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GavekalResear
The Gavekal Monthly
A Possible Return Of US
InflationNovember 2015
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The Gavekal Monthly – November 2015
Overview
Louis’s Take Watch Out For Inflation’s Return Louis-Vincent Gave 3
Key Calls
US Growth The False Recession Alarm Will Denyer/Tan Kai Xian 12
EuropeMore Easing On The Way François-Xavier Chauchat 16
China Will Construction Ever Recover? Rosealea Yao 20
Dashboard
Our Views In Brief Economies, Markets, Themes 24
Indicators Growth, Risk, Inflation, QE 27
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When the Fed worries, worry about something else• After a tempestuous summer, October was a strong month for
most risk assets with the S&P 500 delivering its best monthly performance in four years. This performance was all the more impressive since October tends to be a challenging month for risk assets.
• Several factors contributed (see our last monthly for details), but perhaps most important was the Fed’s dovish decision to “wait and see” before hiking rates. This stalled the US dollar’s rise, which in turn gave breathing room to stressed emerging markets. This brings us back to the old adage that “when the Fed worries about something, it is time to worry about something else”.
• The Fed was clearly worried about China: a possible devaluation, potential financial contagion, and greater stress in emerging markets.
• We believe worries about a Chinese financial market contagion are overblown; and most macro and financial data in the past month have confirmed our view. China concerns are becoming “so summer 2015.”
• A more profitable thing to worry about now is a return of inflation in the US.
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The ‘China Panic’ has abated: four steps to financial stabilizationStep 1: Central bank data shows that the contraction in reserves is
abating and was mostly the result of foreigners panicking rather than Chinese people quitting on the renminbi.
Step 2: Local bond markets make new highs and spreads collapse, highlighting lack of domestic financial stress. The dim sum bond market starts to follow and hits new highs.
Step 3: The difference between the onshore (CNY) and offshore (CNH) renminbi dwindles to meaningless territory, highlighting the lessening of financial stress:
Step 4: Domestic equity markets move higher once again on strong volumes, without government intervention. Particularly telling is the all-time volume high in the ChiNext small cap exchange. Animal sprits have yet to be broken!
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With every passing week, the collapse in commodity prices recedes further into the rearview mirror. Oil is particularly important: starting around November-December, the annual base effect of the oil price collapse on global consumer price indexes will start seriously abating.
Of course, commodities could easily take another step down. China keeps slowing, growth across the western world remains anemic, and so on. Having said that, this information has now been processed well by the market. So the more likely scenario is that in the coming months, the stabilization of commodity prices no longer drags CPI readings lower.
Commodities may have found a floor
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The US dollar is basically trading at the same level as it was on August 11, the renminbi’s “devaluation day”—despite a meltdown in emerging market currencies, a very dovish European Central Bank, capital outflows from China, etc.
Unless the dollar takes another leg up soon, we should see the annual change in the US import price indices move back towards zero, or even positive territory. After all, back-to-back -5% contractions in quarterly import prices usually only occur when something big happens (Asian Crisis, TMT bust, 2008 GFC). Looking ahead, it seems likely that import prices will start contributing positively to inflation.
The US dollar has topped out
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From Walmart, to FedEx, to NetJets, anecdotal evidence keeps coming in that wages are moving higher. Several recent earnings disappointments (e.g. Walmart) were laid at the feet of rising labor costs.
So far this anecdotal evidence has yet to filter through to the monthly data on wages. This could change now that the US$ is no longer rising: a rising dollar keeps wages in check through the threat of offshoring.
Rents are another inflationary factor: since 2010 the number of homes for rent in the US has shrunk by 1.4mn units and is now barely above the year 2000’s level. Meanwhile, the population of young renters has grown by 9.5mn individuals since 2000.
Already, anecdotal evidence shows that rents are shooting higher in many US cities: San Francisco, New York, Seattle, Los Angeles.
Wages and rents are rising
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In sum, if the next few months see a combination of a stable dollar, stabilizing commodity prices, rising US wages, and rising rents, then it is hard to see how US inflation will stay low.
That is a big set of ifs, of course. Yet interestingly, one of our favorite gauges of inflation, the Cleveland Median CPI, is already hovering at post-GFC highs.
Inflation could be the hot-button issue of 2016
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The “pain trade” began in September (see Is The Bull Market Over? (II)). The stalling of the dollar bull market, and the easing of the China panic, started a rally in EM, beaten-up cyclicals and industrials.
A pickup in US inflation would amplify the “pain trade.” Stable US growth stocks and other “volume monetizers” would de-rate; the outlook for “price monetizers” (cyclicals, EM) would brighten.
North Asia tends to do well when US inflation picks up. Asia is the obvious place to offshore production when costs rise at home. And most companies in Asia are price monetizers.
If inflation picks up, the ‘pain trade’ will continue
US + Chinese consumers keep on
consumingUS trade balance
deteriorates
Foreign central bank reserves rise again
EM currencies start to stabilize
China devaluation fears abate and the renminbi rises on
short covering
The PBOC slashes interest rates without a fall in the
renminbi
Dim sum and EM bond yields come
down
EM equities outperform in US$ and local currency
terms
Cyclicals everywhere outperform
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Inflation bounce would likely lead to outperformance in North Asia
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US GrowthThe False Recession Alarm
Will Denyer and Tan Kai [email protected], [email protected]
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US Growth The False Recession AlarmWhat’s happening What it means
The US payrolls report for the month of September came in surprisingly weak
•Consensus: growth is faltering and rate hikes will be delayed until the middle of next year.•Our view: largely due to a tightening labor
market (less low hanging fruit); hawkish stance indicates that the Fed holds similar view; wage growth also remains supported.
Data continues to point to zero US manufacturing growth, but the service sector remains robust
•Under the weight of a strong US dollar and weak global growth, US manufacturing is no longer growing.•The rise in inventory/sales ratios is particularly
worrying.•Yet the direct economic impact is arguably
small, given that manufacturing is just 12% of GDP and 9% of payrolls. •The much larger service sector is holding up—being
less exposed to the currency and benefiting from the tighter labor market.
US 3Q GDP slowed to 1.5% QoQ annualized, with consumption being the only bright spot
•US GDP is likely to continue to muddle through due to widespread inventories build-up, weakening net exports and slower capex.•But the bottom line is that despite the softness
in many indicators, the return on invested capital for US firms is still solidly above the cost of capital. So long as this holds, we probably will not see a recession.
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The US is experiencing numerous developments often associated with recessions. But sometimes these ominous signals flash and no recession occurs. Examples include 1985, 1998, and, we think, today.
In all three cases, the US dollar rose to uncompetitive levels. In turn, US manufacturing activity slipped and inventories piled up.
And yet no recession occurred in 1985/86 nor in 1998/99. The service sectors continued to expand—being less exposed to an uncompetitive dollar and foreign competition. Moreover, in1998 the service sector benefited from a US consumer strengthened by low unemployment and wage growth accelerating in fits and starts. We appear to be in the same position today.
US Growth The False Recession Alarm
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Corporate profits contracted in 1985 and 1998, as today. And as a result, in 1985, 1998 and today equities temporarily sold off and credit spreads jumped. Indeed, with so many things going in the wrong direction today, it is tempting to sell everything and brace for recession.
But 1985 proved to be the middle of the cycle. After the October 1998 pull-back, equities rose for more than a year, and it was more than two years until the 2001 recession.
So how do we know when the situation is bad enough for a proper downturn? We suggest watching our new Wicksellian spreads, which measure the gap between corporations’ cost of capital and their return on invested capital. These spreads are narrowing, but are still quite positive. So long as this holds, recession is not around the corner (see A New Look At Capital: Reassessing Cost And Return).
US Growth The False Recession Alarm
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Europe More Easing On The WayWhat’s happening What it means
Hundreds of thousands of migrants from Syria and other Middle Eastern countries are heading to Europe
•On a continent where immigration issues are increasingly shaping politics, the migrant crisis is creating new political risks.•The good news is that Germany and Sweden will
loosen fiscal policy by 1% of GDP to address the issue.•The rise of the German population since 2010 has
already surprised demographers, on the back of immigration from Eastern and Southern Europe. More to come with the migration from Syria.
Volkswagen admitted that its installed “cheatware” on 11mn vehicles in order to pass emissions tests
•For now the shock seems manageable as VW announced that modified software will cost the company €200 per vehicle. But class action lawsuits could eventually lead to much higher costs.•In the worst case scenario, the VW scandal could lead
to a soft patch in the German economic cycle, but given Germany’s huge margins for maneuver, pessimism does not look justified.
On October 22 ECB president Mario Draghi hinted at further monetary policy easing from December
•Eurozone domestic demand remains resilient, but slower world growth and a higher euro vs EM currencies are making the ECB even more nervous about the risk of an anchoring of “lowflation”.•The ECB will likely expand QE and possibly cut
its deposit rate further into negative territory, with positive consequences for the domestic economy and for asset prices.
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With its largest export champion in crisis—Volkswagen lost -50% on the stock market since the emission scandal started—and hundreds of thousands of Syrian migrants crossing its borders, Germany suddenly looks vulnerable.
But even if the VW crisis worsens, leading the German government to bail the company out and finance the largest car-scrapping scheme in history, the worst case scenario remains easily manageable.
Germany benefits from the best financial situation any G7 country has ever enjoyed in modern times: a current account surplus of 8.5% of GDP, and a fiscal surplus. Even if the migrant crisis and the VW scandal leads Germany to spend 3% of its GDP next year, it will still remain the safe haven of the G7. The main risk is not on the economic front but rather the political: are the German people ready for the immigration shock?
Europe More Easing On The Way
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Although not yet very strong, eurozone domestic demand has continued to improve on the back of lower oil prices and better credit conditions.
The ECB’s QE has already succeeded in considerably reducing financial fragmentation. Bank interest rates in Italy and Spain have now converged on French and German levels, and banks are showing more and more willingness to lend.
Still, the ECB cannot afford to be passive if it wants to be credible in its fight against “lowflation.” Additional deflationary pressures coming from a stronger euro and from even lower commodity prices could lead to inflationary expectations anchored lower than target.
In December the ECB is thus likely to announce further monetary easing: QE extension and probably another rate cut. This should ensure further gains in domestic growth.
Europe More Easing On The Way
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China Will Construction Ever Recover?
What’s happening What it means
Property sales have picked up sharply since May…
•Property sales rebounded strongly in response to multiple rate cuts and other easing measures. •Yet given the traditional two-year cycle, housing
sales will almost certainly be weaker in 2016.
…but unlike in past cycles, construction has not followed suit
•Historically, strong sales translate into construction and investment, with a lag of 3-6 months. But sales and construction have decoupled in 2014-15. Construction starts fell -13% YoY in Jan-Sep and land sales fell -34%. Crude steel use fell -5% YoY in Jan-Sept. •The culprit is inventory overhang. Developers
have no appetite for new investment before inventory draws down sufficiently.
Inventories are peaking but have much farther to fall
•City-level data shows inventories in Tier 1 & 2 cities fell quickly, but inventories in smaller cities fell less. Our own broader estimates show national inventories are just peaking, with highest inventory levels in the smaller cities. •This means more pain in construction is very
likely in 2016. A recovery in construction activity is unlikely to occur until 2017.
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Construction overshot sales in past years and will have to undershoot the demand trend. When it will rebound depends on how quickly inventory can normalize.
In 2015, policymakers essentially took a hands-off attitude toward the supply side, letting the decline in starts continue but being supportive on the demand side. Inventory levels peaked.
Expect the same policy stance in 2016. This means construction starts will fall for at least another year, with some recovery in 2017 to match the trend in sales (see When Will Construction Rebound?).
China Will Construction Ever Recover?
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Assuming all housing starts will eventually turn into sales, the difference between the cumulative starts and amount of sales at any given time will therefore be the inventory held by developers.
This difference was about 2.6bn sqm, or 30 months of sales in 2014, but is on pace to decline to 2.5bn sqm and 25 months in 2015. Clearly more correction is needed in 2016 to reach the normal inventory level of 20 months.
Various indicators show a supply-side correction is deepening and has yet to end. A bigger proportion of housing demand has been and will continue to be met by inventory de-stocking.
The expected weak construction in 2016 will, by extension, mean continued pain in the whole complex of industries that depends on it: steel, metals, coal, etc. And as construction goes, so goes the economy.
China Will Construction Ever Recover?
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Our Views In Brief EconomiesRegion Analyst View Read more
World Charles Gave/Pierre Gave
Sustained low interest rates increase the risk of recession in the US and other rich countries
Gauging The Chances Of A US Recession; A Worrying Set Of Signals
China Andrew Batson/Chen Long
Growth keeps slowing and divergence widens between weak industry and stronger services
The Diverging Fortunes Of The Two Chinas; The Next Step Down In Growth
US Will Denyer/ Tan Kai Xian
Watch out for a return of US inflation
Position For A Pick-Up In US Inflation; Does Slower Job Growth Signal Recession?Eurozone François-Xavier
Chauchat
Rising intra-EZ financial flows are creating a sustained recovery
Animal Spirits And The Revival Of European Finance; A British-Style Recovery For France?
Emerging Asia Joyce Poon
Growth is constrained by high leverage and limits on monetary easing due to weaker currencies
Emerging Asia’s Leverage Problem; China And North Asia’s Deflation Syndrome
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Our Views In Brief MarketsMarket Analyst View Read more
Equities Louis-Vincent Gave
The top of the US$ and the end of the China panic signal a “pain trade” favoring cyclicals and EMs
Is The Bull Market Over? (II); The Birth Of A Pain Trade
US dollar Will Denyer/ Tan Kai Xian
US$ unlikely to strengthen further due to relative competitiveness shift
The Rising Supply Of ‘Earned’ US Dollars; Drop The Dollar Hedge
US equities Will Denyer
Buy tomorrow’s winners (US homebuilders and those producing outside the US); avoid bonds
Portfolio Construction Towards The End Of The Cycle
Europe equities
François-Xavier Chauchat
“Pan-European” stocks offer the best value; balance with peripheral bonds
Tantrum II And European Portfolios; Who Benefits From The Fall Of Europe’s Export Champions?
Renminbi Chen Long
Once the worst of capital-outflow pressures is past, the PBOC will likely allow another -2% to -3% depreciation this year
The Three Options For RMB Policy; Cross-Border Flows And The RMB
Japan equities
Joyce PoonGood earnings and improved corporate governance will keep the bull market going
The Next Phase Of Japan’s Bull Market; Japan’s ROE Revolution
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Our Views In Brief ThemesTopic Analyst View Read more
Oil: lower for longer
Anatole KaletskyAbundant supply means US$50 is a ceiling not a floor
Oil: Lower For Longer; Oil At Its Ceiling, Not Its Floor
The low-rate fallacy
Charles Gave
Zero rates are destroying productivity and leading to a deflationary recession
The Untimely Demise Of US Productivity; The Myth Of Secular Stagnation
China policy uncertainty
Andrew Batson Nationalist politics make policy choices less predictable
Expect The Unexpected; The Nationalist Style Of Economic ReformEurope’s
Thatcherite Keynesianism
François-Xavier Chauchat
Combination of monetary support and supply-side reforms strengthens eurozone
Europe’s Thatcherite Keynesianism; Greece, Europe & The Equity Market
US long-run growth
Will DenyerThe long-run growth rate will be 2-2.5%, thanks to weaker demographics
New Century, New Structural Growth Rates
Renminbi internationalization
Louis-Vincent Gave
Beijing’s drive to globalize its currency is the biggest macro event of 2015
The Crocodile Mouth About To Close; The New Way To Think About China
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Our growth indicators are still pointing to a deceleration in economic activity. Part of this can be explained by the fact that these indicators are biased towards “old” style activity (like manufacturing) which has in fact been quite weak.
The indicators do a less good job in capturing changes in the service part of the economy, which has been far more solid.
As such, one could argue that global growth is perhaps on a stronger footing than our indicators would imply.
Nevertheless, we still find it unsettling that the most volatile part of the economy (industrial production) is clearly struggling. The fact that the most stable part of the economy (services) remains, well, stable does not do enough to shake our uneasiness.
Indicators Our growth indicators are still depressed
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Risk appetite bounced back strongly last month. After it became clear that the Chinese were not playing the devaluation game, investors felt increasingly confident to dip back in to risk assets.
And after the ECB came out on the dovish side, the trickle towards risk became a flood and the world MSCI ended up by 7.9% for the month, the best monthly performance since October 2011.
The VIX, which had been hovering at multi-year highs, collapsed back to the very low trading we saw between 2012 and mid-2015.
Unless something unexpected happens, the stage does appear to be set for a very solid end of the year for risk assets (as is very often the case).
Indicators Risk appetite is back with a vengeance
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But while spirits run high on the markets, the same cannot be said for inflationary expectations.
Notwithstanding the argument made by Louis at the front of this report, most of our price indicators imply that we are dipping towards new lows. Inflation is still very clearly missing in action.
The Fed held off hiking rates in September, hinting at worries on the international scene (i.e. China).
Now that global financial markets have calmed and risk appetite is bouncing, will the Fed raise in December, despite a dismal inflation reading?
Right now, the market expectations of a December hike have been reined in, but we think there is fair chance the Fed will raise rates.
Indicators No sign yet of inflation
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Obviously, policymakers are still more worried about the state of the economic recovery than the potentially destabilizing risk of rising asset prices.
The ECB was again the leader of the pack as Draghi highlighted his continued willingness to err on the side of more easing.
Already, the ECB balance sheet is rising at 40% YoY and is rapidly approaching the levels of 2012.
Part of the reason that the ECB seems so willing to go the extra mile is that precious little of this new liquidity has actually led to a rebound in bank lending.
This is somewhat worrying and highlights the challenges associated with a solely monetary response.
Indicators Is the ECB pushing on a string?
www.gavekal.comFor more information contact [email protected]
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