Set out below is a summary of some of last weeks key events.
House and Senate leaders agreed a budget deal which will establish spending levels over the next 2 years. In addition the agreement amends some of the automatic spending cuts caused by the sequester. Whilst the deal was modest in size, it does enable the government to function without the constant political fighting that has been the case recently. The House ratified the deal and the Senate is expected to do so next week. The debt ceiling will have to be increased early in the New Year.
US regulators approved the Volcker rule which essentially is designed to prohibit banks from proprietary trading. Banks will still be able to take positions to enable them to carry out their market making activities. CEO’s of banks will be more accountable for the banks activities. The key will be the interpretation of the rules by regulators.
A number of FED speakers, even those deemed dovish, talked about the tapering programme starting soon. The FED meets next week and a number of analysts believe that it will announce the start of tapering at that time. The size and mix of the tapering programme will be important, with the FED likely to focus more on Treasuries rather than mortgage backed securities, at least initially.
In terms of the US economy, retail sales came in better than expected with a rise of +0.7% in November, higher than the upwardly revised +0.6% in October. Core sales, a figure which is used to calculate GDP, were up +0.5%. The buoyant market, combined with lower fuel prices and increased employment has improved confidence of US consumers. Business inventories rose by +0.7% in October, higher than expected. The rise in inventories will ease fears that Q4 GDP will come in much lower, as high inventory levels in Q3 are wound down. Disinflationary forces continue to be evident with producer prices declining by -0.1% in November, lower than the unchanged level expected. The job openings data improved, with vacancies up to a 5 year high. This number is important as it is a data point which the next FED Chairperson, Mrs Yellen looks at. Housing data continues to improve, with foreclosures at a near 8 year low, though I expect that residential home prices will moderate next year. In general, the data confirms that the US economy is improving.
Unlike the US, European data was poor. October Industrial output in the eurozone (EZ) came in at -1.1% M/M, much worse than the rise of +0.3% expected. German industrial output declined for the 2nd consecutive month – it was down by -1.2% M/M, worse than the decline of -0.7% expected and the -0.7% in September. French industrial output declined by -0.3%. The only surprise was Italy, which posted an increase of +0.5%. Analysts report that the data implies that Q4 GDP expectations will have to be revised lower to possibly just +0.2%.
Over the weekend, SPD members voted overwhelmingly to back a coalition with Mrs Merkel’s CDU party. At least Germany has a new government in place. Importantly. Mr Schauble, will remain as Germany’s finance minister. Many have thought that the grand coalition will be more EZ friendly, but comments from the SPD suggest that Germany will continue with its previous policies in respect of the EZ.
EU finance ministers announced a series of measures which eventually will lead to a banking union. However, the measures announced are far from ideal. A fund is to be created over a period of 10 years, paid for by levies on banks. However, the use of this fund to provide mutual support for banks is to be phased in over the 10 year period. In the interim, individual countries will continue to responsible for their banks. In other words, the link between the financial sector and the Sovereigns continues. Larger EU countries will have more of a say. Furthermore, the decision making process to deal with problem banks is far from clear cut. Essentially, countries conceded to German demands. The finance ministers also agreed to a common set of rules to deal with failed banks, which will come into effect from 2016, 2 years earlier than planned. Bail-in rules at that time will force bondholders and large depositors to take a hit.
The ECB is in the process of conducting an asset quality review and stress tests in respect of the largest banks, with the results due by November next year. Mr Draghi reiterates that the criteria will be credible. Some banks are very likely to fail the tests. How are these banks to be recapitalised?. It is unlikely that the private sector will provide all the funding that will be necessary and the deal agreed by the European finance ministers does not provide the backstop necessary. A number of countries lack the resources to provide the support necessary. Furthermore, members of the ECB have suggested that banks will no longer be able to use cheap funding from the ECB’s LTRO operations to buy sovereign bonds. One of the ideas proposed by ECB representatives is that sovereign debt will no longer be treated as zero risk – in other words banks will have to reserve capital against their positions. The logical conclusion is that banks will stop buying and/or reduce their holdings of sovereign bonds, thereby increasing rates. Furthermore, banks will be deleveraging their balance sheets in anticipation of the ECB’s stress tests. The net impact is that the availability of credit will be reduced in the EZ and that sovereign yields rise. This is a serious issue and one which could well have a material negative impact on the EZ. To alleviate some of the potential problems, the ECB has stated that it will provide liquidity to banks, in particular to lend to SME’s – a funding for lending scheme, as introduced by the Bank of England, may be announced. However, the risks are high, in particular given the weak EZ economy.
UK economic data continues to improve. Manufacturing activity has risen, as has construction activity. The services sector, the most important in respect of the UK, remain strong. Unemployment is declining and the market expects interest rates to rise sooner than otherwise thought. The Bank of England (BoE) remains concerned about the increase in property prices, with the house price index rising to the highest in a decade in England and Wales. At some stage, I would not be surprised if the BoE takes measures to try and limit price rises. The British Chamber of Commerce (BCC) has increased its forecast for 2014 GDP to +2.7%, up from +2.2% previously. Importantly, the BCC forecasts that business investment will increase to well over 5.0% in 2014 and 2015 – in the past business investment in the UK has been a problem. The risk to the UK remains the EZ.
Japanese calendar Q3 GDP was revised lower to an annualised rate of +1.1%, down from +1.9% previously. Lower investment and inventories were cited as the main reasons. Japan’s current a/c declined unexpectedly to a deficit of Yen 127.9bn in October – a surplus of Yen 150bn was expected. Continued current account deficits will pose a serious threat to Japan. Mr Kuroda, the governor of the Bank of Japan (BoJ) stated that the BoJ will continue with its highly expansionary monetary policy until inflation reaches their 2.0% target – the BoJ core inflation rate, which the BoJ targets, is currently +0.9%. However, much of this inflation is due to the increase in Yen terms of imported goods, in particular energy, as the Yen has declined. His comments suggest that the BoJ may well increase its purchases of Japanese bonds and that the ultra easy monetary policy will remain in place for longer than the 2 years initially stated. There is still very little sign that Japanese companies are increasing wages – indeed, the latest data reveals that wages are declining. If this trend continues domestic consumption will decline. I remain highly sceptical of Abenomics and the BoJ policy.
Chinese exports rose by +12.7% Y/Y in November, much higher than the rise of +7.0% expected. However, the data is suspect. A number of neighbouring countries reported either flat or marginally lower exports. The much higher than expected export data may actually be capital inflows disguised as exports, as interest rates have increased as a result of actions by the Central Bank (PBoC) and the Yuan has strengthened. Furthermore, industrial production came in marginally lower, which also casts doubt on the export data. Imports rose by just +5.3%, lower than the 7.0% forecast. Inflation was lower than expected at +3.0%, down from 3.2% in October. Retail sales were up +13.7% in November, higher than the +13.3% in October. The PBoC has been trying to limit lending. However, aggregate lending rose by Yuan 1.23 tr, much higher than Octobers Yuan 856.4 bn. Property prices continue to rise, in spite of government policies to limit increases.
Recently, the Chinese government announced a number of reforms designed to make the economy more market based. The fear is that a number of vested interests would block these reforms and, in addition, that the Chinese bureaucracy would move very slowly to implement the reforms. As a result, the Chinese government announced that it would withdraw certain powers from a number of central government ministries, including the powerful National Development and Reform Commission. The government also announced that it would strengthen scrutiny of local government financing. In the past local governments have increased spending materially, with the true level of outstanding debt unknown. They added that individuals in local governments would be punished for decisions which resulted in either incurring large losses or for wasting resources or causing environmental damage. The National Audit Office has yet to release details of the level of debt incurred by local governments – some analysts estimate that it could amount to between US$ 2.5tr to US$3.0tr. Over the weekend, the Chinese leadership stated that they would tackle the issue of local government debt next year. Furthermore, there is some speculation that the growth forecast may be reduced to 7.0%, from 7.5%.
Markets closed lower last week. Investors are waiting for next week’s FED meeting to see whether tapering will start. With agreement reached between the Republicans and the Democrats on the budget, the odds of an early start of the tapering process have increased. However, I believe that the FED will hold off till next year, though January is looking more likely than March. Surprisingly, the 10 year Treasury bond is yielding 2.86%, which most expected to be nearer 3.0%. The market seems to have accepted that tapering will start imminently and an announcement should not have a material impact on markets, in particular if accompanied by a statement which confirms that monetary policy will remain accommodative for an extended period of time, which is a near certainty.
Whilst the US and UK economies continues to improve, I believe that the EZ and Japan face significant problems next year. For the reasons stated above, the problems in the European banking sector are likely to flare up again. With banks cutting back on lending to meet the ECB’s stress tests, credit will be restricted, adding further pressure on the region. Furthermore, inflation in the EZ is likely to remain low and may even drift lower. Indeed, other than in emerging markets, disinflationary forces seem to be continuing. The ECB, at some stage, will have to act. The BoJ’s statements suggest an increase in QE next year from its already lofty levels. The risks relating to Japan are rising, in particular if its current account remains in deficit.
The Yen and the A$ continue to weaken and I believe that the Yen is likely to depreciate even further. The governor of the Australian Central bank, the RBA, continues to talk down the A$. Recently, he has raised the prospect of intervention and has even suggested that a level of US$0.85 would be more appropriate – the A$ is currently trading at just below US$0.90. The Euro strengthened to around US$1.38, but has declined to closer to US$1.37. I continue to believe that the Euro will have to weaken against the US$ next year – the EZ cannot live with this rate. I remain a US$ bull for next year.
I expect that volatility will rise in 2014. The VIX which was trading around 12 has risen to around 15 in just a few weeks. Whilst there may well be the traditional rally into the year end and early next year, I remain cautious. I continue to believe that the risk profile of equity portfolios should be reduced at the very least.
15th December 2013
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