It ain’t so much the things we know that get us into trouble. It’s the things we know that just ain’t so.
--- Attributed to several American writers
The most important events in 2014 were not anticipated. At the end of 2013 and early 2014, parallels between 1914 and 2014 were focused on the disputes in the South China Sea, not Russia seeking to secure its sphere of influence in central Europe. US Treasury yields, the key benchmark for global capital markets, were universally expected to increase as the Federal Reserve slowed its purchases. Instead, 10-year Treasury yields fell to 115 bp to hit 1.85% in mid-October and were still trading a lowly 2.15% in early December.
Despite being fully aware of US shale oil production and soft world demand, no one expected a 40% drop in crude oil prices. The consensus favored Japanese stocks that were expected to be lifted by the BOJ’s aggressive monetary policy and yen depreciation. However, until late October when the BOJ increased its efforts, the Nikkei was lower on the year and for its part the yen stronger until early September.
We had recognized that the divergence among the high-income countries was a key characteristic of the investment climate, and have been writing about it in the past six months. This has now become the new consensus. While the logic is still compelling, we can provide more value by considering what can go wrong with divergence rather than simply reiterating what we have been saying ad nauseam.
Could the US Disappoint?
The divergence investment theme is based on positive developments in the US and not-so-positive developments elsewhere. If the consensus ends up being wrong, the US narrative may be the most susceptible to disappointment. There seems to be three different ways that could unfold.
First, growth in the US could disappoint. The contraction in Q1 2014 GDP was largely, even if not exclusively, a function of poor weather. The volatility of the weather makes this difficult to incorporate into economic forecasts.
After the winter weather subsided, the US economy enjoyed the fastest six months of growth in over a decade, from the April through September period. This rate cannot be sustained, and a return to trend growth, which may be closer to 2.5% is not unreasonable. Poor growth in Europe and Japan and the slowing of China act as a headwind on US growth. The strength of the dollar may also dampen growth. Slower growth may also coincide with slower improvement in the labor market.
Second, the Federal Reserve has habitually over-estimated the degree to which its mandated goal of price stability is approached. If the core PCE deflator, the Fed’s preferred measure of inflation, continues to undershoot, it is not clear that a decline in the unemployment rate itself, unless accompanied by stronger wage increases, would spur the Fed into action. While the officials may look past the decline in oil and gasoline prices, the secondary impact, such as on transportation and shipping costs, may feed through into core measures.
Third, in recent speeches, Fed officials have been underscoring their third mandate, which is all too often forgotten or ignored: financial stability. The Bank for International Settlements recently warned of currency and funding mismatches, especially for companies from emerging market countries that are particularly exposed by an appreciating US dollar. Instability in the global capital markets, with reverberations back to the US, could also encourage investors to push out the timing of the Fed’s first hike.
Has Europe Been Over Sold?
Perhaps what derails the consensus is not in the souring of the US narrative, but that the news stream from Europe and Japan is not as poor as anticipated. It may seem particularly difficult to find an optimistic scenario, but the conditions are falling into place. Sentiment is so poor that a mild upside surprise could have significant impact.
Investors have become fixated on the size of the European Central Bank’s (ECB) balance sheet, causing them to lose perspective on the unprecedented accommodation the ECB is already providing. Not only is the price of money favorable, illustrated by the five bp repo rate, it is also highly accessible with the ECB providing as much funding as banks need. It is the full allotment of funding at the first rate. It is a liberal collateral regime. It is the new TLTRO facility. It is buying some assets—now covered bonds and simple asset-backed securities—from banks. When the former LTROs are fully repaid early in 2015, the downward pressure on the ECB’s balance sheet will ease.
With the successful conclusion of the Asset Quality Review and the stress tests, there are preliminary signs that the deleveraging of European banks may be ending. The decline in the euro has also helped to boost the value of external assets, as well as ease monetary conditions.
European banks’ share of the global syndication market and trade finance has increased. The two-year contraction in lending to eurozone households and businesses seems to be ending as well.
The perennial challenge in the euro area is lack of growth in the periphery. It is notable then that the recent weakness in the eurozone was concentrated in the core. The periphery, like Spain and Greece, actually grew faster than core Germany and France in both the second and third quarters. Forward looking indicators, such as machinery orders, suggest the worst may be passing.
Under the consensus divergence hypothesis, the traditional pro-business Republican Party just secured control of both chambers of the U.S. national legislature. In the eurozone, many governments are weak and/or face rising right populist anti-EU challenges, with a number of exceptions to this generalization.
However, by the end of the first quarter of 2015, France and Italy will present concrete structural reforms and commit to a timetable for implementation. Greece will likely hold a national election in early 2015. The polls point to a victory by Syriza, which is not on the political right. What could go wrong the consensus is that investors realize Syriza is more anti-austerity than anti-EU. There is room to negotiate here. It does not need to be a new existential crisis in the eurozone. A compromise can include lengthening maturities and lower interest rates for the bonds held by the IMF, EU ad ECB.
Is Abenomics Back on Track?
Maybe the consensus is too bearish on Japan. The retail sales tax increase on April 1 was a mistake. Whatever tax revenue was expected was lost because of a sharp economic contraction. However, with the postponement of the next leg of the retail tax hike, a corporate tax cut and a supplemental budget, Japan is back on course. The expansionary fiscal and monetary policy that gave average quarterly growth (annualized) of 3% growth in the five quarters before the tax hike is being reinstated.
The drop in oil prices may push down Japan’s core inflation, which does include energy, but it should act as an economic stimulus. In addition, Japanese winter bonus pay and base wages are likely to rise. On top of this, the yen has declined roughly 15% on a trade-weighted basis since the beginning of October. This is tantamount to some degree of easing of monetary policy, and when coupled with the 25% rise of the Nikkei over the same time, and the (small) decline in yields, there has been a significant easing of Japanese financial conditions, which will lend support to the economy.
The consensus might not sufficiently appreciate Abe’s third arrow of structural reforms. Abe has also shown a willingness to challenge vested agricultural interests in the negotiations for the Trans-Pacific Partnership. Without much fanfare, Abe’s government is pushing for corporate governance reform. More companies are beginning to have outside directors, for example, and are embracing traditional shareholder values over the previous stakeholder ethos.
In volume terms, Japan’s exports have risen by around 2% over the past two years. Japanese companies are content to book the translation profits on their foreign earnings, which are inflated by the weakness of the yen, rather than expand market share (and risk antagonizing its trade partners). Japan’s current account surplus may grow even if it continues to run a modest trade deficit. Capital flows overwhelm the flow of goods and services by a wide margin. The foreign income stream earned from past investments, such as interest payments and dividends, may be the key to an improvement in the external balance.
Just like the consensus may be exaggerating the significance of expanding the size of the ECB’s balance sheet, it may be exaggerating the impact of the BOJ’s admittedly aggressive monetary stance. It could be that the largely one-off portfolio adjustment by Japanese pension funds, led by the GPIF is actually having greater impact that QQE. After all, we noted, the yen appreciated well into Q3 2014. It is probably safe to say that there other determinants to currency movement than monetary policy. A small question of whether the yen has declined too much too quickly can be raised at the next G7/G20 meetings early 2015.
What Could Go Wrong?
The point of this exercise was to recognize some of the risks to our central view that has become the overwhelming consensus in the market. The divergence of monetary policy, interest rate differentials and growth trajectories, favor the United States over the eurozone and Japan. This is the key investment thesis of global investors.
Several of the key developments this year, like Russia/Ukraine, the rally in US Treasuries and the historic decline in oil prices (one of the largest in the past half century) surprised even the most seasoned of investors. It behooves us to ask where we can be wrong next year. How will the divergence thesis be wrong?
We looked at different factors that could make the US under-perform and Europe and Japan exceed expectations. The first few months of 2015 will be key for the euro area. The ECB is widely expected to more rapidly increase its balance sheet through buying a broad array of assets, potentially including sovereign bonds. It is also when the Greece may hold its election. Investors are likely to give Abe a couple months before making some judgments about the Abenomics 2.0.
Our base case remains that the Federal Reserve delivers its first rate hike around middle of next year. We are inclined toward the June meeting, as there is a press conference to help guide investors’ understanding and expectations. However, the September meeting could also meet the criteria. By mid-2015, labor conditions would have improved more, and would likely offset a modest undershoot of the inflation target.
If Everyone Agrees, What Could Go Wrong?
Reviewed by Marc Chandler
on
December 24, 2014
Rating:
Reviewed by Marc Chandler
on
December 24, 2014
Rating:
