The US October non farm payroll (NFP) report came in much stronger than expected at +204k jobs, rather than the +120k expected, with August and September revised higher. Furthermore, subsequent weekly unemployment data confirms that the US employment situation is improving. US Q3 GDP was better than expected, at +2.8% on an annualised basis, higher than the +2.0% expected and may well be revised higher. However, Q4 GDP is likely to be lower, reflecting a reduction in inventories, combined with the impact of the partial government shutdown.
The data has lead the market to focus on the timing of the FED tapering programme. This weeks November NFP data will be an important data point. Mr Bernanke has suggested that the FED will remain accommodative, even after it starts tapering. Indeed, the FED’s unemployment threshold (before it considers raising interest rates) could be reduced from the current 6.5%. Low inflation enables the FED to justify such a move.
Mrs Yellen is set to become the next FED Chairperson. During the course of her testimony as part of the appointment process, she confirmed her dovish bias. She stressed that “labour markets and the economy (are) performing short of their potential”, adding that unemployment “was still too high”. Furthermore, she added that “It’s important not to remove support when the recovery is fragile”. In the Q&A’s she stated that the true level of unemployment in the US was likely over 10%, as opposed to the 7.3% rate reported in the Octobers NFP report. She added that inflation was below the FED’s threshold of 2.0% and implied that she did not see inflation as a threat at present – core PCE was +1.2% Y/Y in September. In addition, she stated that she did not see any bubbles forming. Essentially, she stuck to the Bernanke script. Her general tone was dovish, especially in the Q&A’s, which suggests that she will be in no hurry to start the tapering process. As long as she can persuade her colleagues, I continue to believe that tapering will not start before March of next year.
It is clear that the FED is agonising over its asset purchase programme and would like to start tapering, “in coming months”. However, they will want to avoid the experience earlier this year when rates rose sharply following 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.
Whilst there was some mixed US industrial/manufacturing data, 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 maintain a more dovish position. Analysts have increased their 2014 forecasts and are now predicting GDP of around +2.75%.
Analysts were shocked that the ECB President Draghi cut the main refi rate by 25 bps to 0.25% last month. However, with EZ inflation at just 0.7% pa in October (0.9% pa in November), the ECB had to act. Draghi referred to “a prolonged period of low inflation”. Some countries such as Greece are facing outright deflation. I expect the ECB will cut rates by a further 10/15 bps next year. However, such reductions in interest rates are not going to make a difference. Another LTRO (possibly for 5 rather than 3 years) is likely. The idea of negative deposit rates has been raised, though I believe that such a policy is unlikely. The problem for the ECB is that QE, as employed by the FED, BoE, BoJ etc, is far more difficult for it to introduce as a policy, though may be forced into it. With money supply and bank lending declining (which will get worse as EZ banks deleverage ahead of the stress tests), the EZ faces continued problems. The ECB is considering measures to increase credit, in particular to SME’s.
The EuroZone’s Q3 GDP came in at just +0.1%, lower than the +0.3% in Q2. French Q3 GDP declined by -0.1%, whilst Italy remains in recession. German Q3 GDP came in at +0.3%, in line with expectations, though below the +0.7% in Q2. The EU has warned a number of countries may well fail the debt and deficit rules, including France and Spain. However, politically further austerity is going to be a very hard sell. The market has largely ignored the poor French data, though I continue to be highly concerned about the country. President Hollande does not seem to have taken the action necessary and I have no confidence that he will. S&P downgraded France by 1 notch to AA and recent PMI data suggests that Q4 GDP could be negative. If so, France will technically be in a recession. In Italy, political risk is rising as Mr Berlusconi was ejected from the Senate. Germany, Luxembourg and Finland are the only countries in the EZ with a AAA rating, following Hollands downgrade by S&P.
On a more positive note, Ireland and Spain announced that they would exit the bailout programme and Spain was upgraded by Fitch and S&P. EZ unemployment declined to 12.1%, from 12.2% in September. Recent German data suggests that the economy has bounced back from a slight downturn in summer, with business, consumer and investor confidence rising. However retail sales were lower and unemployment edged up for the 4th consecutive month. Mrs Merkel’s CDU has reached a deal with the SPD to form a grand coalition, though the deal needs to be ratified by the SPD membership – the results are expected in mid December. The EZ is bumbling along with very low growth and the the risks are to the downside.
Negotiations over the establishment of the Single Resolution Mechanism in the EU to deal with undercapitalised banks failed to reach a clear cut conclusion. The Germans rejected the idea of using the ESM (in effect they have a veto), as proposed by the a number of countries, including France and Spain. They suggest that rules relating to bail ins by creditors be brought forward. In addition, the Germans do not want the European Commision to be the arbiter of the rules governing the Single Resolution Mechanism – they suggest it should be Council of the European Union, which is made up of representatives of EU countries. The ECB, which takes over EZ financial supervision has stressed that there is a need for a “strong and independent” European Resolution Mechanism, which clearly must be right. However, will that be the case?. Some 5 years into the financial crisis, the EZ has failed to resolve the problems of a number of its banks. This issue will become much more important in the coming year, especially as the ECB is to conclude the assessment/stress tests of the largest banks by next November. It is expected that some banks will fail the stress tests. The big question remains – who will provide the backstop in case the private sector does not come up with the necessary capital to recapitalise those banks which fail the stress tests. You could argue that the ECB’s actions will force the politicians to act, though the relevant banks will have to accept a pretty tough deal. As a result, EZ banks are reducing their balance sheets to try and meet the more stringent ECB capital rules, which will hurt their economies.
The UK economy continues to improve. Q3 GDP rose by +0.8% Q/Q, better than the +0.7% in Q2 and +0.4% in Q1. The main growth drivers were investment and housing, though exports declined. Unemployment has fallen to 7.6% in October, the lowest since May 2009. October services PMI rose materially, which suggests that the UK economy will continue to strengthen. The rise in house prices, in particular in London and the South East has raised concerns, with the BoE announcing curbs on mortgage support programmes. In addition, the BoE has warned that it may introduce further measures to limit home prices next year. The Governor has stressed that the BoE will remain accommodative, even if unemployment declines to its target of 7.0%. The improving economy has increased tax receipts, which will reduce the UK’s budget deficit. In general, the UK economy is strengthening and 2014 GDP forecasts have been raised to around +2.75%.
Japanese Q3 GDP declined to +1.9% on an annualised basis, down from +3.8% in Q2, mainly due to a record trade deficit, together with lower capital expenditure. Consumption was also relatively weak – Japanese companies have not increased salaries and wages. Retail sales, seasonally adjusted, declined in October. Inflation is rising, with the BoJ’s favoured rate rising to +0.9% Y/Y in October. If inflation rises to 2.0% (the BoJ’s target), how can 10 year Japanese bonds yield just 0.60%, as they do at present. Yes, the majority of Japanese bonds are owned by the Japanese, but will they continue to buy bonds which yield well below prevailing inflation – I doubt it. Recent data suggests that the Japanese are increasing their purchases of foreign bonds.That suggests that the BoJ will be the only major buyer of government bonds. It is clear that the BoJ is pressing for a weaker Yen, combined with much higher inflation, to reduce the level of accumulated debt. However, the Japanese government has not pursued the structural changes that are necessary to revitalise its economy. As we all know, Japan’s fiscal position is dire. The only conclusion that I can draw is that the BoJ is set to monetise Japanese debt. However, will other countries sit back and watch the Yen depreciate materially. I very much doubt it. The Nikkei is responding positively to the weaker Yen and is at a 6 year high. I have been a sceptic of “Abenomics” and remain so.
The Chinese official news agency released details of the policy objectives agreed by the Party at their recent meeting. Generally, they included a number of reforms that are welcome and, indeed, necessary to rebalance the Chinese economy by encouraging domestic consumption, whilst relying less on fixed asset expenditure. The 1 child policy is to be loosed somewhat. There was some relaxation of the Hukou system which limits internal migration. SOE’s are to give up more of their profits to build social infrastructure. There was also a reference to property taxes and the ability of the rural community to have more property rights. In addition, the PBoC is to deepen the reforms and open up the financial sector. Currency convertibility was mentioned. The key message was that China would allow markets a more “decisive” role in allocating resources. The main issue, however, is whether these broad principles will be translated into actual policy, accompanied by the necessary legislation. A number of the proposals will not benefit a number of powerful vested interests and I would expect a tendency to water down such reforms. In addition, the actual policies/legislation will take quite a long time to finalise – it looks as if a 2020 deadline has been set.
The Bank of China has allowed interest rates to rise, which will impact the financial sector and businesses. Bad debts are certain to rise. The authorities have not yet announced the “true” level of provincial debt, assuming they can actually quantify the number. However, reported debt to GDP is likely to be grossly understated. Recent data suggests that capital is being withdrawn from China.
Of concern is the announcement by the Chinese authorities of an air defence zone, which covers certain islands whose ownership is claimed by Japan. The US, Japan and South Korea have ignored these measures. Mr Abe, the Japanese PM, has tended to play the nationalistic card and is highly unlikely to back down from its territorial claims. Whilst direct confrontation is highly unlikely, the threat of an accident between the Chinese and other countries is real. China has a number of territorial disputes with countries in the region.
US 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, equities traditionally perform better at this time of the year and market momentum is positive, which suggests that markets have further to rise. US markets are trading at record highs, as is the DAX in Europe and the Nikkei is at a 6 year high. Commodity prices, with the exception of Brent, declined in the month, though in the US, oil prices continue to fall as production increases.
I remain cautious, though it is difficult to short the markets given the current momentum. Markets, however, are no longer cheap and 2014 global growth forecasts (mainly due to emerging markets) continue to be reduced. I 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. One of my major concerns is that the markets are overly complacent over the EZ – France for example. In addition, 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 into 2014. I would avoid emerging markets, especially those countries with current account deficits. These countries will be the first to be impacted as the FED starts tapering, especially as a number have not introduced the economic and structural reforms necessary. Their currencies continue to look vulnerable. The markets have delivered outstanding returns this year which, even if you are bullish, are highly unlikely to be replicated next year.
My preferred theme continues to be to increase US$ exposure – it certainly has worked against the Yen and the A$ and I expect both these currencies to weaken further. The Euro has weakened, but has bounced back from its lows, 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. I remain amazed at the Euro’s resilience, given the real problems of a number of the major countries in the EZ and I continue to believe that the Euro will weaken materially in 2014.
2nd December 2013
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