We may have mentioned the New Normal already a couple of times in our previous newsletters. The term was first introduced by Mohammed El-Erian, co-CIO of Pimco, in May and has triggered a debate among economists on what this means for the long future.
Let us first explain what is meant with this New Normal. Before the Great Credit Crisis broke out in 2007 we were used to robust economic growth numbers north of 3% year on year and a labour market which was close to full employment. The private sector was flourishing and benefitted from a world that got more interconnected.
Since the Great Credit Crisis 2007-2009 all this has come to an end and we will have to adjust ourselves to a new equilibrium which is created by more regulation, higher taxes, less leverage, lower growth and higher unemployment.
There are a number of valid reasons why it will be hard to return to the Old Normal for the next 10 or even 20 years.
The cycle of cheap credit, which was the fuel of the economic growth engine, is definitely behind us. The Shadow banking system collapsed and quite rightly regulators are looking at ways to shut that door for good. Of course markets move in cycles, and there will be again a period in the future where banks will be able to loosen their credit standards. But this will take time. The first phase of deleveraging of the banking sector is behind us. This was an abrupt and disruptive one. Now the second phase has started and should be more orderly. Nevertheless after the residential property market, commercial real estate and credit card write downs will force banks to deleverage their balance sheets further. This means that in the years ahead the supply of credit will be limited and this will be reflected in economic growth numbers.
Then there was the global imbalance of Asian and oil exporting countries that were funding the American spending spree. Although nothing fundamentally has been done yet about this problem, recent rhetoric from the BRIC countries (Brazil-Russia-India-China) shows there is growing caution to invest in US paper which is printed to finance the public household deficits. The Old Normal was based upon a model where the rest of the world was producing cheap products to satisfy American Consumerism and in return received US fixed income paper for it. THE solution to this problem would be that emerging market economies start buying the products that they produce themselves but this is not going to happen immediately and therefore growth will be at a much lower pace.
After the Lehman collapse the private economy imploded and governments all over the world had to issue rescue packages to avoid the global economy coming to a complete stand still. Apart from the banking sector which needed to be rescued anyway for the sake of the deposits of the public, the manufacturing industry needed a helping hand too. The US car industry for example was almost nationalised. Other industries got all kind of life lines and stimulus packages as well and most of them are still in place. Withdrawing these incentives would trigger a new turmoil. As Bill Gross, CEO of Pimco would say, the invisible hand of Adam Smith has been replaced by the visible hand of the public sector.
The US housing market could be considered as the crucial cylinder of the economic growth engine. After the collapse of the dotcom bubble the American consumer used his house in stead of the stock market to keep on spending via several creative refinancing techniques. As a consequence homeownership rose to approximately 70% in the US, but we now know that a lot of people should never have qualified for a home in the first place. At least not if prudent lending practices would have been applied by banks. Under the New Normal homeownership will drop again to pre-housing bubble levels of around 65%. As a consequence, this will not be a driving force for economic growth and the economy will grow at a lower pace as mentioned previously.
The gigantic stimulus and rescue packages issued by governments across the world have derailed the public finances and the taxpayer will eventually pick up the tab. In Europe everybody remembers a similar episode during the early eighties where tried to deal with the aftershocks of the Oil Crises. Fortunately they had the Maastricht Stability Pact to bring their finances back under control. However the problem now is the threat of the aging population in the Western World which is further going to jeopardise the public household deficits of European, American and Japanese governments. This environment will also contribute to lower economic growth.
We concur therefore with Bill Gross’s conclusions that the outcome of this New Normal will be an environment where rates will remain low for a considerable period of time, the USD will face serious difficulties, above average growth will come from new economies in Asia. He even adds two more valid points to this New Normal to be taken into account:
“The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.” (1)
(1)Bill Gross “On the course to a New Normal” Investment Outlook, Pimco, Sep 2009
Friday 25 September 2009
Thursday 17 September 2009
True reasons of USD weakness and other misconceptions...
Dear readers,
Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?
As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.
Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.
Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.
Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.
We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.
Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.
To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.
M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)
Figure 1 M2
Source: Board of Governors of Federal Reserve
The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.
Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)
Figure 2 Fed’s 5y-5y forward break-even inflation rate
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.
This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.
Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.
(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline
Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?
As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.
Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.
Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.
Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.
We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.
Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.
To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.
M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)
Figure 1 M2
Source: Board of Governors of Federal Reserve
The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.
Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)
Figure 2 Fed’s 5y-5y forward break-even inflation rate
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.
This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.
Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.
(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline
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