Three Dimensions of the Investment Climate
There are three dimensions to the broader investment climate: the trajectory of Fed tapering, the ECB's response to the draining of excess liquidity and threat of deflation, and Chinese reforms to be unveiled at the Third Plenary session of the Central Committee of the Communist Party.
There has been increased speculation that the Federal Reserve can begin tapering in December. The FOMC statement dropped the reference to tighter financial conditions and the manufacturing ISM was stronger than expected, as was September industrial production.
For the same reasons we did not think it very likely in September, we are skeptical of a December tapering. First, the impact of the government shutdown will distort much of the data in the coming weeks, including the October employment report on November 8 (for which the ADP data was disappointing). There has been a trend slowing of non-farm payroll growth, illustrated by the fact that the 3-month average is below the 6-month average, which is below the 12-month average.
Second, measured inflation remains low. The core PCE deflator for September will be released on November 8 as well and may tick up to 1.3%, after reaching two-year lows in July just above 1.1%. As we have noted before, the core PCE deflator, the Fed's preferred inflation measure, is lower now than in the early 2000s, when the then-Fed Governor Bernanke recognized the risk of deflation.
Third, when the Fed revised lower its growth forecasts in September, it did not cut sufficiently, especially in light of the government shutdown. It seems unreasonable to expect the Fed to taper at the same time as it reduces its growth forecasts. The effectiveness of the Fed's communication has again been questioned in light of its decision in September not to taper.
Fourth, and while perhaps the least appreciated, it is also among the most compelling reasons for the Fed not to taper in December. The credibility of the institution is clear better served by maximizing the degrees of freedom for the next Federal Reserve Chair. Tapering in December would needlessly tie the hands of Bernanke's successor and any anti-inflation chits to be earned would be wasted on the ongoing Bernanke, who will go down in history for the unorthodox policies adopted upon reaching the zero bound of nominal interest rates.
This is particularly important because the Federal Reserve sits on the cusp of among the largest changes in personnel in the Fed's history. Consider there are two vacancies already on the Board of Governors and that is before a successor to Yellen is found, assuming her nomination is approved by the Senate. Another Governor's term expires at the end of January. Another governor may choose to return to the university from which he is on leave.
In addition, in the coming months, another governor may chose to leave, having long served on the Board and amid reports of philosophical (personal?) differences with Yellen. Lastly, note that the fine print of Dodd-Frank also calls for the Board to have a second vice-chair to oversee the Fed's regulatory duties.
We think there is a strong possibility that Bernanke steps down early. While the Senate Banking Committee might be able to vote on Yellen's nomination later this month or early December, there may be some delay tactics when it comes to the entire Senate vote. Recall Bernanke's nomination for a second term by Obama (Bernanke was initially appointed by Bush-the-Lesser) passed the Senate by a 70-30 margin. Yellen needs 60 votes to over-ride a filibuster than has been threatened.
In any event, shortly after Yellen is confirmed, it is reasonable to expect Bernanke to resign. It serves no one's interest to have two Federal Reserve Chairs. That means Yellen is most likely to Chair the late Jan 2014 FOMC meeting that most expect to be Bernanke's last. What this implies too, is that our March tapering call does not require Yellen to announce such at her first meeting, but rather, the second she chairs.
Europe seems poised to snatch defeat from the jaws of victory. It has been a particularly good year for EMU. After initially blowing it, European officials managed to address the Cypriot crisis and although it retains capital controls, it remains in every other way a member of the monetary union. The six quarter contraction ended. Italian and Spanish stocks and bonds have rallied strongly, helping to ease their debt servicing costs and rebuilding investor confidence. Target 2 imbalances have been reduced and banks have returned nearly 40% of the LTRO borrowings.
Yet the repayment of the LTRO funds has seen the excess liquidity in the system fall. Excess liquidity has fallen by about 470 bln euros to stand just below 150 bln. Nearly 380 bln euros of LTRO borrowing has been returned, including what was announced before the weekend. The remainder of the decline in excess reserves (~90 bln euros) is due to what the ECB calls autonomous factors. Without getting bogged down in the minutia, autonomous factors include items such as bank notes in circulation, government deposits) and the point is that they are not a function of the ECB itself.
At the same time that excess liquidity is falling money supply growth is weak (M3 is up 2.1% year-over-year) and lending to businesses and households continues to shrink. Many observers were still surprised to learn that EMU CPI fell to 0.7% in Oct from a year ago, drawing nearer the record low of 0.5% in 2009.
With the traditional medicine of devaluation denied by the monetary union, the path of adjustment toward increased competitiveness requires inflation to be lower than Germany's. Germany's ordo-liberalism requires low inflation. This forces other countries to undershoot Germany's low target. The surprise to many is that they are doing it. Using EU harmonized calculations, German CPI stood at 1.3% in October. Italy's October CPI was 0.7% and Spain's was -0.1%. France's September reading was 1.0%, while Greece's was -1.0%.
In order to respond to the tightening of financial conditions in the euro area and the increasing risk of deflation, the ECB needs to do something as bold as the OMT announced in mid-2012. Consider the limitation of its options. Many observers are talking about a repo rate cut as early as this week. Yet such a move would be ineffective. In the current environment, the key rate is the deposit rate, which is set at zero. Overnight rates (EONIA) trade closer to the deposit rate than the repo rate (50 bp).
The ECB says that it is technically prepared to cut the deposit rate below zero, but it is obviously reluctant to do so and for good reason. No major central bank has done this and the issue is not only intended and unintended consequences but also foreseeable and unforeseeable effects. It could further harm the fragile financial institutions. It could unsettle the global capital markets.
Many observers expect the ECB to provide another LTRO later this year or early next year. We had thought so as well. However, it has become clearer, and seems only right, that in stress testing banks, those that rely on ECB funds, should be penalized in some fashion. This means that while the ECB may offer another LTRO, it may not meet widespread demand, and, there may in fact be a stigma attached to its use.
The ECB is continues to sterilize the sovereign bonds purchased under Trichet's SMP program. In theory, the ECB could refrain from doing so and thereby ease liquidity conditions. Yet this would not doubt raise the hackles of the Bundesbank, which may still be hoping for a Constitutional Court ruling that finds elements of the OMT program to go against the Germany's Constitution. Remember, the former Bundesbank President and a German member of the Governing Council both resigned over the SMP program.
Further dilution liberalization of collateral rules is beside the point, though incentives to strengthen the asset-backed securities market, may be a way to cope with the reluctance of banks to lend. If the ECB is going to lean against the deflationary forces and address tightening of monetary conditions, it does not have as many choices as it may appear. One way to increase excess liquidity is to reduce the required liquidity (reserves). A refi rate cut in conjunction would send a stronger signal. While the sooner the better, given that the ECB had foreseen base effects and the decline in energy prices, so the low inflation number may not have been too surprising, December looks like a more likely time frame than this week's meeting.
It goes without saying, one would have thought, that Draghi will strike a dovish tone at the press conference following this week's ECB meeting. The real data has lagged behind the survey data that Draghi had previously pointed to and what had appeared to be improvements in the labor markets have been revised away. Austerity among the debtors has not been offset by stimulus among the creditors. Although the citation of Germany in the US Treasury report on the foreign exchange market raised some eyebrows, got some chins wagging and keyboards clicking, there can be little doubt of the unspoken agreement throughout much of Europe.
At the end of next week (Nov 9-12), the Central Committee of the Chinese Communist Party holds its Third Plenary session. The Third Plenary session has in the past been the platform from which important changes have been announced. This one is similarly being promoted as having wide-ranging and substantial reforms.
Chinese officials appear to recognize that reforms are needed or risk the middle-income trap, in which a country exhausts it resources in achieving middle income status. There are three broad areas that reform is likely to be focused on: improving the functioning of the market (including unified market for land), transform government by reducing red-tape and providing a basic social safety net for Chinese citizens, and fostering new private businesses and more competition. The key take away point is that it is not a status quo government, but reformist.
To be sure, despite being reform minded, the new Chinese government has shown little interest in addressing the contradiction that goes largely unspoken yet is ever present, between a modernizing and flexible economy and the archaic and rigid political superstructure. Political reform and competition in that space is most unlikely to be forthcoming from the Third Plenary Session.
The outcome of the session is unlikely to have much immediate impact on the global capital markets. Nevertheless, investors have a vested interest in the strategy of the world's second largest economy. The rise of China since 1978 stands alongside the fall of a little more than a decade later as the two most important geopolitical events since the end of the World War.
China has taken significant measures toward giving greater market influence over some interest rates. It has removed the floor for lending rates, re-opened bond futures and introduced a prime rate. This new prime rate is a weighted average of 9 domestic commercial banks lending rates to their best customers. This supplements and, perhaps, will eventually supplant the PBOC's current benchmark (1-year benchmark has been set at 6% since July 2012, last week the prime rate was 5.71%). Further financial liberalization is expected in the coming months. There are reports suggesting the Plenary Session may also take up calls for national deposit insurance.
Chinese officials also appear to be preparing people for slower growth. The emphasis is shifting toward quality of growth, which seems to emerge only as the quantity has slackened, even according to official data. Although China's manufacturing PMI improved, forward looking new orders and export orders were softer, keeping the near-term outlook less certain at best.
The yuan has been resilient this year and rising to multi-year highs into late October, it spent last week on the defensive, as the US dollar rallied broadly. If our constructive technical outlook for the dollar is correct, it suggest further gains against the yuan as well. The CNY6.12 area may offer a near-term cap. It denotes not only the Oct high but also the 100-day moving average. Above there, the CNY6.15 area is also interesting. It corresponds to a retracement objective of this year's dollar decline and the 200-day moving average.
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