Despite Latest Greek Farce, Eurozone Remains Becalmed…

The euro zone continues to simmer in the background, but shows no signs of boiling over again. Despite the second rating agency downgrade to France’s AAA rating, the euro zone has dropped to the edge of investor’s concerns in recent months, which looked a good bet back in June. Even an unseemly spat between euro zone officials and the IMF about the level to which Greece’s debt/GDP ratio should fall and exactly when has failed to arouse renewed panic, a dispute that has delayed yet again a new €44bn tranche of funding to much Greek frustration, after the latest raft of deflationary austerity measures were passed in the Athens parliament. The IMF initially calculated that without any further relief, Greek debt will stand at nearly 150% of GDP by 2020, while the EU believes it will be just over 140%; of course, even half that would be a challenge for an economy as chronically uncompetitive as the Greek one. Moving the target to 2022 makes a significant difference to designing the debt relief structure, as it may not require official sector write-downs, which the IMF (and ECB) are keen to avoid.

A ‘voluntary’ extension of Greek debt duration to as long as 30 years is being discussed or secondary repurchases of discounted Greek debt from private holders, but ultimately Greece will have to write off another huge chunk of its sovereign debt, and official lenders will have to take the pain this time, but that was never feasible before the German elections next year. Spain still needs a bailout package, but is loath to ask for one; the IMIE index showed a 12.5% y/y decline in Spanish property prices last month, which brings the cumulative decline since the market peak to 33.2%, still 20 percentage points less than in Ireland for even greater overbuilding. Despite some encouraging signs of a potential return to the markets for funding and local probably levelling out, Ireland badly needs relief from the legacy burden of its bank bailouts to become Chancellor Merkel’s ‘poster child’ for financial self-discipline.

Overall, while European deleveraging (particularly for Italian and Spanish banks) will take years to sort out Japanese style, widespread predictions of EMU’s imminent demise in early summer proved very premature. There is still a common view that austerity will prove self-defeating and will collide with political resistance in the indebted countries, or even regionalism with for instance wealthy Catalonia seceding from Spain. However, the euro zone now has a permanent rescue system and a central bank that will finally act as lender as last resort, albeit with strict conditions. Germany has proved much less rigid in policy terms than most observers expected, and by backing the ECB ‘put’ on peripheral debt has got ahead of the markets for the first time in this saga.

One risk remains a reappraisal of French credit risk next year, as the country loses its ‘safe haven’ premium rating on a gradual normalization of capital flight inflows from the periphery. Near term, so long as a Greek deal is signed in the next couple of weeks, the welcome solvency crisis respite should continue while investors nervously watch the footwork of Washington politicians as they wrestle on a cliff edge. As most senior Republicans seem keener to push each other over a cliff rather than the country in the aftermath of the Romney debacle, and the Tea Party’s economic ‘Taliban’ has been largely sidelined, common sense still looks likely to prevail, but there will be inevitable posturing along the way.

China Rebounds, But Can it Rebalance?

China’s economy is bottoming out on schedule (albeit from something closer to 6-6.5% growth than the official data), as the lagged impact on activity of infrastructure announcements since late Q1 is felt. In real terms, retail sales were up 13.5% y/y (helped by the Golden Week holiday), industrial production growth accelerated from 9.2% y/y in September to 9.6% y/y in real terms while the closely watched ‘reality check’ metric of electricity output growth rebounded significantly to 6.4% y/y after staying in low single-digits for the whole of Q3 (see below re coal implications). The recent export rebound (and exports were worth about 31% of GDP in 2011) is impressive considering that the RMB has appreciated by 2.4% against the USD since August, and the euro zone remains grim. However, despite the recent pick- up, China will miss its target for 10% export growth in 2012; exports have increased just 7.8% YTD. There is the risk of a strong base effect flattering the H1 numbers next year, but total planned investment in newly started projects, a leading indicator of FAI, accelerated to 35.2% y/y in October from 31.3% in September.

Consumer inflation eased to its slowest pace in nearly three years in October, with the 1.7% y/y rise below consensus expectations, and surprisingly food prices down m/m, allowing scope for further policy action into Q1 if required. More significantly, corporate deflation pressures eased; PPI fell 2.8% y/y, from September’s 3.6% drop, a marginal boost for companies struggling with falling margins and lengthening receivables. As I’ve highlighted in previous notes, no ‘V’ shaped recovery back to near double digit growth rates is plausible on any sustained basis, given the structural headwinds from low industrial capacity utilization, weak corporate cash flows and  inevitable systemic deleveraging. Near term, the PBoC has used aggressive reverse repos to stabilize liquidity conditions, while the effective lending rate floor is now as low as 4.2%, as the discount rate on the lending rate floor was also widened from 10% to 30% at the same time as the last interest rate cut in July. Since May total social financing has been rising y/y, led by the non-bank sector. In fact, China’s trust companies, with more than $1 trillion under management, provided 755bn RMB worth of new funding to infrastructure projects over the course of the first nine months of the year. Local government financing vehicles (responsible for funding most of the country’s infrastructure construction) raised a further 716bn RMB from bond issuance, according to CICC data.

The trend marks a transfer of default risk from the state (in the form of implicitly central government backed policy bank lending to LGFVs) to private investors, at a time when local government finances are in a very bad shape (with revenues in many large cities typically up 10% y/y and spending up 25-30% YTD). It seems that not only have the banks stepped back from taking the primary role in funding the latest round of infrastructure expansion, but that a portion of funds raised from trusts and bonds has gone toward repaying older bank loans. Xiao Gang, chairman of Bank of China, writing in the China Daily last month, noted that: “It is shadow banking activities that have allowed many projects to obtain fresh funds and hence avoid default …this could be one of the major reasons why the formal banking system in general is still enjoying declining non-performing loan ratios, despite the weakening repayment capabilities of some borrowers”. Despite the pick-up in high frequency data, the quality of incremental credit is a concern.

Overall, Armageddon scenarios were never plausible at this stage, but a decline to 4-5% growth remains feasible by mid-decade if deep reform measures to boost trend productivity growth from current levels at about half of wage growth are not pushed through in 2013. The next couple of quarters should be bullish for Chinese risk assets, but the challenges and inevitable upheaval of the looming economic transition will be the key investor focus by this time next year. It’s clear that China’s new leadership must be comfortable with “the new normal”, and focus on efficiency enhancing reforms. During his opening speech of the 18th People’s Congress, Chinese President Hu Jintao stated that GDP must double by 2020. That implies an annual growth rate in excess of 8%, which is implausible given demographic headwinds without a much larger role for the private sector and radical structural reforms.

The debate is raging in policy circles about now to halt the trend known in Chinese as guojin mintui, roughly translated as ‘the state advances while the private sector retreats’, a trend since 2008 which has driven productivity growth lower and led to diminishing capital returns across the economy. Reformists generally see the growing power and share of  GDP held by state-owned  companies  as  the biggest structural risk facing the Chinese economy. Private SMEs are blocked from investing in sectors such as oil and shipping, over which the government asserted ‘absolute control’ six years ago, and they have limited access to nine other sectors including autos and construction in which state companies were granted ‘relatively strong control’, leaving cash surpluses from the export sector  to  be  reinvested  unproductively  into  real  estate.  Opening  these  key  sectors to both FDI and local SME activity will be an important signal of intent in coming months.

Meantime, a new hukou (residence pass) policy was announced in February 2012, allowing migrants in small cities to apply for local residence if they have a stable job and a place to live. Migrants in medium-sized cities can do the same if they have worked and lived in the same city for three years. This policy, if it is implemented, will greatly boost domestic consumption as rural migrants save much of their income because they have to prepare for going back home someday and China’s household consumption would increase by 3-4 percentage points as a share of GDP if the consumption level of rural migrants were increased to the average level of urban Chinese citizen. Migrants will bring their children and parents to the city once they get the urban hukou (a key factor behind the opposition of urban residents worried about competition for social services like schools). However, this reform in conjunction with a wider social safety net would provide a larger market for services, a sector still hugely underdeveloped and with the potential to offset the falling share of manufacturing in the second half of this decade.

China Rebalancing Trends Deteriorate in Q3…

While the consensus obsesses over GDP growth, the key issue for investors in China and the incoming leadership remains the quality and sustainability of incremental activity. We introduced the China Rebalancing Index back in the February monthly note, and updated it in a July weekly; it’s an equally weighted diffusion index taking a standardized composite measure of seven key economic trends to act as a statistical summary of evolving structural trends, rather than looking for contemporaneous or lagging correlations or cyclical turning points as with a composite leading/coincident index approach. The components offer an insight into whether the Chinese economy is evolving in a sustainable direction toward greater household consumption/private sector service growth or further structural imbalance by experiencing incremental growth driven by SOE/heavy industry/fixed investment activity.

Readings  above  50  represent  trend  imbalance,  and  readings  below  50  represent  trend rebalancing. The methodology follows that used in constructing a Purchasing Managers’ Index (PMI). Quarterly data is used as a default rather than the usual and dubious linear interpolation to create a monthly series; where monthly data is available, the end of quarter data point is selected. Broadly, significant trend shifts in the CRI as seen in 2002/3 and 2009/10 lead the relative consumption share of GDP growth by 9-12 months, which is in line with the real economy lagged impact of factors such as the real deposit rate and REER in terms of metrics like the savings ratio/consumer purchasing power.

The CRI components are:

1. The real (CPI deflated) 1-year bank deposit rate deviation from neutral (defined as 100bps positive i.e. a level at which monetary policy is neither expansionary or restrictive) – every 1% rise in the real interest rate will reduce the savings rate by 60bps on IMF analysis, and vice versa – a positive in Q3 as the decline in average CPI outpaced the cut in deposit interest rates.

2. The Real Effective Exchange Rate (REER) y/y change i.e. the trade weighted and relative inflation adjusted change in the RMB rate as calculated by the Bank of International Settlements – an accelerating REER trend will be positive for rebalancing by boosting domestic retail spending power/curtailing marginal industrial activity –negative contributor in Q3 on relative inflation rates and RMB volatility, as the y/y growth rate fell to 3.5%.

3. The differential between real per capita household income growth (rural and urban, weighted by the annual urbanization rate) and real GDP growth. This is a proxy for wage growth in the absence of direct statistics – positive in Q3 with per-capital real urban incomes rising 9.8% and rural by 12.3%, well ahead of GDP growth.

4. The differential between Secondary (industrial) and Tertiary (service) shares of incremental GDP growth – acceleration in SME service activity is crucial to several positive trends from reduced energy intensity of incremental GDP to absorbing underemployed graduates. Small positive in Q3, as manufacturing industry suffered disproportionately from the policy led slowdown, and services activity accelerated slightly to 7.9% from 7.7% in Q1, both on a YTD y/y basis.

5. The % change in the quarterly Entrepreneur Confidence Index for SOE dominated sectors versus private to capture trends in private SME momentum; the Shibor interbank rate is a useful proxy for funding stresses in this sector but the history only extends to 2006 and this index correlates positively with revenue growth and negatively with funding cost trends. Largest contributor to imbalance in Q3 as SOE/heavy industry confidence stabilised amid on-going weakness in SME sentiment (notably in the social services sector, down from 131.5 in Q2 to 122).

6. The differential between real Fixed Asset Investment (deflated by 6mma Building & Construction PPI) and real Retail Sales (deflated by CPI) growth rates (note as discussed in previous notes that FAI includes land values, which creates distortions in drawing international comparisons, but not in terms of broad GDP trends). Falling inflation helped China’s retail sales rebound to a real growth rate of 12% y/y in Q3 but the 6mma construction PPI slumped far faster than CPI, boosting the real FAI growth rate to 22%, so marginally negative contributor.

7. The differential between heavy and light industry output growth (on a VAI basis) within the Secondary sector of GDP – heavy industry such as cement and steel is capital and energy intensive, and dominated by SOEs with preferential funding access. Light industry is predominantly consumer demand focused, although the category is also exposed to construction activity. Value added of industry = gross industrial output – industrial intermediate input + value added tax; the growth rate is calculated at constant prices. Value-added of Industry refers to the final results of industrial production of industrial enterprises in money terms during the reference period. Neutral in Q3, as the decline in value added output growth for heavy industrial sectors like steel was matched by light industry suffering from softer consumer demand growth.

Have Markets Underestimated Japanese Resolve to Weaken the Yen?

The Japanese have a history of proving inventive faced with desperate circumstances, and in fact rarely move forward without their backs to the wall, given inherent cultural inertia. The exceptional factors which have allowed endless deficits, notably the recycling of corporate retained earnings into JGBs to offset falling household savings, and a surprisingly resilient current account surplus despite a long-term deterioration in the country’s comparative advantage in manufacturing, are now coming to an end.  Near term, the BOJ slashed its economic growth forecast for fiscal year 2012-13 to 1.5% from 2.2% and decided to raise its asset buying and lending program. It was the first time since 2003 that the conservative BOJ has eased policy for two months in a row.

In another radical shift, the central bank issued a joint statement with the government pledging their combined efforts to pull Japan out of deflation. In an unorthodox move (although not dissimilar to a recent BOE bank lending initiative), the BOJ also unveiled a plan to supply banks with unlimited amount of cheap, long-term funds under a new scheme initially set at around 15 trillion yen. Markets reacted with a sense of déjà vu to the latest asset buying plans but this has the potential to be far more significant both in its direct impact on the yen and in the combined determination of the bank and government to stave off another deflationary episode than the consensus thinks. The yen carry trade is back on, backstopped by the BOJ balance sheet…

The near term macro outlook is deteriorating rapidly, bringing the currency headwind into stark focus. Japan’s coincident composite index, which consists of 11 key indicators, including industrial output and retail sales, dropped 2.3 points m/m to 91.2 in September. Excluding quake impacted March 2011, September’s fall was the biggest since February 2009 and marked the sixth straight month of decline. Factors from the persistently strong yen to the on-going territorial dispute with China disrupting the auto sector in particular have undercut economic activity. Output fell an unexpectedly large 4.1% from August, while seasonally adjusted retail sales fell 3.6% on month. The government said that 9 of its 11 main economic indicators deteriorated in September amid a sharp slowdown in industrial production, signaling a “possible turning point” into contraction, the seventh time the government has used such language since 1986, announcements which were indeed followed by four subsequent recessions. Core machinery orders, which measure the change in the total value of new orders placed with machine manufacturers, excluding ships and utilities, declined 4.3% in September, worsening from a 3.3% pace of decline in August. Core machinery orders dropped 7.8 % on a y/y basis in September, from a 6.1% decline in August.

The Cabinet Office defines “turning point” as indicating that there is a high possibility the economy will be acknowledged retrospectively to have peaked several months ago. The risk of a renewed recession has clearly risen in recent months. The October coincident CI will likely show a further drop and lead to another downgrade of the assessment to “worsening,” which is defined as a possible recessionary phase. The index was greatly affected by industrial production, which posted the biggest drop in September in recent years with the exception of the March 2011 earthquake and the global financial crisis of 2008-2009. A survey of manufacturers released by the Ministry of Economy, Trade and Industry on Oct. 30th showed that companies expect output to fall 1.5% in October m/m.

The jointly issued document says that the BOJ will continue with “powerful monetary easing” until its goal of 1% inflation is achieved, and the government will tackle structural reform and carry out appropriate macroeconomic policy. The BOJ decision to expand asset purchases by 11trn yen came after the government announced a 422.6bn yen stimulus package. The newly appointed Economy minister Seiji Maehara appeared at the latest BOJ policy board meeting for the second month in a row. While the DPJ is headed for the exit, the LDP is headed by Shinzo Abe, an outspoken advocate of more aggressive monetary easing measures, such as a higher and binding inflation target (of 2% plus). The BOJ is vulnerable to political pressure as the end of Gov. Shirakawa’s term in April approaches. However, the BOJ’s view that deflation can’t be overcome by monetary policy without deep structural reforms given a huge and persistent output gap and the declining comparative advantage of Japanese industry has apparently been accepted by the government. For investors, the key conclusion is that Japan is approaching a comprehensive attempt to slay deflation.

If PM Noda dissolves the lower chamber while the yen is still painfully strong, it will hurt the DPJ’s already ominous electoral prospects as national consumer electronics champions like Sharp enter their death throes. If the economy slows sharply, it will be difficult to go ahead with the politically expensive consumption tax increase which is the DPJ’s key policy achievement (from the current 5% to 8% in fiscal 2014) as scheduled. State Minister for Economic and Fiscal Policy Seiji Maehara, who played an important role in having the consumption tax hike bill clear the Diet, was also active in pressuring the BOJ to further ease its monetary grip. Having demanded that the BOJ be strictly independent when in opposition, the DPJ in power is aggressively pressuring the central bank to be more interventionist. LDP leader Abe has also suggested that the party will seek to revise the 1998 BOJ Act if it regains power.

 

Despite Investor Cynicism, This Time Really Might Be Different…

Essentially, if the BOJ stands by as another deflationary episode develops, both parties stand ready to lobotomize it. I noted back in the March 1st  Weekly on Japan that: ‘Japan’s experience of low deposit rates has driven a global search for yield which has turned millions of unassuming housewives into frenzied traders of Australian and Brazilian currency and bond markets. As investors respond to incentive signals, the displacement into EM debt and currencies inevitably drains liquidity from low-yielding domestic markets, ultimately creating a need for more QE or other liquidity operations, like endless blood transfusions to sustain a slowly hemorrhaging patient.’ It’s notable in that context that the yield differential between Japanese equities and JGBs has surged this year, and it can only be a matter of time before investment banks offer leveraged structured products harvesting that arbitrage opportunity rather than ones focused on ever more exotic EM debt.

Under the new program, the BOJ will provide funding for banks to expand their lending. The problem is not the ability or even willingness of banks to lend, with loan-to-deposit ratios now in line with US and Asian peers, but a lack of demand for credit due to deflation and the high exchange rate. The impact of Europe’s debt crisis has combined with the slowing Chinese economic growth, the latter trend exacerbated by the territorial row with China and consequent consumer boycotts of Japanese cars. Ultimately, much of the new open-ended BOJ lending is likely to leak overseas. Governor Shirakawa stressed that “Supporting activities by financial institutions and companies, whether domestic or overseas, will eventually lead to growth in Japan.” The BOJ is often criticized for being too conservative, but its balance sheet has swollen to over 30% of GDP; the problem is that it took them 20 years to get there, compared to less than five in the euro zone.

Relative to GDP, ongoing BOJ securities purchases will be significantly larger than the Fed’s QE3+ activity and are likely to be unsterilized. As of the end of October, the BOJ had bought 34.4trn yen of securities under the APP, introduced in October 2010. The new plan is to raise securities holdings to 66trn yen by the end of 2013, implying monthly purchases of about $28bn at the current USD exchange rate, compared with the Fed’s current QE3 run-rate of $40bn per month. The planned purchases by the end of 2013 amount to almost 7% of projected 2013 GDP or more than twice the comparable US figure (assuming that the Fed doesn’t have second thought by H2 2013, which is perfectly feasible).  The scale of the latest initiatives may well be combined with a lengthening the maturity of securities purchases (as longer-term bonds are more likely to be held outside the banking sector, so buying by the central bank results in a direct boost to the broad money supply in addition to a rise in bank reserves). The BOJ currently limits buying of government securities, which account for 58.5trn yen of the 66trn APP target, to bills and JGBs with a remaining maturity of less than three years.

Japanese companies, for their part, are shifting capital investment abroad and snapping up overseas firms. The new lending scheme may thus help Japanese companies that are looking to globalize to survive. How will the unlimited provision of funds by the BOJ affect portfolio capital flows into and out of Japan? On the face of it, the global carry trade based on yen funding has just had a steroid injection. Foreign financial institutions with branches in Japan will be able to receive loans of up to 4 years at an annual interest rate of 0.1%, which they will then be able to lend overseas. While banks themselves are not eligible to receive loans themselves under the program, nonbank financial institutions will be. The carry trade refers to a strategy in which investors borrow funds in yen at a low interest rate and invest in currencies or other instruments in countries with higher interest rates. The carry trade exploded over the past decade as the BOJ’s QE easing effort proceeded erratically.

As the new program will provide funds to banks that boost lending not only in Japan but also overseas, Japanese monetary authorities will implicitly be encouraging that carry trade flow. The BOJ now expects prices (excluding fresh food) to rise by 0.8% in FY 2014. The bank’s Outlook for Economic Activity and Prices report, cut earlier predictions of prices in FY 2012 and 2013 (the median rates of estimates made by nine members of the bank’s Policy Board) to minus 0.1% and 0.4%, respectively. The latest report said that: “In fiscal 2014, it appears likely that it will move steadily closer toward the bank’s price stability goal in the medium to long term of 1%” but it’s notable that two board members recruited from the private sector apparently disagreed.

Ironically, after a decade wrongly calling the tipping point for JGBs, foreign investors have been increasing their exposure to Japan’s bond market since mid-2011, lured by high inflation- adjusted yields. The 3.5% climb in the USD/yen since the beginning of October reflects a growing disparity between high frequency data coming out of the US and Japanese economies. Calling an end to the endaka that has wrecked the terms of trade for exporters, particularly versus Korean rivals, is an even bigger forecasting graveyard than calling the top on JGBs. The key driver historically for the USD/yen rate is still the gap between yields on 2-yr Treasuries and 2-yr JGBs which at sub 20bps is little changed from the average over the past year.

However, if we see a resolution to fiscal uncertainty in the US, the pace of deleveraging and pent up consumer demand in housing and autos suggest that by mid-2013 that differential will probably have widened significantly. Meantime, there have been only three occasions in the past 13 years when investors been more underweight than the current reading of -1.4 standard deviations. On each occasion, Japan has outperformed the MSCI World Index over the following quarter, by an average of 7%. Indeed, of the 26 occasions when investors have been more than one standard deviation underweight, Japan has outperformed the world on 70% of occasions over the following three months.  While I’m no fan of data mining, that offers food for thought. Japan is now about as unfashionable among asset allocators as European assets were back In June, when global investors dismissed the possibility of a radical policy breakthrough. In typically ambiguous Japanese fashion, we’re probably seeing one…