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Liquidity will follow the path of least resistance but not necessarily to the most thirsty

By Chetun Patel, Head of Mariana Strategy, Mariana Capital

As Socrates once said ‘I know one thing; that I know nothing’. This should be posted on the door of every strategist at this time of year as they roll out their predictions and an outlook for 2015. Top of the ‘risk list’ last year were: fears of a spike in US yields (ten year yields are actually down 75bps and 2 January 2014 was the peak); a stronger US$ would put pressure on emerging markets (EEM US is 1% higher ytd); China would experience a ‘hard landing’ (the Shanghai Composite Index is up 35% ytd); and troubles in the Middle East would squeeze oil prices higher (Brent is 37.5% lower over 2014).

These comments are slightly disingenuous; the US$ has strengthened almost 11% over the year whilst the SPX has delivered double-digit returns (again); and the point to point moves highlighted above ignore the fact that these relationships were fluid over the year so that it is only now, for example, that you can see the extent of the issues facing emerging markets as the DXY accelerates higher (see Chart 1). The major theme of 2014 is the establishment of a ‘new normal’ environment which is defined by a low growth, low yield and a low inflation dynamic (see chart 2) and which has driven, and is driving, liquidity gluts.

Chart 1: EEM US Reacting to DXY Strength

CHART 3: EXPANDING CENTRAL BANK BALANCE SHEETS

ECB Too Little Too Late?

Looking ahead to 2015 we see more questions posed than answers. The issue of European deflation is crucial and we are heading to crunch time for policymakers. Q1 2015 should be considered the time when the ECB will be forced into conventional Quantitative Easing (QE) including the purchase of sovereign bonds.

The key here is to understand how, compared to other central banks, the ECB has come to this point. Draghi has been forced into clarifying that the ECB’s mandate compels them to act on deflation risk as inflation levels weaken (see chart 2). This is the justification for QE to be part of the ECB toolkit and thus squares the circle for the more dovish members of the board. It is assumed that the use of this ‘bazooka’ will result in a reduction on the Equity Risk Premium (the return demanded over the risk-free rate), the arrest of deflationary pressures though the debasing of the currency and an improvement in growth prospects through the monetary transmission process.

Chart 2: Eurozone CPI

Chart 2: Eurozone CPI

However, reality may not follow intention. There are particular impediments that will limit the effectiveness of the ECB’s version of QE. The pace of expansion of the ECB’s balance sheet is unlikely to match the pace achieved in the US (see chart 3) even though in absolute terms the balance sheet sizes are similar (the ECB’s balance sheet was more than $1tn larger than the Federal Reserve’s). The Fed, like the Bank of Japan, has stated that there is no limit to its balance sheet expansion unlike in the case of the ECB, whilst legal issues and splits within the ECB make for an uncertain and indecisive policy path. This is compounded by the fact that it is not clear how the composition and quality of bonds to be bought will be defined.

Chart 3: Expanding Central Bank Balance Sheets

CHART 3: EXPANDING CENTRAL BANK BALANCE SHEETS

How Effective is QE?

The next question is whether QE remains effective. Its main justification is the inflation mandate and the hope must be that it will help to avert deflation. Consider, however, that despite the efforts of the Federal Reserve US CPI remains below the 2% target (see chart 4). The flood of cash has stabilised expectations but has not produced the runaway inflation that many predicted when the Fed embarked on QE1, never mind after the third version. In the case of Europe, many of the factors that have caused inflation to fall could worsen. Oil (see below) has been marked significantly lower; the Telecom sector is being pushed into further reductions in regional tariffs; and the air transportation sector is likely to come under significant pricing pressure from new entrants. In fact the idea that QE could impact the real economy has been dimmed by recent global growth numbers, with the IMF recently revising down 2014 growth to 3.3% from 3.7% and stating that ‘the pace of global recovery has disappointed in recent years’ (Guardian October 7th 2014, ‘IMF says economic growth may never return to pre-crisis levels’). The point is reinforced when you hear Christine Lagarde, the IMF chief, state that recent oil falls should contribute 0.8% to global GDP growth, as the suggestion is that it is structural changes that are key to growth.

Chart 4: Fed Balance Sheet and US CPI

ADD TEXT THAT DISCRIBES THE PICTURE HERE

So if the ECB’s impact on the real economy is so limited, can the ECB change investor behaviour through the surprise of the unconventional and by stimulating investor confidence? I fear not as the ECB has come to this point kicking and screaming for the reasons alluded to earlier. Their moves have been painfully flagged offering little assurance that they have depth and durability. The marginal impact of their ‘bazooka’ is minimised because other central banks have already pushed the liquidity button and this has already spilled over into the European markets distorting the valuations of higher yielding instruments.

Bond yields are no longer the issue, as we see with the compression in Spanish yields below US levels at 1.86% (see chart 5) whilst corporate bond spreads (another avenue of ECB purchases) are back to pre-crisis levels. The key point is that there is a reason why the ECB is late to the QE party and this has consequences on its effectiveness. The impact on the real economy is likely to be minimal when one considers QE is a tool to avert solvency issues, not one to foster growth. Instead of QE being the main factor in Europe, investors should have their eyes on reform risk which is a key accelerator/decelerator of policy action.

Chart 5: Global Yields

ADD TEXT THAT DISCRIBES THE PICTURE HERE

Elections Key to Policy Reform in Europe

The SPX has been on a sensational bull-run since 2009 when the Federal Reserve opened its balance sheet. However, the main obstacle in the path of this near 45 degree rally besides the spectre of tapering was the political crisis that emerged as the US government approached its budget ceilings. Draghi understands the importance of a healthy monetary and fiscal mix. He has maintained that monetary policy cannot do everything in reference to the fiscal drag, a legacy of the Eurozone sovereign crisis of 2012. With this in mind, 2015 is likely to be characterised by the European electorate voicing its discontent at continued austerity measures through the ballot box. If the protest votes gain traction, there is real worry that structural reform will slow, limiting much of the beneficial work that low yields is enabling. The risks/rewards are evident as can be seen from observation of the reaction to the recent snap election calls in Japan and Greece. The former is driven from a position of strength, which will enable Prime Minister Abe to push through the third arrow of reforms whilst the latter raises the risk that Greece will turn its back on reform. This is major risk for Europe as we look ahead to the UK, Portugal, Spain and a potential snap election in Italy.

Oil: Structural Shift Lower

On 27th November OPEC made a clear decision that they would no longer influence the pricing of oil and instead let the market dictate prices. This was a structural shift driven by Saudi Arabia, forcing the curtailing of US shale production. The supply/demand dynamic is awful. US production grew by 1.2 million barrels per day against demand growth of 800k barrels, and this is likely to be replicated in 2015. Meanwhile the supply glut is likely to worsen as Libya and Iran come back online. These countries, along with Iraq, feel that they should not be the ones to cut production having suffered the impact of sanctions over the years. Another issue is that the US producers are relatively small and therefore find it difficult to negotiate with one voice. A broad market solution is the answer but this suggests that there is further downside to oil, which will only be arrested once shale producers have time to react and have felt enough pain. Our view is that a $40 price for Brent is not beyond the realms of possibility before we see some reversion on the back of a change in the behaviour of the shale producers.

The repercussions of such a structural change are wide. From a sector perspective consumer cyclicals such as autos, airlines and consumer discretionary clearly benefit. The losers will include the Oil and Services and the Basic Resources sectors. The latter is impacted as inefficient producers continue to produce with lower spot commodity prices, causing further supply issues for the likes of Iron Ore. In terms of regional dispersion, we have seen the major importers India, Turkey and Japan benefit at the expense of Mexico, Russia and the Gulf States.

The World in 2015; A Glut of Liquidity But Not Like We Know It

Since the 2008 financial crisis the world has been awash with a glut of liquidity driven by central banks that has shaped the ‘new normal’ economy: one defined by low inflation, low growth and low yields. This is not going to change in 2015, but the baton has been passed from the likes of China and the US to Japan and Europe. This will drive the price of commodities and goods lower, push the US$ higher and keep asset bubbles inflated.

Asset prices will continue to bubble but at differing rates depending on the transmission mechanism. Europe will struggle to avert deflation, as commodities and goods deflate and policy reform stalls. As an investor you should get long into ECB action and then see that rally fade on a skewed monetary/fiscal mix, a classic ‘buy the rumour, sell the fact’ strategy. In contrast, Japan will get the tailwind of structural reform after the snap election landslide and Nikkei will look to break 20,000 in the near-term.

In the United States, US$ strength will continue as part of a major secular shift with the Fed becoming the first major central bank to start raising rates. Consequentially the DXY index is likely to test, and move above, 100 next year.

As the Bank for International Settlements warned in their December 2014 quarterly report, emerging economies are likely to suffer with US$ offshore lending having doubled since 2008 to $9tn. Borrowing countries are likely to find the cost of servicing that debt unsustainable with the strengthening US$. This is going to be exacerbated by a fall in the supply of QE US$ but the impact thus far has been dampened by the flexibility in exchange rates which has taken much of the strain.

Under this scenario, the likes of Russia (it is inevitable that Russia will suffer a severe recession and with Putin unlikely to soften his stance, there is likely to be an extension of sanctions), Thailand, Brazil and South Africa are vulnerable because of the size of their foreign borrowing, whilst countries with fixed exchange rates (like Singapore) appear brittle if sentiment worsens. India, as a net oil importer, is the one country we favour in the region considering the structural changes that are being enacted and the projected fall in deficit numbers aided by falling oil prices.

Buy USA Plc

Of the Anglo-Saxon economies, the US should continue to attract inflows despite the headwinds of a stronger US$ and a shale producer price war. We have observed in the volatility markets how quickly the realised levels returned to their lows after the ‘flash crash’ on October 16th, suggesting that the US continues to be a buyer’s favoured destination. Meanwhile, it seems, based on the December payroll numbers, that the Yellen Optimal Policy Choice is finally being realised. She has been willing to keep rates lower than the Taylor Rule would imply, in the hope that employment numbers would eventually push wages higher, and we have witnessed various wage indicators point to building inflation. This will be important for the next leg of US self-sustaining growth once the Federal Reserve’s balance sheet starts falling.

Finally, the UK looks particularly vulnerable, facing the perfect storm of falling commodity and oil prices, a UK election that may not provide a clear victor and currency strength that adds to price deflation and lower growth dynamics.

In a world awash with liquidity, the overflow will find the path of least resistance and that is why the moves in Japanese, US and Indian assets are likely to be accentuated. This will have a major ripple effect on other regional assets. Hold onto your belts as this wave of liquidity may make for a bumpy ride as divergences become increasingly stark.

The views expressed in this article are those of the author and do not necessarily represent those of StructuredProductReview.com.