London-based Prologue Capital is holding 50 per cent less risk compared to when the markets were safe from the threat of a liquidity pullback.
At a breakfast presentation hosted on 19 June 2013, David Lofthouse (pictured), principal and chief investment officer of Prologue Capital – which aims to deliver low volatility returns in global fixed income markets – said: “Now there is doubt. The liquidity tap could be turned off. This will create choppy, though not bear market conditions, in fixed income. For us, that means taking less risk on the margin until we get further clarity.”
Looking at the Japan market, the government is getting backed into a corner and might need to respond again as JGB yields continue to rise – although the 10-year JGB yield fell 2.5 basis points to 0.835 on 20 June 2013 as US 10-year Treasuries reached a 15-month high. Nevertheless, since the Japanese government announced plans of 4 April 2013 to inject USD1.4trn into the Japanese economy to kickstart growth in the economy, JGB yields have steadily risen from 0.315 per cent.
Tomas Jelf, partner and chief economist at Prologue Capital, says: “They deployed their full arsenal at the time as they expected enough time for the government’s growth policies to be worked through. I do think they are surprised by the extent of the pullback; I think the magnitude of the pullback is still in the danger zone.”
He adds that one mistake the Bank of Japan made was not to communicate clearly enough what they intended to do if they reached the two per cent inflation target.
Europe remains a difficult market to get excited about. It remains firmly in the clutches of a credit crunch, with credit growth continuing to contract despite the ECB’s best efforts. At the same time, unemployment levels in Europe continue to head north, whilst those in the US and UK show signs of improvement. At a recent press conference, ECB President Mario Draghi said that the growth of loans to the private sector continued to be weak, adding that the annual negative growth of loans to non-financial corporations increased from -1.3 per cent in March to -1.9 per cent in April.
“Monetary policy in Europe needs to stay loose for a long time yet, you haven’t got any cyclical lift at in the European markets. We expect monetary policy to become proactive again at some point,” says Jelf.
The outlook for the UK is more upbeat. Ian Amstad, senior economist at Prologue Capital, says that one sector that is expected to deliver positive growth, over and above the expected 0.3 per cent growth per quarter, is housing, even though mortgage approvals remain depressed.
Amstad says: “If that were to move by 50 per cent over the next couple of years it would take provide quite a large stimulus to the economy. Whilst the banks are not in great shape, we think Carney will adopt a pragmatic approach and try and get the flow of lending going.”
The house view on the UK, says Amstad, is that further monetary policy easing will be necessary due to the significant slack in the economy. The IMF estimates a four per cent output gap; the largest ever output gap for the UK. Even by the end of the forecast period, 2018, they still expect that gap to be two per cent.
Another reason is the fact that wage inflation is running at such low levels; around one per cent.
Amstad says that with respect to how monetary policy may play out, it expects “forward guidance” to be the most likely innovation under Carney, despite the scepticism.
“We think a Fed-style forward guidance would be attractive. Under Carney we expect to see this, if not in August, then soon after.”
On China, there are real concerns over the potential pace of slowdown in the economy. Admittedly, there was a recovery of sorts in 2H12, but this year things have continued to cool.
One of the main reasons for this is because the new government is looking to deal with the issue of shadow banking in China, before it gets too much of a mess. This, says Amstad, is at the top of the list of concerns for China’s growth outlook.
“They need to deal with this issue of rapid credit growth. Banking system credit (including shadow banking) is now 200 per cent of GDP. It was 125 per cent of GDP before the financial crisis. That’s high, even by Western standards. Factor in government and household debt and it’s probably on par with the US in terms of total economy wide debt:GDP, which for an emerging market is rather worrying.”
To clarify, shadow banking in China involves banks extending credit lending off balance sheet and non-bank financial institutions extending credit by issuing wealth management products.
It has a perfectly legitimate function in terms of supplying credit to SMEs, but if the plan is to reign this activity in, and prevent a credit bubble, it will create collateral damage for Chinese SMEs, and the wider economy; hence the bearish outlook.
“Over the medium term there could be some form of bank crisis in China, so the issue for us is what impact and systemic risk might that have on the rest of the world?
“There are, however, a number of mitigating circumstances. Firstly, the banks are predominantly made up of domestic deposits. Secondly, the PBOC has built up a significant liquidity buffer through raising reserve requirements – approximately CNY19trn in reserves – so these could be drawn down aggressively in the event of a bank run,” says Amstad.
