PIIGS bailouts

It seems that the UK is preparing to participate in an Irish bail-out, presumably on the grounds that the UK cannot ignore what is happening next door. The whole euro-zone crisis is increasingly becoming an exercise in papering over cracks as they get larger and larger. So far, there has not been a proper restructuring exercise putting the various PIIGS on a sustainable fiscal path going forward. Rather, it has been a serious of manoeuvres to keep the financial sector afloat with any pain being forced on local populations, so far most notably on the Greeks. We can tell that nothing substantive has been achieved as PIIGS bond yields have yet to return to pre-crisis levels and in most cases are at unsustainably high levels. The sole achievement of the EU has been to seriously compromise the financial strength of the ECB as it has taken on low quality debt as collateral and bought what are effectively bankrupt countries national debt. We are talking about bail-outs, throwing good money after bad just like the Japanese did in the early 90s and so socialising risk.

Global PMIs

Although we are still waiting for the services PMIs from Europe and the US, it seems likely that the global PMI for October will be higher than that for September. Certainly, the manufacturing PMI rose from 52.5 to 53.7 with an encouraging rise in the new orders sub-index from 51.4 to 53.7.

Much has been made of the rise in US inventories over the last two or three months, with the argument being that once this had been stripped out of the GDP figures, final demand remained weak. This argument never really made once sense. Why would companies want to increase inventories if they knew demand was weak? And surely they knew enough about the state of final demand not to allow an involuntary build-up in inventories.

That said, the strong build-up in inventories over the last six months remains something of a puzzle. It has corresponded with a deterioration in the US (and UK) trade deficits. Logic dictates that if final demand in the US is weak, then the trade deficit should be improving as US companies seek new markets overseas to compensate for domestic weakness. Hopefully, the answer to this conundrum will become clear over the next few weeks.

Double-dip?

Equity markets are stronger again today, which prompts to pose the question ‘ ‘double-dip recession, what recession’? It is quite possible that equities have lost touch with reality but more likely equities are responding to the promise of more liquidity. This will explain why the gold price is so strong.

The other argument is that the recovery from the 2008 recession is still very much in place, despite the recent softening (unless there is a full-scale crisis PIIGS inspired crisis in the euro-zone. The OECD lead indicator and the JP Morgan Global PMI both suggest that the world economy is still slowing, resulting in cries for the Federal Reserve ‘to do something’! But some of the more immediate indicators are suggesting that the slowdown is past it worst as companies have readjusted their inventories downwards to match slightly slower than expected sales. Growth momentum in the developing world still seems to be intact despite tightening in China and India. Growth in the 4th quarter of 2010 should exceed our somewhat dismal expectations.

Ireland

Ireland is under the spotlight again with her 10 year bond premium to German bunds reaching 355 basis points (at the beginning of 2010, the premium was ‘only’ 145bps. The reason is that her banks need further capital to offset their huge losses in the housing sector. There is nothing very surprising about this; what is surprising is that we are not seeing similar moves in other EU countries where losses must be almost as bad. Or perhaps it is just the Irish being a little more honest about their problems.

Economists that know say there is a shortage of safe assets, hence the rush into Treasuries, Bunds, Gilts etc. This is not just a case of bonds versus equities as there are plenty of bond markets which are not safe, e.g. Greece, Ireland and Portugal. The premium of these markets to G3 bonds continues to widen. I think there is another banking crisis underlying the edginess of today’s markets.

The yen

Recent weakness in equity markets has been due to some poor domestic data from the US. Quite why this should be such bad news is something of a puzzle as we are not looking to domestic demand for growth in the US. Eventually, strong growth in Asia and other emerging economies should be reflected in the US external sector sooner or perhaps later. But no matter, investors want 'safe assets' such as bonds. They are also buying the yen, the logic of which escapes me. It is possible that what we are seeing is the unwinding of ‘carry trades’, which creates an artificial and temporary demand for yen.

In response, the Bank of Japan did take some small steps to increase monetary stimulus – by extending the time horizon of their monetary operations, allowing commercial banks to borrow funds for a duration of six months at very low interest rates. Such is the nervousness of financial markets that it had minimal impact and the yen has continued to appreciate.

With a bit of luck, or false optimism, the continuing strength of the yen might force the BoJ to do something a bit more drastic, which would help not just the Japanese but the rest of us. More likely, the defeatist attitude that there is nothing they can do will prevail.

GDP growth April to June

It is worth trawling the details of some of the 2/Q GDP reports to get some idea what might be behind the economic slow-down that started in April. In the case of the US, strong growth in investment and exports has been met from imports. The UK saw good growth in the second quarter boosted by stock building rather than final demand. Japan, as always, has to rely on growth in net exports with very little in the way of domestic demand whereas Germany has the benefit of very strong investment demand as well as net exports. In summary, aggregating the four economies, it does not seem that it is domestic demand that is the problem. This grew by an annualised 2.6% in the first half of 2010. For some unexplained reason, this was reduced to 1.7% by a drag from net trade but on top of that, there was a build up in inventories which resulted in overall GDP growth of 3.0% in the first half of 2010. It may be that the surge in imports has led to some involuntary stock building, the run down of which might explain the recent weakness in production.

Watch this space for additional comments as more countries release data.

UK housing

The evidence is that the recovery in the UK housing sector is now petering out. Given the inability of the banks to lend and the persistent overvaluation of the UK housing stock, it is hard to be bullish. Whilst bad news for the perennial geared up bulls, whose ‘house is their pension’, it is largely irrelevant for the long term health of the economy. What the economy needs is not another bout of house price inflation but rather a long-term structural improvement in the external sector.

The yen versus the dollar

At just under Y86 to the $, the yen remains close to its recent high of Y84.7, the highest it has been in 15 years. Surprisingly some economists are forecasting a further rise despite attempts by Japanese officials to talk the currency down last week. This morning’s 2Q GDP figures showed minimal real growth and another fall in nominal GDP. The last thing the Japanese economy needs is a further rise in the currency. Sadly, what is driving these forecasts is analysts’ bearishness on the U$ and resulting predictions for a fall in the dollar. What they fail to see is that Japan needs a fall in the yen far more than the US needs a fall in the $.

Gloom and doom is the order of the day for the US economy. Whether that is justified is another matter. The ECRI weekly leading index, which correctly forecast the current slowdown in the economy, reached its low point in early July and has now turned up again. This is not to say that the US economy is out of the woods, but it does suggest that the bearishness on the dollar is overdone.

Deflation risks in the US

The bearishness over the outlook for the US economy is increasing with concerns over deflation with falling wages and prices. The dollar is very weak hitting new recent lows against the yen and sterling. I remain of the view that this is overdone. A weaker dollar will boost exports if nothing else.

Falling prices is not quite the end of the world. The real killer is a fall in nominal GDP. This is the situation in Japan where there has been no growth in nominal GDP in the last twenty years. Debt repayment is impossible in this environment. The good news for the United States is that nominal GDP has grown by over 4% in the last four quarters and is now higher than its previous peak in September 2008. The bad news is that this is only the first step in the right direction. Japan’s nominal GDP did grow by just over 1% pa from 1990 to 1997, whereupon it then fell back again to 1992’s level in 2001. It grew again until 2007 and then fell back yet again to 1992’s level in 2009.

Was this inevitable? I think Japan fell into the trap of trying to grow the economy out of its debt trap but at the same time manage the exchange rate. Japan was always under pressure by the Americans to keep the yen high so as to not achieve an unfair trade advantage. Unfortunately for Japan it needed to inflate its way out of trouble, not so much to achieve ‘real’ growth but rather to achieve ‘nominal’ growth. This implies a much weaker yen, something that was ruled out by politics. Deflation has been the consequence.

The lesson for the United States is to let the dollar weaken, particularly against emerging market currencies. Now whether this will happen is debateable and for another post but economic logic says it has to happen.

US 2nd quarter growth

On Friday, the US reported 2nd quarter growth of 2.4% at an annualised rate, a little less than the expected 2.7%. This perceived ‘disappointing’ figure is in addition to other evidence of a slowing economy. Whether or not the report was quite as bad as some make it out to be, there are a couple of very valid negative points. The first is that the recovery is not as vigorous as previous recoveries, and the second is that the US still faces a huge output gap. This will intensify deflationary pressures increasing the similarities with Japan of the 1990s.

Looking at the detail, the figures are rather more encouraging. It is clear that consumption expenditure remains weak, growing at a rate of 1.6%. This is inevitable; one cannot expect the US consumer to be an engine of growth. Investment expenditure is recovering at a rate of 4%, led by equipment growing at 9%. That is the truly positive news. Much is made of the increase in the trade deficit. One needs to treat this with care. Exports are still growing rapidly; it is that imports have been growing even more rapidly. This is because industry has been restocking. The first phase of the recovery in 2009 saw inventories contributing to growth through the slightly bizarre fact of a slowdown in the rate of reduction in inventories. The first half of 2010 has seen actual inventory rebuilding met by an increase in imports. As long as the rest of the world continues to recover, it is likely that export growth will overtake import growth again such that the external sector will again be a net contributor to growth.

I believe it is a mistake to focus too much on the bad news in this GDP report. Whilst economic growth has slipped in the second quarter in the US and China has been aggressive in tightening policy, there is still enough growth momentum elsewhere to keep global growth intact.

Double dip?

Fears of a double dip have risen with many now expecting the global economy to slip back into recession by the end of the year. The clearest indicator of this possibility is the ECRI index for the US, which has fallen sharply in the last few weeks. In Europe, the German ZEW index has also dropped significantly since late last year. Other leading indicators are less clear cut. The JP Morgan all-industry PMI index, which summaries all the monthly national indices, peaked in April and fell slightly in May and June. The OECD lead indicator is still rising but its rate of change has decelerated sharply. It could also be argued that global stockmarkets which fell by 7.6% in the first half of 2010 are suggesting a deteriorating outlook.
It is perhaps not surprising that the decline in equity markets coincided with the onset of worries over Greece defaulting and the possible break-up of the euro-zone. The response of governments within the euro-zone has been to impose fiscal deflation on many of its member states. Germany has refused to reflate to compensate. Given the fragility of the global recovery, this is lunacy. The timing of the UK government’s desire to get its fiscal books in order, while generally desirable, leaves a lot to be desired. This moment in time is not the best for fiscal cut-backs. The other factor that is not helping is China’s need to tightening policy. China is running the risk of a property ‘bust’ and needs to bring bank lending under control. In the short run, this is negative but from a long term perspective, it is should ensure that China’ dramatic growth story should continue.
Generally, leading indices normally slow about 12 months into a recovery. This is often due to fluctuations in the inventory cycle, and the recovery reasserts itself a few months later. This may well happen this time but the concern is that the fiscal stimulus put in place by many governments in late 2008 is now coming to an end with nothing to replace it. If this is correct, it is beholden on governments to come up with a new fiscal stimulus and to bin any thought of cut-backs. St Augustine remains relevant – please make us virtuous but not yet.

Hedge funds

Hedge-fund managers, those ‘masters of the universe’, are struggling. They have not made any money so far in 2010 after the worst second-quarter performance in a decade. With all the macro-economic volatility and issues within the euro-zone, one would have thought hedge funds would be in their element. Instead, they have scaled back trading after bad losses amid sometimes vicious crosscurrents in stock, commodities and other markets. . For example, one of the Paulson funds lost 12% in June alone. Man Group has seen an outflow of c$1bn from their hedge funds. Outflows from the sector will continue as trustees cannot justify paying 2% management fees for zero returns and 50% correlation with equity markets.

The outlook for the 3rd quarter

I was optimistic about the durability and strength of the global economic recovery at the beginning of the year and I retained that optimism at the beginning of the 2nd quarter. Now I am much less optimistic for which I blame Europe. Too many European banks are effectively bust and the authorities are lothe to do anything about it. The upcoming publication of the stress tests for the banks should make interesting reading. Greece should not be part of the eurozone, as it refuses to abide by the rules. Germany macro policy and her political will is deflationary. Europeans are determined to shoot themselves in the feet. As for the rest of the world, the extent of tightening in China is an issue and bad news for commodity producers. But I think the Chinese authorities are handling the situation well (in contrast to the Europeans). Generally, there are concerns about the durability of the economic recovery, as companies sit on cash and employment markets remain in a dreadful state throughout the developed world. But the recovery is not being driven by the developed world but by the developing world, and the emphasis of that growth is shifting from exports to consumption.
Equity markets have weakened by about 15% in the second quarter, after rising by 70% from the nadir of the bear market in March 2009. The current sell-off is providing buying opportunities for the themes that have dominated the recovery – namely, emerging market growth and exporting to these markets. Infrastructure and health are other themes. I would be wary of sectors dependent on growth in the developed market, e.g. consumption or anything to do with employment or government spending.

China's renmimbi revaluation

On the 21st June, the Chinese announced that they would loosen the RMB tie with the dollar. This first happened in July 05, when the fixed peg of 8.28 against the dollar was abandoned. By the end of 2008, the RMB had appreciated to 6.83, when the turmoil of the financial crisis persuaded the authorities to hold the RMB at that level for the time being in the interests of stability. The recovery in the global economy in 2009 and the implementation of a domestic stimulus package resulted in an economic boom in China with GDP reaching 11% in the year to March 2010. Despite this, the Chinese still managed to run a large, albeit declining, trade surplus with the rest of the world. With the US still running a large trade deficit, the Americans put China under pressure to allow further RMB appreciation. The whole issue became political and the essential point got lost in diplomatic dialogue between the two countries. This is that it is in China’s domestic interests to allow the RMB to appreciate. China is the mirror image of the problems of the Euro-zone. The peg with the dollar implies that China and the US are running similar monetary policies, but the domestic demands of each economy are very different (as is the case with Greece and Germany). China is booming and the US is struggling, meaning that they need very different monetary and exchange rate policies. It is the need for an independent monetary policy that is domestically determined that should drive China’s exchange rate policy and is very much in her long term interests. The fact that she has relented is good news from everyone’s point of view. It is a pity that the Europeans cannot resolve their own economic contradictions so easily.

The euro saga continued

Written 9th June. The euro crisis has abated a bit, if only for the time being. It is interesting that the epicentre of the global financial crisis has moved decisively from the US to Europe. Frankly, Europe has very little going for it. The crisis is ongoing as the authorities desperately paper over the cracks throwing good money after bad. The Greeks can always call the EC’s bluff on fiscal consolidation as the alternative for the EC is too awful to contemplate. Markets react by trashing the currency and who benefits – the Germans. The only things worth buying in Europe are German, or North European, exporters. And as for European banks; they cannot access capital markets, which in turn makes them even more reliant on holding government securities.

In contrast in the US, the Fed chairman said yesterday that the US economy is still improving, and the Beige book out today confirmed this.