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And the award for EM safe haven of choice goes to ...

... China!

At least this is the conclusion from some fascinating number crunching from JPMorgan's Flow & Liquidity team in their report last week. I had a feeling that this was the case looking at the surge in Chinese FX reserve growth (capital inflows) in the past 6-12 months, but it is still interesting to see such clear evidence from the data.

Here is F&L on the outflow data;

(...) around $80bn of capital left these 22 EM economies [read: essentially EM ex China and the Middle East] cumulatively since last May. This $80bn outflow is likely understated by $20bn due to the 1.6% decline in the dollar between the end of May and end of February, as a weaker dollar pushes up the dollar value of non-USD denominated reserves. Adjusting for this leaves us with around $100bn of estimated capital outflow from these 22 EM countries between May and February.

This estimate of $100bn worth of EM outflows since the tapering scare began in May/June last year is not the controversial number. The main question is then where the money went and here it gets very interesting.

This capital outflow does not necessarily reflect capital leaving the EM universe as a whole. In fact it seems that China, perceived as safe haven, has attracted a similar amount over that period. Using similar calculations of FX reserve changes adjusted for current account flows, we arrive at a $125bn cumulative capital inflow into China between May and December, as the outflows of last May/June more than reversed in subsequent months. Of this $125bn figure, around $25bn reflects the 2% decline in the dollar between the end of May and end of December. This leaves us with around $100bn of estimated capital inflow into China between May and December.

What is particularly interesting about these numbers is that the breakdown reveals that only a small fraction of this, $20bn according to JPM, reflects net FDI. The rest represent so-called hot money flows in the form of portfolio flows and short term flows into demand deposits (to take advantage of sharply higher interest rates in China).

With the CNY just having seen its strongest bout of volatility in a long time last week it may seem rather inopportune to publish a note on the inexorable and inevitable rise of the CNY. Personally, I would be wary taking the consensus view at face value here. In fact, on many accounts the CNY looks overvalued here and this is exactly what the market is also telling us I think (at least in the short run). CNY volatility and weakness are also the two main markers I would be watching for signs of capital outflows and ultimately how China could become a big headache for the rest of the world. 

All this however does not detract from the fact that JPM gets the completely unofficial award this week for the best sell side data crunching exercise. The tapering scare that emerged last summer has been linked to all kinds of bad outcomes for emerging markets as a whole. Clearly, this is not an accurate description and something which investors should not lose focus of.


Tweaking the Fed's unemployment target 

Last week I had a look at the US labour market over at Variant Perception's blog based on this excellent piece by Ellen Terry, an economist at the Atlanta Fed, which discusses the drivers of the decline in the US labour force participation rate. The issue should be well known for US economy watchers. The unemployment rate has declined noticeably but if we factor in the declining labour force participation rate the picture looks largely unchanged. 

The following sums up the main point from Terry's study and my own comments. 

The most interesting aspect of Terry’s analysis however is the finding that the bulk of the decline in the US labour force participation rate (80%) is due to one of three reasons.


  1. Wants a job, but can’t find one
  2. Disabled/ill
  3. Retired


The disabled/ill category is interesting because of the increasing evidence that receiving disability aid is better paid than having a low wage job. Several academic and journalist sources have been pointing to the unsustainable rise in the prevalence of social disability entitlements in the US. Finally, it is interesting to ponder retirement as one of the major causes of the decline in the labour force participation rate. This is significant for two reasons in our view. Firstly, because retired workers are unlikely to re-enter even if economic conditions improve (and if they do it will most likely be in part-time and/or low wage occupations). Secondly, it casts a pessimistic empirical light on the prospect (in all OECD economies) to increase the labour supply by inducing later retirement to correct for a rise in life expectancy. This may work in theory, but it seems much more difficult to implement in practice. 

In the context of the official unemployment rate moving rapidly closer to the Fed's target as per the Evans rule the recent labour market trends have obviously put the central bank in a bind. The Fed has already assured markets that the Fed funds rate will be kept low well past the point at which the unemployment rate declines below 6.5%, but for how long and should the rate to which forward guidance is attached be amended (e.g. from 6.5% to 5.5%)? Continuingly massaging forward guidance to reflect a complicated interplay between structural and cyclical drivers of the US labour force participation rate could turn into a big communication challenge for the Fed. 

The question surrounding the dwindling labour force participation rate has been the center of much debate and analysis. A recent contribution comes from Morgan Stanley's US economics team also citing Terry's piece. The piece largely come to the same conclusions as above (in terms of the drivers of the labour force participation rate decline), but MS appears optimistic on the prospect of the participation rate to recover as the economy improves. In other words, MS argues that there is scope for significant cyclical improvement. 

The gist of the suggestion is that there is more slack in the US labour market than meets the eye and that the Fed could conceivably change the labour market measure it looks at to anchor forward guidance. 

Should the Fed, then, shift focus to some alternative measure of labor market slack? A broader measure of unemployment, the U-6, may help. It includes marginally attached workers such as those that are working part-time, but would prefer full-time if it were available (“part-time for economic reasons”), and workers who would like a job but don't search because they don't believe any jobs are available (“discouraged” workers). The U-6 unemployment rate was 13.1% in December compared with the standard (U-3) unemployment rate of 6.7% (Exhibit 7).

The spread between U-6 and U-3 reflects what we consider to be shadow labor - deserters ofthe labor force that could come back if job prospects were to improve enough.

I am skeptical that this shadow labour will be as sensitive to the business cycle as MS suggests. This is especially the case since we have already seen a noticeable improvement in the US economy without any reaction from the shadow labour component (on the contary). The most interesting proposal however is obviously the suggestion that the Fed should change its unemployment target from the U-3 to the U-6 measure. Needless to say this would immediately alleviate a lot of the pressure on forward guidance, but it would also mean that the Fed would need to buy the idea that the difference between these two measures is cyclical. In coming posts I will have a look at whether this can be argued to be true. 


US data may test the tapering resolve in coming months

This, in a nutshell, is the message from our recent look at US manufacturing data. The point here is not that forward looking indicators are currently justifying a very negative outlook; clearly that is not case. The point is that with growth indicators already largely normalised the challenge is now to maintain momentum. With expectations still fairly bullish on the US economy there is room for some slight disappointment in coming months. 

The last seven months have seen an impressive improvement in US manufacturing. Almost all components of US manufacturing have been growing strongly and the US ISM has staged an impressive comeback from sub-50 in May last year to 57 in December. However, our growth diffusion index now implies the potential for short-term disappointment.

The most interesting thing in this regard is how it will affect the very finely balanced QE exit strategy that the Fed has currently put into place. For example, economists polled by Bloomberg do not expect Friday's poor non-farm payroll number to put a dent in the Fed's tapering plans. 

I agree on the importance of the non-farm payroll report; no serious economist would ascribe any importance to one reading (especially not with the strong ADP report). If this was indeed weather related the only thing we can say is that we are in for another "blip" in January as the big freeze is sure to exert notable distortions on 1Q14 data.

However, a more interesting question is how this will alter Fed communication and action. We know QE is conditional on the data so we now get to survey just what that conditionality means. Another critical point is how the Fed will adjust to the rapidly declining unemployment rate. We will thus hit that 6.5% anytime now. So does that mean that the Evans rule is massaged down to 5.5%, does it mean rate hikes(!?) or just that tapering will continue? How will the market price this on the short end? These are key questions that we are yet to answer and which can only be answered in conjunction with how serious the Fed is concerning its resolve to exit QE and how sensitive it is to US economic data. 

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