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FLOWS - Liquidity, Credit & Debt

GROWING UNALLOCATED - SHRINKING US$

GLOBAL RISK - Mispricing of Risk Reaching Extremes

JAPAN - Pace of 60 to 70 trillion yen a year May Become "Open Ended"

Japan’s Economists Unconvinced by the Bank of Japan’s Optimism 08-25-14 Bloomberg

A recent trip to Tokyo revealed pessimism among market economists on Japan’s prospects. At the top of the list of concerns was the extent of weakness evident in the second quarter GDP data.

A backlash following the April increase in the consumption tax was expected. The extent of the downturn came as a surprise, and pointed to lack of resilience in the economy. Netting out the contribution from inventory, second quarter GDP contracted at an annualized rate of 10.7 percent. That’s the worst result since the start of the financial crisis in the final quarter of 2008.

It’s also considerably larger than a 6.7 percent contraction in the second quarter of 1997 — the last time Japan’s consumption tax was increased.

The impact of the tax increase might not be limited to the second quarter. Higher consumer prices and limited gains in salaries mean growth in real incomes is now deeply negative. Real disposable income fell minus 8 percent year on year in June, the largest drop in the 10-year history of the series. Falling real incomes will deal a sustained blow to consumption.

The Bank of Japan maintains that core CPI will edge down toward 1 percent year on year over the summer from the current level of 1.3 percent. From there, it expects upward pressure from rising wages to start pushing CPI up toward the 2 percent target starting in the fourth quarter.

Most economists we spoke with were unconvinced. They thought core CPI would edge down to 1 percent or below, and then hold steady at that new low level. That reflected pessimism about the outlook for wages.

The hope is that elevated inflation expectations and stronger corporate profits mean workers will demand higher wages and firms will have funds to pay for them. The alternative view is that inflation expectations are already starting to moderate and firms see higher profits as a windfall from 2013’s weak yen, not a structural improvement that can be passed on in increased pay.

If inflation is set to head off track, what will the response from the BOJ be? The most plausible view is that the central bank will make its current policy of increasing the monetary base at a pace of 60 to 70 trillion yen a year open ended, rather than commit to buy more.That reflects the physical limits of Japan’s government bond market.

With the BOJ already snapping up more each month than the Ministry of Finance is issuing, there just isn’t much more left to buy.

The mood was not entirely negative. One government adviser argued that the BOJ’s strategy remained firmly on track. Everyone agreed that higher rates in the U.S., triggering a renewed round of yen weakness, would make the picture more positive.

Sitting in the departure lounge of Haneda Airport though, my impression is that risks to Japan’s outlook are distinctly on the downside

JAPAN - Pressures on Exports

The Mystery of Japan’s Amazing Shrinking Exports 08-12-14 Bloomberg

The yen is down close to 25 percent from highs at the end of 2012. So why are Japan’s exports falling?

A large part of Japan’s manufacturing base has shifted overseas. Reacting to higher production costs at home and an overvalued yen, firms spent much of the past decade building factories elsewhere in Asia.

Sony makes batteries in Singapore, televisions in Malaysia and mobile phones in China. Toyota has 51 production bases in 21 countries. Foreign production means insulation from a rising yen, and reduced benefit from a falling yen.

Japan’s firms, once unassailable titans of advanced manufacturing, now face intense competition.

ELECTRONICS

In 2001, Sony’s $66 billion in revenue was double that of Samsung and 10 times Apple. Fast forward to 2013 and Sony’s failure to keep pace with the world of smart phones and tablets has pushed it into a distant third place.

AUTOMOTIVE

In automotive, since 2006, Toyota and Honda have seen their global market share fall from 17 percent and 7 percent to 13 percent and 4 percent, respectively. Korea’s Hyundai and China’s SAIC have seen their share grow.

EMERGING MARKET DEPENDENCY

The shifting pattern of Japan’s trade is also a factor. Ten years ago, 22 percent of Japan’s exports went to the U.S. and the BRICS accounted for 15 percent. Now, that order has been reversed. In general, closer trade links to faster growing emerging markets are a positive. At the same time, it also means Japan now suffers more from the current slowdown in emerging markets and benefits less from the pick-up in the U.S.

CHINA

Frosty relations with regional rival China have also not helped. Japan’s share of China’s total imports is on a long-term declining trend. That has been accelerated by an escalating territorial dispute and a revival of historical animosity.

Angry Chinese mobs smashing Japanese branded goods are not good advertising. Japan’s share of China’s total imports fell from 10 percent to 8 percent in three months at the end of 2012. It has not recovered since.

In an economy where exports equal 16 percent of total output those structural challenges are bad news.

With energy imports rising as a result of the post-Fukushima nuclear shutdown net exports have been a drag on GDP for the last three quarters.

Recent research by the International Monetary Fund suggests the boosts to exports from a weaker yen can take up to 18 months to materialize. By that calculation the acceleration should start right about now.

If the shift to overseas production, intensified competition, and regional tensions keep overseas sales stuck in reverse gear, Japan’s recovery could also stall

GERMANY -Draghi signaled additional monetary easing is likely to materialize - Possibly by September

German Ifo Survey Decline Adds to Indications of ECB’s Need for QE

The German Ifo survey released this morning suggests that gross domestic product growth in the monetary union will continue to weaken through the start of next year.

That raises the prospect of additional monetary easing from the European Central Bank, especially after the dovish speech by President Mario Draghi on Friday at the Jackson Hole conference.

Draghi signaled additional monetary easing is likely to materialize. He even hinted that action may be announced as soon as the meeting in September.

The Ifo expectations component fell to 101.7 in August from 103.4 in July and a recent peak of 108.8 in January, data released this morning showed. That was below the median forecast of 102.1 of the economists surveyed by Bloomberg. The quarterly average of the expectations component of the Ifo survey tends to lead the year-over-year rate of change of euro-area GDP by three to six months. When the publishing lag is included, the lead is about four to seven months.

That development is consistent with the signal from the German ZEW survey. Its expectations component plunged to 8.6 in August from 27.1 in July and a recent peak of 62 in December. The quarterly average of the expectations component of the ZEW survey is most-highly correlated with year-over-year euro-area GDP with a lead of three quarters.

The current assessment of the Ifo survey fell to 111.1 in August from 112.9 in July. The figure recently peaked in April at 115.3. That component is a coincident indicator. The headline figure of the Ifo survey — the business climate reading — declined to 106.3 from 108. That number is the geometric mean of the figures for the current assessment and expectations.

Draghi indicated that the monetary authorities should act to stimulate additional demand. He said, “We need action [to reduce unemployment] on both side of the economy: aggregate demand policies have to accompanied by national structural policies.”

He clarified that previously-announced measures from the ECB may be insufficient. He added, “I am confident that the package of measures we announced will indeed provide the intended boost to demand, and we stand ready to adjust our policy stance further.”

The catalyst for the increased dovish- ness seems to have been the recent decline in inflation expectations. Draghi highlighted: “Over the month of August financial markets have indicated that inflation expectations exhibited significant declines at all horizons. The five-year/ five-year swap rate declined by 15 basis points to just below 2 percent — this is the metric that we usually use for defining medium term inflation.”

EU - Warnings of Euro-Area Downturn Strengthen ECB’s QE Case

Early Warnings of Euro-Area Downturn Strengthen ECB’s QE Case 08-13-14 Bloomberg

Several leading indicators suggest the euro-area economy will continue to experience weak growth through the third quarter and beyond. The proponents of quantitative easing at the European Central Bank will probably find it easier to argue in the months ahead for additional monetary stimulus.

FRANCE

The business sentiment indicator from the Banque de France suggests the monetary union’s second-largest economy is stagnating in the third quarter.

It fell to 96 in July from 97 in June. That compares with an average of 96.9 for the second quarter, 98.5 for the first and a recent peak of 100.4 in November. The business sentiment survey is a coincident indicator of French economic growth.

The quarterly average of the survey is most-highly correlated with quarter-over-quarter gross domestic product growth for the same period.

GERMANY

The German Ifo survey has signaled a deceleration of growth in the second half of the year for the euro-area economy relative to the first. The expectations component dropped to 103.4 in July from 104.8 in June and a recent peak of 108.8 in January. The figure for this month will be reported on Aug. 25. The quarterly average of the expectations component of the Ifo survey tends to lead the year-over-year rate of change of euro-area GDP by three to six months. When the publishing lag is included, the lead is about four to seven months.

The German ZEW survey points to the deceleration of euro-area economic growth carrying into next year. The expectations component sank to 8.6 in August from 27.1 in July. August marked the eighth consecutive month of decline. The time series recently peaked in December at 62. The quarterly average of the expectations component is most-highly correlated with year-over-year euro-area GDP with a lead of three quarters.

M1 MONEY SUPPLY

Euro-area real M1 money-supply growth paints a similar picture. The year-over-year figure stood at 4.9 percent in June. That compares with a recent peak of 7.3 percent in April 2013. Real M1 money supply growth is the indicator of economic growth that provides the longest lead. It leads GDP growth by about four quarters. The figure may be closely related to overall economic expansion because it is composed primarily of funds that can be accessed quickly by businesses and consumers for spending. It mostly includes cash, and assets that can be converted easily into cash such as demand deposits.

By contrast, the PMI surveys point to an acceleration of growth in the third quarter. The composite reading for the euro area of 53.8 in July was above the second- and first-quarter averages of 53.4 and 53.1, respectively.

The Governing Council will find less comfort in the inflation component of that survey. The figure on output prices from the composite survey has been below 50 since April 2012. Euro-area GDP growth for the second quarter will be reported tomorrow.

The median estimate of economists surveyed by Bloomberg stands at 0.1 percent quarter over quarter. That has drifted down from the 0.3 percent that appeared in the last monthly survey published on July 14, with responses collected from July 4 to July 10. The same survey revealed a figure of 0.3 percent for the third and fourth quar- ters. Recent data suggests those fore- casts will be revised down as well.

The ECB may also have to lower its growth forecast for 2014. It stands at 1 percent.

Expansions of 0.1 percent in the second, third and fourth quarters would still only produce an annual figure of 0.7 percent. The central bank’s updated forecasts will be released next month.

In turn, that is likely to force the ECB to lower at least one of its inflation estimates for the period through 2016. The revision would enable the doves in Frankfurt to enlist more support.

CHINA - Yuan Falls As Economy Weakens

CHINA - Yuan Has Diverged From its Market Basket

China’s Yuan — Getting Back in the Basket 08-19-14 Bloomberg Brief

The yuan has been drifting away from a trade-weighted currency basket since the 2008 global financial crisis. Chinese authorities’ political preference for comparative strength in trend versus key trade-partner currencies is apparent in the yuan’s performance against a basket modeled by Bloomberg Economics.

U.S. Federal Reserve policy and the yuan’s approach to fair value are both factors in weighing its future course. The yuan clung close to the currency basket in the three years starting from the Chinese central bank’s 2005 announcement of a revaluation of the currency through to the outbreak of the global financial crisis in 2008. From that point on, China’s yuan decoupled from the reference basket and continued to diverge even after the currency resumed appreciation in July 2010.

Had it followed the basket in the last four years, the Chinese currency would have gone up to 7.70 per dollar, according to Bloomberg estimates. That’s 20 percent lower than the current 6.16 per dollar.

More importantly, there is little co-movement between the yuan’s exchange rate and its projected course had it adhered to the currency basket. Following a currency basket in the wake of the 2008 crisis would have forced the yuan to depreciate against the dollar. This would have been politically unacceptable for China’s main trading partners and would have risked turmoil in global markets. As a result, policy makers halted ties to the currency basket, and the yuan rose. Now approaching its fair value, China’s currency may move in either direction.

The diminishing one-way pressure for the yuan to appreciate makes a case for Chinese policy makers to revisit the currency basket. A major obstacle, however, is the further strengthening of the U.S. dollar following the normalization of the Federal Reserve’s benchmark interest rate.

Bloomberg Economics’ trade-weighted currency basket model comprises the currencies mentioned in the PBOC’s August 2005 statement. The PBOC reference basket consists of primarily the U.S. dollar, euro, Japanese yen and Korean won. It also adds the Singapore dollar, British pound, Malaysian ringgit, Russian ruble, Australian dollar, Thai baht and Canadian dollar. In addition to these currencies, Bloomberg’s model incorporates the Indian rupee, Brazilian real, Mexican peso and Saudi Arabian riyal because of their growing weights in China’s external trade.

As China’s yuan gains global prominence, its relationship to a currency basket becomes increasingly important.

From the perspective of the yuan’s marketization, the basket is a key pillar for a managed floating currency regime. For investors, the basket may also predict the yuan’s moves. Thus a representative currency basket is likely to play a bigger role in both policy makers’ and analysts’ future determinations.

CHINA - The Emerging Threat of the "Post-China 16" Countries

As a maturing China moves beyond the low-end manufacturing and export-led model that defined its dramatic three-decade rise, a new group of countries is emerging to assume that role in the global economy. The outlines of this group, what we call the Post-China 16, or "PC16," are only now coming into focus. Indeed, the specific countries may change and the precise roles they play in this transition -- their success in following the path China has trod -- remain to be fully seen. Even though the movement of two indicator industries -- garment manufacturer and mobile telephone assembly -- signals change, this is a transition that is as yet pre-statistical; few if any reliable trade numbers or volumes now exist to plot the contours of this shift. But it is, Stratfor has concluded, a shift that is already well underway.

ASEAN COMMON MARKET - Second largest economy in emerging Asia, behind China

A NEW COMMON MARKET - ASEAN

The Association of Southeast Asian Nations consists of 10 members:

• Brunei,
• Cambodia,
• Indonesia,
• Lao PDR,
• Malaysia,
• Myanmar,
• Philippines,
• Singapore,
• Thailand,
• Vietnam.

The integration of Asean, due next year, may take longer than planned. Even if more protracted, the journey to a common market will provide incremental benefits along the way — not just at the destination.

Though the poorest members have the highest hurdles to clear, this is where the payoff of regional integration may be the greatest. Asean has set 2015 as the target date for regional economic integration, including a single market and production base allowing for the free movement of goods, services, investment, skilled labor and the freer flow of capital.

In February, Asean senior officials signaled that development gaps — especially in Cambodia, Myanmar, Lao PDR and Vietnam — may hinder plans for the creation of an Asean Economic Community. A formal mid-term review of the integration progress, due in May, has not been made public. Together, the members of Asean now have the second largest economy in emerging Asia, behind China.

The bloc’s average per capita income surpasses China’s and economic growth in many Asean members already rivals that of their northern neighbor.

Integration will further boost incomes and growth potential in an area of 625 million inhabitants. More streamlined rules and regulations will reduce costs and increase the competitiveness of firms doing business across the region. More transparent and harmonized investment standards and procedures will attract both foreign and intra-Asean investment. Fewer impediments to cross-border investment will, in turn, support the funding of regional infrastructure projects, including an integrated transport network.

EU COMPARISONS

All of this stacks up to higher profit margins, tax revenues and growth in the broader economy. Europe’s experience with economic integration provides a benchmark on what Asean members might expect.

• Real GDP growth in the three years after joining the EU was 1.7 percentage points higher on average than in the three years prior to membership for those countries joining the EU since 1995.
• Over the same period, investment as a share of GDP rose 3.2 percentage points and
• GDP per capita, an indicator of wealth, rose 32.5 percent on average.
• The increase in average income after inflation ranged from a low of 9.4 percent in Malta to a high of 79.9 percent in Latvia.

With Asean’s economic union in an earlier stage of development compared to Europe’s, gains from integration as the difficult work of integration takes place are more piecemeal, more difficult to measure and harder to appreciate. Nevertheless, the benefits are accumulating.

GLOBAL EQUITIES - Up 145% Since 2009 Lows

The value of global equities has hit a record $66.158 trillion

The value of equities globally has soared from $27 trillion in February 2009.

Stocks were valued at $62.572 trillion at the 2007 peak.

The S&P 500 closed at a record 2000.12.

RISK - Exhaustion Signal

RISK - Computer Generated Elliott Wave Counts Indicate Minimally an Intermediate Top

See TRIGGER$ - September Edition to be Released This Weekend

RISK - Relationship Between Risk & Return

SEE SUPPORTING RESEARCH BELOW

VALUATION - Metrics suggest cause for Concern, not Complacency

Is the U.S. equity market overvalued? Fed Chair Janet Yellen’s recent congressional testimony included a report suggesting aggregate valuations of stocks (aside from a few sectors) are:

“roughly in line with historical norms.”

A varied suite of metrics provides limited affirmation on that score.

These suggest aggregate valuations are elevated though not extreme. More concerning, those metrics that incorporate longer-term growth prospects for U.S. firms are the most elevated, and several have approached levels last seen during the dot-com bubble.

In this quick tour of a few valuation tools, it is important to note that for each measure, there are multiple versions and secondly, the numerator and denominator change over decades in ways that reduce comparability across eras. Given these complications, comparing the results across various valuation methods can be useful, as is common in investment banking analyses of individual firms.

PE

Looking at a traditional price-to-EPS (earnings per share) ratio provides initial reason to take comfort. Currently, the 12-month trailing P/E for the S&P 500 is about 40 percent lower than its all-time peak in late 1999 and about 5 to 10 percent above its average since 1954; a chart of the 12-month forward P/E tracks the backward-looking measure relatively closely.

PEG

Other ratios, though, appear less benign, as the table demonstrates (with “heat map” coloring for levels of concern). The widely varying results testify to the difficulty of estimating fair value. For instance, a chart of the Zacks Research System PEG ratio (ratio of P/E to 3-5 year EPS growth rate) for its S&P 500 ETF Composite looks significantly less encouraging than current P/E ratios.

The PEG ratio goes beyond the P/E by incorporating longer-term EPS growth assumptions. In this case, with the Zacks survey current consensus of 10 percent growth as the PEG denominator, the ratio shows that analyst expectations of lower EPS growth relative to past years have been undermining the rationale for the recent run-up in stock prices.

CAPE

The academically designed Shiller Cyclically-Adjusted P/E (CAPE) ratio assumes that EPS multiples will revert to long-run averages and that the key adjustment to make is for inflation’s effects on both stock prices and reported earnings. The Shiller CAPE ratio is well above its long-run average and this week its creator Bob Shiller said it is

“hovering at a worrisome level.”

That said, it is still well below its levels during the dot-com bubble.

TOBIN'S Q

A different approach is to dispense with earnings themselves and instead compare market value to corporate assets, a presumptive source of earnings. For instance, Tobin’s q compares equity market value to the replacement cost of firm capital (which we calculate using nonfinancial corporate net worth from the Federal Reserve’s Flow of Funds data).

This ratio is now at its highest level since 2000, about halfway between the extremes of the dot. com bubble and the mid-2000s, or close to its mid-1990s levels. It remains an open question how much technological innovations in e-commerce and other industries have reduced the asset intensity and increased asset longevity, thus shrinking the denominator of Tobin’s q.

STRAIN GAUGE

Another way to frame “the nexus between financial markets and markets for goods and services” (as economists Tobin and Brainard once put it) is what one co- author (Barnier) calls the “strain gauge.”

Like Tobin’s q and trailing P/E ratios, it is backward-looking, but it focuses on sales, setting aside changes in asset and industry composition trends over time. In its inclusiveness, this ratio raises more concern of frothy equity values. While this macroeconomic strain gauge provides a view of U.S. equity market values compared specifically with the U.S. corporate contribution to GDP, it ignores the full value of U.S.-based companies’ overseas business activities.

PRICE TO SALES (P/S)

A simple corporate revenue or sales multiple, the P/S ratio, does incorporate profitable overseas activities, and it shows less strain, although it is still at its highest levels since the dot.com years. That the P/S ratio still shows more strain than the P/E reflects the fact that in recent years, U.S. aggregate corporate EPS growth has been driven by cost-cutting more than revenue growth. Corporate revenue growth, in turn, depends upon broader economic growth, whose prospects have clouded under recent concerns about possible secular stagnation at home and slowing demand abroad.

In sum, measures such as P/S, the PEG ratio, Tobin’s q, and the strain gauge encapsulate outstanding concerns about the outlook for capital investment and macroeconomic growth in the U.S. The Shiller CAPE ratio is also elevated.

While demographic and globalizing forces complicate their precise interpretation, these alternative metrics suggest cause for concern, not complacency.

Brian Barnier is a strategist at ValueBridge Advisors, LLC

RISK - Relationship Between Risk & Return

Cape Around the World: Update 2014 – The Relationship between Risk and Return

Klement, Joachim and Dettmann, Oliver, Cape Around the World: Update 2014 – The Relationship between Risk and Return (July 24, 2021). Available at SSRN: http://ssrn.com/abstract=2470935 or http://dx.doi.org/10.2139/ssrn.2470935

Abstract:     

This is the chart that stock bulls don’t want you to see 08-26-14 MarketWatch

At some point in the next five years, the U.S. stock market is likely to be more than 30% lower than where it stands today.

That is the frightening conclusion in a recent study by Swiss economic and financial consultancy Wellershoff & Partners. The company, whose chief executive is former UBS chief economist Klaus Wellershof, found a strikingly strong inverse correlation between the stock market’s valuation and its maximum drawdown over the subsequent five years.

The reason this finding is such bad news for U.S. stocks: As judged by the cyclically adjusted P/E (CAPE) ratio that is championed by recent Nobel laureate Robert Shiller, the U.S. stock market’s current valuation is at one of its highest levels in history. The latest CAPE reading is 25.69, which is 61% higher than its historical median of 15.95 (and 55% higher than the historical mean of 16.55).

Wellershoff & Partners found that, since 1900, the average five-year decline following CAPE levels as high as current readings is between 30% and 35%. In contrast, when the CAPE has been below 15, its average drop over five years was below 10%.

Furthermore, the study found that there is little basis in the historical record for thinking the market will somehow be able to sidestep a big decrease during the next five years: “Going back to 1900, there has been only one instance when the valuation levels we see today were not followed by drawdowns of 15% or more over the subsequent five to six years. Thus, at least for the U.S. market, it seems fair to say that the risk of losing capital is substantial.”

In addition, as you can see from the chart, there is a remarkable similarity in outcomes between developed and emerging markets. This increases our confidence that the inverse correlation the study reports is statistically significant.

To be sure, this recent study is not the first to point out the bearish implications of the above-average CAPE level in the U.S. But what is unique is that it focuses not on overall returns but on drawdowns. That’s important because long-term averages mask how volatile the market may be along the way, which, in turn, is related to how likely it is that we’ll bail out of stocks at some point in the next few years. The bailout point is usually at the point of maximum loss.

Imagine, for example, that the stock market will provide an inflation-adjusted return of 1% to 2% annualized over the next decade. That’s consistent with some analyses of what today’s high CAPE reading means. While that return is mediocre, it may still be high enough to convince you that it’s worth remaining invested in stocks, especially given the bleak outlook for long-term bonds.

But what if, on the way to producing that modest longer-term return, the market at some point plunges 35%? Many investors would find that loss intolerable and, therefore, bail out of stocks — which means they would not participate in any subsequent recovery that produces the net longer-term return of 1% to 2% annualized.

Note carefully that this study, by focusing on a drawdown that may occur at some point over the next five years, sheds no light on when it might occur. But if the study’s conclusions are right, the bulls are playing a very high-risk game.

Do you really want to play that game with your retirement assets?

YIELD DIFFERENTIALS - Too Large to be Stable With Draghi Wanting a Lower Euro

A "CARRY TRADE" DREAM

Borrow in Euro to Buy US Dollar Rate Products

Even Bankrupt Spain & Portugal are Below US Treasuries!!!

EURO- Growing Short Activity