Winter is not (yet) coming…
Afew weeks ago, we had written that Draghi was trying to make the transition of the Fed less painful through forward guidance, which he intended to use as a control variable. This is normal because forward guidance has been pretty common in the last few years. However, the “control” has probably overshot, and the euro nearly reached 1.20 against the dollar. Given this, it is unlikely that the European Central Bank (ECB) will launch a frontal attack and raise its policy rate any time soon. Indeed, there is talk of a delay until March 2018 at least, and this would also imply a postponement of the balance sheet move. Otherwise, the euro could gain further strength, and this much is probably unwarranted not only for Europe, but also for America. The US has already benefited from the strength of the euro via an oblique route, the valuation effects on its international investment position. Further down the road awaits volatility and asset market exuberance, which would both be cause for concern for the Fed.
ECB expected to hold t ght
The reasons can be encapsulated in a short remark. Take the emerging markets (EM) universe, for instance EM-25. Loose monetary policy in the advanced world leads to a rising demand for EM exports, causes “tsunamis of liquidity” (Delma Rousseff ), and EM cur- rencies tend to appreciate. Since international financial architecture is not conducive to a full coordination mechanism, there are episodes during which the alternative of capital controls is being voiced loudly, or there is talk of “currency wars.” True, there has been no come back to fully fledged protectionism but there is a problem here as witnessed by no lesser name than Olivier Blanchard. Furthermore, devices directed to alleviating the pains from spillover effects are not complete even in advanced economies. Both the Fed and the ECB causes such effects both among the top-tier economic regions and in the EM universe. Hence, the only way out at a time of policy reversal seems to be implicit coordination, leading to often bilateral synchronized timing efforts for both for- ward guidance and actual monetary policy changes on behalf of the leading central banks. The central banks do that consciously of course, but also is it true that leading market participants give them feedback and re-route them sometimes. Hence, 1.20 EUR/USD looks the peak, although technically 1.22 is not unimaginable. 1.24, on the other hand, would imply a complete reversal of the path that led to the same level in February 2010 after the weekly Fed H1.4 report that had shown signs of a drastic balance sheet contraction. At that time, the dollar had appreciated all the way down from 1.49 EUR/USD to 1.24 in a couple of months. An asymmetric mirror image of that path, causing this time around an unwarranted depreciation of the dollar, wouldn’t help any party in our opinion. Hence, we ex- pect the ECB to stay put, both in deeds and in words.
FX nflows los ng steam
There is another reason for this to happen. Starting from 2016, capital inflows to emerging markets soared. However, the recent data is not that optimistic, which is why we referred to the (weak but real enough) possibility of an anti-climax in our last issue. Last month, interest in emerging market debt and equities weakened, and capital inflows fell to $18.5 billion, the lowest figure since January 2017. The January print was $13.2 billion, at a time when direction was unclear. EM equities were in the red, while debt attracted the money, i.e. $16.5 billion. China displayed the hardest hit with $23 billion outflows, which caused a stir in the form of comments underlining yet again the fragility of the Chinese domestic credit boom. China’s still impressive growth story was put under close scrutiny with claims that it all depended on the continuation of GDP growth. IIF reports that total equity and debt capital inflows to the EM universe reached a solid $200 billion, year-to-date. That is lower than previous years’ average, but almost twice as high compared with 2016 and 2015. The “common factor” that led to the stock market boom in Turkey, and also to financial stability and a high growth rate thus far, is about to die off or so it seems. There are signs that the flow is out of steam because most of the inflows poured in during the first four months of 2017. At the very least, we should anticipate a pause since “winter may indeed be coming.” However, although surely it will come one day, it may not be that near. It may not be that close since there are other metrics that showcase resilience in terms of inflows. Brazil attracts attention with $5.9 billion inflows in equities, and In-
dia-led Asia – excluding China – is also still strong with foreign investments worth $6.1 billion in debt and equities. We conclude that there are bad omens, but after a stupendous rise in inflows an equally meteoric exit is not on the cards anytime soon. If that happens, it is more likely to be the combined result of the implicit coordination of the Fed and the ECB than anything else. So much for spillovers.
Eng ne runn ng purely on domest c demand
If China is bound to grow at a high pace, not less than 6% per annum, in the coming years because the credit boom is otherwise unsustainable, then what about Turkey? Is the story somehow similar? Does it make sense to issue warnings piling up one on top of another to the effect that both public spending and fiscal deficit run up fast and there is a credit boom unjustified by earnings? Confidence indices look good with the exception of consumer confidence. That is extremely important given that, in the absence of any sustainable contribution from net exports, the engine keeps running on account of domestic demand alone, and most of it is household expenditure. We are not in the boom phase of an investment drive that could produce enough input-output links through a cycle of “production of commodities by means of commodities.” No, it is consumer demand mainly. Here, I offer two bad statistics, but my comments will be more benign than anticipated. (After the statistics, that is.) We may note than in an economy like Turkey, which shows unusual resilience and buoyancy time and again, an overdue reliance on some ( bad) statistics is generally not conducive to healthy conclusions.
Publ c sector debt rollover rat o reaches peak
Firstly, the public sector’s debt rollover ratio has indeed recorded a peak. This is the highest ratio since 1998. Now, 179% is eye-catching, which is why I have claimed the tight monetary policy/loose fiscal policy mix should be reversed. However, we should not be hasty in jumping to an unpleasant conclusion because much of what happened is now bygone. Hence, we may see a lower ratio by the end of the year, and indeed we probably will. The slack that existed in public finances has been amply used in Q1 2017, and this is the result. Unless early elections are held in 2018, next year we may see a marked improvement in that ratio. With a rather low public debt-toGDP stock, any government would have resorted to that, possibly. The second bad omen comes, however, from house prices. Again, as posted last week, “the housing market is segmented, and there are areas and intervals of value that still show stamina as opposed to luxurious zones in Istanbul that depict a stagnating pattern.” Again, “Another awkward thing is the rate of increase of mortgaged house sales throughout Turkey. The July figure stands at 38.575, showcasing a 62.4% increase over July 2016. This is in flagrant contradiction with the received wisdom to the effect that mortgages are very sensitive to mortgage rates because the duration is long. Even with high rates, mortgages seem to have gone up visibly.” Nevertheless, there obviously is a cycle here running its course. We are confident that insisting on over-investing in real estate will be conducive to a dead end. The “mortgage cycle” so to speak had begun in 2004 when housing loans skyrocketed for the first time, reaching an incredible pace. That was because the cycle had started from scratch. Pricing exuberance of some sort has driven the cycle for so many years that nobody can remember now. Surely there is continuous demand for housing given that the population is still young, and internal migration goes on, albeit at a lower speed. Even so, the segments that showed overpricing and that were driven by investment demand should lower their speed a bit unless they want to lose steam altogether.
Quest ons p l ng up l ke Rube Goldberg contrapt ons
September is notoriously bad for US equities. This is what historical data tell us. It is not a theorem. Nevertheless, if this happens, it will more likely be spread to EM equities than not. Then, we shall read lots of reports inquiring into the possibilities of further growth, structural weaknesses and so on. Frequently asked questions will pile up, some uttered by foreign observers, and many amounting to nothing but Rube Goldberg contraptions piled one on top of another. (A Rube Goldberg contraption is a machine or device that works in an indirect and convoluted way either to do absolutely nothing useful or perform the most simple task in an overly elaborate way. It is named after the American Pulitzer-winning cartoonist – and engineer, sculptor, inventor, author – Reuben Lucius Goldberg, 18831970.) Nonetheless, a few questions have real bite. How can an economy grow in sustainable fashion if unit labor costs rise? Especially if the currency remains overvalued we must add, which is not the case. This is a positive. How can it grow if – with respect to whatever metric one may use – unemployment remains high, and trade deficit tracks an upward trend? Would disinflation not come to a halt should domestic demand truly pick up? If prices, and inflation, are never to become sticky, then have generations of New Keynesians, Massachusetts-style, been busy researching only to produce papers destined for the dustbin? Should we truly bet on ever-decreasing interest rates? Who will pay for further growth? Could we rely on exports for further growth? Some of them are indeed good questions.
Answers to the real quest ons
Answers: (1) Interest rates will not fall. In fact, they are more likely to rise than fall. (2) The trade deficit will rise a bit, but qualitatively it amounts to nothing. (3) Public finances will reverse course unless early elections are held. (4) Unemployment is always high. One structural reason is the low female participation rate. (5) The only claim on the inflation front is it can be confined to the 8-10% band, with trend inflation already bolted from 6.5% to 8%, another reason why interest rates cannot easily fall. (6) Credit pays for the moment. The credit boom couldn’t go ad infinitum, and it didn’t. Still, 18-20% loan growth is within each. That should suffice for yet another two quarters. (7) We can’t rely on exports. However, we can rely on a stable currency because the EM cycle has not entirely lost its steam – at least not yet. Also, because we still bet on the possibility of a limited spillover effect on the EM after the Fed/ECB concerted action bears fruit. Note that the EM can go down a storm after this, but the damage can to a certain extent be contained.