Global Chief Investment Strategist
February 9, 2016
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A pattern of self-reinforcing fear has developed in financial markets in recent days, spilling across regions
Left to fester, this may weaken real economic fundamentals. This feedback loop is best addressed with a coordinated monetary and regulatory policy response across regions, though this is difficult to achieve. Policymakers may be far from action. Fed Chair Yellen’s semi-annual monetary policy testimony Wednesday should be watched closely in light of these market events.
An unusual, sharp jump in correlation between almost all asset prices and crude oil has developed; a pattern that would only be sustained during a global recession. This has impacted oil importers in Japan and Europe even more deeply than petrol-linked markets, likely reflecting investor positioning. No economic spill-overs of proportional magnitude have been seen through 1 and a half years of declining petroleum.
While risks have not abated, a feared Chinese currency devaluation has not occurred as a month of FX stability has followed early January’s Yuan devaluation. Similarly, there are very tentative signs that the petroleum price collapse may be in its final stages.
Shocks that are feared but don’t materialize leave markets with rebounding confidence. Nonetheless, markets have found yet new reasons for concern in the circular growth panic which has pulled interest rates down in a way that could negatively impact banking, credit markets and future expansion. Policymakers should take heed.
Circular Growth Panic
A pattern of self-reinforcing fear in financial markets has developed in recent days that is spilling across regions, and disturbingly, generating negative feedback in markets where the fears began. A “poor lead” in Asia Pacific share markets, for example, has led regional declines in Europe and the Americas, only to be the apparent source of new declines in Asia the following day. The QE zones of Japan and the Eurozone, where markets have been policy driven and economic recovery is less firmly established, have seen particularly sharp pullbacks in asset prices, with Japanese shares falling more than 5% today. The market dynamic has some root fears in commodities, credit and currencies. Away from this, however, the flight from risk is now having substantial impact on exchange rates and interest rates. This “tail chasing” could find its own end with side-lined investors moving to take advantage of market dislocations. However, the longer it lasts, the greater the likelihood that it negatively impacts real economic activity, thus justifying the economic fears.
Our purpose is not to debate the role of government policy interventions, which are with us regardless of their long run efficacy and risks. We would point out, however, that the dynamic of regional spill-overs from domestic financial conditions is best addressed with coordinated policy efforts across the world. Coordination ordinarily takes time and effort to achieve. Amid a significant policy divergence between the U.S. and others and questionable intensions from the Federal Reserve given the advanced state of the U.S. recovery, coordination may be even more difficult. Fed Chair Yellen’s semi-annual testimony to Congress on the monetary policy outlook beginning Wednesday will be closely scrutinized in this light.
Bearish Markets Move the Goal Posts
Have investors become unusually anticipatory of “late cycle” economic risks or have they over-reacted to most recent news in a state of panic? This is a question that hangs in our minds as world financial markets have swooned in reaction to each piece of news or seemingly no information at all in the young new year.
We can't experiment with history, but we have significant doubts that global investor confidence would be as shaky as it is now if central bankers from Frankfurt, Tokyo and Washington had not taken the decisions they did in December 2015. Their actions have coloured investor perceptions of risk in dealing with some larger questions. In our view, the key questions are 1) Will China deliver the world a new financial and economic shock? 2) Will the global petroleum producer distress lead to contagious economic weakness everywhere else? 3) Will policymakers allow the re-emergence of systemic risk?
Each of these questions has been a focus for financial markets in the young new year already. The slight de-emphasis of one has yielded to a new, envisioned crisis source. The latest question that has gripped markets is focused on the credit performance of European financial institutions. In essence, the fears keep changing.
1 - Will China Deliver Its Death Blow?
As figure 1 shows, much like the period following last August’s small move to realign China’s currency, global markets fell very sharply in January on minor steps toward devaluation (“freeing market forces.”) The August/September 2015 decline in global equities was 4X the change in the Chinese Yuan/USD exchange rate. After a recovery in global equity markets - but none in China’s exchange rate - this pattern has been repeated in 2016.
This 4X “beta” for world equities/Chinese Yuan calls into question just how China would actually deliver such a shock to the world outlook with just the small exchange rate adjustments seen so far. The most obvious answer would be an anticipation of much larger, disruptive moves and new drivers of stress that would result. We can’t discuss the full range of possible transmission sources here. However, it is notable that like the August period, China has not seen a new low in its currency for roughly a month.
A stable Chinese currency is not anticipated by financial markets. It would not come cost free for China. Yet demonstrating control of the exchange rate might just be of greater value to China's internal interests than the risky choice of freeing it to perhaps find a substantially lower level (as negative implications of depreciation fully unfold). We believe fully managed exchange rates move either less or more than markets anticipate. Forecasts for China's exchange rate mostly straddle an unlikely middle ground. If an anticipated shock fails to materialize, expectations adjust and strengthen. A significant new China shock that has yet to unfold, yet it has harmed confidence.
2 - Will the global petroleum producer distress lead to contagious economic weakness everywhere else?
On the second question, we need to point out that asset prices are answering in the affirmative. World financial markets have seen an unusual rise in correlation with petroleum across many loosely related asset prices. As figure 2 shows, the correlation between non-energy U.S. shares has risen from a long-run negative to +80%. Transportation shares or Petroleum-importing regions in Europe or Asia have seen spikes to +80%-90% positive correlation. This is a pattern that would make fundamental sense only in a severe global recession. We would stick to a view that this is an unsustainable jump that is not supported by fundamentals.
While the rise in broad asset market correlation to oil signals a market expectation that substantial "economic contagion" is coming, we should question why that has not yet really been seen to date. The oil price has been falling hard since September 2014. Many U.S. economists and others substantially glossed over the risks with over-simplified "net benefit" consumer-centric views in the aftermath of a U.S. energy investment boom. World oil prices, deeply below the production costs of some, are a concentrated financial stress, asymmetric for producers compared to the widespread mild benefits for consumers. Yet economic data released to date should be showing larger "scars" from the negative shock to non-oil producers if direct economic contagion was likely.
As figure 3 shows, the breadth of employment gains in the U.S. is as strong in early 2016 as in recent years. Industrial production has slowed more, and we believe there are greater forward looking risks to U.S. labor markets than coincident data show. Yet, the negative divergence of growth rates in the energy sector from other industries has never been so large (see figure 4). Like the feared collapse in China, crude oil hasn't made a new low in two weeks.
So where to on the oil price if everything is to rise and fall with it? The Saudi decision to raise production into the face of falling oil prices and Iran's return to global markets, "doubled down" on the cartel's "war of attrition" strategy last year. At the same time, signs that higher cost non-OPEC producers are reducing output are minimal. For a debt-strapped producer operating at a loss, some oil revenue is better than none.
While there are great near-term uncertainties, maximizing world output into the face of record (measurable) inventories should assumedly deepen the declines in oil prices and accelerate the speed at which a bottom is reached (see figure 5). Like the early 2015 period, which preceded a sharp, temporary snapback in the oil price (+40% over four months), a wide gap has now opened up between oil price quotes for distant delivery and prompt delivery prices (see figure 6).
The oil price for delivery two years hence partly reflects the market's collective view of world oil producing capacity in the future. Falling capital investment and rising producer credit defaults suggest shrinking supply. With a high premium for future oil compared to today's prices, some incremental demand should come to store physical oil and earn a return on future delivery.
There are obvious risks to such views, particularly over the near term. Yet this storage demand, along with now substantially lower prices and a likely renewed reluctance for the Fed to raise interest rates, could finally generate a bottoming in world oil quotes.
3 - Will Policymakers Allow the Return of Systemic Risk
Just as two significant risks seem to have some probability of fading, financial markets in recent days saw credit turmoil beyond the well documented energy-sector distress. One large European bank saw significant weakness in convertible securities designed to shield taxpayers from liabilities in the event of a capital shortfall. With it, the entire global financial sector has shown significant weakness. (The issue has exacerbated declines in share prices driven by falling global interest rates).
This latest episode demonstrates the fragility of investor confidence. While senior secured investors and taxpayers may be shielded from liabilities, there is no guaranteeing that others will take the risk needed to secure expansion by ensuring robust lending. The profitability of the financial sector has consequences on the incentives to lend, which was strongly demonstrated in 2008 to have large economic spillover effects.
Notably, European subordinated bank debt spreads were 6X wider as recently as 2011 (see figure 7). Broader financial credit was dramatically more impaired in 2008-2009. Equity capital raised since the crisis has greatly expanded, thus limiting systemic risks (please see our last bulletin, Surprise, Stumble, Fall, Not “Doomsday” Revisited
Thus far, with all the signs of “growth panic” in markets, senior secured lending stress between financial institutions has not been seen in any large region (ex. LIBOR, Euribor, rates etc.) In assessing the outlook and their policy course ahead, both policymakers and investors should be careful not to take the progress toward financial stability of recent years entirely for granted. Fear itself can manifest as an important fundamental, at least as potent as QE.
Is this what we did ourselves in focusing attention to the advanced state of the global business cycle recovery? Please see Outlook 2016.
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