The Fed could be back in play in 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:

Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir - especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed's primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.

Source: Investing.com

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

Source: Gallup

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Source: Markit

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Canada`s Changing Financial Landscape, Part 1: the Securities Industry

Guest post by Norman Mogil

The worldwide collapse in commodity prices is now working its way through the financial markets in Canada.  Canada is just now experiencing  fundamental changes in the financial community, the sector  better known as F.I.RE  ( Finance, Insurance and Real Estate ) . This sector accounts for approximately 20% of national income and employs more than one million workers, providing a  broad spectrum of  services to all parts of the economy. One subsector, in particular, the investment or securities industry has been hardest hit of late.. This blog examines the adjustments in the securities industry; future blogs will look at the banks, life insurance and real estate markets.

To appreciate just how much the F.I.R.E. industry has suffered , we turn to the TSX and its major components as listed in Table 1.  In the period 2007 to 2014, the Canadian stock market as a whole fell by 4%. However, the  financial sector as a whole  performed relatively well increasing by some 21%, largely on the back of the commercial banks, supported by good loan  growth and capital market activities.  However, within the investment community, independent investment houses have taken quite a beating. The two publicly traded companies, GMP and Canaccord, have seen their corporate value been  truly been decimated ( a price drop of  80%) . Finally, the lifecos have yet to recover from the 2008 crisis and continue to see their stocks trade well below pre-crisis levels ( as much as 60% lower).

These  trials and tribulations  continued over the past 12 months as all segments of the FIRE industry have seen values drop further.  Along with the decline of the TSX60 , the finance sector is off a further 19% , partly in concert with  the decline  in world stock markets, but more reflective in the fall in oil and other commodity prices. Even the much vaulted Canadian banks are feeling the impact of losses in the energy sector. REITs which have been a haven for investors are now in decline( off by 18%). And, of course, the investment dealers continue  their slide as they suffer under the weight of several factors unique to the industry. We now turn our attention to those issues.

       Investment Industry Under Pressure

The securities industry, and in particular, the independent dealers are crucial to a well-functioning capital market. The big six banks have swallowed up major investment dealers in the 1990s; they use these  investment firms to continue to fund large publicly traded companies . Independents, on the other hand, supply funds to  small and medium size industries, especially in the  resource and tech sectors. Often these companies are deemed  too risky to qualify  for  conventional bank lending . Thus, they have filled an important gap in the capital markets and their  current weakened position will have an adverse impact on  the effectiveness of the Canada's  capital markets to promote economic growth.

These are not happy days for the investment dealers. Revenues are weak, costs are escalating and the nature of their business is undergoing structural changes.
The number of firms have declined as part of a wider consolidation as profitability is squeezed throughout the industry. Chart 1 illustrates the change in revenue sources between 2007 and 2015.

With the exception of fixed income trading, all categories of revenues have declined, especially equity trading commissions and investment banking fees - two stalwarts of  the past. Table 2 summarizes the main financial operating results of the past 12 months. The two notable impacts have been  the reduction in revenues and the rise in the  cost of operations. Overall, profitability is dismal compared to prior years--- 4.6% rate of return in an industry accustomed to rates of 20% or more. As a result, shareholders' equity has taken a beating, forcing weak companies out of business and others to shore  up capital to meet regulatory requirements. What is behind this poor performance?

A series of  radical changes  has hit the industry simultaneously :

•  the collapse of the commodity markets. Many of the independent firms specialize in financing  medium size resource/extraction enterprises; the collapse resulted in very few investment banking opportunities, shrinking that  revenue segment of the industry significantly,

• technological driven price wars. There has been a relentless move towards lower commission prices and electronic trading, contributing to the fall off in revenues.

• compliance and regulatory changes.   Ian Russell  the President of the Investment Industry Association of Canada (IIAC), estimates these costs have risen by 7% in 2015, on top of a 6% rise in 2014. He believes " the relentless rise in operating costs will squeeze profitably" in 2016.

 The industry features many small independent, boutique -size firms that no longer can compete for capital; the bulk of the firms are capitalized at $10 million or less, precluding them from participating in larger financing deals. Russell expects a further consolidation as firms either merge and/or shut down.

The IIAC recently conducted a survey of its members on the outlook for the industry.
The majority of members remain pessimistic , citing the following:

• Rising costs owing to higher compliance  and new technology requirements; both add to staff and to total operating costs;

• Weak economic conditions as Canada adjusts to the new realty in commodity prices and the slowdown in world trade;

• Consolidation and restructuring. Over the past 4 years, 25% of the industry has left the business through mergers and amalgamations , closing operations entirely or transferring business out to competitors.

It is no wonder that the majority of the industry leaders expect further contraction in the coming years as part of shake out in the industry . It may turn out, in the longer run, that the Canadian capital market will benefit from this re-structuring and may be stronger as a result. However, at present,  the principal concern is that this consolidation will negatively affect the  viability of the industry to participate in the financing of future economic growth.




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The case for “global quantitative tightening”

Guest post by Marcello Minenna

In January 2016, global foreign reserves (FX) continued their decline after an absolute peak in June 2014, declining significantly in distressed emerging countries and some notable oil-producing economies (see Figure 1).

Figure 1.

China and Saudi Arabia, the leading owners of foreign reserves outside the OECD circle, both experienced an outflow greater than 5% of their outstanding reserves in less than 6 months (see Figure 2). A common factor explains these drawdowns: both the countries are struggling to defend their currency peg to the Dollar. The pressures on the exchange rates can be traced back to three intertwined drivers: the (still to come) interest rate hike cycle in the US, the low oil price and the China slow growth. While the “US rate hike tantrum” can be considered as a symmetrical shock for all the worlds currency different from the Dollar, the other factors have hit the distressed countries in differentiated ways.

From the Chinese side, the worsening growth’s prospects and strong capital outflows are forcing the People bank of China (PBOC) to employ its FX reserves with the aim to manage a controlled, but unavoidable, devaluation. Meanwhile, the persistent slump oil price (that depends a lot from China’s slowdown) have decimated the revenues of the Saudis. Since these money flows count for over 80% of the State budget, the government is now tapping the debt market at the astronomical pace of 16% of GDP at year to compensate for the loss. This dramatic reversal in the health of public finances obviously put pressure on the fixed peg with the dollar.

Figure 2.

Indeed, as it emerges from the comparative analysis of Figures 1,2, both the declines for China and Saudi Arabia took off and reinforced during the prolonged crash of the oil price. The same phenomenon can be appreciated on a global scale (Figure 3): world FX reserves peaked and declined in sync with the oil price. Net of “value effects” that depend from the changing composition of the reserves, falling oil revenues and GDP slowdown in major exporting countries remain significant explaining factors.

Figure 3.

A central bank’s monetary policy stance is often captured better by changes in their overall balance sheet that comprehend both FX reserve movements than other conventional monetary policy actions, e.g. reserve rates cuts or repo operations.  Broad-based indicators such as monthly variation in central bank total assets are more informative of the aggregate global value of central bank liquidity.

Figure 4 illustrates the historical movements of central bank assets in the past 6 six years: Fed QE 2 and 3 are clearly identified by the navy bars, and Shinzo Abe’s QQE (Qualitative and Quantitative Easing) is captured by the red bars. The first expansion in ECB balance sheet of 2011-2012 (light blue bars) is attributable to the two big LTROs, and the subsequent contraction is due to LTROs repayment by European banks. In 2015 the Draghi QE (the Public Sector Purchase Programme or PSPP) has taken off and has pushed the ECB net liquidity flows in positive territory. It’s interesting also to notice the expansionary pulses of the Swiss National Bank (SNB) monetary policy, aimed at maintaining the peg of the Swiss Franc with the Euro in 2012-2014. The last frantic efforts ended suddenly in January 2015, when the ballooning the of SNB balance sheet and the accelerating expansion of the monetary base forced the SNB to readjust the CHF /EUR exchange rate.

Figure 4.

Declining FX reserves caused concern in global markets following the decision of the PBOC to abandon the Renminbi fixed exchange rate with the Dollar. Struggling against mounting pressures on the Renminbi / Dollar exchange rate, the People Bank of China flooded the market with US Treasuries, causing a spike in yields and turmoil in global equities. Since selling foreign assets acts as a counterbalance to Quantitative Easing, some market participants applied the phrase Global Quantitative Tightening (QT). In other terms, by liquidating US Treasuries and other OECD government and private bonds, the central banks of emerging countries resupply the market of securities, balancing the purchase made by their OECD counterparts. This QT action by emerging and oil-exporting countries would therefore drain liquidity from the market, neutralizing expansionary policies of Eurozone and Japan. In this perspective the $ 130 billion of fresh money injected monthly via asset purchases by the OECD central banks would be offset by their emerging counterparts.

Our indicator of central banks' global liquidity seems to support this reconstruction. In 2015, EM central bank sales of foreign assets reduced central banks’ liquidity flows (Figure 5). The effect began in July and peaked in September during the Renminbi crisis.

Figure 5.

The concept of global QT gained traction in September 2015 as the negative correlation between global equities and foreign reserves increased. The Fed’s decision to maintain interest rates relieved the downward pressures on Renminbi and the interest in QT quickly waned. 

There have been reasoned opinions on the economic theory behind global QT. More than one analyst correctly observed that a USD asset sales by foreign central banks will not drain liquidity and counteract Fed monetary policy because these assets simply change hands and do not disappear. Changing ownership does not preclude reinvestment in the US banking system, which limits the sale’s tightening effect. Moreover, as already pointed out, changes in foreign reserves may not reflect a central bank’s attitude towards monetary policy since they do not account that other conventional monetary policy actions on banks’ reserves or interest rates can dominate changes of foreign reserves.

In the last quarter of 2015, the correlation between global stock indices and central banks net liquidity is again up (see Figure 6).

Figure 6.

Remarkably, temporary positive net flows of central banks liquidity are associated with the markets rebound of October 2015.

We are obviously aware that correlation does not necessarily mean causation. From a broader perspective, it's more than reasonable that the same three cyclical drivers that explain drawdowns in foreign reserves (China’s slowdown, the US rate hike cycle, and collapsing oil prices) are also affecting equity markets.

We should acknowledge these changes in foreign reserves as a reaction by emerging countries central banks to these three primary factors. Nevertheless, their impact on net liquidity, which may mitigate monetary expansion by the ECB and BoJ should be worthy of further investigation.

Further Reading:

Winkler, Robin, “The Great Accumulation” Is Over: FX Reserves Have Peaked, Beware QT”, Deutsche Bank Market Research (September 2015).

Asymmetric Wager Blog, September 11, 2015 Economics: The Myth of "Quantitative Tightening" http://prodiptag.blogspot.in/2015/09/economics-myth-of-quantitative.html

Discussion on FT Alphaville, September 14, 2015 "Debunking quantitative tightening in one paragraph?" http://ftalphaville.ft.com/2015/09/14/2140021/debunking-quantitative-tightening-in-one-paragraph/

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The Golden Age

Guest post by $hane Obata


Some people say that gold is dead. They point to deflationary pressures and a bear market that started back in September of 2011. The bulls have been wrong for years; however, that may be about to change…

At present, there are multiple reasons to consider gold:

• Sentiment is very negative and almost everyone is underweight

• Supply & demand fundamentals are positive

• Chinese demand continues to rise

• Gold is a means to portfolio diversification

• The main risks to prices are overblown

In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?

Sentiment & Positioning

In the latest Barron’s Big Money Poll, only 3% of respondents thought that gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in $GLD (the SPDR Gold Trust ETF) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in $GDX (miners) and $GDXJ (junior miners) has been increasing; however, interest in “gold mining stocks” has been falling since mid-2011. This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.

In terms of positioning, market participants are heavily underweight materials and commodity stocks. Is this a contrarian buying opportunity? It could be. Especially because the current bear market is getting old. The following table shows the 5 most recent bull and bear markets:

Gold prices fell by 44% over the 52 months from September of 2011 to January 7th of 2016. Those numbers match the median length and average cumulative return of the previous 4 bear markets. Gold may continue to fall from here; however, we are probably closer to the end of the bear market than to the beginning…

Supply & Demand

~46% of gold production is FCF negative at current prices. In other words, $1100 is not the equilibrium price. If we stay at these levels then supply will likely decline. Analysts at Credit Suisse ($CS) are projecting a deficit to begin in 2016. They expect that mine supply will fall by 11.5% from 2015 to 2018:

Even at higher prices, gold miners will be unable to replace all of their depleting reserves. Also, it will be very expensive for them to bring new projects online. Lastly, it is important to note that major gold discoveries have become scarce. These trends are negative for supply and positive for prices.

On the demand side, Asia and Europe should continue to support the market. Total bar and coin demand (in tonnes) increased 33% YoY from Q3’14 to Q3’15. Furthermore, consumer demand was up across the board, with exceptionally big numbers in the US. According to the World Gold Council (WGC), “coin sales by the US mint during the quarter were on par with that of Q4 2008.” Another key source of demand is central banks. They have continued to buy as they look to diversify their reserve assets. This speaks to gold’s utility as a portfolio diversifier. Total demand has been falling; however, the quarterly numbers suggest it could be stabilizing. Going forward, consumer demand is likely to offset ETF outflows.

India & China are the main drivers of demand for gold. In 2014, they accounted for ~1710 tonnes of demand. To put that in perspective, 1700 tonnes = 53% of total consumer demand:

Gold is a big part of both India’s and China’s culture. As such, it is likely that demand will remain strong.

 China’s Gold Market

There is an interesting divergence taking place in the physical gold market. China’s demand numbers, as measured by withdrawals from the Shanghai Gold Exchange (SGE) are much higher than those reported by the World Gold Council (WGC). SGE withdrawals exceeded the WGC’s demand estimates by 3,193 tonnes from 2007 to 2014.

The following passage is from Bullion Star’s Koos Jansen helps to explain the discrepancy. “The difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the China Gold Association (CGA) as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). The WGC doesn’t count net investment on its demand balance, but only measures what is being sold at retail level. Net investment, which roughly equals the difference, can only be caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal.”

In China, gold imports must pass through the SGE before entering the market place. In addition, bullion exports are prohibited. It follows that Imports + Mine Supply + Scrap = Total Supply = SGE Withdrawals. Said another way, SGE withdrawals are equivalent to domestic wholesale demand. The preceding formula is supported by reports from the CGA and the SGE. For example, the SGE reported that 2197 tonnes were withdrawn its vaults in 2013. That is the same number that the CGA reported for total demand in 2013. More evidence comes from the SGE’s chairman, Xu Luode, who said the following in 2014:

The main conclusion is that the SGE’s measure of Chinese gold demand is much higher than the WGC’s. If the SGE’s number are correct then China is absorbing most of the world’s mine supply. Gold withdrawals from the SGE for 2015 amounted to 2596 tonnes, or 91% of world gold production:

Diversification & Protection

Gold has a negative correlation with US stocks during expansions. More importantly, its correlation with both global and US stocks is more negative during contractions:

As a result, gold tends to rise when stocks fall, which is good for portfolio diversification.

Gold is also an FX hedge for foreign investors. In 2015, it performed relatively well in non-dollar currencies such as the Brazilian Real, the Russian Ruble, the Chinese Yuan and the Canadian dollar. This is important because non-US countries are the main consumers of gold.

Loose monetary policy is here to stay. This cycle, every central bank that tried to raise rates has had to reverse course. That is bad for currencies and good for gold, since no one controls its supply.

Gold can also protect us against a rising cost of living because it tends to hold its value over time. If you look at the CPI then inflation seems relatively low. That said, the CPI is a utility index, not a measure of the cost of living. Most people would agree that cost of living is rising. For example, education and medical care costs have been outpacing the CPI for years.

Risks

Gold’s main threats are…

1) A stronger USD

Typically, the US dollar index and gold are negatively correlated. Said differently, when the dollar index does up, gold goes down. Even so, last year, the US dollar (USD) influenced gold prices more than it usually does. In 2015, the correlation between the two was -0.50 in 2015, much higher than -0.36, which is the 30-year average. Going forward, it’s likely that the correlation between gold and the USD will revert back to normal.

An additional concern is rising rates. One may assume that higher interest rates are good for the dollar. Actually, that is not the case. Historically, the dollar has stopped appreciating when the US raised rates. If the USD index has peaked then that would be good for gold prices.

2) Rising rates

Despite the fed’s intentions, the yield curve (2s10s) has flattened to its lowest levels of the expansion. The short end has increased but the long end, which is driven by growth expectations, has not. Basically, the market is not convinced that the era of low rates is over.

Even if rates do increase, gold may perform well. According to Sundial Capital Research, gold actually does quite well in rising rate environments. Gold prices increased by an average of 25.2% in each of the rising rate environments from Dec31’76 to Dec27’13. The median gain was 5.2%, which is much less impressive but still positive. Low rates are probably better for gold than high ones. That said, it may show good returns either way.

3) Leverage

In the US, the paper gold market is much bigger than the physical one is. In other words, many contracts are traded but not much gold changes hands. The level of gold dilution has reached unprecedented levels. In a recent blog post, zerohedge showed that there are 40 million ounces worth of open interest but only 74 thousand ounces of registered gold at the Comex. This works out to a gold cover ratio (open interest/registered gold) of 542! The takeaway point is that the amount of gold that is traded is much greater than the amount that actually exists.

The downside risk is that supply in the futures market overshadows demand in the physical market, thereby weighing on prices. Still, there is an upside risk. If demand for physical gold remains strong and inventories continue to fall then then the Comex may run out of supply. If that happens then gold prices will rise as market participants start to question the divergence between the paper and physical markets.

Conclusion

Gold should be considered as a contra buy…

• It is hated
• Its fundamentals are improving
• Demand from the east is robust
• It is negatively correlated with stocks
• The benefits outweigh the risks

Gold is massively under owned. If sentiment improves then it could easily outperform other asset classes in 2016…




$hane Obata & Richardson GMP AM

Edited by Matt Garrett.
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Canada Adjusts to the Oil Price Shock

Guest post by Norman Mogil

What does the oil price  collapse mean for Canada?  A simple question with an  the answer  that is anything but simple. As the Governor of the Bank of Canada (BoC), stated  the "oil price shock  is complex because it sets in motion several forces " that will alter the  path of Canada's economic future. The Governor  goes on to argue that "it may take up to three years for the full economic impact to be felt, and even longer for all of the structural adjustments to take place.”  Just what are the structural and time factors that we need to understand as we adjust to the new environment of lower commodity prices?

We start out by considering the structure of the  Canadian economy. This will  help identify how the various sectors of the economy will be impacted in the future. Broadly speaking, Canada is a service-based economy (70% of output) and only selectively a goods-producing  country (30%). The largest component of services is the finance, insurance and real estate (FIRE) which now comprises about 20% of national income. These industries surpass the contribution of mining, oil/gas and energy distribution (17%) and manufacturing (10%). The strength of the services sector blunts much of the pain of falling oil prices.

Immediate Impacts of the Oil Price Collapse

Taking a snapshot of what has happened in the past 12 months, we note in Table 2 that:

• Oil prices  declined by 40% in 2015, the Canadian dollar sank another 20%, on top of a 20% drop in 2014.  The  currency bore the greatest adjustment ;

• The currency devaluation did not , however, affect trade picture. The current account balance remained deep in negative territory;

• National output clocked in at a dismal  rate  of less than  1%;

• The rate of inflation accelerated due to the falling currency and its impact on basic imports, especially food products; and,

• Unemployment remained steady at around 7% for the year 2015.

Viewed from a national perspective,  the oil price collapse  has had a marginal impact on the economy during 2015. The burden of adjustment has fallen almost exclusively on the exchange rate; most other  indicators have not change appreciably .  However, below the surface, we are seeing evidence of the deteriorating conditions.

Within the resource sector, employment declined by 9-12% and incomes have fallen as much as 15-16% ( Table 3). More importantly for the future, the cumulative decline in business investment in this period was 8% and ,in the case of engineering structures, (related to resource development) the decline was 13%.

The dominance of the service sector and other non-energy goods producing industries allows for  national income and jobs to remain in positive territory. In other words, the impact of falling oil prices has, temporarily, been confined to the resource sector and to its geographic centre. The emphasis is on temporarily since there are longer term consequences facing the country as it comes to terms with the worldwide deflation in commodity prices.

Longer Run Adjustments

Research staff at the  Bank assessed the path of economic growth over the next 3-5 years assuming that commodity prices remain at current levels.(1) Theirs is an attempt to map out the path the economy would likely take ,given the new reality of low commodity prices..

The analysis sets a  control" scenario in which  commodity prices remain at mid-2014 level.  Results are then measured against the "control" scenario. Thus, an outcome that  is “lower”  implies it is lower than in the "control "case, not that it is lower in absolute terms.  By the end of  2020 we can expect that:

• capital investment in the commodities sector to be lower , reducing  the economy's buildup of productive capacity;  this results in a lower potential GDP growth rate;

• the share of commodities in the economy  will decline toward the pre-boom levels of 2002;

• exports as a share of national income will be lower due to the decrease in the terms of trade;

• domestically, households will gradually adjust to lower wealth and incomes; and

• personal consumption will be lower,  reflecting the reduction in incomes.

These outcomes strongly indicate that it will take much longer to absorb the current excess capacity.  Investment, consumption and overall growth will be lower than had the oil prices not collapsed . Simply put, the road to recovery has now  become longer and steeper.


------------------------
(1) http://www.bankofcanada.ca/wp-content/uploads/2016/01/san2016-1.pdf


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US consumer is the last defense against strong dollar drag on the economy

We continue to receive questions about the impact of the recent dollar strengthening on the US economy. The most immediate impact of course is on trade, which has created an immediate drag on the GDP growth.

Source: St Louis Fed, Goldman Sachs

We know that the impact on US industrial production in particular has been terrible.

On the other hand this currency appreciation, combined with weaker energy prices, is supposed to improve consumption as imports become cheaper.

The chart shows US import price index

And of course all the cheap fuel (combined with a warmer winter) should be providing material support to US households.

US average gasoline price

Will that be enough to give US consumer spending a boost? Goldman outlines two potential scenarios, the second one of which leads to a contraction in US gross output.

Source: Goldman Sachs

The full impact of the US dollar rally thus depends very much on the behavior of the consumer in the months to come. From a balance sheet perspective US households certainly don't seem to be "stressed", as the Financial Obligations Ratio remains near multi-decade lows.

Source: @SoberLook, FRB

Moreover, high-frequency economic sentiment data, while showing some stock-market induced jitters, remains robust.

Source: Gallup

Whether this will translate into stable spending patterns remains a question. According to Gallup, at least through December, US consumer spending has been solid.

Source: Gallup

The equity markets however are now pricing in a much weaker discretionary spending pattern, while companies focused on staples seem to be doing much better. Note that much of the divergence has taken place this year. Is the market concerned about consumer retrenchment?

Source: Ycharts

The December GDP report (0.7% growth) showed that growth has already slowed as financial conditions tightened. A great deal of this tightening has been driven by the US currency appreciation.

  Source: @jbjakobsen  

Consumer spending stability in the next few months is therefore critical. Strong US dollar has created a significant drag on economic activity but economists are betting that the consumer tailwinds should support growth,. If however the consumer (spooked by the recemt sharp correction in the equity markets) retrenches, US growth could stall.


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Currency Realignment and Export Growth

Guest post by Norman Mogil


The realignment of currencies in the past 18 months has been the most dramatic in decades.  A perfect storm is occurring:  Federal Reserve tightening; Eurozone and Asian monetary easing; and  a collapse of major commodities, all conspire to drive  just about every currency in the world to lower values against the USD. Governments are anticipating that this re-alignment will revive economic growth, lead by the external sector.  How likely is to happen?

Two recent studies, from the IMF and OECD,  draw attention to the question of
how effective are devaluations in changing the fortunes of "open" economies. The term "open" refers to those economies which generate  a significant portion of national income from exports, such as Germany, Canada, and several Asian economies.  Before reporting on the studies, it is helpful to get a sense of the reasons behind devaluations, the extent of currency adjustments  and the importance of exports to major trading nations.

Table 1 groups these devaluations by size and by importance as measured by the contribution of exports to national income.

* Depreciation in excess of 25% The greatest depreciations has happened in those countries that are highly dependent on commodity exports, --- Russia, Canada, Australia and South Africa. The worldwide collapse of major commodities resulted in significant declines in their respective trade accounts and national income. Commodity markets  are over-supplied and  these currencies are not expected to recover anytime soon .The  big concern is when will commodity cycle reach  bottom and for how long will they remain there.

*Depreciations of 20-25% . This group includes both manufacturing exporters
( eg Germany) and natural resource exporters ( eg Sweden). The European currencies have adjusted downwardly in part a reflection of the EU debt crisis and domestic deflation.

* Depreciations of 10-20%   This group includes highly industrialized countries such as Japan and the UK , countries that have benefited from lower commodity prices, and

* Depreciations of less than 10%. The final group features emerging economies,
( eg China, India)  that convert  imported raw materials  into intermediate and final goods for export.

 No major trading country escaped the surge in the USD last year, a condition that is carried forward into 2016, especially in the wake of further declines in oil and other major commodities.

The IMF Study

The IMF study starts with two basic questions: how responsive are exports to changes in the exchange  rate; and has that responsiveness changed over time?(1) The  agency estimates the  "elasticity of demand"; this  measures how price changes affect demand.  A number equal to or greater than 1 indicates that demand for exports is very sensitive to exchange rate changes ( ``elastic``) a number less than 1, demand is less sensitive to exchange rate adjustments (``inelastic``). (2).

The  IMF  examined dozens of countries and  several sectors over a 15-year period . Their findings are summarized in Table 2. Exports are less sensitive to exchange rate movements over time; half as much in the case of all exports and nearly half as much in the case of manufactured exports. That elasticity has lessened  over time and across sectors casts doubt on the effectiveness of the recent currency realignments in promoting growth of exports.
      

The IMF researchers offer some explanation for why demand for exports are less responsive to exchange rate depreciation compared to previous decades. First, worldwide trade has slowed, especially since the 2008 crisis, although the IMF points out that the change in elasticity pre-dates that financial crisis year. Secondly, a more important reason is offered. The IMF states "intuitively, as countries are more integrated in global production processes, a currency depreciation only improves competitiveness of a fraction of the value of final good exports" (1) . This explanation  leads us to the OECD study on importance of the foreign value added in determining the effectiveness of depreciating one's currency.

The OECD Study

The OECD examined one aspect of globalization that relates to devaluation and export performance. It recognized that a country`s exports are increasingly reliant on intermediate goods imported from foreign suppliers. The agency measures
"trade in value added" in which it traces the value added in each country and in each industry as part of the production chain leading to final exports.  Often overlooked is that devaluation raises the cost of imported inputs. The more a country is integrated within the worldwide supply chain, the less it can expect a currency depreciation to drive  export growth--- the high cost of imports mitigates much of the advantages of a lower currency.

Take the case of Canada .(Chart 1). Canadian exports contain 25% foreign value added, more than that of the US , its largest export market and competitor.  The comparison is even more pronounced in the case of transportation equipment. Canadian transportation exports contain more than 50% foreign content ; the US  contains only 29%  imported value added  .  Transportation exports comprise the second largest export sector in Canada after oil. This degree of reliance on foreign content suggest that the  devaluation of the Canadian dollar will have limited effectiveness in improving  the trade imbalances .

So,will devaluation work as a means to stimulate export growth and trade in general? Canada is a good case in point.

At the global level, trade is expected to expand at less than 3% this year, one of the slowest paces since 2000.  The forces that lead up to the currency re-alignments, namely a collapse in commodity prices and a slowdown in world manufacturing continue to plague the world. Canadian non-energy exports have to contend in this difficult environment.

As long as commodity prices remain down for long count, Canada  will not see any marked improvement in its trade balances . Many observers are pinning their hopes  that  fall in the Loonie will promote the expansion of non-energy exports. However, it is more likely that Canadians will  undergo a fall in their standard of living as long as oil prices remain at these current levels. Simply, the slack is too great to be picked up by non energy exports alone.

Canada relies heavily on  the worldwide  supply chains  for production of exports, more than its US competitors .This integration works against the perceived advantage of a lower Canadian dollar.

No longer can we expect devaluation to be a panacea.
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1) IMF,  "Depreciations without Exports ?" (2015)

2) The negative sign indicates that the exchange rate and  quantity demand are inversely related.
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Big Bad China

Guest post by $hane Obata

It seems like every day we are inundated with news out of China. Investors are already concerned. The offshore renminbi (CNH) is more international than the onshore one (CNY), which is tightly managed by the government. As such, the rising spread (CNH-CNY) between the two may be indicative of mounting skepticism about China’s economy and its markets. Likewise, capital is fleeing the country as hot money flows have accelerated:

Source: @vikramreuters

In the following sections we will attempt to analyze China’s markets and determine the biggest risks facing its economy. Lastly, we will try to answer the following question: does it matter to us?

Financial Markets

As the first week of trading in 2016 came to an end, the Chinese markets had already been halted twice. Newly minted circuit breakers, which have since been suspended, were triggered when China’s main equity index, the CSI 300, fell 7% on two separate occasions. The first selloff was triggered by a rumor that the China Securities Regulatory Commission (CSRC) was planning to suspend a short sale ban that has kept a reported ~$185 billion off the market. Subsequently, the CSRC decided to extend the ban in order to calm the markets. The second drop followed a significant devaluation of yuan by the People’s Bank of China (PBOC). China has also backtracked on that move. Basically, the Chinese markets are confusing…

That said, the volatility is not surprising considering how unsophisticated China’s market is. One university study found that 2/3 of the new investors at the end of 2014 did not have a high school diploma:

Source: Bloomberg Brief

Along the same lines, individuals account for at least 80% of trading on the mainland exchanges. In other words, there are many speculators and few investors. China’s markets are undeveloped and relatively unimportant. Nonetheless, they may offer some clues into consumer sentiment and the government’s ability (or inability) to control the economy.

Economy

China remains an indispensable part of the global economy. In nominal terms, China is the world’s second biggest economy with a GDP of ~$10.3 trillion. However, in terms of Purchasing Power Parity-adjusted GDP (PPP), it has surpassed the US. Moreover, it accounts for ~40% of global PPP-adjusted GDP growth:

Source: The Economist

In regards to trade, China is the world’s biggest player. In 2013, it led the world in exports ($2,209 billion) and was the number two country for imports ($1,950). The combined value of its trading amounted to $4,159 billion, marginally higher than the US’ $3,909 billion.

Debt

China’s aggregate debt level is one of the highest in the world, although it may not seem to be at first glance. China’s government debt-to-GDP ratio is 55%. To put that in perspective, the US and Japan are at 89% & 234%, respectively. Even so, it is always prudent to consider a country’s debt composition. China’s mounting debt comes into focus when we account for non-financial corporate debt (125% of GDP), financial institution debt (65%) and household debt (38%). The grand total is an astounding 282% of GDP, or $28.2 trillion:

Source: McKinsey

The rate of debt growth is also a concern. Non-financial corporate debt, increased from 72% to 125% of GDP from 2007 to 2Q14, a 73.6% increase.

China’s debt load is a global risk because of how tightly managed its economy is. The government has allowed unprofitable companies to stay in business. Though defaults have been very limited, China must allow these companies to fail eventually. Otherwise, it will continue to suffer from high debt servicing costs (~30% of GDP).

Overcapacity

Government investment has been a big part of China’s economy. Massive amounts of stimulus went into factories, leading to overcapacity in sectors such as coal and steel. This is making it very difficult for companies that operate within those sectors to make profits – both domestically and abroad. Fiscal stimulus also went into housing and infrastructure, which are both clearly overbuilt. Despite the overcapacity, gross capital formation still represents ~45% of GDP:

Source: Gordon T. Long

That is more than twice as high as it is in both the US and the European Union.

Monetary Policy & FX

The PBOC has been very active trying to support the economy. It has cut rates 6 times since November of 2014. Likewise, it has been lowering its Reserve Requirement Ratio and selling its foreign reserves in an attempt to prevent excessive devaluation of the yuan (CNY). They are down more than $400 billion (from a peak of ~$4 trillion) since mid-2014:

Source: @TomOrlik

FX is also a risk because China has a great deal of USD-denominated debt. In mid-2015, non-bank borrowers held ~$1.2 trillion worth of it. This debt becomes more expensive as USDCNY rises, which is exactly what the markets expect to happen.

Corruption Crackdown

China’s anti-corruption campaign is a step in the right direction. That said, it is a big political risk for foreign investors. High profile businessmen and officials have been disappearing while others are being investigated. Moreover, securities regulators have been cracking down on market manipulators, “ensnaring some of the nation’s most high-profile money managers and announcing more than 2 billion yuan of fines and confiscated gains” (source: BBG Brief). Critics of the campaign suggest that it may deter business while failing to address the corruption that exists within the ruling party.

Implications

As investors, we should be concerned because China is one of the biggest economies and the world’s leading trader. Therefore, if it slows down then so will global growth:

Source: Goldman Sachs

China is also important because it is a massive source of demand for many commodities. Thus, its weakness is spreading to undiversified economies such as Russia, Brazil, and South Africa. Recessions in those countries might not spill over to the rest of the world. Nevertheless, it is important to consider the amount of debt they have accumulated since the financial crisis. In the US, credit is already tightening. If borrowing costs rise for the emerging markets, especially China, then we may see a wave of defaults with untold consequences.

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- $hane Obata & Richardson GMP AM

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author's judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. The comments contained herein are general in nature and are not intended to be, nor should be construed to be, legal or tax advice to any particular individual. Accordingly, individuals should consult their own legal or tax advisors for advice with respect to the tax consequences to them, having regard to their own particular circumstances.. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons.

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