Europe's outlook

Our Euro area forecast implies that GDP growth will improve slowly in the coming quarters but nevertheless remain sluggish. On the positive side, we expect some of the factors that held the economy back this year to prove temporary, and we think that some of the deeper headwinds that the Euro area faces will ease at the margin. Set against this, however, those headwinds remain brisk and we expect this to restrain the recovery. Outside of the Euro area, we expect growth to be stronger, but to be curtailed by the weakness of Europe's largest economy.

At a time when Euro area growth has been weak, inflation has fallen to close to zero. While we expect inflation to remain undesirably weak for some time, we nevertheless think the risk of a sustained period of outright deflation across the Euro area is limited, for two reasons.
First, reflecting the structural rigidities in Euro area labor markets and despite high levels of unemployment, domestic cost pressures in the Euro area remain consistent with low but positive inflation.
Second, the cross-country evidence suggests that deflation is rare and difficult to generate among countries that set monetary policy independently.

Given weak growth and weak inflation, we expect the ECB to maintain Euro area overnight rates at close to their current levels until 3Q2017. We also expect the ECB to announce further easing measures in the coming months, extending and deepening the T-LTRO, covered bond and ABS purchase programmes that it has already announced. However, reflecting the high (political) fixed cost of adopting sovereign QE, we continue to ascribe a probability of around 1/3 to the ECB engaging in a large-scale sovereign purchase programme.

A key risk to our forecast - one that would almost certainly prompt the ECB to engage in large-scale sovereign purchases - is the possibility that falling inflation expectations become entrenched in wage- and price-setting behavior, provoking a self-fulfilling dynamic of area-wide price deflation.

Secular Stagnation in US?

We expect the US economy to grow above trend through 2017, as the healing of the private sector continues and fiscal drag abates. Given considerable labor market salck and low inflation, we forecast the first funds rate hike for September 2015. While the pace of hikes is likely to be gradual at first, we expect the funds rate to reach 3.75-4% in 2018.

This outlook is more optimistic than the "secular stagnation" view put forward by Havard economist Lawrence Summers one year ago. He suggested that the economy may be in a situation where the "neutral" real interest rate is deeply negative and may remain low for a long time to come, preventing a return to full employment.

We agree that the nuetral real interest rate has likely been negative in recent years. But we see a number of reasons to view this as more cyclical than secular.

First, the pickup in growth over the last year suggests that the earlier weakness was primarily due to long-lasting but ultimately temporary headwinds, such as household deleveraging and fiscal drag. Of course, the growth acceleration has come with zero rates and it is still early, so the pickup is only weak evidence against secular stagnation.

Second, our estimates of the nuetral rate are negative at present but projected to normalize as the economy returns to full employment.

Third, the secular stagnation view contrasts with the historical record. In a sample of 19 countries stretching back mostly to the 1800s, we find that the average 2% US real rate of the postwar period looks reasonably representative of the longer-term historical record.

It is still early days and we only view these considerations as preliminary evidence against secular stagnation. Moreover, many of the policy implications may still be valid if the weakness is more cyclical than secular, including the need for continued accommodative policy. Finally, other parts of the world - for example, Europe - may be better candidates for secualr stagnation. But for the United States, we are more optimistic.

Q&A with Japanese Investors

【Economy】

1.         Please provide us with the outlooks for economy and inflation in Korea. Especially, please touch on the possibility of deflation in Korea.

 

Prior to comment about growth, the consumer prices continue to down beat market expectations. It’s somewhat odd because CPI decreased during two consecutive months although economists expect to increase. In fact, in autumn, after thanks giving holiday in Korea, CPI tends to decline as reverse last seasonal rising up. Nonetheless, in this circumstance, Bank of Korea maybe will fail to expect inflation during only 3 months. BOK issued new economy forecast for this year and next year on the last month’s Monetary Policy Meeting. They forecasted this year’s CPI would be about 1.4%. This number is average of monthly CPI number year on year and their expected 1.4% implied average 0.1% increase m/m during next 3 months in this year. But, CPI in October decreased 0.3% from a month earlier and it was too deviated from BOK’s forecast. Although BOK expect CPI to be over 2% next year excluding already planned increase of cigarette price, current CPI y/y maintains under only mid-1% level. It was 1.2% last month.

 

So, the woes about deflation in Korea has been widen recently. But, many governors and economists see little possibility about this because this low inflation has been influenced by not demand side, but supply side. Actually, decreasing oil price and agriculture price has driven consumer price decline from last year to this year.

Not only in Korea but also in Euro area, someone argues that their inflation would follow Japanese lost decades finally. However, others do not think so, because after 90s Japanese deflation was affected by huge asset prices shortfall not by supply side such as commodity prices.

On the other hand, Korea faces the problem of aging population like Japanese experience. So, the possibility of deflation remains in longer-term. But, we think, unless external or internal economic shock to be followed by significant asset prices collapse, deflation would be longer-term theme. Maybe individual and corporate economic behaviors should adjust this long-term trend slowly without forced to be adjusted by any crisis, we think.

So, current low inflation means the possibility of mid-term disinflation more likely rather than deflation, in our view.

 

And then, about the economic growth in Korea, we see moderate growth on the step of recent growth pace. Exports would be relatively solid and domestic consumption would pick up slowly, we expect. But, headwinds from export side by Chinese economic slowdown and higher inventory burden remain. Recently the woes about KRW appreciation against JPY arise. I will comment parts about China and JPY later. We forecast next year’s Korean economic growth would be approximately 3.6% lower than BOK’s 3.9% in line with those headwinds.

 

 

2.         Recently, I’ve seen concern about decelerating economy in China. And I think that the economic slowdown in China can affect Korean economy. Will you provide us with the outlooks for economy in China?

 

Many experts are very skeptical that Chinese economy continues high growth over next decades and we agree. Back-ground of this is the concern about property market, over capacity and shadow banking in short-term and about aging population in longer-term. Now, we focus on the possibility of the soft landing of Chinese economy. On the property market, the imbalance between supply and demand seems not too negative to lead hard landing. And about excess capacity problem, relative to other developed countries, the burden is smaller than them, some economists argued. Including shadow banking problem, almost these woes could be managed by China government, we think. China faces aging problem, this is structural problem and government continues to try reform economic structure for this in longer-term.

 

Although Chinese growth seems to be soft landing, the headwind against Korean exports companies remains. About 25% of total Korean export is toward China. And in micro view, Chinese corporate competitiveness of manufacturing has been grown and seems to be threat for Korean companies in near-term. We think the reason that KOSPI, Korean equity market, has been underperformed recently is somewhat this structural problem in each industry.

 

So, we are afraid of the future ahead of both Chinese economic slowdown and threat against Korean manufacturing companies in mid-term.

 

 

【Market】

3.         Please provide us the outlooks for economic management by the Park Geun-hye  Administration.

 

We summarize this government’s economic policy to three points. One is macro policies including expanding fiscal expenditure and easing monetary policy. Second one is boosting up the property market. And last one is structural inform like all of countries nowadays.

 

First of all, Bank of Korea already cut the policy rate twice by 50 basis points totally and governors seem to be satisfied with this. So, the government has to practice fiscal expansion next year. But, we are somewhat skeptical about their willingness about it. They provide only small expansion fiscal budget under the reputation risk from fiscal balance.

Second, the property market improvement is real hope for governors, we think. Many concerns such as domestic consumption slowdown and household debt problem would be cured by higher home prices. However, due to aging population, home prices rally unlikely continues for long-time.

Eventually, Korean economy likewise other developed countries needs structural reform. Many economists focus on savings glut. In Korea, companies’ savings are over than before. The distribution problem from companies to individuals is in line with this. The governor announced the possibility of tax on cash in companies, but this looks like very difficult to do.

 

(In short, we are somewhat doubtful about overall policies.)

 

4.         What do you think of the possibility of further rate cut by central bank?  If it’s possible, when do you think the Central bank will take one more action?

 

It depends on the willingness of government, we think.

Indeed, the chairman of BOK signaled that this policy rate, 2.0%, the historical low, is sufficient for boosting economy on the monetary policy meetings last and this month. He revealed the woes about the stability of finance including household debt problem. Extremely low interest rate could deteriorate this problem. So, many market players interpreted him hawkish.

However, since Bank of Japan decided to expand QE and JPY depreciated rapidly, the woes about negative influence for Korean export companies increase. In line with the woes, expectation for additional policy rate cut in near-term arises.

However, ahead of the possibility of policy rate hike in US, and under expectation about moderate recovery next year, it’s not likely easy to decide easier monetary policy which would be lower than Lehman crisis’.

So, we think BOK should cut the policy rate if external or domestic downward pressure in economy increase. But, under the stressed environment, the policy movement would be very fast. So, we recognize the possibility of additional policy rate cut until 1H next year at least.

 

5.         What do you think of the possibility of exchange intervention by the Korean Government?

 

We think FX traders already recognize the possibility of government intervention as their normal behavior as a way to mitigate market volatility.

Recently, FX market sees 950 won, exchange rate against JPY, as the implicit or explicit target rate of the government. So, some players say that government’s intervention appears under 950 won in the FX market.

But, as you know, US government and IMF seem uncomfortable at FX intervention by Korean government because of excessive current account surplus. So we think the intervention would not be aggressive than before.

If government hopes rapid KRW depreciation, they forced BOK to cut the policy rate. But, it’s not likely yet, we think. It maybe depends on how much JPY depreciate against USD in short-term.

 

 

6.         Could you tell us your mid-term (6 month) view of Korean bond market?

 

We’ve seen the bull market during last 10 months since start of this year. Bond yield already is lower than last lowest level in 1Q last year in almost tenors from 1 year rate to 20 year rate.

Short-end rate, much lower than last year’s low level, is reasonable because influenced by policy rate mainly, we think. However, on the long-end rate, it looks like follow economic growth and inflation rather than policy rate. Actually, both the level and direction of 10 yr Korean Treasury bond rate follow summation of growth and CPI year on year path.

And now, 10yr rate is similar with 1Q last year. But, while GDP growth recorded 2.1% from a year earlier at that time, last quarter’s GDP growth was 3.2% higher by 1.1%p that that. On the inflation side, it was 1.5% in 1Q last year and 1.1% last quarter this year. The difference is 0.4%p.

From this calculation, we could estimate fair value of 10yr rate for now and that is about 3.0% higher than now by 30 basis points.

So, we see long-end rate would underperform in short-term because it looks like overshooting now. While long-end rate could increase from now, the short-end rate would be prevented from upward pressures because the expectation of policy rate cut remains, we guess. In short, we see slightly bearish steepening in short-term.

In mid-term, it’s somewhat difficult to forecast. Until mid-next year, the possibility of policy rate hike in US would increase but its effect on other countries is difficult to guess because the cycle of monetary policy is different each other.

Recently, many analysts argue that they hardly find evidence to lead higher interest rate under the savings glut, capex constraints and aging people. Indeed, we don’t find any evidence about this, too. Because of recent decline in oil prices, inflation does not seem to be forced toward higher. And many economists refer that Korean economy and interest rate would follow Japanese lost decades or Taiwan rate plunge. So, if you ask about mid-term or long-term interest rate forecast, it’s so convenient to answer that the rate would decline more and more for us.

So-called Secular Stagnation is already main theme and widespread. Actually, JP Morgan argued this theory recently, too. We agree this, either, but we continue to try to find any evidence denying this. Someone said when the new paradigm was recognized everywhere, it would be the end of bubble. So, while we expect bond bull market would continue in mid-term and long-term, we try to find opposite scenario at the same time.

 

 

EM including China

The pickup in global growth momentum now underway is being tempered by a deceleration in China. China's October activity indicators out this week were mixed but generally consistent with our expectations for a moderate 7.4% annualized gain in real GDP this quarter. Exports were stronger than expected as was fixed asset investment, while retail sales growth held steady. However, industrial production increased just 0.5% mom, the same as the average for the previous two months, hinting at some drag from the inventory cycle. With excess manufacturing capacity, lower oil and other commoditiy prices, and only a moderate GDP expansion anticipated, we forecast inflation to ease to 1.5% yoy, or below, in coming quarters. Although this backdrop creates flexibility for easier monetary policy if it is needed, we expect two RRR cuts of 50bps each in 2015 intended mostly to maintain stable growth in the money supply amid a declining pace of FX reserbe accumulation. Still, the probability of a cut in policy rates is rising. Over the last six months, the PBOC has used liquidity operations to try to bring down bank lending rates, but the efficacy of this approach is limited, and if lending rates do not decline appreciably in 1Q15, the chances of a rate cut would rise substantially.

Inflation also is sliding across the remainder of EM Asia, fueling expectations for rate cuts more broadly. In India, inflation fell below 6% yoy in October, the lowest since the new CPI index was introduced three years ago. Nonetheless, we expect the RBI to remain on hold. The reputational risk of missing the 6% inflation target by January 2016 would be damaging, and the RBI will need more data to be convinced that food disinflation is structural and that core is not reaccelerating.
The chances of a rate cut in Korea have increased as well. Last week the BOK kept its policy rate on hold after easing 25bp in October. However, the central bank's statement was dovish, based on concerns over near-term growth and a potential loss of competitiveness from the weaker yen. Nonetheless, we are maintaining our forecase for a stable 2% policy rate. Growth is expected to pick up and the rise in the trade-weighted KRW has been much more muted that the move against the JPY. Moreover, the BOK is more likely to respond to additional yen weakness with FX intervention than a rate cut.

Europe...Japanisation?

A slowdown in Euro area growth momentum from an already anemic pace, combined with ongoing concerns about deflation risks, has pushed the question of whether the Euro area will follow in the footsteps of Japan's so-called "lost decades" to here. The question is a complicated one. For starters, what do we really mean by Japan's "lost decades?" In general, the phrase seems to refer to a prolonged period beginning in the early 1990s when Japan's economy was characterized by two features that are distinct but often muddled together : stagnation - which denotes low growth - and deflation - which denotes declining prices.

In one's interview, there have been two phases of the stagnation that characterized the "lost decades" with very different underlying problems : initially, deleveraging post the bursting asset bubble in the early 1990s, followed by a rapid decline in the working-age population over the recent decades.

The notion of "Japanese-style" deflation also often seems misunderstood. He clarifies that while Japan has experienced the more malign so-called "deflationary spiral" in which price declines lead to further prices declines and, ultimately, a vicious, demand destroying spiral. He believes that drivers of this deflation were related to - but not the same as - the drivers of stagnation, with wage flexibility playing a prominent role.

With all of that in mind, he emphasizes that Japan's underlying problems in recent decades are very different from the fundamental challenge facing the Euro area today - the lack of economic integration. So in some sense, the Japanese experience has little insight to offer to the Euro area. But the key lesson Europe can take from Japan is that focusing on fixing the underlying problems is the only path to recovery. In his view, framing Japanese and Euro area problems in terms of the monetary phenomenon of deflation rather than fundamental drivers gives the misguided impression that the problems can be solved by monetary policy. He does not hold out much hope that monetary policy can improve the outlook for the Euro area economy.

Another one is more optimistic about the ability of policy activism to lead to a stronger Euro area economic and asset market recovery than what Japan experienced. But she emphasizes that demand-boosting monetary and fiscal policies alone will not be a panacea for the Euro area.

And someone sees a near-to-medium term path for the Euro area that is not dissimilar to Japan's past experience - very low but still positive growth and potentially some bouts of benign, and more malign deflation, even though the causes of these developments are, in large part, different from those in Japan. He also maintains that - similar to the Japanese experience - the likelihood of a malign deflationary spiral akin to the Great Depression remains remote.

One professor is far more concerned about the outlook for the Euro area. He is perhaps the most optimistic that the combination of the right fiscal and monetary policies, namely, a rolling-back of austerity and full-blown sovereign QE, could jump-start Euro area growth. But he sees little scope for these policy shifts given the large political obstacles to both. In his view, the Euro area remains materially velnerable to a return of a liquidity crisis, a solvency crisis, and even political upheaval should the region continue on its current path.

Even barring this worst-case outcome, another one underscores that Euro stagnation could be more costly to the global economy than was Japan's earlier experience given the Euro area's larger economic weight and stronger financial linkages with the rest of the world.

Finally, one analyst zeroes in on equity market parallels between Japan and Europe. She concludes that despite worrying similarities between recent, lackluster profitability of European companies and Japanese corporates in the 1990s, more reasonable starting valuations suggest that European equity performance is unlikely to repeat Japanese equities' dismal experience in decades past.

Global View Weekly

Stock markets continued to perform well, gaining another half a percent last week, with the US again scoring a new historic high. In local terms, YTD stock returns are approaching the 10% return mark that we consider a great return. Bonds and credit are mixed last week and commodities were down again heavily on a collapsing oil price. For a change, EM was no longer underperforming and in places was beating DM.

In the current cycle, we expected weak growth, but for four years running, got even less than that.
Initially, we thought we were just facing a post crisis demand side problem with a large number of economic agents in a continued and under-appreciated need to repair damaged balance sheets. But now, almost six years after the crisis, and still no pickup in growth, it is becoming clearer we are also having a supply-side problem, with much slower growth in both labor supply and productivity. What are the implications of a weak supply side for markets?

Besides giving it a name - secular stagnation - the economists profession has not yet agreed on its cause or on how long it will last, except that it is a reality and that such realities usually do not go away fast. Partial explanation range from the crisis having left capital in all the wrong places and that greater constraints are preventing banks from aggressively helping to reallocate capital, to the possiblity that technology and the web have completed their role in making us more productive and that EM ecomonies are not as effective anymore in importing DM economic know how. It will take a long time before we know all answers. In the meantime, investors have to deal with the reality of much weaker supply side.

The most important impact of a weak supply side, in our mind, is a lower reutrn on capital. For financial assets, this means a lower than normal required IRR; for bonds, a lower real interest rate. In micro, we teach that the equilibrium interest rate is set by the interplay of time preference and the marginal return on investment. In macro, this becomes the intersection of the investment and savings curve. The post-crisis rise in savings and now also a lower return on capital thus produce a much lower interest rate.

14.11.12 US Economy about Disinflaton

Early this year, we expected a gradual pickup in core inflation as slack continued to decline. But today, a return to the target looks more elusive. The upward pressure from reduced slack now has to contend with downward pressure from a stronger dollar and lower commodity prices.

While these forces are likely to be roughly offsetting, we place somewhat greater confidence in the disinflationary pressures for two reasons.
First, it is difficult to be sure about how much slack remains. Second, the relationship between slack and price inflation is subject to substantial uncertainty. Indeed, mojor US cities with lower unemployment rate have only modestly higher core inflation on average, and many do not follow the expected pattern. In contrast, pass-through from a stronger dollar to cheaper import prices or from lower energy input costs to prices of airline fares, for example, is usually more mechnical.

These competing pressures are likely to appear in different categories of the core price indeces. Reduced slack should contribute upward pressure primarily to the prices of services, while a stronger dollar should contribute downward pressure primarily to the prices of goods such as apparel and new vehicles. We incorporate these findings in our bottom-up inflation model, which now projects flat to slightly lower core inflation over the next year.

Despite the recent decline in market measures of inflation expectations, we do not think that another year of 1.5% core inflation would constitute a substantial threat to the anchoring of long-term inflation expectations. But  it would at the very least complicate Fed officials' intension to hike the funds rate sometime in mid-2015 or a bit later.
Moreover, the consequences of an average miss on either side of our forecast would probably be asymmetric. A quicker acceleration to the target would likely shift liftoff forward by at most one quarter from our September 2015 baseline, while a more substantial decline might delay liftoff by significantly more.