Random Shots - Catching Up

After a week with the family in a cottage in Sweden Alpha Sources is ready to get back into the grind. Returning from holiday as a macro analyst is always daunting given the barrage of news and data that you will have inevitably "missed". From reading the news and last week's sell and buy side research this morning Alpha.Sources sees a bit more positive note. Apparently, the significance of recent months' very aggressive monetary policy easing around the world seem to be having their slow, but predictable effect. A few more sell side notes than Alpha Sources had expected are now looking towards the second half with a bit more optimism.

There is still the strange feeling among many investors however that 2012 will be a repeat of 2011 and that sideways movement into the summer will eventually be released in another sharp draw down in global risk asset prices. As always, the extent to which this remains the consensus among investors even as monetary policy continues to ease in both conventional and unconventional fashion, Alpha Sources is getting more confident that bears may just get caught out. 

It is important though to be extremely sensitive to the data at this juncture with key economies such as China and the US at obvious inflection points.

In the US and despite the visible deterioration of the data in the past month, the call for a recession is still at risk. An ISM at 49 is normally not associated with a recession and further deterioration into the mid 40s in July would be needed to give a recession signal. Still, global bond markets continue to predict a very dire future with more and more investment grade yields going into negative territory and anything generally assumed safer than handing over your money to a teenager in a department store, seeing bid. Still, I am skeptical that such signals from an essentially manipulated and stretched market are all they are made out to be and prefer to stay close to the real economic data for now. This week sees a big chunk of data releases as well as the Fed chairman is scheduled to speak, so watch out for direction. F

China Rising or Falling?

In the case of China, Prime Minister Wen recently warned that positive momentum is not yet visible in the economy. This suggests more stimulus is on its way beyond the two rate cuts already implemented.

But, is this bullish because monetary stimulus in China will lead the economy up and indeed lead a general continuation of the global EM easing cycle? Or is it bearish because it suggests that conditions in China are worse than expected?

Alpha Sources would lean towards the former, but unless the data starts to turn this remains a hope and perhaps even a fool's one as it depends on the authorities' ability to micro manage the economy. As ever, the discourse on China is stretched by unrealistic expectations. On the one hand there are those who believe that China is able to reach pre-crisis growth rates of 10-12%. It isn't and there is no doubt that many global commodity producers have too much capacity relative to the growth level that China is able to attain. On the other hand, the chorus of those calling for a hard landing and essentially a collapse of the Chinese economy has, at times, been deafening. Alpha Sources finds it difficult to see exactly why this is supposed to happen now. China may be headed for a big crash, but such things rarely occur on the back of and in the midst of extreme euphoria and not excessive pessimism. 

Alpha Sources' base case scenario is that more stimulus from China will be able to drive positive sentiment forward, but also that between those calling for status quo and a crash, China is likely to achieve neither and in stead simply achieve a new trend growth level much lower than before. 

Upside surprises in Europe?

Despite the perceived victory of the periphery in the recent EU summit Merkel remains resilient in her demand that if Spain and Italy eventually will need bailout, the price has to be considerable handover of sovereignty to EU and Germany on the fiscal side. This is a reasonable claim even if the message to the outside is that Spain will avoid direct involvement in sovereign affairs due to the technical nature of the bailout money being distributed to its banks.

Still however, the recent sharp reversal in the rhetoric by the Spanish Prime Minister Rajoy and the promise of yet another round of cuts come in nicely on the back of the market finally starting to see signs that perhaps even senior creditors of Spanish banks be forced to take losses. Alpha Sources welcome such realism by part of the periphery, but is still left with the bitter taste in the mouth from watching drastically different measures being applied to the little ones (Greece and Ireland).

In this sense, the ever eloquent Chris Wood is spot on in his recent juxtaposition between the situation in Spain and Ireland.

GREED & fear has been calling for losses to be imposed on subordinated bank bondholders for some time as the best way of imposing a loss, and allowing the capitalist system to start working again. It is, therefore, encouraging that this approach may actually be adopted as already discussed in the case of Spain as one of the Eurozone’s preconditions for recapitalisation, which by the way means a significant diminution in Spanish sovereignty. Still, given that so much of this subordinated debt has been sold to retail investors as savings products, such a policy is going to create a firestorm in Spain politically. It must, therefore, be wondered if the loss ends up being imposed anyway on the sovereign balance sheet of Spain as buyers of these products demand to be made good. The Spanish owners of junior bank debt may also wonder why he or she is being treated so differently from Ireland where the ECB seemingly forced the Irish Government not to impose losses on subordinated bondholders thereby putting the Irish taxpayer on the hook. GREED & fear would not like to be viewed as a cynic. But the difference could be that the Irish subordinated debt was owned by big institutional investors whereas in the case of Spain it appears to be the little guy.

Another case in point that I feel the need to elaborate on is Greece. Only two months ago did the consensus hold that Greece would leave the Eurozone or perhaps even that the country would be forced out. Alpha Sources always thought that this was mad and we know now that it was. The difference between the first PSI and the warmongerings from Merkel and the EU were clear.

In the case of the former, the risk was chiefly that Greece would not accept the terms under the restructuring (laid out by the IMF and the EU) and simply apply a unilateral haircut. In the case of the latter however, Greece was seen being in the corner pleading that the country would not want to leave but simultaneously also getting starved of essential liquidity to keep the country running. 

Investors should remember that differential treatment between large and small economies in what has become a near perpetual bailout effort by part of the EU, the IMF and the ECB is a mistake that may eventually become the problem itself. 

Finally, it is important to dwell a bit on the recent ECB meeting where not only the main refi rate was reduced but also, and much more significantly, where the deposit rate was cut to 0%. This marks the first major central bank trying to take a stab at the problem of a slump in velocity and essentially a broken monetary policy transmission mechanism. As such, bulging reserves without a corresponding pick up in lending to the real economy remains one of the main problems in the developed world (from the point of view of monetary policy makers that is). Sweden enforced negative interest rates on reserve balances in 2008, and now the ECB is essentially following in the Riksbank's food steps. 

In this way and just as Alpha Sources has spent the last couple of days catching up with the news, so it seems that European policy makers with Spain now apparently open to imposing losses throughout banks' capital structure and the ECB delivering the boldest monetary policy step since the Fed opened up the QE bag in 2008, Europe may finally be catching up.

Random Shots - Above Expectations

The market action of last week repeated a lesson that many a punter appeared to have forgotten. Never run a bearish book into a European summit and especially not one where expectations for a result are as lows as they were going into Friday's meeting. Risk assets went up like a rocket with especially oil releasing heavily oversold momentum and you really could not do much wrong if you were running even moderately net long. 

Above Expectations in Europe

Obviously, the market is buying the rumour and not the fact. In traditional summit fashion we got a lot of road maps and promises but very little concrete effort. Details were exceedingly sketchy and to talk about game changers is premature. We usually do not get game changers from the EU, but merely fudge cakes. Alpha.Sources would however like to remind investors that such fudge cakes may be enough to quell the market's sugar addiction for several weeks.  

Three points are worth making. 

Firstly, the ESM appears to get the ability recapitalise banks directly and the door has also been opened up for the ESM/EFSF to buy peripheral debt without implied seniority. This is a big step in breaking the link between banks and the sovereign. Ireland and Spain in particular will be the beneficiaries of this. Alpha.Sources remain skeptical that the broadcasted notion of no conditionality will hold, but at least in principle there is a now a negotiated result which seems to allow countries to get help for their banks with little or no conditionality on the sovereign and no addition to sovereign debt to GDP. This is a significant step towards risk mutualisation through a banking union and ultimately a fiscal union. Alpha.Sources would note however that without applying haircuts to bondholders of both sovereign and private debt, One link is broken but another one is created between core Europe and the entire European banking system. While such a link may be stronger through the effective backing of the whole eurozone balance the key question is how far Germany and the EU will go. This question is particularly relevant (and binding) as it will inevitably become clear that whatever initial amount of euros ceded to the ESM/EFSF to sprinkle over Europe's barren financial markets, it will almost surely be too low. 

Secondly, the electorate and political establishment in Greece have every right to be perplexed. Greece has thus spent the past 3 months under an effective threat of being kicked out of the eurozone only to watch Spain and Italy get away with what is essentially preferential treatment.  The fact that systemically important entities, sovereign as well as private, are given special treatment in this crisis is nothing new, but it remains a democratic problem in the EU. Like Portugal who remains the only country ever to get fined under the Stability and Growth Pact even as virtually every country violated the rules, Greece may rightfully feel a sense of injustice. 

Alpha.Sources would then venture the claim that a Greek exit is now out of the question in the short run (i.e. in 2012). Even as Germany may still move to extract its pound of flesh from Italy and Spain, there is now little chance that Germany and the EU can play hard ball against Greece in the coming negotiations with the Troika. Greece could obviously still become the whipping boy, but the continuing argument that Greece is special is now so worn that even European politicians must be able to see that they can't use it anymore. On this background, Alpha.Sources can't see the ECB shutting off Greece from the ELA while the ESM/EFSF is loading up on Spanish bank equity as well as non-senior Italian and Spanish sovereign debt.

Thirdly, the modest but clear movement towards official creditors not being considered senior could potentially go a long way to break the doomsday loop by which once a country enters bailout proceedings it will never access the market again. Alpha.Sources emphasizes potentially here however and for now, Alpha.Sources will stick to the main rule that whatever we might constitute normal market access the eurozone periphery is far from it, but there is another silver lining to this. Consequently, in Greece it will alleviate the pressure on the ECB, EU and the IMF as it is clear that the country will need a second write down of its debt which will inevitably involve its official sector creditors. 

As a general conclusion, the summit results implies a very large degree of risk mutualisation which it is unclear that Germany will ultimately go for, but multiple conclusions are not possible at the same time and so far the market and punditry seem to view this, rightly or wrongly, as victory for Hollande, Monti and Rajoy. This also means that the decoupling of Bunds from US treasuries and Gilts as well as the recent steady increase in German CDS is set to continue. This is also why Alpha.Sources believes that unlike the German national team who might have to wait two years and the World Cup to redeem itself, Merkel will get her shot much sooner.

One thing Germany will push for is the fiscal compact rules to be put in motion at a fast track pace and also, if the ESM is to take direct and equal ownership of European banks Alpha.Sources feels certain that this will come with extended EU supervision of the involved banks.

Unimpressed in Japan

Another seemingly important political result this week was the approval of the increase in Japan's consumption tax, an increase which has been debated consistently for 5 years in Japan. If the final tax bill is passed, the tax rate will increase from the current 5% to 10% in two steps from to 8% in 2014 and 10% in 2015. 

While the consumption tax has long been touted as the first step to put an end to the fiscal train wreck of Japan's public finances Alpha.Sources believes that the measure will ultimately be counter productive. Japan's fiscal problems consequently do not stem from a lack of revenue, but rather from too much spending. Trying to extract more revenues from a domestic economy where aggregate demand is already chronically weak due to an ageing population will only steal consumption from a future which is, in an almost literal sense, not there. 

In this piece written on a similar VAT hike in Germany, yours truly presented a relatively simple economic framework for what it means to increase indirect taxes in the context of a rapidly ageing economy. In a nutshell, the argument is that while there will be a pure statistical effect on inflation readings as a result of the tax hike as well as positive effect on consumption as the purchase of durables is pushed forward, the end result is likely going to be deflationary. 

The following quote, while requiring a little bit of basic microeconomic intuition, presents the argument, 

(...) students of applied microeconomics learn to distinguish between the point of impact and point of incidence of a tax. The former constitues the party who actually levies the tax towards the government whereas the latter denotes the party who actually supports the tax. In the case of a value-added tax (an indirect tax) the point of impact would then be the consumer who (through an intermediary; e.g. a retailer) levies the tax towards the government. However, it is much more interesting in this case to discuss the point of incidence of the tax that is who actually supports the tax. In order for us to do so we need to introduce yet another economic concept, namely supply and demand elasticities of the tax hike. Consequently, the party with the highest relative elasticity (i.e. flexibility) towards the tax will also avoid supporting the lion’s share of the tax increase. What this means in the concrete case of the German tax is of course very difficult to asses. Yet, since for example consumers’ demand elasticity in this case can be operationalized as the relative fraction of disposable income which is consumed and saved (i.e. the MPC and MPS) we might actually be able to sketch a framework which suggests why the VAT hike in fact should not have been expected to rapidly push up inflation in the first place. The point would then be that the consumers’ demand elasticity towards consumption and thus flexibility towards avoiding the tax relative to businesses would be positively correlated with the marginal propensity to save.

In a rapidly ageing society, the attempt to extract tax revenue through consumption taxes fundamentally misunderstands the consumption and saving dynamics in the context of population ageing. 

Still, we should expect higher consumption in Japan and also, ironically, that inflation may nudge its way up close to the 1% mark set as the target for the BOJ. It would be tragic if this prompted the central bank to lay down its guard because the end result would almost surely be more deflation and contraction. 

With that dear reader it seems that just as Italy spearheaded by the enigma that is Balotelli managed to exceed expectations against Germany (only to come crashing down in the final!), so did we also get a number of political results which, at a first glance at least, were above expectations. In Europe, Alpha.Sources harbours a scant hope that the seeds layn may provide a little calm in the coming months however fleeting this might be while in Japan, the sentiment here at this blog is decidedly unimpressed. 

The Eurozone Doomsday Machine of Austerity

Interesting perspective on the effect of fiscal contraction in the eurozone by Econbrowser. I guess it makes sense. If the multiplier at the zero bound is high for positive spending it should be equally high (with a negative sign) if fiscal spending is cut back. The only issue is obviously that most of the Southern European economies are, in my book, fundamentally insolvent and thus the end solution is somewhat different than just cranking up fiscal spending, but monetisation of fiscal deficits will inevitably be part of the solution if this continues. 

The logic is as follows. The standard multiplier assumes each country can be treated as a relatively small open economy, where decreases in output induce decreases in imports, which offset the initial decline. However, when all countries are simultaneously shrinking, then the decline in imports is in turn mitigated.Thinking about the eurozone in terms of individual countries highlights the fact even if some countries are constrained by borrowing costs (compare against the US Federal government with current real funding rates of zero), Germany and other northern European could stimulate their economies. This would help brake the continent’s contractionary spiral.