It’s Liquidity, Stupid …
January 11, 2007
By David Miles | London
Do we learn much by talking about ‘liquidity’ as a driver of what is going on in financial markets? Liquidity, and its overweight offspring ‘excess liquidity’, are certainly often put forward as an explanation for movements in asset prices. And there is a lot to explain. Despite recent upward movements in rates, yields on government debt across the developed world remain at historically low levels. In the US and UK, nominal yields on 10-year debt stand below 5% — significantly below policy rates set by their central banks. In the euro area, yields on benchmark 10-year bonds hover around 4%. Real interest rates on longer-dated bonds — either directly read off the pricing of inflation proof debt or inferred from the pricing of nominal debt and taking optimistic views on long-term inflation — remain well below averages over the past few decades. Even more striking is the very low level of credit spreads that has taken the cost of corporate debt for some distinctly non-prime borrowers down to unusually low levels.
So do we learn much of what has been behind all this by pointing to high levels of ‘liquidity’? Part of the problem here is in figuring out what we might mean by liquidity — something that Morgan Stanley’s economists will be contemplating in some detail soon. That is not just an academic exercise. Since ‘liquidity’ is often put forward as a justification for what look like high prices of many assets, figuring out what that might mean and whether it is coherent is important in figuring out what might happen in financial markets next. At this point I am skeptical that the concept of ‘liquidity’ has much value as an explanation. First of all, if ‘liquidity’ is meant to be a measure of the ease and cost with which people can access funds then it is hardly an explanation of the level of yields. In some ways, ‘liquidity’ is really just a description of the phenomenon to be explained rather than an explanation of it. In fact, invoking ‘liquidity’ as the cause of low yields sometimes sounds a bit like ‘explaining’ global warming in term of temperatures having gone up. But maybe liquidity should be interpreted as being about the ease with which people can access credit — the amount they can borrow — rather than its price. But then we run into a paradox. It is very likely true that many people can now borrow more than in the past — households with poor credit histories and companies with less-than-solid balance sheets — are certainly now able to borrow more in many countries than 5 or 10 years ago. But that cannot be much of an explanation for a relatively low level of yields on debt. If it is easier to borrow, the amount of saving is likely to be lower, not higher. And it is a strange idea that lower savings could be a cause of lower real interest rates. Some will say that these points are irrelevant because ‘liquidity’ is about the amount of cash held, rather than about ease of access to credit. By cash we really mean bank deposits of various types, which constitute the largest part of measures of the broad money supply. Certainly, broad money has grown fast in many countries — particularly within Europe. But what this means is that the private sector — households and companies — want to hold a lot of their financial wealth in low-risk assets with a return that is, measured over the very short term, highly certain. That can hardly be much of an explanation for low yields on longer-dated and more risky assets — for example, corporate credit. One could argue that the build-up in bank deposits just means people are waiting to buy longer-dated, more risky assets and it’s the anticipation of this that drives the value of those longer-dated and more risky assets up. Well maybe. But then the build-up of money in bank accounts is just a consequence of those soon-to-be implemented portfolio decisions, it is not a causal explanation of them. But ‘liquidity’ might mean something different. It could be a roundabout way of referring to the level of saving. But across the developed world, savings rates have not been high — and in the US and the UK they have been pretty low. So, if liquidity is something to do with saving then it would not make much sense to talk about liquidity being unusually high within the developed economies. Indeed, even at the world level it would make little sense to talk about liquidity being unusually high because, as has often been noted, the world rate of saving in recent years has been somewhat below the average over the past 25 years. I think in the end that we would do better to think about the drivers of asset prices in terms of fundamental forces. For real returns these would include: the perceived risk characteristics of different assets; the appetite to take risk; and the degree of impatience of investors. In figuring out how those factors combine to generate nominal returns, we need to add in the forces shaping inflation — actual and expected, and both over the short term and over the longer term. That gives us plenty to look at.
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Remembering Milton Friedman
January 11, 2007
By Serhan Cevik | London)
The behavior of inflation volatility confirms the secular nature of disinflation in Turkey. Milton Friedman, one of the greatest economists of the 20th century, made Nobel prize-worthy contributions to our understanding of economic behavior and especially inflation dynamics. One of his insightful arguments is particularly relevant to disinflation and stabilization in Turkey and elsewhere. That is, the feedback mechanism between inflation and the volatility of inflation makes the reduction in inflation uncertainty a basic requirement for macroeconomic stabilization. In other words, the sustainability of any given (dis)inflation trajectory partly depends on the behavior of inflation volatility. Although the Turkish economy, albeit making significant progress in the last five years, is still away from price stability, the marked drop in inflation volatility confirms the secular nature and thereby sustainability of disinflation. In our view, after suffering an unfortunate series of supply-side shocks that disturbed the disinflation process, monetary tightening and secular forces will keep normalizing inflation dynamics. Our time-varying calculations show the normalization of inflation dynamics. Since volatility is not constant over time, conventional measures like standard deviation may present a distorted picture. This is why we have developed a time-varying gauge based on a generalized autoregressive conditional heteroskedasticity model to examine the behavior of inflation volatility in Turkey (see GARCHing Ahead, February 21, 2005). Until the global shock last year, the volatility of inflation declined from an average of 11.1% in the 1989-2001 period to as low as 1.2% last April and an average of 1.9% in the post-crisis period. Even though higher energy prices and the lira’s sharp depreciation resulted in an increase in inflation volatility in the second half of 2006, its magnitude and duration nevertheless remained consistent with the normalization of macroeconomic variables (see Still GARCHing Ahead, August 7, 2006). Indeed, after peaking at 2.3% in August, inflation volatility has already started easing once again and declined to 1.7% at the end of last year. In our opinion, despite a number of challenges, the moderation of inflation uncertainty is great news for disinflation and overall economic efficiency in the coming years. Consumer price inflation has already moved back into the single-digit territory. The consumer price index posted a year-on-year increase of 9.7% in December, down from the post-volatility peak of 11.7% in July. Though the latest reading was significantly above the upper bound of the central bank’s uncertainty band, extrapolating a temporary setback would be misleading, in our view. After all, the rise in inflation was not a result of overheating in the domestic economy, but an amalgamation of higher commodity and unprocessed food prices and the lira’s weakness. Of course, given Turkey’s painfully long history of instability, it is not surprising to see mental inertia and volatility in the formation of expectations. Nonetheless, we believe that fundamental determinants will regain more influence and drive inflation towards the central bank’s multi-year targets. As a matter of fact, the correction is already underway, and not just because of lower oil and unprocessed food prices. The ‘core’ CPI (excluding the prices of energy, unprocessed food, alcoholic beverages, tobacco products and gold) declined to 8.9% last month, after rising from 5.1% in March to 9.1% in November. More significantly, seasonally adjusted figures show that the annualized rate of inflation over three months decelerated from the peak of 13.4% in June to 8.1% by the end of the year. The moderation of domestic demand will help to put disinflation back on track. Turkey achieved rapid disinflation from an average of 77.5% in the 1990s to the single-digit territory, without experiencing output loss, in the past five years. However, internalizing low inflation will take time and Turkey may go through periods of higher volatility, as happened last year, due to exogenous developments. In other words, as Professor Friedman used to say, there is no such thing as a free lunch. Under the current circumstances, the price of achieving price stability and sustainable income growth is tighter monetary conditions and a slowdown in domestic demand. Since household debt increased from 7.5% of disposable income in 2003 to 25.6% last year, higher interest rates have lowered discretionary consumer spending. In our view, with sustained productivity improvements and spare capacity in the labor market, the moderation of domestic demand will help to put disinflation back on track. Lower inflation volatility will support sustainable growth and financial deepening. Although some see the rise in real interest rates and credit constraints as a significant risk to the growth outlook, we see managing volatility in a challenging period of global unease as necessary for sustainable growth and financial deepening over the medium term. So, until inflation moves within the uncertainty band, the Central Bank of Turkey will maintain the current monetary policy stance. According to our projections, the ‘breakthrough’ moment in inflation dynamics is likely to emerge in 2Q, allowing for a 150bp reduction in interest rates in the remainder of the year.
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Net Gains
January 11, 2007
By Serhan Cevik | London
The shekel’s appreciation is not just about the dollar’s weakness, in our view. Imbalances in the US economy and the dollar’s depreciation have become an overwhelming theme in global financial markets, triggering significant shifts in portfolio allocations. However, although the dollar is likely to remain weak in the near future, our currency economics team expects it to get stronger towards the end of this year and especially in 2008 (see Cyclical Dollar Correction in 1H; Story May Change in 2H, January 4, 2007). Of course, such a turnaround in the dollar’s valuation and the reasons behind it would have a range of implications for Israel’s economy and financial markets. Nevertheless, we do not see a major risk to our call for the shekel’s continuing strength. The dollar’s weakness may have been a trigger, but the shekel’s appreciation is certainly not just about what has happened to the dollar. As we have long argued, the shekel is fundamentally undervalued against the dollar and even more so against the euro. Therefore, we still expect economic fundamentals and financial developments to keep supporting the shekel and the country’s domestic assets. Israelhas the strength and dynamism to weather a global slowdown. Despite geopolitical constraints and indeed the eruption of a guerilla war in Lebanon, the Israeli economy has continued to grow at a robust pace. Real GDP increased by 5% in 2006, even a little bit faster than our 4.8% estimate, thanks to 6.3% growth in the private sector. Although the war lowered the annualized rate of GDP growth from 5.9% in the first half of last year to 2.9% in the second half, the economy has already bounced back from the ‘pause’ in the third quarter. The strength of the global economy is certainly an important factor for Israel’s export growth and overall economic performance, but it would be unfair to dismiss the effect of fiscal consolidation and structural reforms in accelerating the private sector-driven expansion cycle. With the correction in the budget deficit from 5.4% of GDP in 2003 to 0.9% last year, the corporate and household sectors have benefited from a more rational, predictable macroeconomic outlook. This is why we believe that Israel has the strength and dynamism to weather a slowdown in the global economy. Current account surplus not just a cyclical phenomenon. Israel’s current account balance moved from a deficit of 0.5% of GDP in 2002 to a surplus of 2.9% in 2005 and about 6% last year. This is an amazing performance, especially considering the worsening in the country’s terms of trade because of higher commodity prices. Although the global business cycle has been an important determinant of trade flows all around the world, Israel’s specialization in high-tech goods and services is far more important than the volume effect, in our view. In other words, higher value-added in technology-intensive sectors brings a structural improvement in the current account. Of course, this is only one aspect of a greater story in progress. For example, the current account surplus is also a reflection of the downward trend in domestic investment relative to GDP after the immigration-driven increase in capital accumulation in the 1990s. Another important factor that we need to consider is the increase in net income from investments abroad, as Israel has become a capital-exporting country. Financial globalization has led to a secular decline in home bias. Structural changes in the capital markets, particularly the equalization of taxation on investment abroad, have accelerated residents’ portfolio diversification. Institutional investors, for example, already increased the share of foreign assets from 1.2% of total assets in 2002 to 7.2% in 2005. The response of households to the tax reform and the narrowing interest rate differentials have also evolved in a similar fashion. As a result, foreign assets owned by Israelis grew from US$69.6 billion in 2000 to US$122.9 billion in 2005 and US$148.4 billion by 3Q06. While residents kept accumulating assets abroad, foreign capital flows to Israel surged from US$3.2 billion in 2002 to US$11.6 billion in 2005 and a record level of US$23.4 billion last year. However, since assets abroad increased faster than liabilities, the country’s net international position improved significantly from US$50.3 billion in 2000 to US$30.1 billion in 2005 and US$17.3 billion in the first three quarter of 2006. Even though the decline in home bias in residents’ portfolio allocations is a headwind against the shekel, the increase in net income from investments abroad and foreign participation in Israel’s financial markets will continue to support the valuation of shekel-denominated assets, in our view. Currency appreciation has lowered inflation and allowed for monetary easing. CPI declined from 3.8% in April to -0.3% in November, as the shekel’s strengthening lowered dollar-linked prices across the economy (see Technical Deflation, November 20, 2006). Facing such a currency-driven correction in inflation dynamics, the Bank of Israel has opted for monetary easing and lowered short-term interest rates even below those in the US. Even so, we believe that the economy’s underlying strength still supports lower real interest rates.
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Jobs Galore — but Trend Has to Slow
January 11, 2007
By Gerard Minack | Sydney
Another cracking employment report — 44,600 new jobs in December — has confounded forecasts for a return to moderate labour growth. In addition, there were revisions up to the past two months, reflecting revised population estimates. Employment is now running 3.0% above year-ago levels. More to the point, yesterday’s job vacancy data suggest that the labour market could remain strong. There is very little detail in the labour force report. However, the state breakdown shows that Queensland has become the jobs engine, with employment rising by 5.5% at an annual rate over the second half of last year and accounting for over 40% of the nationwide increase. The first point to note from all this is that, in my view, there is no way that the RBA would contemplate easing policy with the labour market this buoyant — even if, as has been the case recently, wage pressures remain moderate. Second, the ongoing strength in employment puts a question mark over the published GDP data. Either the GDP data are under-stated, or we are seeing a collapse in productivity. On the basis of recent employment gains, productivity growth has turned negative. The third point to note is a bigger picture issue. Trend economic growth boils down to two variables: productivity and employment growth. Over the past decade Australia has seen significantly faster growth in employment than in population. That reflects two changes: falling unemployment (that is, employment growth faster than labour force growth) and rising labour force participation (that is, faster labour force growth than population growth). Over the past five years, employment growth has been a full 1% above working-age population growth. Although there’s no sign of these trends turning in the short term, over the medium term they are clearly unsustainable, in my view. As trend employment slows towards population growth, trend GDP growth will have to moderate (barring an offsetting rise in labour productivity). There’s one final point to note about this structural issue: it seems to have been driven by increasing labour supply, rather than increasing labour demand. How can I tell that? The rise in labour participation has been associated with a falling labour share of national income. This is typical of a supply-curve shift: volume (employment) rises at the same time that price falls. That has been a marvellous support for business — they’ve had more workers available, and willing to work for less (not in absolute terms, but certainly for less relative to their output). That too, is a trend that will ultimately turn — and may well have already in some sectors where anecdotal evidence points to firms bidding up wages.
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