Japanese economic trouble: why we should underweight japanese financial markets

An excerpt form our latest Top Down Outlook. Go on our website for a 1 month free trial.
Over the last few weeks, investors have been focusing on the negative outlook for peripheral Euro Zone countries, especially Greece, due to their high deficit and public debt. However, albeit at a slower pace, uncertainties over the future of public accounts concern a vast majority of developed countries. For instance, public debt, in % of the GDP, may rise to 65% in the USA, 88.2% in the UK in 2011 and 83.7% in the Euro Zone as a whole.

Notwithstanding the above, the country that may suffer the most in the next few years due to elevated public debt is Japan. Indeed, public debt ballooned in the last two decades from 59% of the GDP in 1990. Further, the International Monetary Fund estimates that debt may have risen to 218% in 2009, and thus could reach 227% and 246% in 2010 and 2014 respectively. This jump in public debt substantially replaced the falling private sector debt, increasing the level of total debt/GDP, according to data from McKinsey Global Institute, from 420% in 1995 to 471% in Q2 ‘09. We used 1995 as a benchmark year, since this is when non-financial business debt reached its highest level (148% of GDP). After 1995, non-financial business sectors began a deleveraging process that finished only recently (non-financial business debt fell to 91% of the GDP in 2005 and now stands at 95% of the GDP).

Despite the huge increase in public debt and the estimated further increase in the years ahead, government bond yields have remained very low. The 10-year Japanese Government Bond yield has been below 2% since 1998, with no meaningful changes over that period. By now, Japan holds the record for both the highest general government debt and the lowest long-term government yield among developed countries; which is in stark contrast with economic theory.

The grounds for this “conundrum” are explained in a recent working paper “The Outlook for Financing Japan’s Public Debt” by IMF economist Kiichi Tokuoka, who enumerated the factors behind the low and steady JGB yields:

1) Large pool of household assets: household saving rate was around 10% until around 1999 when it began to decline sharply;

2) Strong home bias: JGBs have been financed largely by domestic investors (94 %of holdings as of end-2008), who may exhibit more stable behaviour than foreign investors. The strong home bias is driven by the household sector whose appetite for risk assets has remained weak. The share of currency and deposits in households’ financial assets is as high as 55% (at end FY2008)—well above 16% in the U.S.—and a large part of these funds is invested in JGBs mainly through the banking sector;

3) Existence of large and stable institutional holders as the Japan Post Bank and the Government Pension Investment Fund;

4) Recent large saving flows from the corporate sector.

Nevertheless, Tokuoka explained that structural shifts in the Household Balance Sheet and key market players could weaken the absorptive capacity of the JGB market, making yield more sensitive to the debt level. For instance, the role of the household sector in providing funds to the JGB market is likely to decline as the savings rate may further fall from the current level (2.2% in 2007). The author’s simulation indicated that, based on current trends, the gross public debt in 2015 could exceed gross households’ financial assets, that is, of course, assuming that the household saving rate remains at 2.2%.

Tokuoka concluded that it would be critical to establish a credible framework over the medium term to ensure fiscal sustainability. The framework would need to feature a clear timetable for comprehensive tax and expenditure reforms to be implemented once the economy recovers.

However, a shift in the expansionary fiscal policy adopted by the Government in the last few years is not yet on the horizon. The latest macroeconomic data, while posting a better than expected growth of 1.1% q/q GDP in Q4 ‘09, indicated that economic growth is mainly driven by exports in spite of the surprising rebound of both consumer spending and business investment. The most worrying aspect of Q4 GDP figures, however, was the 0.9% q/q decline of the GDP deflator – a 54 year low. 

Deflation weighs on the Japanese economy in two ways: 1) it weakens consumer spending, and 2) it dampens business investments because real yield is higher than in the rest of the developed world.

This negative situation will unlikely change in the short term as the output gap is indeed very wide (about 7% according to the Cabinet Office’s estimate for July-September 2009), and a meaningful recovery is not expected over the next few months. Moreover, internal demand is likely to remain weak as wage declines are influencing sales over a broad range of discretionary goods, and investment spending will unlikely pick up considerably due to uncertainties on current economic recovery. For these reasons, only further significant improvements in exports could trigger a sharper upturn in the economy.

On the other hand, increases in exports are limited by the Yen's sharp appreciation in recent months, particularly against the U.S. Dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with its June 2007 peak, the Yen has advanced by over 27% against the U.S. Dollar, eroding profit margins for the nation's exporting companies. Based on the OCSE Purchasing Power Parity estimate, the current level of the Yen surpasses an overvaluation of 25% against the U.S. Dollar.

Therefore, a devaluation of the Yen is the most efficient way to spur growth in Japan’s economy in the short term, even though it appears difficult to implement, given that almost all major international economies rely more or less heavily on their currency devaluation to revive the economy. Moreover, both the Bank of Japan and the Treasury Minister seem to have limited possibility to implement further policy action to stimulate the economy. Last week, the BoJ left rates unchanged at 0.1% and did not take decision on its quantitative easing program.

All the same, we believe that should the Japanese Yen’s upward trend versus the U.S. Dollar resume in the months ahead, the Bank of Japan will be ready to take extraordinary measures to weaken the exchange rate, i.e., increasing lending term facility for commercial banks or raising government bond purchases. Fiscal deterioration is another factor prompting a decline of the Japanese Yen. We believe that there are no likely prospects of the Japanese Yen strengthening beyond its current level in the months ahead.

For this reason, we would not invest in any asset classes denominated in Japanese Yen. The Japanese equity markets have underperformed other major international equity markets. Thus, in view of potential Yen devaluation in the medium term and low bond yields, we recommend not to invest in the Japanese bond market.

Finally, the economic scenario for the Japanese economy we have depicted above reinforces our recommendation to BUY the AUD/JPY exchange rate, which fell in the previous weeks due to a surprising RBA decision to leave rates unchanged at 3.75% at February’s monetary policy meeting in conjunction with the increase in risk premiums on international financial markets. However, the AUD/JPY rebounded last week as the RBA made clear in the minutes of February’s monetary policy meeting that the tightening monetary policy will resume in the next few months. Following the higher than expected increase in employment in December, we foresee the RBA hiking rates to 4% as soon as in March. We continue to expect the Australian and Japanese Central Banks to each implement a highly restrictive and expansionary monetary policy in 2010 among major Central Banks, making the AUD/JPY the favorite exchange rates for carry traders.

Momentum indicators still say overweight equity

An excerpt form our latest Top Down Outlook. Go on our website for a 1 month free trial.

Following the sell-offs of recent weeks, major international equity markets continue brandishing negative performances since the beginning of 2010: The S&P500 has declined by 3,55%, the DJ Eurostoxx by 8,22%, the Nikkei by 4,3% and the FTSE100 by 4,99%. Emerging markets as a whole also have kindled negative performances in 2010: the MSCI Asia fell by 5,9%, the MSCI European emerging by 3,8% and MSCI Latin America by 3,7%.

Even renowned strategists and economists now differ on the outlook of equity markets over the next few months, especially with regard to the S&P500. Barton Biggs, chief global strategist at Morgan Stanley from 2003 to 2007, and now head of the hedge fund Traxis Partners, recently said that valuations are ok, and that there are a number of good opportunities on the market. Last September, Biggs said that the S&P500 may climb to 1350 in 2010. However, according to New York University Professor Nouriel Roubini, the stock market will be flat or almost unchanged at the end of the year. More pessimistic is the outlook depicted by Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co, who said investors should underweigh stock because the S&P500 is above what he believes to be its fair value at 850.

As we indicated in 11 January’s “Global Strategy Weekly” , we believed that the S&P500 was slightly overvalued at the beginning of the year according to our long-term valuation model, which analyses the average earnings for the past 10 years, the average earnings annual growth rate and the average P/E for the past 30 years. Following last week’s sell off, investors may now expect a compound return of 6% in the coming 10 years, slightly below the actual historical average return of 7%, but above the average of 5.4% predicted by the model in the past.

Nonetheless, we have also maintained a BUY rating on many equity markets; especially those in emerging countries (see 1 February’s “Global Strategy Weekly – Equity Emerging Markets Outlook”). Among the equity markets in developed countries, we have a BUY recommendation on the Nasdaq 100. In 1 February’s report, we have underlined all the fundamental reasons behind our decision to confirm our rating on those markets. However, an important reason for this rating is that we are great followers of momentum strategies and these markets are still in an upward trend. In this week’s “Global Strategy Weekly”, we will be analyzing what the most popular momentum strategies say on the perspectives of major international financial markets.

Momentum strategies have been the subject of a long series of working papers in academic literature that indicate how they are able to generate significant extra yields. One important report by Jegadeesh and Titman, "Returns to buying winners and selling losers: Implications for stock market efficiency", published in The Journal of Finance (1993, Issue 1), prominently demonstrates this theory. In this report, the two authors affirmed that the strategy of buying securities which, during the last period (3 to 12 months earlier) had achieved the best performance, gained positive abnormal returns during the period 1965/1989 in the U.S. market. For instance, the strategy which selects stocks based on their past 6-month returns and holds them for 6 months realizes a compounded excess return of 12.01% per year on average. This is an important verification by the two authors that these returns were not due to the presence of systemic risk or a delayed reaction to common factors. This study was followed in subsequent years by several reports related to other international equity markets that found similar results.

Leaving aside what might be the causes of these results, we are going to examine the results of a very simple momentum strategy with reference to the major international asset classes. We will take some Eurizon’s mutual funds (Eurizon is one of the bigger asset managers in Italy) as a benchmark, not in order to judge their goodness, but in order to assess the actual return achievable by an Italian investor in the past 11 years using momentum strategy. We evaluated 10 mutual funds that invest in different asset classes: as regards the stock markets, we considered funds invested in Asia, Europe, Japan, Italy, North America and Nasdaq100; and as regards bond markets, we considered funds invested in Euro medium/long-term Government Bonds, Euro short term bonds, US Dollar bonds and emerging markets bonds. The strategy consists of: at the end of the month to buy the 3 mutual funds (out of 10) with the best year-over-year performance and keep them in the portfolio until the end of the following month, and then make a new selection. The chart below indicates that such a strategy would have granted an investor a performance close to 60% from 1999, compared to 6% which would be recorded dividing the initial investment in equal shares in each of the funds.

Considering the 30 major asset classes identified among the Italians ETF (stock markets, bonds and commodities), the six financial markets that this strategy suggests as overweight now are: equity Eastern Europe, equity Latin America, equity Emerging Asia, equity Africa, equity China and the Nasdaq 100. With the exception of China, which we do not include in our portfolio due to fears of excessive credit growth in 2009 (as we explained in 19 December’s Top Down Outlook), these are the asset classes that we overweighed in our Top Down Portfolio (Equity emerging Asia has been recommended since 19 December, the whole of the other equity markets since the inception of the portfolio on 5 December).

Choosing these assets would appear to go against the trend of recent weeks, which saw major stock markets trend downwards. However, this should not come as a surprise when considering that the buy or sell indications of momentum strategies lags behind the reversal of the trend. On the contrary, the decline of recent weeks afforded investors, who had not entered the equity markets in recent months, to possibly invest with a better risk/return profile than at the beginning of the year. In fact, after the fall, most of the stock markets were brought closer to what is seen as a watershed between upward and downward trends: the 10-month moving average. In the following table, we have highlighted the results of a very simple trading system: buy an equity index when the closing price is greater than the 10-month moving average and exit the market when the closing price is lower. Performances using this simple strategy are rather positive (we did not consider the gains from bond markets in the months when we were not investing in equity markets).

 

We have also highlighted the distance of the current close from the 10-month moving average. A combination of the two previous strategies could be used to buy equity markets currently indicated by the momentum strategy, setting a stop loss below their respective 10-month moving averages to limit losses in the case of reversal of the long-term upward trend.

The Week Ahead in US: CPI and capacity utilization most important data

Empire Manufacturing Index (Tuesday 16) – The Empire Manufacturing Index rose in January to 15.9 from 4.5 in December, indicating improved conditions for the manufacturing sector in early 2010 in the New York area. The data was substantially in line with indications coming from the ISM Manufacturing Index as regards the USA as a whole. The index is likely to indicate that industrial production will continue to trend upwards in the months ahead, remaining almost unchanged at 15.2. The equity markets’ decline in the past few weeks is likely to be the main reason behind the slight downtick in the index.

NAHB Housing Market Index (Tuesday 16) – Confidence among US Homebuilders dropped in January from 16 to 15 – its lowest level since June ’09. We expect the index to rebound to 16 in February, as real estate may begin feeling the effects of the tax credit extension and expansion for home buyers.

Housing Starts (Wednesday 17) – Housing Starts tumbled by 4% to 557k in December, with poor weather conditions probably taking their toll on the data. With weather conditions still negative for the sector in January, housing starts may have continued falling over the month: we estimate a 2% m/m decline to 545k. Housing Starts are likely to rebound in the months ahead thanks to a tax credit extension to June.

Industrial Production and Capacity Utilization (Wednesday 17) – Business confidence indexes rose in January (the ISM Manufacturing Index marked its highest level since August 2004), anticipating a continuance of the upward trend in industrial production. In line with the increase in the index of aggregate weekly hours, we estimate industrial production to rise by 0.5% m/m in January. Compared to January ’09, industrial production may rise by 0.9%, the first year-on-year positive change since March ’08. Capacity utilization is likely to increase to 72.3% from 72%. The index should nevertheless remain well below its historical average (80.6%), indicating soft inflationary pressures in the months ahead.

FOMC Minutes (Wednesday 17) – In line with our estimates, the FOMC upgraded its view on the US economic outlook in a statement released after its 27 January Monetary Policy Meeting. The FOMC confirmed that “economic conditions, including low rates of resource utilization, subdued inflation trends and stable inflation expectations are likely to warrant exceptionally low federal fund rate levels for an extended period of time”. However, this opinion was disputed by Kansas City Fed President Thomas Hoening, who said in the press release that “financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Federal funds rate for an extended period was no longer warranted”. The minutes of the latest monetary policy meeting will furnish more insight on the particular views of the members of the Board of Governors concerning the economic outlook. In particular, it has to be seen whether other members, aside from Hoening, would have preferred removing the expectations of a low level Federal Funds rate for a long period, but might have decided to concur with the majority.

Consumer Price Index (Friday 19) – The Consumer Price Index rose to 2.8% y/y in December from 1.9% y/y in November, exclusively for the base effect in energy prices. The core inflation edged up to 1.8% y/y from 1.7% y/y in November, due to higher vehicle prices that were only partially compensated by shelter prices (unchanged m/m in December). We expect consumer prices to increase by 0.2% m/m and by 2.7% y/y in January as inflationary pressures are likely to remain subdued in the short term, hence reflecting low pricing power. Core inflation may edge up 0.1% m/m to 1.7% y/y.

Central Bank Monitor: BoE and Riksbank on the spotlight

Bank of England:

At the press conference on the Inflation Report, the BoE’s Governor King confirmed that the decision to forestall purchasing government bonds was not definitive, and that its extension could be decided if consumer prices became worse than previously estimated. As for the projections on economic activity and inflation, the BoE has slightly lowered its estimates on GDP growth and raised its estimates on inflation in the short term, vis-à-vis November’s Inflation Report. The growth rate of GDP is projected to be about 3% y/y in late 2010, and to surge at the same pace in 2011 should interest rates coincide with market expectations, or scend by 4% should rates remain steady at 0.5%. Nonetheless, Governor King stressed that the British economy will not recover the pre-crisis growth trend for many years. Inflation is foreseen to breach 3% y/y during the first part of 2010, probably in January, mainly due to the disappearance of the temporary VAT reduction. Towards the end of 2010, inflation should submerge below 1% and should not buoy up to 2%, the targeted high tide in two years. With inflation expected to remain below the 2% mark at a two-year horizon, a wide output gap expected for the long haul, and a fiscal policy that could become more restrictive in the coming months, we think that the Bank of England should find little reason to raise rates substantially in the near future. We pencil in the BoE to raise rates only by the end of 2010 and only after the Fed and the ECB have decided on a similar action.

Riksbank:

As widely expected the Riksbank left rates level at 0.25% at the end of last week’s monetary policy meeting. In the Monetary Policy Report, the Swedish Central Bank revised the CPI projection for 2010 upwards, from 0.8% to 1.6%; and slightly downwards for both 2011 (from 3% to 2.9%) and 2012 (from 3.6% to 3.1%). As regards economic growth, the GDP is expected to climb by 2.5% in 2010 against the 2.7% projected in December’s Monetary Policy Report update. This is the result of both the improved functioning of financial markets and positive economic indicators, signaling that economic recovery stands on much firmer ground. The Riksbank anticipated monetary policy normalization as the first rate increase in now expected during the summer or early autumn (in December it was expected in autumn). At the same time, the current assessment is that the Repo Rate increase may occur more gradually and its forecast in the longer term has therefore been adjusted downwards slightly. The Repo Rate is expected to grow to 1.25% in Q1 2011 (previous estimate at 1%) and to rise to 3% only at the end of 2011 and not in Q3 2011 as previously expected. The real Repo Rate has been revised upwards, but will remain negative during 2010.

Riksbank outlook: no rate hike on the radar screen

At December’s monetary policy meeting, the Riksbank decided to leave the repo rate unchanged at 0.25%. The Central Bank also confirmed its previous path estimate of the rate for the coming years, as it is expected to remain steady at the current level until autumn 2010, then rise to 0.5% by the end of 2010, to 2.5% by the end of 2011, and to 4.25% by the end of 2012. The Riksbank is widely expected to leave the rate unchanged at 0.25% and to confirm the previously estimated rate path in the Monetary Policy Report released at the end of the meeting. The report will also contain the new projections on the progress of inflation and economic growth. Deputy Governors Nyberg and Wickman-Parak may enter yet a third consecutive reservation against the repo rate path. During December’s monetary policy meeting, they considered that it would be necessary to raise interest rates sooner than indicated by the proposed interest rate path, but that the path would consequently not need to be so steep during the remaining forecast period. We do not expect Deputy Governor Svensson to vote for another rate cut. Despite the better-than-expected economic data published over the past few weeks, we believe that the Riksbank will not tighten rates until the ongoing economic recovery proves itself well established. Moreover, the Riksbank is seeking a Krona appreciation in the coming years. Thus, it is highly unlikely that rates will be raised before other Central Banks (i.e. the ECB). Subsequently, we do not pencil in a rate hike by the Riksbank before H2 ’10. Nonetheless, we believe that the Riksbank will raise rates higher than actually forecasted.

US and Euro Zone Bond Market Outlook

Since its inception, we have not incorporated any bond asset class categories in our Top Down Portfolio.

This is simply because the “Top Down Portfolio” is designed to replicate the asset allocation of a diversified macro hedge fund and is therefore well suited for the most aggressive section of any active investor’s portfolio. Considering our preference for momentum strategies, we have seen many equity markets (especially emerging markets) and some currency exchange rates (i.e. AUD/JPY and NOK/SEK) offering a better risk/rewards profile compared to bond markets, while Gold and Silver provide stronger protection against the potentially increasing risk premiums on the international financial markets.

However, we are well aware that bonds are usually the main asset class category in investment portfolios, going unaltered even through the steep yield decline over the past few years. Nevertheless, according to the latest US data gathered by Michael Belkin, author of “The Belkin Report”, only USD24bn had gone into various kinds of equity funds over the entire recovery rally starting in March ’09, versus USD178bn into bond funds.

Accordingly, this week’s “Global Strategy Weekly” will be analyzing bond market perspectives in both the US and Euro Zone, though we shall not be altering the 10 asset class categories in our “Top Down Portfolio”.

In the “Global Strategy Weekly” published on 18 January entitled “What is the yield spread telling us?” (look here for an exerpt), we underscored that very steep yield curves (the spread between 3m US T-Bills and 10y T-bonds is still well above 300bp) are usually followed by a decrease in long term rates and an increase in short term rates. We are of the opinion that a flattening yield curve in both the US and Euro Zone (we consider the German bond market as a benchmark) is the most likely scenario in the medium term.

With short-term Government Bond yields close to historical lows in both the US and Euro Zone, we see very few reasons to invest in them now. Thus, investing in short-term Government Bonds would make sense solely in the event of fresh financial turmoil, or should deflationary pressures resume.

More uncertainties surround the outlook of long-term Government Bond yields. On the one hand, we are skeptical insofar as the decline of long-term rates in the next few months, as the steepness of the yield curve would indicate. Indeed, despite huge advances since its lowest level, posted in December 2008 (at 2.42% in the US and at 2.95% in Germany), long-term yields still remain low, especially considering the global economic recovery. On the other hand, we cannot agree with the general belief that yield may climb much further in the next few quarters (the economists in December’s Livingston survey conducted by the Federal Reserve Bank of Philadelphia predicted that rates may rise to 4.1% in the US by the end of 2010, and to 4.64% by the end of 2011).

Further, we estimate that economic growth in the US and Euro Zone over the next few years is likely to be subdued, since the potential growth rate has declined following the past two years in crisis. Moreover, the deleveraging process that would take place in major developed countries (i.e. total Debt as % of GDP is at 296% in the USA and at 285% in Germany) should eventually take its toll on economic growth.

Two other factors will play a positive role in lowering long-term yield in the next few quarters. US long-term Government yield will continue to benefit from foreign purchasing of US bonds. According to the paper “International Capital Flow and US interest rate”, the Federal Reserve’s economists Francis Warnock and Veronica Warnock demonstrate that foreign flows have an economically large and statistically significant impact on long term interest rates. While a slowdown of foreign buying is possible, the prospects of international investors completely abandoning the US market in the months ahead are unlikely. For this reason, foreign acquisition of US bonds should likely continue benefiting the US economy.

In the Euro Zone, difficulties surrounding the outlook of peripheral countries are likely to have a positive effect on German Bonds, which should continue to be seen as a safe heaven.

Our main scenario is that long-term Government Bond yields in the US and Euro Zone should rise in the short term (especially in the US), which is in line with economic recovery gathering momentum in early 2010, and then decline when the respective Central Banks begin increasing rates in H2 ’10, with investors setting off to discount more moderate economic growth and lower inflationary pressures. While we are not recommending investing in long-term government bonds now, we do see the potential for long-term Government bonds to gain positive returns in the next few months. We believe that the best choice for bond investors is to have their portfolios buttressed to last as long as possible.

Notwithstanding the above, a sudden increase in inflation is the main risk to our projection. In the working paper “Inflation Hedging for Long-Term Investors”, published in April 2009, IMF’s economists Alexander Attiè and Shaun Roache verified that “long-term treasury bonds are the worst performing asset class in the immediate aftermath of an inflation shock as yield increase”. However, the two economists also noted that “after about 3 years the return dynamics begin to work in favor of long-term treasuries, albeit gradually.”

Nonetheless, we believe that the prospects of a big spike in inflation are slim due to slack capacity utilization and the effects of deleveraging process on consumer spending, which we have emphasized previously. We substantially concur with the economists’ consensus in the Livingston Survey, in that consumer price should rise by 2.2% in 2010, and by 1.8% in 2011. The break-even inflation rate for the next 10 years (implicit in the TIPS) is at 2.27%.

Should inflation rise well above current expectations, bond investors should switch to inflation-linked bonds.

The Week Ahead in US: retail sales and U.Michigan consumer confidence Index

From our weekly Top Down Outlook

Trade Balance (Wednesday 10) – With consumer spending rebounding at the tail end of the year, we expect exports to increase more than imports in December, widening the trade balance deficit. Our estimate is for imports to increase by 2.6% to USD179.12bn and exports by 2% to USD141bn. Should our estimates prove correct, trade balance surplus may rise to USD38.1bn.

Retail Sales (Thursday 11) – Retail sales figure were highly volatile over the last few months, probably reflecting problems with adjusting data for seasonal issues. Retail sales rose by 1.2% m/m in October, by 1.8% in November, and fell by 0.3% m/m in December. Notwithstanding December’s decline, the underlying trend in retail sales remains solid, and we expect the sales’ climb to resume in January. We project retail sales to increase by 0.6% m/m in January (3.8% y/y), and by 0.9% m/m ex-auto (4.3% y/y). These figures would suggest that a consumer spending rebound is likely to continue in early 2010.

Michigan Sentiment Index (Friday 12) – The Michigan Sentiment Index rose to 74.4 in January, up from 72.5 in December. Given the broad sell-off in equity markets over the past few weeks, labor markets still bogged down, and notwithstanding signs of an emerging bottoming-out in the last few months, we do not pencil in a sizeable short-term improvement in consumer confidence. We expect the Michigan Sentiment Index to remain unchanged at 74 in February, remaining well below the long-term average (89.6), which indicates that consumer spending recovery may remain subdued.

Monetary policy Update: a review of CB's Meeting over the past week

From our next Top Down Outlook:

The ECB decision to leave rates unchanged at 1% at the end of last week’s monetary policy meeting was widely expected. Addressing the press after the meeting, President Trichet reiterated the outlook depicted at last month’s monetary policy meeting with respect to a cautious approach to current recovery, emphasizing the temporary nature of the stimulus and strengthening the view that inflationary pressures would remain subdued in the medium-term. However, the most important element of the press conference was Trichet’s indication that in March “the Governing Council will take decisions on the continued implementation of the gradual phasing out of the extraordinary liquidity measures that are not needed to the same extent as in the past”. As regards the interest rate outlook following last week’s ECB monetary policy meeting, we see no reason to alter our estimate that rates are likely to remain unchanged, at least until the end of H1 2010, where they should gradually climb to 1.5% by the end of 2010, in line with our projections on downside risk.

Following last week’s monetary policy meeting, the BoE announced its widely-expected decision to leave rates unchanged at 0.50% and to pause its asset purchase program totaling GBP200bn. In a statement released after the meeting, the BoE said that “the Committee will continue to monitor the appropriate scale of the asset purchase program and further purchases would be made should the outlook warrant them.” It appears that the BoE is keeping the door open for a possible expansion of the program, though it does not expect to do so at this stage. The Inflation Report due for publication last week will give more information on the BoE’s economic outlook for the months ahead.

The Norges Bank decided to leave rates unchanged at 1.75% at the end of last week’s monetary policy meeting. The CB indicated that “activity in the Norwegian economy has increased, but capacity utilization is still lower than normal”. Other important factors influencing the outlook of monetary policy were “house price inflation is high and growth in household credit remains relatively strong” and “at end-January” the Krone was a good 1.3% stronger than projected for the first quarter in the October 2009 Monetary Policy Report. The result of last week’s meeting is in line with our base scenario; hence the Norges Bank should increase rates to 2% at the next monetary policy meeting scheduled on 24 March. According to our estimated equilibrium rate model, the NB’s ever-tightening monetary policy is likely to continue in the months ahead: the Key rate may rise to 2.75% by year-end.

The Reserve Bank of Australia (RBA) surprised markets by deciding to leave rates unchanged at 3.75% during last week’s monetary policy meeting. This came after having increased them by 0.25% in each of the last three monetary policy meetings in 2009. All 20 economists in the Bloomberg survey predicted a rate hike.

In the press release published at the end of the meeting, Governor Glenn Stevens explained that “since information about the early impact of those changes is still limited, the Board judged it appropriate to hold a steady setting of monetary policy for the time being”. However, Stevens added that “interest rates to most borrowers nonetheless remain lower than average. If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term”. Although, last week’s decision to leave rates unchanged came as a surprise, we believe that further rate hikes in the months ahead are still a clear possibility. Moreover, should employment and home loans data, which are due for publication sometime next week, come out higher than expected, the RBA may decide to raise rates again at next month’s monetary policy meeting.

ECB and BoE decisions' on extraordinary measures expected

From our latest Top Down Outlook:

The ECB is widely expected to leave the rate unchanged at 1% at the close of its monetary policy meeting on Thursday, since economic data published in the last few weeks did not change the economic outlook depicted by ECB Chairman Trichet during the latest press conference in January. While economic activity continued dilating at the end of 2009, uncertainty as to the sustainability of current economic recovery remains high as a number of supporting factors are merely temporary. Moreover, inflationary pressures have been well contained and are expected to remain below the ECB’s 2% target both in 2010 and 2011. Trichet also emphasized that the ECB will continue supporting the credit market, but will gradually phase out extraordinary liquidity measures. We estimate that rates are likely to remain unchanged at least until the end of H1 2010, gradually rising to 1.5% by the end of 2010. Nevertheless, we believe that the running risk facing our projections is that rates may be lower and not higher than our year-end estimate.

With interest rates expected to remain unchanged at 0.5%, the main item of interest of Thursday monetary policy meeting will be the BoE’s decision on the asset purchase programme. At the end of January’s monetary policy meeting, the BoE announced that thus far the purchase of GBP193bn out of GBP200bn has been made and that the programme shall take another month to complete. We believe that the BoE may decide to stop the programme in February as the economy is showing signs of bottoming out from recession. However, we believe that a rate hike by the BoE is hardly at hand. The latest economic data published in the UK (i.e. Q4 GDP figures) indicates strong prospects of economic activity rebounding in the next few months, though economic recovery is likely to be subdued. Moreover, even if the CPI rose to 2.9% y/y in December, and possibly exceed 3% in January, inflationary pressures are likely to soften in the months ahead. We do not pencil in a rate increase by the BoE, at least until Q4 2010. The inflation report of 10 February and the ensuing press conference by BoE Governor King will further detail the BoE’s monetary policy outlook.

Why we are still bullish on emerging countries equity markets

This is an excerpt from our weekly Top Down Outlook. To subscribe a 1 month free trial go to our website

Equity markets in emerging countries gained spectacular returns ever since major equity indices began their overall upward trend in March ’09: the MSCI East Euro advanced by 81%, the MSCI Emerging Asia by 102% and the MSCI Latin America by 67%. Unsurprisingly, these indices were also the hardest hit by sell-offs in the past two weeks. Compared to 2010’s highest value recorded in the first days of the year, the MSCI East Euro declined by 6.2%, the MSCI Emerging Asia by 7.5% and the MSCI Latin America by 6.3%.

The negative performance over the past two weeks weighted on our Top Down Portfolio, as we recommended buying the whole of the emerging countries’ equity markets since the inception of the Portfolio. However, even after the correction over the past two weeks, we are not going to change our buy recommendations on these markets because the majority of the elements spurring the emerging markets rally are still soundly in place.

The most important factor supporting equity emerging markets are the expectations that economic growth is likely to be robust both in 2010 and 2011. For instance, in the World Economic Outlook Update released over the last week, the IMF raised its estimate for GDP growth in emerging and developing economies compared to 2009 WEO projections, from 5.1% to 6% in 2010 and from 6.1% to 6.3% in 2011. This major upward revision concerned Asia, which is projected to grow by 8.4% both in 2010 (against the 7.3% forecasted in November) and 2011 (8.1%). China is expected to continue growing at a robust pace, with a 10% GDP growth projected in 2010.

Nonetheless, news sources coming from China are the main reasons behind the underperformance of Asian/ex-Japan equity markets in the last few weeks. After the higher than expected GDP growth in Q4 ’09 (+10.7% y/y), Chinese authorities have initiated the first restrictive measures to slowdown credit growth and to curb inflationary pressures (1.9% y/y in December). In fact, the People’s Bank of China raised the ratio for required reserves, the timing of which was earlier than expected for the market. The PBOC also raised its 3-month, 6-month and 1 year bill over the past weeks. However, rumours that major banks were said to stop lending were denied.

While the markets were disappointed by signals of a more restrictive monetary policy in China, which dragged down commodity prices and should most likely trigger lower economic growth, we believe that this decision is the consequence of both strong economic growth and the Chinese Authorities’ willingness to curb excessive credit growth, subsequently precluding much bigger problems in the months ahead. The sharp increase in the country’s debt pile throughout 2009 (new loans amounted to 9.21 trillion Yuan in 2009 and they are expected to fall to 7.5 trillion Yuan in 2010 according to Morgan Stanley estimates) is indeed a big concern when considering the forward course of China’s financial stability. For these reasons we see the PBOC decisions as positive in the medium term.

Emerging markets are also likely to continue benefiting from excessive liquidity created by the major central banks around the world. Although the improvement in economic activity, monetary policy is likely to remain expansive in the major international economies. This is especially true in the USA, Euro zone, UK and Japan. As we have pointed out in past editions of “Global Strategy Weekly”, we believe that the Fed, the ECB and the BoE shall start increasing rates in H2, while the BoJ is expected to leave rates unchanged for the whole of 2010 (and probably 2011). This means that rates are likely to remain below their neutral levels for all of 2010. Contrariwise, Morgan Stanley analysts pointed out from a recent investigation that emerging countries’ central banks could hike rates sooner than expected due to strong economic growth. The tightening monetary policy in EM will bring capital inflows, a strong basis for expecting continued economic and asset overperformance.

Finally, the most important emerging markets may benefit from the lower leverage of the economy as a whole when compared with most developed countries. A recent study conducted by the McKinsey group showed that the total debt/GDP is much lower in developing countries than in developed countries. The deleveraging process that would take place in developed countries over the next few years would drag economic growth in these countries for many years to come, making the outlook of emerging countries appear rather rosy.

Moreover, albeit the recent strong upward trend, emerging markets do not appear as excessively overvalued at current levels. Indeed, the 12 month forward P/e is below historical average both in Asia (13.2x versus 14x) and Emerging Europe (8.9x versus 10.4x) and it is above the historical average only in Latin America (13.6x versus 10.6x).

We would reiterate our buy recommendation on emerging countries equity markets in view of the trend for these indices to remain on the upside. Indeed, notwithstanding the recent correction, the whole of the benchmark indices are still well above the respective 200-day moving average, and our preferred momentum indicators (based on performance in the latest 1 month, 3 month, 6 month, 9 month and 12 month), which gave a buy signal at the end of April ’09, are still positive. Should these indicators turn negative, we would reconsider our position on the indices.

Norges Bank's tough decision

Following the unexpected rate hike by 25bp to 1.75% in December, the outcome of wednesday's Norges Bank monetary policy meeting is highly uncertain. At the end of December’s meeting, the NB said that it did not pencil in another rate increase until the publication of the March Monetary Policy Report (March 24) and announced that the Key policy rate would likely be raised gradually thereafter. Our base scenario is that the Bank will raise rates by 25bp to 2% in March. However, with underlying inflation being higher than expected in the last few months, we are well aware that a rate hike following next week’s monetary policy meeting is a clear possibility. The Norges Bank’s tightening monetary policy is also likely to continue in the months ahead. According to our estimated equilibrium rate model, rates may rise to 2.75% by year end.

Reserve Bank Of Australia preview

The Reserve Bank of Australia (RBA) hiked rates 3 times in 2010, raising them from 3% to 3.75%. The RBA is likely to continue its tightened monetary policy in February, raising rates to 4%. Economic data published in the last few weeks indicate that economic recovery is well under way in Australia. The more positive indication came from the labour market: in December, employment rose by 35.2k, three times more than economists had expected. Moreover, the consumer price index increased by 0.5 q/q in Q4 versus market expectations of 0.4% q/q, signalling that inflationary pressures may be higher than expected in the months ahead. With housing prices expected to trend upward in the next few months, the RBA may further tighten monetary policy in the months ahead.