Markets Insight

January 16, 2013 11:26 am
Time to start switching out of US assets
With bad news priced in to risk assets, havens are looking expensive

The market had hoped for a “Grand Bargain”. Instead, it got a small, ultimately insufficient fiscal deal. The best to be said of the agreement hammered out on New Year’s eve is that it beat the alternative. While investors still cheered, nobody should mistake this for an economic, fiscal, or financial positive. Ideally Washington would have crafted a deal coupling long-term tax and entitlement reform with short-term stimulus. Instead, we got the opposite. The US now faces significant fiscal drag on an already sluggish recovery.

The drag might have been justified had the agreement actually addressed the long-term fiscal outlook. But it failed to tackle the US tax code’s dysfunction or the sustainability of major entitlement programmes. In abdicating any effort to stabilise the national debt, Washington now risks an eventual loss of international confidence in the US. Short-term, it is not even clear that this deal does much to address the deficit. With significant fiscal drag still embedded in the deal, the economy is unlikely to grow as fast as current budget estimates assume. If growth disappoints, as it almost surely will, revenue will be below expectations and deficits above.

Investors face the same challenge of the past several years: how to generate positive real return in a zero-rate world. While the next episode of Washington’s fiscal soap operalack of clarity over the debt ceiling – will expose investors even further, they should fight the temptation to abandon stocks and other risky assets. Policy chaos has been the norm throughout the past three years. Despite the lack of progress, equities and other risky assets have climbed the proverbial wall of worry; those willing to take on risk have done well. The reason: while the world is far from perfect, much of the bad news is already reflected in equity prices. Ironically, it is “havenassets that appear most expensive.

Rather than abandoning risky assets altogether, investors should tap market segments most geared to faster global growth and less exposed to US consumption. Practically, this suggests lowering exposure to small and mid-caps and favouring large and mega-cap companies, which benefit the most when global growth accelerates and are the least sensitive to a slower domestic economy.

To benefit from global growth even more directly, investors can reduce their overall US allocation. For most of the past three years, the US has been a safe port in the storm. Part of the reason is an incredibly resilient corporate sector, which until recently has effectively delivered double-digit earnings from low single-digit economic growth. But US competitiveness was not the only factor. On a relative basis, the US has been the unintended beneficiary of an unexpected slowdown in emerging markets, Europe’s existential crisis, and an aggressive Federal Reserve.

Today, while US companies are still reasonably priced, they are relatively expensive compared with the rest of the world (the S&P 500 trades at a 40 per cent premium to international markets based on price-to-book). Given the near-term outlook for slower growth, more volatility, and a debt-ceiling showdown, that premium may no longer be justified. At the same time, the rest of the world is in marginally better shape. Given the shift in relative fundamentals, investors should consider reallocating some portion of their holdings out of the US and into emerging markets, smaller developed markets and European exporters.

For example, many smaller developed markets Australia, Singapore, Hong Kong, Switzerland, Canadacame out of the financial crisis much better positioned than the larger, developed countries. Generally, their labour markets were less traumatised and their fiscal situation looks credible and, in some cases, quite good. While these nations have their own challenges, valuations are generally more forgiving and growth estimates may be less prone to disappointment.

Few bargains exist on the fixed income front, thanks to the world’s central banks, but credit looks relatively more attractive. While low rates and relatively tight spreads suggest opportunities for capital appreciation are limited, high-yield bank loans, structured credit and even municipal bonds still offer attractive relative yields. Conversely, US Treasuries are both expensive – with a negative real yield – and deceptively risky. A low coupon payment translates into a high rate sensitivity. Even a small increase in yields will quickly erase a year of income.

Washington has not offered investors an easy ride. Yet, investors still have better alternatives than a permanently high allocation to cash.

Fundamentals are improving in much of the world, with even Europe looking somewhat less scary than a year ago. While policy paralysis is likely to keep volatility high, given the alternatives, it may still be worth the ride.

Russ Koesterich is chief investment strategist at BlackRock

Copyright The Financial Times Limited 2013

A Breach in the Eurozone Dike

Ashoka Mody

Jan. 16, 2013.

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            Illustration by Barrie Maguire
PRINCETON – While all eyes have been on the European periphery, has the core been cracking? The Bundesbank has lowered its forecast for German annual GDP growth in 2013 to 0.4%. The Central Bank of the Netherlands expects Dutch GDP to shrink by -0.5% this year – and to contract further in 2014.
The eurozone crisis may be entering its third stage. In the first stage, beginning in the spring of 2008, the locus of the North Atlantic crisis moved from the United States to the eurozone. Banks in the eurozone came under pressure, and interbank tensions increased.
In the second stage, starting in the spring of 2009, the crisis spread to the sovereigns, as investors grew increasingly worried that propping up banks would strain government finances. In turn, sovereign weakness made the banks appear riskier, and the banks and their home governments became joined at the hip.
Throughout the crisis, it has been widely assumedat least so far – that the eurozone core would remain solid, and would continue to write the checks for the periphery’s distressed governments and banks. That assumption appeared plausible. A “two-speedEurope was the new normal.
In particular, Germany stood above the fray. Following strong performance in 2010, Germany’s GDP exceeded pre-crisis levels by early 2011, a somewhat better achievement than that of the US. Indeed, given Germany’s surprisingly impressive employment performance, another Wirtschaftswunder appeared to be in the making.
Then a subtle change occurred. The US – despite a historically slow return to normalcypulled ahead of Germany. Absent a prolonged fiscal-cliff and debt-ceiling mess, the US may be cobbling together a sustainable recovery. Following the German economy’s sharp contraction in the last quarter of 2012, the question for the country today is whether it can avoid a technical recession (defined as two consecutive quarters of economic contraction).
Europe does not have its own growth engine. The German rebound was initially robust because world trade rose rapidly after a precipitous fall. China’s voracious appetite for German cars and machines provided the needed boost, even as Germany’s traditional trade partners in Europe struggled.
Since then, however, Chinese demand growth has slowed, and Germany’s European trading partners are in even deeper trouble. Fiscal austerity in the periphery requires cutting back on imports; hence, the countries exporting to the periphery need to curtail their own imports – and so the process cascades. This trade multiplier is causing European economies to drag each other down, and the rest of the world is feeling the effects.
The Dutch economy’s poor prospects are similarly alarming. The Netherlands is second only to Germany in the volume of credit that it channels through the so-called Target 2system to the eurozone periphery, and it is the periphery’s largest creditor in per capita terms.
Economic forecasters continue to promise that growth will revive. Things will begin to look up in the second half of 2013, we are told. But the track record of charting this recovery has been discouraging. In his book The Signal and the Noise, the American statistician Nate Silver says that forecasters perform worst when faced with a circumstance that they have not encountered before. This is such a circumstance.
In April 2010, the International Monetary Fund’s World Economic Outlook projected 1.8% annual GDP growth in Germany and the Netherlands in 2013. In October of last year, the IMF lowered its 2013 growth forecast for Germany to 0.9% and to 0.4% for the Netherlands. And, a mere two months later, both countries’ central banks report that even these reduced expectations are
too optimistic. Who is to say that the second half of 2013 will bring more hope and cheer?
The European crisis-management process has been predicated on the Scarlett O’Hara principle that “tomorrow will be a better day.” Although everyone knows that postponing hard decisions only makes the problem larger, they could still believe that there would always be a firm line of defense. That may be changing.
The third stage of the eurozone crisis will arrive when the economic strength of the core is in doubt. Those very doubts undermine the credibility of the safety net that has been supporting the European periphery.

A solution to the eurozone crisis that relies on Germany has always been politically uncertain. It may soon become economically untenable.

Ashoka Mody, a former mission chief for Germany and Ireland at the International Monetary Fund, is currently Visiting Professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs, Princeton University.

Markets Insight

Last updated: January 15, 2013 5:37 pm
Too much rides on central banks steering stable course
Unconventional measures turned 2012 into a dash for trash

The search for yield turned 2012 into a veritable dash for trash in global markets. The lower the credit quality, the better the performance was the guiding principle, with poor quality credit outperforming investment-grade credit. At the same time, credit securities more generally tended to outperform government bonds and equities.

With the notable exception of Japan, it was a triumphant year for the central banks, whose unconventional measures to secure ever looser monetary conditions worked a remarkable spell on global markets. In the first two weeks of 2013 it has been more of the same as risk appetite remains rampant across the world.

The sense of déjà vu is palpable and points to a serious vulnerability. In many parts of the market credit spreads are now nearly back to pre-crisis lows. As the Institute of International Finance points out in its latest Capital Markets Monitor, bonds with relaxed credit discipline are back. Among them are instruments such as “payment in kind”, a particularly hairy product of the credit bubble, while the issuance of covenant-lite loans is now above its previous record level set in 2007.

In the meantime, all manner of seemingly anomalous valuations are to be found across markets. The fact that dividend yields on many very stable big companies are higher than the yield on their corporate bonds has been widely noted. In the UK, it is possible to buy index-linked property leases in food retailing on a similar yield to that on related corporate bonds on which the income is fixed.

The nature of a market driven by central bank liquidity is that momentum triumphs over fundamentals. Anomalies are thus to be expected, but are hard to exploit when the authorities are firmly committed to continuing market manipulation.

That does not necessarily mean that there is no case for switching from credit into equities in the short term. Yet it is important to recognise that what central banks give can equally be taken away, a point that applies particularly to the US Federal Reserve.

This is partly because the Fed has been the driving force behind global markets over the past 12 months. The clearest evidence for this comes from the relative performance of developed world economies and emerging markets.

While emerging market economies were harder hit at the start of the crisis they very quickly exceeded previous peak levels. By contrast, the big developed economies, with the exception of the US, are still not back to their previous peaks. Yet emerging market equities have not followed the stellar performance of their underlying economies back to pre-crisis levels. They have simply tracked the developed markets, which remain below their previous peak.

The other concern for equities is the marked polarisation in the developed world between the US and the rest. The US is more advanced in its deleveraging process. Its banking system is now better capitalised than that of Europe.

The housing market is on the turn. With fiscal concerns showing the potential to become more manageable, the likelihood of some of the non-financial corporate sector’s near-$1.4tn nest egg finding its way into increased investment is growing. So if unemployment comes down faster than expected, the markets will become increasingly preoccupied with an early retreat by the Fed from quantitative easing.

Nobody can be entirely certain how much the rise in equity prices owes to these liquidity injections. Last year’s analysis by the Bank of England of the macroeconomic impact of its gilt buying programme between March 2009 and May 2012 for the Treasury select committee nonetheless provides clues.

Using the Bank’s numbers, the independent pension consultant John Ralfe estimates the great majority of the increase in the FTSE 100 index since the start of that period is a result of QE. There must be a chance that any retreat from QE in the US would thus have a pretty significant impact on equities, as well as on overblown government debt and corporate credit markets.

The US economy is probably now sufficiently robust to weather any resulting storm, even if the financial system retains its capacity to spring nasty surprises. The same can hardly be said of Europe.

The European Central Bank would not find it easy to offset the market impact of the Fed in tightening mode. And investors would inevitably refocus on Europe’s underlying structural weaknesses, along with unresolved faultlines in the monetary union.

In the enduring risk-on/risk-off game that has prevailed since the crisis began, the scope for a juddering reversion to risk-off is painfully clear.

The key message for markets in the year ahead is that the central banks will once again call the shots. Muchalmost certainly too much – is riding on their ability to steer a stable course back to normality.

Copyright The Financial Times Limited 2013

January 15, 2013 6:06 pm
Japan should rethink its stimulus
The real problem is a return to deflation and an overvalued currency, says Adam Posen
Ingram Pinn illustration

What happens when an economy runs out of fiscal space? The presumption is embodied in the image of “hitting the wall”. Under this assumption, public debt exceeds a certain limit and financial confidence collapses. As a result, interest rates rise, the currency falls and panic ensues. At times this scenario holds true – for economies with sizeable foreign-denominated public debt or for economies that create political breakdowns.

Japan demonstrates a different reality about the problems of excessive debtone that Shinzo Abe, its new prime minister, should keep in mind as he launches a fiscal stimulus package. Japanese public debt has ballooned for 20 years, rising from 60 per cent to 220 per cent of gross domestic product (though the true figure net of government holdings may be 130 per cent). During that time Japan has been in recession, recovery and back in recession, but interest rates on Japanese government bonds have remained below 2 per cent for the past 13 years. While the debt accumulated, the yen appreciated from Y130 to Y78 to the dollar, before reversing to Y89 over the past few months.

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan’s banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan’s households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders of JGBs (less than 8 per cent of the total) and the threat that the Bank of Japan could purchase unwanted bonds. Fourth, the share of taxation and government spending in total Japanese income was low.

Getting away with something is not the same as getting off cost-free. Each of these factors enabling the ongoing fiscal deficits has had its costs to Japan. Stuffing bank balance sheets with JGBs has constrained commercial lending by those banks – even during the recovery of 2003-08 – which harmed small and new business development. The persistently low returns on Japanese savings have further squandered investment opportunities, thereby creating a negative feedback loop with deflation and older savers’ risk aversion. The absence of external pressure has fed the combined long-term appreciation of the yen and stagnation of Japanese stock market returns, both severely distorting the economy. Needed public investment and funds for adequate healthcare and disaster recovery have been crowded out by debt payments, given a relatively fixed share of government in Japanese GDP.

When I and others advocated aggressive stimulus in Japan in the second half of the 1990s, it was intended as a temporary response to three conditions. First, the recession was acute, severe and eroding the stability of a Japanese financial system already weakened by substantial non-performing loans. Second, the actual stance of Japanese fiscal policy then was, on balance, contractionary. And third, the net public debt level was low enough that short-term stimulus would not crowd out public investment (let alone private investment).

The case for continued deficit spending in Japan ended by mid-2003. Though it is often overlooked, Japan’s economy recovered well following a rectification of financial and macroeconomic policies – including banking recapitalisation – in 2002-03. From 2003 to 2007, per capita real income growth was the same in Japan as in the US (averaging 1.8 per cent annually) and kept pace with the US on average even during the volatile years of 2008-11. Meanwhile, the costs of running recurring deficits during an expansion accumulated.

Mr Abe’s new fiscal stimulus initiative is therefore questionable. Not because another 2 per cent of GDP will be the proverbial tipping point on Japanese debt sustainability, for the factors protecting Japan from overt fiscal crisis remain. Nor because it will be ineffective; if anything, when combined with monetary expansion and a likely consumption tax rise in the near future, I expect its multiplier and thus short-run impact to be high.

The additional stimulus in Japan is counterproductive because it adds to the long-term costs without addressing Japan’s real problem: a return to deflation and an overvalued exchange rate. The BoJ pursuing a higher inflation target through large-scale purchases of a wide range of assets, as Mr Abe and his economic adviser Koichi Hamada rightly advocate, would be sufficient and appropriate.

Persistent fiscal policies that fail to adapt to changing cyclical conditions result in long-term damage. This holds true whether a government errs on the side of excessive austerity, as in Europe of late, or on the side of unjustified indiscipline, as in Japan since its recovery a decade ago. Either way, the consequences are real, though rarely as dramatically visible as hitting a wall. Italy, the UK and the US should fear the structural damage of following Japan’s example if fiscal expansion is not timed to end with recovery. When a large country with its own currency reaches its fiscal limit, growth ends not with a bang but a whimper of declining vitality and diminishing resilience.

The writer is president of the Peterson Institute for International Economics and a former member of the Bank of England’s Monetary Policy Committee

Copyright The Financial Times Limited 2013.