Fed Creating Inflation with QE3+, But Also Market Distortions…

The rather discredited Philips curve taught in Econ 101 classes relates the inverse trade-off of unemployment to inflation; the Fed seems to have decided that if lower unemployment can cause inflation, higher inflation expectations can create employment. Spain’s equity market is up 40% since the late July low, the S&P 500 technology and financial sectors are up 23% this year (with Bank of America up 70%), and the euro has rebounded above 1.30 versus the USD, while medium term US bond market implied inflation expectations have broken 3%, versus just 2% last autumn. Back in early June, the smartest brains in the investment world would have confidently bet against most if not all of those developments, as reflected in the underperformance of hedge funds since, with the benchmark Bloomberg index up just 0.7% last month and lag the MSCI World YTD by over seven percentage points on a total return basis. The Fed’s previous QE efforts were flawed in that they removed safe asset collateral from a financial system chronically short of them and left markets convinced that 2% was an inflation target ceiling. Last week, we got a clear signal that it won’t be.

The Fed was most always likely to act via the mortgage bond rather than Treasury market this time, but the open-ended nature and ‘acceptable’ employment target have raised the stakes considerably. The Fed hopes to generate more economic activity per dollar of balance sheet expansion because the program is open-ended, even though $40bn a month is smaller than QE1 or 2, via faster bank mortgage origination and hence boosting a promising early stage housing recovery. One reason banks have been hesitant to step up that origination capacity (which has been running at just $4bn a month net YTD) was that they didn’t believe the low-rate environment would last. As the policy wonks at the Fed might put it, the portfolio balance channel (i.e. goosing asset prices) works better when accompanied by use of the expectations channel (i.e. low rates indefinitely). As ever, things are likely to prove more complicated than those neat econometric models predict…

One risk with relentless monetary expansion via bond purchases is that a false market developing in US fixed income, such that the global risk-free benchmark rate is distorted. We are certainly in an unprecedented situation as regards price discovery because as well as MBS, it’s quite possible that the Fed will continue to purchase longer-term Treasuries ($10-15bn a month) simply to prevent the stock effect of its previous purchases leaking back to the market, but probably without the short-end Treasury sales that to this point have been neutralising the impact on the monetary base, as its supply of these Treasuries to sell will be close to exhausted. The Fed has become the dominant buyer of Treasuries, accounting for almost 50% of 7-year and over 60% of 10-year new issuance. Over the next few months, it will be the dominant buyer in the market for agency-backed mortgage securities, where gross issuance totals about $130bn per month but accounting for securities that reach maturity, the Fed’s purchases will actually shrink overall supply. Unsurprisingly, the yield on the commercial MBS index tumbled to a new low of 2.26% last week and MBS spreads over Treasuries fell to their lowest level in over 20 years.

Junk bond yields are already seeing a ‘displacement’ effect along the risk curve. All of this activity will take its balance sheet toward $4trn by 2014, but will also squeeze fixed income market liquidity even further.   I’ve often noted that the essential investment implication of QE is to artificially suppress macro tail-risks and the Fed has been selling volatility into the markets to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk). Economist Hyman Minsky’s brilliant insights into the impact of low volatility (ignored pre-crisis, and still only grudgingly accepted among policymakers) on speculative behaviour suggest we’re setting ourselves up for another ‘Ponzi finance’ bubble and the only question is where it will inflate this time (aside from bond markets). For China, even if its trade surplus has fallen sharply from 11% of GDP to say 3%, recycling even $300-400bn annually into Treasuries will be a nightmare competing with the Fed as buyer of first resort.

The slowdown overseas is beginning to cut into US corporate profits, which had benefited in the last few years from exports/foreign affiliate earnings outpacing domestic demand. Analysts expect earnings in the S&P 500 to decline 2.2% in Q3 y/y, according to Thomson Reuters, the first annual drop since Q3 2009; earnings are expected to be down 3% from Q2 while the Shiller CAPE is now almost 23x. Certainly, GEM equities have underperformed DM this summer as the BRIC slowdown hits earnings momentum and valuations look far less stretched that in the US and some euro zone markets. EM USD debt has surged further with the desperate global hunt for income, and focusing on stable cash flow, high dividend equities has been a successful investment strategy just about everywhere. That trend looks well supported by the latest Fed move, but having gone back to a long risk stance back in June, I’m weighing up the implications of these cross currents for this month’s Q4 portfolio strategy note. I’d suspect that the ‘washboard’ ride for markets isn’t over just yet.

China Turns on Investment Tap to Offset Liquidity Trap

The tendency of Asian rich brats from Bangkok to Singapore and Beijing to treat city streets as racetracks (frequently crashing their Ferraris spectacularly, and often mowing down pedestrians and fleeing the scene) is a disturbing insight into the sense of elite entitlement which is exacerbating political risks from historic levels of wealth and income inequality. That backdrop complicates the very predictable transition underway in China not only to a lower trend growth rate but with a very different incremental composition (despite the current Pavlovian policy response of state bank funded infrastructure stimulus). Back in the 27th  July Weekly, I concluded that: ‘Every traditional policy lever will be pulled in coming months to restore momentum, and we’ll soon find out whether they’re still attached to anything in the real economy’.

The August lending data suggests that they are, and we should consequently get a ‘dead cat’ bounce in some cyclical sectors this autumn. However, beyond the current slowdown, recent well publicised events suggest that the party probably faces a legitimacy crisis to rival 1989, when Beijing students were more worried about being crushed by tanks than Italian sports cars. Cancelled Macau junket trips, Burberry coats left on the racks and slumping steel and other commodity prices all reflect the aftermath of the deflating 2009-11 credit bubble which much as many commentators seem to wish, can’t be resurrected.

The downside risks in the Chinese steel sector were obvious early last summer as the policy squeeze began, and covered in a note at the time; prices for hot-rolled steel fell to an almost two decade low in recent weeks, the latest sign of deflationary forces engulfing the heavy industrial parts of the Chinese economy, reflected in a still slumping official PPI. The China Iron & Steel Association has said the situation is “disastrous”, with even the strongest groups such as Baosteel losing money. Even before the impact of inflation and GDP growth since, the latest RMB1trn investment package compares poorly to the RMB4trn stimulus after the Lehman crisis, although is combined with a provincial spending spree of dubious funding; Chongqing and Tianjin have each unveiled $240bn programs.

Having been bearish since last summer on the whole construction related heavy industrial area of the market, if I had to bet on one cyclical Chinese sector as a Q4 trade it would be cement, simply because the product is inherently perishable and hence not subject to the vast inventory overhang in say steel and non-ferrous metals. It’s also distinctive in that output trends are already stabilising. Overall, the headwinds on the cyclical part of the market should abate in coming months, although that doesn’t help the longer-term rebalancing narrative. The biggest question for global investors right now is whether China is fully invested in terms of its physical capital, and the answer depends on how you view the data. On a per-capita basis, the country’s capital stock remains a fraction of that in more developed Asian economies such as Malaysia or Thailand, let alone the US and Germany. However, relative to the country’s GDP (or indeed GDP per capita), things look more ominous for industrial commodity bulls.

The bottom line is that while you can make a cost-benefit analysis argument for urban mass transit etc., the number of truly economic infrastructure projects in China at its current level of per-capita GDP/household income is probably tiny after the fast-forward rollout of projects previously planned to 2020 and beyond funded by the post-crisis stimulus. A 200km race track around Beijing for those Ferraris would be a nice multi-billion project appreciated by the party princelings and which would technically add to GDP as it absorbed steel and cement, but it would also add to an economy wide debt burden heading for 200% of GDP. There is a widespread misconception that China has overturned the dismal laws of economics and doesn’t face financial constraints because of the 50% of GDP in foreign reserves etc., but that is simply deluded as the FX inflows those reserves represent have already passed through the economy when sterilised by the PBoC.

Investors are as addicted as Beijing policymakers to the investment ‘fix’, and when last week the NDRC approved 60 new projects, led by railways, roads, harbours and airports; the Shanghai Index jumped 3.7% (although the ECB news was at least as important on the day) and even steel shares bounced, despite chronic overcapacity and unprofitability. Between January and July, China churned out 419mt of crude steel, still up 2.1% y/y despite crumbling demand. The fragmented industry’s gross margin was as low was only marginally positive  and sector wide profits sank 49% y/y to 66bn RMB in H1 according to data from the NDRC.

Sentiment if not financial reality should benefit from project approvals and new investment picking up with bank lending and total credit growth, consistent with a more proactive policy stance in recent months (and signs of life in real estate, a very mixed blessing).  Of the new loans in August, medium- to long-term loans accounted for RMB286bn, versus RMB210bn in July, with their share of total new loans rising to 40.6% from 38.9%, suggesting that banks are funding the pickup in infrastructure investment from announced new projects in Q2. While this will help draw a line under the recent free-fall, it’s constructive only in the literal sense. Banks are supporting the government’s move to fast-track infrastructure projects (not that they had much choice when those red phones rang).

The cash flow squeeze throughout the corporate sector remains intense, but there are signs of credit life; China’s total social financing aggregate, a broad measure of liquidity in the economy, rose to 1.24trn RMB in August from 1.04trn in July. Soft M2 growth was probably due to a transfer of RMB savings to deposits in USD on expectations of further local currency weakness, a trend I covered in the 24th  August Weekly. Outstanding deposits in foreign currencies rose 62.1% y/y at the end of August to $415.1 billion while RMB outstanding deposits rose only 12.2% y/y to 88.31trn at the end of last month.

One positive from the slowdown in FX inflows is that the PBoC is becoming a more ‘normal’ central bank, freed from the straitjacket of relentless FX sterilisation and increasingly reliant on the policy tools of its global peers such as reverse repos in its open market operations to support interbank liquidity growth; that also implies that the period of explosive M2 growth in China is now over. Looking ahead, in H2 only RMB275bn of bills and RMB40bn of repos are set to mature, counterbalanced by the RMB300bn of reverse repos outstanding, limiting the ability for open market operations to boost liquidity further. That makes a belated further reduction in the RRR more likely. Added to some form of export support scheme in the works, it all should goose animal spirits at the margin but 7.5% growth is the ‘new normal’ for China and would actually be a good result.

Value-added industrial output in China rose 8.9% in August from a year earlier, down from 9.2% in July, and the slowest growth since May 2009. The slower industrial production growth was likely due to continued destocking of inventories in cyclical sectors as well as weak domestic demand. This destocking process is likely to continue until late Q4 or early Q1 next year. The country’s CPI rose 2% y/y in August, up from July’s 1.8% rise; the main driver was the price of food, which rose by 3.4% from a year earlier, compared with a 2.4% rise in July. China’s inflation always looked likely to pick up in the coming months due to the upswing in global food prices caused by drought conditions in the US, which alongside a stubbornly resilient real estate market is restricting the opportunity for aggressive stimulus measures. Meanwhile, China’s PPI fell 3.5% y/y, compared with a 2.9% decline in July, and a sustained debt deflation across heavy industrial sectors plagued by chronic overcapacity is another threat to bank NPLs. Fixed Asset Investment growth stabilised at just over 20% growth y/y. Even before the latest spending plans were announced, the fiscal deficit was widening; fiscal expenditure growth accelerated from 17.7% y/y in June to 37.1% in July but revenue growth slowed from 9.8% y/y in June to 8.1% y/y in July.

The level of economic activity in August looks consistent with economic growth of about 7.5% for this year, against the 9% plus consensus forecasts coming into 2012, and no significant rebound should be expected next year. Headwinds from excess capacity and inventory build-up, corporate deleveraging, subdued investment, and banks facing rising NPLs mean that the best hope is that with appropriate policy easing growth will stabilise in a 7-8% trend range. In the February 2011 monthly on China’s sobering historical parallels, I concluded that: ‘The key is a rational capital allocation system which finances projects based on marginal economic returns…that economic ‘reboot’ will inevitably mean a major dip in growth to maybe 6% for 2-3 years before it reaccelerates toward a trend 7-8% on a more sustainable services and consumption led basis. If the current distorted and increasingly wasteful model is pursued much beyond 2012/13, a hard landing is likely soon after which will depress growth for the rest of the decade and have destabilising political implications.’

As foreign investment banks scramble to downgrade 2013 growth estimates toward 7.5%, it’s still plausible that a multi-year growth dip to as little as 6% is in prospect as the economy deleverages amid huge asset write-offs (whether than number is ever reported as such is a different matter). If that leads to productivity rather than input driven growth amid wider reforms/deepening of capital markets, it should ultimately be very positive for long-term China investors. After all, crude GDP growth has never correlated well with EM risk asset returns, and nowhere less so than in China…

Judgement Day for the ECB, as Spain Ponders a Bailout…

Nobody would confuse the self-effacing Mario Draghi with Arnold Schwarzenegger, and the title of the ECB’s movie would be Target 2 rather than Terminator 2, but this week’s meeting will be a blockbuster event for markets, which have anticipated a bond buying spree by pushing 2-yr Spanish and Italian yields to multi-month lows and to the lowest ever relative to local 10-year bonds. The key to ‘surprise’ policy developments since June is that the euro zone payments system has been operating as an implicit bailout mechanism. I highlighted this back in the June 7th  note, when I wrote that: ‘The most dangerous trend in the euro zone is that financial institutions are increasingly trying to match assets and liabilities by country, defeating the original purpose of EMU in fostering integrated and more efficient cross-border capital markets, while a rising share of cross-border risk is now assumed by the ECB and de facto by the Bundesbank.’ If the ECB collapsed in a euro zone break-up, the biggest loser via both the financial and trade impact is Germany. The reluctance to abandon Greece stems from the fact that if it departs from the euro zone or if its Target 2 balances are capped, the current slow bank run from the periphery would accelerate uncontrollably, unless the other peripheral nations were backstopped explicitly by the ECB, which is where things are heading.

After a brief respite in sovereign funding costs for Italy and Spain following nearly €1 trillion in LTRO (long-term refinancing operation) lending to euro zone banks by the ECB at the turn of the year, in Q2 these rates rebounded as Spain in particular had to revise its fiscal target for the year and concern mounted about its banking clean-up costs, with many commentators fearing a possible debt restructuring for Spain. Interest rates on 10-year bonds had fallen from peaks of 7.3% for Italy and 6.7% for Spain in late November 2011 to lows of 4.9% for both countries at the beginning of March 2012. By the third week in July, however, these rates had rebounded to 6.6% for Italy and 7.6% for Spain. The EU summit at the end of July agreed in principle on a banking union that could potentially relieve the Spanish sovereign of those bank bailout costs, and the ECB pledged forceful ECB support for two-year bonds subject to policy conditionality. These have been very positive developments, but ultimately, the prospects for avoiding debt restructuring in the two economies will depend on whether economic fundamentals enable them to boost solvency dynamics with a higher nominal growth trend.

This intra euro zone payments system was the critical issue driving my expectation in Q2 of a German compromise this summer; before the current crisis, these balances more or less offset each other or were settled through the private interbank market, which has ceased functioning. As a consequence, large positive Target 2 balances have arisen with the national central banks in the four northern Eurozone countries (Germany, the Netherlands, Luxembourg, and Finland) and corresponding big negative balances with eight countries (Italy, Spain, Ireland, Greece, France, Portugal, Belgium, and Austria). The causes of these balances are current-account deficits of the southern countries as well as transfers of bank deposits from the south to the north. Germany’s surplus alone corresponds to about a third of its GDP.

While Spain looks set to turn to the EFSF for a formal bailout subject to stringent conditionality in order for the ECB to buy its bonds, Italy’s situation remains more benign. There was no real estate bubble in Italy; Italian banks are weakened by recession but their balance sheets do not bear the legacy of mortgage NPLs. At 123% of GDP, public debt is clearly high, but the government runs a primary surplus (3.4% of GDP this year) while Spain has a primary deficit of 3.3%. Italy’s net external position is balanced while Spain has run current account deficits close to 10% of GDP per year over a decade. If Italians were to swap their foreign assets with the government bonds held abroad, Italy would look like Japan: a highly indebted country at the sovereign level but one in which a private funding surplus means the vast bulk of that debt is held domestically.

In part this ‘domestication’ of Italy’s outstanding debt has already happened as a result of the ECB’s LTROs. The share of government debt held by foreign residents has fallen since late 2011 from 45% to 34% of the total. Italy’s technocratic government owes its legitimacy to its ability to steer the country through this crisis, which would vanish if a formal bailout were requested. If that happened, an early election would be inevitable with the likely result being a hung Parliament, probably dominated by a resurgent Berlusconi. As things stand, a general election is due in the spring of 2013 and parliament needs the intervening period to pass a new electoral law that should reduce the probability of a hung Parliament.

The day (later this month?) that Spain goes to the EFSF and the ECB starts buying its bonds, Italian bonds will be under renewed pressure. Without a bailout, Italy will need to reduce the volume of medium- and long-term bonds it auctions from now until the general election because yields will not fall until the political uncertainty is resolved. Some €100 billion of these will come due in the next six months; rather than rolling them over, they should be redeemed through the future revenue from asset sales.  The government still owns large shares  in publicly traded companies, among them Enel, Eni and Finmeccanica. There is also a huge stock of prime real estate, harder to sell outright near-term but feasible to mortgage/ securitise to raise cash.

If a credible program of asset sales is launched in Q4, bridge financing could be also provided by the Cassa Depositi e Prestiti, a government-controlled institution which finances itself through saving deposits issued by the Post Office worth €220 billion. The Cassa lends to local authorities and these loans are accepted by the ECB as eligible collateral. They could be turned into liquidity that the Cassa could use either to buy government bonds or to lend directly to the Treasury. None of this would solve Italy’s underlying trend growth and productivity problems, but it would give the country a period of relative calm which Monti could use to give new impetus to his government.

Meantime,  the  euro  zone  economic  data  continues  to  disappoint,  although  the  pace  of deterioration has abated; the euro area manufacturing PMI was revised slightly down in August, to 45.1 from the flash estimate at 45.3. The revision was driven by similar moves in Germany (to 44.7 from the flash at 45.1) and in France and by mixed releases in the periphery. In the latter, manufacturing PMIs remain well into negative territory and consistent with a sharp contraction in activity. The Italian manufacturing PMI fell to its lowest level since October 2011, to 43.6 from 44.3 and has failed to improve from the lows recorded in Q2. The Spanish manufacturing PMI, on the other hand, rose to its highest level in 6 months, up to 44.0 from 42.3. The rise was mainly driven by new orders, up to 43.1 from 39.2 (export orders up to 48.2 from 44.2, its strongest reading since Aug last year). Employment also moved up a bit, to 42 from 41.5. In Ireland, the PMI index fell in August, but it is the only one still above 50, at 50.9 from 53.9.

Will the current plan work as outlined? In principle, the ECB can eliminate ‘convertibility’ risk (i.e. risk premia associated with investor fears of an EMU break-up) in peripheral debt markets by acting as lender of last resort and capping yields at a level that ensures solvency. The ‘target’ yield would need to be sufficiently low to be consistent with debt sustainability but sufficiently high to maintain the incentives to undertake domestic reforms. This would theoretically eliminate (or at least reduce massively) the risk of default and start a virtuous cycle. However, in order to be ‘successful’, the ECB would need to be credible that it is going to defend its desired target rate. Clearly, the ECB has the balance sheet to buy as much debt as needed to defend the target yield it pleases. But in practice, the ECB is unlikely to commit to the magnitude of the intervention that may be required to cap yields because of concerns that moral hazard in policymaking could lead the weakest countries in the Eurozone to slacken their efforts to reduce structural deficits and the ECB may not be willing to accept the associated credit risk.

Instead,  in  conjunction  with  the  EFSF,  it  is  going  to  provide  limited  conditional (and potentially sterilised) lending. This raises the issue of subordination. Mario Draghi commented that “private investors’ concerns about seniority will be addressed”. Despite these assurances, investors cannot rule out the possibility that in an eventual restructuring, the ECB would claim seniority regardless; Draghi is almost certainly unable from a legal standpoint to renounce irrevocably the institution’s seniority in a credit event. The second problem is that limited and conditional ECB/EFSF intervention may not reduce yields sufficiently, because the ECB is unwilling to make purchases unconditional on the underlying fiscal position. Spain and Italy face credit risk compounded by the fact that while ECB lending may or may not be unlimited it is conditional, so bond investors have to assign some probability to a scenario in which the ECB bond buying is curtailed because of missed fiscal targets.

The new plan certainly increases the chances of eventual resolution of the crisis as an interim step toward eventual fiscal union/common bond issuance. Success over the next 6-12mths should be measured in the ability of Italy and Spain to regain market confidence such that longer duration (5-yr plus) yields start falling on a sustained basis as private sector buyers return. Given the conditionality, if domestic political support for further adjustment evaporates in say Spain, the end game will still be either default or debt mutualisation, either of which will be traumatic for a different group of investors. The flurry of policy initiatives since June should be welcomed as providing an overdue respite from the euro zone solvency crisis allowing global investors to focus on asset fundamentals and other macro risks from China’s painful post-stimulus deleveraging to the US debt ceiling, but no more than that.