Gavyn Davies: An unmistakable shift in the Fed’s centre of gravity

(…) But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.

The markets still seem entirely untroubled by this impending headwind for asset prices, but it is the new reality, unless the economy slows sharply.

(…) why did the bond and (briefly) the equity market sell off after the FOMC meeting? Undoubtedly, the main reason was Ms Yellen’s willingness to define what the FOMC meant by the “considerable time” between the end of tapering and the start of rate increases. She said this was “something on the order of six months”. Even if this was a rookie mistake (which is hard to believe), it still revealed very clearly what she was thinking, and it was a shorter period than most investors would otherwise have inferred from the word “considerable”. (…)

Where does this leave the big picture for US monetary policy? The smoke signals are confused. Wage inflation remains too low, as Ms Yellen specifically pointed out. But it is surely significant that the hawkish shift in the dots is the first time this has happened since QE3 was launched in 2012.

Previously, the predicted date of initial rate increases has tended to be shifted further out almost every time the dots have been published. And this is where I believe we are learning something new about the attitude of the “mainstream doves” who have dominated Fed policy since 2008.

These mainstream doves have increasingly accepted that the falling unemployment rate may be telling the truth about labour market tightening, with less expectation that the participation rate will rebound. They have now abandoned the “Evans rule”, which previously envisaged a period in which inflation could rise to 2.5 per cent, and the Fed’s 2 per cent inflation target once again resembles a ceiling.

The optimal control approach to policy, under which rates would be deliberately kept lower than indicated by standard policy rules in order to ease policy at the zero lower bound, is no longer in favour. Instead, the path for rates is determined by the FOMC’s assessment of “headwinds”, which can rapidly change.

And there is increasing evidence that the FOMC as a whole, not just the hawks, is concerned about an excessive reach for yield in the financial system, as it certainly should be. (See the forensic Tim Duy on this.)

The upshot is that the committee has moved a long way from the highly unconventional territory it occupied a year ago. Paul Krugman complains that the liquidity trap has been replaced with a “timidity trap”. Timid or not, investors for the first time in years now face a two-way risk in US monetary policy.

Economic Conditions Snapshot, March 2014: McKinsey Global Survey results

Concerns about geopolitical instability and its implications for global growth have surged, according to McKinsey’s latest survey on economic conditions. Seventy percent of all respondents cite geopolitical tensions as a risk to growth in the global economy over the next year, up from 27 percent in December, as the recent turmoil in Ukraine and Russia has left executives across Europe divided.

On average, executives remain optimistic about conditions in both their home countries and the global economy, though sluggish demand still tops their list of domestic concerns. Among non-eurozone respondents in Europe, however, economic expectations have taken a turn for the worse. They cite geopolitical issues most often as a risk to their countries’ domestic growth. Relative to their peers in the eurozone, they are much more negative about current conditions at home and in the world economy—and more pessimistic about economic prospects in the months ahead. (…)

On average, executives are as positive about economic conditions at home as they were in December. Forty-three percent say current conditions are better now than six months ago—close to the 49 percent of executives who, six months ago, expected conditions would improve by now—and 43 percent expect conditions will improve over the next six months. Across regions, respondents in North America and developed Asia remain the most upbeat. Yet those in Asia are much likelier now than in December to say conditions have worsened, and they are less likely than most others to expect improvements in the coming months. (…)

EM held back by weak global recovery Economies with reliance on commodity exports remain fragile

(…) In aggregate, emerging market exports grew 4.3 per cent year-on-year in January, up from 4.2 per cent in December, but this meagre uptick masks a sharp divergence in fortunes between regions. Latin America and some parts of Africa have performed poorly, while emerging Asia and eastern Europe have been relatively buoyant. Within regions, there have also been significant country-specific differences.

These discrepancies not only help to reveal the influences suppressing an export-led emerging market recovery, they also identify differing levels of vulnerability among fragile five and other emerging economies to further market turmoil.

On the optimistic side, India and Indonesia appear to be graduating if not quite yet from the fragile five then at least from the grouping’s critical list. Their current account deficits have been shrinking as a percentage of GDP mostly because whopping currency depreciations last year – 28 per cent for the rupee and 20 per cent for the rupiah between May and August – have brought significant reductions in imports.

Stock, bond and currency markets in both countries are already rewarding this turnround, even at a time of instability in Ukraine and continued fears over the unwinding of US monetary stimulus. But these upbeat readings do not obscure the fact that such deficit reductions derive more from slumping domestic demand than from a resurgence in developed world purchases of Indian and Indonesian exports.

“Indeed, there are still reasons to be relatively gloomy about the emerging market export story,” said David Lubin, head of EM economics at Citi.

“In the US, for example, [there is] evidence to suggest that non-energy import growth has been considerably weaker than it was at similar stages of the US cycle at any time since 1980,” Mr Lubin added. “And the persistence of the eurozone’s current account surplus suggests that prospects for a sharp increase in import demand there are weak.”

Part of the problem with US and EU demand, says Louis Lam, Greater China economist at ANZ Research, is that it has not yet broadened out to include electronics, which account for between 30 to 60 per cent of total exports from countries such as Malaysia, Thailand and the Philippines.

Until such a broadening in US and EU demand takes place, the export fortunes of Southeast Asia will continue to be dictated by Japan – where demand has been relatively strong – and by China, where a slowdown in construction investment this year has sent non-food commodity markets into a tailspin.

The spectre of weakening Chinese imports of iron ore, copper and other resources looms large for Brazil, South Africa and Indonesia among the fragile five, but is also negative for Chile, Colombia, Russia and Peru, says Mr Botham, who has ranked emerging markets according to their vulnerability to a Chinese slowdown. (…)

Non-food commodity exports account for well over 80 per cent of total exports to China in Columbia, Chile, Brazil and Peru. The same is true in South Africa, Russia and Turkey, while in some frontier markets such as Zambia, reliance on copper exports to China is so heavy that the national currency, the kwacha, has depreciated against the US dollar by as much as 8 per cent in the past month.

The stresses afflicting China, therefore, add emphasis to hopes that a strong upsurge in US, EU and Japanese demand for emerging market exports will soon materialise. But in the absence of such a recovery, two fragile five members – Turkey and Brazil – appear particularly exposed because their current account deficits failed to improve in the fourth quarter of last year.

South Africa did manage to shrink its deficit but remains vulnerable because it did so largely by raising interest rates and hobbling its domestic economy to reduce imports. Overall then, the outlook for an export-led solution to emerging market woes appears remote. “Looking ahead, in theory, the currency falls over the past year could – in time – support a rise in manufactured goods exports,” said a Capital Economics research note. “But…we’re not holding our breath.”

Bundesbank Says German Growth to Slow

Germany should see strong economic growth in the first three months of the year before slowing down in the next quarter, the country’s central bank said Monday.

“Germany is poised to see a substantial boost to its economic expansion in the first quarter,” the Deutsche Bundesbank said in its monthly report.

A very mild winter, especially in the first two months of the year, has boosted construction output in Europe’s largest economy. Production should also be strong in the first quarter, the central bank said, citing an upward trend in industrial contracts. Growth in the second quarter should be “considerably lower” than the first, the Bundesbank added.(…)

Data provider Markit said the preliminary composite purchasing managers index for Germany—which measures activity across the services and manufacturing sectors—slipped to 55 in March from February’s 56.4. It was the lowest level since December. (…)

Germany Inc. on Edge as EU Steps Up Response to Crimea

(…) The EU’s biggest economy has a lot riding on Russia. Volkswagen AG (VOW),Siemens AG (SIE), and HeidelbergCement AG are among the largest foreign investors there, the economic linchpin of a relationship nurtured by successive Berlin governments. Retailer Metro AG sells groceries to Russians, Adidas AG clothes the national soccer team, and Deutsche Lufthansa AG (LHA) flies to more Russian cities than any other western European carrier. (…)

Among the large countries that use the euro, Germany sends the highest proportion of its exports to Russia, about 3.3 percent, Olivier Bizimana, a Morgan Stanley economist based in London, said in a March 20 research note. Bilateral trade between the two countries hit 77 billion euros ($106 billion) last year, and German investment in Russia totals 20 billion euros, according to the German Association of Chambers of Industry and Commerce. (…)

“Germany will be harder hit than almost all other countries” by sanctions, especially if Putin retaliates by halting gas shipments, said Holger Schmieding, chief economist at Berenberg Bank in London. “A stop of Russian energy imports throughout next winter — that would stall the European and the German economic recovery.” (…)

Only Best Credit Scores Getting Mortgages Mortgage credit continues to loosen up, but getting a loan to buy a house is still difficult for the average American. This is especially true for people without top credit scores.

(…) The average FICO score for a conventional mortgage – one that’s sold to mortgage giants Fannie Mae and Freddie Mac — was 755 in February, according to Ellie Mae’s latest mortgage origination report.

The average FICO score for FHA loans – which are backed by the government and attract buyers with lower credit in part because FHA loans require down payment as low as 3% – was 686.

The U.S. average FICO score was 711 in October 2013, the latest available data, so conventional mortgages remain difficult to get for most borrowers. A look at the distribution of credit scores shows why this is: Banks continue to avoid the worst borrowers like the plague.

The accompanying chart, from CoreLogic, shows the historical credit score distribution of purchase mortgages. As you can see, the largest losses have been among buyers in the lowest two tiers, and they aren’t budging much.

Borrowers with FICO scores below 620 accounted for 0.35% or mortgages in January, down from about 13% in February 2003 and a peak of 17% during the frothiest peaks of the housing bubble. The best borrowers, with scores above 780, have taken their place, swelling from about 13% or originations in 2003 to a little less than 30% today.

But, as the chart shows, the share mid-range borrowers — those with scores of 640 to 779 — are in line with their historic norms.

Sinopec to Cut Spending

China Petroleum & Chemical Corp. said Sunday that it would reduce capital expenditures 4.2%. PetroChina Co. said Thursday that it would cut capital spending 7%.

Mohamed El-Erian
Markets underprice geopolitical risk

(…) While each geopolitical shock has been small on a standalone basis, in aggregate they are starting to affect a more meaningful part of the global economy. And few, if any, can be resolved easily. Meanwhile, leaders in Europe and the US will come under increasing domestic pressure to act more forcefully externally, weakening the circuit breakers.

Do not look to global co-operation as a way to diffuse most of today’s geopolitical tensions. Hampered by national politics, the effectiveness of multilateral institutions has failed to keep up with the increasing complexities on the ground.

This weakness could even start playing out in earnest in Ukraine in the next few weeks. All it would take is for additional blatant territorial intervention by Russia to trigger comprehensive financial and economic sanctions by the west. With Russia likely to retaliate by disrupting the supply of energy to western Europe, the world would be thrown into recession, along with renewed financial instability – a situation that would certainly derail capital markets.

While a notable risk, this is not the most likely scenario for the next few weeks. Instead, the situation is likely to stabilise temporarily at a new geopolitical equilibrium, albeit a fragile one, in which the west tolerates the annexation of Crimea and Russia’s “legitimate interests” there, while Russia pays lip service to Ukrainian territorial integrity and supports international help for the country while deferring some of its own claims.

Should this indeed materialise, markets would again feel vindicated in having responded rather calmly to the Crimea crisis. Yet they should guard against complacency based on a simple extrapolation of the past. Underlying geopolitical tensions around the world have been gradually building towards a tipping point. Should this continue, it would quickly become evident that many markets are underpricing geopolitical risk.

THE U.S. ENERGY GAME CHANGER

Follow-up on my Oct. 2012 Facts & Trends: The U.S. Energy Game Changer:

Chemical Firms Pounce on Cheap Gas Chemical companies meeting in Houston this week will discuss how to ensure that multibillion-dollar bets on cheap natural gas pay off.

(…) the trend has given chemical and plastics producers a reason to expand in the U.S., creating jobs and reviving a sector of the economy that many people had written off.

The manufacturing renaissance sweeping across the U.S. today is a shift from the turn of this century, when it seemed unlikely that new petrochemical plants would be built in places such as the coastal region near the Gulf of Mexico, according to Dave Witte, general manager of IHS Chemical, an energy consulting group.

The assumption was that new petrochemical plants and associated investments in plastics, rubber resins and metals manufacturing would be focused in Asia and countries rich in natural gas, such as Iran. (…)

New petrochemical projects are under way, with Dow Chemical, Sasol Ltd., Phillips 66 and other companies building 48 factories and plant expansions, thanks to the plentiful natural gas now available in the U.S., the American Chemistry Council said.

The combined price tag for that construction: more than $100 billion, the council said. IHS Chemical estimated that $125 billion in petrochemical investments related to U.S. shale gas have been announced, with more likely to come.

In an about-face, the U.S. is drawing foreign manufacturing investments, Mr. Witte said. Inexpensive gas is luring Canada’s Methanex Corp to pack up its one-million-ton-a-year methanol plant in Chile and move it to Louisiana at a cost of $550 million. But all that building could cause construction costs to balloon as companies compete for a limited supply of labor and materials, particularly in Gulf Coast states, according to IHS.

The resurrection of U.S. manufacturing in the service of developing the chemical sector and pumping more oil and gas—including building machinery and fabricating steel and iron—is breathing new life into major metropolitan areas, according to an IHS report released last week that was commissioned by the U.S. Conference of Mayors.

From 2010 to 2012, energy-intensive manufacturing sectors added more than 196,000 U.S. jobs and increased real sales by $124 billion in the nation’s metro areas, according to the report.

Steel plants across Indiana’s Rust Belt and from Birmingham, Ala., to Knoxville, Tenn., to West Mifflin, Pa., have more orders for metal. And machinery-sector growth exploded between 2010 and 2012, with Houston leading the way, followed by Chicago, Detroit, Los Angeles and Milwaukee, the report said. “That means jobs,” said Lansing, Mich., Mayor Virg Bernero. “There are still people who need jobs, and advanced manufacturing is the ticket.”

And, BTW:

South Korea, the world’s second-largest importer of natural gas, is positioned to be the first Asian importer of U.S. natural gas, as it has contracted to purchase 3.5 million tons a year of LNG from the Sabine Pass project.

Houston-based Cheniere Energy Inc. operates the Sabine Pass LNG terminal, which is expected to be the first U.S. gas project to export LNG, with a total capacity of up to 13.5 million tons a year and shipments set to start in 2015. (WSJ)

WORDS OF WISDOM

• Oaktree Chairman Marks Gives Advice To Students At His Alma Mater

(…) success in investing is not a function of what you buy. It’s a function of what you pay.

(…) what’s important is finding a company with good intrinsic value that will weather difficult economic times, which are sure to hit any long-term investment, and avoid losing money more than seeking big returns. As long as losses are kept to a minimum, he figures that there will be enough winners to pull up the average and provide good returns. The result is that Oaktree has averaged 23% returns over the last quarter century with 95% of all outcomes being positive.

He also warns students to stay away from assets without any intrinsic value (gold, internet start-ups, Bitcoin) because you are relying on other people’s opinion of what they are worth, while a company that pays dividends and will likely do so for many years has at least some baseline value. 

• Good Shorts Vs Bad Shorts