Credit - The Pigou effect

"Nothing is perfect. Life is messy. Relationships are complex. Outcomes are uncertain. People are irrational." - Hugh Mackay, Australian scientist

While continuously following the evolution of the Euro convolution, with the temporary relief of the outcome for a Greece and the high probability of a Grexit in the end, as well as looking at the continuous fall in one of our favorite global demand indicator namely the Baltic Dry Index falling below its 1986 level towards 513 on the 22nd of February, we reminded ourselves for our title analogy of the Pigou effect, which is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. For Arthur Cecil Pigou, real wealth was simply defined as the sum of the money supply and government bonds divided by the price levels. He argued that when an economy was in a liquidity trap, monetary stimulus to increase output could not be used given there is little connection between personal income and money demand. Of course what we find of interest is that if the Pigou effect had been effective, then Japan should have exited deflation much sooner. Pigou, (just like our central bankers of the world today) hypothesized that falling prices would make consumers feel richer (and increase spending, that famous "wealth" effect) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further, which of course is exactly what has been happening.
It appears that "The Pigou effect" has been highly criticized as well by Michał Kalecki because: "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."

But, when it comes to our title analogy and the "Pigou effect", we find it quite amusing that Pigou had been John Maynard Keynes' professor. Pigou's theory is completely flawed as it is based on the hypothesis that there cannot be a prolonged period of overproduction (China) and the artificial life support of "zombie" companies (European banks, Chinese shipping companies, etc). Arguably, the trajectory of the Baltic Dry Index is indeed putting to the test that very assumption from the University of Cambridge professor. It is interesting to note that his student, John Maynard Keynes argued that a drop in aggregate demand could lower both employment and the price level in unison, an occurrence observed in the deflationary depression, which is what we are currently seeing in Europe and what is also coined by some economists the "Keynes effect":

"The effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase." - source Wikipedia

Of course both the teacher and the student were wrong, as the former ignored the probability of extended oversupply and the latter implied that insufficient demand in the product market cannot exist forever. The Keynes effect does not occur in a "liquidity trap" according to "Keynesians", which is the result we are seeing in Europe with lack of aggregate demand due to lack of private credit as most European banks as they are constrained by their inherent "lack of capital". It is also particularly due to ZIRP and the Zero Lower Bound Problem. The result of this "liquidity trap" is, for us, self-inflicted. We discussed the issue of "crowding out" of the private sector in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector."Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments. It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

In this week's conversation we will take another look at the long term prospect for the European banking sector, as we strongly sit in the deflationary camp. We believe that rates will stay low for longer, particularly in Europe, which is caught in a vicious "japanification" process. We will also reassess some of our earlier views (long US treasuries, long Gold, short JPY), particularly in the light of the increased volatility and the impressive rise in US yields during the month of February which we highlighted in our most conversation.

Synopsis:

• The "crowding out" effect
• Banks stocks or credit?
• Banking crisis? Sweden lead the way
• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!
• Reassessing some of our earlier views
• The battle against the deflationary bust looming will not be won by ZIRP and QEs
• Real wage growth is the Fed's greatest headache
• Volatility is a buy and will greatly impact negative convexity assets
• On the fallacy of "Balance accounting" as per Sir James Goldsmith

• The "crowding out" effect:

The "crowding out" effect we mentioned on numerous conversations pushes yields down further meaning bonds investors are having a field day. Weak demand and ZIRP entices speculations and buy-backs rather than investments and employment. Banks play heavily the carry trade and therefore increase their link to their respective sovereigns while the private sector (SMEs) hasn't been able to easily access credit, leading to a credit crunch in Europe in the last couple of years triggering weaker aggregate demand, surging unemployment, etc.

In similar fashion to Japan, government bonds have replaced private sector lending on European banks' balance sheet. The comparison between Japan and Europe in terms of "evergreening" bad loans (extend and pretend that is, such as "shipping loans" for instance) and impaired financial sector can be ascertained from German bank Berenberg's note entitled "Turning Japanese...we really think so" published on the 10th of February.

"Policy responses – lessons not learned: In terms of fixing the banking system (the need to recapitalise banks rapidly and early on) and monetary policy (the need for shock and awe), European policy makers appear to be aware of, but have not taken on board, the lessons from Japan or the US in the 1930s. Perhaps, like their Japanese peers before them, they believe the economy is facing cyclical not structural challenges, or maybe they are concerned about their reputations or wish to prevent panic. But to be clear: fixing the European banking system remains unresolved and will remain so until hidden loan losses are dealt with.
● Interest rates will be lower for longer than anyone is prepared for: Deflationary forces arising from the balance sheet recession will see loose monetary policy
persist for another 10-15 years. For European banks, the implications are clear.

o Balance sheet structures to transform: Private sector deleveraging, continuing fiscal deficits and tightening regulation will make balance sheets smaller, drive the loan-deposit ratio below 100%, see (sovereign) fixed income assets double their share of bank assets, and lead to ever increasing equity-to-assets ratios.
Non-performing loan (NPL) ratios may yet double as they did in Japan following the onset of deflation.
o Balance sheet profitability to decline: Flat yield curves close to the zero bound and a substitution of private sector loans with sovereign bonds will push the net interest margin lower for many years to come. Combined with elevated loan losses, returns on assets (RoAs) will remain at half the levels of the precrisis, golden age.

● Share price and valuation parallels offer no support: The parallels with Japan have also held at a share price and valuation level, and suggest that there remains considerable relative downside to come (30-40%?) for European banks." - source Berenberg

Japan and the "crowding out" effect as illustrated by Berenberg in their lengthy note:

- source Berenberg

• Banks stocks or credit?

As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe. This can also be ascertained by the comparison in terms of returns for banks between Japan and Europe as highlighted by Berenberg in their great note:

"Given the continuing poor disclosure of loan quality by the European banks, we cannot say for certain what the capital deficit really is. However, history consistently shows that at the end of a 60-70 year debt cycle when an extended balance sheet recession takes hold, there are substantial hidden loan losses. But at some point, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus crystallise the loan losses." - source Berenberg

This support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

The extend and pretend game of hidden losses has been of course been supported by both LTROs and by now the much anticipated ECB QE.  So, forget about "dead cat bounces" in European banks share prices, as Japanese history has shown, pain is here to stay for shareholders as illustrated as well clearly by Berenberg:

"In Figure 29 we compare the relative performance of banks against the market in Europe and the US with that of Japan (with the Europe/US data rebased by 11 years to map the timescale of Japan). The good news is that the material relative underperformance of Eurozone, UK and US banks matches that of Japan both in terms of scale and duration. The bad news, however, is that the worst is not over. Japanese banks staged a three-year rally on the back of the restructuring of the banking system driven by the 2002 Takenaka plan (which forced the recognition of NPLs and the recapitalisation of banks). However, the underperformance resumed over the last eight years and Japanese banks are now at close to their 40-year+ relative lows. With Europe yet to achieve closure on balance sheet uncertainty (ie achieve a successful restructuring of the banking system) and with flat yield curves at the zero bound squeezing net interest margins, European banks are likely to continue to grind lower relative to the market. Further, as we show in Figure 30, banks do not like QE. In Japan and the US, banks underperformed during episodes of QE (QE flattens yield curves thus squeezing net interest margins and also signals an environment of low nominal growth which is negative for asset quality)."

- source Berenberg

• Banking crisis? Sweden lead the way

When it comes to the outperformance of "Nordics" share prices versus Japanese banks as displayed above it can be very simply explained. Sweden decided to tackle head on the issues of its ailing banking sector on numerous occasions. Sweden has a good firsthand experience of financial crisis unlike Europeans. 

Sweden suffered through a banking crisis in the early 1990s and then again in 2008 and 2009. It chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.

The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office. 

As far as European banks are concerned, regardless of the European Banking Union, AQR and other shenanigans, we agree with Berenberg's take on the triviality of the AQR adjustments:

"The triviality of the AQR adjustments was the most damning in our view. It is simply not credible that at the end of a 60-70 year debt cycle and after seven years of near nonexistent economic growth that the adjustment to Non-Performing Exposures equalled just 62bp of total assets. Charitably, this could be blamed on IFRS and its requirement to only identify losses on an “incurred” basis rather than expected one (indeed, rephrasing the critique given IFRS only allows provisioning on an incurred basis and given the adjustments were so trivial, it must imply that the ECB acquiesced in covering up the scale of hidden losses in banks’ balance sheets). Indeed, as Hoshi and Kashyap wrote presciently in October 2013, the European authorities “appear to be hesitant to admit to the size of the problems facing the banks” perhaps out of fear of triggering a panic.

In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans. As shown in Figure 36, NPLs were over-valued for in excess of a decade.

Such forced disposals should help achieve price discovery around the true value of bank assets. And in turn, this should pave the way to achieving confidence around the capital bases of the European banks." - source Berenberg

• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

In relation to our title the "Pigou effect" and central banks' intervention leading to a "liquidity trap therefore neutralizing the "Keynes effect" , Japan is clear illustration of the failure of the "wealth effect" of Pigou's proposal as pointed out by Berenberg:

"In Japan, where the burden was shifted early on from monetary to fiscal policy, a Catch-22 is emerging. The Japanese government cannot afford to allow rates to rise, yet keeping rates low risks increasing distortions in the economy through the mispricing of risk. It has been estimated that a 2ppt increase in average bond yields would require almost all tax revenues to be used to service the government’s debt. Thus QE and the monetisation of the national debt must continue in size (apparently the Bank of Japan purchases the majority of all new debt traded) until the Bank of Japan owns most of the government’s debt. But if the quantity of something is increased and demand is constant then the price must fall, ie the yen must weaken further (and Japan exports deflation).

As noted in the previous section, abundant liquidity and low interest rates squeezed net interest income for Japanese banks (two-thirds of the revenues for a typical bank). This arose through two effects. Ample liquidity and a lack of private sector demand for credit meant that the Japanese banks materially increased their holdings of government bonds (with typically lower yields than private sector loans). Secondly, low interest rates and QE flattened the yield curve, reducing the benefit of the maturity transformation.

Markets are rejoicing that the ECB is finally following the Bank of Japan and other central banks in embracing QE. But what if, as Kiyohiko Nishimura observed (the former deputy governor of the Bank of Japan), the problems facing Europe and Japan are driven by a demographic not financial cycle. He has noted that in Europe and Japan, as well as the UK and US, crises have almost always coincided with a decrease in the ratio of the working-age population to the non-working age population":

- source Berenberg

 You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price! Exorbitant bond prices? How about Portuguese 10 year bonds at 2.13% trading briefly below US 10 year bonds?

• Reassessing some of our earlier views

Duration - party on Wayne! party on Garth!

While we endured the proverbial battering on our long duration exposure during February (offset somewhat by our short JPY stance), as discussed in our last conversation, the latest raft of weaker than expected US data such as US home resales falling to their lowest level in nine months last month at an annualized rate of 4.82-million units, as well as Industrial companies indicating they would only raise capacity by 1.8 percent in 2015, which is  the smallest increase since 2011, after boosting it 3.1 percent in 2014 according to  the Fed said in its Feb. 18 release on production, reinforce our view that we have probably seen the top of widening move in US yields for the time being. The current levels make it interesting to think about increasing slightly more our own long duration exposure.

Gold - everything that glitters...

In terms of flows, it seems precious metals saw their first outflows of $0.3bn in 5 weeks according to Bank of America Merrill Lynch "The Flow Show" from the 19th of February entitled "Out with the Safe, In with the Risk":

"YTD asset returns: stocks +3.1%, bonds -1.0%, commodities +1.4%, US dollar +4.4%; vol, gold & long duration bonds were the clear Jan “winners”; but risk assets have rallied big in Feb and quietly Treasury yields have jumped sharply (30-year up 50bps in Feb)" - source Bank of America Merrill Lynch

Our gold and duration calls from our conversation of the 6th of January entitled the "Fright of the Bumblebee" performed well in January and got punished in February:

"In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves,
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015"

The latest US raft of economic data has given some support of the $1200 level. We still remain positive for gold prices, given the lack of clear resolution of the Greek situation in conjunction with geostrategic tensions flaring with interventions looming in the Middle-East and with Ukraine 's economy in complete meltdown.

• The battle against the deflationary bust looming will not be won by ZIRP and QEs:

Looking at the global economy as a whole, we think the globalization of ZIRP is not reducing the deflationary forces at play but in fact reinforcing them, pushing us towards additional currency war which is reminiscent of the build up towards the crash of 1929 and the Great Depression that ensued. On that specific matter we share Dr Lacy Hunt's views and concerns. He is the Executive Vice President of Hoisington Investment Management and gave a month ago a long interview with Gordon T Long on the current economic situation. While gathering our thoughts since our previous conversation, we also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.
“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

• Real wage growth is the Fed's greatest headache

In similar fashion the slack in US real wage growth is the real problem to clearly validate the much vaunted US recovery  according to a University of Wharton article entitled "The Economy Is Coming Back — Why Wages Are Stuck in a Rut" and published on the 23rd of February:

"Despite that one bright moment in the late 1990s, U.S. real average hourly wages haven’t budged much for decades. The U.S. average hourly wage of $20.80 in January 2015 is about the same as that in January 1973, adjusted for inflation, according to the Bureau of Labor Statistics." - source Wharton University

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

Real wage growth, we think is the most important indicator to follow we think from a Fed tightening perspective.

We also indicated at the time:

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

• Volatility is a buy and will greatly impact negative convexity assets

From a market perspective, we recommended in our first conversation of 2015 that investors needed being long volatility as we enter a higher volatility regime, this is confirmed by the rise in the CVIX index (CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs) as displayed by Bank of America Merrill Lynch in their Liquid Insight note from the 23rd of February entitled "Letting the data speak again on G10 FX":

"This is just the beginning
We expect that the year so far is a preview of what will follow. Our year-ahead had argued FX volatility would increase as data dependence replaces forward guidance in monetary policy, ECB and BoJ QE would not be enough to replace Fed QE as boosters of global risk appetite, and oil prices would be lower and more volatile. In the global monetary union with the US we pointed out that loose Fed policy and forward guidance in G10 central banks had killed market volatility and FX correlations with data and fundamentals, and argued volatility and such correlations would come back as Fed QE ends, G10 monetary policies diverge and USD strengthens.
We believe these forces remain valid. We recently argued FX volatility has become the prime driver of global volatility, as central banks react differently to the common oil price shock and some are behaving as if they are in a currency war. The latest FOMC minutes also suggest the Fed is unlikely to continue ignoring the drop in inflation expectations, suggesting the upward USD." - source Bank of America Merrill Lynch

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

•  On the fallacy of Balance accounting as per Sir James Goldsmith

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.
But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent.
When the Asian countries, as mentioned by the European Commission, invest their 'excess cash' abroad, normally they do so by buying into businesses or by lending money. The latter normally takes the form either of buying government debt or of deposits, say in sterling or dollars, in the banking system. Now consider the position of the nations which, unlike the Asian countries, import more than they export and which, as a result, have a deficit as opposed to an excess of cash.
To finance their deficit, businesses or other assets are sold and debt is issued. This puts them in exactly the same position as an individual who sells his house or borrows money to cover his debts. Such a haemorrhage can last only a limited time before ending in bankruptcy." - Sir Jimmy Goldsmith

Hence the need for central banks to issue more debt to sustain the global financial system...until it doesn't work but that's another story...

Thanks to Global ZIRP and our central bankers we are indeed living on the Planet of the Apes...oh well.

"If you pay peanuts, you get monkeys."- Sir James Goldsmith

Stay tuned!

Credit - The Shrinking pie mentality

"I am neither bitter nor cynical but I do wish there was less immaturity in political thinking." -Franklin D. Roosevelt

Reading with interest the latest take on China by both Russell Napier from CLSA in his latest Solid Ground opus as well as Albert Edwards on the similar subject of a potential Chinese devaluation risk which would push the world further into outright deflation, we reminded ourselves of the "Shrinking pie mentality" in relation to our chosen title. Indeed, when the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries. 

When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.

In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:

"Revaluation of Japanese Yen, a historical lesson to draw: analysis" 

"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!" - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Of course we all know what happened next, from the same article:

"By the end of 1989 the Nikkei average stock price had climbed to 389,000 yen, expanding two times in four years! While during 1998 alone the land price around Japan's three major metropolitans rose by 43.8 percent, the Tokyo Rim rising even by 65.3 percent. 

In early 1990s, the economic bubbles created by the yen revaluation suddenly blew up, plunging the nation into an unprecedented recession, from which the country has been trying to struggle out till today. During the recession lasting longer than a decade, almost all the important economic indexes registered the worst post-war record. By then Japan had completely lost its long-term advantageous position held in the after-war pattern of western economic growth, especially that over the US. To some degree we should say, after years of efforts as set out at the "Plaza Agreement", America finally has defeated its biggest rival in the field of international trade." - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

On another point the demise of the Japanese rival was a "blessing" for the US economy which had been under duress due to the Saving & Loans crisis of the 80s. In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again...

As an illustration of the lack of the Fed progress we think in recent years has been no doubt in the Employment to population ratio as displayed in the below Bloomberg graph:

Does the recent uptick is indicative of the recovery finally taking shape in the US? The jury is out there and the next employment figures to be released in the coming months will be key particularly hourly wages data when it comes to validating the "escape velocity" plight of the US economy. But, as Roosevelt, we are neither bitter nor cynical, we are just merely economic observers and when we see that the US housing market which saw sales of previously owned properties tumbling in March by 7.5% from a year earlier to the slowest pace in 20 months while purchases of new houses sank 14.5% from February as reported by Bloomberg, we have our doubts on the "escape plan".

As we indicated last week, US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index pointing, to some important "crosswind" in this much vaunted US recovery.

One of the prime reason of our disbelief in the much hyped global recovery has been indicated by our regular observation of the shipping space where, for instance the Drewry Hong-Kong-Los Angeles container rate benchmark has been displaying clear lack of traction for 10 straight weeks despite numerous rate increases due to overcapacity still largely plaguing the container shipping industry - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell to $1,900 for the week ended April 23. Rates declined 3.3% after a general rate increase of $300 per 40-foot container implemented April 15 failed to hold due to slack capacity. The three general rate increases ytd have not been sustainable. Rates have remained below $2,000 for 10 straight weeks. Container rates are down 10.4% yoy." - source Bloomberg.

Given the annual rate of inflation in the euro zone was 0.5% in March, well below the ECB’s target of just under 2%, and it has been less than 1% since October, many pundits are tentatively analysing the various forms of QEs which could be attempted in Europe as well as pondering the benefits. Therefore, in this week's conversation, and given the glaring "Shrinking pie mentality" taking place in the world today, we will look closely at this very subject and the potential impact it could have.

In terms of our take on the Euro currency's strength, in our conversation in early January 2014 entitled "Third time's a charm" we argued the following:

"As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":

"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

We also added:

"Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014."

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:

This seems to indicate that the market clearly anticipates at some point some "nuclear" action from the ECB and also indicative of the tapering effect on the US dollar versus the Euro we think.

But, as shown by the "Japanese experience" the Euro strength may not simply be reversed by the "nuclear" QE option as indicated by Bloomberg:

"The impact of quantitative easing programs on currency is not clear, based on the experience across the U.S., U.K. and Japan. While initial announcements in both the U.S. and U.K were followed by a weakening of domestic currency, Japan's approach failed to stem currency appreciation, which instead followed Premier Shinzo Abe's 2013 reform announcements. The scale of program and type of assets purchased will determine the impact on currency and inflation across the euro zone." - source Bloomberg.

We do agree with Bloomberg, when it comes to QE "size matters".

In particular when one relates to the "japanification" of Europe and the deflationary risk we have been mentioning on a regular basis in our conversations. We did read with interest the comments on this very subject from Mansoor Mohi-uddin from UBS in the Financial Times back in November 2013:

"During Japan’s two lost decades, domestic banks were too weak to cut non-performing loans and absorb the losses. That prevented them from supplying fresh credit to the economy. Only when Tokyo began substantially recapitalising the financial sector – a full 13 years after the country’s bubble burst in 1990 – were Japanese banks able to start expanding their loan books.

Deflation risk

The eurozone’s banks are in a similar position to Japan’s in the 1990s. Six years after the credit crunch began in the western economies, eurozone banks have only hesitantly shrunk their balance sheets. Loans-to-deposit ratios remain roughly 110 per cent, at levels comparable to Japan’s ratios during its first lost decade. In contrast, US banks, forcefully recapitalised by the US Treasury in 2008, have been able to reduce bad credit and now only have loans accounting for 75 per cent of deposits. That rapid deleveraging has allowed the financial sector to provide stronger credit growth to the US economy.

Tokyo’s inability to strengthen quickly its banking sector led to Japan’s economy falling into recession frequently throughout the 1990s and 2000s. In addition, the country suffered entrenched deflation for most of the past decade.

Likewise, the eurozone has already endured two recessions since the credit crunch started in 2007, with the second downturn lasting six consecutive quarters until this year. Furthermore, the eurozone’s latest inflation data show consumer prices are increasing only 0.7 per cent year on year, increasing fears that the region will also fall into deflation.

Paradoxically, such economic weakness has been accompanied by persistent exchange rate strength. In both economies faltering gross domestic product growth has constrained demand for imports. Until the 2011 earthquake, Japan ran consistently large trade surpluses. That year the yen hit an all-time high of Y75 against the dollar. Similarly, the eurozone’s trade balance has become strongly positive over the past couple of years, pushing the euro up to a two-year high of $1.38 last month." - "ECB must act to prevent euro aping strong yen" - Financial Times, Mansoor Mohi-uddin, UBS.

Of course many see the continuation of the strong euro as a catalyst of QE in Europe as indicated by Bloomberg:

"Mario Draghi's April 12 assertion that "a strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability" suggests the likelihood of quantitative easing is increasing. According to Bank of France Governor Christian Noyer, inflation would be running at 1% absent the exchange rate's strength, twice March's 0.5% figure. Implementing a QE program would boost liquidity, and likely profit, at euro-area banks." - source Bloomberg.

Yes, implementing QE would no doubt boost liquidity but would, in similar fashion to the LTROs amount to "Money for Nothing" we think unless proper unconventional measures were taken such as helping out the deleveraging process of the private sector in peripheral countries. On that point we do not think that the Euro Sovereign-Loan Yield link may be restored as the LTRO runs down as posited by Bloomberg:

"A key goal of future ECB activity is to reopen lending channels to small and medium-sized enterprises across southern Europe. While attempts to invigorate the combined $2 trillion corporate loan markets of Italy and Spain have failed to drive new business loan rates lower, some sovereign and asset yields are at record lows. Until 2009, the correlation between sovereign yields and corporate loan pricing was meaningful. Re-establishing this would lower borrowing costs." - source Bloomberg.

No matter how large QEs where in the US, we have yet to see the transmission of credit for small businesses, which are essential for a strong recovery scenario in employment figures as shown in the below graph from a recent note from Bank of America Merrill Lynch entitled "When the tide turns" from the 25th of April 2014:

Of course the big beneficiaries of a QE in Europe would be the pure high beta play namely banks as posited by Bank of America Merrill Lynch in their recent European Banks Strategy note entitled QE without a real AQR:
"QE makes risk assets go up

There is a lively debate as to what Quantitative Easing actually is but we believe the market has a rule of thumb that is being applied to the euro area QE debate, which is that QE makes risk assets go up. Riskier assets tend to go up by more. Banks are risk assets and have behaved according to this rule YTD. Using a low starting price-to-tangible book multiple as a proxy for a bank being riskier, Chart 3 shows the riskier banks have strongly outperformed (bottom ten vs top ten by 23 percentage points YTD)"

- source Bank of America Merrill Lynch

European banks have already benefited from the "whatever it takes" carry trade which they set up following Mario Draghi's July 2012 comments and have purchased large quantities of peripheral government bonds, boosting their earnings in the process thanks to the central bank's generosity and of course not severing the link to the sovereign but increasing it drastically in the process.

As an illustration of the significance of the performance from the beta play set up by the ECB can be seen in French bank BNP's stock price performance as displayed by Bloomberg:

"Since Mario Draghi's July 2012 "whatever it takes" pledge, the correlation between falling Italian and Spanish yields and appreciating bank stocks has strengthened. While there may be some scope for further falls in rates, much of the recovery in confidence has now taken place, questioning the extent to which further declining yields can act as a catalyst for bank stock appreciation. BNP, only 7% of the Euro Stoxx 600, moves in tandem with the index, offering a good proxy." - source Bloomberg.

The European Banking Union was sold to the public on the premises it was supposed to break the link between sovereigns and financials and reignite lending. It looks to us, it hasn't happened and won't happen any time soon as displayed by the below graph from Bank of America Merrill Lynch's note on QE and the AQR:

- source Bank of America Merrill Lynch

The recent Portuguese auction is reflecting a return of confidence thanks to Mario Draghi's magical talents as displayed in the below Bloomberg graph:

"The Portuguese republic has successfully placed 10-year debt for the first time since January 2011, with an accepted yield of 3.575%, very nearly half the level required last time a placement was made. A bid-to-cover ratio of 3.5x underlines investor interest, a key positive as Portugal has 37 billion euros ($51 billion) of debt maturing by end-2015. A key read across for periphery banks is likely to be cheaper access to liquidity, which can help kickstart lending." - source Bloomberg.

Kickstart lending...

It has not happened in the US for small businesses and from a conversation with a friend who is a small business owner in Tokyo it hasn't happened there either. Small businesses in Japan cannot easily get credit lines to fund expansion. Only large corporates are able to access credit it seems.

When it comes to loan growth in the Euro area, we agree with Bank of America Merrill Lynch's take on QE in their recent European Banks Strategy note entitled QE without a real AQR:

"Capital works better than QE

We see the AQR as an opportunity for the ECB to jump-start bank lending more effectively than QE, if it were to be used to drive bank recapitalisation. The evidence to date is not reassuring in this regard. 

Less effective this way

We believe that QE without something to accelerate banks becoming confident enough in themselves is likely to be significantly less impactful on the real economy than one stapled to bank recapitalisation. While share prices would in our view likely respond positively to QE, banks’ behaviours are set to be slower to change. As a result, euro area growth is set to remain well below that of other major economies through 2015 (Chart 13)" 

- source Bank of America Merrill Lynch

The reason for the continued divergence in funding terms for corporates loans in the European space is due to the pace of deleveraging and the loss recognition process and rising nonperforming loans hence our "japonification" stance when it comes to assessing European woes and our well documented deflation bias. The below chart from Bloomberg highlights the difference in funding terms in various European countries:

"The disparity in cost of and access to corporate credit between north and south Europe was cited by Mario Draghi at the time of the ECB's November statement as a reason for the need to cut. New business rates and gross loan flows will remain a vital indicator that will inform policy decisions. If and when the ECB manages to reinvigorate the asset-backed market to unlock corporate credit, the differential between northern and southern rates will also be a key determinant of success." - source Bloomberg

To that effect, cleaning up banks' balance sheet would not be purely accelerated by QE in Europe, but banks recapitalization needs would be "reduced" by rising share prices in the financial space. When it comes to capital needs for European peripheral banks and rising nonperforming loans the race is on as displayed in the below graph from Bloomberg:

"Aggregate bad debt across the banks of Greece, Ireland, Italy, Portugal and Spain exceeded $925 billion at the end of 2Q13, 300% higher than in 2008, according to IMF data. As banks continue to prepare for the ECB's asset quality review in late 2014, and levels of restructured loans and various foreborne assets come under new scrutiny, many of these loans may be considered for sale. Italy and Spain will likely be a focus for private equity and distressed debt investors." - source Bloomberg.

As we pointed out last week, Europe is indeed for sale on a "fire sale" mode at least for banks.

"The deleveraging for Italian banks has hardly run its course and in similar fashion to the Italian government shedding real estate and its car fleet, Italian banks are as well busy shedding non-performing loans backed by real estate" - Macronomics 

"The non-performing loan ratio for all domestic EU lenders tripled on average to more than 4.5% at the end of 1H13, from full-year 2007. The coverage ratio (provisions as a percentage of bad debt) also fell by a third to 43%, as income statement charges failed to keep pace with ballooning bad debt. The imminent ECB asset quality review in the euro zone may require banks to reclassify more loans as bad debt, prompting pre-emptive portfolio sales." - source Bloomberg

In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity

The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities. No wonder the riskiest part of CLO have returned 16% in 2013 as indicated by Kristen Haunss in Bloomberg in her article "CLO Returns at 16% for Risky Slices Buoys Loans":

"The riskiest portions of specialized loan funds that have helped finance the biggest buyouts in history are luring investors with returns that exceed even junk bonds.

The equity slices of U.S. collateralized loan obligations, which get whatever money is left-over after more senior investors are paid, returned an average 16 percent last year, according to JPMorgan Chase & Co. data on funds raised since the end of 2008. That compares with 7.4 percent for the Bank of America Merrill Lynch U.S. High-Yield Index of bonds.

Investors say the prospect for above-average returns remains, even as the Federal Reserve starts to flag that it will raise interest rates as soon as next year. Demand for the equity slices of CLOs is helping fuel issuance, providing money for the neediest borrowers." - source Bloomberg

Of course thanks to these stellar returns as per the same article, the asset class has been booming:

"Investors poured a record $61.3 billion into leveraged loan mutual funds last year, according to Morningstar Inc. data, as they sought protection against rising rates. CLOs were the largest buyers of high-yield loans in 2013, with a 53 percent market share, according to the New York-based Loan Syndications and Trading Association.

Sales of CLOs reached $82 billion in 2013, the third-largest year on record, and have topped $32 billion in 2014, according to RBS." - source Bloomberg.

When it comes playing credit, we have to confide that, indeed we did participate and bought some junior subordinated debt from a French bank in October 2011 at a cash price of around 94.5 for a perpetual bond paying a nice 12.5% coupon seeing it rise meteorically to 138 cash price, a 46% appreciation with limited volatility, hence applying our lesson learned from the Japanese experience thanks to our continued study of central bank magic...

In the case of credit, if indeed the ECB does indeed embark on QE, another big beneficiary will no doubt be in the financial bond space as indicated by Citi in their credit weekly commentary entitled "How would ECB impact credit":

"So if the ECB wanted a serious percentage of any QE programme to be made up of private assets, then it seems quite probable that that would have to extend beyond secured assets.

Unsecured bank debt would seem the most obvious candidate for them to turn to next. The rationale for lowering bank funding costs is obviously that: 1) it would facilitate further recapitalization (now that revenues from the periphery-sovereigndebt-carry trade are fading), 2) it would lower the rate at which is it efficient for banks to lend without distorting the market-based allocation of credit, and 3) that the ECB through its comprehensive assessment should have a decent insight into the quality of the collateral that it would implicitly be buying into.
Although more probable than we previously thought, we still think it is less likely that the ECB would extend any purchases to regular non-financial bonds. It might suit a political purpose, but from an economic perspective we struggle to see much merit in lowering what are already record low funding levels for the large investment grade non-financials.
That said, even if the ECB chose not to buy them directly, by purchasing assets which fund managers hold interchangeably with non-financial bonds, the impact on non-financial spreads would be significant even at these tight levels." - source Citi

Given last week we indicated that Italian banks have relied more on debt issuance for their funding needs and given the significant rise in nonperforming loans on Italian banks balance sheet, should the ECB embark on a QE spree, you should rightly expect a strong outperformance of Italian financial bonds which be prime beneficiary of the central bank's renewed generosity. 

As per Nomura's take in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets" remember this:

"Unlike corporates, financials have just started what is likely to be a long deleveraging process, suggesting opportunities in financial credit.

-As dealers, they will carry lower inventories. As investors, they will have less demand for assets. And they will be supplying assets to the market." - source Nomura

On a side note, those who listened to us have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

In fact, US thirty-year debt has gained 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988 as reported by Bloomberg by Wes Goodman in his article entitled "Treasury Long Bond's Record Year-to-Date Return Four Times S&P:
"A rally in 30-year Treasuries has pushed returns past 10 percent in 2014, the best start to a year in at least two and a half decades.
“It’s going to continue for some time,” said Yusuke Ito, a senior fund manager in Tokyo at Mizuho Asset Management Co., which has the equivalent of $39.1 billion in assets. “The pace of the recovery is not enough to generate inflationary pressure.”
Long bonds climbed 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988. The broad market rose 2.1 percent and the Standard & Poor’s 500 Index returned 2.3 percent. While bonds gained on the outlook for slow inflation, shorter notes lagged behind on speculation the Federal Reserve will raise interest rates in the years ahead." - source Bloomberg.
We have to confide we have also been playing this game via ETF ZROZ (we do indeed learn a lot from our central bankers and their magic tricks...).

On a final note, when it comes to the "Shrinking pie mentality", exporting deflation  and China, given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", we have interestingly noted that China's services have recently replaced manufacturing and construction as per Bloomberg's recent Chart of the Day from the 22nd of April:

"Services have replaced manufacturing and construction as the biggest part of China’s economy, a sign that the Communist Party’s goal of getting people to spend rather than just make cheap exports is working.
The CHART OF THE DAY tracks contributions from services, industry and agriculture to gross domestic product since 1992, with sectors such as real estate, retailing and finance overtaking manufacturing last year for the first time since at least 1978, with a 46 percent to 44 percent proportion. In 1996, the breakdown was 48 percent industry and 33 percent services. Agriculture’s contribution fell by half in the period to 10 percent, according to National Bureau of Statistics data compiled by Bloomberg.
“It’s an irreversible trend that the share of services in the Chinese economy will keep growing,” said Chen Xingdong, the Beijing-based chief China economist at BNP Paribas SA. “The days are gone when everything is manufactured in China,” partly because the younger generation is more demanding and better-
educated, he said.
The lower panel compares urban and rural populations, with cities taking the biggest share starting in 2011, the data show. As recently as 1998, the rural population was twice as big as its urban counterpart, the data show. Of China’s 1.36 billion residents as of 2013, 54 percent lived in cities.
The shift toward services marks a milestone for the government and Premier Li Keqiang, who has made a priority of moving people from farms to cities to spur domestic demand as people accumulate more wealth and spend their money on homes, electronics and entertainment. There is room for more growth: China’s urbanization rate compares to 80 percent in developed nations like the U.S.
“In the past, a Chinese worker basically ate and prepared for work, but now they are pursuing a better lifestyle,” said Chen, who previously worked at the World Bank. Shifts in habits and demographics will put pressure on traditional industries like cement and steel and bring new opportunities to consumer, health-care and education businesses, he said." - source Bloomberg

The winner takes it all. Period.

"We are neither bitter nor cynical but we do wish there was less immaturity in macroeconomic thinking." - Macronomics

Stay tuned!