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GLOBAL RISK - China Credit Risk Overshadows Outlook for Emerging Equities

China Credit Risk Overshadows Outlook for Emerging Equities 07-24-14 John-Paul Smith is a London-based emerging- market strategist at Deutsche Bank AG via Bloomberg Brief

China’s soaring debt and questions about the health of the Chinese economy have become a liability for the entire emerging-market asset class. China’s economic growth exerted a strong impact on the top lines of the emerging-market corporate universe and was the single biggest force behind the emerging-equities bull market during 2002 to 2007.

The dramatic oscillations in sentiment toward China are still a major driver of fund flows into and out of emerging equities. The overall lack of clarity surrounding the eventual outcome to the Chinese growth story has meant that the MSCI Emerging Markets Index has been locked in a trading range since the end of 2009.

During the five years through 2007, the MSCI China index rose close to 500 percent. With a plethora of initial public offerings, the index became the largest constituent of global emerging markets, currently at about 19 percent of the MSCI Emerging Markets Index compared with just over 6 percent at the start of 2002.

By 2007, the so-called “Beijing consensus” of state-directed growth had gained broad acceptance by policy makers and investors alike. Positive sentiment toward state capitalism reached its zenith when Chinese state-controlled banks led a massive monetary stimulus in late 2008. Within two and a half years, the ratio of bank credit-to-GDP rose to 175 percent from about 130 percent in 2008.

Commentators proclaimed that China had indeed saved the world from a prolonged slump. Unfortunately, these claims proved hubristic. The emphasis on state-led devel - opment across much of global emerging markets had come at the expense of pro - ductivity-enhancing reforms. This became clear in 2010 from an examination of the slump in the real rate of return on invested capital across the emerging-markets cor - porate universe.

The deterioration accelerated in the wake of the Chinese stimulus, and the obvious implication was that the macroeconomic forecasting community was far too optimistic about the medium-term rate of sustainable economic growth for emerging markets, including all of the BRIC nations.

In the four years since 2010, all four BRICs have undergone downgrades of growth by 300 to 400 percentage points. Meanwhile, the MSCI Emerging Markets benchmark has underperformed the MSCI U.S. index by 70 percent.

Economists and investors are now belatedly focusing on prospects for structural reforms to both sovereign and corporate governance. In China, Russia and Brazil there is a clear need to reduce the role of the state through deregulation, while the priority in India is to make the role of the state more effective.

China became the poster child for this reform process following the Communist Party’s third plenum in November 2013 and the flurry of policies announced in subsequent months. The difficulty lies in distinguishing rhetoric from real implementation. To date, there appears to be little attempt to enforce market-led disciplines over the priorities of central and local governments at the listed-company level.

China’s stock of credit has risen to higher than 200 percent of GDP. Since the over - whelming proportion remains internally financed, the consensus view is that it has not yet reached crisis levels, albeit potentially dangerous.

The beginnings of a debt trap are discernible in some key industrial sectors, which may have repercussions for the stability of the broader economy.

The exchange-listed material and industrial sectors have both been generating negative free cash flow for a number of years, and their overall leverage has now reached problematic levels. The majority of individual companies have responded by cutting back capital expenditures as a percentage of sales in order to conserve cash.

The unintended consequence of their collective actions has been further to weaken demand in the economy, so that many companies are faced with the prospect of even lower capacity utilization — the exact opposite of their intended result.

The result is a ‘stop-go’ policy cycle in the Chinese economy, which is unable to grow at a rate deemed acceptable by the government without ever more frequent stimulus programs. The situation is unlikely to be resolved until policy makers tackle the root causes of industrial overcapacity with comprehensive reforms, or until the funding mechanisms are exhausted.

Deutsche Bank sees a better-than-even chance that the emerging-markets index will eventually break out and decline, and hopes to be proved wrong by more decisive policy implementation from Beijing.

ECB - Euro-Area Data Deterioration Points Toward QE

Euro-Area Data Deterioration Points Toward QE 07-24-14 Bloomberg Brief

Recent data from the euro area suggest economic growth is decelerating. That increases the probability of large-scale quantitative easing for the monetary union.

• The latest PMI surveys indicate the recovery may be faltering. The composite reading for the euro area has declined for two consecutive months to 52.8 in June from a recent peak of 54 in April.
• The Now-Casting Index for the euro area, published by Now-Casting Economics Ltd., provides a similar signal. The figure declined to 94.2 in July from a recent peak of 98.7 in April.
• Industrial production data also signal that GDP growth failed to improve in the second quarter from the first. The seasonally-adjusted index for the euro area averaged 100.85 in April and May and 100.93 from January to March.

The faltering recovery will delay the closing of the euro area’s output gap. The level of real GDP is still 2.5 percent below its pre-crisis peak. The labor market also suggests spare capacity remains in the economy. The unemployment rate is 1.4 percentage points above the non-accelerating inflation rate of unemployment. The former stands at 11.6 percent. The Organisation for Economic Cooperation and Development estimates the latter to be 10.2 percent.

The spare capacity is likely to weigh on inflation. The headline number has dropped to 0.5 percent year over year from a recent peak of 3 percent in November 2011, and the core figure has declined to 0.8 percent from a recent high of 1.7 percent in July 2012. The institutional constraints of the European Central Bank tend to make its monetary policy more reactive than proactive. Frequently, an agreement among the members of the Governing Council remains elusive until the need to react is overwhelmingly obvious. The Governing Council would probably be forced to move if core inflation were to be clearly probing unchartered territory. The record low was registered in May at 0.7 percent. A decline to 0.5 percent would be difficult to ignore.

One of the euro area’s greatest monetary problems is the large divergence in real corporate borrowing rates.

For example, the spread between the real corporate borrowing rates in Portugal and Germany for loans over five years up to and including 1 million euros stood at 5.09 percentage points in May. The spreads versus Germany are 2.91 percentage points for Italy and 2.65 percentage points for Spain. Those spreads rise using the latest inflation figures, which are for June. They measure 5.39 percentage points for Portugal, 3.51 percentage points for Italy and 3.25 percentage points for Spain.

The spreads on loans of that category are among the highest. That may be because they are mostly provided to small and medium-sized corporations. Lowering real corporate borrowing costs is a two-pronged problem. The rate of inflation must rise and/or nominal interest rates must fall.

The first issue could be tackled through large-scale unsterilized purchases of government bonds. The second may require purchases of corporate loans, mostly likely in a securitized form.

The ECB has already announced an intention to make the second type of purchases. The central bank’s statement from the June meeting indicated that “further details of the initiative [to purchase asset-backed securities] will be announced in due course.”

The key to the success of the program will be the quantity of purchases. In turn, they will be based on the central bank’s ability to incentivize banks to expand the size of the market by securitizing additional loans.

Before the end of the year, the ECB is likely to provide hints on when it may start buying government bonds again, details on when it may start buying private debt and an indication of the size of both programs

RISK - US Financial Conditions Index Falls Below S&P 500 Index

The chart of the Financial Conditions Index shows it has declined 24 percent from its seven-year high on July 3.

DRIVER$ - The Euro is poised to continue its decline

The euro is poised to continue its decline versus the U.S. dollar as the currency pair

• Loses interest-rate support and
• The technical outlook deteriorates.

EUR/USD has been most highly correlated with its short-term interest rate differential among the variables of the cross-asset correlation matrices. The daily correlation for the last month stands at 0.55 between the first difference of the spread between the two-year swap rate for the euro area and that for the U.S., and the percentage change of the exchange rate. The figure for the last three months is 0.36. That spread yesterday hit its lowest level since August 2007. It has declined to mi- nus 36 basis points from five basis points at the start of the year. The move may continue as the European Central Bank is likely to ease monetary policy again.

Core inflation in the euro area stands at 0.8 percent year over year, only a tick above the record low of 0.7 percent reported for May.

The technical outlook also suggests further declines for EUR/USD.

• The currency pair on Friday closed below the 23.6 percent retracement level of the rally from the 2012 low to the 2014 high for the first time on a weekly basis.
• EUR/USD is also battling support at 1.3505 created by the trend line that extends from the 2012 low.
• Options pricing suggests sentiment toward EUR/USD is negative and has deteriorated during the last week.
• The one-month 25-delta risk reversal skew declined to minus 0.6 vol from minus 0.5 vol. That is 0.3 standard deviation below the one-year average.
• Positioning data send a similar message. Speculators increased their net-short position in the euro by 2,699 contracts to 64,341 contracts in the week ended July 15, according to the Commodity Futures Trading Commission. That was 2.1 standard deviations below the one-year average.
• The technical outlook may attract investors to the options market. For example, declines could be captured with a three- month EUR/USD put spread with the first strike at the money and the second at 1.3248, the 38.2 percent retracement level of the rally from the 2012 low to the 2014 high. The structure would cost 0.66 percent of the notional value of the trade, according to the Bloomberg Professional Service.
• Investors may also be attracted by the decline in the cost of options. Implied volatility of EUR/USD on one-month at- the-money options is 29 percent below the one-year average at 4.6 vols.

US HOUSING - Housing Starts

US GROWTH - America's Potential Growth Rate Is Barely Half What It Was 20 Years Ago

America's Potential Growth Rate Is Barely Half What It Was 20 Years Ago 07-20-14 Economist via BI

MONETARY POLICY - ECB v FEDERAL RESERVE

Real Shadow Policy Rate Shows Why Euro Has Been Resilient Versus U.S. Dollar

BLOOMBERG BRIEF: One of the major puzzles that FX analysts and traders have had to contend with in the past couple of years has been the surprising resiliency of the euro versus the U.S. dollar. Consensus forecasts have been calling for a steady weakening of the euro during the past two years, yet the euro has confounded the consensus by marching higher. This has forced the forecasting community to continually play catch-up and adjust their three-, six-, and 12-month forecasts accordingly.

On the surface, forecasters have had several good reasons to expect a steady weakening of the euro.

First, economic-growth expectations have been favoring the dollar versus the euro for some time. Euro area real GDP has been growing at or below a tepid 2 percent pace in each of the six years since the global financial crisis, and projections by private sector economists and the ECB are calling for growth rates of 1 to 1.8 percent for 2014-16. That would be nine consecutive years of sub-2 percent growth. In comparison, expectations are that U.S. real GDP growth will average upwards of 2.7 percent during the upcoming three years.

Second, the euro is estimated to be overvalued versus the U.S. dollar by around 15-16 percent on a purchasing power parity basis. While such an over - valuation reading is not overly excessive, it does suggest that the balance of risks should have been leaning in favor of a weaker euro, not a stronger one.

Third, on the interest-rate front, nominal yield spreads between the euro area and the U.S. at both the front and back ends have been moving in favor of the U.S., not the euro area during the past two years. The nominal 2-year yield spread has moved from a near zero reading to around 50 basis points in favor of the U.S., while the nominal 10-year yield spread has swung from a 30 to a 135 basis-point differential favoring the U.S. in the past two years. One would have expected such spread widening to favor the dollar versus the euro, but that failed to happen.

Why then has the euro proved to be so resilient?

One reason is that the trend in nominal yield spreads described above might not be fully capturing the degree of monetary-policy ease being pursued by the Fed relative to the ECB as policy rates in each of the economies reached the zero lower bound.

Two academics – Jing Cynthia Wu and Fan Dora Xia – have estimated “shadow” policy rates for the U.S. and euro area that capture the path the short-term policy rate would have taken, theoretically speaking, in response to central bank forward guidance and quantitative eas ing measures had those policy rates not been constrained by the zero lower bound ( http://faculty.chicagobooth.edu/jing.wu/ research/data/WX.html ). As shown in the chart above, Wu and Xia’s estimate of the Federal Reserve’s monetary policy stance – combining both conventional and unconventional measures – would have been about equivalent to a series of short-term policy rate cuts that would have pushed the Fed funds (shadow) rate down to around minus 3 percent if the Fed funds rate were free to move into nega tive territory.

The chart also suggests that the ECB’s policy stance has been far less accommodative – its shadow policy rate is shown to be presently hovering around zer percent, not all that different from today’s actual ECB policy rate. It should be evident that the nominal euro area-U.S. shadow policy rate spread has been following a far different path than the actual 2-year and 10-year spreads have taken. Looking at policy rates in real terms, the real shadow policy rate spread has moved even more in the euro’s favor in the past couple of years. This reflects the fact that the euro area inflation rate has fallen relative to the U.S. inflation rate. As shown in the chart (click to view chart), this suggests that much of the firmness in the euro’s value versus the dollar in recent years can be explained by the widening in the real shadow policy rate spread – a reflection of the (inappropriate) relatively tighter monetary policy stance being pursued by the ECB compared to the Fed. Looking ahead into the first half of 2015, a likely gradual move toward a less accommodative monetary policy by the Fed and the possibility of quantitative easing by the ECB could prove to be the catalyst for a trend reversal in the respec - tive shadow policy rates and thus in the euro’s fortunes.

US ANALYTICS - M&A Deal Activity

M&A heating up at elevated stock prices. What does history tell us about such a correlation? Its different this time?

PATTERNS - HY Credit Sending Clear Warnings of a Shift Underway

GLOBAL GROWTH - Few Are Paying Atttention to the Baltic Dry

What might the Baltic Dry tell us about a slowing Global Aggregate Demand Growth Rate? Few seem to care?

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BOE’s Carney Leads Push For Bail-Ins - China and Japan Against

Officials led by Mark Carney, the Bank of England governor, are attempting to bridge sharp differences among leading G20 countries as they prepare a landmark set of proposals aimed at tackling the problem of “too big to fail” banks according to the Financial Times today. Talks under the auspices of the global Financial Stability Board (FSB) over the summer are approaching a key stage as officials aim to clinch an agreement on bail-ins and the bailing in of creditors including depositors of banks.

The issue is of major consequence also to depositors who could see their savings confiscated as happened in Cyprus. Bail-ins are coming to banks in the western world with consequences for depositors. READ MORE

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The real danger comes if central banks try to use macropru as a semi-permanent way to keep interest rates lower than normal, as Mr Napier fears. In this case investors will face a double setback: they will not be treated as part of the “real economy” deserving of funds, while state-directed allocation of assets has a terrible history of supporting duds, hurting growth.

The Bank of England has been flashing an amber light for months about the complacency shown by low market volatility, but in house-price obsessed Britain, mortgage excess is the focus of its worry. Last month it became the first of the major central banks to set out to try to control credit using non-monetary tools: in the jargon, “macroprudential measures”. Ms Yellen has been highlighting macropru as the first line of defence against bubbles for a while.

The problem SEEMS simple central bankers. Central bankers want money to lubricate the real economy, not to flow into pointless leverage of existing assets. Higher rates could reduce the incentives to leverage, but at the cost of damage to the real economy. Their solution is to set up barriers inside the banks to direct the flow.

If central bankers ever get serious about using macropru to control bubbles, it will mean limits on more than just mortgages. The obvious place to start is with the froth in junk bonds and the leveraged loans used by private equity houses. It is interesting, therefore, that the Fed’s monetary policy report last week emphasised that the central bank is “working to enhance compliance” with leveraged loan underwriting and pricing standards. If it becomes harder for private equity groups to gear up, they can afford to pay less to buy companies, cutting back one source of demand for shares. READ MORE

It is no secret that unlike other banks who, while directly intervening in the bond market only manipulate equity prices in relative secrecy (usually via HFT-transacting intermediaries such as Citadel), the Bank of Japan has historically had no problem with buying equities outright, traditionally in the form of REITs and equity-tracking ETFs. Which explains why overnight it was revealed that in order to boost the stock market, pardon, economy, the Bank of Japan is preparing to purchase exchange-traded funds based on the JPX-Nikkei Index 400 as an "option to boost the impact of unprecedented easing," according to people familiar with BOJ discussions.

Bloomberg reports that including funds that track the index would broaden the range of shares in the BOJ’s ETF purchases, and encourage companies to deploy cash for investment. That is the official storyline. It goes without saying that what the BOJ is really after is to generate further upside in the Nikkei225 which unlike other stock markets, is still notably in the red, because not only will the primary impetus behind QE - the wealth effect of the 1% - suffer, but also all those new billions in Japanese pension funds reallocated away from bonds and into stocks will continue to lose money. And the last thing the Abe cabinet, its popularity already flailing needs, is the realization that it has gambled the retirement funds of the locals on the biggest Ponzi scheme in Japanese history. READ MORE