The Real Tapering Threat Is Not The Fed, but China

by Michael J. Howell25. January 2014 11:50
Emerging Market weakness is supposedly all down to Washington and the threatened tapering of QE policies by the US Fed. Simple but wrong. The evidence from our regular studies of World capital flows tells a very different story. Of course, no one should suggest that Fed tapering when it comes will be positive for EM, but the underperformance is caused by something bigger. 15 years ago EM economies were tied into the US consumer cycle and US policy mattered a lot. Lately EM have moved to supply the Chinese capital goods cycle. In short, Chinese monetary policy now matters and the tapering by China's PBoC (Central Bank) over the past 18 months has had a devastating effect on EM. Chinese policy makers are still struggling to contain the excesses of a boom launched five years ago at the time of the 2007/08 World financial crisis: they may have to wrestle well into 2015 before the tide turns. The result is weak Chinese capex; a fast-slowing economy and continuing fall-out across EM. If the culprit was genuinely American monetary policy surely the smaller Frontier Markets, which are more dependent on dollar capital flows, would now be in the eye of the storm? Yet they like Wall Street have been booming. The EM puzzle is explained by Chinese tapering not Fed, and it may last another year!

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Capital Flows to EM 2013

by Michael J. Howell23. January 2014 13:44
2013 saw another net outflow of money from EM Financal assets. We reckon around US$31 billion left EM stocks, bonds and credit markets last year. This compares to a net outflow of US$166 billion in 2012 and a net outflow of US$21 billion in 2011. For the record 2009 and 2010 were big positive years for EM seeing nearly US$600 billion flow in. We may be near the bottom in some EM markets. However, our overall EM risk appetite index at minus 6 stands well-above its minus 40 index lows, but admittedly still below the normal plus 40'ish peaks. In short, we should still wait a little before venturing back.

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Time To Buy Commodities?

by Michael J. Howell23. January 2014 13:38
Latest GLI liquidity data highlights The recent drop in private sector liquidity across a number of economies suggests that money is starting to be diverted into a strengthening World economy. Ignoring the on-going problems in EM, which is stumbling rather than contracting, the faster pace of DM growth should begin to lift commodity markets. Given the huge underperformance of commodity equities in recent years, there may be an opportunity here. Certainly, this being an entirely 'normal' cycle in our view suggests that commodities are due a run. Provided that the dollar/ gold axis remains stable this year, commodity equities might be worth buying.


Risk Appetite Data Still Rising

by Michael J. Howell14. January 2014 21:12
Risk Appetite can be measured by deviations of actual portfolio composition away from average levels, country-by-country. We do this now for more than 50 markets Worldwide by subtracting Government bond exposure from equity exposure, normalising the result and expressing it in index form. The index tends to range between +/- 50: risk asset markets tend to peak out around an index of 40 and readings of 30 and above suggest some prudence needs to be taken. Latest end-2013 puts developed markets at 17.1 and emerging markets at minus 3. Japan has fallen back to 10.3, but the UK exceeds 22 and the US at 30.8 is straying onto more volatile ground. The party is not over yet, but it may be about to get more rowdy! For full list see CBC Add-in database.


Are We All Behind the Curve? What Are Bonds Telling?

by Michael J. Howell14. January 2014 08:25
The medium-term yield component of long-term bond yields has been rapidly expanding – we measure this by ‘bootstrapping’ the implied 5-year yields, 5-years out (or 5s at 5).This implied forward yield, or ‘core’ yield, is the major influence on the more widely-quoted 10- year spot rate, the traditional bond benchmark. Think of these spot yields as comprising 'core' component, refecting economics, and a short-term premium or discount measuring the effect of monetary policy. The 'core' component provides the most efficient guide to where future spot yields will settle as roll-down effects dissipate. In the past six months, US 5s at 5 moved up by 60bp to 4.26% and they stand at a 127bp yield premium to spot 10-year Treasuries. In Germany, the 5s at 5 yield rose by 49bp over the period to 3.27%, or a 116bp yield premium to 10-year Bunds. For the UK, the equivalent 5s at 5 yield hit 4.32%, up 48bp in six months, and also sit at 116bp premium to 10-year Gilts. Only in Japan did 5s at 5 fall (by 15bp) to 1.23%, although they are at a 49bp yield premium to 10-year JGBs. The 5s at 5 component is rising both faster than 10-year spot yields and is doing so because of increasing real interest rates. In turn, this may be because the marginal return on industrial capital is itself expanding once again, which we ascribe both to DM cyclical economic recovery and to the structural slowdown in China. The bottom line is that bond yields are not only rising faster than investors think, but the structure of forward rates tells us that they have already risen a lot. As we argue in a report published today, most investors are behind the curve.

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Global Liquidity Data End-2013

by Michael J. Howell12. January 2014 14:17
According to our latest calculations, the Global Liquidity Index (GLI) ended 2013 at a value of 53.8. Normal range 0-100. This was lower than November (56.9) and below the 2013 June peak of 61.5. Admittedly, major cross-currents between the EM (Emerging Markets) and DM (Developed Markets) drag down the overall total but even examining the buoyant DM liquidity data they confirm what looks like an inflection point. EM liquidity remains weak. The equivalent DM GLI hit 67.2 at end-2013, or down from its 70.1 November reading. Looking inside this data adds further colour since Central Bank Liquidity is sub-par and drifting, whereas the recently far more dynamic Private Sector Liquidity index is high but now fading.


Economics and Liquidity

by Michael J. Howell3. January 2014 11:27
Liquidity can be thought of as money serving as means of purchase, i.e. funds that 'start' the monetary circuit. Keynes realised that in a Capitalist economy liquidity and not savings determine the volume of investment, and reinforced later by Kalecki, that investment rather than consumption is the key dynamic behind profitability and economic growth. Liquidity has real effects because it changes the structure of production by increasing duration through portfolio effects and in the process raises the demand for long-dated financial assets, such as equities. Conventional economics not only muddles this by focussing on money as means of settlement, i.e. funds that 'close' the circuit, but it also confuses the price of money --the exchange rate -- with the cost of credit -- the interest rate. Interest is a category of profits and has little or nothing to do with monetary policy. However, attempts to 'fix' interest rates and ignore or 'float' exchange rates always creates instability. Thus, ever since the 1971 end of Bretton Woods and the more recent attempts to straightjacket interest rates into a Taylor Rule, the financial system has suffered a near regular 8 1/2 year repeating cycle of boom and bust. For example, markets saw peaks around end-1973, mid-1981, early-1990, mid-1998, early-2007 and should again around mid-2015. Within around a year of each peak they fell heavily. The way to mitigate the cycle is to stabilise exchange rates, not interest rates. Because liquidity is dominated by credit, the monetary system is debt-based and leveraged. Collateral becomes vulnerable when debt-repayment is compromised and so liquidity becomes hugely pro-cyclical. What's more, since in a crisis the only true collateral is legal tender aka Central Bank money, leverage can be extreme. After having moved down through 2007 and 2008, collateral and liquidity have been together moving up since 2009, helped by Central Bank QE. They still have a bit further to run, but be warned what goes up inevitably comes down. A 2016 Crash perhaps?


It's Not About Money, Nor Interest Rates.. Liquidity Matters Most

by Michael J. Howell3. January 2014 10:42
Like Mums and apple pie, more Liquidity is better than less. But surely interest rates and money matter more? Interest rates are important, but they are set by the market and not by Central Banks, despite all the pantomime and puff. What's more they derive from liquidity, viz the yield curve which as we show moves 3-6 months behind the liquidity cycle. Sure Central Banks can fix policy rates, like discount rate, but these seem to have little effect on market rates as 2008 proved. A more important price is the 'terms of a loan', but these reflect funding availability (ie liquidity) and typically move oppositely to policy interest rates, anyway. So what about money? For the non-economist, money is probably what we think of anyway as liquidity, ie. sources of funds, such as household savings, retained earnings and credit. For the economist, money supply is defined by bank deposits, or what has become a diminishing part of banks' funding sources, notwithstanding the fact that banks' themselves are also a smaller part of the lending universe. For example, our measures of US liquidity total some US$25 trillion, compared to roughly US$8 trillion for M2 money supply.' However, the damming evidence against money is 2013. US M2 money supply slowed to around a 5% annual growth rate. Admittedly, US credit growth was also tepid, but our measures of total sources of private sector funds leapt higher because US household rebuilt savings and US corporations enjoyed a big jump in their cash flows, viz the pick-up in M&A and persistent share buybacks. Adding these to the small rise in credit still allowed our index of US private sector liquidity to hit multi-year highs in 2013. Therefore, if we are correct this extra cash should underpin a stronger American economy in 2014. Flow of funds and liquidity should matter most.

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What Liquidity Events to Watch For In 2014

by Michael J. Howell3. January 2014 10:13
US monetary 'tapering' was the most talked about story in 2013, but in the event it proved the least important. The same may be true in 2014. The two big events last year were: (1) the success of QE ('quantitative easing') in driving Private Sector liquidity higher in the US, UK, Australia, Canada and Japan, and (2) the fallout across EM from Chinese PBoC 'tapering'. These made for a very 'normal' cycle in the DM and for an unusual one for EM, which despite the pick-up in the Global Economy suffered another sell-off. DM are being driven by their private sectors and not by policy-makers; ironically, it is EM that need policy support. There are four things to look out for in 2014: # positive effect of US shale oil on US flow of funds and US dollar # signs that 'normal' DM cycle continues with a capex revival and negative turning point in credit markets # evidence that Abenomics is continuing to work in Japan # persistence of 'tight' monetary policies in China We accept that the two most out-of-favour asset classes are gold and EM equities, but it still may be too early to jump back in. China needs to adjust away from its heavy bias towards capex and this will be a multi-year transition and runs similar risks to that experienced by the Soviet Economy in the 1980s when it too tried to change. China is capital abundant but energy short: not a good mix. Gold's fate is tied up with the US dollar and with the shale oil boom adding so much to US liquidity and the Fed more like to trim QE than not, the greenback could be in short-supply. This is the greatest risk in 2014. Already the rise in its 'sister' Sterling suggests a firmer dollar ahead. A stronger US dollar is not great news for EM, but it is better news for Europe and Japan. Japan will be a barometer in 2014 partly because Abenomics needs to work and partly because Japan is benefitting from a weak China. If Japan fails to get traction, it could warn that the World return on capital is again coming under pressure. This may compromise any capex recovery in DM; push down real interest rates and bash down risk appetite. All told, with the Global Liquidity cycle at or near a peak 2014 is likely to be a positive year, but it will definitely also be more volatile.

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Safe Assets, Low Risks

by Michael J. Howell31. December 2013 12:42
At CrossBorder Capital we measure risk appetite by the 'normalised' actual portfolio exposure of investors to equities less bonds. Based on an index that can range +/- 100, the current reading is around +20 for Developed stock markets. Significant corrections tend to occur at +60, or noticeably different from current readings. These readings reflect the balance between risky and 'safe' assets. In other words risk appetite is currently above average, but not by too much. What are safe assets? Simply, cash and government bonds or looked at another way the sum of Central Bank QE policies and the swollen Government deficits. Any chance of these reversing? Not much. Therefore, the safe asset mix is only just below average and the supply of safe assets looks set to continue expanding. Not too bad for risk asset prices? See Report 'Risk Appetite Indexes'

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