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Debt Monetization, QE, Inflation, Deflation and Expropriation PDF Print E-mail
Written by Burnham Banks   
Friday, 12 December 2014 01:44

Central Bank Large Scale Asset Purchases, by which is meant the buying of government or agency debt, is intended to ensure demand for such bonds and to keep borrowing costs low for the government and any other debt issuer whose cost of debt is correlated or benchmarked to government bond yields. Large Scale Asset Purchases, or QE, as they are popularly called, are meant to be a boost to the economy. The experiment has worked in the US, to  a certain extent. Lower borrowing costs have certain allowed corporate bond issuers to liquefy their balance sheets. Lower mortgage rates have spurred a rebound in housing prices which have led to healthier household balance sheets. The follow on impact from businesses to labour and employment has been slow.

QE directly funds government whereby a central bank buys bonds issued by the government. The central bank’s assets rise by the value of the bonds it has bought, and the liabilities rise by the same amount as it issues liabilities to fund the purchases. These can take the form of cash in the government’s reserve or cash accounts. It is convenient if the bonds are sufficiently highly rated that they consume no capital. It is hoped that central banks are thus able to help governments refinance themselves and buy enough time to return to fiscal balance and thus more attractive to private lenders. A growing economy is necessary, but not sufficient, for a government to improve its fiscal position through improving tax receipts. Fiscal profligacy can confound even a growing economy and rising tax receipts. It would appear that debt monetization cannot go on indefinitely if the government’s financial position is steadily deteriorating. Note that a constant budget deficit or a constantly rising level of debt has been demonstrated to be sustainable whenever there was sufficient domestic savings to fund this debt. It helps if the savers have no option but to fund this debt. In the absence of a such private funding there is debt monetization by central banks. The result, however, is an ever inflating balance sheet as more debt is issued to central banks in return for more printed money. This type of creative accounting can be quite persistent.

 

If rates rise and the bond prices fall, the central bank can either not mark them to market arguing that they will be held to maturity, or, they can mark them as available for sale and mark them to market. At that stage, any loss incurred by the bank will impact its equity. If the issuer, that is the government, buys back these bonds at below par, they will have made a profit equal to the loss incurred by the bank. The government could then recapitalize the bank by precisely the loss it had incurred in the first place. The value of the bonds, therefore, once in the hands of the central bank, are immaterial. This is pure money printing.

 

The government’s reserves with the central bank do not count as the money base. A government that is printing money is, however, likely not to leave too much money in its reserve account but to spend it quickly. The money thus finds its way to the commercial banks and becomes part of the money base. The money base is the multiplicand to which the velocity of money is multiplier in the identity that equates to nominal output. A sufficiently large money base makes an economy vulnerable to inflation or hyperinflation. Hyperinflation is usually a consequence of loss of confidence rather than a continuous process and will require more than an over inflated money base to trigger. But, persistent inflation can lead to a loss of confidence at some point.

 

Inflation aggregates domestic and external purchasing power. The measure of the external purchasing power of a currency is its exchange rate. Where debt monetization results in acute currency weakness, external inflation is already underway. This can impact headline inflation through imported goods and inputs.

 

In many ways, inflation is a signal rather than a lever. Targeting inflation religiously can distract policy from underlying causes. Disinflation can either be a result of productivity gains or deficient demand, or both. Persistent QE and low inflation can be a sign of an acutely weak economy as efforts at supporting sagging demand only just compensate for natural weakness. If the currency is also weak at the same time, it could signal that price support from rising costs were being compensated by substitution in a flexible economy with high productive efficiency which was also operating below capacity.

 

Where a country has financed itself in a foreign currency and or with foreign capital, as many emerging markets do, the ability to borrow is limited. Countries can default on debt not denominated in their own currency. The risk of default limits the demand for ever increasing issuance. Countries are not compelled to, but may choose to default on debt denominated in their own currency. Venezuela (1998), Russia (1998), Ukraine (1998), Ecuador (1999), Argentina (2001) are some examples. The ability to choose not to default, come hell or high water, on local currency debt, comes at a price, being the external value of that debt, thus the currency bears the brunt, and a de facto default occurs with a recovery rate equal to 100% less the depreciation of the currency relative to the bond holders base currency. Where the bond holders are hapless domestic investors, forced to lend to the government, no default de facto or technical occurs. Such investors would behave rationally if they save more to make up for the debasement of their forced saving and invest abroad as far as possible to compensate for the de facto expropriation. This can result in lower demand and deflation. Governments of such countries have to spend more to compensate for this demand deficiency, worsening their balance sheet and necessitating further debt monetization or de facto expropriation.

 

 
Gold. Just Another Thought. PDF Print E-mail
Written by Burnham Banks   
Friday, 05 December 2014 06:59

Gold.

To determine the value of an object one has to determine its usefulness. To determine the price of an object one has to understand the convolutions of the collective human mind.

Last Updated on Friday, 05 December 2014 07:41
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China Outlook 2015 PDF Print E-mail
Written by Burnham Banks   
Thursday, 13 November 2014 23:59

The Chinese government has focused on a number of things some of which include:

  • An anti corruption initiative.
  • Rebalancing the economy towards domestic consumption.
  • Maintaining financial stability and a certain level of economic growth.

The anti corruption initiative is a long term structural reform to strengthen the rule of law in China. The government appears to be serious about the rule of law despite doubts from many observers who see the law as a means of control. The Fourth Plenum saw an elevation of the Constitution which may signal that China is, albeit gradually, shifting to a rule by institution than by person. The anti corruption initiative is, however, a brake on growth, as many investment decisions and projects have corrupt elements in them and these projects may either fall away or need to be reorganized in a more acceptable form. Expect delays.

The rebalancing of the economy is an important factor in assessing China’s prospects. Most countries must by now recognize that globalization has been slowed if not reversed post 2008 as countries struggle to grow. In the aftermath of the crisis, the calculus recognized the constraints on fiscal policy, consumption and investment and naturally defaulted to exports to fuel growth. This placed the world in a state of a cold trade and currency war. In such an environment, currencies would range trade. Logical tolerable bounds would be 2007 levels for JPY and 2008 levels for the European currencies. These countries must also realize that the cold trade war is nearly over and that long term solutions need to be found besides beggaring thy neighbor. Cold wars are sometimes a balance of tacit collusions and conflicts. The end of such conditions will likely drive countries to pursue greater self sufficiency. A base of domestic demand and consumption is an important resource in the face of slowing or reduced globalization.

For many reasons, China’s growth is slowing. One reason is that unless one is the generator and owner of intellectual property, one’s economy is hostage to being a low cost producer. When costs rise, business moves elsewhere. China has long had a technological disadvantage compared with the West. It clearly recognizes this. The number of patents filed by Chinese firms has accelerated recently relative to the rest of the world.


 

It is hoped that this push to improve its competitiveness in intellectual property will result in higher productivity and a higher long term growth rate. In the meantime, however, growth has slowed from the double digit pace in the early 2000s to 7.3% at latest count. Some observers are quoting a rate of just sub 6% actual growth this year, slowing in 2015 and the coming years. If the economy indeed slows along this path, policy must be expected to adjust to a more accommodative state.

It can be argued that the PBOC misread the impact of the US Fed led global QE and easing policy on price levels in China. Certainly inflation rose steadily from 2009 to 2011 during which food price inflation ran into double digits. Concerned about inflation through tradable goods markets, the PBOC has been too tight. The low inflation in Europe, the US and Japan, the falling domestic inflation and the end of US QE has prompted the PBOC to switch to a more accommodative state. This will likely steady tradable goods while creating inflation in services and semi-closed asset markets.

If growth should slow more than planned it is likely that China will resume growing the economy through investment in infrastructure. This could provide some respite to commodity metals and energy markets regionally as well as globally. (Miners have been acutely weak of late and could represent a buying opportunity if China growth slows much more.) Another area of potential interest would be European and US industrial equipment companies.

Generally, the outlook for China is positive. Equities are relative cheap and growth is robust. The one impediment to the Chinese stock markets has been an overly tight PBOC. With a neutral to accommodative stance, the latent investment themes can be animated.


Longer term risks:

There are of course risks associated with investing in China. The anti corruption drive will deal, if tangentially, with corporate governance. There is a risk that the campaign might be a cynical and politically motivated power consolidation exercise. Only time will tell but the focus on constitutionalism is an optimistic signal.

The growth of leverage in the corporate and local government sectors, enabled by the bond and nascent securitization markets has been an area of concern. However, most of the debt is local currency denominated and therefore within the control of the government. Central government and household balance sheets are not overly leveraged. This will allow the government to bailout any credit issues that threaten to become systemic. A strong current account is not entirely relevant to the potential imbalances in Chinese credit markets but is a help in case of contagion into the hard currency credit markets.

Perhaps one of the most intractable risks to China is its irrevocable progress and the concomitant social change. The Umbrella Movement in HK, the troubles in Western China and Tibet, threaten the status quo. Government has to address the needs and wants of a new generation facing rising wealth and at the same time greater inequality. Greater freedom of information complicates this task. China’s vagueness about whether it is a secular (prescribed by the constitution) or atheist (preferred by the party) state remains unresolved, a dangerous condition given the correlation between ethnicity and religion in a country with significant diversity.

Geopolitically, the world has become a harsher place. The years leading up to 2008 saw relatively little turbulence between the major powers as credit fuelled prosperity tempered old rivalries. The world was, is and ever shall be a contentious place, however, pre 2008, the conflicts were localized and fragmented. The deceleration of globalization, the cold trade war, the competitive devaluations and monetary debasement make the post 2008 environment more fractious and fraught. The relationship between China, the US and Russia will have important strategic implications. One country is governed by institutions and offices, another by a party apparently shifting towards governance by institutions and offices, and the third by a man. The scope for policy miscalculations and mistakes are high.

 


Last Updated on Friday, 14 November 2014 00:07
 
Ten Seconds Into The Future. 2015 Macro and Investment Outlook PDF Print E-mail
Written by Burnham Banks   
Wednesday, 26 November 2014 02:41

Themes: Risk On and Pray Hard.

 

Rates and Credit:

Long US treasuries at the long end. 30 year and 10 year USTs remain attractive relative to short end. Expect further curve flattening.

Overweight / Long China equities. Despite slowing economic growth, earnings growth remains robust and the PBOC will likely be expansionary and China equities are cheap compared with most international equity markets. Longer term prospects are supported by structural reform.

Developed market credit is still attractive but investors have to be selective. Despite healthy profits and balance sheets, US corporate credit is expensive and high yield particularly so.

European corporate credit remains attractive based on fundamentals but pricing is also getting stretched. We prefer idiosyncratic situations such as regulation driven bank recapitalization trades.

European bank capital is a trade which is long in the tooth but remains attractive as ECB policy supports the recapitalization and reorganization of bank balance sheets.

The leveraged loan market is underpinned by healthy fundamentals but secondary market liquidity is becoming a concern. Fundamentals remain healthy with default rates likely to be in the 2% region with high recoveries in the coming year. The risk of a sharp correction is significant but such should be regarded as a buying opportunity.

In securitized products, US non agency RMBS remains an attractive asset class despite the trade being long in the tooth. Agency RMBS derivatives are cheap and can be used to also hedge a long duration portfolio. Australian RMBS has done well but bonds are now expensive. European ABS and covered bonds will be underpinned by the ECBs asset purchase programs.

The thirst for yield has caused the high yield market to run ahead of itself. Generally, globally, we prefer investment grade to high yield on a relative value basis as high yield is now trading tight to investment grade.

Underweight LatAm equities and corporate bonds. With the exception of Mexico, the region is in or close to stagflation on the back of over-reliance on China demand for commodities and failure to reform or a regression towards inefficient and populist policies.

Equities:

US equities are not cheap but they are supported by strong fundamentals. Relative to other regions, US equities have the advantage. While a long term buy, valuations are too rich. To buy US domestic risk, look to credit. High yield is similarly expensive, however, so focus on private label mortgages and investment grade corporates.

China equities will benefit from the PBOC’s newly accommodative stance. Despite strong growth and cheap valuations, China equities have been constrained by tight monetary conditions at home. This is already changing with noticeable effect. Buy the domestic listings.

European equities were cheap but no longer. The international nature of European equities and the level of dispersion in their financial performance means that Europe is an excellent place to generate alpha. The rate and policy environment do, however, recommend corporate credit ahead of equities as the more efficient trade expression. In Europe, underweight equities in favour of credit.

Reform countries including India, Indonesia and Japan will be well supported as investment is revived. Where corporate governance lags the developed markets, side with business owners and own the equity instead of the debt.


FX and Commodities:

The long USD trade has become an alarmingly consensus trade. While the long term fundamentals are constructive for the USD, volatility is picking up and a trading strategy is recommended. The obvious candidates to short are the EUR and JPY where policy is decidedly in favour and economies are sufficiently weak that the US will tolerate the clearly mercantilist policy.

China’s slowdown may be more pronounced than reported or expected. This will likely trigger more infrastructure investment boosting basic materials and industrial metals.


Last Updated on Thursday, 27 November 2014 00:00
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China. A positive outlook at last. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 04 November 2014 00:49

The China A share market surged last week. It is time to reiterate my optimistic appraisal of the China market. It is not too late.

Back in July, we noted that

  1. China equities were underowned.
  2. China equities were trading cheap.
  3. China equities had been in a 6 year bear market. This was most likely the consequence of the PBOC’s tight monetary conditions.

We postulated that the PBOC’s stance was driven by inflation concerns in the traded goods sector and the volatility in the commodities and food markets. 3 years ago food prices were rising at nearly 15% YOY and has since hovered between 2.5% to 5% since. It is likely that the PBOC views the US Fed’s expansionary balance sheet policy as a source of inflation in the traded goods sector and felt it necessary to compensate. Another concern was the growth of the Shadow Banking system in the form of off balance sheet funding vehicles. This is a more complicated topic but one which I believe has less of an impact on PBOC policy. The reason is that credit can be isolated in a semi closed economy whereas traded goods are sufficiently open to be impacted by international flows.

The trigger for the buy recommendation was the impending end to the US Fed’s expansionary balance sheet policy. With the end of QE, while the Fed’s balance sheet will not likely shrink quickly, or at all in the short term, it is at least static. The latitude that this provides the PBOC in expanding liquidity to support a slowing economy is important. China’s inflation has slowed to 1.6% with food inflation down to 2.3%. Widespread global disinflation will impact the traded goods markets in China providing further room for expansionary policy. The impact on semi closed markets, whether by nature or regulation, such as services and asset markets, is inflationary.

I previously held that China had a long term innovation deficit and that it had to buy or otherwise acquire technology. I am still of this view, but there are nuances to that view. The cutting edge of technology remains in the developed Western economies, bit China is catching up. There is a chance that this long term trajectory can be reversed.For investors and traders, a shorter time frame is more relevant.

One of the more important developments in China took place last week. The Fourth Plenum produced a number of interesting and constructive signals. The Central Committee chose to reduce the influence of local level officials over the legal system, establishing circuit courts with greater independence from local Party officials. There was some woolly announcement about accountability and transparency of government but details were scant. The most important announcement was the elevation of the constitution within the rule of law. The consensus is that the Party’s authority would not be weakened by constitutionalism but an optimist would hope that while the Party might not be compelled to work within the constitution, it might work with the constitution to more efficiently and fairly govern the country. Certainly this focus on the constitution places the anti corruption efforts in a less cynical perspective.

Bottom line: We are likely to have an expansionary PBOC and we are hopeful that concrete legislative reform is underway. At the same time we have cheap stocks and healthy growth at a time when developed markets face deflation risks and other emerging markets like LatAm face stagflationary risks, China is a good place to invest.

Last Updated on Tuesday, 04 November 2014 00:53
 
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