Five Shocks Push Investors Off Balance

Archimedes said that if he had a lever long enough and a place to put his feet, he could move the world. Investors have access to incredible pools of capital and can lever immensely. They thought they had some place to put their feet.

The foothold was made of several planks. The unorthodox monetary experiment and large deficit were inflationary. The debasement of paper money among the high income countries would boost the price of gold and spur flows into the emerging markets.

If the large deficits were not brought under control, interest rates would rise and growth would slow. Japanese investors, in particular, would respond to the return of the previous Liberal Democrat strategy, now on put on steroids, by protecting their savings by sending it abroad.

Intuitively these all made sense and perfectly consistent with neo-liberal orthodoxy and, ironically, perfectly consistent with the ordo-liberalism which has come to dominate the euro area (if not the EU) through Germany's influence. Yet, over the past week or so each one these planks has been shaken. Individually, it might not be a big deal, but collectively, it is shaken investors and economists and may impact policy, going forward.

With the exception of the UK, measured inflation in the high income countries is falling not rising.  Japan, Switzerland, and Greece have deflation.  The US and the euro area are seeing CPI slip further below 2%.  Last month, Sweden said its consumer prices in February showed no change on a year-over-year basis.  Last week, Canada report its consumer prices have risen 1% in the year through March. 

China, the world's second largest economy, recently reported that its non-food inflation is up less in the past 12 months (1.8% in March).  Other emerging market countries are facing greater challenges, including Russia and Brazil, where the central bank hiked rates last week.  India's consumer prices increases may have peaked, but remain high.  

It is difficult to find much evidence for assertions seen from time to time that easy monetary policy among the high income countries is effectively exporting inflation to low and middle income countries. The channel of transmission is understood to be the capital markets.  Yet capital flows into the emerging markets has been trending lower and, while the major equity markets have rallied to new record highs, as in the US, or multi-year highs as in Europe and Japan, the emerging markets have under-performed.  The MSCI Emerging Market Index is 14% below the 2011 high and is currently at five month lows.  

Rather linking this under-performance to QE, a more compelling narrative is more grounded in  specific developments, such as the Apple product cycle and pressure on the supply chain, largely in Asia.  Weaker Chinese growth is another source of specific and local pressure.  The decline in commodity prices has taken a toll on equities in many emerging markets, including Russia, Brazil and South Africa.  

The CRB Index has fallen nearly 9% over the past three months.  Copper has shed a fifth of its price seen in early February, which as an industrial metal may be saying something about Chinese demand.  However, it is the dramatic drop in the precious metals, and especially gold, that has shaken the ideological belief system of many investors.   

Gold's recent precipitous drop did not come from record highs set last year as the Fed launched an open-end program of long-term asset purchases and then doubled it at the end of the year.  Nor was the recent sell-off from highs set when the ECB unveiled a program of Outright Market Transactions last summer; nor when an Abe victory first seemed likely in Japan in middle of Q4 12.  No, gold's record high was set in September 2011 and it is now down about 30% from the high water mark.  And despite the neo-liberal rhetoric and analyses, many investment houses are suggesting the price of gold has peaked.  

Just like we did not read much into gold's ascent, we do not read much into its descent.  If analyzed as any other commodity, stripped of its magical powers often attributed to it, what happened to gold is understandable.  Three events took place that spurred the sell-off.  First, was a violent short-covering of the yen in the foreign exchange market.  The yen had been used as a financing currency over the past several months to fund other investments, including gold.  The unwinding of this carry trade hit a vulnerable market.  

Around the same time, it became clear that countries in Europe seeking aid would be under more pressure to raise funds through asset sales.  Those assets are not only commercial in nature, but also include the gold reserves.  The 10 tonnes of gold Cyprus may sell is a relatively modest about for the gold market, with a value of about 400 mln euros.  It is also a relatively small amount relative to the size of the Cypriot contribution to its assistance program of now estimated around 26 bln euros.  However, the gold holdings of other periphery countries and assumed to be a new source of overhead supply.  

Lastly, the performance of competitive assets, like equities, in a low inflation environment, and slowing growth, also seemed to reduce the conviction that gold was where to be now.  As it has done for the past couple of years, the US economy is appears to be slowing markedly in early spring.  Europe continues to contract.  China's growth has downshifted.

In this context, the distinction between decline in paper claims on gold (futures and ETFs) and physical demand (gold bullion and coins) that some gold proponents have resorted to is not very helpful.  It is similar to contending that the drop in the corn futures is somehow less significant because consumers are still buying corn on the cob or cornflakes.  

The behavior of Japanese investors has also gone against the conventional view as well.  The  Bank of Japan's program that entails doubling of its asset purchases and the doubling of the average maturity of those purchases was going to force Japanese investors to export their savings to protect the value.   Contrary to the numerous claims that attributed the decline in European bond yields or the rally in some emerging market bonds to Japanese investors, the most authoritative data shows Japanese investors have continued to sell foreign bonds.  

In fact, the weekly Ministry of Finance data shows that Japanese investors have sold bonds every week this year, with three exceptions and two of those were in January.  The benchmark indices that many Japanese institutional investors use give only a small weighting to emerging markets.  

There is a clear preference for the liquidity and safety of core bond markets in the North America and Europe.  The investment proposition does not seem particularly attractive as these bond offer near-record low yields and the quality is suspect, as the downgrade of the UK's credit rating by Fitch (following Moody's move last month) illustrates.  

Japanese insurance companies and pensions do seem likely to boost their foreign allocation in the coming weeks as the FY13 plans are implemented.  However, the combination of a weak yen and strong foreign asset prices may also encourage some investors to book profits on the large stock of foreign investments that have been accumulated.  Moreover, as the recent data indicates, the foreign appetite for Japanese shares remains strong.  The latest weekly report showed record foreign buying of Japanese stocks 

The questions raised over the Rogoff-Reinhart work have also shaken the neo-liberal and ordo-liberal analyses and prescriptions.  The first response by the ideologues is that the critique raises narrow issues, such as is 90% debt/GDP a tipping point, not the general and important claim that high levels of debt cause coincide with weak growth.  

Even though the austerians in the US and Europe frequently cited Rogoff and Reinhart's work to support their agenda, it did not create the agenda in the first place.  Nor will any criticism of their work negate the contention that one cannot solve a debt crisis through the creation of more debt.   

Nevertheless, just like Rogoff and Reinhart's essay "Growth in the Time of Debt" (2010) and their book "This Time is Different:  Eight Centuries of Financial Folly" was a touchstone austerians, the critique of the work is part of the coalescing push-back.   Recall that over the past year, the IMF, which previously seemed to act as that its acronym really did stand for Its Mostly Fiscal, has 1) admitted that it had under-estimated the fiscal multiplier, or how much tightening of fiscal policy would have on the overall economy, and 2) urged some countries to balance the austerity efforts with growth measures, and 3) has been increasingly critical of the UK's austerity drive.  

In the euro area, the EU is conceding extensions to several countries that are over-shooting this year's deficit targets.  Several members have simply refused to enact any more spending cuts or tax increases.   In Japan, Abenomics is not simply about monetary policy, but it also includes more fiscal stimulus, even though debt/GDP stands near 230%.  

Ironically, the austerians have moved into ascendancy in the US.  The fiscal drag from the US this year will be greater than from Europe.  Indeed, the deficit is falling faster than many expected and this is prompting economists to lower their forecasts for the current fiscal year.  

Half way through the fiscal year and revenues are greater than expected  and expenditures less than anticipated.  The nominal growth rate in spending is the lowest in decades.  Revenues are up 12%  in the current fiscal year.  This means that the full year deficit may come in below 5% of GDP.  It is not just a function of the end of the payroll tax holiday as revenue was increasing prior to January 1. Similarly the spending decline preceeded the sequester.  Making some conservative assumptions, it is possible the US budget deficit fall below 3% (of GDP) in FY15, which may be before this is achieved by many euro area members.  

In any event, the point Rogoff and Rinehart's works was not ideologically neutral and the criticism of also has ideological implications.  The key issue is not really over tipping points or even broader methodological questions, but over the causal narrative that is told (including in speeches and essays by Rogoff and Rinehart) between high debt and slow growth.  As many, including ourselves, noted, the causal arrow often seems the reverse; that slow growth creates larger debt burdens.  Stronger growth in the US (than Europe) is one of the reasons why the US deficit is falling quicker.  

It may take some time for investors to regain their balance after being discombobulated by recent events.    Neo-liberalism and ordo-liberalism have a flexibility that is often under-appreciated.  Nor should our ability to manage cognitive dissonance be under-estimated.  Nevertheless, the foothold for investors and policy makers seem less secure than before.