Shaw Capital Management August 2010: Financial Markets

Sentiment in the financial markets has improved over the past month. There has been further evidence that

the recovery in the global economy is continuing; the sovereign debt crisis in Europe has not yet produced a major casualty; there has been a modest rally in the euro; and the Chinese authorities have announced that they intend to adopt a “more flexible” policy towards the renminbi that is expected to allow it to appreciate at a slightly faster rate.

Shaw Capital Management August 2010: Financial Markets - These developments have suggested that the gloom was overdone. The effect in the currency markets had been to slightly weaken both the dollar and the yen, as the “risk appetite” amongst investors and traders has increased, and to strengthen the commodity-linked currencies and ease the pressures on the euro. Sterling has also improved over the month, helped by the measures announced by the new coalition government in the UK, both before and during the recent budget statement, to significantly reduce the huge fiscal deficit.

Shaw Capital Management  views on financial market - But overall movements in the major currencies have been fairly small, and there is still considerable optimism about prospects.

The latest evidence on the performance of the US economy has enhanced the prospects for the dollar, and this should also continue to provide some stability for the yen.

The sovereign debt problems in Greece, Spain, Portugal, and even in Italy, continue to worsen, and may well lead to defaults and put further pressure on the single currency system.

There must also be serious doubts about the latest improvement in sterling.

The new government in the UK is making credible efforts to reduce the size of the fiscal deficit; but it faces a daunting task, and will find it very difficult to maintain its tough stance.

There is therefore a serious risk of a crisis in the UK currency market, and so it is crucial that the international agencies prepare contingency measures to enable them to act quickly if the situation appears to be running out of control.

The latest available evidence on the performance of the US economy; show the recovery from recession remains on track.

Retail sales were 1.2% lower in May than in April, emphasising the cautious mood amongst consumers; non-farm payrolls increased by 431,000 in May, but 411,000 jobs were accounted for by temporary government hiring to complete the 2010 census, leaving the increase in “real” jobs well below expectations; new home starts fell sharply in May following the withdrawal of government measures to prop up the market, and existing home sales also fel.

And the M3 measure of broad money growth is also continuing to decline because of weak loan demand from reliable borrowers, and the reluctance of the banks to lend to anyone else. There are offsetting factors in the strength of the manufacturing sector; and consumer confidence figures remain reasonably strong.

The Commerce Department has recently revised its estimate of growth in the first quarter of the year down to a 3% annualised rate; but this rate may not have been maintained in the current quarter; and this has already led to a strong plea to Congress from the government to authorise additional spending programmes costing up to $50 billion “to keep the recovery on track”, it is not clear how Congress will respond.

The Fed chairman, Ben Bernanke’s recently testimony to Congress; that the pace of the recovery will not be strong enough to fix the jobs market or reduce the budget deficit without further help, also argued that, despite the size of that deficit, “to avoid sharp, disruptive shifts in spending programmes and tax

policies in the future, and to retain the confidence of the public and the markets, we should start planning now how we will meet these budgetary challenges”. This view about the economy is repeated in the statement after the latest meeting of the bank’s Open Market Committee, and so, although the bank believes

that the recovery is continuing, it is not surprising that it is quietly considering what steps it might have to take if the recovery unexpectedly falters.

There has been a modest recovery in the euro from a low-point in the early part of the past month, although it is still ending the period slightly lower.

The economic background in the euro-zone is continuing to improve, and there has been evidence of support for the euro, particularly from the Swiss National Bank, which reported an increase in its foreign currency reserves of more than $100 billion in May. But the benefits have been limited by the on-going sovereign debt problems amongst some member countries of the euro-zone, and especially by the serious deterioration in the situation in Spain, and so the improvement that has occurred remains very fragile.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target

Japanese Finance Minister Naoto Kan has recently exerted pressure

on the Bank of Japan (BOJ) to act more quickly to defeat deflation,

saying he wants the falling price trend to end this year. “Two or

three years is too long. If possible, I hope that the consumer price

index turns positive by the end of this year” Kan told a parliamentary

session.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. The finance minister also said that the BOJ may have to set an

inflation target aimed at dragging the economy out of grinding

deflation … a policy where a central bank declares a target for

inflation and guides actual price levels toward that goal through

monetary policy such as interest rate changes.

BOJ Governor Masaaki Shirakawa made it clear he had no intention

of taking such a step, and explained in detail why he considers it

inappropriate. “There is a mood to reconsider the use of the

framework of inflation targeting following the recent financial

crisis," Mr. Shirakawa said at a recent news conference.

“If a central bank concentrates only on achieving a short-term

price goal, that could have an adverse effect on sustainable economic

growth, which is the final goal of monetary policy”, Shirakawa said.

Moreover, “such a mechanism would reduce the BOJ’s flexibility

on policy”.

Inflation targeting has become a favoured policy among many

central banks worldwide, but since the start of Japan’s deflationary

era in 1999, the BOJ has stoutly resisted calls to set an inflation

target against which it can be judged, and by which it can be

embarrassed if it misses it.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. Instead it has relied on softer price guidance in determining policy.

Its inflation objective is defined in the loosest terms, as a rate

between zero and 2% for the core consumer price index, as one

that meets its “understanding of medium- to long-term price

stability”, with no time-frame to achieve it and no penalty for

failure.

Still, core consumer price index, which excludes volatile fresh food

prices, fell 1.3% on year in December, dropping for the 10th straight

month.

Shirakawa’s comments suggest the central bank will not embark

on any further easing for now to put a stop to deflation. However

the BOJ might be forced to loosen policy toward the middle of the

year if the domestic economy loses momentum from its recent

strong performance … recent data showed the economy grew at a

4.6% annualized pace in the final quarter of 2009.

And with a key upper house election coming up in the summer, at

which the ruling Democratic Party of Japan hopes to win a majority

in the chamber, political pressure on the BOJ to do more to improve

the economic picture could rise.

Can the introduction of inflation targeting under deflation and

zero interest rates contribute to the Japanese economic recovery?

Generally, inflation targeting has been increasingly viewed as a

good monetary policy framework and widely applauded by

economists and policymakers.

In the literature, there are benefits of inflation targeting for both

inflation and output behaviour.

Inflation targeting should stabilise the level of inflation, reduce its

variability and persistence, and also decrease the variability of

output.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. A recent study by Daniel Leigh, an economist at the IMF, shows

that had Japan introduced an inflation target in the 90’s its

economy’s performance would have substantially improved and

the BOJ would have avoided the zero lower bound on nominal

interest rates.

But the essence of the question is to what extent the introduction

of inflation targeting will enhance credibility of the BOJ’s reflation

policy in a deflationary phase and help economic recovery.

More importantly, whether or not the BOJ monetary policy is

credible enough for inflation expectations to be anchored to an

inflation target.

Takehiro Sato of Morgan Stanley says that, unlike the Federal

Reserve, which has won a high degree of respect for its handling

of monetary policy, Japan’s central bank is not yet trusted by

markets because of its past moves. “The BOJ’s policy track record

is bad.

A target for inflation helps to anchor future expectations of

monetary policy, but BOJ lacks credibility.

The mere announcement of an inflation target would not change

expectations”, he said.

Indeed, the introduction of inflation targets among advanced

countries tends to be accompanied by an institutional framework

that makes inflation targeting credible and accountable.

In several countries, including New Zealand and Australia, inflation

targeting is an agreement between the government and the central

bank, and both are committed to policy that is consistent with the

inflation target.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. In several countries, including New Zealand and the UK, when

inflation exceeds the target by a wide margin, the Governor is

required to provide an explanation to the parliament. With

accountability and commitment, inflation targeting does become

credible.

A central bank in a deflationary environment

is subject to a time-inconsistency problem: it

cannot credibly commit to “being

irresponsible” and so continue to shoot for

high inflation.

Furthermore, there is a concern that once the Japanese economy

has emerged from a deflationary spiral and starts to recover, the

central bank will be tempted to renege on its commitment to a

high inflation target, because it would like the economy to return

to an inflation rate consistent with price stability.

Thus a central bank in a deflationary environment is subject to a

time-inconsistency problem: it cannot credibly commit to “being

irresponsible” and so continue to shoot for high inflation.

The result of the time-inconsistency problem is that the markets

would not be convinced that inflation would remain high, and

inflation expectations would not be high enough to lower real rates

sufficiently to stimulate the economy out of the deflation trap.

To overcome deflation and restore economic activity Japanese

policymakers may not need to adopt an inflation target.

They could simply use unconventional instruments, such as

purchases of riskier assets and foreign assets, more aggressively

so to persuade the markets and the public that there will be higher

inflation.

Shaw Capital Management Korea: Financial Markets

For most of the past month sentiment in the financial

markets continued to improve.

There was further evidence that the global economic

recovery was still on track, and short-term interest

rates remained very low.

But towards month-end the mood changed after the

decision to downgrade Greek debt to “junk” status, and

to reduce the credit ratings of both Portugal and Spain.

There was a fear that the contagion would spread still

further, and that the bond market pressures resulting

from the massive fiscal deficits around the world would

have serious financial consequences.

There was always the risk that some of the measures

that were introduced to counter the recession might

have adverse consequences, and this is now proving

to be the case.

Shaw Capital Management Korea: Major Equity Markets

After moving ahead for most of the month, most of the

major equity markets are ending the period unchanged

or slightly higher, and there have been sharp falls in

many of the minor markets.

Wall Street has been the exception, and is ending

higher, encouraged by some favourable corporate

results.

But markets in Europe, including the UK, are lower,

and there have been falls in the Chinese market, and

other Asian markets, after the measures by the

authorities to reduce the risk of over-heating in the

Chinese economy.

However views about longer-term prospect are still

fairly positive, and the markets seem to be simply

pausing until some of the uncertainties have been

resolved.

Bond markets; have produced a mixed performance,

with the major markets holdings fairly steady, despite

the worsening background situation, but with the minor

markets, especially in Europe, suffering very sharp

falls, and yield spreads between the stronger and weaker

markets opening up to record levels.

The threat of sovereign debt defaults has increased

and urgent action is needed, especially in Europe, if

they are to be avoided.

However there are also warnings that similar conditions

could develop in the UK and in Japan if there are no

early moves to reduce the level of fiscal deficits.

It is still expected that an aid package will be agreed

to avoid a default on Greek debt; but this may only

provide temporary relief.

Shaw Capital Management Korea: Currencies

Movements amongst the major currencies have been

relatively small over the past month.

However the weakness of the euro has enabled both

the dollar and sterling to improve as investors have

rushed to reduce their exposure to the European

currency.

There is a fear that the debt problems affecting Greece

and other countries in the euro-zone will make it

extremely difficult to restore the credibility of the euro,

and that it might make it necessary for some countries

to leave the single currency system, at least on a

temporary basis.

Shaw Capital Management Korea: Short-Term Interest Rates

There have been no changes in short-term interest

rates in the major financial centres over the month.

The Bank of Canada though has indicated that it is

considering pushing rates higher, and this has

encouraged speculation that other central banks may

be planning similar moves.

Shaw Capital Management Korea: Commodity Markets

Moved higher over the past month as sentiment in the

financial markets improved.

Salamat Shaw Capital Management Korea: Portfolio Recommendations

We have made no changes in our portfolios this month.

The latest developments in the government debt

markets have increased the uncertainties about

prospects for both the bond and financial markets.

However, although the pace of the global economic

recovery may be affected, there appears to be enough

momentum to enable it to continue.

We have therefore maintained the level of our exposure

to the equity markets; and we have left 10% of the funds

in the portfolio in cash deposits as a contingency

measure. Bond exposure is zero.

Shaw Capital Management Korea: Portfolio

Recommendations - The UK Hung Parliament

The bond markets are totally calm about the hung

Parliament, as they are about both UK and US bond

prospects, with yields still below 4%, in spite of the

huge deficits both countries are running.

What is going on?

The first point is that both countries are recovering,

and seem set for growth rates in the 2–3% range.

Such growth is not ‘V-shaped’ but a V was unlikely

given the shortage of oil and raw materials, which

continues to limit world recovery potential. It does

give a prospect of improving tax revenues and falling

benefit expenditures.

As growth goes forward it will be possible to work out

more accurately how much of the current deficit is

‘structural’ — i.e. will not disappear with returning

growth.

For the UK the current estimate is that about 8% of

GDP is structural: still requiring a huge programme of

retrenchment.

The second point is that neither the UK nor the US has

ever formally defaulted in modern times.

Indeed for the UK, they can date this from the end of

the Napoleonic Wars when public debt reached around

300% of GDP.

The third point is the new unwillingness to use higher

inflation to bring down the debt in real value. Inflation

(implying an ‘inflation tax’ on government monetary

liabilities which thereby lose their value) is now

proscribed after the poor experiences of developed

countries during the ‘great inflation’ of the 1970s.

Electorates have rejoiced at the new inflation targeting

policies that have formally ended governments’

experiments with this form of taxation.

The electorates hated the messy and unintended

redistributions of wealth this tax implied — often from

the weak such as pensioners to the wealthy and the

unionized.

In this context bond markets have treated Mr. Obama’s

delays and the UK’s election result as simply policy

deferred.

In that they are likely to be right.

Shaw Capital Management Korea: Portfolio

Recommendations - The state of the eurozone

By contrast the situation in the euro-zone looks

increasingly difficult.

The problem is that Greece and Portugal — the two

main current problem cases — joined the euro in the

expectation that low interest rates would keep their

public finances under control.

Internally these countries have difficulty in raising

taxes and curbing expenditure but joining the EU and

then the euro gave them the authority to insist on fiscal

discipline as the ‘price’ of joining.

Now the discipline is becoming harsh and yet interest

rate premia are rising, as the risk of default increases.

Germany and the other euro-zone countries are

unwilling to transfer resources to them — and even to

provide loans on terms below these market rates.

Germany’s position in particular has hardened

massively under hostile home reactions to perceived

‘bail-out’.

Germany is simply unwilling to make transfers after

the huge costs of its integration policies for East

Germany.

There will come a point where the advantages of being

in the euro are outweighed by the disadvantages for a

country like Greece.

Once interest rate premia get high enough inside the

euro, the attraction of floating the currency down

outside it and still paying similar interest rates will

become overwhelming to governments faced with

public hostility to further sacrifice.

A large devaluation is a way of allowing the economy

to recover and produce extra revenue.

Furthermore reintroducing the local currency will

allow the government to re-denominate the debt in

that new sovereign currency … so effecting a de facto

partial default.

These exits would not spell the end of the euro. But

they will remind markets that the euro is bound

together by political convenience only and not by some

deep commitment to European integration.

Up to now there has been a general belief in such a

commitment; however, Germany’s recent actions have

destroyed this belief.

It was this belief that kept interest rate premia down

on sovereign debt of euro-zone countries; rather like

the debt of UK local authorities — formally underwritten

by the UK government, it was felt that these countries’

debt was being implicitly underwritten by other eurozone

members. No longer.

But of course what can happen to Greece could happen

to any other country. If so its risk premia too would

rise and it too would face the same trade-off between

staying in or exiting with the freedom to float at similar

interest rates outside.

Hence the chances of more break-up would get larger

and the system would become gradually closer to a

system of ‘fixed but adjustable’ exchange rates like the

old European Monetary System.