All in all it was a pretty quiet week for the global equity markets. The S&P 500 added +0.4% for the week while the overseas markets gained fractionally more. Two standouts for the week were 1) China and Hong Kong (+3% and +2.2%) on news that Chinese domestic A-shares will become easier to buy, and 2) Japan (+3.6%) on the news that the VAT hike may be delayed.
Commodities were much more interesting to watch during the week as oil continued to plunge (down -3.7% for the week) while gold tried to find a bottom after a period of just miserable performance.
Japan Pulls Out All the Stops
The correction in late September and early October was spurred in part by the worry that global central banks might either take the punch bowl away too soon (U.S. Fed) or fail to spike the punch just a little bit more (Japan and Europe). Well, since our last letter the Bank of Japan (BoJ) simply started serving straight shots.
On October 31st the BoJ took the opportunity to remind investors (to quote BCA) “what the essence of Abenomics is about: using whatever means necessary to get the country out of its deflationary trap.” Simply put, the BoJ is going to do a lot more of what its already been doing. They will now increase their QE program so that their balance sheet expands at an annual rate of 80 trillion Yen (roughly $688 billion), implying that an additional 10-20 trillion Yen will be injected into the financial system in the next two months. It looks likely that this larger program will also persist into 2015.
A trillion yen here and a trillion yen there – but these trillions are really starting to add up. The chart below shows the size of the balance sheet for the Fed, Bank of England, European Central Bank (ECB), and BoJ as a percent of GDP. The BoJ’s balance sheet is set to hit a staggering 80% of GDP by the end of next year, four times that of its nearest rival.
Furthermore, on the same day as the BoJ’s announcement, Japan’s Government Pension Investment Fund (GPIF) adjusted their asset allocation targets. They will now allocate a larger portion of their assets to global equities and less to Japanese bonds. The allocation to international equities will jump significantly – from 27% to 40%. While this move was widely expected, the size of the equity increase was larger than anyone expected.
This week the dovish news continued. Many of us worried that fiscal policy would play the Grinch in Japan with another VAT hike in December. This worry may have been unfounded. The Japanese media have widely reported in the past few days that the Lower House is likely to be dissolved for a general election before the end of this year. Many analysts view this as a tactic to delay the VAT hike for another 9-12 months.
“The most important lesson, perhaps, is that Abe and his soldiers remain committed to defeating deflation and getting the economy on track. Investor should extend this most recent lesson to their thinking on fiscal policy and structural reform. Abenomics is not a policy concocted by PhDs in economics and technocrats, it is a populist response to a populist demand for nominal GDP growth.”
What are the implications for the rest of the world?
– Competitive devaluation is all the rage. Japan is shooting for a lower yen to help break the back of deflation and spur growth.
– A weaker Yen will put huge pressure on the rest of Asia to devalue. Those countries that resist will suffer slower growth as a result.
– While China may not devalue, this puts pressure on them to ease internal constraints on the economy.
– Japan will also steal growth from Europe, especially Germany.
– The ECB is now under huge pressure to increase their monetary support. The odds of more QE in Europe have gone up significantly.
The easy global liquidity environment isn’t going away. To the extent the dollar rally persists, this should put downward pressure on domestic inflation and ease the pressure on the Fed to hike in 2015. Is it possible the Fed does nothing next year?
The Winners from Oil’s Decline…
Up until a few weeks ago we’d have said the biggest surprise about 2014 was the fall in bond yields. However, we’d have to change our assessment after watching oil prices. The slide in crude has to be the biggest shock for the global economy in the past couple years by a long shot. As you can see below, oil prices have dipped (plunged) -20% to -25% this year and are off roughly -30% from their highs.
Credit Suisse had an interesting note on Wednesday:
“For American drivers, this means celebration at the pump. On November 10, the average price of regular unleaded gasoline had fallen for 46 consecutive days, and on November 1 it dropped below $3 per gallon for the first time since 2010, according to the American Automobile Association. If oil prices follow the bank’s forecasts, nominal consumer spending on energy will fall from 3.2 percent in June of this year to 2.5 percent by March 2015, giving consumers an effective tax cut of about $80 billion, according to a report by Credit Suisse analysts James Sweeney and Jay Feldman. That would be the lightest aggregate gasoline bill for U.S. households in more than a decade. It would be especially positive for lower-income Americans: spending on gasoline accounts for 13 percent of pre-tax income in the lowest quintile of U.S. households, compared with 2.5 percent in the highest quintile.”
Global growth should also get a boost. The chart below from the FT shows that a $25 drop in oil boosts global GDP anywhere from +0.5% immediately after the fall to +1.4%. The red line is the impact from higher consumer and corporate spending. The blue line takes into account the consumer and corporate confidence boost from lower energy prices.
Inflation also should fall. As you can see in the right panel above, inflation dips anywhere from -0.5% to -0.9% in the year after an oil price fall (it picks up later because growth accelerates). With inflation as low as it is already, some countries should see flat to lower prices in the year ahead.
So this sets the stage for modestly better growth in 2015 and somewhat lower inflation – both good things. And if Japan’s move takes some of the pressure off the Fed, the fall in oil prices compounds this.
…and the Losers
The obvious losers are the oil producers, particularly those who have built their budgets around $100+ oil prices. The chart from BCA below highlights the most exposed countries. The x-axis shows the price of oil needed to balance the budget for various large producers. For example, Venezuela would need an oil price of roughly $150 to balance their budget. Needless to say they are bleeding money and the bond markets are assigning a pretty high probability Venezuela defaults in the coming months.
Russia is another example. They need prices close to $120/barrel to balance their budget, and fear about the Russian economy has pushed the ruble down by -23% in the past three months. Note that the chart below shows how many rubles it takes to buy a dollar – a rising line means the ruble is going down in value.
As The Economist notes, this is stoking all sorts of interesting fears:
“Such a plunge inevitably brings inflation in the form of more expensive imports, a worry given that consumer prices in Russia are already rising at over 8% a year. Yet in recent weeks there have been creeping signs of something scarier. Faced with a clamour for dollars, Russia’s banks have raised the rates they pay on dollar deposits to try to suck some in. Demand for safety-deposit boxes is up, suggesting customers are hoarding foreign currency.”
As a result the Russian central bank is caught in a vice. They have to raise interest rates to stop the flood of money out of the country (they hiked rates to 9.5% on November 5th), but higher rates come at the same time the economy is tanking because their major export good (68% of export revenues comes from oil and gas) is going down in value. Talk about a vicious circle.
And finally, just to make things interesting, Russia has about $120 billion in external debt denominated in foreign currency maturing in the next year. Sanctions prevent many companies from borrowing abroad to refinance this debt, and companies outside the energy sector do not have dollar revenues to pay the debt back. The squeeze is really on!!
Russia has to be hoping that OPEC makes some pretty dramatic production cuts at their November 27th meeting.