Low Growth And High Debt: Financial Repression Is Here To Stay

In case we needed to be reminded, the IMF’s latest World Economic Outlook included a section on the rather dismal long-run outlook for economic growth. Trends in demographics and productivity are expected to deliver average potential growth of only 1.6% a year in the advanced economies during the remainder of the decade. Such measly growth will make it very difficult for governments to lower current high debt-to-GDP ratios.

In this Special Report, BCA’s Chief Economist, Martin Barnes, explains why debt burdens are more likely to rise than fall over the short and long run given demographic trends and the low odds of another economic boom. If governments cannot easily bring debt ratios down to more sustainable levels, then the obvious solution is to make high debt levels easier to live with. This can be done be keeping real borrowing costs down and by regulatory pressures that encourage financial institutions to hold more government securities. In other words, financial repression is the inevitable result of a world of low growth and stubbornly high debt.

Martin argues that central banks are not overt supporters of financial repression, but they certainly are enablers because they have no other options other than to keep rates depressed if they cannot meet their growth and/or inflation targets. A world of financial repression is an uncomfortable world for investors as it implies continued distortions in asset prices, and it is bound to breed excesses that ultimately will threaten financial stability.

For the full report and investment implications, please see Low Growth And High Debt: Financial Repression Is Here To Stay.

The Spike In German Bund Yields Will Not Last

The recent selloff in German bunds has been driven by two factors. First, Grexit risks have abated. Second, and more importantly, euro area growth continues to surprise on the upside.

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The IMF reckons that the lagged effect of a weaker euro alone should boost real GDP by a cumulative 1.7 percentage points by early next year, with lower oil prices contributing another 0.3 points. In addition, we estimate that increased government spending could boost growth by a further 0.3 points this year, while the shift from negative to modestly positive credit growth could add a full percentage point.
This is a lot of extra growth in a very short period of time, and so it is not surprising that investors have begun to reconsider their view that the ECB will keep rates on hold for many years to come. However, while the euro area economy is likely to fare well over the coming few quarters, the party will not last far into 2016. Please see the next Insight, (Part II) The Spike In German Bunds Will Not Last.

Don’t Bet Against The PBoC

Monetary easing will continue to drive a multiple expansion in Chinese shares.

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With the latest cut of reserve requirement ratio (RRR), the PBoC is stepping up efforts to ease liquidity conditions for the banking system. Historically, the PBoC has adjusted the RRR by 50-basis-point steps; the latest 100-basis-point cut suggests that the central bank is becoming more aggressive. With the RRR still standing at historically high levels, room for further liquidity easing remains wide open.

Our China investment strategists maintain the view that liquidity easing holds the key for lowering the cost of funding of the banking sector as well as the overall economy. As interest rate deregulation continues to advance, the interbank rate has been an important benchmark for the returns of wealth management products of banks and other financial intuitions, which have increasingly been competing with conventional bank deposits. Therefore, falling interbank rates also depress the return of wealth management products and lower the marginal cost of funding for banks – this in turn allows banks to lower their lending rates. Furthermore, the interbank rate is tightly correlated with short term funding costs within the corporate sector, such as the discount rates of bankers’ acceptance bills. The liquidity easing measures by the central bank so far have significantly lowered interbank rates across the board over the past two months, which should begin to filter into the economy soon.

We expect that the authorities’ reflation efforts will eventually put a floor under growth. Monetary easing will continue to drive a multiple expansion in both A shares and H shares, and investors should not bet against the PBoC’s reflation battle.

 

Fed Lift-Off Conditions: A Look At Prior Cycles

The Fed’s decision to raise rates will remain data dependent, and liftoff will be delayed if the economic and inflation data continue to underwhelm the Fed’s expectations.

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Our U.S. fixed income team recently compared the economic data today with prior Fed liftoff cycles. A few observations stand out:

  • Current GDP growth is below the level that preceded previous Fed liftoffs, especially in nominal terms;
  • Headline inflation is also far lower than in past liftoff cycles, although core PCE inflation is at the same levels seen five months before the 1999 and 2004 Fed liftoffs;
  • Unemployment is close to the levels that prevailed in the run-up to the 1997 and 2004 initial Fed rate hikes, although the growth in labor productivity is well below that of all past cycles;
  • Among conventional measures of economic slack, the output gap is close to the levels of the 1994, 1997 and 2004 liftoffs, while the unemployment gap (U-3 minus NAIRU) was only lower prior to the 1999 Fed liftoff.

Judging by history alone, a Fed liftoff in September 2015 appears pre-emptive with regard to current growth and inflation rates, but far less so when looking at measures of excess slack in the economy. The Fed has downgraded the importance of the latter, especially given that structural trends make it particularly difficult to gauge slack this cycle.

 

Dollar-Bloc Commodity Currencies: More Downside

Our FX strategists expect the dollar-bloc commodity currencies to remain under pressure versus the greenback. China holds the key for the commodity exporting currencies. Despite the soaring stock market, thus far there are scant signs that the Chinese economy is accelerating.

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  • Particularly important for the Australian dollar, iron ore prices are still falling. This means that Australia’s terms of trade and currency have yet to bottom. Additional downside for the Australian dollar comes from the prospect of additional RBA rate cuts. Although the central bank held policy steady last week, it maintained its easing bias. Our RBA Monitor remains in “easy money required” territory, warning that more rates cuts are ahead.
  • We also see further downside risks in the Canadian dollar. Our Commodity & Energy Strategy service remains bearish on crude oil. Downside risks to growth could necessitate further rate cuts. Last week’s Business Outlook Survey was broadly weak with future sales growth, employment and investment posting declines.
  • The kiwi ranks the best among the three dollar-bloc currencies. NZ’s economy and commodity basket, which is biased towards dairy products, are much more resilient. Unlike the Australian dollar, which is still overvalued relative to its terms of trade, the kiwi is closer to fair value. Also, the RBNZ does not have an easing bias. Nevertheless, it will be difficult for the NZ dollar to decouple completely from the other commodity currencies.

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