Plan B

Global and US equity markets are hitting new all-time highs at an almost metronomic rate while the VIX continues to hover around a historically-low 11. Moreover, major currencies have remained within narrow ranges in the past couple of months.

Rising global economic activity, still accommodative central bank monetary policy, a historically average crude oil price and increasingly realistic prospect of US tax cuts, among others, continue to buoy global financial markets and tame asset price volatility.

Financial markets have seemingly largely ignored macro, political and geopolitical risks which include 1) monetary policy uncertainty and risk of central banks “getting it wrong”, 2) the impact on emerging markets from higher rates and stronger funding currencies, 3) the shaky underpinnings of global economic growth and 4) political uncertainty in Europe.

The question is whether governments and central banks have a Plan B to reflate their economies and/or support financial markets in the event of an exogenous shock to global growth and/or sharp correction in global financial markets.

The willingness of the private sector in developed markets to borrow more in order to fund economic activity would likely be greatly tested given already high levels of indebtedness and I would not expect corporates or households to be the main source of reflation.

Similarly, the ability and willingness of developed central banks to cut policy rates further and re-start QE programs would be limited in my view.

Precedent suggests that central banks in emerging markets, including China, would likely use considerable FX reserves of around $8trn to slow, if not stop, any shock-induced, rapid and/or sustained depreciation in their currencies.

However, aggregate data mask significant country-side variations while large percentage changes in FX reserves tell us little about their absolute size.

Governments in developed economies could ultimately take over from central banks in a more pivotal role while the governments of China and other Asian economies have repeatedly shown their willingness and scope to use a broad arsenal of measures.

Read the article in full on my blog.

Chinese Renminbi – Squaring the Circle

China’s exchange rate policy is one of many significant uncertainties or “known-unknowns” for 2017 (as it arguably was in 2016 and prior years).

The market’s focus is still very much on the rise in USD-CNY but Chinese policy-makers are keen to emphasise the importance of the Renminbi’s performance against a basket of currencies – the CNY Nominal Effective Exchange Rate (NEER). This comes as no surprise.

The monthly pace of CNY NEER appreciation or depreciation has rarely exceeded 3% in the past seven years, suggesting that policy-makers have sought to control the Renminbi’s rate of change.

Large (and well documented) capital outflows from China have been the main source of Renminbi pressure but China’s current account surplus-to-GDP ratio has also edged lower to around 2.5% due to a rising deficit in the services balance. This perhaps dents the argument that the Renminbi is still materially undervalued.

Moreover, despite the Renminbi’s gain in competitiveness in the past year, China’s trade surplus has somewhat counter-intuitively shrunk, not increased. This may be due to price effects outweighing demand-effects (for exports) and still strong credit-fuelled Chinese imports.

In response to quarterly capital outflows of between $100bn and $200bn since late 2015, the PBoC intervened in the FX market to the tune of about $280bn in January-November.

This strong commitment likely reflects the perceived economic and geopolitical benefits of limiting the Renminbi’s depreciation.

Near-term, I think the PBoC may continue to see some value in a broadly stable Renminbi or only very modest CNY NEER depreciation. If capital outflows re-accelerate this would likely require the introduction of further capital controls and aggressive FX intervention. This is certainly an option in the short-run.

If capital outflows stabilise or recede, the PBoC may be able to slow or even stop FX intervention. This is not a totally unfeasible scenario if global yields stabilise and a slightly stronger CNY attracts capital back into China or if capital controls take greater effect.

In the more unlikely scenario whereby China experiences capital inflows, which last happened in Q1 2014, I would expect the PBoC to have limited appetite for rapid and/or sustained Renminbi appreciation and instead use this opportunity to rebuild FX reserves.

Chinese PMI very sensitive to underlying economic activity

China’s official and (unofficial) Caixin manufacturing data for May will be released tomorrow and Friday before the usual deluge of monthly economic indicators. Markets tend to give weight to the early release of PMI data in the world’s second largest economy and the question is whether this is justified.

There was a good correlation up till about 2012 between China’s official manufacturing PMI and exports, imports, industrial output, retail sales and GDP, with the added advantage of the PMI leading by a couple of months. But since then these correlations on the surface appear to have broken down, even if we use the sub-components of headline PMI.

The main issue is seemingly one of calibration. Since 2012, the official manufacturing PMI has only fallen marginally in a narrow 49.0-51.7 range while monthly economic indicators have weakened considerably. If we shorten the time scale, the PMI’s correlations with monthly data again look reasonable.

Markets need to take into account this increased sensitivity of the PMI data, as small moves may ultimately be associated with significant changes in underlying economic activity.

Even so, the official manufacturing PMI has seemingly over-estimated China’s economic strength in recent months. An alternative view point is that monthly economic indicators are about to rebound quite sharply.

The unofficial Caxin manufacturing PMI data – which have been more volatile than the official measure – and the official non-manufacturing PMI have even over longer time-frames been somewhat better correlated with monthly economic indicators. They too point to a rebound in economic activity in coming months.

You can read the full article on my website.