Emerging Market Strategy March 2013 Published

by Michael J. Howell7. March 2013 14:31

Latest Report 'The Waiting Game' has been published. Main point is sign of rebounding EM liquidity vs. threat from stronger US dollar. Contact us for more information

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Finance and Economics, Or Economics and Finance?

by Michael J. Howell7. March 2013 14:12

It is widely-accepted that financial markets respond to economic phenomenon. However, we see it the other way. Finance is far more important to economics, than economics is to finance. Think of it in terms of flow of funds accounting. Economics focuses on ‘uses of funds’; finance focuses on ‘sources of funds’. Sources naturally lead uses. Thus our research is always more interested in whether the pool of liquidity is actually rising or falling, rather than the prediction of whether or not more will be spent on consumption. Two corollaries of this work are that Central Banks do NOT set interest rates, the market does (2007/08 confirmed this), and that interest rates are not the ‘price of money’. Rather interest rates are the ‘cost of capital’ and they are high or low ultimately depending on the profitability of industry. The ‘price of money’ is the exchange rate. Thus, low US interest rates and a weak US dollar tell us that US profitability is weak and the Fed is loose. In contrast, low Japanese interest rates and a strong Yen tell us that Japanese profitability is weak and the BoJ is tight. This also explains why real interest rates are higher in Emerging Markets.


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Do Central Banks (Really) Create Inflation?

by Michael J. Howell5. March 2013 08:50
It's a provocative title worthy of the John McEnroe stabbing retort 'You cannot be serious?' Indeed, the linkage between Central Banks and inflation must the most accepted 'fact' in economics. However, for some policy-makers right now, perhaps in deflating Eurozone or deflation-weakened Japan, creating inflation would be high on their wish list. Consider the four major crises of the past century: (1) Weimar Germany; (2) 1930s America; (3) 1974/5 Britain, and (4) 1990s Japan. All four suffered banking crises and faced huge debt problems, and all four saw similar policy responses with Central Banks significantly expanding their balance sheets, or much like today's QE. But two cases were inflationary and two were deflationary. Jury out? The defining feature is not the scale of the money printing, but who holds the debt? In the deflationary cases - America and Japan - the private sector was largely the debtor, but in the two inflationary cases - Germany and Britain - the largest debtor was unquestionably the government. Here is the lesson. When the private sector is in debt they will attempt to pay off their debts with any surplus cash printed by the Central Bank. In economic parlance the marginal utility of means of settlement money is high. But when the private sector carries low debts, they have less need for new cash and will tend to spend it, thereby creating inflation. The moral here is two-fold. First, Central Banks are not a sufficient condition for inflation, because they need the government to act as the 'helicopter'. Second, we much watch out for inflation to pick up once private sector debts have been run down and if the Central Banks continue to monetize. That is our risk.

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Britain's Naughty Banks

by Michael J. Howell27. February 2013 18:53
The threat of negative interest rates aka a rap over knuckles of Britain's commercial banks was mooted last night by the Bank of England as a way to stimulate lending. Negative rates are not new to Switzerland where they have been used to dissuade investment in the Swiss Franc, but they seem a strange tool for boosting lending! Sadly it again shows that the Bank has lost its touch. Why penalise the banks? The reason they are not lending is that they can't, and not that they won't. Lending has little these days to do with reserves and everything to do with interest margins and an ability to garner long-term funding. Structurally, the loss of a branch banking culture and the widespread use of 'computer says 'no'' technology means that Britain's banks cannot easily lend to those SMEs that need capital. But even allowing for this, long-term funding remains problematic and a sufficient doubt to constrain new loans. What we have learned in the last decade ( or should have) is that the size of the Central Bank balance sheet controls the size of market risk premia. A bigger balance sheet ( more QE) means smaller risk premia and wider net interest margins, and hence more lending. The US Fed has successfully learnt this lesson. Making a scapegoat of the high street banks yet again will do nothing to boost British lending, and by making funding harder, the BofE proposal could weaken lending still further.

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Liquidity Databook Published

by Michael J. Howell27. February 2013 18:53
February Liquidity Databook published today. Key points to look at are (1) reversal of ECB liquidity (2) acceleration of US Fed balance sheet, and (3) strong end-2012 growth in Total US credit.


Does Size Really Matter?

by Michael J. Howell27. February 2013 10:46
According to latest market-talk the BoJ is the 'loosest' Central Bank worldwide simply because its balance sheet now stands at nearly 35% of GDP. Second is the ECB at 28%, while the BoE and the US Fed trail at 25% and 20%, respectively. Of course, this is absolute rubbish! Consider a counterfactual. A poor, cash-based economy, with no developed financial sector may well have a Central Bank balance sheet that is near 100% of GDP. Does this make it very loose? What matters here is the change in the size of the balance sheet. The last decade has (or should have) demonstrated that changes in the size of Central Bank balance sheets move risk premia on risk assets in the opposite direction. Thus QE policies reduce market risk and promote recovery. The size of Central Bank balance sheets relative to GDP is greater (1) the more that cash is used for trade; (2) the greater required reserves, and (3) the smaller the shadow banking sector. Hence, our point that this ratio cannot judge the stance of monetary policy. Rather it is a measure of financial development, if anything. Changes in absolute balance sheets matter way more. And, here is the main point. If the Fed had just shrunk its balance sheet by 15% would Wall Street still be at current levels, or would it be 20% maybe even 30% lower? Risk premia matter. Tell that to the ECB who have just let their balance sheet fall by 15%, and somehow (we scratch our heads) claim this is an easing. Watch out Eurozone!

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Big Week for the BoJ and...

by Michael J. Howell24. February 2013 22:58
Who becomes next BoJ Governor will likely be announced in coming days. The result may matter a lot to markets, at least as a signal. The BoJ has already expanded net liquidity provision well-above the critical Y40 trillion threshold. More importantly they have unusually done so when the Yen is weak. More, probably much more liquidity is coming. The Yen will drop further. Probably through Y100/US$: possibly to Y110/US$. A weaker Yen is part of our stronger US dollar story for 2013: it may also play a part in pushing the Eurozone towards another bout of financial volatility by squeezing competiveness another notch. In markets, there are no unrelated events.

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What Is Important?

by Michael J. Howell21. February 2013 11:34



We regularly monitor around 30 fund flow series for each of some 80 economies, monthly (and have done since the mid-1980s). These are available for clients to download from our website, and by using an Excel add-in. Which among these timeseries are the key pieces of liquidity data that investors need to focus on? Many have their own specific preferences, but here is our list of 13:



1.    Global Liquidity Cycle (GLI) is our 'headline' index published each month. This is a proven lead-indicator of prospects for risk assets. The series peaks during asset booms and troughs just ahead of banking crises. It leads the business and profit cycles by 12-15 months.


2.    US dollar area liquidity. This includes the liquidity cycles of those countries that use or shadow the US currency. It consistently and pro-cyclically leads the US Treasury 10-2 year yield curve by 3-6 months. More liquidity therefore raises the risk premium on government bonds and reduces the risk premia on other assets.


3.    Monetized US savings flows. This series defined as the difference between US private sector and Fed liquidity is an important lead indicator for the value of the US dollar. Greater Fed liquidity and fewer savings unambiguously weaken the US dollar around 6-12 months ahead.


4.    Emerging Market Liquidity Cycle. Like its developed economy counterpart this data series leads the reported earnings cycle of EM companies by around 18-24 months.


5.    Crossborder flows to EM. This important data series tracks the confidence of global capital and highlights the scale of inflows into EM securities. This is so often a lead indicator of EM outperformance.


6.    Central Bank policy indicators. In short, measures of 'effective' QE policies by the key Central Banks. We regularly compare the US Fed, the BoJ, the ECB, the SNB, the PBoC and the BoE.


7.    Investor exposure data showing the split between holdings of stocks and bonds. This balance sheet data which derive from the same sources as our flow data show actual holdings at each month-end. They are not investor sentiment surveys, but they serve as a robust measure of risk aversion.


8.    Investor exposure to EM against 'normal' benchmarks.


9.    Investor exposure to US dollar assets. This data is based on reported end-month balance sheet holdings of all US dollar financial assets. Shown as a normalised series as a proportion of all Worldwide financial wealth.


10.Ranking of liquidity conditions market-by-market each month.


11.Ranking of investors' exposure market-by-market each month.


12.Financial conditions (FCI) measures of short-term credit spreads across all 80 markets we monitor. This serves as a cross-check on our volume-based GLI.


13.World financial wealth (WFW) a US dollar aggregate of the value of all liquid asset holdings; listed stocks and listed government and corporate bonds across our databases.



Currency Wars Or Just Approaching Dollar Strength?

by Michael J. Howell20. February 2013 22:07
The most important decision we take is which currency to hold our wealth in. All else are just footnotes. In the long-term currency values are determined by productivity trends, but in the medium-term Central Banks and savings flows matter alot. The recent jump in forex volatility is understandable. A similar theme coloured the mid-to-late 1930s. As we have previous remarked, the French Franc was then very very strong until it was very very weak. The collapse in the Franc destroyed much of the wealth of France's then middle class. Eighty years on we are seeing another bout of competitive devaluations? Sterling is just the latest example. But why do so many seek to cheapen their exchange rates? We figure the reasons lie with the dollar. Not only has America become much more competitive over the past five years and able to compete with any EMs, but her liquidity and savings flows are strongly supportive of a rising US dollar. Two things are important here. First, unlike the QE1 and QE2 periods, QE3 will not see dollar weakness. Second, a strong dollar is the biggest threat that risk assets face in 2013. Surprisingly this threat gets little air time. Add up America's surging savings flows; the jump in wholesale funding by banks in the last 6 weeks; the shale oil boom and the narrowing current account deficit, and you may agree that the rest of us might soon be starved of dollars. If the latest FOMC minutes are taken at face value, a stronger economy ( its coming) will persuade policy-makers to slowdown QE3. At that point stand back and watch the dollar soar. Even gold, once everyone's friend, is now being shunned. The bottom line is that our Liquidity data has been warning for some months of coming dollar strength. It may just have arrived?

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GLI Update

by Michael J. Howell13. February 2013 17:29

January 2013 Global Liquidity Index (GLI) estimate at 57.8 ('normal' range 0-100) from 64.5 at end-2012. Global trend likely upwards, but ECB liquidity collapses. Full database released to clients. The GLI leads the business cycle by 12-15 months; equity markets by 9 months and bond and forex markets by 3-6 months.


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