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November 24, 2014

Are Central Banks Panicking?

By Leo Kolivakis for Pension Pulse

Koh Gui Qing and Jason Subler of Reuters report, China surprises with interest rate cut to spur growth:
China cut interest rates unexpectedly on Friday, stepping up efforts to support the world's second-biggest economy as it heads towards its slowest expansion in nearly a quarter of a century.

The cut, the first in over two years, came as factory growth has stalled and the property market, long a pillar of growth, has remained weak, dragging on broader activity and curbing demand for everything from furniture to cement and steel.

"It's comes right after China's disappointing PMI figures showing that manufacturing activity is getting dangerously close to contraction," said Alexandre Baradez, chief market analyst at IG in Paris, referring to a private factory survey this week which added to worries about slowing global growth.

"China's central bank is now following the path of the Fed, the ECB and the BoJ. Central banks are really driving markets," he said.

Just a few weeks ago, Chinese President Xi Jinping had assured global business leaders that the risks faced by China's economy were "not so scary" and the government was confident it could head off the dangers.

In a speech to chief executives at the Asia Pacific Economic Cooperation (APEC) CEO Summit, Xi said even if China's economy were to grow 7 percent, that would still rank it at the forefront of the world's economies.

The People's Bank of China said it was cutting one-year benchmark lending rates by 40 basis points to 5.6 percent. It lowered one-year benchmark deposit rates by less - just 25 basis points. The changes take effect from Saturday.

"The problem of difficult financing, costly financing remains glaring in the real economy," the PBOC said.

LIMITING THE IMPACT

The central bank also took a step to free up deposit rates, allowing banks to pay depositors 1.2 times the benchmark level, up from 1.1 times previously.

"They are cutting rates and liberalising rates at the same time so that the stimulus won't be so damaging," said Li Huiyong, an economist at Shenyin and Wanguo Securities.

Recent data showed bank lending tumbled in October and money supply growth cooled, raising fears of a sharper economic slowdown and prompting calls for more stimulus measures, including cutting interest rates.

But many analysts had expected the central bank to hold off on cutting interest rates for now, as authorities have opted instead for measures like more fiscal spending, as they also try to balance the need to reform the economy.

Chinese leaders have also repeatedly stressed they would tolerate somewhat slower growth as long as the jobs market remained resilient.

More recently, the central bank injected cash into the system in the form of short-term loans to banks in an attempt to keep down borrowing costs and encourage more lending even as bad loans increase.

But a growing number of economists said those moves were not translating into either lower financing costs or more credit for cash-starved Chinese companies.

Analysts expressed doubts over whether the impact of the rate cut would find its way into the real economy, either, as the cooling economy makes lenders more risk-averse. Some predicted multiple cuts would be needed well into next year.

Hurt by the cooling property sector, erratic export demand and slackening domestic investment growth, China's economy is seen posting its weakest annual growth in 24 years this year at 7.4 percent.

China's rate move comes after the Bank of Japan sprang a surprise on Oct. 31 by dramatically increasing the pace of its money creation, while European Central Bank President Mario Draghi shifted gear on Friday and threw the door wide open to quantitative easing in the euro zone.

"There is definitely more concern around about the state of the global economy than there was a few months ago, you see that not just when you talk about Europe," British finance minister George Osborne told an audience of business leaders in London on Friday.
Reuters also reports world shares surged on Friday as China surprised markets with its first interest rate cut in more than two years and the European Central Bank's Mario Draghi threw the door wide open to full scale money printing:
European shares and other growth sensitive commodities all leapt as China's move to cut rates to 5.6 percent gave markets a welcome lift after a week where data has shown its giant economy heading for its worst year in almost quarter of a century.

It came as ECB head Draghi spoke in Frankfurt of his determination to use more aggressive measures such as large scale asset purchases -longhand for money printing- to ensure the euro zone did not slump into a new crisis.

"We will continue to meet our responsibility - we will do what we must to raise inflation and inflation expectations as fast as possible," Draghi said in a heavyweight speech.

"If on its current trajectory our policy is not effective enough to achieve this ... we would step up the pressure and broaden even more the channels through which we intervene."

Both the euro zone and China have been lagging the momentum of the United States, stimulus-driven Japan and faster-growing Britain over the last month, but a ramping up of the ECB's rhetoric and Beijing's actions will stoke hopes of a turnaround.

Germany's DAX, France's CAC and pan-regional Euro STOXX 50 were all up between 0.8 and 1 percent by 1230 GMT, leaving them on course for weekly gains of 4.5 percent, 2 percent and 2.4 percent respectively.

"The two together, (China cut, Draghi speech) suggest to me there is still a lot of hard policy work to be done next year," said Neil Williams, chief economist at fund manager Hermes in London.

Beijing's move also carried a hint of an escalating currency tussle in Asia.

A sharp fall in the yen this year as Tokyo has introduced wave after wave of stimulus, has been putting the squeeze on China's exporters due to a loss of cost advantage.

Japanese Finance Minister Taro Aso said on Friday that the yen's fall over the past week had been "too rapid". It was one of the strongest warnings against a weak yen since the aggressive stimulus efforts began two years ago and saw the currency leap off a 7-year low to 117.98.

OIL SURGE

Currency markets everywhere were shaken into life by China's move and the signals coming out of Frankfurt.

The euro fell sharply, slicing its way back down through $1.25 to $1.2430, while 10-year Italian government bond yields, which have been one of the biggest beneficiaries since Draghi took charge of the ECB in 2011, hit a new all-time low.

Hopes that China's growth will now quicken provided a shot in the arm for the Australian dollar, often used as a more liquid proxy for Chinese investments, and likewise lifted other key commodity currencies. 

The rate cut also added to a positive mood among oil traders, many of whom expect the Organization of the Petroleum Exporting Countries to trim production, at what looks to be a landmark meeting in Vienna on Nov. 27.

Oil jumped 2 percent, or $1.75 to $81.07 a barrel as it surged towards its first weekly rise since mid-September in its biggest daily rise in a month.

ALL RISE

Global investor sentiment was also underpinned by record finishes by the Dow Jones industrial average and S&P 500 on Thursday after a spate of upbeat U.S. data that offset the recent signs of spreading weakness in China and Europe.

Wall Street was expected to add a further 0.6 percent when trading resumes with the day's upbeat sentiment expected to more than make up for a lack major data.

In emerging markets, Russia's rouble, which is closely tied to the fortunes of oil, was heading for its first weekly rise since early September as the pressure it has been under eased.

Copper and gold also got a lift, with the red metal up 1 percent and spot gold climbing to $1,197 an ounce as traders cheered the prospect of more global stimulus.

"Commodity prices have risen across the board," said Carsten Fritsch, senior oil and commodities analyst at Commerzbank. There is hope that this step (lower Chinese interest rates) will lift commodities demand."
So what's going on here? China's surprise interest rate cut comes a few weeks after the BoJ's Halloween surprise. Global stock an commodity markets are rejoicing after this latest central bank "surprise" but I'd be very careful here because after the initial knee-jerk reaction, reality will settle in.

And the reality is that apart from the United States, the world economy is very weak, with many big economies are teetering on recession. Nowhere is this more alarming than in Europe where shrinking incomes are wreaking havoc on periphery and core economies:
Seven years after the financial crisis first struck in 2007, Europe continues to teeter on the brink of a recession. Many economies in the region are yet to regain the levels of per capita income they saw in 2007. For some, incomes are much lower than what they were seven years ago. The accompanying chart shows those European economies that continue to see a fall in per capita incomes, computed in their national currencies at constant prices, compared with 2007. The data have been taken from the International Monetary Fund’s World Economic Outlook database, updated in October.

Greece has been the worst affected, but it is not only southern Europe that has been hit. Incomes in Finland, Denmark, Luxembourg and Norway are still considerably below where they were in 2007. While there’s much talk of a recovery in the UK, per capita incomes there are still below their 2007 level (click on image below).


The weakness in Europe will have several consequences. The obvious one is exports to the region will suffer. The frailty of the euro zone will ensure that monetary policy at the European Central Bank will remain easy for a long time and the ultra-low interest rates there will be a source of liquidity for global markets. Further, with incomes not rising, fresh investments in Europe are likely to be delayed. As a result, funds are likely to move out of Europe to greener pastures, to markets such as India.

The long stagnation in Europe is already having social repercussions, with mainstream parties losing ground to populists of the right and the left. But the stark question that confronts Europe today is: in an era of globalization and footloose capital, is it possible for its welfare states to survive? Or, is the welfare state a hoary relic of a bygone Keynesian age?
Indeed, I visited the epicenter of the euro crisis in September and saw deflation in the form of much lower wages and pensions. I also witnessed how the bloated public sector keeps thriving, weighing Greece down. And this isn't just a Greek problem.

Importantly, as long as Europeans keep putting off major structural reforms, their deflation crisis will just deepen and potentially spread throughout the world, including the United States. Everyone is underestimating the risk of deflation coming to America but I think global central banks are terrified of this prospect and will do anything they can to fight deflationary headwinds spreading throughout the world.

The big question remains will the titanic battle over deflation sink bonds? I don't see it and apparently neither does George Soros who just handed Bill Gross at Janus $500 million of his money to manage. 
And if deflation does eventually come to America, all those global pension funds flocking to riskier investments are going to get clobbered. 

But for now, markets are rejoicing, hoping for the best. You're seeing a major relief rally going on in energy (XLE) and materials (XLB). Beaten down sectors like coal (KOL), gold (GLD) and oil services (OIH) and especially stocks like Freeport-McMoRan (FCX), Cliffs Natural Resources (CLF)
Petrobras (PBR) and Vale (VALE) are all rallying hard off their 52-week lows on Friday as investors think the latest central bank moves are all positive for the global recovery.

I haven't changed my outlook at all. I think short-sellers are licking their chops and using this relief rally to add to their short positions in these sectors and stocks. Be very careful here, don't read more into China's surprise interest rate cut than the fact that they're very worried and we can be on the precipice of a major currency war which will propel the mighty greenback higher and commodity and oil prices lower. 

Deflation will be the final nail in the coffin. I had an interesting exchange earlier this week with an astute private equity investor who shared these comments with me on Yves Smith's latest rant against private equity and Blackstone:
Some truths mixed in with rants which could apply to any and all facets of the investment industry. If you don't like Blackstone, don't put money with them. PE even in its golden age did less well across the board then generally perceived, but has played its role reasonably well in dealing with the unpleasant reality of mature companies in mature economies. The bigger picture involves risks around deflation, China, quiet changes to the ISDA contracts that govern counterparties, etc. these things matter more.
I want you all to keep this in mind as global markets rejoice the latest "surprise" move by a central bank.  

Having said this, the deflation scenario I have in mind is still a few years off. This is why I told my readers to plunge into stocks in mid October but to choose their stocks and sectors carefully:
I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come.

Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

Are there other stocks I like at these levels? Yes but I'm waiting to see what top funds bought and sold in Q3 before delving into more stock specific ideas. All I can say is tread carefully here and know when to buy the dips and more importantly, when to sell the rips.
This is still very much a stock pickers market. If you ask me, it's too late, the ECB has pretty much lost all credibility and is well behind the deflation curve and central banks in Asia are right to fear the worst. Stay tuned, the macro environment is about to get a lot more interesting going into 2015.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

Courtesy Leo Kolivakis, founder of Pension Pulse (EconMatters author archive here)

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