View of 21st September, the net impact either way on the UK economy would be more muted than is generally touted.

    Moreover, the UK has suffered for the last 20 years from a form of ‘Dutch Disease’ due to a structurally overvalued sterling. One of the positives emanating from Brexit is that this has now been reversed which will be a necessary pre-condition of a much needed rebalancing of the economy away from financial services and London towards manufacturing and the regions.

    My colleague, Michelle Lam, sets out below that although below trend growth will continue awhile as the UK consumer adjusts, real wages will start to stabilise in 2018 and exports and FDI will recover. She also explains the background to the recent Bank of England interest rate hike.

    ‘The economy flirted with below-trend growth over H1, as we previously forecast. Low growth was twinned with strong employment – a repeat of the post-GFC recovery. Britain’s flexible labour market has allowed firms to substitute labour for capital, leaving real wage growth and consumer spending taking the strain of the economy’s adjustment.

    Because that adjustment is continuing, growth in consumer spending and therefore GDP will be slower than it was in the recovery from the GFC, at 0.9% and 1.5%, respectively. We forecast that demand will improve over the course of next year once the current soft patch is over. With import price pressures already starting to moderate, the end of the squeeze on real wages should support household spending in 2018. The Goldilocks state of the global economy, with the US and Europe to the fore, is set to amplify the stimulative effect of a weak pound. Indeed, the UK’s export market share has stopped falling over the past four quarters. Further sterling depreciation against the euro should help as the ECB begins to taper its asset purchases.

    Of course, as Brexit uncertainty lingers, business capex will be sub-optimal even though the conditions for a strong recovery are in place. A transitional agreement, which is looking more likely, would avert the immediate threat of a cliff-edge Brexit but would not end the uncertainty facing firms with a long investment horizon. Not every firm is affected, however. Only 10% of companies surveyed by the BoE reported that Brexit would have a large negative impact on their investment next year. On balance, we expect capex to pick up modestly.

    The risks of under-investment should concern not only the demand side of the economy, but also the supply side. The recovery in business capex after the GFC has been shallower than in the wake of previous recessions. If uncertainty continues to restrain investment, already weak productivity could eventually be undermined further. Potential growth could also be held back if the labour force expands more slowly as a result of the population growing older or if net inward migration falls due to economic strength in Europe or the UK’s exit from the EU.

    This does not mean that policy should not continue to be accommodative. We expect some withdrawal of stimulus, but real interest rates will remain negative.  The timing of the BoE’s recent hawkishness seems odd given that the economy is slowing, but the Bank has succeeded in nudging up the interest rate expectations of a hitherto sceptical market, with the aim of avoiding a jump in short-term borrowing costs later on.

    There is no smoke without fire. As long as real wage growth resumes, which we expect to happen over the course of next year, further tightening will do little to slow the recovery. That’s because household balance sheets have improved, with the debt service ratio back down to pre-crisis lows. Overall, household sensitivity to interest rate changes and potential political upsets points to a gradual normalisation of interest rates.

    Having signalled interest rate rises as early as 2014, the MPC voted by a majority of 7-2 to increase the policy rate by 25bps for the first time in a decade. Given that British consumers are facing the worst real income squeeze since the Great Financial Crisis, some see the move as a mistake and are puzzled by the timing since the BoE’s assessment of the economy has barely changed. But having failed to guide interest rate expectations higher, the BoE clearly felt it was time to translate words into action.

    Moreover, the hike merely reversed the August 2016 rate cut, undertaken on the heels of the EU referendum to mitigate a feared slowdown that has not materialised. It is important to bear in mind that a 25bp increase in borrowing costs will have a fairly limited impact on the economy. Thanks to a decline in household debt and low interest rates, the debt-servicing ratio of UK households has fallen to just 7% from a pre-crisis peak of 11%. With 40% of mortgages on variable rates, down from 60% in 2010, we estimate that a quarter-point rise will knock less than 0.2 percentage points off household disposable income growth next year. An end to the squeeze on real wages should allow households to maintain a decent rate of spending while affording a slight increase in interest payments. Of course, after a decade of near-zero interest rates, households will have to reacquaint themselves with the fact that policy rates do in fact change - in the pre-crisis era, they did so once every four months. But the shock ought not to be great: only one in five of today’s mortgage borrowers have yet to experience a rate rise.  

    What we are interested in, of course, is the future path of interest rates. Here, the Bank endorsed market expectations for only two more 25bp hikes over the next three years. It provided forward guidance that “conditioned on the gently rising path of Bank Rate implied by current market yields, GDP grows modestly over the next few years at a pace just above its reduced rate of potential”. The Bank also expects CPI inflation will remain slightly above 2% at the end of 2020. In other words, the hike is not “one-and-done”, but nor is the BoE in a hurry to jack up rates.

    But if the economy makes a smooth transition to trend growth, as the BoE predicts, the Bank risks falling behind the curve by leaving real policy rates at minus 1% at the end of 2020. Like the BoE, we see limited risks to the economy. We believe growth will nudge up to trend after 2018 Q1 as net trade and capex fill a gap left by flagging consumer spending, leading to a further diminishing of economic slack. Goods exports have enjoyed robust growth, thanks to synchronised global expansion. Capex is not spectacular, but nor is it rolling over. At the moment most firms are making contingency plans that involve only minimal relocations, while awaiting more clarity from the government. Despite the lack of immediate wage pressures, capacity utilisation rates have been above their historical average, and slowing migration and weak productivity will almost certainly push up labour costs.

    Understandably, in the face of Brexit uncertainty, the Bank does not want to back itself into a corner and commit to raising interest rates more quickly than markets have been pricing in. Whether the BoE wants to admit it or not, the pace of tightening will be dictated by political events. Moreover, raising rates too quickly risks hurting business investment and thus further damaging the supply side of the economy. Opinions on the state of the supply side are divided, even within the MPC. But if you take the view that the rate of growth during the pre-crisis period, bolstered by strong consumer spending and rising house prices and debt, was simply not sustainable, then one would see why the BoE is content with slightly lower growth rates. 

    Investors are puzzled by low inflation in the US and the euro area. But if the BoE does indeed stick with its forward guidance and leaves interest rates in negative territory going into the next decade, inflation may well remain above target for longer than the Bank assumes.

  • 22 Nov 2017 - Martin Shenfield

    Saudi Arabia Is Not Driving Oil Markets

    My colleague Marcus Chenevix sets out below why political instability in Saudi Arabia has little significance for oil markets, but rather should concern investors exposed to Saudi assets. Broader Middle East geopolitics may however be a more plausible oil price influence.

    The IEA has recently turned to a more bearish structural view on the oil price based on the conventional US shale output ramp-up market consensus. (It now predicts overall shale production to double over the next decade.)

    However, shorter term robust global demand reflecting the global synchronised economic and trade recovery is driving positive demand surprises and hence pushing the oil price trading range up to US dollars 50/60 and which in turn is supported by the relatively recent move from contango to backwardation.

    Against a constructive demand backdrop, the recent decline in excess global oil & liquid fuel inventories has conferred some more credibility on OPEC’s output cuts, nurturing investor optimism – evident, for example, in the extent of speculative long positioning. The Saudi story does not have direct implications for crude prices at this juncture; it has, however, introduced an uncertainty premium (ie, risk of escalating tensions in the broader M. East) that serves to reinforce the market’s bullish bias in what remains a goldilocks/risk-on investment environment

    'Saudi political risk has suddenly re-emerged. Investors, who mostly prefer not to think about Saudi politics at all, have realised that the oil-rich kingdom is at quite a volatile moment in its history. Both internal strife and regional turmoil could ensue as a result Many commentators have pointed to this volatility as the main explanation for the last two weeks of strength in oil markets – we disagree.

    It is true that the de facto ruler of the kingdom, Crown Prince Muhammad bin Salman (“MBS”) is struggling to maintain political equilibrium as he tries to force through his reform programme. The wave of arrests earlier this month are particularly worrying in that they do not appear to have been planned well in advance (the authorities do not seem to know how many people they were going to arrest when the purge started). This implies that politics was as much of a motive as corruption, and hence that the arrests were most likely a pre-emptive counter to some kind of threat to MBS. This is all very concerning if you hold Saudi or Bahraini debt, and quite a worry if you own certain Saudi equities – but it is not an issue for oil markets.

    The investment risks stemming from political instability in Saudi Arabia do not extend to any serious prospect of a systemic collapse (which would disrupt oil output), but instead have to do with the effects of reform blockages. In other words, latest developments should concern investors exposed to Saudi assets rather than the global oil market. As far as the Saudi investment case is concerned, it is vital that the Kingdom reforms its fiscal system and fixes its structural problems (a glut of cheap labour, a secular deterioration in productivity and a massively bloated state). Failure to reform would mean prolonged low growth and de-rating of debt but it would not pose a threat to oil supply and would not imply a change in oil policy. 

    On that last point, Saudi Arabia has now definitely abandoned attempts to control its oil policy. The last such attempt – which was initiated in late 2014 by the previous oil minister Ali al-Naimi and cost him his job – failed in its goal of driving US shale oil competition out of the market since depressing the oil price low enough (probably around US$40/bbl) for long enough to achieve that aim would also jeopardize the Kingdom’s survival. Saudi Arabia is therefore reduced to being a price taker, sacrificing marginal market share by means of the “OPEC+” output taper in the hope of keeping the oil price out of any such danger zone. In short, MBS, otherwise such an influential figure, has minimal freedom of action on oil policy.

    The geopolitical implications of Saudi Arabian volatility are a more plausible oil price driver. The extraordinary Saudi decision to bring down Lebanon’s coalition government, coupled with an Iranian-supported militia nearly landing a missile on Riyadh airport has considerably raised the geopolitical temperature of the region, but we are still a very long way from a war between Saudi Arabia and Iran. Plotting a path to war between the two states is hard, and relies on the assumption that Saudi Arabia and her allies might sacrifice a decade of economic growth in the Gulf. Furthermore, this summer, when some kind of conflict in the Gulf over the Qatar crisis appeared to be on the cards, oil prices market barely raised an eyebrow.

    Since US shale oil became the price-setting marginal supply source, the oil price has become less sensitive to Middle Eastern political tremors. Actual outages – such as from Iraqi Kurdistan last month – rather than mere worries now tend to be necessary for material price movements. To change that would require a proper shooting war or other such geopolitical earthquake. Sentiment may now be marginally more jumpy about such tail risks given that oil has been coincidentally buoyed by demand on the back of the strong global economy; but this is all about sentiment and volatility.

    For now – i.e. pending the longer-term impact of EV penetration – supply is driving the oil market, not through a fear of shocks coming out of the Middle East, but rather through the chronic over-supply generated by the US shale boom. In its annual World Energy Outlook published yesterday, the IEA – long a sceptical voice on the US shale oil outlook – turned notably more bullish, predicting that shale production is going to double over the course of the next decade. In the long-run, this trend must eclipse concerns over geopolitically imposed supply crunches.'

  • 07 Nov 2017 - Martin Shenfield

    Why China Is Not on a Minsky Brink

    Recent comments by the PBoC Governor Zhou  Xiaochuan have resuscitated the China debt debate but these were as ever non-time specific & more in the nature of a general warning. We note that some of the most prominent foreign China ‘Minsky Moment’ bears (no names no pack drill!) have been & remain longstanding stale bears/’stopped clocks’. This does not mean that China’s rapid accumulation of debt is not a huge risk, not least in terms of the massive misallocation of capital it represents & hence concomitant decline in productivity growth, just that an imminent ‘hard stop’ debt crisis is most unlikely. Bo Zhang our China economist has explored this in more detail below.

    Nothing is going to be linear or smooth in China but we remain in the ’half glass full ‘camp with respect to policymakers’ commitment to ‘Deleveraging‘ as already evidenced by the effective clampdown on shadow banking activities & supply-side capacity cuts in steel, coal & aluminium.

    ‘It is fashionable to ask if China is on the brink of a “Minsky moment” after its surge in debt over the past decade. During this month’s Party Congress, Zhou Xiaochuan, the long-serving governor of the People's Bank of China, cautioned that the country had to fend off risks from excessive optimism that could lead to a Minsky moment. His remark raised eyebrows and gave China bears an opportunity to reaffirm their longheld, long-unrealised thesis of an impending debt crisis.

    Caution over rapidly rising asset prices is sensible. But the triggers for a true Minsky moment appear absent in China today. A debt crisis is neither imminent nor likely, despite the rapid build-up in borrowing. Zhou’s remarks have to be seen in the specific context of a respected official who is about to retire and is keen to protect his legacy. It would be easy to cry wolf after what he said. Much more challenging is to take a stab at the timing of a meltdown – something Zhou and others who speak of a Minsky moment scrupulously avoid. Following are four reasons why we think China is not on the brink of a debt crisis. 

    1. Zhou’s reference to a Minsky moment was part of an answer to a press conference question on systemic financial risks. He was making an assumption, not delivering a statement on the state of the economy. Since he is due to step down in the next six months, his comment may well have been a final appeal directed to the political hierarchy and to his successor to press on with financial reforms he advocates. Remember, Alan Greenspan’s talk of “irrational exuberance” in the US stock market many years before equity prices corrected. Even central bank governors want a place in history - or at least to have been proved right. 
    2. China’s high debt level does not automatically point to an imminent threat. For a debt crisis to occur, a liquidity trigger is needed. People have been forecasting a Japanese debt crisis for two decades, but it has not happened. China’s rising debt ratio reflects, amongst other things, the reluctance of banks to pull the plug on zombie companies. In stark contrast to other emerging economies that have suffered debt crises, China owes little foreign debt and holds more than $3trn in FX reserves. It is virtually impossible for speculators to induce a crisis by shorting the renminbi. According to our estimates, China’s capital outflows have fallen from an average of $150bn per quarter in 2016 to $30bn in the first three quarters of 2017. Foreign reserves have been rising for nine months, and the RMB is up 4.2% against the dollar this year. So we can virtually rule out risk of an externally triggered debt crisis in the short term. 
    3. While Minsky’s analysis is often applied to the onset of the Asian financial crisis and the US subprime crisis, he also believed the threat of a destructive collapse could be averted by a strong government ready and able to step in. In China, this is the case. The Communist Party and the government have the power and the ability to force agreements between creditors and debtors. This is key, given how disagreements between debtors and creditors lead to defaults, triggering financial crises. Most corporate debt in China consists of obligations of SOEs to state-owned banks – in other words, the state has lent to or borrowed from itself. It is highly unlikely that the Party State, which Xi Jinping is set on strengthening, will allow banks to force SOEs to repay debts in a way leading to a plunge in asset prices and fire sales. Instead, it will shift assets among its various balance sheets to preserve stability. The government could still tap a wide range of assets should it run into servicing problems. As long as the overall Communist Party balance sheet does not blow up, there will not be a system-wide financial crisis. 
    4. Chinese debt problems and the risks they pose are not new. Top leaders are fully aware of this. That is why Xi explicitly made financial sector deleveraging a matter of national security. To that end, the PBoC has deliberately allowed market interest rates to creep up since last November. Through new macro-prudential assessment procedures and by keeping a stable bank repo rate to dampen market volatility, the central bank has targeted non-bank financial institutions with excessive leverage. The corporate sector’s debt- to-GDP ratio has declined from 166% at the end of last year to 162% at the end of Q3.

    China's total debt to GDP ratio of 264% is similar to the advanced economies like US and Europe, and below countries like Japan and Spain. We believe the greatest long-term financial risk in China stems from the lack of options for households to diversify their wealth. This raises risks of bubbles, especially in property prices and equities. As we have argued previously, high property prices are a result of market distortions caused by government policies in education and healthcare, lack of urban infrastructure, the gender imbalance and financial liberalization, all of which can only be resolved in the long term. So we do not expect a property bubble crash in the near  future. With tight controls on outflows and limited investment options, the risk of an internal debt crisis will certainly escalate if the rapid accumulation of debt and easy  credit continues at the previous rate to support growth in coming years. But, for the moment, we do not see China facing an imminent risk of the MM in debt.’

  • 06 Nov 2017 - Martin Shenfield

    Fed to Hike in December, March & June

    Our US economist Steve Blitz continues to argue that the Fed is as confused as anyone over the drivers of inflation in general & in particular what the real neutral  rate( ‘the inflation-adjusted level of the federal funds rate consistent with keeping the economy operating on an even keel’) should be. Contrary to the Fed Steve believes it might actually still be below zero given the still sluggish pace of capital spending by businesses & households. Although importantly we now do expect an imminent notable pick-up in domestic capex , irrespective of any Trump tax incentives.

    Indeed the Fed has been waiting for just such a pick-up in the demand for capital that will raise real rates as one of their roadblocks to normalising rates has been the late summer collapse in US TB  10 year real yields which fell 40bps under the weight of Chinese buying at a point when US economic growth was accelerating! Bringing forward QT was done partly in the hope that this would push yields higher again allowing the Fed to hike without coming close to precipitating an inversion of the yield curve.

    The September data imply that finally the upturn in capital expenditure is gathering momentum which should prompt sufficient yield curve steepening for the Fed to raise rates in Dec, March & June-regardless of who the next chair is. Importantly although we are thus much more hawkish than the market we only expect US 10 year TB yields to grind higher to 2.8%( a 50 bps reversal of the QE induced term premium compression),to be followed by further yield curve flattening and not a bear market in US bonds just yet.

    Fed to hike in December – March and June too

    Market participants still don’t respect the Fed’s view of all things economic. They attach a near 90% probability to a 25bp hike at the December 13 FOMC meeting, meaning a 10% chance of a random event that stays the Fed’s hand. As for another 25bp in March 2018, the odds are set at 32%, and there is only a 13% probability of the FOMC going another 25bp next June, which would take the funds rate to 2%. Lowballing the Fed’s trajectory has been the right bet throughout this cycle. The way we see the economy unfolding in the coming year, we believe the Fed gets to a 2% funds rate by June, regardless of who the next Fed chair is.

    Our viewpoint is rooted in earnings and, by extension, wages, as we saw in September, though not in the published BLS average. This measure is weighted by sector employment and so was boosted in last Friday’s employment report for September by a sharp decline in restaurant workers, who make about $13.50/hour against a national average of around $24. Rather, we were struck by the momentum in our own unweighted average and in pay for a number of industries. Wage momentum is rising in most sectors, and this argues strongly for the Fed to raise policy rates in December.

    With profits improving, pay should continue to reaccelerate into yearend and continue into 2018. One caveat is that the forces of globalisation and technology are still holding back the pace of wage gains (in many cases the two forces are one and the same) – notably in industries that are most impacted, including manufacturing and financial services. As a consequence, the pace of pay increases may still broadly disappoint relative to the revival in earnings, based on historic relationships.

    The economy has given off mixed signals this year, reflecting leading and lagging sectoral responses to the inventory cycle in 2015-16 that helped create a small profits recession. Since then, manufacturing has picked up but wages growth slowed in response to weaker earnings. As a result, retail spending growth has pretty much spun in place. Commercial construction, also a lagging indicator, has slowed, and singlefamily housing, strong earlier in the year, has begun to tail off some of late.

    Considering how the global economy continues to expand, as does domestic industry aside from autos, our expectation is that next year the various sectors of the economywill all be growing. At the same time, the cost of carry for non-financial firms (nominal growth in final sales minus the rate on prime commercial paper) remains more than favourable to expansion. 

    Against this backdrop there is little justification to keep holding the federal funds rate below core inflation. In addition, while the equity market is currently not overvalued by our measures (nor is it cheap), as growth continues there is a good chance that inflows, undeterred by higher short rates, could propel share prices into seriously overvalued territory. Confidence in growth, wage hikes and QT should also push up term yields to steepen the yield curve a little and thereby create some runway for the Fed to act. A higher core rate of inflation would also help in this regard by lowering the real funds rate.

    As such, a 2% funds rate next June would be, at worst, about 25bp above core inflation with the core rate trending higher and wage settlements accelerating. This is not a very bold or constrictive level for policy rates. And we haven’t even mentioned the likelihood of some tax cut.

    Capital demand pushing Fed… to higher rates

    The FOMC has been anticipating accumulating signals of improved demand for capital that will raise real rates, albeit slowly. They are focused on the business side, figuring that jobs, income and demographics will eventually raise consumer capital spending (ie, on new homes). September data for durable goods indicate their recovery from the 2015-16 slowdown is accelerating. Last month’s rebound in new home sales, related to the hurricanes that hit Texas and Florida, confirms that average sales are back to their long-term median pace of 600,000 units SAAR and are drifting higher.

    The slump and recovery in new orders for non-defence capital goods ex-aircraft, also evident in other figures such as wholesale sales ex-oil and autos, are what the Fed should keep in mind when figuring out why 2017 data on growth, wages and inflation seem so mixed up (to them). For a good chunk of the economy, 2017 is the first full year of recovery; at the same time, the knock-on impact of the 2015-16 downturn has been slowly rippling through various sectors. From our perspective, positive growth trends in different parts of the economy are starting to get back into sync. This should be increasingly evident in the coming months, lifting wages and eventually inflation in its wake. 

    To be clear, not all corners of the durables industry are recovering. Computers, electronic equipment and appliances have not yet turned up. But new orders for  primary metals, machinery, fabricated metal products and communication equipment are back in their 2011-14 ranges with inventories in line.

    The longer-term picture shows that the level of nominal new orders has effectively been capped since June 2000, even though almost all other nominal indicators of economic activity have reached successive new highs with each cycle. The reason why durable goods orders haven’t kept pace is not immediately apparent, but the point is they have a lot more scope to increase and, in effect, catch up with the rest of the economy. When that begins in earnest, real yields on 10-year maturities should begin to rise and steepen the yield curve.

    On the housing front, there is also reason to believe the peaks for this cycle have yet to be reached. After an extended period of overbuilding and subsequent recession that caused demand to plummet, the recovery in the number of 25- to 34-year-olds with a job, as measured by Y/Y percentage growth has finally gone on long enough to hoist new home sales back to their long-run average of around 600,000 units SAAR. Yet the employment/population ratio for this age group is not quite yet back to its pre-recession high and is still below the 2000 peak. So it is reasonable to presume that Y/Y growth in the number of those employed in this age cohort can be sustained in the 2%-4% range. In addition, the longer they are in work the more their incomes and credit scores rise. If all this comes to pass, and we believe it will, new home sales should slowly trend up towards 800,000 – the top of the cyclical range before mortgage madness took over.

    What the September data imply is that the upturn in capital spending that the Fed has been waiting for (or revival in durable goods, to be more exact) appears to be gathering momentum. With that, the yield curve is set to steepen enough for the Fed to raise policy rates in December, March and June – regardless of who is the next chair. We haven’t weighed in yet on the rest of 2018 because we don’t yet know the extent to which federal tax cuts and spending increases will aid and abet growth in the coming year.

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