Thursday, 23 May 2013

Summary
For the time being, the consensus expects major central banks to keep their feet firmly on the stimulus pedal. In our view, the Fed will start to wind down QE in the fall. Over the coming period, we foresee more market speculation to this effect. Japan is stumbling into a difficult situation; it badly needs to prevent rising interest rates and an overly weak yen. Its only option is to impose restrictions on the outflow of capital, in one way or another. Eurozone tensions could flare in the course of the year on large budget deficits in the debt-laden countries and less capital flowing into the markets outside Europe. The ECB will likely continue to ease its policy. It could focus especially on "bespoke measures" to boost the supply of credit in the weak member states. To hedge against Eurozone risk, we advise to go short on French bond futures and long on German futures (gradually). In addition, we recommend steadily decreasing equity positions. The 10-year US Treasury yield (now around 2.0%) could climb to 2.5%-3% towards year's end and then to 3.25% early in 2014. The 10-year German Bund yield (now near 1.4%) will probably not exceed 1.8% (by much) over the coming period. EUR/USD could drop to 1.20 in the next few months or quarters and then to 1.10. Rallies in-between will probably stop near 1.34. In the near future, USD/JPY can fluctuate between 95 and 105. EUR/JPY could peak, then fall back to 115.

Calm before the storm

At first glance, it would appear that the situation of the global economy and financial markets is clear-cut. In the US, the economy had been picking up at a fair pace until the fiscal consolidation (from January 1st) started to bite. Early in Q2, growth slowed to around 1.5%. The fiscal drag is expected to wear off in the course of the year. Nevertheless, many analysts do

not think the economy will accelerate much beyond a 2% growth rate. US inflation is expected to ease rather than rise as unemployment decreases very slowly. If so, this would imply that incomes are unlikely to rise rapidly and consumers cannot up spending to any great extent. At least: not without extra borrowing. As to the latter, there are few signs that this is on the cards. The post-war baby boomers, in particular, will be more inclined to save than to take out new loans, as their old-age provision is shrouded in uncertainty. Based on this, many economists conclude that

the Fed is poised to keep its foot firmly on the stimulus pedal and that it will wait until early 2014 before winding down QE. If they are correct, cheap money will flood the markets for the foreseeable future. Europe And what about Europe? On the whole, the Eurozone is still in recession. At best, it will gradually emerge from this as the year progresses.

Yet all of this will continue to be an uphill struggle, as the banks have no choice but to reduce their balance sheets. On top of this, Germany is far from sanguine about a much looser ECB policy, which could cause the German economy to overheat. In addition, the country fears it will be saddled with losses run up by banks outside Germany. In short, the German government is very wary of such policy measures. However, the situation has changed now that German exports are in competition with export products from Japan, where businesses have obtained an advantage after prices dropped 30%. As a result, Germany may become more enthusiastic about an ECB policy that drives down the euro. Clearly, good things and bad things can be said about the European economy, but it seems that the highest achievable growth rate in 2014 will be approximately 0.5%-1%. So in any case, the ECB is unlikely to lift its foot off the monetary gas pedal in the near future.

The main reasons for this forecast are that the effects of the fiscal tightening will likely wear off while there is downward pressure on inflation. Both factors can be expected to boost consumer purchasing power. However, this effect will not be strong; the banks have to shrink their balance sheets so will not be able to supply a lot of credit. Especially the banks in the weak Eurozone countries. The ECB is pursuing a loose monetary policy in order to fight the recession. Before long, it could take new measures to help the banks. The latter is also being debated at European level. Particularly the possibility of a banking union and increased support by the European emergency fund for the distressed banks.

The ECB's current stance may be less accommodative than the policy of the Fed but it helps to create a positive outlook for the

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interest rate and equity markets. At the same time, it could contribute to a weakening of the euro. Abenomics In Japan, "Abenomics" (the nickname for the administration's new policy) consists of three components: Flooding the system with liquidity in order to boost the economy. One objective is to drive down the yen. In addition, the authorities want to transform deflation into a 2% rate of inflation. This is crucial, as Japan has huge debts, at various levels. In a deflationary climate, the debt burden weighs increasingly heavily (for as interest payments and capital repayments stay the same, nominal incomes decline).

GDP, there is not much scope in this respect. Expanding the budget deficit is only possible in the short term, in order to provide the economy with a temporary impulse. As soon as growth takes off, the fiscal policy should become more neutral. (The administration plans to do this through a VAT hike. To some degree, this will put a drag on the economy. To offset this, a persistently loose monetary policy is required, as well as the measures described below).

To kick start the economy, and regardless of the fact that the budget deficit already amounts to 9% of GDP, initially a substantial fiscal stimulus is needed. As the Japanese public debt is around 240% of

The third arrow on the government's bow comprises structural growthboosting measures. Especially the abolishment of existing regulations. Many of those restrict competition between domestic businesses in Japan as well as import competition, which is hampering innovation. In addition, the job market should become far more flexible.

Success of Abenomics is an open question It remains to be seen whether the Abe government will achieve all of this. Some months from now, new elections will be held,

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which will act as a litmus test. The markets assume that, in the meantime, the money taps will stay open and that, on balance, Japanese stock prices will therefore continue to rise as the yen depreciates further. Japan has a current account surplus. Consequently, this is only possible if a lot of capital leaves Japan. In the circumstances low growth rates in Europe and the US most of this money will flow to other Asian countries, where growth is still quite robust. However, these states are not at all keen on an inflow of foreign capital that will make their currencies more expensive and impede competitiveness, which forces them to intervene in the foreign exchange market. (And sell the domestic currency against, for example, the US dollar and the yen). This will increase money supply in the countries in question and heighten the risk of bubbles. However, there seem to be no alternatives. The above is evidence of enormous money creation around the world. So far, this has driven up stock prices and other asset prices to ever greater heights. Meanwhile, the real problems are being glossed over and obscured by a smothering layer of money as investors threatened to fall prey to euphoria. The trillion dollar question is how much longer will this continue? More about this below.

boost economic growth, against a background of high indebtedness. Yet, the problem is that gigantic money creation is required to achieve this: Without a better economic outlook, it is very difficult to boost asset prices. In the past decades, asset prices have soared a number of times, only to tumble again soon afterwards. It is barely possible to convince people and companies that they should take out more credit once the value of their assets goes up. Most of all baby boomers who are approaching pensionable age.

The problem is that once credit picks up, inflation fears will flare up. Owing to the massive money creation, if credit were to be supplied on the same scale as it was in recent decades, the specter of hyperinflation will haunt the markets. The only remedy is to remove money from the system on a large scale, as credit supply increases. This is easier said than done for before long, it will send asset prices lower, which have been artificially boosted. If they fall too sharply, tightening credit will nip the economic recovery in the bud. Unless enough money is removed, inflation fears will send long-term interest rates higher and if the debt burden is colossal, soaring borrowing costs could be "fatal". In short, the central bank will need to perform a delicate balancing act. In the past, it has often been unable to do so. Although the US is the first country where credit shows signs of picking up, we think the problems will start in Japan. For a number of reasons. Limited benefits from weaker yen Many investors assume that the Bank of Japan will continue to pursue a loose monetary policy for a long

Change on the horizon first of all in Japan

In previous reports, we have extensively described that central banks are trying to turn the usual state of affairs on its head. Whereas "normally", stock and other asset prices tend to rise in response to improved economic prospects, this time round, massive liquidity creation is used as an instrument to drive up asset prices and improve the economic prospects. The idea is that as the value of assets appreciates, debts remain the same. Central banks hope to promote borrowing and discourage saving, as this seems the only way to stave off deflation and

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time as the yen continues to depreciate. We fear they are mistaken. Japan's imports exceed its exports. And, although the yen has become significantly cheaper, exports have not suddenly exploded. It frequently takes years to open up new markets. In addition, few businesses will decide to move production to Japan based on currency fluctuations alone. Not least because experience shows that sooner or later exchange rates tend to move in the opposite direction. If the yen depreciates, established exporters can earn substantially more without expanding exports or committing to higher investment in Japan itself. At the same time, as soon as the yen weakens, import prices start to rise. Originally, when USD/JPY was below 80, the Japanese currency may have been significantly overvalued. From this angle, the rally so far has done Japan good. However, various studies show that the balance will tip the other way if USD/JPY climbs above the range of 100-110. A recent survey of the Japanese business sector also indicated that most companies do not want the pair to exceed 105. Understandably, voices within the government say they hope the currency market will not weaken the yen too much. This suggests that the verbal interventions is effectively halting or delaying the depreciation of the JPY near its current level of 103. Also relevant in this respect is that other countries really do not want a stronger domestic currency. Japan needs to tread carefully, or it could have a currency war on its hands. Keep in mind that the Asia crisis in 1997 followed a period of yen weakness. At the time, this generated excessive money supply in other Asian countries and various bubbles emerged, which popped eventually. In conclusion, we can say that although Japan needs a very loose monetary policy, the yen should not fall much further, as this would

damage rather economy.

than

help

the

Japanese

Japan has to prevent rising interest rates Another problem is that lately, Japanese (longterm) interest rates have risen considerably. This is no surprise. How many investors are prepared to accept a Japanese government bond yield below 1% if the administration and the central bank say they will do everything to raise the rate of inflation to 2%? The risk of an additional depreciation of the yen will remove the incentive for foreign investors to purchase and/or own Japanese government bonds. Self-evidently, the Japanese central bank can extend its bond-buying program in an attempt to keep interest rates down. The snag is that this will place downward pressure on the yen and increase the chance that the authorities will overshoot the 2% inflation target. At the same time, they need to counter the upward pressure on borrowing costs for if interest rates continue to rise, the government will soon go bust (the reason why the previous Policy Board of the Bank of Japan refused to go down this road). The root cause of these problems is the fact that Japan has a humongous national debt. On top of this, Japan has to beware of a "crisis of confidence". The latest data suggests that Japanese economic growth is close to three percent, due to the fiscal and monetary stimulus and the cheaper yen. This could continue over the coming quarters but what will happen next? To start with, next year the fiscal policy will switch from accommodative to restrictive. Not much can be done to change this as the budget deficit and public debt are huge. Plus, the wrong kind of inflation could occur in Japan. That is to say, a "cost push" instead of a "demand pull". If so, inflation will rise on the back of higher import prices and not because of higher demand as a result of wage increases or easier credit. The question is will this benefit Japan? In our view, wages will not rise substantially in the coming

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period. Under such conditions, higher inflation will only undermine consumer spending power. Structural reforms are key Finally, it is uncertain if the current administration will manage to implement the necessary structural reforms. Typically, the latter initially act as a drag on the economy before boosting growth at a later stage. Clearly, it is unwise to simply assume that the yen will continue to depreciate for the foreseeable future and that stock prices will soar unabatedly. The easy part of Abenomics is behind us; the hard work is about to begin. At the very least, the Japanese government should prevent interest rates from rising and counteract the depreciation of the yen. This implies it needs to reduce the outflow of capital. Probably the first weapon of choice will be verbal intervention. This has already started. There have been statements that the JPY should not weaken much further and there is a lot of pressure on major Japanese investors to continue to purchase Japanese bonds on a large scale. If this is not effective, the Japan can also sell part of its foreign bond holdings. In the most extreme case, the Bank of Japan could wind down QE. Whatever the tactic, eventually the rest of the world will have to learn how to live with less cheap money. Many investors continue to count on a Japanese "river of liquidity" but this could dry up sooner than expected.

continues to ease. If this process continues, deflation will loom. Unemployment is only going down very slowly. In other words, the central bank's objectives (inflation close to 2% and jobless rates below 6.5%) have not been achieved or have moved further out of reach. Many investors think this automatically points to ongoing stock market rallies, low interest rates, shrinking credit spreads, and dollar weakness. However, this is just part of the story. The fiscal drag on the US economy may be substantial put it will lessen from Q3 onwards. This is important. Recently, the IMF calculated that underlying growth in the US i.e. in the private sector is around 4%. Quite possibly, towards year's end, overall growth could be near 2.5%-3% and near 3%-3.5% in early 2014. Meanwhile, that growth rates in the private sector are close to 4% can only be down to higher borrowing and/or a lower savings rate. In essence, wages are not increasing sufficiently to boost growth to this degree. In other words, without the fiscal drag, the Fed would already have started to lift its foot off the stimulus pedal. So now we have a bizarre situation of soaring asset prices whereas the Fed is expected to unwind QE later this year which will drive down those same asset prices. For the moment, the central bank cannot change tack; it is terrified of throttling down too soon and failing to boost the economy at all. However, it would be preferable if asset prices could stop rising so they would fall less sharply later on. (This applies to stock prices and credit spreads more than housing prices, which are still far below their peaks and therefore less vulnerable). US economy strong enough to cope with tighter Fed policy? In view of the above it is understandable that debates rage inside the Fed about the timing of unwinding QE.

The Fed is beginning to have doubts

As we explained, the consensus seems to be that the Fed will continue to flood the economy with money for the time being. Presently, US growth rates are near 1.5%. As a result, inflation

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Regardless of Europe's many unsolved problems, the EMU has been remarkably quiet off late. This is still connected to Mario Draghi's promise that the ECB would "do whatever it takes to preserve the euro. An additional reason is the worldwide search for yield. As loose monetary policy around the globe drives down interest rates on deposits and government bonds to historically low levels, the superfluous liquidity is "searching" for higher-yielding assets on a massive scale. These developments have had an upward effect on the capital markets in Spain, Italy etcetera. This is not necessarily beneficial for the countries themselves. Nursing their economies back to health requires lower wages and asset prices, which is very painful. They also need to implement a raft of unpopular structural reforms (see also our recent reports). Until approximately six months ago, high bond yields meant they had no choice in this matter. Now that bond yields have dropped, there is less pressure on the politicians to take decisive steps in the right direction.

The main issue here is the estimation of the strength of the underlying economy. We think the US economic data will point to so much inherent vigor that the markets will start to discount that the Fed will unwind QE in the fall. Of course we realize that the fiscal drag will only disappear gradually. However, this is offset by lower commodity prices (especially oil prices) which will help consumers. As will higher property prices. In addition, the US banks seem more minded to supply credit. On balance, we expect these stats to improve from the summer onwards. If so, the financial markets will increasingly realize that the era of "unlimited" money creation is drawing to a close. In our view this will impact more and more on stock prices, bonds, and credit spreads whereas it will underpin the dollar. The process will probably unfold gradually. Meanwhile, the rest of the world will come to understand that, as in the case of Japan, the US capital flows will decline. Which brings us to the situation in Europe.

Europe profits from search for yield

We fear they may come to regret this in the second half of the year.

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Even if borrowing costs remain low, the growth prospects for most weak Eurozone countries are far from buoyant. In all likelihood, budget deficits will be large for the foreseeable future. This would not be so bad if cheap money would continue to flood the global markets. However, as indicated above, we expect this to change, slowly but surely. In addition, we foresee growing Eurozone tensions in the later part of 2013. Increasingly, this will put pressure on the ECB to apply more QE and depress the euro. Germany in particular is opposed to largescale monetary easing. However, there is a high chance that the other member states will overrule Germany and that Berlin will resign itself to restricting the scope of the expansionary measures. To achieve the latter, Germany will probably insist that the ECB focuses mainly on facilitating the supply of credit to small and medium-sized businesses in the peripheral Eurozone countries.

Implications for the financial markets

Summarizing, current and future market conditions are as follows: That US economic growth is slow is not exactly surprising. In Q2, the fiscal drag amounts to 1.75%-2%. In other words, if overall Q2 growth runs to 1.5%-2% we assume this is the case underlying growth is around 3.25%-4%. As the effects of the fiscal tightening will wear off gradually, in itself the prospects for the US are good, unless the private sector falls short of expectations. The data indicates the latter is unlikely. The chance is high that growth rates will rise to 2.75%-3% later this year and then to 3%-3.5% in early 2014. In other words, to stave off inflation risks, the Fed will need to unwind QE at some point during the fall. More and more Fed members seem to be hinting at this albeit with the qualification that depending on the data in the coming months this could happen earlier or be put off for longer. The implication for the financial markets is that although QE will not wind down immediately, this process will certainly be on the cards in the not-too distant future. Japan is increasingly vocal about the risks should USD/JPY rise much further. Even more importantly, it needs to keep interest rates down. The only way to achieve this is though restrictions on the capital outflow. Success in this respect will benefit the Japanese bond and stock markets. The reverse of the medal is that the rest of the world will have to live with a decreasing capital inflow from Japan.

Plus, it cannot be denied that a weaker euro would be convenient to the Germans at this point in time.

Back to summary ^

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The Eurozone has been pretty quiet in the past period. This is thanks to the earlier statements by ECB president Draghi, but also because of the large worldwide liquidity surplus. However, in the near future we could see the adverse effects of persistently large budget deficits and minimal economic growth in the peripheral countries, as less capital is flowing into the markets from Japan and the US. As a result, the euro could weaken on higher Eurozone tensions especially after the German elections in late September and mounting pressure on the ECB to ease its policy. Theoretically, a depreciated euro would be an effective way to help the debt-laden countries and boost Germany's competitiveness, especially in relation to Japan. Nevertheless, it is important to remember that the ECB has limited room to ease its policy because of German opposition. In all likelihood, this will force the central bank to concentrate on getting the banks in the problem countries to lend again.

foremost, the rallies in the US equity markets as the Fed could wind down QE before long. If Eurozone tensions flare simultaneously, and regardless of a more accommodative ECB policy, the European stocks could drop concurrently. We think the latter is a real risk. In this context we refer to the warning issued by the Chief of South Korea's central bank, earlier this week. He indicated that bond yields in many countries could soar once the Fed begins to scale down the pace of bond purchases. Many banks own large bond portfolios so could run up substantial losses. It very much remains to be seen if they can survive this. This is also relevant when we consider Italy and Spain. Less cheap money from Japan and the US and unrest in the euro area could send bond yields higher later this year. In our view, a reasonably cost-effective hedging method in regard to a euro break-up as well is to go long on German government bond futures and short on government bond futures. Increasing turmoil in the Eurozone places upward pressure on French bond yields. In the meantime, the French economy is diverging from the economies in the strong EMU countries. It seems a good idea to profit steadily as the France-Germany yield spread continues to shrink; especially as the costs need not be high.

End of an era Our main conclusion is that the period of abundant money creation all over the world is coming to an end. Perhaps not in Japan (at least not straight away). However, in any case Tokyo will have to restrict the amount of capital that flows to foreign markets. In all likelihood, the United States will be the first country to slowly lift its foot off the monetary gas pedal. The opposite applies to Europe, where the central bank may well ease its policy further, albeit to a limited extent while for the moment, the ECB is applying far less monetary easing than the Fed. We think the rally in the stock markets does not have much further to go. True, in the final phase a rally can gather steam but time wise, it largely seems to have run its course. First and

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Implications for bond yields and currencies Based on the absolute interest rate levels in the US and Germany, we think the yield on 10-year US Treasury Bonds (now near 2.0%) will have risen to 2.5%-3% by the end of the year and to around 3.25% in early 2014. However, we cannot rule out that stock prices will tumble in the course of 2013. This could hit the economy so hard that it forces the Fed to increase QE. If so, bond yields will fall again. For the moment, we do not believe this to be the most likely scenario. As we mentioned earlier, the stock markets could peak before long, especially in the US. At first, the subsequent pullback could unfold slowly. Such a gradual drop will probably not prevent long-term interest rates from rising. Usually, higher US bond yields drive up interest rates in Germany as well. On the other hand, it is clear that the European economy is much weaker and there will be pressure on the ECB to ease its policy sooner once Eurozone tensions flare. Under such conditions, German government bonds will be a safe haven. This is why we do not think the yield on 10year German Bunds now around 1.4% will climb far beyond 1.8% in the coming period. Whereas the Fed is expected to unwind QE, the ECB is more inclined to ease its policy. This will have a downward effect on EUR/USD. In addition, we foresee mounting Eurozone tensions. Therefore EUR/USD could slide to 1.20 over the coming months or quarters and later to around 1.10. Rallies in-between will probably end near 1.34, if that (it would surprise us if the pair exceeds 1.30). As indicated, we doubt whether USD/JPY will rise much further in the near future; it will probably stay around 95-105 over the coming months or quarters. As a result, EUR/JPY could peak shortly and then drop to 115.

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Back to summary ^

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