Perhaps I should restart the daily macro note with some observations about the environment in general; but first a few observations prompted by today’s news flow.
The FT discusses the European ABS market in the light of Mario Draghi’s initiative to revive private interest in buying the senior tranches of packaged business loans (such packages are still being created because they can be used as collateral at the ECB). The FT observes that capital requirements are now quite high for small business lending and higher still for ABS, and that regulators are still considering whether the next round of capital requirements should be higher still, based on the risks posed by the worst kinds of ABS during the financial crisis (like US subprime). I am mostly in favour of tighter regulation of banks, but if it is right that regulators are considering capital requirements that would allow a bank to survive a situation wherein all of its ABS performed as badly as the worst ABS in the worst financial crisis of a generation, then that seems excessive. It is an unfortunate fact that the vast benefits of fractional reserve banking come at the cost of inherent vulnerability if liabilities are withdrawn or assets decline in value. The problem that regulators face is to balance the vast benefits against the risks and costs of failure. Banks by their nature cannot be made completely safe, and the potential requirement for government bailouts cannot be completely eliminated.
FT Alphaville has a report on global inflation trends, and points out that CPI has been falling for some time in the US, Eurozone and Japan. I note also that breakeven inflation in the US has fallen quite sharply in recent weeks. Is a deflation scare around the corner? With all the central bank action that is going on, that is perhaps a tail risk; but it would be very dangerous were it to materialise. It would indicate that markets had lost faith in the ability of central banks to generate inflation by the use of extraordinary monetary policy — a faith that, it seems to me, is the main reason that extraordinary monetary policy has had any effect.
Now, what about the news of yesterday, that the Chinese State Council statement announced that a plan to allow freer movement of capital into and out of China would be announced this year? First, the timing. It is a long-stated goal of Chinese policy to move to a floating exchange rate by 2015. Perhaps one should take that to mean that full liberalisation cannot be expected to happen earlier. At the least, the plan has to be made before anything happens, which means that any market implications of this announcement are likely to occur in 2014 or later. Second, the implications. It is widely assumed that a liberalisation of China’s capital account would lead to large inflows and an appreciation of CNY. I do not think that that is so obvious. Investors around the world already have good allocations to international securities, although China could become a greater part of their portfolios; but China’s growth has created enormous wealth, and the portfolios of wealthy Chinese are undoubtedly hugely underexposed to international securities. So the opening of the capital account could mean large capital outflows from China and a weakening of CNY. I am not sure which would actually happen, but I think it reasonable to be ready for either.
Essentially, there isn’t very much news, and there hasn’t been for a while now. Since the Cypriot bailout, really, if you exclude the Reinhart-Rogoff controversy. Political events and central-bank action have not been of the momentous nature that one feels has been the norm since the global financial crisis. Perhaps markets and economies have reached a broad status quo, and data and market movements will increasingly take centre stage.
What is the status quo? US consumers have finished most of their deleveraging and the economy is slowly recovering, as indicated by the continued moderate growth rate and the recovery of residential investment. This process is being helped by loose monetary policy, and hindered by the tightening of fiscal policy (which might, or might not, be enough to upset the apple cart, depending upon how solidly the wheels turn out to have been attached — the status quo view is that it will not be enough). Europe is locked into cycles of austerity by the logic of its currency union, and will remain so for the foreseeable future (absent a sudden boom in Germany or popular revolt against the EU). Growth in the Eurozone as a whole is likely to be flat to negative. China’s growth has slowed but remains strong by the standards of anywhere else. This picture could persist for many months, and if it does, then the tendency should be for risk assets to rise gently on moderate US growth, EUR to fall gently as interest-rate expectations for the Eurozone decline, and commodity prices to remain fairly subdued on account of Chinese demand being less hot than it was. AUD should not rise further as slower Chinese growth moderates the demand for Australian resource exports, and USD should be the passive counterpart to these moves.
However, there is a problem with this picture: equity markets. The “status quo” story would be consistent with relatively subdued markets in emerging markets — because of China, as for commodity markets — weak markets in Europe and gently-rising markets in the US as economic growth slowly lifts corporate profits. Well, we do have relatively lacklustre markets in EM (South Korea, India, China, Russia, Brazil), but European equities are toying with post-crisis highs and US markets are rallying very strongly. Why, why, why?
The obvious answer is: Japan. It has seemed to me since January that the weakness of JPY indicated significant capital outflows from Japan (an idea that seems to be supported by the regular banking data, which shows acquisitions of foreign securities by Japanese banks). Andrew Hunt also finds evidence of strong outward investment flows from Japanese corporates. Some of this liquidity may be finding its way to Europe (after all, the European markets are deep and the Eurozone is a large, stable bloc), but the most popular destination would logically be the US, it being the developed economy with the best apparent medium-term prospects. These ideas are consistent with the relatively high level of European equities and with the strength of US markets. The catalyst for the outflows appears to have been the LDP’s election victory, which served as a green flag for Japanese investors to invest abroad without fear that their returns would be offset by currency appreciation.
How long can this process go on? Is it a one-off portfolio reallocation or a secular reversal of a reluctance to invest abroad because of the long-lived upward run of JPY? Either way, will the process be perpetuated by a money-flow effect from the BoJ’s various loosening measures? For what it’s worth, I first thought of it as a one-off reallocation (and therefore bet against continued appreciation of US equities), but now am inclined to think of it as a secular reversal, which means that it could go on and on, as a pool of dammed-up liquidity exits through a breach. That is an argument for being long USD/JPY and long US equities. But it is an argument by analogy with water, and liquidity is not water. I feel I need more of a model than I have here. Clues to the exact nature of what is going on may be discernible in the Japanese flow of funds (and the banking data I mentioned earlier), and I need to look here more carefully than I have done hitherto.
Is the Japanese situation affecting global markets in other ways? There are certainly funny things going on. AUD dropped in January and February when, as far as I could see, it shouldn’t have (moving as it usually does with global commodities or US 2-year real rates (which are two sides of the same coin)). Gold has sold off sharply, which, if you think of gold as a combination of long-term US real rates and the exchange rate of the dollar against Asian currencies, makes sense in the context of the fall in JPY. What exactly are the Japanese doing, who else is playing in JPY, and what other effects are they having on financial markets? This is a topic that I feel requires further exploration.
UK IP 0.7% MOM Mar but -1.4% YOY. On a two-year chart the downtrend in the IP index seems intact.
China PPI -2.6% YOY Apr. Has been negative since early 2012 and is becoming more so it seems — the last two months have seen declines in the YOY rate. A reminder that economic performance is not perfectly captured by the PMI!
China CPI 2.4% YOY Apr. On a plateau.
China trade balance 18.2bn b.e. Apr. Exports and imports both rose, although everybody is sceptical about the export numbers, including the Chinese authorities, who have announced a clampdown on companies’ reporting (and the fact that there were two extra days in April seems to account for the rise in any case).
Australian unemployment fell to 5.5% b.e. Apr, but is still higher than two months ago. The media were excited.
German IP 1.2% b.e. Mar. This is only one data point in a volatile series, but it was the strongest since July 2012. The media were even more excited.
Swiss CPI -0.6% YOY Apr.
UK Halifax house-price index 1.1% b.e. Apr. Flat trend since the series bottomed out after the financial crisis may be turning into an uptrend, but any trend is in its early stages. House prices are around 4.5x average income, compared to a recent peak of around 6x and a long 1990’s trough at around 3x.