FLOWS: Liquidity, Credit and Debt

We have now strategically added

Richard Duncan's "Liquidity Gauge"

to MATA FLOWS

FLOWS - Global Deflation

THE GLOBAL DEFLATION THREAT

"Here’s the bottom line. You are going to hear a lot of talk about Fed tapering. And, sometime between now and March, the Fed will begin to reduce the amount of money it creates each month. This could cause the stock markets around the world to have a significant correction. My suggestion is to be prepared for a selloff, but don’t panic. There is a very big difference between tapering QE and ending QE. I believe the Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation."

Global Deflation is becoming an acute threat. Consequently, while the Fed may soon begin to “taper” the amount of money it creates each month, it is unlikely to stop printing money altogether any time soon.

Today, I will discuss how the risk of deflation will influence the Fed’s decision-making process over the next few years.

Chart 1 shows the Personal Consumption Expenditure Price Index (excluding Food & Energy), otherwise known as the Core PCE Index. It is the inflation index for the United States that the Fed monitors most closely.

In October 2013 (the most recent data available), the index was up only 1.1% compared with one year earlier. The rate of inflation has been lower than this during only eight months since records began in 1960. Moreover, as you can see in the chart, the recent trend is downward, suggesting the possibility of even more disinflation in the US during the months ahead.

Keep in mind that this weakness in US consumer prices is occurring even though the Fed is creating $85 billion a month and pumping it into the economy. I’ll come back to the US in a moment, but first consider Japan (Chart 2) and the Euro Area (Chart 3).

As you can see in Chart 2, consumer prices in Japan began falling in 1995. Since then, the country has experienced deflation during 12 out of the last 19 years. This year the Consumer Price Index (CPI) is expected to rise by 0.5%. However, the Japanese Central Bank is printing money much more aggressively than even the Fed. The US central bank is currently printing new money roughly equivalent to 6% of US GDP per year, while the Bank of Japan (BOJ) is printing something closer to 18% of Japan’s GDP. Given that scale of fiat money creation, it is very surprising that inflation in Japan is still barely positive.

Finally, consider the Euro Area, shown in Chart 3. The European Central Bank (ECB) is not creating fiat money through a program of Quantitative Easing, as are the Fed and the BOJ. But, in light of the pronounced downward trend in consumer price inflation during 2013, they have begun to consider it. The ECB’s key policy interest rate was cut from 0.5% to 0.25% in November; and ECB Governor Draghi has made it clear that the ECB has numerous policy tools it could employ, if necessary, to insure price stability.

Against this background of global disinflation, it is unlikely that the Fed will be able to stop printing money any time soon. Here’s why.

There are three kinds of inflation:

1. Consumer Price Inflation
2. Commodity Price Inflation; and
3. Asset Price Inflation

As we saw in Chart 1, consumer price inflation excluding food and energy in the US has rarely been lower than it is now.

Commodity prices are falling sharply. The high commodity prices of a few years ago have resulted in a surge of new supply for many types of commodities; and that new supply is driving prices down. The Jefferies CRB Commodity Price Index has dropped 25% since mid-2011.

Asset prices, on the other hand, are inflating sharply. The reason they are inflating is because the Fed is printing money and using it to acquire assets. The S&P 500 stock index is up 25% this year and US home prices have risen by 13% over the past 12 months. This increase in asset prices has driven up the “Net Worth” of the household sector by 11% over the past year to $77 trillion, creating a wealth effect that has allowed those Americans who own assets to spend more. Their spending has added to aggregate demand. Without the increase in aggregate demand brought about by QE and its impact on asset prices, the United States would most probably be experiencing deflation now.

If the Fed ends QE altogether, asset prices will fall and aggregate demand will fall. Then, the chances are high that consumer prices will fall as well. Falling prices make it very difficult for people and businesses to repay their debts. That increases the danger that the economy will spiral into a debt-deflation depression. Deflation is the Fed’s worst nightmare.

So, here’s the bottom line. You are going to hear a lot of talk about Fed tapering. And, sometime between now and March, the Fed will begin to reduce the amount of money it creates each month. This could cause the stock markets around the world to have a significant correction. My suggestion is to be prepared for a selloff, but don’t panic. There is a very big difference between tapering QE and ending QE. I believe the Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation.

The Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation.

Richard Duncan was a consultant to the IMF in Thailand during the Asian Crisis, worked for the World Bank in Washington and was head of Global Investment Strategy for ABN AMRO in London. Few in the world are better qualified to decipher Global Liquidity and Credit FLOWS than Richard Duncan.

MONETARY POLICY - Dollar, Currency & Gold Outlook

Merk 2014 Dollar, Currency & Gold Outlook 01-14-14 Axel Merk, Merk Investments

Nothing normal about U.S. monetary policy

During her confirmation hearings, incoming Fed Chair Janet Yellen testified that U.S. monetary policy is to revert towards more traditional monetary policy once the economy is back to normal. With due respect, in our assessment, that’s an oxymoron. In a “normal” economy capital is allocated according to the risk profile of the project under consideration. However, when the Fed actively distorts the price discovery mechanism with its QE programs, we believe it is impossible to move back to a normal economy.

Inflation promise?

The Fed has told the market in no uncertain terms that it is in no rush to raise rates. Outgoing Fed Chair Bernanke often argued one of the biggest policy mistakes during the Great Depression was to raise rates too early. Trouble is, removing stimulus might allow deflationary forces to take over once again, negating the “progress” that’s been made with cheap money. We interpret that to mean the Fed has all but promised to err on the side of inflation.

Yellen is said to favor a rules-based approach to setting policy rates. In theory, that’s laudable, except that Yellen in particular appears to prefer “rules” that heavily discount inflation indicators in favor of employment indicators.

Hawkish Fed? Do Pigs Fly?

There is a bewildering opinion shaping that a Yellen Fed will be hawkish, especially since former Bank of Israel (BoI) Governor Stanley Fischer has been nominated to become Vice Chair. Already rumors are creeping up that uber-hawk Tom Hoenig will join the team. Let’s get a few things straight:

• Stan Fischer has a mixed record on the “dove-hawk” scale. After the outbreak of the financial crisis, he raised rates in Israel before any major central bank did. But he also peddled back, lowering rates again in due course. That’s not being hawkish, but pragmatic. While Israel has worked hard to play in the big league of central banks, it’s still a small country and policy action there might shed little light on what Fischer will do at the Fed. More relevant to U.S. policy is that Fischer is no friend of “transparency” at any cost, having criticized the Fed for tying Fed policy to the calendar. His former student Bernanke got the message, denying on every occasion now that the course of tapering is pre-set.


• In our assessment, the real reason Janet Yellen wants Fischer to join her is to have a statesman back her up. The hawks at the Fed have increasingly been voicing their unease. Without Fischer, their gripes might have gotten a lot of attention. Should it get uncomfortable for Yellen, she counts on Fischer to have her back, taking the punch out of hawkish rhetoric. Should Fischer disagree with Yellen, we believe he’ll work things out with her behind the scenes.


• The 2013 Federal Reserve Open Market Committee (FOMC) may have been the most dovish on record. In 2014, we have two outspoken hawks voting again: Charles Plosser and Richard Fisher (hence Yellen asking Stanley Fischer to join). In recent days, there was even chatter that Tom Hoenig, who used to be a regional Fed President and outspoken hawk, would come back as a Fed Governor. The background here is the current FOMC lacks community banking experience; some community bankers have pushed for Hoenig’s nomination to become a Fed Governor. Unlike regional Fed Presidents, however, Fed Governors are nominated by the White House and confirmed by Congress. In our assessment, it’s unlikely an outspoken hawk will be nominated. Here’s what the 2014 FOMC looks like:
  

Taper? Anyone?

Let’s look across the border to get a better assessment of what all this taper talk is all about. Unlike the taper rhetoric, the practice has looked a little different. Please consider the change in central bank balance sheets across the biggest central banks:

• The European Central Bank (ECB) is the only one that has not only been tapering, but mopping up liquidity. It’s not so much that the ECB wants to play the tough guy on the block, but that Eurozone central banking is more demand driven: as banks clean up their balance sheets, they return liquidity received from the central bank. In a page A1 article in the Wall Street Journal at the beginning of the year, we received praise for our controversial call a year ago suggesting the euro might be the rock star of 2013; it turns out the euro was indeed the best performing major currency last year. We believe the euro will continue to benefit from risk friendly capital returning to the Eurozone. Capital that continues to flee weaker emerging market countries (remember those hot emerging market local debt funds?) is flirting with both peripheral Eurozone debt and equity markets. And while the ECB is not happy about the strong euro, we don’t think the central bank can engineer a weaker currency. This does not suggest problems are over in the Eurozone, but this year may prove once more that lackluster growth is not an impediment to a stronger currency. We have been quoted as giving a price target of 1.50 versus the dollar in 2014.


• On the chart above, the Bank of Japan (BoJ) has been the most prolific money printer over the past year (physical currency is not actually printed, but central bank action to increase the monetary base is colloquially referred to as the printing of money). It may come as no surprise that the yen was the worst performer last year amongst major currencies. The yen has drifted sideways of late as Prime Minister Abe’s policies have lost momentum. Unlike the past, however, we think Abe may aggressively double down, pursuing ever more expansionary fiscal policy. Meanwhile, the BoJ has recently ramped up its rhetoric on doing what is necessary to meet their 2% inflation goal. We don’t think it’s a surprise that Japan won the bid to host the 2020 Olympics, as the infrastructure investments needed are squarely in line with Abenomics. In that context, expect higher military expenditure as well. Our price target for the yen continues to be infinity, meaning we don’t see how the yen can survive this. That’s because the biggest threat facing Japan (the U.S. as well, by the way) is that economic growth actually materializes: good economic data might cause bonds to sell off, making it ever more difficult to finance government deficits; if so, we expect the Bank of Japan at some point to step in to lower the yield on Japanese Government bonds (JGBs); the valve, we expect, will be the currency.


• One reason why few analysts had predicted the euro to outperform others is because the common currency is historically often less volatile than other major currencies. But the euro had a lot of catching up to do. This year, we would not be surprised if the British pound were to outperform the euro given the tailwinds in the British economy. We also continue to see an adjustment in expectations at the Bank of England (BoE), as Governor Mark Carney is not as aggressive as had been expected by the market. Carney has not become a hawk, but won’t need to push the accelerator for now. At some point, structural weaknesses in the UK might take the upper hand again; that’s why we caution that this outperformance may only last for the first half of the year; we’ll keep a close eye on developments. On that note, if we look at a chart that compares central bank balance sheets since August 2008, we see that tapering (by the BoE in this case) means plateauing out at a high level:

While central bank balance sheets for the biggest countries have been indicative of currency moves, there are limits as to what these charts show. Notably, the Swedish central bank a few months ago, as well as the Reserve Bank of Australia just recently have shown a spike in the size of their balance sheets. These movements have less to do with monetary policy than to changes in regulations and payment systems, in part requiring higher cash reserves. While on the topic of Australia: the formerly beloved commodity currency took a beating last year. While pessimism reigned in Australia, New Zealand was on a tear. In fact, the Reserve Bank of New Zealand is expected to raise rates a couple of times this year. Historically, both of these currencies are highly correlated to one another. Based on fundamentals, the New Zealand dollar should do great and continue to beat the Australian dollar. However, New Zealand isn’t exactly the biggest country and its currency can be notoriously volatile. So while things look good, that provides no assurance the currency will actually do well. At some point, good economic indicators coming out of China may well push up the Australian dollar and cause substantial profit-taking in the New Zealand dollar.

Norway & Sweden

Throughout 2013, we became increasingly cautious about Norway. From a dovish central bank concerned about a strong currency to an increasingly populist government, we became rather disillusioned with the prospects. That, in turn, left the Swedish krona as the Nordic currency of choice. Sweden is likely to cut rates once more this year, although that action is mostly priced in. Being a smaller country, policy shifts tend to be more dynamic.

Canada

Oh Loonie! Once dovish Mark Carney left the Bank of Canada, we – like many in the markets – thought his hawkish deputy Tiff Macklem would succeed him. Not only did he not succeed him, he is calling it quits. Aside from losing hawkish intellectual leadership, the Bank of Canada has had, to put it mildly, fostered a benign neglect of its currency. The key risk we see with our cautious outlook for the Loonie is that we are not alone in that view.

Emerging Markets

Emerging markets tend to be less liquid than developed markets. Last spring showed this matters: when volatility spikes because of uncertainty over the future course at the Fed, the previously perceived free lunch in capturing yield with low volatility in emerging market local debt markets causes stomach cramps. Not only will we likely have local disturbances with numerous elections coming up in emerging markets, but we think the heavy hand of policy makers in major economies may well persist. Most vulnerable in this context are the weaker EM countries – those with current account deficits. The notably exception here is India, where Reserve Bank Governor Raghuram Rajan has introduced major reforms since taking the helm last September. While Indian reforms always suffer from implementation risk, the Indian rupee has a lot of catching up to do. Conversely, however, even as Brazil may yet again raise rates, Brazil lacks a credible inflation fighting strategy.

China

China is moving ever closer towards opening up its capital account. This may well be the year where China reduces its U.S. Treasury purchases in a meaningful way and paves the way for market forces to play a greater role in setting exchange rates. For those with doubts about China’s commitment, please read this interview with Yi Gang, Deputy Governor of the People’s Bank of China, as well as administrator of SAFE, China’s foreign exchange regulator. In our assessment, little can stop the rise of the Chinese yuan as a major currency in the coming years. The creation of a major currency takes more than a free float, but China is fostering all the other necessary elements.

Gold

The biggest risk for 2014 may be economic growth. That’s because economic growth throws a wrench into the bond market, making it ever more difficult for developed countries to finance their deficits. We believe it’s very unlikely the U.S. could afford significantly positive real interest rates for an extended period. As indicated earlier, theFed may have all but promised to be “behind the curve” in raising rates.

Even if the Fed wanted to raise rates, the stockpile of excess reserves accumulated from QE means that they will have to rely on new tools that require them to pay increasing amounts of interest directly to financial institutions. The potential political backlash of these new rate-setting tools may make it more difficult to mop up liquidity. Meanwhile, if economic growth and demand for loanable funds comes back, the banking system could pyramid those excess reserves into new loans that could dramatically increase the money supply and stoke inflation. The Fed may need to rely on capital adequacy ratios to contain bank balance sheet expansion, but it should be easy for banks to raise more capital in a good economic environment.

It’s in this context that the future may look bright for the shiny metal. Importantly, even with the price decline in 2013, gold played its role as a diversifier. The time to rebalance an equity portfolio is when times are good. We are not suggesting all this rebalancing should necessarily go into gold, but we are not convinced the bond market is the right place either. As our readers may well know, we think that the currency markets may provide opportunities that offer diversification.

SHADOW BANKING - Safe Harbor Privileges

The roots of shadow banking 01-16-14 Enrico Perotti

VALUATIONS - Gap between price inflation and unit labor cost inflation Drives Profits

The Most Important Driver Of Profit Margins 10-30-13 BI

One of the hottest debates among experts covering the markets and the economy is over the sustainability of record high profit margins.

Goldman Sachs' Jan Hatzius offered his forecast for margins in his "10 Questions for 2014" note.

"Will profit margins contract?" asked Hatzius. "No."

"As shown in Exhibit 10,

"The most important driver of profit margins is the gap between price inflation and unit labor cost inflation. When prices grow faster than unit labor costs, firms typically manage to raise their profit margins, and vice versa. In our view, the price/ULC gap is likely to move back into slightly positive territory in 2014."

Hatzius expects wage growth to stay low at least in the near-term.

"[T]he underlying trend calculated from the three primary measures of hourly wages—average hourly earnings, the employment cost index, and compensation per hour—is still only growing 2%," added Hatzius. "Going forward, we expect only a modest acceleration to perhaps 2.5%. Meanwhile, we expect productivity growth to reaccelerate to 1.5%-2%. Together, these numbers imply unit labor cost growth of 0.5%-1%, which would be slightly below the rate of price inflation of 1%-1.5%."

Labor market slack is one of the main reasons why economists believe inflation will stay low for a while. But getting back to profit margin dynamics, we know that wage growth is only part of the story.

"Of course, the price/ULC gap is not the only driver of margins," continued Hatzius. "But other factors are also likely to look reasonably friendly.

We expect foreign profits to improve in 2014 as the global economy gathers some momentum, and see no major changes in corporate income taxes or financial profits."

VALUATIONS - Historically Elevated Margins

Corporate profit margins are at all-time highs. The stock market's bulls and bears are willing to agree with this fact. But that's about it.

The bears are convinced that margins are doomed to mean revert. Among other things, they note that companies are no longer able to squeeze further productivity out of their workforces. They also warn that rising interest rates mean higher interest expenses.

The bulls will acknowledge that margins are at risk of pulling back especially if revenues fall or if the economy goes into recession.  But for now, they don't see much giveback. Furthermore, they believe that margins are in a structural upswing as companies have slashed their exposures to debt and increased their exposures to low-cost, high margin overseas regions.

Blackstone's Byron Wien thinks this is a crucial story.

In fact, when Business Insider asked Wien for what he considered to be the most important chart of the year, he sent us a chart of historical profit margins on the S&P 500.

"This chart worries me," said Wien. "Profit margins are at a peak and they appear to be rolling over. This could mean trouble for 2014 earnings."

Blackstone, WisdomTree

VALUATIONS-

JEFF SAUT: I Don't Buy The Profit Margin Compression Argument, I Think The S&P 500 Can Go To 2,000 01-04-14 BI

"Year-end letters are difficult to write because there is always a tendency to discuss the year gone by or, worse, attempt to forecast the coming year," said Raymond James' Jeff Saut earlier this week. But perhaps begrudgingly, Saut offered his forecast anyway.

He warms into it by first reminding us of the various psychological hurdles in recent years:

Speaking to the news backdrop, consider this. For the past two years the markets have been confronted with numerous issues.

• The debt downgrade,
• The fiscal cliff,
• The sequester,
• The government shutdown,
• Dodd-Frank,
• Rumors China would implode,
• The call that interest rates would skyrocket,
• Europe’s debt crisis,
• A potential U.S. debt default,
• Fukushima,
• The Arab Spring,
• Iran,
• North Korea,
• Iran,
• Egypt,
• Syria, etc.,

... yet the equity markets traded higher. In contrast, except for Obamacare, this year could be relatively, news-wise, trouble free. Moreover,

• Bond yields have already risen and are unlikely to move much higher in the short/intermediate term,
• Tapering has been announced,
• GDP and earnings guidance has been raised,
• There is more political cooperation (budget deal, Yellen, WTO deal, EU bank accord, bailouts over, Mexico reform, etc.),
• The American Industrial Renaissance is alive and well,
• Our oil independence is almost assured, and
• The central banks remain accommodative.

To this accommodative point, it has been proven that quantitative easing lifts stock prices; and despite the taper announcement, the Fed’s balance sheet should still expand by some $435 billion in the new year (front-end loaded).

...there has been a very tight correlation (R2) between the expansion of the Fed’s balance sheet and stock prices since 2009.

If the Fed expands its balance sheet by another 12% over the coming year, it is conceivable the SPX could increase by another 12%. That would also be consistent with the S&P’s bottom-up, operating, earnings estimate increase of ~13% year-over-year ($122.11e vs. $107.40e).

And it's not just about Fed balance sheet expansion. Saut sees plenty of bullish fundamentals driving stocks higher.

Plainly, the U.S. macro uncertainty is falling with the budget deficit falling to a six-year low. That glide path should extend into 2014 with the CBO projecting a further drop in 2015 to a deficit of only 2.1% of GDP. Accordingly, I think a lot of things could indeed go right in 2014. The slowdown in housing, due to the increase in mortgage rates, should reverse now that mortgage rates have stabilized. A recent data point would be Lennar’s (LEN/$39.55/Strong Buy) admission – best month of the quarter was November in terms of sales and pricing. The capital equipment cycle (cap ex) should strengthen in 2014. In talks with companies’ senior management teams, they are telling me “We have put off investments in cap ex as long as we can because ‘things’ are just plain wearing out.” Furthermore, credit conditions are improving, loan demand is slowly picking up, M&A activity is increasing, dividends and buybacks are on the rise, profits are decent, inflation is contained, money is rotating out of most bond funds and (at the margin) into equity funds (given the amount of money that has flowed into bonds since 2008, this rotation has a lot further to go), the bad performance figures for 2008 are about to disappear from asset managers’ five-year track records, and the list goes on. All of this should make for interesting discussions in the new year when financial advisors meet with their clients to talk about future asset allocations. Unsurprisingly, most investors remain underinvested in equities...

Saut thinks it's possible we go straight up without a meaningful sell-off for a while.

As we begin 2014, I think the rally extends without much of a pullback. In fact, my sense is we could travel into the 1900 – 2000 zone on the SPX before succumbing to any meaningful correction. Right now the inflation-adjusted all-time high for the SPX is around 2060, but I doubt if we can make it there before getting some kind of “hiccup.”

Currently, the SPX is better by 31.3% YTD and up about 40% from the June 2012 low without any meaningful correction. The historical median drawdown following such a rally is between 6% and 7% over the next three months and between 10% and 12% sometime during the next 12 months.

And since it's one of the hottest debates in the market these days, Saut offered his position on record high profit margins.

Price/Earnings (P/E) multiple expansion has contributed heavily to the upward path of the equity markets over the past few years and there has been a lot written about that. In 2014 it is doubtful P/Es will expand very much because of the tapering announcement and fears interest rates will rise. Yet even if the SPX just trades at its current P/E multiple (17x), it suggests an SPX price target of 2076 by the end of 2014 if the earnings estimates are anywhere close to the mark. Of course that brings about cries that elevated profit margins cannot remain where they are, and therefore must revert to their historic mean hurting earnings, an argument from the negative nabobs we have heard since 2010; and I just don’t believe it.

• Many companies are moving their IT needs to the “cloud,” which saves a huge amount of money permitting margins to stay wide.
• Then there is the change in the composition of goods produced in this country that has moved from low margined goods to higher margined goods like jet engines.
• Or, how about the accounting term “income from affiliates,” which means a parent company has a minority stake in another company that brings in income but doesn’t record revenues associated with that stake, suggesting 100% margins.

So, no, I do not buy the margin compression in 2014 argument.

So overall, he's bullish

GLOBAL IMBALANCES - The Real Source of the Financial Crisis

The flows that mattered (Regarding the Financial Crisis) were not the net flows of capital from the rest of the world that financed America’s current-account deficit. Rather, they were the gross flows of finance from the US to Europe that allowed European banks to leverage their balance sheets, and the large, matching flows of money from European banks into toxic US subprime-linked securities. Both critics and defenders of global imbalances almost entirely overlooked these gross flows in both directions across the North Atlantic.

A Requiem for Global Imbalances 01-13-14 Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International