According to companies’ survey in Germany and in France the economic activity was marginally down in August. German’s companies were a little more pessimistic for the 6 month period to come.
Even if levels are different we perceive in the following graph that there is a kind of stability in economic activity during the last twelve months. This synchronization of the business cycle suggest that France and Germany cannot really expect a stronger growth momentum in the short run. In other words, it seems that German and French economic activity are not able to accelerate from their current level. It’s not worrisome for Germany as its unemployment rate is low but it is problematic for France as its unemployment rate is just below 10%. As there is no impulse from outside as world trade trend is flat, it means that the impulse must come from inside. The ECB has done the job so we must expect a more proactive fiscal policy in order to jump on a higher trajectory.
For Germany, the main source of weakness is a slowdown in expectations. The index is back to 100.1 which is marginally below its historical average (100.3). The current condition index (112.8) is weaker but at a level way above its historical average (103.2).
In France, the Personal Outlook index on Production is shifting downward in the industrial sector. There is, both Germany and France, the perception by companies that the economic activity will not have the necessary impulses that could provoke an acceleration in the economic momentum. This can be linked with Brexit and its consequences or by the fact that the global situation is at risks and not only on economic side. We see political risks almost everywhere (elections in the US, in France, referendum in Italy, Brexit,…) and this could be a drag for economic growth.
The detail of each survey shows that internal demand has been weaker in August. This can be seen on the German graph below. There is a deep drop in retailing and in wholesaling in August.
In France the main source of concern is the weaker momentum in the industry. All indices are close to their historical level (except construction) and there is no source of rapid improvement. The industrial sector was perceived as stronger 3 to 6 months ago but this is no longer the case and its recent momentum is problematic. This means that we can have a rebound in the third quarter for GDP (after 0 in Q2) but the government target growth of 1.5% for 2016 will not be reached.
It’s no surprise when markets take a break in August. Too many people are on the beach during the “dog days” of summer for important decisions to be made. Even so, August 2016 will go down as an exceptionally sleepy month.
Markets Barely Moved in August
Leading up to the meeting of central bankers in Jackson Hole last week, the S&P 500 Index went through 34 trading sessions without a 1% one-day move, up or down. It only broke 0.5% six times. That made it the least volatile 30 days in more than 20 years. Similarly, Bloomberg reports that the August trading range for the 10-year U.S. Treasury was the tightest for any month in a decade.
Moreover, investors appear to believe that these conditions will persist for some time. Not only has the VIX Index of one-month implied volatility in the S&P 500 been sinking since its spike after the Brexit vote, but according to Bank of America Merrill Lynch, there is now a record level of shorts in the VIX futures markets—bets that the index will fall even further.
Remarkably, this has happened before a Jackson Hole symposium in a year when central banks have been the only game in town. Janet Yellen’s speech there was one of only three she has made this year (the other two were in Philadelphia in June and New York in March). In 2015 she made 11 appearances and on average Fed chairs have given almost 20 addresses per year—so this ought to have been a hotly-anticipated event, especially as a number of Fed Presidents made notably hawkish noises leading up to it.
Is This Fatigue, or Complacency?
After the excitement of the global growth scare in January, the central-bank innovations of the spring, and the Brexit vote in June, perhaps markets needed some particularly “doggy” dog days to recover.
The more worrying conclusion is that they have grown complacent. One can understand why. Brexit turned out not to be the end of the world; U.S. jobs data is back on track; Europe’s economic data continues to improve; bond yields have fallen and corporate earnings have disappointed, but stocks keep climbing; rate hikes keep getting postponed; and opinion polls started to favor the more predictable U.S. Presidential candidate.
Low Volatility Can Heighten Market Vulnerability
But complacency is unwise—and not just because all of this could flip around by mid-September. In financial markets, complacency itself can store up danger, increasing vulnerability to unexpected changes in conditions.
A driver on a perfectly straight highway can be tempted to take his eyes off the road and put his foot on the gas, and investors often behave in a similar way. As “risk” appears to diminish, they add leverage or take bigger bets to use up their risk budgets. They become less inclined to hedge against downside losses, even as the premiums to do so get cheaper—hence the low level of the VIX. That makes for a harder crash when a tire blows out.
Market volatility reverts to its mean, but even taking this into account, periods of unusually low volatility have often preceded bouts of unusually high volatility. Volatility was low just before the dollar came off the gold standard in August 1971, for example; it was low at the beginning of 2007 just before the financial crisis began to unfold; and it was low early in 2011 before the Eurozone crisis erupted. Low volatility didn’t predict events like these, of course, but it created the vulnerability that explains some of the unusually high volatility when those events occurred.
When the Dog Days Are Over, Be Prepared
Given that a lot could happen this fall to reveal how complacent and vulnerable markets have become—from an inflation or rates shock to another twist in the U.S. elections or a geopolitical tire blow-out—investors should make sure their seatbelts are fastened.
The old proverb advises us to let sleeping dogs lie: prodding them awake can result in a nasty bite. Markets have slumbered deeply during the dog days of August. Investors should be prepared for when they rouse again.
CC-BY-SA-2.0, FlickrPhoto: Jorge Elías
. Late Summer / Late Cycle
Here in Boston, cooler nights and unwelcome back-to-school advertisements tell us summer is beginning to draw to a close and autumn is approaching. Like seasons, business cycles often signal their coming demise.
One thing that recurs with greater regularity during the last phases of business cycles is a scramble by companies to purchase competitors. Corporate acquisitions have been rising and are now near peaks seen in other cycles. Late in the cycle, companies often see flagging internal rates of growth and seek to boost growth through mergers and acquisitions. Historically, companies often overpay for such acquisitions late in the cycle. We’re seeing that now with widespread takeovers and significantly higher premia in prices paid.
Another signal of changing cycle dynamics is the profit share of the economy. The share of gross domestic product going to the owners of capital in the form of net profits often dips in the final 12 months of a cycle. The United States is now experiencing the third quarter of such profit deterioration as the owners’ share of the expansion starts flowing to other parts of the economy, rather than to profit gathering.
Late in the cycle, companies often seek to add debt to their balance sheets in order to boost profit growth. Frequently, this results in a broad scale deterioration of credit quality, which is subsequently made worse by the onset of recession. US consumers also tend to add debt to their collective balance sheets in the late phases of a cycle. And indeed we see that the borrowing of both corporations and consumers, which has been comparatively subdued in this cycle, is now starting to rise.
Signs not totally aligned
Not all the usual signs of recession are present now in the US. Some typical late-cycle signs have yet to appear, and this should cheer investors. Typically the shape of the yield curve becomes distorted in the late months of a cycle as short-term rates rise above long-term rates, reflecting market expectations of subdued growth ahead. We’ve seen a flattening of the yield curve in this eighth year of the cycle, but not an inversion of yields, as short rates remain slightly lower than long rates.
Another late cycle characteristic is widespread fear of inflation taking hold and accelerating. The US Federal Reserve often acts to forestall inflation pressures by raising short-term rates, which can slow the economy’s momentum. So far, signs of gathering inflation pressures are scant, but worth watching. As our regular readers know, there are currently no signs that the Fed is about to act aggressively to prevent an inflation spiral.
As long-term investors, we know that fundamentals matter most. In this cycle we’ve seen profit margins hit near-record levels. Likewise, operating income compared to revenues and free cash flow compared to market capitalization have been consistently high for over six years. The return on equity of companies in the major US indices has been outstanding.
Fundamental shift
But in the past three quarters, margins and profits of US companies have been pressured, and not just by weak energy prices. Cost pressures in other sectors have appeared as rising general and administrative expenses and weak sales growth combine to trim profits. That environment makes it harder to grow profits than was the case in the first six years of the business cycle. Worryingly, this shift comes at a time when the S&P 500 price/earnings ratio has reached over 18 times expected 12 month forward earnings, a valuation measure which lies on the high side of history.
Despite the arrival of back-to-school ads in early August, and the return of neighborhood youth to US college campuses later in the month, we can choose to shrug off the passing of summer and instead relish the last warm sunny days. But the evening breezes now bring a chill to the air that we didn’t feel in June or July — a chill that should not be ignored. What we find most concerning is that late in the cycle, market behavior often seems to be propelled more by hope than fundamentals. Maybe that is happening today, as market averages for both large and small caps rise while revenues, margins and profits continue to diminish. It may be comforting to look the other way and pretend the days will remain warm and bright. But investors keen to hold on to their wealth should not let the hope of catching the final gains of the cycle keep them hanging on too long.
CC-BY-SA-2.0, FlickrPhoto: Bo Jayatilaka. India: Strength in Numbers
Asia is home to about 60% of humanity. With 1.3 billion people, China has demonstrated over the last three decades how an economic miracle can be created by productively employing such masses. It moved millions of people from a rural low productivity, agrarian economy to a more productive industrial and urban economy, thereby radically lifting its economic standards. In 1990, more than 60% of the Chinese population was below the poverty line but by 2015 that proportion was less than 4%. India and the ASEAN (Association of Southeast Asian Nations) economic bloc maintain a similar strength in numbers with populations of over 1.2 billion and 650 million, respectively.
India’s case is particularly unique. Estimates suggest India will add over 115 million people to the global labor force in the next 10 years, and then an additional 100 million over the following decade. By some estimates, this means that India will add more people to the global labor force than the rest of the world combined, excluding Africa. This has significant macroeconomic implications not only for the country, the region and the world, but it should also create opportunities for investors.
A paramount challenge for India is effectively employing these millions and generating strength from numbers rather than merely allowing resources to become constrained by rapid population growth. The need for sustainably high GDP growth to generate new jobs is not a debatable topic. The debates center around whether India is doing enough and whether it is on the right path. India went through liberalization in 1991. And since then, the country has seen significant benefits as GDP growth moved from low single digits (3.5% from 1950-1980) to high single digits. There remains much criticism, however, that government reforms around land, labor and taxation have not been completed. But over the last two years, there have been several government efforts that are worth highlighting.
Bankruptcy Law: More Power to Banks
A structural factor to India’s banking woes has been the lack of a bankruptcy code, which distorts the system. “If a loan goes bad in India then the promoter (owner of the business) tells the bankers that he’ll see them in court and will keep seeing them in court for the next decade,” noted Indian central bank Governor Raghuram Rajan. This is aptly summarized given that politically well-connected promoters historically have not lost ownership of the asset even when loans have gone bad. Recovery takes much longer (more than four years versus less than two years in the U.S.) and recovery rates are dismal (25% versus 80% in the U.S.).
Recently passed insolvency and bankruptcy legislation, however, could critically revamp the current system by superseding existing laws, reversing the balance-of-power in favor of banks (i.e. promoters run the risk of losing their assets), and providing transparent and shorter time-bound resolution guidelines. The new law should remove willful defaulters from the system and prevent nonperforming loans (NPLs) from significantly jamming the banking system. Improving the efficiency of capital utilization is important in supporting entrepreneurs, and thereby helping job creation.
Inclusion for “Unplugged India”
When investors see India’s major urban areas, they see a lot of people but that does not describe the real story behind Indian demographics. Many in India still live in villages, rely on agriculture as their primary means of livelihood (about 65% of the population) and feel largely unconnected with the urban ecosystem. India cannot move forward without including this significant majority, or in other words, if included, the country should be able to produce tremendous national growth.
Much progress has been made over the last two decades in connecting “unplugged India” by improving and adding to its roadways and electricity grids. “All weather” roads have moved from fewer than 50,000 kilometers to over 450,000 kilometers; households with electricity have jumped from about 44% to more than 70%. These simple projects have provided a significant productivity boost to SMEs in India’s smaller towns.
In 2014, Prime Minister Narendra Modi launched a plan for comprehensive financial inclusion for all Indian households. This plan has added more than 175 million banking accounts to the existing 400 million over just two years. In India, consumer companies have been known to do well selling products in individual-sized “sachets” versus typical product sizes for such things as toothpaste or shampoo. In this way, this “sachetization” of the banking system over time will help broader access and increase participation in the financial system, leading to more efficient savings, credit availability for business, increase in investments, and hence, job creation.
Governance: a Prerequisite to Development
India ranks very poorly in terms of ease of doing business (130 out of 189 countries). Hence, the current ecosystem seems inadequate for the creation of enough new jobs to employ the millions expected to join the labor force. The numerous reasons for this poor ranking include layers of bureaucracy and corruption. In my view, improvements in governance are a precursor to improvements in physical infrastructure.
In May 2015, the government also passed the Black Money Act, which made ownership of illegal money a criminal offense. Some say it is an overly aggressive remedy, but necessary medication. The government also implemented a biometric check-in and check-out system for their officials, notorious for being missing-in-action while still being employed. Other improvements include the relaxation of certain rules for SMEs in order to promote a “start-up culture.”
Glass Half Full
Central bank Governor Raghuram Rajan’s announcement that he will not seek an extension to his term has created some anxiety. While some angst may be justified, I believe there is evidence that progress is in motion at various levels to improve the economic landscape. It should also be noted that the average length of tenure for the Reserve Bank of India (RBI) governor position has generally been shorter than that of Western countries. Already during Rajan’s term, he adopted an inflation-targeting framework, worked in conjunction with the Ministry of Finance to help resolve nonperforming assets in PBSs and set up a new Monetary Policy Committee as part of an institutional framework. These changes will become part of his legacy. The RBI has long been hailed as an institute of high repute in India, and should remain so even after his term.
Stepping back from the nuances of individual events, overall, I am impressed at the amount of activity and clear intentions by key officials in resolving the myriad of challenges at hand. Don’t get me wrong, there is still a long way for policy makers to go but some credit is due to them. India has a high cost of capital, hence, freeing up capital from dead physical assets, improving the allocation of that capital by an improved banking system and providing a higher governance environment for entrepreneurial talent in SMEs, will go a long way in delivering the strength of demographics. I hope that policy makers continue their good work and continue to take on the challenge of tough reforms to satisfy the need to create more jobs. Entrepreneurial businesses out of this fertile landscape would be good investment candidates for us.
At Matthews Asia, our investments are not based on macroeconomic projections or policy changes. That said, we still do try to understand the implications of the actions of key policymakers for our economies and businesses in the region. For us, macroeconomic understanding is not about predicting GDP, interest rates, and/or currency changes, but more about socioeconomic developments related to the social fabric of Asian societies. I look at these broader developments through that lens while seeking quality businesses and management teams.
Column by Mathews Asia written by Rahul Gupta, Senior Research Analyst and Portfolio Manager at Matthews Asia
CC-BY-SA-2.0, FlickrPhoto: Studio Incendo. No Headwind Strong Enough To Derail Emerging Market Performance
Emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Emerging market (EM) equities and bonds continue to perform well, benefiting from the global search for yield and the tentative improvements in EM fundamentals. With regard to fundamentals, it is important to note that the better overall EM capital flow picture and the pick-up in EM growth momentum are largely linked to the benign global liquidity environment of the past quarters. But regardless of the exact explanation, the general state of the emerging world is much better now than it was in the last few years and the beginning of this year.
Emerging markets have to deal with several headwinds
Currently, there is no situation of critical capital outflows that can easily make policy makers panic, EM growth has been picking up somewhat since June and EM exchange rates have adjusted to a more realistic level. This partly explains why EM assets have not been affected by a number of issues that not so long ago could easily have caused investors to take their money elsewhere. First, there is the sharp decline in the oil price since June. Second, the market started to re-price Fed rate hike expectations following the strong US labour market report of July. And third, most recent Chinese economic data were far from convincing. In other words, emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Of course, recent moves by the Bank of England and expectations about the Bank of Japan and the European Central Bank have kept investors confident that easy monetary policy in developed markets will continue for longer. In this environment, some adverse data and news flow are considered manageable. At any case, investors are not intending to throw in the towel on the EM yield theme yet.
Lower oil price not seen as evidence of EM demand problem
What is particularly remarkable is that the sharp decline in the oil price of the last two months has not affected emerging bond and equity markets. Oil-sensitive markets such as Russia and Colombia have underperformed, but emerging markets as a whole have not suffered. This is in sharp contrast with the second half of last year, when the falling oil price created a lot of additional nervousness about the overall EM growth picture and the external and fiscal vulnerabilities of the commodity-exporting economies.
The main explanation of the different market interpretation of the lower oil price lies in the better EM growth picture. Growth momentum is clearly improving throughout the emerging world. This makes it easier to believe that, this time, oil is declining primarily because of oversupply concerns and not because of a worsening EM demand outlook.
No significant impact from repricing of Fed expectations
In our base-case scenario, the Federal Reserve will hike interest rates in December. A December hike was completely priced out a month ago. Now, the probability is almost 50% again. The re-pricing of a Fed rate hike this year has not affected emerging asset markets and we feel that a further re-pricing of a December hike should not be a big problem either. The main reasons are the better EM growth backdrop and reduced external financing requirements in most emerging economies. A crucially important condition for a limited market impact of the re-pricing of Fed tightening is that the market continues to believe that the normalization of US interest rates will remain a very slow process.
Current pace of China slowdown appears manageable
At this stage, we are more concerned about the recent deterioration of Chinese economic data. We still think that the Chinese economy is generating reasonable numbers, but doubts about the growth stabilisation have emerged again. Real estate sales growth seems to have peaked, while private investment growth continues to struggle. The capital flow picture remains a big positive change compared with last year and the beginning of this year. The authorities have been successful in stabilizing flows, which suggests that policy makers are in control again.
We are keeping our view that Chinese growth is in a multi-year slowdown. A sharp deceleration with increasing system pressures was what we feared last year. Recent data still give enough comfort that the current pace of slowdown is manageable. But at the same time, we continue to think that a deterioration in Chinese growth is the single-most important risk to all EM assets. So if we talk about the recent resilience of emerging market assets, we feel that the most remarkable has been that investors have shrugged off the disappointing Chinese data.
EM central banks will continue to ease monetary policy
As long as the global liquidity environment remains benign and inflation in the emerging world continues to decline, central banks in emerging countries will continue to loosen their monetary policy. Our monetary policy stance indicator has been in positive territory since March and has sharply risen since May. It tells us that more monetary easing has been taking place recently. For emerging debt markets this is hugely important. Not only because declining yields push the value of the bonds higher, but also because more easing of financial conditions should help the EM growth recovery to broaden out and strengthen.
Jacco de Winter is Senior Financial Editor at NN Investment Partners.
CC-BY-SA-2.0, FlickrPhoto: Ben Sutherland
. Stressed? A Low Volatility Strategy May Help
Investing means taking calculated risks, but nobody should have to lose sleep over it. If your portfolio is keeping you up nights, it may be time to consider a low-volatility strategy.
No matter what country they call home, investors who need their portfolios to generate steady income know they have to take some risk to get returns. But markets have grown more volatile and less predictable this year, and high-income assets are usually the first to sell off when sentiment sours or the market outlook changes.
Yet pulling out of high-income sectors altogether isn’t an option for most of us—particularly when income is so hard to come by. So how can investors stay the course and generate the income they need without taking undue risk?
Our research shows that high-quality, short-duration bonds have over time dampened portfolio volatility and held up better in down markets.
What’s the secret? A lot of it has to do with duration, a measure of a bond’s sensitivity to changes in its yield. In general, bonds are highly sensitive to yield changes—when yields rise, prices fall. The shorter the duration, the less damage a rise in yields will do.
For most investment-grade bonds, yield changes are driven primarily by changes to interest rates, or the yields on government bonds. High-yield bonds, though, are less sensitive to interest-rate changes than other types of bonds. But yields can rise for a number of reasons. When concern about global growth and falling commodity prices hit high-yield bond markets hard earlier this year, the shorter-duration bonds held up best.
Like any strategy, a short-duration one can lose money in down markets—but it generally loses much less than strategies with higher duration and additional risk.
Riding the asset-allocation seesaw
In up markets, on the other hand, investors who follow a short-duration strategy give up some return in exchange for a smoother ride—but not as much as they might think. To understand why, it can help to think of one’s various investment options as an asset-allocation seesaw, with cash in the middle; interest-rate sensitive assets, which do well in “risk-off” environments, on the left; and return-seeking assets, which thrive when investor risk appetite is high, on the right (Display 1).
Moving away from cash in either direction increases return. On the rate-sensitive side, moving away from the center increases duration, but investors are compensated with higher yields. There’s a catch, though: yields rise on a curve, not a straight line, so the further out one moves, the smaller the yield increase. Moving from cash to three-year government bonds can provide a hefty bump in yield. But the pickup available when moving from 10-year to 30-year bonds can be tiny.
It’s a similar story on the return-seeking side: return expectations increase as one moves away from cash, but by ever diminishing amounts. Moving from high-yield bonds to equity, for instance, increases returns only slightly, but doubles drawdown risk.
The good news is that this works when moving toward the center, too. An investor who wants to reduce risk doesn’t have to go all the way to cash. For example, she can shorten duration by moving from high yield to low-volatility high yield and only give up a little return in the process.
Don’t skimp on quality
Of course, not all high-yielding securities are alike. Credit quality varies widely, and that’s particularly important in short-duration strategies. The primary risk for short-duration high-yield bonds is credit risk.
We’re in the late stages of the credit cycle in many parts of the global high-yield market. Reaching for the high yields on low-quality, CCC-rated “junk bonds” in that environment is dangerous. In our view, the yields don’t justify the relatively high risk of default.
How investors choose to balance returns, risk and downside protection will vary depending on individual needs and comfort levels. But in our view, the ability to reduce risk and not sacrifice too much return makes this strategy a compelling one in today’s volatile markets. At the very least, we think it could help investors rest easier at night.
Gershon Distenfeld and Ivan Rudolph-Shabinsky are Senior Vice President and Credit Portfolio Managers at AB.
It may be time to add to inflation-sensitive assets.
I recently was giving a presentation on the various risks stalking global markets, speaking from a list in a PowerPoint deck. Included were the usual suspects: negative growth shocks, China, commodity prices, over-aggressive action by the Fed, the strong dollar, etc. But then someone raised their hand and asked, what about higher inflation? I realized it wasn’t even shown.
Pausing for a moment, I thought, did that omission make sense? Should we relegate inflation risk to a footnote and focus our attention on the more obvious challenges that face the global economy and markets? After all, U.S. headline inflation is running at just a 0.8% annual rate, while in Europe it’s a mere 0.2%. Inflation is something that central banks are trying to catalyze, not eradicate, and generally with limited success.
On the other hand, that doesn’t mean that higher prices won’t make a comeback. A few weeks ago, my colleague Brad Tank explored the potential value of an unpredictable Federal Reserve in addressing inflation, and noted Alan Greenspan’s recently articulated view that a combination of economic stagnation and price increases could be something to worry about.
In my view, unexpected inflation could emerge from a combination of flashpoints, whether the strong U.S. housing market, firming wages or health care costs, which have been low but are now starting to surge, three years into Obamacare. Other potentially inflationary trends are (aside from a post-Brexit bump) this year’s decline in the dollar as well as the rally in commodities. Employment figures are already at the Fed’s target levels, implying that wage pressures may be building, while the most recent print for U.S. core inflation (excluding energy and food) was 2.2%, or north of the central bank’s long-term target.
Thinking about Inflation Hedges
In the context of a multi-asset portfolio, it is important to consider the potential cost of hedging the risks of extreme economic environments. Right now, it is very expensive to hedge against negative growth shocks—because the traditional vehicles for this purpose, cash and government bonds, pay investors very little, if anything. In contrast, the cost of hedging against inflation is relatively low. Although commodity prices have increased this year, they remain at deflated levels, while the breakeven rate for 10-year Treasury Inflation Protected Securities (TIPS) is about 1.5%, which is lower than the current core inflation rate in the U.S. (implying a return premium if inflation continues at or exceeds current levels).
Based on the pricing of inflation in the markets, it’s clear that few investors are really focused on it as a risk. But given the low price of inflation-sensitive assets, our Multi-Asset team believes that it may make sense to add to them in diversified portfolios. At this point, we prefer TIPS over commodities, which given recent gains are likely to be range-bound in the near term. TIPS also have the advantage of providing some duration exposure, which can be helpful if we experience further declines in interest rates. Although U.S. bonds appear pricey in relation to U.S. fundamentals, we acknowledge that their yields may decline further based on the influence of negative rates in Europe and Japan.1 Nevertheless, on balance, our view is that rates are likely to creep up from here.
In sum, although I don’t believe higher inflation is a front-and-center concern, I do think that its importance is growing. It is often said that “the time to buy insurance is when it is cheap,” and inflation-hedging exposure is definitely cheaper than many other components of global markets. The potential for rising prices definitely merits an “upgrade” to my list of key risks the next time I give a talk on market prospects and asset allocation.
Imagine a helicopter flying overhead, spilling thousand-dollar bills all over your backyard. That’s the visual that comes to mind when I read about “helicopter money”, a proposed alternative to quantitative easing (QE). The most recent headlines on this topic have centered around Japan. As the Bank of Japan approaches practical limits on its purchase of government bonds, several economists have argued that it might be time to consider helicopter money.
Simply put, helicopter money is a direct transfer of money to raise inflation and output in an economy running substantially below potential. Thus far, conventional QE has not achieved Japan’s 2% inflation target. According to a paper by the St. Louis Fed, this could be due to expectations that it would eventually be unwound, diminishing the policy’s credibility. Since helicopter money is free and never has to be repaid, this approach may have a better shot at achieving Japan’s inflation target.
One form of helicopter money being discussed is the issuance of a zero coupon perpetual bond (with no maturity) by the Ministry of Finance to the Bank of Japan. The Bank of Japan “prints money” via an electronic credit of cash on its balance sheet, and uses the cash to buy the bonds. Because the bonds will pay no coupon and no principal, the Ministry of Finance would never have to pay it back.
It is important to point out the distinction between this “helicopter money” approach and QE. In QE, the central bank prints money and uses the money to buy bonds. However, the bonds eventually have to be repaid, so it adds to the overall debt levels of the country. The distinction here is the permanent nature of a perpetual bond. With QE, assets purchased are expected to be unwound at some point in the future, i.e. future generations would still have to pay back the money spent by today’s generation. With a zero coupon perpetual bond, the debt is never repaid, making this tool “helicopter money” rather than conventional QE.
Continuing with the helicopter analogy, QE is like the helicopters spilling 1,000 yen bills from the sky, but Japanese consumers and investors have been reluctant to pick up these 1,000 yen bills because the bills come with a string attached, a promise to pay back 999 yen sometime in the future. (One can think of negative interest rates as paying back less than the principal borrowed.)
The zero coupon perpetual bond would instead give the money to the government for free—call it a gift. With this free money, the government should be able to embark on the most ambitious public works program ever—hire people to upgrade roads, for example, or just deposit the money directly into its citizen’s bank accounts.
But once a government undertakes helicopter money, how easy is it to wean a populous hooked on free money? Can helicopter money be done incrementally? What if the Bank of Japan manages expectations by explicitly stating that this would be a “unique event which will never be repeated” as per Milton Friedman? Can taking baby steps lead to a gradual rise in in ation, wage growth, a mild depreciation of the yen, and nominal GDP growth?
Empirical evidences
The empirical evidence is mixed on helicopter money. The well-documented historical experience of Germany in 1923, Hungary in 1946, and most recently, Zimbabwe in 2008 were disastrous. At the risk of over-simplification, the tone of the policies these countries undertook was a drastic increase in the money supply, which led to hyperinflation, and a worthless currency, and ended in a major economic recession and political turmoil.
However, other less well-known historical evidence points to the opposite conclusion. A recent case study by the Levy Economic Institute on the Canadian economy in 1935–75 concluded that the permanent monetization of debt, with no intention of unwinding later, did not produce hyperinflation or exceptionally high inflation.
The huge increase in the money supply and credit engineered by the Canadian central bank was instead absorbed by a vast expansion in industrial production and employment.
In a recent article by former Federal Chairman Ben Bernanke, he said: “(Helicopter money policies) also present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. However, under certain extreme circumstances—sharply de cient aggregate demand, exhausted monetary policy, and unwillingness of the legislature to use debt- nanced scal policies—such programs may be the best available alternative. It would be premature to rule them out.”
In conclusion, we just don’t know whether or not helicopter money will work. The historical evidence has been mixed, with cases of success and failure. While helicopter money is still a low probability, we should not be surprised if some form of it gets implemented. Governor Kuroda is known for surprising the market, as he did when he introduced negative interest rates several days after signaling otherwise. It would certainly be a bold experiment from which most of the developed world would be able to learn from. In the meantime, we will wait for an announcement which could come by the end of the week and assess how the markets will react.
The immediate knee-jerk reaction would likely be a steepening of the yield curve and a depreciation of the Japanese yen on expectations of higher in ation over the long run and an increase money supply as a result of this policy. The longer-term impact on the economy and the markets will depend on the effectiveness of this policy.
Teresa Kong is Portfolio Manager at Matthews Asia.
CC-BY-SA-2.0, Flickr. Sales Force Regulation is Slowing Transfers Between Afores
The implementation of new regulatory requirements has led in recent months to a significant contraction in transfers carried out by the Afores. From an average of 165,094 monthly transfers in 2015, to 10,239 last June and 73,083 in July. The latter figure shows a recovery from the previous month, but do not reach even half the average transfers.
Until last year the business model most Afores was based on attracting a larger number of accounts and for this, recruited many promoting agents who were engaged in convincing workers to transfer their account, but not necessarily convenient for employee. Today this model is complicated.
In order to improve services to affiliated workers, in January last year, new surveillance checks, sales force supervision as well as new training criteria were implemented. The implementation has been gradual over 2015 and 2016. This led to a 10% drop in the sales force between January and October 2015 to locate in 42,070. As part of these changes, in May this year the use of biometrics, which means reducing the use of paper and incorporating digital, voice prints and digital signature which strengthens the verification of the identity of workers affiliated and security controls.
Practically since inception the pension system in Mexico (almost 18 years from November 1998 to July 2016), the figures show that 6 of 10 workers affiliated have been changed Afore. The data for the past 5 years show that the average transfer annual of the last 5 years is about two million workers annually representing nearly 4% of the 53 million registered accounts in the Afores, reflecting a significant reduction. Only between 2006 and 2010 the average transfer was 3.3 million workers annually that is a contraction compared to the current trend.
In the fall in transfers, only a couple of Afores have been able to recover such as Azteca, Profuturo and Sura which are above its monthly average affiliate of 2016. In June, for example, three Afores made no affiliation (Metlife, Invercap and PensiónISSSTE) and in July these three Afores don’t reach a thousand affiliations.
The cost of transfers
One point that has done much emphasis Consar refers to expenditure by the Afores for transfers which rose from 31% –vs. fee income in 2014–, to 26% in 2015. These resources could be used in a better way by Afores, such as investments in human capital in order to have better management and investment of resources.
According to Consar, 2015 figures show a new trend in transfers:
The proportion of workers they are changed before a year permanence in the AFORE was 5%.
Workers who are transferred between one and three years of stay was 31%.
Workers who transferred after three years spent accounted for 64%.
Young workers are most changed Afore (SIEFORE Basic 4), as it accounted for 40% of all transfers in 2015.
Dimensioned to organic growth (transfers) between the Afores, this will lead in the medium term search for mergers. Even should not rule out the possibility of strategic alliances which have not been seen between Afores.
CC-BY-SA-2.0, FlickrPhoto: d26b73. A Sigh of Relief
After a run of bad news, we are seeing more signs that growth trends are re- synchronizing among the major economies. Markets have responded in kind, with help from more policy stimulus around the world.
The widely anticipated acceleration in US economic growth seems not completely abandoned, just postponed. Following a stunningly weak second-quarter US GDP report, most economic reports point to a significant improvement over the summer. In Japan, the announcement of a massive fiscal stimulus program may not lift the mediocre growth rate right away, but it should boost business and consumer confidence and start adding to GDP growth in the fall. Meanwhile, business sentiment in China has improved to the highest level in a year and a half, highlighting the durability of its recent growth rebound.
Only the eurozone doesn’t fit the bill. The same surveys that track China’s improvement point to a modest European slowdown in the months ahead. Part of that is Brexit, but the bigger issue is its shaky banking system.
Financial markets get a sentiment boost Global equities posted solid gains last month, led by strong performance in Europe (rebounding from the June Brexit selloff) and Japan (in anticipation of more policy stimulus). Fixed income markets also made a good showing: Government bond yields declined marginally, but corporate bond spreads rallied, contributing to the overall gains. Not surprisingly, the US dollar lost some ground against the major developed world currencies in the initial phase of the risk-on market rally. But it also weakened vis-a-vis emerging market currencies, particularly the South African rand and the Korean won.
The Fed lays low in the US The weak second-quarter US GDP report has all but shut the door on further Federal Reserve rate hikes in the US this year. And a downgrade in future policy rate expectations at the next Federal Open Market Committee (FOMC) meeting in September looks likely. In June, the median of the FOMC members’ policy rate forecasts showed expectations of two more rate hikes this year. But that meeting also revealed how little conviction the Fed has in forecasts – both its own and the market’s. So, while most members may still be leaning toward raising rates further, we suspect the Fed will wait for stronger growth and, more importantly, evidence that it’s sustainable before acting again.
That is especially likely as long as inflation remains below target. With only three more meetings on the calendar this year and an increasingly contentious US presidential election campaign ahead, staying on the sidelines seems the best risk management strategy for the Fed. That alone should further support risk assets, as will the coming cuts in future policy rates.
The UK joins Europe with more QE While the European Central Bank (ECB) has not announced any additional easing measures since March, some programs were only just implemented. The €20 billion increase in the bank’s quantitative easing (QE) program added corporate bonds to the list of eligible assets, the purchase of which started in June. This has already significantly compressed eurozone corporate spreads, indicating another noticeable easing in financial conditions. Adding to that, July saw the first auction of the ECB’s latest Targeted Long-Term Refinancing Operation (TLTRO) program, which is designed to ease the pass-through from easier financial conditions to more bank lending.
Almost immediately after the Brexit vote, the Bank of England (BOE) hinted at rate cuts over the summer. This came as no surprise to central bank watchers, but something else did: The BOE restarted its asset purchase program and included corporate bonds for the first time and, similar to the ECB, also announced a lending scheme. That won’t be enough to offset a sharp slowdown in the UK in the second half of 2016, but it should contribute to the easing of global financial conditions and may help avoid an outright recession.
Japan makes a fiscal push Japan’s government announced a new massive fiscal stimulus program designed to boost aggregate demand– something monetary policy has failed to achieve in the past few years. At ¥28 trillion, or nearly 6% of GDP, it’s the biggest package since 2009. However, only ¥7.5 trillion represents new government expenditures that will directly contribute to GDP in the next two years, suggesting growth forecasts will only rise by 0.5% this year and 0.75% next year. The rest is harder to score and is likely to have a much smaller multiplier effect on the economy. Still, on the margin, the package will provide a much- needed stimulus to pull Japan away from the recession danger zone. And, if combined with more monetary policy easing in the next few months, the impact could be stronger.
China picks up the pace China’s growth surprise in the second half and its apparent sustainability through the summer quarter also has a lot to do with more policy stimulus. The underlying trend in aggregate social financing (the proxy for credit supply) started to re-accelerate last summer. While it started slowly, the pace picked up in November, indicating another round of monetary policy stimulus.
The government has also increased outright fiscal spending, indicated by a significant increase in the budget deficit to boost growth. Finally, the nearly 7% depreciation in China’s yuan since last August is starting to affect export revenues. Measured in US dollars, exports were still down 4.8% from a year ago in June, whereas local currency denominated exports values increased 1.3%. The combined effect of monetary, fiscal, and currency stimulus should keep the quarterly GDP growth trend between 6.5% and 7% for the rest of the year.
We are still optimistic It was a dissonant first half of 2016 for global GDP growth. The US experienced disappointingly weak economic activity in all six months. The eurozone and Japan surprised with stronger-than-expected growth in the first three months, but reverted to a weaker trend in the spring. It was the opposite in China, where growth in the first three months of the year slowed to the weakest pace in more than six years, only to rebound strongly in the second quarter.
After some excessive macro volatility, the second half of the year could deliver a more harmonious performance. China and the US are leading the growth acceleration, and more monetary and fiscal policy support in Japan and Europe should contribute to an easing of global financial conditions.
Yes, a few risks remain: Europe’s latest banking crisis hasn’t been resolved, a key constitutional referendum in Italy could trigger new elections, and the US will decide who will be its next president. But we think the year is likely to end on a more positive note, setting the stage for a stronger 2017.
Markus Schomer is managing director and chief economist at PineBridge Investments.
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