10 Apr 2013

Macro Strategy Update

Policy Implications

In recent weeks, policy and politics have been grabbing headlines and driving investors' actions. Fears of another round of crisis in the eurozone erupted after a clumsy attempt by the EU to contain the Cypriot banking crisis. However the overall negative sentiment was easily erased when the Bank of Japan borrowed a page from the Federal Reserve with its massive quantitative easing program. In this issue, we consider the short and long term impact of such events on financial markets, in light of the current economic cycle.

New European bailout approach is short term negative

The biggest takeaway from the Cyprus debacle is how the EU has changed its approach in tackling banking crises. Although the EU and the ECB have stated that the Cyprus approach (taking money from bank deposits) will not be a template, we do get conflicting statements by various EU and government officials that the resolution of failed banks in Cyprus can be applied in future cases. In essence, large depositors are unlikely to be protected by tax payers' monies in future.

In the long run, this is a positive move as it encourages efficient allocation of capital. Under EU law, deposits above 100,000 euros are not insured when a bank fails, so large depositors, who are usually deem to be sophisticated investors, need to exercise some form of credit review on banks. As a rule of thumb, a bank that pays a higher rate of interest typically takes on higher risk on its books. This was the case with Cypriot banks that failed1. Depositors need to be more prudent when it comes to choosing a bank, and banks need to better manage their risk exposure to attract deposits.

In the short term, we could see some pressure on European banks as funding becomes an issue. Depositors are likely to migrate to stronger banks, even non-European banks, leaving the weaker banks short of funding. This is likely to exacerbate the already weak lending environment in Europe. The underperformance of European financials (Figure 1), both on an absolute and relative basis, is indicating such a scenario. The recession in the eurozone looks likely to continue as credit remains scarce. This may trigger another funding crisis in the eurozone and as the German election approaches, additional monetary help may not be that forthcoming.

Image courtesy of Stockcharts.com

Figure 1: European financials underperforming the European equity market

This may be the reason why the ECB, in its latest policy meeting, did not lower interest rates as it is saving such actions for later. The ECB has been jawboning markets since last year and so far, has yet to be tested on its promise to do whatever it takes to keep the euro intact. Unfortunately, the damage (surging bond yields and collapsing stock markets) will have to come first before the ECB takes the necessary action to hold the eurozone together. Hence, the risk is clearly rising in Europe. Italian and Spanish bond yields will likely be the proverbial canary in the coal mine. So far, they are still stable but the underperformance of European equities (Figure 2) is likely to continue in the near future.

Image courtesy of Stockcharts.com

Figure 2: European equities underperforming US equities

Positive implications from the Bank of Japan

Investors have been used to being disappointed by policies from the land of the rising sun. However this time round, the changes announced by the Bank of Japan surprised markets. The magnitude of the asset purchases, estimated to be double the Federal Reserve's QE program when compared to the economy, has been described by market observers as a significant game changing move. From an investor's point of view, it does not matter if Japan can get out of its deflationary rut from such a bold monetary policy. What matters is the change in Japanese investors' behaviour as a result of the BOJ's "shock and awe" quantitative easing program.

Since the announcement of the QE program, we have seen a sharp decline in the yen against most currencies (Figure 3), and a surge in the Nikkei (Figure 4) and emerging market bonds (Figure 5). From a Japanese saver perspective, in an environment where the yen and yen interest rates are set to decline, it makes sense to channel savings into higher yielding assets. Today, Japanese investors are spoilt for choice when it comes to investing in higher yield assets since their rates are among the lowest in the world, with their two-year bond yielding just 0.1%.

Figure 3: Yen depreciating against US dollar

Image courtesy of Stockcharts.com

Figure 4: Nikkei225 surging

Image courtesy of Stockcharts.com

Figure 5: Emerging market bonds pop on BOJ announcement

There are positive implications from the BOJ's action. According to the central bank, more than half of Japanese household assets are in cash and deposits, amounting to around US$7.6 trillion. A portion of this amount is likely to flow out of Japan (further depressing the yen) into foreign assets that pay a decent yield. This is likely to provide a support for high yielding assets in the months ahead.

Like the Federal Reserve, the BOJ has clearly stated the constraints of its QE program. Unless inflation hits 2%, asset purchase will continue. As such, the assumption investors should have is that the yen would depreciate, but nonetheless be mindful of factors that will cause a change of heart by the BOJ or the politicians. Monitoring inflation, especially energy cost, in Japan would be important to assess when the yen would stop depreciating.

Along with these changes in European and Japanese policy, we continue to receive positive data from the global economy. The US economy continues to surprise those calling for a recession, with new orders, production and retail sales rising. Even the latest employment report, which many pundits have claimed to be worrisome, contains nuggets of good news. Yes, 88,000 jobs is far below the usual 100,000+ jobs generated. However, January and February numbers were revised up by 61,000 jobs. Both weekly hours worked (Figure 6) and overtime hours in manufacturing is at a cycle high (Figure 7). Temp help services, often seen as a leading indicator of employment trends, is also at a cycle high (Figure 8). There is thus no reason to worry about the March jobs report.

Figure 6: Workers are putting in longer hours

Figure 7: Workers are putting in more overtime hours

Figure 8: Temporary staff hiring - a leading indicator - continues to rise

East Asian economies have rebounded from the Lunar New Year break, with China (51.6) and Taiwan (51.2) reporting better PMI numbers for March, up from the previous month. Other large emerging economies like Brazil, Russia, India, Indonesia and Turkey are also in an expansionary phase, according to their manufacturing PMI surveys. Overall, there are more positive economic data than negative ones, confirming the uptrend in global economic growth.


Markets are currently in a correction phase. There are no signs to suggest that the preference for growth assets has changed. Even after taking Europe into consideration, global markets are likely to be flooded with liquidity as money leaves Japan in search of yield. The odds of higher highs in global stock markets continue to remain good.

Portfolio Positions

No changes to our asset allocations or funds at this time.

1. Bank of Cyprus Boosted Greek Bond Holdings in 2010, Report Shows. 6 April 2013, Bloomberg News

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