Liquidity Downturn Drives Markets and Economies
Jun 20, 2006
Andy Xie (Hong Kong)
Summary & Conclusions
Central banks have buffered the global economy against deflation shocks repeatedly since 1998 by releasing more money into the global financial system. The liquidity has kept the global economy strong by inflating financial assets. This unique episode is ending as deflation shocks end and the deflation-exporting economies begin to export inflation. The sell-off since mid-May is to retrace the overshooting between November 2005 and April 2006. The boom of emerging markets and commodities during this period took place despite the sluggish liquidity environment due to reallocation of liquidity out of big markets. Inflation is likely to remain a problem for central banks over the next two years, as the excess liquidity in the financial system turns into inflation in the absence of deflation shocks. As central banks fight inflation, liquidity could decline significantly, which would cause re-pricing of all assets. The global economy could experience a period of all assets depreciating. Economies that have become addicted to portfolio inflows to fuel consumption would suffer most in the process. Their virtuous cycle of buoyant stock markets, strong currency, low interest rates, and rapid consumer credit growth could turn into the vicious cycle of declining stock markets, weak currency, high interest rates, and consumption recession. A soft landing for land prices in the US and China is a necessary condition for the global economy to avoid a recession in 2007. If investors can be convinced to accept lower returns on capital than they hope for today, the soft landing is possible. The hard-landing risk is quite significant. It Is Not Just a Correction I have been visiting Asian equity investors in the past two weeks. The mood among investors is sombre. The sell-off is a painful surprise. Most have a hard time digesting what has happened. Most investors believe that the sell-off is a correction. However, not many want to buy now, as they fear redemption. Indeed, many are hedging through futures market and, if liquidity comes back, would like to sell high beta stocks. I shared my view with investors (1) that the sell-off was due to the liquidity cycle turning down, (2) that the sell-off so far was just adjusting for the overshooting since November 2006, and (3) that global liquidity would decline due to inflation, which would cause a bear market. I did not get much feedback on my view that the world was headed for a bear market. Instead, most investors wanted to discuss with me what other investors were doing. Apparently, many investors have gone into survival mode and are interested in technical details of the market to help them make decisions. It appears that fear has taken over from greed. More redemption is quite likely in the coming days. It would take very good news on inflation for greed to come back. I doubt that the news on inflation will turn benign within the next 12 months. That is why I think any market bounce will not last. The Sell-off Corrects Overshooting since Nov. 05 Emerging markets and commodities took off in November 2005 and kept rising until April 2006. It happened in an environment of sluggish global liquidity. The G-3 free liquidity (short-term money growth rate minus nominal GDP growth rate for the US, Euro-zone, and Japan) was growing at a 1.1% annual pace between 2004-05 compared to 8.1% in the previous two years. The boom was due to liquidity reallocation out of big markets, or rising risk appetite. The bond market has been in a bear market for two years. The property market has rolled over in all major economies. The US big-cap stocks have not performed in the past 18 months. Essentially, the performance of big asset markets has reflected the sluggish liquidity environment. The boom of emerging markets and commodities between November 2005 and April 2006 was against the global liquidity tide, not part of a rising tide lifting all the boats. The ‘rising risk appetite’ could not be sustained in a sluggish liquidity environment. It would not take much to trigger a reversal. Liquidity Could Decline The global economy has experienced a ‘deflation boom’ since 1998. There have been a series of deflation shocks. A string of emerging market crises, China’s SoE reform, and Japan’s banking reform raised deflation fears. Central banks around the world turned on the monetary spigot. Financial speculation has been the main source of demand for money and rising asset prices due to financial speculation have led to rapid global economic growth. The tech bubble of 1999-2000 and the global property/emerging market/commodity bubble since 2000 belong to the same liquidity cycle, I believe. As long as inflation is not a problem and speculative appetite strong, the global economy will just cruise from one bubble to another. However, inflation has become a problem. Global free liquidity is about 60% higher than ten years ago. So much more money is not inflation only if the world continues to receive deflationary shocks. However, wages are rising in China, land prices are rising in Japan, and emerging economies that went into crises have big foreign exchange reserves now. Indeed, the economies that sent deflation shocks to the global economy are exporting inflation now. The 60% extra money in the global financial system has become inflationary in the new environment. It does not matter if it works through oil prices, wages in China or the US. If the money is not taken back by central banks, it will cause inflation. This inflationary pressure will not let up even if the US economy slows down significantly. Again, it is a monetary phenomenon. The technical transmission channels are not important. I can see two that will persist even in a US downturn. First, oil price is likely to remain high. I believe that the commodity bubble is bursting, with the exception of oil. Oil exporters have made so much money in the past two years that their selling eagerness has declined dramatically. Most oil exporters are enjoying their newfound global status. They would not mind cutting production to sustain high prices. Second, China is raising production costs regardless of global economic strength. China is to cheap manufacturing products as Saudi Arabia is to oil. China is in a position to raise export prices. The world wants China to raise its export prices also by putting pressure on China to revalue. China is doing it through removing export subsidies, which benefits domestic consumption, rather than through currency revaluation. These two forces should keep inflation on an upswing even if the global economy cools in 2007. This is why central banks cannot cut interest rates even if the global economy dipped into recession in 2007, I believe. Virtually all investors that I met in the past two weeks believe otherwise. A Multi-year Bear Market Could Lie Ahead The amount of liquidity reduction, considering that liquidity relative to real economy is 60% higher than 10 years ago, could be dramatic. Even if half of the liquidity increase in the past decade is sustainable due to the permanent disinflationary effect of globalization, it would still cause the prices of all assets to decline by about 20% on average. When asset prices decline, the global economy could be quite sluggish, in my opinion. More importantly for equity markets, the share of corporate earnings in the global economy could decline. Two trends have exaggerated corporate earnings. First, rising commodity prices have increased corporate earnings through inflation tax on consumers. As the commodity bubble bursts, such earnings are given back. Second, financial speculation has exaggerated the financial sector’s earnings. The real estate bull market, for example, has increased the earnings for financial institutions dramatically. Part of the asset inflation in the global economy has become the earnings of the financial sector. Third, the high-end consumer market could suffer severely from the negative wealth effect. The positive wealth effect in the past has exaggerated the demand for high-end consumption goods and services. There has been much more inflation in the high-end consumption segment, which has boosted corporate earnings in this market. This is why it I believe it is wrong to look at the current earnings to judge how expensive the market is. The asset inflation-driven global economy has exaggerated corporate earnings substantially. A more meaningful indicator is to look at the stock market capitalization to GDP ratio. It has gone up dramatically in the past 10 years. A big chunk of the increase could be given back in this bear market. Some Economies Could Go Into Crises Soon Several economies have been supporting their consumption by attracting foreign portfolio inflows. The inflows have kept their currencies strong, inflation low, stock markets high, and consumer credit buoyant. As foreign portfolio inflows stop, their currencies begin to weaken, inflation accelerates, interest rates rise, and consumer credit turns down. The vicious cycle could in my view lead to a currency crisis. In addition, some emerging economies have run current account surpluses on high commodity prices. As the commodity bubble bursts, their currency accounts could turn into deficits again. They are also vulnerable, I believe.
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Bucking Global Tightening
Jun 20, 2006
Gray Newman (New York) and Heloisa Marone (New York)
Last month, as central banks around the globe scurried to hike rates, Brazil’s central bank showed little hesitancy in cutting rates. And despite the market turmoil seen in both developed and emerging markets of late, we believe that Brazil’s central bank should be able to cut rates again by a similar magnitude when it meets next month. Over the past four weeks, we have counted at least nine central banks from the ECB to the central banks of India, Korea, Turkey, South Africa, and even Iceland hiking rates. While Denmark and Switzerland joined the list of hikers and Sweden is expected to move on Tuesday, June 20, the list is largely dominated by the "who’s who" of emerging markets. Given Brazil’s legacy of hyperinflation and mixed picture on the inflation targeting front, our view that Brazil is not likely to join the list of hikers and, indeed, should continue to cut rates may seem wildly optimistic. But we argue that Brazil finds itself in a very different situation than other central banks and hence should be able to continue to ease monetary policy during 2006 and 2007. Unlike the "hikers" It is perhaps an exaggeration to compare the US inflation rate with that of Brazil, but last month the annual rates were indistinguishable without resorting to measurements of one-hundredths of a percentage point. Both the US and Brazil reported that annual inflation for the twelve months ending in May reached 4.2%. Brazil was slightly higher if an additional decimal point was added – 4.23% compared with the US rate, which had been rounded up from 4.17%. Of course, the comparison is not entirely fair. Core inflation in the US is lower than in Brazil and much of the drop in May in Brazil came about from an abundant harvest yielding lower food prices. The harvest also helped reduce transport costs thanks to Brazil’s increased reliance on sugar-cane derived ethanol rather than gasoline. Still, with the Fed struggling to decide how much farther to raise the fed funds rate from 5%, Brazil’s overnight rate, which stood at 15.75% until last month’s 50 basis point reduction, seems clearly too high. Still, the comparison with the US underscores one of the key differences between Brazil and many other hikers: Brazil is still enjoying a bout of disinflation. Not only is headline inflation now running below the central bank’s target of 4.5%, but other inflation indices are also showing remarkable progress. Sao Paulo’s measure of inflation (FIPE) dropped 0.22% in May (and -0.38% in the four weeks ending in early June) producing the lowest monthly reading in six years. Meanwhile, Brazil’s IGP-M index, still widely used to set tariffs in regulated industries, has produced outright deflation in its annual reading since April (-0.9% for the twelve months ending in April and -0.3% for the twelve months ending in May). Brazil already had an inflation shock in late 2002 and early 2003 and its strong response then continues to be felt in inflation expectations today. At the time, headline inflation went from 7.5% in August 2002 to 17.2% by May 2003. At the time the current central bank leadership took office at the beginning of 2003, annualized inflation (monthly rates raised to the twelfth) had risen above 30%. Brazil’s response then was to tighten fiscal and monetary policy despite the significant political costs to the new administration that had just taken office and despite the significant collapse in near-term economic activity. By June 2003, Brazil was experiencing a whiff of deflation as the combination of tight fiscal and monetary policy sent consumer spending collapsing as it experienced one of its sharpest falls in a decade. The move, though costly in terms of output, was in our judgment necessary given the credibility challenges facing the central bank and the fiscal authorities during the first year of the Lula administration (see, for example, our remarks at the time in "Brazil’s Triple Inflation Challenge" in WIB, May 12, 2003). We are not arguing that Brazil could not experience an upturn in inflation. Part of the improvement in inflation in recent months is tied to an unusually strong harvest and some of the recent gains could revert in the coming months. And part of the improvement has come as the Brazilian real has gained ground moving from near 3.8 at the beginning of 2003 to 2.06 in early May 2006. The recent bout of real weakness has prompted some to conclude that the currency’s nominal appreciation is over and that, in turn, could reduce some of the disinflationary pressures seen to date. But we are arguing that Brazil’s inflation picture looks much different that that of many other hikers today and that it did not hesitate when tested to respond with tough fiscal and monetary measures. Unlike its past Of course, some Brazil watchers look to Brazil’s past to draw the opposite conclusion that we do. They argue that in the second half of 2004, just a little over a year after Brazil had engaged in a double combo of tight fiscal and monetary policy, inflation began to rear its head and could do so again easily today. We would argue that the differences between 2004 and 2006 are significant. Brazil’s central bank, in our view, not only finds itself in a different situation than most other central banks do today, but also finds itself in a different situation from the one prevailing in 2004 when a mild outbreak of inflation once again conjured up concerns of a repeat of last 2002 and early 2003. We would highlight five differences that distinguish Brazil’s central bank and the context in which it is conducting monetary policy today from that which prevailed in 2004: First, aggregate demand pressures were much stronger in mid-2004 than today. By the second quarter of 2004, Brazil’s real GDP was growing at a 5.1% year-over-year rate; in contrast, today real GDP in the first quarter was up only 3.45% and is expected to be below that in the second quarter. Second, Brazil’s external situation is much stronger today with a near record trade account surplus of over $45 billion in the twelve months through May 2006 versus a surplus of $28 billion in the twelve months through May 2004. The larger trade (and current account) surpluses should provide some cushion in the event of a sharp currency move, likely limiting the inflation impact. Third, Brazil’s external position has improved dramatically. As of May 2004, Brazil had only $24.5 billion in reserves and net public external debt (net of reserves) stood just over $56 billion. In contrast, as of last month international reserves stood at $63.4 billion and net public external debt stood at $5.3 billion as of April (We’ve excluded IMF monies in both cases to make the comparison apple-to-apples). Furthermore, in mid-2004, Brazil still had just under $39 billion in dollar obligations in domestic debt (including FX swaps). By contrast today, we estimate that Brazil’s public sector is net short dollars to the tune of nearly $8 billion in domestic markets. Fourth, two years ago when inflation began to rear its head in Brazil, the central bank had just finished a dramatic 1,050 basis point period of cutting, today the cuts since September 2005 have only totalled less than half of that. Today, even with the 50 basis point cut last month, rates have come down by only 450 basis points from 19.75% in August to 15.25% by May 2006. Fifth, Brazil’s central bank has developed a track record that is much stronger today than in 2004. There was considerably doubt at the beginning of 2003 whether the central bank and the finance ministry would be able to reign in inflation and inflation expectations. Despite the successful efforts in 2003, by 2004 we were once again hearing doubts about whether monetary policy could be used to tighten ahead of key mid-term elections. The central bank’s move in September 2004 and in the subsequent months helped to consolidate its reputation as a serious inflation fighter. We would credit that reputation for the limited volatility in the most recent sell-off in Brazil. Despite all of the market panic, local rates have behaved much better this time than they did in the 2004 episode. During the April and May 2004 sell-off, the currency lost about 12%, moving from 2.87 to 3.21, while one-year DI contracts jumped more than 340 basis points from 15.4% to 18.8%. This time, a larger currency move from 2.06 to 2.35 saw one-year DI contracts widen by less than half as much (from 14.65% to 16.12%) as was seen in 2004. Caveat Of course, there are risks to our view that Brazil can continue to buck global tightening. Currency moves could continue as investors continue to reduce Brazil positions in face of the need to raise cash for redemptions. That, in turn, could put more pressure on the real and begin to contaminate expectations. So far we have not seen that as Heloisa Marone highlighted last week ("Brazil: Inflation and the Volatility Ghost" in WIB, June 13, 2006). But a prolonged bout of currency pressure could change Brazil’s inflation dynamic. Higher oil prices could force Petrobras to adjust prices and force consumers to pay more at the pump. Bottom Line With the current emerging markets sell-off, it may seem foolhardy at worst and irrelevant at best to be highlighting the fundamental improvement in Brazil. At times, context can get swept away as investors rush to deal with a sell-off. But unless the current global turmoil continues unabated (which we doubt) or produces a calamity for the US consumer (which is not the call of our US team), we suspect that Brazil’s central bank will continue to have room to buck the global tightening trend and reduce interest rates. We expect another 50 basis points of cuts in the July meeting to bring overnight rates to 14.75% and believe we can still move lower towards our end-year forecast of 14%. With inflation under control, with a stronger track record that should help keep expectations in check, and with overnight rates currently at 15.25%, we suspect that Brazil can continue to seek out neutrality on the rates space. Neutrality for Brazil, unlike for most of the world, should mean lower not higher rates.
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Undervalued Advantage
Jun 20, 2006
Serhan Cevik (from Vancouver, BC)
The undervalued shekel has cushioned Israel against the global volatility shock. In the midst of one of the worst waves of risk reduction in global financial markets, Israel has become an extraordinary sanctuary. The shekel has kept appreciating and domestic long-term interest rates hardly moved. Is this surprising in a country that has a short-term interest rate differential of just 25 basis points vis-à-vis the US, and when all the other markets keep jumping up and down with every bit of movement in American bond prices? Not really, considering a number of interrelated factors that have set Israel apart so far. First, Israel is just at the beginning of a new political cycle driven by a strong coalition committed to fiscal discipline and to move ahead with the disengagement plan (see Almost Perfect, May 4, 2006). Second, the economy is growing at a robust pace and attracting an increasing amount of foreign direct investment. And last but not least, the undervalued shekel has provided an advantageous cushion against the global volatility shock. Thanks to the shekel’s appreciation, the peak in headline inflation may well be behind us. The consumer price index remained unchanged on a month-on-month basis in May, slightly better than our projection for a 0.1% increase. As a result, the year-on-year inflation rate declined from 3.8% in April to 3.5% last month. Although this is still above the central bank’s target range of 1-3%, it signals that the peak in headline inflation may well be behind us. However, this does not mean that the underlying inflation threat is over. As a matter of fact, the most important factor contributing to the benign inflation data is the shekel’s appreciation against the dollar that has lessened inflation pressures in currency-linked components of the CPI basket. For example, consumer prices excluding the housing category (which actually declined by 2.1%) posted a monthly increase of 0.5% in May, following a 1.9% increase in the first four months of the year. However, beyond the expected effects of higher energy quotes and seasonal adjustments in clothing and food prices on the upside, core inflation is also drifting higher. The Israeli economy is, without a doubt, growing at an accelerating pace. Real GDP grew at an annualised rate of 6.6% in the first quarter of 2006, up from 5.1% last year, thanks to a staggering 10.6% increase in business-sector output. More importantly for inflation dynamics and the monetary policy stance, the rate of growth in private consumption accelerated to 10.3% in the first quarter, with spending on durable goods growing at 12.9% on an annualised basis. According to our estimates, real GDP will increase by 4.8% this year, with risks certainly on the upside, we believe. Indeed, the projections by the central bank and the Ministry of Finance are even more optimistic, pointing to output growth of 5.0% and 5.3%, respectively. This is good news, but also means that the economy — and especially business-sector GDP — will be growing at a rate that is well above its potential growth rate for the third consecutive year. Even considering structural reforms and fiscal prudence, the sustained recovery in the labour market — the unemployment rate declined from 9.2% in the first quarter of 2005 to 8.7% this year — and the fast disappearance of the output gap will certainly add to inflationary pressures in the domestic economy. With higher interest rates abroad, the shekel’s strength is no guarantee for low inflation. As Israel’s economy has kept expanding at an above-trend pace, we thought that the central bank would have increased the policy rate by 25 basis points to 5.5% last month (and then to 5.75% in August). It seems that the authorities prefer experimenting with a lower interest rate differential, putting a lot of faith in the shekel’s strength and fiscal measures in managing inflation dynamics. So far, it is working, even against heightened uncertainty all around the world. However, short-term interest rates are still at around the ‘neutral’ level and tightening through currency appreciation is not enough to mitigate broader inflationary pressures. This is why we still expect the Bank of Israel to adjust the monetary policy stance by 50 basis points in the coming months. That should keep bringing inflation well within the target range and help maintaining financial stability in a challenging global environment.
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