Archive for August, 2013
One of the effects of the market’s recent taper tantrum has been to depreciate developing-world currencies, provoking fears in some quarters that we are on the cusp of a re-run of the events of 1997 which saw various tiger-shaped dominos tumble across the Asian part of the emerging market landscape. Particularly badly hit has been India. At one point on Wednesday the rupee stood 31% weaker against the dollar than it had done at the beginning of May, when the panic kicked off. Despite a muted recovery it is still down about 25% at present. Is the writing on the wall for the BRICs? Is it the Asian crisis all over again?
The short answers are “no”, and “no”.
It is true that Indian GDP has slowed and that today’s release for the year to Q2 came in below expectations. On the other hand, 4.4% annual growth in real terms doesn’t look so bad from a developed-world perspective, disappointing though it is set against an average rate for India over the last ten years of 8%.
It is also true that the Indian balance sheet is not as strong as some of its EM peers, with IMF putting its gross government debt to GDP ratio for 2012 at 67%. And India is running a budget deficit of about 5% of GDP at the same time – though again, these figures look downright enviable if you’re the US, Eurozone, UK or Japan.
So far, so worrying. But we are still some distance from 1997 and here’s why.
Going into the ’90s collapse the Asian tigers had been over-hyped and over-invested in by exuberant developed-world investors drunk on low inflationary growth and technological advancement. At the same time they had begun to have the rug pulled under them in certain industries by lower-wage China through an insistent combination of economic liberalisation and currency devaluation. (When Thailand, first casualty of the 1997 collapse, stood on the brink of annihilation in June of that year its economy was already in recession.)
Furthermore, the level of foreign currency debt at the time was huge, and countries including Thailand were trying to maintain currency pegs against the dollar with derisory levels of foreign exchange reserves to back them. On the way into the crisis, external debt to GDP in Thailand and elsewhere in the region was running at over 60%.
Today the attitude towards emerging market investment is far from exuberant – indeed has been relatively gloomy since the crash of 2011. And even with debt to GDP of 67% India has gold and foreign exchange reserves of almost $300bn. That’s much less than China, or Russia, but brings the net debt position down to under 50% of GDP. In addition, with budget deficits and real GDP growth balancing each other out, that debt ratio is not increasing.
Neither is there a sudden attack on a currency peg to contend with. The rupee already devalued from 45 to 55 against the dollar in 2011-12 and inflation at that time peaked just shy of 11%. There seems little reason to expect the current devaluation to 65 to result in something much more dramatic.
At the same time, export growth has bounced: up 11.6% on the year to July, an eighteen-month high. We should expect that kind of thing in a period of material currency weakness. (This is exactly the supposed cure-all remedy some have in mind for the beleaguered members of the eurozone periphery.)
It is precisely when we come to exports and growth, however, that we stumble over the real disconnect between fantasies about a reprise of the Asian crisis and the reality of the situation today. When India was booming back in 2010 and the rupee was moving sedately sideways, US monetary policy was in very much the same position as it is today. It has not changed in the interim. Therefore, the slowdown in the Indian economy cannot reasonably be attributed to a change in American monetary tapering, tinkering or anything else. Therefore, there is no reason necessarily to expect the Indian economy either to benefit or to suffer from changes in the US monetary environment over the next few quarters.
What has changed since 2010, however, is that Europe (including the UK) re-entered recession, Japan joined them in the aftermath of a calamitous natural disaster, the US recovery slowed, Greece defaulted and confidence collapsed. If we seek the cause of strain on the economy of India as elsewhere in the developing world, it is surely here that we find it – not in the press releases of the Federal Reserve.
Which brings us back to the present. It is not 1997 which lies around the corner, but 2014. So far – further shocks permitting – the coming period looks likely to be one of continued recovery. This will make an especial change coming from Europe, though if this week’s GDP revision for Q2 is anything to go by the pace might be picking up in the US too.
Can the Indian economy benefit from stronger growth across the developed world without reacting to changes in quantitative easing by the Fed any more than it has done so already?
Now there is a question to which the answer might just be, “yes”.
The release of minutes from the July meeting of the Federal Open Market Committee generated headlines this week. Fears of the effects of “tapering” – the reduction by the Fed of the amounts of fixed income security purchases it makes under its “QE3” programme of quantitative easing – have continued to unsettle markets.
There was no clear steer from the minutes as to when this will eventually begin. But according to research released by the San Francisco Fed earlier this month it doesn’t matter much anyway. The Fed economists who wrote the study estimate that a QE2-sized programme ($600bn of US Treasuries purchased over two years) without accompanying dovish guidance on interest rates would have added only 0.04% to GDP growth and 0.02% to inflation. Even with this guidance they assessed the impact at a meagre +0.13% on GDP and +0.03% on inflation. As they conclude:
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation … those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.
Moreover, one of their key model assumptions was that QE would lead holders of longer-dated Treasuries to reallocate capital to other asset classes or the wider economy (they assume no impact on holders who are indifferent to bond maturities):
If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.
This analysis will be familiar to readers who remember the numbers involved in our own programme of QE here in the UK. As this blog observed some time ago, however, with the government issuing at least as much debt into the bond market as the Bank of England is taking out, this “helicopter drop” monetary model simply doesn’t fly:
Imagine that you were in the crowd underneath the helicopter and had managed to scramble successfully for £50. Then, as the helicopter flies away and you are about to put the money into your wallet, you feel a tap on your shoulder. You turn to see a man standing in front of you with a knife, who mugs you for it. Would you feel like the beneficiary of a windfall and embark on an inflationary spending bonanza, or would you put your wallet away in bewilderment, feeling as if the whole exercise had been an elaborate distraction?
Unsurprisingly for an economy which has seen the level of public debt to GDP rise from a little over 60% at the start of the Great Recession to over 100% today, the same logic applies over the Atlantic. Since the Fed started QE it has bought $2,196bn of Treasuries. Over the same period, BoA Merrill Lynch data on the Treasury and TIPS markets shows that the face value of the US government bond market has increased by $5,251bn – almost two and a half times as much.
So the numbers suggest US QE has been a monetary sideshow, as does a study made by the Fed’s own specialists. The same is also true if we look at other possible transmission mechanisms which the study ignores, such as the weekly Fed data on loans and leases made by US commercial banks for example, which after a prolonged decline only exceeded their previous (2008) peak towards the middle of last month.
This is not to denigrate the Fed’s whole programme of unconventional policy measures. The purchase of mortgage-backed securities alongside government bonds for instance might well have helped repair bank balance sheets – as well as contribute to lower mortgage rates, and alongside the effect of initial emergency measures such as the Troubled Asset Relief Programme, the Federal takeover and capitalisation of Fannie Mae and Freddie Mac, etc. In fact the speed of the banking sector recovery in the US – as opposed to in Europe (including the UK) – has been one of the great relative strengths of the American economy. The Fed’s activities during the subprime crisis and its devastating aftermath are not to be sniffed at.
Nonetheless, some participants are betting that ending, or merely reducing, a programme whose actual monetary effects are likely to have been trivial will destabilise economic recovery in the US and across the globe.
This appears to betoken an unreasonably heightened level of concern.
The eagerly-anticipated arrival of Mr Mark Carney as new Governor of the Bank of England apparently produced its first real news this week. Presiding over the regular release of the Bank’s quarterly Inflation Report on Wednesday, Governor Carney announced that UK interest rates will not start going up until the ILO measure of unemployment falls to 7%. This measure has not moved much over the last four years, stuck around an average of 8%, so who is to say when this might happen? But not to worry: the condition is subject to three “knockouts”, which are in fact two. If inflation looks like it might be getting troublesome, then rates might go up. And if the financial system looks like it is imploding due to the low level of interest rates – how this might occur is yet to be clarified – then a change will also be considered.
This generated some coverage, though market reaction was understandably confused. The pound rose somewhat, trade weighted sterling bouncing back to about what it averaged in June. On the other hand stocks fell, with the FTSE 100 falling by 93 points on the day. Meanwhile, gilts bobbled around a bit before finally deciding to do nothing at all.
For the benefit of readers however, this blog can state that there is one new development of note: namely, that the supposed commitment to a 2% CPI target over a 2-year forecast horizon has been effectively abandoned. Its replacement is a supposed commitment to a 2.5% CPI target over a 1.5-2 year forecast horizon (“knockout” number one).
Nobody seems to have noticed this usurpation of the Exchequer but it doesn’t matter anyway. The Bank’s inflation forecasts have been garbage for years. They have consistently underestimated CPI over their forecast period in good times and bad while doing everything they can to drive it higher.
From the volume of comment in the business pages one might find this hard to believe. But it is August, they have to have something to write about and it is true: other than this one change nothing is different. The first paragraph of all the Inflation Reports since February 2004, when CPI took the limelight from RPIX, has read along these lines:
In order to maintain price stability, the Government has set the Bank’s Monetary Policy Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%. Subject to that, the MPC is also required to support the Government’s economic policy, including its objectives for growth and employment.
Mr Carney’s predecessor was explicitly prioritizing this supposedly secondary aim as far back as January 2011. The emphasis is not new. In fact even the soft target for unemployment is a poor show compared with targeting nominal GDP growth, as some had been hoping Carney would do.
In other words the Bank will carry on ignoring inflation and doing everything it can to push up activity and job numbers (beyond what it has already done: not much).
We must be fair to Mark Carney. As well as presiding over monetary policy he also has a firm to run, and has let it be known that he wants more women at the top of the Old Lady, with a view to one of them becoming Governor in the fullness of time. He is likely to be pre-empted in this ambition by the Fed if recent speculation is to be believed, but then they were the first ones to start linking monetary tightening to specific unemployment figures too so this cannot bother him.
In any event, his legacy is unlikely to be overshadowed by that of the newly-ennobled Mervyn King. All those years at the helm and the only prices he managed to contain were those of the sandwiches in the Bank’s canteen.
Whether Mr Carney manages any better on the inflationary front remains to be seen. The early signs are not encouraging.
The S&P 500 index has roared through 1700 for the first time ever. US GDP for Q2, expected to come in at 1.0% annualised, hit 1.7% on the advance estimate instead. Jobless claims reached a new five-year low. It is clear in some quarters that “the US is the engine of global recovery“.
Elsewhere, enthusiasm about the growth data in particular has been tempered. After all, the number for Q1 this year – which began life estimated at 2.5% and was later cut to 1.8% – was revised down further to 1.1%. And the figure for Q4 2012 was cut to an almost flat 0.1%. In fact, in real terms the American economy expanded by a rather torpid 1.4% over the full year from Q2 2012 to Q2 2013.
Which brings us on to the stock market. The S&P 500 is 25% higher than it was a year ago but reported earnings per share for the quarter so far (393 index members) are up by only 3.6%, and have actually fallen by 2% for non-financials. So over the last twelve months the p/e ratio has jumped back to its pre-recession level – about in line with the long run average for the index. US stocks are not yet expensive by this measure but they are no longer cheap.
This is not to knock the rally. There is a bigger gap between rhetoric and reality than there is between reality and market behaviour. Confidence and activity indicators are consistent with continued, solid growth, albeit at a sub-trend pace, and that’s always better than the alternative. There was a marked correction across equity markets in May-June, which slowed the pace a little, and there will doubtless be more volatility to come. It does not look as if there should be much reason to argue with a measured, patchy uptrend in the US stock market. That’s what’s happening to growth and earnings too.
It is instructive to compare the lie of the land this year with the immediate aftermath of the credit crunch. In 2009 confidence began to improve way before the Great Recession ended. It became clear that capital losses and writedowns in the banking system had peaked in Q4 2008, and that was enough for the S&P to return 50% over the year to 31 March 2010. It was not until the Greek crisis that the scale of contagion began to be more widely understood, and market confidence has still not fully recovered from the demeaning misery of having to absorb fixed income ephemera such as what a “Fitch” is and how one might go about swapping a credit default.
So US equity has shown about half the exuberance in price terms since last summer as it did over the 12 months from Q1 2009. Again, let us stress that this does not appear unreasonable. But back in ’09 of course it was not just a select group of developed-world stock markets that embraced the transformation in morale.
Over the same 12-month period – from Q1 ’09 to Q1 ’10 – the MSCI Emerging Markets index returned 82%. The yield on the ten year Treasury rose by 1.4%. The trade-weighted dollar fell by over 8%. Investment grade credit spreads in Europe fell by 95bp. Brent crude futures were up 68%, COMEX copper futures up 93%.
Much of this seemed absurd at the time, and in hindsight seems especially so. What is useful, perhaps, is to note what a really abandoned recovery in confidence looks like, and to compare these numbers and others with the very much more tentative present upturn.
The move in Treasuries has been similar, with the ten year yield up 1.2%. Compared to ’09, therefore, bond bearishness has outpaced stock market optimism. And that optimism has been much narrower: the MSCI EM equity index has returned only 4%. Credit markets have broadly kept in step with Treasuries, tightening by most but not all of what they managed back in 2009-10 (80bp so far). On the other hand oil has gone nowhere and base metals have fallen.
There are always risks and always fundamental changes to consider. So there were four years ago. What differentiates markets today is that they are less certain – more confused – than they were back then. If the confidence felt on Wall Street is justified, and if this confusion should diminish, there are a number of dots which need to be joined before the picture across asset classes looks composed once again.