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A Look at MV=PQ
GaveKal Research
GaveKal Research
20.0
14.0 12.0
17.5
10.0 8.0
15.0
6.0 4.0
YoY % Change
YoY % Change
M Indicator
12.5
2.0 0.0
-1
-2.0 -4.0
7.5
-3
-6.0 -8.0
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-5
-10.0 -12.0
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USA government bond index in local currency all matur. daily GaveKal Indicator of Liquidity (M)
Central banks all around the world have been printing money aggressively to either fight off the deflation/depression demons (USA, UK, EMU) or to prevent their currencies from rising too quickly (Japan, China, India). The recent level of monetary activism is reflected by the up-tick in our Global M Indicator. An expanding global money supply is usually good for stocks and bad for bonds. In light of the major central banks activism, the recent behaviour of bond and equity markets is understandable.
GaveKal Research
Irr ti
l x
, cl s
il
GaveKal Research
. . .
V l city F lli
. . . .
. . . . . . . . . .
The
eKal Vel
it (V) I
i at r
Vix I
ex
Our velocity indicators bottomed in September 2002 and returned to positive territory in March 2003. With the continued contraction in quality spreads and the pick-up in bank lending, we do not fear a new contraction in velocity. The question today is not whether velocity will once again collapse, but whether the velocity rebound is already priced into the market?
Vi I
I ic t r
i at r
ds y f
A E RI F t re I flati
r m nt s
Gauge
125
P Indic t r l
7.5
R= 0.84
5.0
120
Our P indicator indicates that there will be very little inflationary pressures over the coming months. As such, central banks will be able to continue their anchoring of short rates and their aggressive printing of money.
115 2.5
0.0 110
PI
)( & ! ! $ # !
1992=100
-10.0 94 PI 95 ic t r t t s, I fl ti ic t r 96 97 98 99 00 01 02 03 04
95
it
.i. .,
RI F t r i fl ti
D
Source: EcoWin
GaveKal Research
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4.5
12
4.0
-16
0.0
-10.0 -12.0 92 93 94 95
-0.5 04
HS
GaveKal Indicator of aily Economic Senstive rices GaveKal Indicator of aily Economic Senstive rices EC I total industry, olume, sa
GaveKal Research
P P
R= . , lead ti e three
onths
da s
96
97
98
UU T
0.5
99
00
01
02
RI I
PI Q
ED
A @
Q Indicator
-7.5 03 04
+
Inflationary Boom
Buy: Scarcity Assets & Cyclicals Sell: Bonds, Interest Sensitive Stocks
Accelerating growth, accelerating liquidity and tame prices: we are back to the glory days of the deflationary boom. A deflationary boom is a very exciting, and dangerous, investment environment (see Theoretical Framework for the Analysis of A Deflationary Boom on our website).
Inflationary Bust
Buy: Gold, Cash Sell: Financial Assets
Deflationary Bust
Buy: Government Bonds Sell: Equity, Negative Cash Flow Assets
Deflationary Boom
Buy: Efficiency Shares Sell: Price Inelastic
Economic activity + It is very propitious to overinvestments, overexcitements, and bubbles. Where will the next bubble be? Our guess is Asiaand we want to participate in it! In any event, the markets recent moves make sense in light of economic fundamentals.
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Who will benefit structurally from the Boom A Wicksellian Analysis of the World
Central Banks, Inflation, Deflation and Financial Markets
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Introduction.
Wicksell, the Swedish economist had a very powerful intuition. His view was that economic cycles could be explained by the divergences between what he called the natural interest rates, and what he called the market rates. (More on those two later) If the market rates were too low i.e. if money was too cheap, it led to a boom centred on excess capital spending, excess borrowing, excess consumption. These boom conditions led eventually to a rise in the market rates above the natural rate, and this changes in the price of money eventually brought about a bust, which would lead in due time to a fall of the market rates below the level of the natural rates. And on and on With every country (at the time of his writing) operating under the Gold Exchange Standard, there was little that could be done to stem these periodic booms and busts, more a function of gold discoveries and international capital flows than the results of conscious decisions by the central bankers. This is not the case anymore: central bankers do control market rates at the short end.
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Wicksells Children
Three economic schools can be traced to Wicksell. 1. The Keynesians. Their view is very simple: since the rise of the market rate above the natural rate creates the bust, the central bank should prevent the market rate from ever going above the natural one. Their view was developed during a depression, and was dominant up to the end of the seventies. The Austrians. They believe that preventing the market rate from going up distorts the price mechanism and that the central bank should leave the interest rate as close as possible from the natural rate all the time. Their view, represented by the Bundesbank was developed during an inflationary period and prevailed from the end of the seventies to the end of the nineties. The Fischerians, who after Irving Fischer considered that the role of the central bank was to manage short rates contra-cyclically. Their views were developed into a historical period full of potentially very dangerous financial accidents (Oil shocks, Banking collapses, countries going bankrupt etc) Their best representative is of course the Fed with Mr Greenspan
2.
3.
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ex
ual I
reases
5.0
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3.0
2.5
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0.5 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
IP t t l i r ss D
,V l stic Pr
,s ct, V l
, R, s
GaveKal Research
WV
ca
A erage Gr
b
th Rate f the
ca
A erage Gr
b
Ya
X YX
WV
The
N t r l Rate m st e ar
nd 3%
IP
Over the last twenty five years, the US GDP has grown by 3% per year on average, and the Industrial Production by 2.7%. So the natural rate for the US economy must be slightly below 3% real Why?
12 t s V ri ti sT Y rs r
12
Reasoning ad absurdum
US GDP (Volume)
340
US ash--Flows
290
240
190
140
90
40 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Over the long term, the growth rate of the US GDP=the growth rate of the US Corporate cashflows (profits). If short term rates capitalised (the green line) grew faster than corporate profits or the GDP, overtime the system would implode. Ergo, the upper limit of the natural rate must be the growth rate in volume of the economy,
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GaveKal Research
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6 5
-1 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
lR t si t
We are reasonably happy with our market rate proxy. It moves between 0 and +3 %, which is what we were expecting, and there is no discernible trend, a sign that we are using the right inflation rate to deflate the nominal interest rates. Next question of course: does it work ?
15
R lR t s
GaveKal Research
The Proof
US GDP Variations
9 8 7 6 5 4
Recessi ns
g ie
Market Rates A
3 2 1 0 -1
3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9
Ever Recession Took Place AFTER Market Rates r se ABOV Nat ral Rate
68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
r ss D 0 rk t R t s
stic Pr rB l
ct, V l
, R, s
N t r lR t
GaveKal Research
fe
-2 -3 -4 -5
Every recession since 1968 in the US took place after a rise in real rates above 3% (Gray boxes above zero). When market rates were below the natural rate, the US economy grew normally. So it works
Y/ /Y s
16
12.5
10.0
7.5
?
5.0
2.5
0.0
-2.5 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 Market ates ominal G Growth ate ( alue) USA C I 12 Months ariations four Years Moving A verage
The characteristic of a Keynesian central bank is that short rates will be maintained all the time below the growth rate of the economy. This always leads to everybody and his brother borrowing, money supply exploding and inflation going up structurallyUS 1958. 1979
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u u
q r
ts
ercent
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3 2 1 0 -1 -2 82 12 83 84 85 86 87 [ 88 12] 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 t s V ri ti s DP i V l rk t R t s R l rk t R t s N i l
GaveKal Research
le
Vel city
Banking
risis llapses
y x y y x x
20
Preliminary Conclusion
A French Politician once confronted with a very favourable development in France said Lets feign to be the organisers of these phenomena that we do not understand. This is a luxury that a central bank cannot afford. The most dangerous phase when a central bank moves from Keynesian to Austrian is after a few years of boom when real (market) rates start moving above the structural growth rate of the economy (natural rate), when everybody has understood and borrows to buy financial assets This usually coincides with the peak of the bubble (Japan 1989). The central bank must then talk tough, but be willing to cut short rates aggressively and very quickly to prevent a collapse of the house of cards, i.e. it must move from Austrian to Fischerian in no time Maintaining real rates above the structural growth rate of the economy during more than five years as the BOJ did was suicidal. If such a mistake is made then the third phase unfolds, centred around a collapse of the financials in general and the commercial banks in particularand monetary policy becomes ineffective.
GaveKal Research
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GaveKal Research
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th
-1
-2
-3 82 Fr 83 84 85 86 87 88 c DP t t l, V l, s [ rk t R t i R l T r s Fr c DP t t l, V l, s [ 3, c. . 12] 3, c. . 12]
98
99
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ed
ed f
Market Rate el
00
01
02
03
Rates in France are 200 bp too high. The French Economy should continue collapsing. Question: is it going to be saved by a positive movement in foreign trade (boom in exports)? See next pages
P rc t
23
-1
11
13
15 87 88 Using I *C I 0 rench I 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
GaveKal Research
Mar et Rate
j
Mar et Rate
j
Markets rates have been above the natural rate 95 % of the time since 1987.
g g
gi
ercent
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7.5
7.0
6.5 5 6.0 4
5.5
5.0 1
4.5 86 87 88 89 90 91 92 93 94 95 96 97 98
99
rance Exchange rate US / urchasing arity ne Standard eviation U ne Standard eviation own
GaveKal Research
US
ollar
ver alued
US
npn o r r q n
ollar Undervalued
0 00 01 02 03
On a PP adjusted for the differences in productivity, the Euro is overvalued by at least 15 %...and this is not to mention the PP with China, Korea etc
o o
US /
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1.3
-2.0
-2.5 1.1 -3.0 -3.5 -4.0 -4.5 -5.0 -5.5 -6.0 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 0.8 0.9
1.0
The EuroLand economy is not benefiting from the rise in productivity which we are seeing in the US. In fact productivity keeps decelerating in Europe (UK included)
Exchange ate
GaveKal Research
v w
ifferences
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French Exports
20 15
10
10
12
-5
-5
-10
-10
-15
-15
-20 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-20
c Fr c
r t rts f
D/ s
R s r ic s, V l
, s , Ri
t c l
GaveKal Research
x y z { | | y z
12
x y z { | | y z
t s V ri ti
t s V ri ti s
27
-15
10.0
2.5
0.0
-2.5 10 -5.0 15
-7.5 Jul 95 Jul 96 Jul 97 Jul 98 Jul 99 Jul 00 Jul 01 Jul 02 Jul 03 Jul 04
20
Who else but the French companies? After all, we have a Government which has not repealed one of the stupid Socialist laws Like the UK conservatives before Mrs Thatcher, they are managing the decline.
rance alue added, by sector, industry, alue, sa eviation rom urchasing arity with the Yen
GaveKal Research
alue Added
EU /J Y
28
An Austrian central Bank by gravely misreading the long term structural growth rate of its economy can create a disaster about as bad as anything a Keynesian central bank has achieved in the past.This state of affairs cannot not lead to the collapse of the Euro. We are not sure that the Euro will survive in its present format.
GaveKal Research
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2.5
0.0
-2.5 50 -5.0
War+Tax Increases
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-10.0
-12.5 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
USA IP total index, Volume, sa [ma 3, c.o.p 12] Changes in Fedeal Funds Rates RHS Inverted [ma 3, c.o.p 12, lag 12]
GaveKal Research
Lead Time
Months
-50
25
75
100
125
Twelve months after a fall in US rates, Economic activity picks up, the reverse being also true. As a result the US central always maintain the fed funds rates between the long term growth rate of the US economy and 0 (in real terms)
F F
Y Y%
s V ri ti si rt
30
US GDP
-1
97
98
99
00
01
02
03
04
There is no alternative (TINA as Mrs Thatcher was fond of saying) , but to be a Fischerian central bank, manipulating short rates, putting them above the growth rate of the economy when the economy is booming, and putting them at zero or below when the economy is busting.
GaveKal Research
R lR t s
31
Conclusion
Of all the countries which we follow, the biggest positive spread between the natural rate and the market rate are to be found in Asia in general and China in particular. (see our Research on Asia & China) A new boom there has started or is imminent. The way the local central banks will manage the passage from Keynesian orthodoxy to Fischerian pragmatism will be the key between a new boom and bust cycle or a sustained period of economic growth. In the US the fundamentals have seldom been better for risks takers and corporate profits. The US companies are back to positive cash flow. In the US, we should see a massive depreciation of the US dollar vs. the Asian currencies, and an export surge, accompanied by a boom in capital spending. The Fed will have to tighten pretty soon, or run the risk of inflation accelerating markedly. No hope for EuroLand, except if the Euro collapses and brings about a surge in nominal activity through exports, allowing the market rates to move below the natural rate at least temporarily. Unfortunately, we tend to believe that if the Euro were to fall the ECB might be raising rates The procedures of the ECB are economically incoherent, and cannot work. We are not sure that the Euro is going to survive in its present format. It could very well disappear. EuroLand is entering into a massive political crisis.
GaveKal Research
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For more information, please contact Louis-Vincent Gave at louis@gavekal.com or call us on 852- 2869 8363, fax: 852- 2869 8131. This presentation is available on our website: www.gavekal.com
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