To Cut Or Not To Cut ?

Calm after the storm

The US economic calendar is thinly populated this week following on from Friday's surprise jump in Non-Farm Payrolls. However there is plenty of news due from elsewhere to keep us occupied. At the recent G20 meeting, in Shanghai, the closing message talked about co-ordinated global stimulus as means to head off any impending economic downturn. Though that is increasingly looking like wishful thinking, it does provides us with an excuse, if any were needed, to look at the interconnectedness of the global economy as a whole.

Chinas Communist party concluded its annual congress at the weekend. During which it outlined a growth target of 6.5% to 7% out to 2020. Marginally lower than its prior guidance, this still seems to fly in the face of what appears to be the situation on the ground.

However for the moment markets seem to have stabilised, in the expectation that PBOC and the Government will continue to add stimulus and use looser monetary policy to the keep the Chinese economy moving. Despite a pledge by G20 members not to use competitive currency devaluations, as a tool to bolster economies, we still think further rounds of yuan easing are likely over the coming months.

We will get the chance to take another peek at Chinese economic performance early on Tuesday morning. When we get Balance of Trade data for February. Chinese Exports have been declining since March 2015, whilst Imports have fallen since November 2014. Imports have posted some hefty double digit percentage falls over that period, a clear sign of a faltering economy. I note that we will also see both PPI and CPI data for February from China, early on Thursday morning. Inflation of course is usually associated with or seen as a proxy for growth.

The chart shows the value of China's Imports and Exports over the last 5 years. (Trading Economics)

Bank of Japan on hold?

We heard on Monday morning from Chinas principal regional rival Japan. Bank of Japan (BOJ) governor Kuroda spoke on monetary policy and likely future actions from the bank. Mr Kuroda suggested that the Japanese central bank will not cut rates further in the near term, rather that they will take a step back and examine the effects that negative interest rates are having on the economy. However Mr Kuroda also stressed that the BOJ would be ready to cut rates if required, to help it meet its 2% inflation target. The governor was also resolutely optimistic on Japans economic outlook saying that
"Current negative rates would have a very powerful stimulus effect on the economy by driving down borrowing costs and nudging firms into boosting investment."

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The chart below currently tells a different story however with both GDP and inflation in Japan heading lower.

Chart shows Japans GDP growth rates and change in inflation MoM (Trading Economics)

The ECB's turn to play its cards

The main event this week however will be the ECB meeting and interest rate decision on Thursday lunchtime. The ECB of course followed the BOJ and moved to negative interest rates in February. To some extent that move took the markets by surprise and though they have had a month to get used to the idea, there still seems to be some confusion as to what the next moves will be from here.

A futher cut in rates is a definite possibility and there may be some finessing of the policy. Perhaps through the adoption of a tiered approach ala Japan, such that individual consumers would effectively be shielded from the day to day implications of those negative rates.

That said sub-zero rates were introduced to encourage businesses and individuals to spend money rather than keep it in the bank. Consumers are a significant part of the Eurozone economy so this is not a given. At the same time negative interest rates encouraged money to flow into safe haven assets, such as German ten year bonds. Whose yields also fell below zero as a result. German bond yields have bounced back, above zero, in early March. However a further cut in Eurozone interest rates could send these and other Eurozone bond yields, back below zero. And in doing so undermine the effectiveness of the ECBs on going QE (bond buying) program.

The issues facing the ECB are summarised in the chart below. Which shows how the power house Germany economy is losing momentum at the same time that the rate of inflation there is turning lower once more , despite the ongoing ECB stimulus.

Chart shows German GDP growth and the German inflation rate.

Risk is back on the menu.

Markets have moved away from the Risk Off stance with which they started the year.We note that the VIX (CBOE Volatility Index) is trading at substantial discount to its 60 day EMA line . Readers will recall that we believe that "Risk Off" periods are signified when the VIX trades at 10% or more above that moving average. We can see further evidence of this "Risk On" attitude in the performance of some leading equity indices over the last week. The top five performers have been: The Brazilian Bovespa +18%, China A share index +7.8%, India's Sensex +6.4%, Japan's Nikkei +5.5% and the Spanish IBEX, also up by 5.5% (data as of close 05-03-2016). There is a clear bias here towards Emerging Markets and indices that have underperformed in 2016.

Commodities are also back in vogue, the FTSE 350 Mining Sector Index is up 31% year to date, having added almost 18% last week. Although I note that underlying commodity prices, as measured by the CRB Commodity Index, remain down by -4.4% in 2016 and so still have some work do.

To my mind none of the problems that caused the sharp sell off seen in the late summer 2015 and again in the opening weeks of 2016 have not been resolved. Rather they have been swept under the carpet once more and are therefore likely to raise their ugly heads once more at some stage in the near future.

Written By: Admirals