posted on 05 July 2016
Written by Jim Welsh
The Global Economy Before Brexit
In 2007 global GDP growth was 5.7%, with Advanced Economies up by 2.8% and Emerging Developing countries forging ahead by 8.7%, according to the World Bank. Fast forward to 2015 and global growth has slowed markedly, especially for Developing Countries. In 2015 growth in Developing Countries was 60% slower, clocking in at just 3.4%. Growth in Advanced Economies was 35% slower in 2015 than in 2007.
In January, the World Bank forecast that global GDP growth in 2016 would increase to 2.9% from 2.4% in 2015, with Developing Countries growing 4.2%, up from 3.4% in 2015. Growth in Advanced Economies was forecast to accelerate from 1.8% to 2.1%. But in June, and prior to the Brexit vote, the World Bank downgraded global growth in 2016 from 2.9% to 2.4%. This is an unusually large revision and noteworthy coming less than five months after their January report.
If the World Bank's forecast proves accurate, the global economy will not show any improvement from 2015, when growth was the slowest in a decade outside of 2009.
This outcome is amazing and must be disheartening to central bankers. During the last two years the European Central Bank (ECB) has initiated negative interest rates and a quantitative easing program to spur growth in the European Union (EU). Despite all the heavy lifting GDP growth in 2016 will be no better than it was in 2011. Since 2013, the Bank of Japan (BOJ) has expanded its balance sheet enormously, with its bond holdings as a percent of GDP, rising from under 20% to almost 60%.
When QE proved ineffectual in lifting economic growth, the BOJ, following the ECB's venture into the monetary netherworld, introduced negative interest rates in February. The World Bank estimates Japan's GDP will be .5% in 2016, compared to 1.4% in 2013. If this "success" continues, the economic program of Prime Minister Abe may be changed from "Abenomics" to "OhNonomics."
Although the Federal Reserve increased the federal funds rate from .12% to .37% in December, the Fed has maintained the size of its balance sheet and the .25% rate increase to .37% hardly represents a tightening of monetary policy.
In the last two years the Peoples Bank of China (PBOC) has cut interest rates five times and the reserve rate for banks three times. Credit expanded by $1 trillion in the first quarter, representing 10% of China's GDP. Despite the unprecedented stimulus, China's economic growth is expected to stabilize around 6.5%, rather than boom as it did in 2010 and 2011, when a similar amount of stimulus was applied after the financial crisis.
This litany of monumental monetary exertion, and the paltry harvest of economic growth in its wake, reinforces the diminishing effectiveness and rising impotence of monetary policy I have discussed for two years. Central banker's unconventional monetary policies have wrought a number of negative unintended consequences that have weakened European and Japanese banks, and insurance companies throughout the world.
The combination of negative interest rates and the ECB's quantitative easing program has done wonders for the stocks of Europe's largest banks. Over the last 52 weeks, Barclays, Royal Bank of Scotland, Deutsche Bank, and Credit Suisse have lost more than 50% of their value, with about 10% of the declines occurring after the Brexit vote. UniCredit, one of Italy's largest banks, is down 70% reflecting the weak state of Italian banks which have not been helped by the ECB's policies. Italy is considering an infusion of $44 billion into its banks to offset loan losses. The cost of the government's bailout could be a lot less, if Italian banks could increase capital through a sale of equity. The depressed level of Italian bank stocks eliminated that option.
When Bank of Japan announced on January 28 that interest rates would be lowered to a negative -.1%, the BOJ was fully expecting the Yen to weaken. Rather than weakening the Yen as expected, the Yen has rallied 17% against the dollar in 2016, and Japanese stocks are down 18.2%.
In April, Nippon Life Insurance suspended, due to negative rates, the sale of a savings product that had generated $3.2 billion in revenue in the prior nine months. In early June, the Bank of Japan, the largest bank in Japan, announced it might stop acting as a primary dealer of Japanese government bonds. Japanese bankers have said negative rates haven't created more demand for loans but have hurt profits and hit their stock prices. In assessing the impact of negative interest rates, the president of the Bank of Japan said,
When Abenomics was introduced in the fall of 2012, the Yen began to decline and the Nikkei 225 soared from a low of 9,000 to 16,000 by the end of 2013. The dramatic shift in monetary policy, simultaneous rise in the Nikkei and fall in the Yen attracted a lot of money.
In 2013 foreign investors bought Y15 trillion ($140 billion) of Japanese stocks. Many hedge funds bought stocks and shorted the Yen to hedge their stock purchases and to profit from the falling Yen. Between the end of 2012 and mid 2015, the Yen fell 35% versus the dollar, while the Nikkei was rising to 20,800 from 9,000, a gain of 130%.
After Japan increased its sales tax from 5% to 8% in April 2015, the Japanese economy began to slow and the Nikkei topped out, and by October had fallen by more than 15%. As hedge funds sold Japanese stocks, they covered their short position in the Yen. The pressure to unwind the long stocks / short Yen trade intensified as the Nikkei lost 25% from November 2015 into a low in February. After bouncing from 15,000 to 17,500 in late April, the Nikkei retested the February low after the Brexit vote, while the Yen spiked higher.
Japanese interest rates have been near 0% since 1995, so the Yen has been the funding source for carry trades for more than 20 years. No one knows just how much money is effectively short the Yen, so the unwinding may have further to go. Given the overwhelming negative response to negative rates, the BOJ will be reluctant to go more negative with interest rates. I would not be surprised if the BOJ intervened directly in the foreign exchange market to push the Yen down, since the increase in the Yen is weakening an already weak Japanese economy.
The Fed's zero interest rate policy (ZIRP) and negative interest rate policy (NIRP) by the ECB and BOJ have punished savers, retirees, and put into jeopardy insurance companies and pension plans. In the U.S. state pension funds are underfunded by more than $1 trillion, according to pension consultant Millman Inc. According to the Hoover Institution, 564 state and local pension systems are underfunded by $1.19 trillion, but that deficit could triple in the next 10 years. State and local government pension funds expect to average an annual return over the next 30 years of 7.6%. In a world where $12.7 trillion of government bonds sport a return below 0%, and the yield on the 30 year Treasury bond is less than 2.3%, averaging 7.6% is widely unrealistic.
According to Bianco Research, 36% of the $35.07 trillion of sovereign global debt yields less than 0%, 41% yields less than 1%, and 16% has a yield between 1% and 2%. If future investment returns fall short of 7.6%, the funding shortfall will increase, beyond the impact from retiring baby boomers. State and local governments currently allocate 7.3% of revenue for public pensions, and government officials know the numbers don't add up.
Knowing that the underfunding of pension funds will worsen in coming years is not likely to lead to action. Politicians are unwilling to address the pension funding problem since any increase from the current 7.3% of revenue in pension funding would need to be financed from higher taxes or spending cuts in other programs. The problem of underfunding in government pension plans has been and will continue to be magnified by the Fed's monetary policy.
Insurance companies and their policy holders have also been adversely affected by the Fed's monetary policy. Since 2000 the average investment returns on insurance company's investment portfolios have fallen from 7.8% to 4.3% at the end of 2015. As the Chief Executive of Metlife said in March,
For the 8 million Americans who own long-term care insurance policies, it has been a disaster since premiums are based on investment returns. With returns almost cut in half since the financial crisis, long term care policy holders have seen their annual premiums soar by 50% to make up for the reduction in investment returns due to low interest rates. Most of those experiencing these premium increases are in their 70's and 80's, and with rates likely to remain low, are likely to receive more premium increases.
Needless to say, the global economy was not in great shape before the Brexit vote. Global growth has slowed from 5.7% in 2007 to 2.4% in 2016, with no meaningful pick up in sight. Central banks have more than pushed the monetary envelope in recent years, and the negative unintended consequences from unconventional monetary policy are becoming more pronounced.
The global economy is vulnerable to negative shocks since growth is weak and monetary policy is running on empty. Whether Brexit poses a significant risk to the global economy won't be known for quite awhile, since Britain has a two year period to negotiate its exit from the EU.
However, the devaluation of the pound relative to other currencies is having an immediately impact on corporations inside Britain and globally. The 10% decline in the Sterling Pound versus the Euro is already causing stress for companies that export goods and services from the E.U. into Britain. The 10% devaluation of the Pound effectively raises the price of E.U. goods being sold in Britain. Virtually overnight E.U. companies must decide whether to accept lower profit margins by lowering prices, or lose sales to British competitors. Either way, profits for E.U. exporters to the U.K. are likely to be less.
British companies that source a large share of their products from Asia, where suppliers are paid in Dollars, face higher costs due to the 10% appreciation in the Dollar versus the Pound. These firms must choose between raising prices to cover higher costs, or accept less profit by absorbing higher costs. While the politicians in London and Brussels dither in coming months, companies in the trenches are forced to deal with the Brexit fallout immediately. Markets are overlooking this reality and its impact on corporate profits.
Formal negotiations will not commence until Britain exercises Article 50, and British leaders have said that won't happen until a new Prime Minister is elected and assumes office in September or October.
Although former Prime Minister David Cameron has said there is no chance of Britain not following through on leaving the E.U., his decision not to exercise Article 50 immediately could be a shrewd move. Cameron was against Brexit and postponing the official action to leave the E.U. might allow enough negative sentiment to build against Brexit that the next Prime Minister decides not to exercise Article 50. If the British Pound and U.K. stocks continue to fall, and signs emerge that Britain may be slipping into a recession, a growing number of those who voted for Brexit may have second thoughts and support doing nothing. This is far more likely than a do-over vote, since it requires only inaction.
No matter how Brexit unfolds it is going to be a divisive factor within Britain for years to come. More than 72% of potential voters cast a ballot, with the results almost split down the middle. This suggests at least half of the people are going to be unhappy about the direction of the country. This discontentment will be fanned by a slowdown in the Britain's economy if not outright recession, as businesses shelve plans to invest, spend, and hire.
The Sterling Pound dropped to its lowest level since 1985 and there is the potential for more weakness in coming months. Scotland and Northern Ireland have raised the possibility of seeking their independence from Great Britain. If a referendum in Scotland or Ireland appears possible, it would likely lead to more weakness in the U.K. stock market and the Sterling Pound.
The U.K. has a large current account deficit of more than 7% of GDP. This is a structural weakness for any country, as it leaves a country's currency dependent on foreigners' willingness to fund the current account deficit. If foreigners lose confidence in a country's leadership and economic future, funds are pulled out of a country by selling its currency. If the outflow becomes excessive, the country's central bank is often forced to support its currency through higher interest rates, or as a last resort, intervention in the foreign currency market by buying its currency. Intervention in the foreign currency market can be expensive as Britain found out in 1992 when George Soros forced the Bank of England to forego its support of the pound. The unsuccessful intervention cost England more than $3.3 billion pounds.
Given the uncertainty facing Great Britain and its current account deficit, the table is set for another shoe to drop in coming months. Since World War II Great Britain has experienced a currency crisis every 8.0 to 8.5 years, with the Pound Sterling making a multi-year price low in the process. The lows occurred in December 1967, November 1976, February 1985, February 1993, June 2001, and January 2009. It's possible the Brexit vote has caused the Sterling to post a low in less than 8 years, since 8 years from January 2009 targets January 2017. I suspect the Sterling will encounter more selling later this year or in early 2017, as the fallout from Brexit causes more consternation and a lower low in the Sterling Pound.
There is a populist movement sweeping through advanced economies (Sanders, Trump in the U.S.), as voters rail against the status quo as it is seen responsible for wage deflation, immigration, income inequality, and high unemployment especially in southern Europe. In some respects there is greater risk for the European Union than Britain, since the issue of leaving the E.U. is likely to percolate in an E.U. member country like the Netherlands or even France. Should another country seriously consider leaving the E.U., it could make the unraveling of the E.U. seem inevitable. This is why the negotiations between Great Britain and the EU could become as contentious as a bitter divorce. The EU will be tempted to make Britain's exit from the E.U. as unpleasant as possible as a warning to any other country that might consider leaving. This is likely to lead to headlines like "Talks Between Britain and the E.U. Collapsed Today After Failing to Come to an Agreement on (Fill in the blank)." A recent quote by the Belgian Prime Minister captures the tone of the coming negotiations.
The Global Economy After Brexit
If the E.U. tries to make an example out of Britain so no other country attempts to leave the E.U., economic growth in Britain and the European Union will suffer. I doubt this strategy will be successful since populism and nationalism are rising in response to failed policies that didn't improve the standard of living of the average worker.
There is a real risk that the Euro could drop well below 1.00 versus the Dollar if the E.U. mismanages Brexit, or if another country plans a referendum to leave the E.U. Brexit would then be viewed as the first domino that leads to the disintegration of the European Union. Globalization and trade during the last 15 years has lifted hundreds of millions of workers in emerging countries out of poverty and improved their standard of living. This positive was not without a cost, as millions of blue collar workers in advanced economies lost their jobs.
Globalization cannot be put back in the bottle, but that reality won't stop politicians in advanced economies from spouting slogans that appeal to those adversely affected by globalization. The real risk is that some of the slogans succeed in erecting barriers to trade that ultimately slows global growth and risks a debt deflation that makes 2008 look like an opening act for the Big One.
Despite the abject failure of unconventional monetary policy to spur economic growth since 2013, the time for a handoff from monetary policy to fiscal stimulus funded by deficit spending has not yet arrived. In the U.S., any fiscal stimulus is on hold until the next president assumes office in January. The European Union and Great Britain will have their hands full negotiating Britain's exit from the E.U. for many months. Should global growth falter or financial markets unravel, central banks will be called upon to create one more unconventional monetary gimmick. Negative interest rates have proved toxic for banks in the E.U. and Japan, so I doubt the ECB or BOJ will push rates further into negative territory.
I suspect the goal of any additional monetary intervention will be to buy time until a coordinated plan of fiscal stimulus can be launched under the guise of rebuilding infrastructure in the U.S., job training for workers displaced by globalization, and more income redistribution to address income inequality. The debt issued by governments to fund the Coordinated Global Fiscal Program will be purchased by central banks to minimize any increase in interest rates. The balance sheets of the Fed and ECB have a long way to go to catch up to the BOJ. If mortgage securities were included, the Federal Reserve's percent would be close to 26%. If this scenario develops, equity markets could have one final run for the roses, as hope overwhelms common sense. An economic rebound will develop similar to the spurt in global growth in 2010 and 2011, but likely fade as the burden of debt proves too much and demand too weak to sustain growth. In many respects the post Brexit global economy won't look that much different than global growth before Brexit - sub-par growth, too much debt, and dwindling policy options.
Although Fed members want to nudge rates up over time so rates are high enough so they can be lowered sufficiently to offset any slowdown or recession in the future, any notion to increase rates at the July or September FOMC is on hold due to Brexit.
As I noted in the June Marco Tides, I expect the second quarter rebound to stall in the second half of 2016, based on the Federal Reserve's labor market conditions index (LMCI) and higher lending standards. The monthly LCMI turned negative in January and was more negative (-4.6) after the May employment than at any time since the deep recession in 2008-2009.
This suggests that job and wage growth is not likely to strengthen in coming months, which should put a lid on consumer spending. In the first quarter, banks increased lending standards for large, medium, and small firms for the third consecutive quarter. Some of the increase was likely related to banks involved in lending to energy firms, but not all of it. Higher lending standards are a head wind and one of the reasons growth has been tepid, and will continue to weigh on any economic improvement until standards are lowered. In addition, the percent of banks reporting an increase in demand for loans has been negative for the last two quarters.
The lack of demand for loans is an indication of slow growth and is another reflection of weak business investment. Rising health care costs are also causing consumers to pare spending in other areas, like going out to dinner. In 2008, 2009, and 2010, Americans were told that the Affordable Care Act would lower premiums by $2,500 annually.
The increase in consumer spending on health care helps explain why the decline in gas prices didn't spur the economy as many economists forecast.
In the May issue of Macro tides, I thought the Dollar had made an intermediate low on May 3 and would rally until it ran into stiff resistance between 96.00 - 96.70. The dollar recorded a key monthly reversal in May, which is technically a long term positive, and one of the reasons why a rally above the March 2015 high of 100.51 is coming.
As I said in the June commentary, this rally "will not be sparked by Fed policy, but by events outside the U.S." In the wake of the Brexit vote, the Dollar spiked to 96.705. While the Sterling Pound suffered the most, a number of emerging market currencies were also hit hard. As the value of the dollar rises, emerging market debt becomes more burdensome, especially for companies whose revenues are in the local currency.
Since late April, the Mexican Peso has lost 12% of its value against the dollar. In an effort to support the Peso, the Bank of Mexico on June 30 increased it benchmark rate by .50% to 4.25%. While it may help support the Peso in the short run, higher interest rates will not be a plus for economic growth in Mexico.
Since the Dollar bottomed on May 3 and rallied from under 92.00 to 96.705, the Peoples Bank of China has very quietly allowed the Chinese Yuan to depreciate against the Dollar, Donald Trump be damned. This has been possible since all the world's attention has been focused on whether Brexit would pass or not, and the fallout once it did. The depreciation in the Yuan underscores the intent of China to do anything to support economic growth, which indicates that growth is still insufficient.
As discussed at length in the May issue of Macro Tides, GDP increased by only $175 billion in the first quarter, even as debt increased by $1 trillion. For each $1 dollar of new debt, GDP only grew by $.16. The imbalance between economic growth and debt is unsustainable and will end badly, despite Chinese securities regulators, media censors, and government officials suppressing warnings by economists, investment analysts, and business reporters who have delivered less than rosy assessments of the Chinese economy. As I wrote in the May commentary,
In early June George Soros said the debt problem in the Chinese economy
As I discussed in the April 25 Weekly Technical Review, the low in February may represent wave 4 of a 5 wave rally from the March 2009 low, since the market was extremely oversold and sentiment was in the dumps. If correct, it suggests that wave 5 began at the February 11 low and could potentially lift the S&P to 2360 in early 2017. My goal has been to identify the top of wave 1 and the low of wave 2 of wave 5.
As noted in the June 8 Macro Tides, the market had become overbought and sentiment far more optimistic, which suggested the end of wave 1 up was near. As it turned out, the S&P topped on June 8, the day the June commentary was published. In June I thought that 'if wave 1 of wave 5 ends soon, the S&P should be set up for a decline below 2026 before wave 2 finishes.' On Monday, the S&P traded down to 1991 as financial markets convulsed after Brexit was passed. Although it is certainly possible that wave 2 of 5 ended at 1991, I don't think so for a number of technical reasons. The market was not oversold on an intermediate basis when the S&P bottomed on Monday. The 21 day average of net advances minus declines provides a good indication of how overbought or oversold the market is at highs and lows. At solid intermediate lows, the 21 day average of net advances minus declines drops below -400, as indicated by the green arrows under the indicator. At the lows last August and in January it exceeded - 700. At Monday's close the 21 day net advances minus declines was not oversold (only -63), and by yesterday's close (June 30), it was +463 and overbought.
A number of technicians have pointed out that new highs on the NYSE have expanded robustly and reached 396 on June 30, with the 21 day average of net new highs representing 4.93% of all the issues traded on the NYSE. With interest rates diving, a significant number of the new highs were bond funds and preferred stocks.
I like to compare new highs on the NYSE with the number of new highs on the Nasdaq Composite, since there are very few if any bond related issues trading on the Nasdaq. On June 30 only .09% of Nasdaq stocks made a new 52 week high. At the June 8 high, 1.6% of Nasdaq stocks were making a new 52 week high, while 4.64% did on the NYSE. The percent of stocks making new highs on the NYSE and Nasdaq Composite normally move together. In recent months, the spread has widened noticeably, which is not positive.
The decline from the June 8 high is clearly an a-b-c decline and therefore corrective. However, if I'm correct and Monday's low was not the end of wave 2, it would have to be the first part of a larger wave 2 correction. If this is the correct pattern, Monday's low represents wave A, and the rally from Monday's low would be labeled wave B, and probably won't exceed 2120. Wave C of 2 would follow and result in a decline below Monday's low of 1991. This would then complete the wave 2 correction from the June 8 high of 2120.
The rebound from the low on Monday June 27 has been very impressive. I suspect some of the lift came from end of quarter window dressing and short covering. Nevertheless, I have to accept that Monday's low might represent the wave 2 low and that wave 3 of big wave 5 to 2360 has begun. We'll know soon since the S&P 500 should explode to new highs on huge volume, after pushing above the May 2015 high of 2134.
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