Summarised below are some of the key events of last week.

The Australian Central Bank continues to talk down the A$ – the governor suggests that the country may consider intervening to reduce the relative value of the A$. The IMF reported that the A$ is relatively overvalued. In addition, Australia is materially dependent on the Chinese economy and, as I believe that China’s fixed asset expenditure will  be reduced, Australian exports of basic materials should decline, which in turn will hurt its economy.

The most recent Chinese PMI data, whilst positive, was below October levels, with new orders and employment lower. However, the major news was the release of broad details of their proposed economic reforms. Essentially, the goal is to allow markets a “decisive” role in allocating resources. A number of sensible policy objectives were announced, including, a loosening of its 1 child policy, some easing of the Hukou system, (which restricts the internal mobility of the Chinese population), the introduction of property taxes and spending more (30%, up from a maximum of 15% at present) on social infrastructure, through allocating more of the profits of SOE’s. Furthermore, the Chinese leadership announced that the private sector would be allowed to invest in the SOE’s. The PBoC announced a number of reforms, including liberalising the level of deposit rates that banks can pay, effectively legitimising the Chinese shadow banking market, allowing more competition in the financial sector, withdrawing from its current intervention in the currency markets and to allow the Yuan to trade freely (initially by widening the trading band)  and introducing much needed financial regulations and reforms. Once again, no timetable was provided.

The above proposals are sensible policies. However, there was no real detail and the changes are expected to take many years to formulate into actual policy/legislation. A number of vested interests, who will be hurt by these proposals, are likely to oppose these reforms. Furthermore, the Chinese bureaucracy is renowned for being extremely slow. It is clear that the new leadership recognises the need for structural and financial reforms and understands that it has to move away from its previous dependency on fixed asset expenditure as the main engine for economic growth. China has to increase domestic consumption as a greater proportion of its economy. The above proposals, if implemented, will certainly go a long way to achieving these goals. Markets responded positively to the news, though tempered their gains as they began to understand that these reforms will take a long time to implement and could well face resistance. In addition, the proposed reforms, if implemented, will have negative effects in the short to medium term, though will clearly benefit the country in the longer term.

The true level of Chinese provincial debt remains uncertain. The total is likely to be scary number to say the least, assuming that the central authorities can actually quantify the amount. Furthermore, the PBoC is allowing SHIBOR rates to rise. As a result, the level of bad debts is bound to rise and some financials will certainly be under pressure. Manufacturers are being squeezed by both a stronger Yuan and increasing labour costs – China’s ability to produce cheap goods in volume for export is declining. There is evidence that an increasing amount of foreign manufacturing businesses are moving out of China. Output prices are declining, which is bad news for Chinese manufacturing companies, as a number of these businesses survive on thin margins.

The Japanese October trade deficit came in at just below US$11bn, a record and the 16 consecutive month of deficits. The closure of its nuclear electricity programme has forced the country to import energy which, together with the weakening Yen, is a major reason for the increasing trade deficits. At present, Japan benefits from a surplus of investment income, which ensures that it maintains a current account surplus. However, investment income is expected to decline as the population, which is getting older, increasingly uses up its savings. At that stage, Japan will need to access capital from the international markets. The impact on its bond yields will be dramatic, in particular given the government’s significant level of debt and the very low yields on Japanese bonds at present – the 10 year bond is yielding just 0.62%. The BoJ’s massive bond buying programme is, in effect, monetising Japan’s debt which should continue to have a material negative impact on the Yen. The government must introduce structural, including labour reforms – however, the government seems unwilling to tackle these issues. The Nikkei continues to appreciate as the Yen weakens, but I can’t help feeling that the current policy has serious flaws.

The issue as to the ownership of the disputed islands in the South China seas has been escalated by China – it has announced “defensive emergency measures” against aircraft that don’t identify themselves. Neither China nor Japan want direct confrontation, but these measures increase the risks of an accident. The Japanese PM, Mr Abe has played the nationalistic card and it will be difficult for him politically to back down. This issue is serious and needs to be monitored carefully, in particular as China and a number of countries in the region have competing claims over territory in the South China seas.

The Eurozone (EZ) continues to debate the vexed question as to who is to act as the Single Resolution Authority in respect of the largest of the EZ banks. In addition, whilst the potential use of funds from the ESM to recapitalise banks has been “agreed”, the German Parliament has a veto right. The lack of a government in Germany has not helped – the CDU and the SPD continue to negotiate to form a coalition government.The ECB takes over as the supervisor of the largest EZ banks as of January. It has made it clear that its asset quality review and the subsequent stress tests will be credible, clear and consistent. The results of the stress tests are due next November and at that stage the EZ must have a structure in place to deal with banks that fail the stress tests – it is highly likely that some will fail. Creditor bailins are likely, as EZ politicians are not going to want the taxpayer to contribute. It is unlikely that the private sector will provide the capital necessary to recapitalise all the banks. Whilst the EZ is likely to create a fund, to be financed by levies on banks, it is still to be established and, in any event, is unlikely to have sufficient capital to fulfill its role next year. At the end of the day, the ESM or something similar will have to be used as a backstop to recapitalise banks directly but, as has been the case in the past, agreement will be slow and only when a crisis is imminent. The only good news is that the ECB will have forced the politicians to fix the banks at long last.

Bloomberg carried a story which suggested that the ECB is considering the introduction of negative deposit rates. Whilst Mr Draghi has certainly talked about negative deposit rates in the past, I feel that he is not keen on the idea – it does have a number of negative effects. The ECB next year will almost certainly cut its main refi rate by 10/15 bps and, in addition, announce another LTRO, most likely with a longer duration – 5 years rather than 3. However, I remain unconvinced that such measures will be sufficient. QE remains an option, but will be strongly resisted by the Bundesbank and its allies. Furthermore, QE in the EZ will require the ECB to buy the bonds of all the countries that use the Euro. However, QE or something similar will have to be introduced – the EZ cannot live with the current strength of the Euro, especially as disinflationary trends look set to continue.

The material economic differences between the major countries in the EZ is clear. Germany seems to have recovered from its slight slowdown in summer. The German flash November PMI reading came in stronger than expected, as did the confidence reports from both investors and industry. Domestic demand, construction and investment were the main contributors, though there are some signs that exports are being hit – the stronger Euro?. German manufactures/exporters have focused on emerging markets for growth in recent year. If, as I expect, these emerging markets slow, the strong Euro, combined with its high energy costs, will negatively impact German exports.  The weaker Yen is also a threat to a number of German manufacturing/export sectors. I will be following comments by leading German industrialists very carefully. Having said that, the Bundesbank reports that Germany is on a “solid growth path”.

However, unlike Germany, the flash November PMI’s for France – both manufacturing and services – came in below 50, at 47.8 and 48.8 respectively. A reading below 50 signals contraction and suggests that Q4 French GDP will be negative. If so, France will technically be in recession, as Q3 GDP came in at -0.1%. The French government continues to dither and backs off taking the necessary steps to reform its economy. The economic situation in France is, in my humble opinion, a major problem for the EZ.  The EU have repeated that the Italian and Spanish 2014 budgets look like failing the debt and budget deficit rules, which should come as no surprise. Both countries have rejected the EU’s conclusions, though I suspect that the EU is almost certainly right. However, I do not see these countries bowing to EU pressure. The slight economic stabilisation/pickup over the past few months has really been as a result of these countries ignoring their budget/austerity targets. The continued problems in the EZ remain one of my major concerns, though markets are ignoring these problems at present.

The UK continues to perform strongly. The services sector is rising rapidly – services PMI expanded at the fastest rate since 1997. However, its not just the services sector -  manufacturing is also expanding, rising by the fastest in 18 years. The improvement in the UK economy will increase the tax revenues and reduce budget deficits, allowing the Chancellor to announce tax cuts ahead of the next general election. Sterling has been resilient, though will be impacted by any problems in the EZ. The BoE has no desire to strengthen Sterling and the Governor, Mr Carney has confirmed that  rates may be kept lower, even if unemployment hits its previous threshold of 7.0%. The decline in inflation will help the BoE to remain accommodative.

With Mrs Yellen set to become the next Chairperson, the FED is agonising over its asset purchase programme. It seems clear that the FED would like to start tapering, as they put it, “in coming months”  – my view remains March next year. However, they will want to avoid the sharp rise in rates earlier this year which followed  the mere suggestion that the FED could start its tapering programme. As a result, the FED has stressed that tapering will still mean that the FED will be buying treasuries and mortgage backed securities, albeit at a reduced rate. In addition, Mr Bernanke and Ms Yellen have emphasised that the FED accommodative policy would be maintained for an extended period – indeed they have stated that it could continue even if unemployment hits their target of 6.5% ie the 6.5% rate is no longer deemed a threshold for the FED to raise rates. The 10 year bond yield did rise to around 2.80%, though backed off to close at 2.75%.

Whilst there was some weakness in the US industrial/manufacturing data, Philly FED for example, October retail sales came in higher than expected. The disinflationary trend in developed markets has spread to the US, with CPI declining by -0.1% in October, as compared with +0.2% in September. However, the lower inflationary trends allow the FED to take a more dovish position. Higher inventory levels suggest that Q3 GDP may be revised higher, though the improvement will reverse in Q4. Analysts have increased their 2014 forecasts and are now predicting GDP of around 2.75%. Employment data is also improving.

The 6 world powers announced that they had reached a 6 month interim agreement with Iran over its nuclear programme, during which time a more comprehensive agreement is to be negotiated. The terms of the agreement allows Iran to enrich uranium up to the level necessary to generate electricity from nuclear power stations. Some sanctions have been lifted, though Iran has to meet its commitments. The main financial sanctions and those on oil are to remain though Brent may well decline on the news.

Overview
Bond funds continue to witness outflows, with money being redirected into equities, rather than into money markets and the housing sector, as was the case previously. In addition, margin debt has risen materially. Generally, these kind of indicators are good contrarian indicators. However, markets traditionally perform better at this time of the year and market momentum is positive. My concerns over the EZ (France for example) continues, but market momentum has resulted in the Dow closing above 16,000 and the S&P above 1,800. The Nasdaq looks as if it will test the 4,000 level. In Europe, the German Dax is trading at record levels. However, I remain cautious, though it is difficult to short the markets, other than some momentum stocks which have been bid up to ridiculous levels. I continue to believe it sensible to buy protection, especially in respect of Q1 and later next year. In addition, I believe that the risk profile of equity portfolios, should be reduced.

The markets have delivered outstanding returns this year which, even if you are bullish, are highly unlikely to be replicated next year. I continue to believe that risk is rising. In the EZ, Germany seems to have shrugged off its recent slowdown, though France, Italy and Spain, the next largest EZ economies, are suffering and there is little evidence of any meaningful rebound. Analysts are promoting European equities, as the markets are cheaper than the US – yes they are, but I have to say, with the exception of the UK and possibly Germany, together with some more internationally focused (US, in particular) large caps, I would not do so. I simply do not believe in Abenomics, especially in the medium to longer term. The Japanese policy is limited to devaluing the Yen and increasing inflation. Much needed structural reforms have not been introduced. In general I believe that stock picking will become much more important in coming months. The one area I would avoid are the emerging markets, especially those countries with current account deficits. A number of these countries have not introduced the economic and structural reforms and will be the first to decline materially if markets turn. Their currencies continue to look vulnerable.

My preferred theme continues to be to increase US$ exposure – it certainly has worked against the Yen (currently over Yen 101 to the US$) and the A$ (the A$ is below 0.92 to the US$) and I expect both these currencies to weaken further. The Euro has declined, but has bounced back from its lows (currently around US$1.3560), though not quite to its recent highs. The much better UK data has supported Sterling, though Sterling is susceptible to problems in the EZ. A number of forex analysts talk about the Euro rising to US$1.40. All I can say is that I remain amazed at the Euro’s resilience, given the real problems of a number of the major countries in the EZ. I continue to believe that the Euro will have to weaken materially, though it may well be more of a 2014 play.

Kiron Sarkar
24th November 2013

Category: Think Tank

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