Overview
US: The broad characteristics of the investment climate are unlikely to change very much in the first part of next year. The largest policy change is the beginning of the long awaited slowing of the Federal Reserve’s long-term asset purchases. The process will likely be gradual and may take the better part of 2014 to come to a complete stop. The drag from fiscal policy will likely lessen. The roughly 1.7% annual growth in employment since 2009 is set to continue and underpin a continued expansion of the world’s largest economy.
EUROZONE: The ordo-liberalism as articulated by Germany, embodied in treaty agreements, and enshrined by the European Central Bank condemns the euro area, and by implication, many of the countries that move in its orbit, to a protracted period of slow growth and low inflation. The institutional evolution in Europe continues and the pieces of an imperfect banking union are being established. The ECB is likely to respond to the adverse monetary developments, but unless the perceived threat of deflation increases, it is likely to refrain from extreme measures, such as a negative deposit rate or outright purchase of bonds.
CHINA: The Chinese economy may slow modestly in the coming quarters, though officials will likely respond to evidence that growth is falling below 7.0%. The focus has shifted toward the implementation of reforms announced by the Third Plenum. These entail financial and governing reforms. The special economic zone in Shanghai will be viewed as a test case of the ability of the reformers to implement their program over the obstacles posed by inertia, corruption, and outright opposition.
JAPAN: The first year of Abenomics has seen growth strengthen, deflation pressures ease, the yen weaken and Japanese equities advance smartly. The early turbulence of Japanese government bonds has eased and nominal yields remain low (real rates negative). The second year is bound to be more challenging, as the economy has lost momentum in the second half of 2013.
There may be some increased consumption ahead of the April 1 hike in the retail sales tax from 5% to 8%, but this is likely to be borrowed from subsequent quarters. This may not occur until closer to the middle of the year, when the Bank of Japan decides to provide more financial support for the expansion in addition to extra insurance around its 2% inflation goal (excluding fresh food and the retail sales tax).
FOCUS ON THE FED AND US GOVERNMENT
Investors have come around to the Federal Reserve’s admonishments that tapering is not tightening. Unlike in Operation Twist, under which the Fed sold short-term Treasury securities and bought long-term, the current guidance is that the Fed does not want to see short-term rates rise. It is more willing to accept curve steepening.
The Fed’s structure is characterized by a strong core of 7 governors and 12 regional presidents, whose majority is diluted by a rotating voting system that empowers only five to vote on the FOMC decisions. Under-appreciated by many participants, the Board of Governors is likely to change significantly. This is not just a function of Bernanke stepping down. There are already two vacancies on the Board of Governors. In addition, there may be another two or three governors that step down, suggesting that 4-5 people may be new next year (assuming Governor Powell is reappointed for another term).
The $10 billion of tapering, divided equally between Treasuries and mortgage-backed securities, announced December 18, speaks to the Federal Reserve’s gradualism. The forward guidance suggests a rate hike is highly unlikely in 2014. Although the probable expiration of emergency jobless benefits at the start of the year will likely push the unemployment rate down through a further reduction in the participation rate, the Federal Reserve has signaled that the unemployment rate is likely to fall below the 6.5% threshold it has identified.
We had expected the tapering move and greater forward guidance to be delivered by the new Federal Reserve chair. We had argued that the Fed’s forward guidance would be more credible if the chairman that will implement it, issued it. Due in part to our concern that after an inventory-fueled 4.1% SAAR Q3 GDP, the US economy is going to slow back to what now seems to be its growth trend of around 2.25%-2.50%. In addition, we are concerned about downside risks to the core PCE deflator in the coming months. Finally, with Republicans seeking more spending cuts in exchange for lifting the debt ceiling, which President Obama refuses to negotiate, another fiscal impasse cannot be ruled out.
The November 2014 congressional elections may produce substantial changes to the composition of the legislative branch. The entire lower chamber, the House of Representatives and one third of the upper chamber (Senate) face voters. There is a very low support rating for both parties, but the power of incumbency in the US political system should not be under-estimated.
There may be important signals from the primary contests. The partial closure of the Federal government highlighted the internecine struggle for the reins of the Republican Party, largely between the northern and southern wings (identify more with the Tea Party movement). Although the business community is mostly supporting the north, the passions, energy and populist appeal may favor the southern wing. Its anti-Washington rhetoric has found a responsive chord.
The primaries will test whether the southern wing can wrest control of the entire party by beating some key northern Republicans. Such a victory though may prove to be pyrrhic, in the general election and, arguably more importantly, in the 2016 presidential contest. Indeed, with the November election, the 2016 presidential campaign begins and President Obama becomes increasingly a lame duck, with diminishing influence.
EURO ZONE: SUCCESS WILL PROVE CHALLENGING
After being hobbled by existential doubts over the sustainability of monetary union, credit degradation, financial fragmentation, the euro area is now challenged by its successes. The return of the funds borrowed under the long-term repo agreement has been the principle drain of the excess liquidity that kept EONIA (key index of overnight rates) nearer the zero deposit rate than the repo rate (which is at 25 bp, following the ECB’s surprise November rate cut).
At the same time, the only path of adjustment for the uncompetitive periphery members is internal devaluation, which means a relative decline in domestic prices has produced a disinflationary environment on the general level. This coupled with the compression of domestic demand, has improved external accounts, while the infamous Target2 imbalances decline. Yet, core countries, especially Germany, have refused to offset the austerity in the periphery with sufficiently strong enough stimulus. This has served to protect the German external surplus, while creating low inflationary conditions.
On top of the growing EMU current account surplus, foreign investors have returned to Europe. Several large institutional investors and wealthy individuals have been acquiring property and other distressed assets in Europe. A few hedge funds made the news with moves into Greece. Through early December, the Athens Stock Exchange was up 30%, the most in the region.
Greek banks and corporate bonds were among the most distressed assets and, arguably, offered the best returns in turn-around situation. Many global investors were under-weight on European stocks and bonds, and then in mid-2013 the surveys suggested that an economic recovery was at hand, causing many investors to move back in. Spanish and Italian stocks and bonds seemed to have been favored. US money market funds increased their exposures to European paper.
European banks continue to de-leverage and sell non-core assets, often in other countries. With a banking union gradually being built, some investors will look more favorably toward European bank shares. Before the ECB assumes regulatory authority over the systemically important European banks, it will review the quality of the assets, ensure the proper uniformed classifications are employed, and stress test the banks. While not ideal due to reliance on national resources, a resolution mechanism has been agreed upon.
The crisis and the policy reaction in Europe have weakened the political center. Rather than the cuts in social programs and high unemployment fueling a move to the left, it is the populism on the right that has emerged in Europe. This is not simply a phenomenon in countries in the periphery, like Greece; rather it is evident in the stronger countries, like Austria and Finland. It is perhaps most evident in France, where recent polls put (Marine) Le Pen’s National Front at the top.
This disenchantment will likely be felt in the EU Parliamentary elections and local elections in May 2014. National political elites may feel besieged. While the crisis forged a tighter union, despite expectations in some quarters of the dissolution of EMU, the recovery may see rearguard action, to recapture some of the sovereignty surrendered.
In addition to these forces, when considering the outlook for the euro-dollar exchange rate, the two-year interest rate differential continues to provide useful insight. Investors now accept that reducing the amount of long-term assets purchased by the Fed and a rate hike are two completely separate events, which allows the U.S. 2-year yield to remain anchored. At the same time, the prospects of more liquidity provisions by the ECB, slow growth and low inflation points to a low 2-year German yield.
The US 2-year yield peaked in early September, ahead of when many, though not us, had expected the Fed to taper, at almost 55 bp. By late November, it had fallen to almost 25 bp. Given the risk of a Fed rate hike by late 2015, such a yield on the two-year note seems too low. As yields return toward fair value (37-50 bp), the dollar’s descent may slow. However, a significant rally may require even higher yields.
German 2-year yields fell to 5bp in early November amid speculation that the ECB could adopt a negative deposit rate. As an aside, the lower yields German has enjoyed as a result of the crisis, has saved the German government more money than it has actually paid to aid peripheral countries. In any event, the yields rose sharply, back up above the 100 day average (~17 bp) and near 25 bp in early December was closer to the year’s high (~38 bp). As yields return to fair value, the euro’s appreciation will likely be corrected.
CONTINUING CHANGES IN JAPAN
While the euro-dollar exchange rate seems particularly sensitive to the movement of short-term rates, the dollar-yen rate often seems more sensitive to long-term interest rate developments. The prospects of Fed tapering have seen long-term US interest rates move back toward the upper end of the 2013 range. However, as the whiff of disinflation remains, and Q3 growth of 4.1% is a one-quarter wonder (inflated by inventories that will be worked off at the cost of future output), we expect the rise in US 10-year yields to be contained.
Japanese bond yields, on the other hand, may rise in 2014, but not because the BOJ stops its buying program. Rather the low rates of return will push institutional investors, including the Government Pension Investment Fund, into equities. New government-sponsored investment schemes are designed to encourage equity investment, though given the risk-averse nature of Japanese households, relatively high dividend stocks will likely be preferred.
In a deflationary environment, low nominal Japanese Government Bond (JGB) yields still translated to positive real rates, and sometimes, relatively high ones at that. However, with the rise in inflation, real yields have turned negative. This may further squeeze households out of fixed income. At the same time, the disinflation in North America and Europe has seen real interest rates there rise and Japanese foreign bond purchases may continue to attract Japanese investors into 2014.
Japanese households are not only being squeezed by the negative real return on their savings, but also by the reluctance of businesses to share their strong profits growth with their employees in the form of higher wages. On top of that, retail sales tax will further erode the purchasing power of Japanese households.
Although officials generally expect the JPY5.5bln supplemental budget (to be financed by higher tax revenues generated by the economic recovery and using previously allocated but unspent funds) to offset the economic impact of the sales tax increase. We are less sanguine and expect the erosion of household finances will erode support for the Abe government and prompt additional fiscal support, as well as re-energize the debate of the second leg of the retail sales tax hike (from 8% to 10% in 2015).
Whereas many observers had expected the yen to trend lower throughout 2013, we had anticipated a broad trading range to begin shortly after the much anticipated quantitative easing by the new BOJ Governor Kuroda began. We now see pressure from interest rates and capital flows to help fuel another leg down for the yen, against the dollar and euro. It may meet increasing resistance from officials at the multilateral meetings in the first part of 2014, where critics see unfair advantage stemming from a policy aimed at currency devaluation. Indeed, the drive to double the money base within two years has achieved where overt (and apparently covert) intervention failed.
We see scope for around a 5-7% depreciation of the yen as the dollar moves into a new trading range against it, while the dollar stays range-bound against the euro. Later in the year, we expect the dollar-yen pair to find a new trading range as the dollar trends higher against the euro.
HIGH INCOME COUNTRIES ROUND UP
To round out this overview, let’s turn our attention away from the US, Japan and euro area and look at a few other high income countries.
UNITED KINDGOM: The strength of the UK economy was a pleasant surprise in 2013 and the momentum looks to carry over into 2014. Although price pressures are stubborn, barring a significant data surprise, we do not expect the BOE to hike rates in the New Year, though we see some risk that rates will be hiked before the next general election in May 2015. After the May EU parliament and local elections, Scotland’s referendum (Sept 18) will move more into the spotlight. While there may be some apprehension beforehand, lasting market impact may be minimal.
AUSTRALIA: We are not convinced that the Reserve Bank of Australia’s monetary policy cycle is complete. Barring a dramatic decline in the Australian dollar, we think that late Q1 or early Q2 may offer a window of opportunity for the RBA to move. Poor economic data, including easier price pressures, and/or an appreciation of the Australian dollar, would raise our confidence of another rate cut.
CANADA: Canadian monetary policy is more likely to be on hold through 2014 and the Canadian economy is likely to under-perform the US. We look for further depreciation of the Canadian dollar. Our forecast anticipates the US dollar to move toward CAD1.10 by mid-year.
SWEDEN: In the face of disappointing economic activity and the risks of deflation, the Riksbank cut the repo rate to 75 bp and implied scope for another 25 bp rate cut in the first half of 2014. Household debt levels remain a concern to officials, but interest rate policy is not the most efficient way to address it. Look for macro-prudential efforts to be stepped up in the coming months.