A Different Perspective
Asking the Right Questions
IMF downgrades economic outlook
There was a lot of hype last week around the IMF’s release of their latest World Economic Outlook (WEO), in which they downgraded their forecast of GDP growth for the world economy. Entitled “Legacies, Clouds, Uncertainties”, the IMF revised downward their projection for this year to 3.3 percent, 0.4 percentage points lower than in the April WEO while their projection for 2015 was lowered to 3.8 percent. In their April WEO, entitled “Recovery Strengthens, Remains Uneven” the IMF wrote “Global activity has broadly strengthened and is expected to improve further in 2014–15”. The fact that they and other economic forecasters are consistently wrong is not surprising given the dynamic nature of the global economy. However, the fervour around the release of the IMF’s projections that fuels their belief that they are sharing something earth shattering is laughable. Surely with the year almost complete their 2014 forecast is less a “projection”, and actually a survey of what has happened in 2014.
Market Recap Week of October 13th
The sell-off in global equity markets continued last week as market participants have woken up to the fact that the global economic recovery has lost momentum, at the same time as the US Federal Reserve is ending their bond buying program (QE3). However, the real source of the increased volatility is Europe. Germany, the big dog of the Eurozone economy, reported a big drop in factory orders and industrial production, stoking fears that a recession might be on the cards.
Amidst the increased volatility last week European equity markets fared the worst. The FTSE Eurofirst 300 index fell over 4.02% while the German DAX index dropped to the lowest level in over a year, down 4.42%. In the US, the much watched Dow Jones Industrial Average has now erased all of its YTD gains while the S&P 500 had its worst week since May 2012, down 3.14%. The tech-heavy NASDAQ Composite fell 4.45%. Core government bonds were in demand as yields moved lower again last week with the German 10-Year yield closing at 0.89%. Gold bounced as investors looked for a place to hide, the precious metal rose 2.66% to $1,227 per troy ounce.
Week Ahead
Key macro data this week includes reports on industrial production and inflation from around the globe. There is a host of economic data released from the UK including inflation, retail sales, housing and the labour market. There is also a raft of data due out from China over the week, increasingly important as investors fret over the slowdown in the global economy. Disappointing Chinese data would put further pressure on markets. The Irish Government will release their latest budget on Tuesday, with a few tweaks here and there expected to keep the people happy. Of course there will be outrage from the opposition and the various lobby groups either way. I’ll prefer to listen to Dunphy and Giles wax lyrical on the beautiful game as we head to Germany Tuesday night for a showdown with the world champs!
Jen says Nein
Everyone knows that the German Bundesbank president Jens Weidmann has been a thorn in the side for ECB President Mario Draghi. The Italian would love to unleash the type of unconventional monetary policy that would have financial markets salivating, the purchase of Eurozone government bonds. Jens is not only against this, he opposed the purchase of asset-backed securities by the ECB given what he says is the “risk that we will overpay for these assets”, a valid concern since one has to question why a market starved of yield would not buy these securities. PRICE! “That would represent a transfer of risk from the banks and other investors to the central banks and ultimately to the taxpayers” said the German in an interview that was published in the Wall Street Journal last week. Entitled “Decision on risks for taxpayers lies with elected politicians” the full interview is well worth reading to get an insight into the diverging views developing that could have massive implications on the direction of the European project.
US Fed Minutes: concern over stronger dollar
The minutes from the US Federal Reserve’s FOMC meeting of September 16-17th, added to volatility last week as financial markets initially bounced on a more dovish tone on the outlook for interest rates. However, after poor German data and the IMF downgrade of the economic recovery, investors thought more about the Fed’s comments regarding the impact of a strengthening US dollar. “Some participants expressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector”. A couple of participants felt that a stronger dollar “might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal”.
This is the possible negative feedback loop I wrote about two weeks ago, whereby a stronger US dollar, on the prospect of a stronger US economic recovery and interest rate hikes, actually hurts exports and dampens inflation, thereby delaying monetary policy normalisation. Some in the financial markets may view this as a positive, lower rates for longer, or even more QE, but in reality it would destroy any illusion of a self-sustaining economic recovery. The US Federal Reserve knows this and will be keen to avoid another backtrack on monetary policy normalisation.
Why are investors only waking up to risks now?
We have known for some time that the German economy was slowing. The economy contracted by -0.2% in the second quarter and since then the business and consumer confidence surveys as well as the PMI data have shown weakness. So why are investors only waking up now?
The reason is that the European Central Bank has so far disappointed with their monetary policy measures and it has become increasingly clear that the Germans will not give Mario Draghi free rein to implement full scale quantitative easing in the near term. The markets turned after the ECB’s first targeted liquidity auction spectacularly failed on September 18th and then Draghi failed to elaborate on the size of the program for purchasing asset-backed securities at the October ECB meeting.
The German DAX equity index is down over 10% since September 18th. At the same time the German finance ministry has made it clear they have no intention of embarking on a deficit spending program to appease the French and others in Europe who feel that Germany should start spending to stimulate the Eurozone economy.
Market Recap Week of October 6th
Global equity markets closed lower last week despite a late relief rally on Friday after better than expected US payroll data. While the unemployment rate is at a 6-year low of 5.9%, weak wage growth dynamics and the labour force participation rate being at a 36-year low will prevent the Fed from moving faster on rate hikes. European PMI data provided further concern for the slowdown in Europe, but it was the ECB’s Mario Draghi who caused the most upheaval in markets last week, the “detailed modalities” he promised on the ECB’s ABS program just weren’t detailed enough!
Overall, volatility has started to pick up recently as financial markets digest the mixed economic data and what it means for monetary policy from the world’s ‘omnipotent’ central banks. The major equity indices in the US fell less than 1%, while the major indices in Europe and Asia were down in the region of 2% to 3%. The German DAX and Japan’s Nikkei 225 were among the worst performers, down 3.11% and 3.21% respectively. Core-government bond yields were moved lower last week with the German 10-Year yield closing at 0.93%.
Beyond the equity and bond markets a more subdued outlook for the global economy and a stronger US dollar are weighing on the performance of commodities. Brent crude oil is down 20% since mid-June, the lowest level in over two years. Gold has given up all of the YTD gains, the precious metal falling to $1,192 per troy ounce.
Outlook
On the macro front this week there are reports on industrial production, trade and inflation from around the globe. Germany, the powerhouse of the Eurozone economy, will be in focus with reports on factory orders, industrial production and the balance of trade. The standoff between the West and Russia has definitely been felt in Germany and if the slowdown gathers pace the Eurozone economy could be in deeper trouble.
Of the major central banks, the Bank of England and the Bank of Japan will both hold their monetary policy committee meetings this week. No change in policy is expected from either central bank but there is a chance that the Bank of Japan may do something to show their commitment to ridding Japan of deflation. The US Federal Reserve will release the minutes from their most recent meeting on Wednesday, providing further insight into the Fed’s thoughts on the normalisation process. On Thursday, ECB President Mario Draghi will give a speech and participate in a panel discussion with US Federal Reserve Vice-Chair Stanley Fischer in Washington DC, while a number of regional Fed Presidents are also on the speech circuit this week.
The importance of long term perspective
While the global economic recovery is in the balance under the stewardship of politicians and central bankers, I have much more faith in the ability of Brendan Rodgers to bring back the good times at Liverpool FC. Football fans are like investors in financial markets, constantly seeking instant gratification. However, a long term perspective based on solid foundations is the key to building a robust portfolio, as is the case in football and other walks of life. The near term may be more challenging than last year for Liverpool fans as we adjust to life after Suarez, but not to fear, Brendan Rodgers is the man that can once again build Liverpool into a “bastion of invincibility”. Like anything worth waiting for, it will just take time!
Why own gold? The bubble maker tells us why…
With the price of gold in decline, despite massive central bank money printing, it begs the question why should anyone own gold? Well according to the bubble maker himself, former US Fed Chairman Dr. Alan Greenspan, it is because “for more than two millennia, gold has had virtually unquestioned acceptance as payment”. In his recent article, entitled Golden Rule: Why Beijing is Buying, he goes on to write: “Today, the acceptance of fiat money — currency not backed by an asset of intrinsic value — rests on the credit guarantee of sovereign nations endowed with effective taxing power, a guarantee that in crisis conditions has not always matched the universal acceptability of gold.” In essence, gold is an insurance policy against central banks and governments eroding the value of paper currency.
Pricing an illiquidity premium in liquid assets
When considering the available investment opportunity set investors should theoretically be rewarded as they move out the risk curve. That is, as an investor moves from the safest asset class, being cash (obviously requires some assumptions), there should be an extra return or premium to reward investors for the extra risk. One such risk is illiquidity risk, the risk that you may not be able to sell at a ‘fair value’ in a timely manner (the idea of ‘fair value’ is also a discussion for another day).
Illiquidity risk tends to be associated most with real assets like property, but anecdotally I have been hearing more about this risk being under-priced in bond markets, particularly lower rated corporate bonds. Dubbed ‘high yield bonds’ they should more aptly be named higher-yield bonds since central banks have driven yields lower across the risk spectrum. In other words, the reach for yield has pushed spreads on bonds with even less investor protection near record lows.
High yield bond investors and investors in general are assuming the US Fed can “pass the camel of massive quantitative easing through the eye of the needle of normalizing monetary policy without creating havoc”. In the event that the camel gets stuck and the Fed causes another market ‘tantrum’, assets classes, like high yield bonds, that now appear liquid may not be liquid in the future, when it is needed most. Think of it like your mobile phone network on New Year’s Eve, everything is working fine until everyone wants to text or call at the same time and suddenly the network jams!
Size matters: Mario Draghi disappoints financial markets
It turns out size does really matter, well when it comes to central bank balance sheets anyway. While confirming that purchases of asset back securities (ABS) and covered bonds will begin mid-October, for at least two years, Mario Draghi disappointed investors by not announcing the actual size of the bond purchase program. After the failure of their first targeted liquidity auction last month, the concern among investors is how the ECB are actually going to return their balance sheet to early 2012 levels, circa €2.8 trillion, up from the current €2 trillion. Bank shares fell on the news as the ECB bailout may now not be as clear-cut as anticipated.
