Monday, September 21, 2015

Michael Pettis notes

I heard Michael Pettis speak last week. Here are my notes:

Key conclusions

·         China - we should applaud a sharper growth slowdown, as this would make non-destructive adjustment more likely

o   Low capital stock/capita relative to DM is not a good argument to justify high investment/GDP

o   Watch for SOE privatization, transfers of wealth to households and centralization of power under President Xi Jinping

o   Low chance of further CNY devaluation


1.       EM countries have had two unique problems

a.       Very low savings rate

b.      Private sector does a very poor job of identifying productive investments

2.       Old solution was to push up savings, keep savings in the banking system, and have gov't direct investments

a.       How do you force up the savings rate?

                                                               i.      S=GDP-C

                                                             ii.      Reduce consumption (C) by reducing household income share of GDP

                                                            iii.      Side note: need to distinguish hhld savings from total savings

                                                           iv.      Hhlds in China spend as much as other countries - Chinese hhld savings aren't abnormally high

                                                             v.      Total savings are high because hhld income share of GDP is low

3.       Brazil's model - raises taxes, use domestic savings to fund investment

4.       East Asia / Japan model - raises implicit not explicit taxes

a.       1st tax - undervalued FX

                                                               i.      Similar to a consumption tax on imports

                                                             ii.      Subsidizes tradable goods sector

                                                            iii.      Reduces growth of hhld income

b.      2nd tax - have wage growth lower than productivity growth

                                                               i.      Lowers ULC

c.       3rd tax - financial repression

                                                               i.      Set bank deposit rates extraordinarily low

                                                             ii.      Huge transfer from net savers to net borrowers (SOEs, local govts, producers of GDP)

5.       Old argument in favor of high investment/GDP: China has very low capital stock per capita and this needs to converge with DM

a.       This is nonsense - the causation is backwards

b.      Countries aren't rich bc of high investment

c.       Countries have high investment bc they're rich

6.       China started misallocating investment in late 1990s

a.       NPV was less than cost of investment

b.      This leads to debt levels rising faster than debt servicing capacity

7.       Now China is trying to increase hhld wealth at expense of gov't

a.       Two ways to do it

                                                               i.      Japanese way: transfer debt from private sector to gov't

                                                             ii.      Hopefully, China transfers assets & wealth from gov't to private sector

b.      Turning point was (ex-)Premier Wen Jiabao's 2007 four "un"s speech: China is unstable, unbalanced, uncoordinated, unsustainable

c.       Rebalancing are rarely successful

                                                               i.      Historically, only successful under democracies (US in 1930s) or highly centralized autocracies (Deng Xiaoping), but countries in the middle of the political spectrum have a lot of trouble

                                                             ii.      Xi Jinping needs to become Deng Xiaoping and centralize power in order to pass reforms

8.       Ideal slowdown would be for growth to decrease by 100-150bps a year until end of decade

a.       Try to control credit growth -> Inv falls, C is maintained -> GDP falls

b.      Japan in 1990-2010: while GDP grew slowly, consumption growth was steady

c.       Problem is that this comes at the cost of vested interests

                                                               i.      Anti-corruption is about destroying vested interests which benefit under current policies

d.      1st group of reforms is to reduce implicit taxes - this has more or less happened

                                                               i.      Wages are growing as quickly as productivity

                                                             ii.      FX is not undervalued as much as before, look at trade weighted CNY not just USDCNY

                                                            iii.      Standard trade theory says deleveraging low growth DM should have surpluses against high growth China

                                                           iv.      Imbalances have peaked and there have been small improvements - consumption share of GDP has risen 2-3% since bottoming in 2011

                                                             v.      Financial repression has been resolved

e.      2nd group of reforms is actual wealth transfer - hasn't happened yet

                                                               i.      Hopefully starts end-2015 or 2016

                                                             ii.      Third plenum reforms are all about transfer wealth to hhld

1.       Hukou residency reforms - this will allow migrants to have educational/social services/welfare, which will make them richer

                                                            iii.      March 2015, Shandong province announced a transfer of SOE shares into their pension fund

1.       Unfortunately, not a very efficient transfer

2.       Depends on credibility of the pension fund, which is low

3.       Downside is that Shandong inhabitants prob don't feel richer and thus spend more

4.       One virtue is that because the gov't controls the pension fund, it doesn't lose control of the SOE

5.       SOE profitability goes to hhld, but not control

9.       China needs to give up on the 7% growth target

a.       Best-case scenario: 2013-2023 avg growth is 3-4%

                                                               i.      The faster they slow, the less likely the chance of a destructive adjustment

                                                             ii.      West needs to stop applauding high growth numbers from China - we should applaud a sharper slowdown

                                                            iii.      You can have any growth you want - e.g. US could easily have 10% growth today through a credit boom but would  lead to very painful adj later

b.      GDP target is for domestic political purposes

                                                               i.      If they relax this, XJP can be confident about reform

                                                             ii.      If privatization speeds up, this is good - watch for developments here

                                                            iii.      Only just started the adj process, iron prices could fall further

                                                           iv.      Need to recognize losses so that they can allocate capital efficiently

c.       Bad case scenario: 7% for 2-3y then debt capacity limits are hit and system collapses

                                                               i.      If gov't backs all debt, then debt won't stop growing

                                                             ii.      Banking crises usually allocate losses to hhld

                                                            iii.      In China, C needs to replace Inv, so hhld can't take losses

d.      More than 50% chance of best-case scenario (non-destructive adj)

10.   Composition of state reserves is secret, may have illiquid assets

a.       However don't worry, China can take many measures

                                                               i.      E.g. stop outflows with capital controls or devalue FX

b.      Gov't monetizes inflows, prints and buys dollars

c.       Now capital acct outflows are larger than current acct inflows

11.   Low chance of further FX devaluation

a.       PBoC is opposed to further FX deval - PBoC not going to quickly liberalize/internationalize the FX

b.      FX deval transfers wealth from hhlds to tradable goods sector - opposite direction of the correct rebalancing

c.       FX deval might increase outflows

d.      FX overshooting occurs when there's lots of external debt - China doesn't have much

e.      China is pouring reserves to prop FX

f.        If outflows continue at high levels, then they need another solution

                                                               i.      Re-peg? Low chance, this would be a huge loss of face

12.   The idea that the offshore CNY rate (CNH) is a pure mkt expectation of where CNY will go is WRONG

a.       SOEs have ways to arb CNH and CNY - the frictional cost is <2%

b.      SOE will no longer misallocate bc IR are high

morning market color

Greece - Syriza won 145/300 seats, more than expected

o   will need to form a coalition, likely with previous partners Independent Greeks (10 seats)

o   Syriza is bound to austerity program and committed to implementation - this outcome removes ST risks

o   in the prev election, bonds sold off on a Syriza win; on the other hand, now it's a relief to get Syriza elected

·         Fed - mkt can deal with good news or bad news, but it hates uncertainty

o   Sept 17 meeting gave less clarity than mkts would like

o   futures pricing in 51% chance of no hike this year

o   13 "dots" looking for hike this year

o   US tsy 2y yield peaked at 80bps, fell to 66-68bps after the Thurs meeting, now back up to 70bps

o   Yellen speaking on Thurs - hopefully schedules a press conference for the October mtg, but unlikely

·         HY correlates better with eqy mkts than EM mkts

·         Credit spreads widening out while eqy mkts are stabilizing/up - are fixed income investors seeing sthg that eqy guys aren't?

·         Q3 earning season starts in the next couple of weeks

o   historical trend has been for expectations decline to during the course of the previous quarter, earnings beats this declined exp

o   ^ this hasn't happened this quarter

·         Volkswagen (VLKAY) - admitted that their cars met emissions standards only during tests and not on the road

o   diesel sales are halted - this is ~one-quarter of US sales

o   potential penalties/fines of billions of dollars

o   shares down 20% overnight

·         DAX is still up +11bps despite VW

·         Alibaba (BABA) - share lockup period on 63% of shares is ending, may lead to ST weakness

·         Data flow is focused on the US this week

o   M: US existing home sales at 10am

o   T: US FHFA house prices

o   W: PMI day (China, EZ, US, Japan)

o   Th: US durable goods, new home sales

o   F: US Q2 GDP 3rd revision, UMich consumer survey

Thursday, September 17, 2015

notes from Ben Bernanke

I had the opportunity to hear from (and even ask some questions to) Ben Bernanke last week at a conference. Here are my notes. My impression is that he would NOT hike right now, but you can decide for yourself:

1.       US is doing pretty well

a.       Heart of the recovery will be will be housing sector - housing recovery is only mid-cycle, will continue to provide gains

b.      US is in a virtuous cycle - increased job creation, higher incomes, low energy prices, better balance sheets due to deleveraging, and more wealth

c.       Hhlds feeling good, decent consumer spending

d.      Domestic economy is firing its cylinders

2.       Biggest puzzle is low inflation and wage growth

3.       Potential growth trend can be decomposed into labor force growth and productivity

a.       On productivity growth, I'm a modest optimist

b.      I would expect this to snap back - things that go down will go up

c.       R&D spend is coming back

d.      Mkts are open, lots of credit availability

e.      Low productivity growth means high job creation and low GDP growth

4.       Fed pays more attention to labor force slack than GDP slack

a.       That's why the Fed is considering hiking despite the output gap

5.       Main risks to US recovery are from abroad

a.       Strong dollar

b.      Weakness in trading partners

c.       I was surprised by the recent mkt reaction to China

                                                               i.      Influence of China on US is indirect and small

                                                             ii.      They're entering the classic middle income trap

                                                            iii.      Hitting the limits of its growth model

d.      China is making gradual, deliberate and careful movement towards mkt and reforms

                                                               i.      Avoid rapid capital flows which are hard to control

                                                             ii.      PBoC is not independent, the admin (XJP & LKQ) will always wins against the PBoC

1.       Gov Zhou is very capable and reform-oriented, but nearing retirement age

                                                            iii.      There's different stories internally about why you want to move to a flexible FX rate

1.       Admin wants to ease monetary policy and to strengthen domestic economy

2.       PBoC, on the other hand, emphasizes reform

e.      China influences the Fed significantly

6.       Financial conditions are now tighter than before; lower eqy prices and higher spreads

a.       This weakens the economic outlook in the Fed staff models

b.      Volatility makes the Fed more cautious than otherwise

                                                               i.      Is the mkt seeing something that we don't understand?

7.       An analogous period to now would be Sept 2013 (see chart below)

a.       After the taper tantrum of May 2013, mkts were expecting taper but we didn't do it

b.      Financial conditions were tighter, mortgage rates risen quite a bit, we believed these conditions were not consistent with tighter MP

c.       We are seeing the same thing now

d.      August 2013 labor figures got revised up as it often does

e.      Tapering in December was the right decision

8.       Timing of the first hike has a lot of informational content despite the small size of the move itself

9.       One aspect of today is that we're at zero

a.       Cost of overshooting and going too soon is higher than otherwise

b.      We'd need to come back to zero and we don't really have any reliable tools at zero

c.       Fiscal policy is off the table

d.      Nobody has ever gotten off of zero - everyone finds themselves back at zero

e.      Take Sweden in 2010-2011  - they raised rates from 0.25%->2%, now they're back at zero!

10.   Look at Stan Fischer's comments at Jackson hole

a.       Ultimately we believe in the Phillips curve and that inflation will come back

b.      Lags in policy, takes some time for ZIRP to work

11.   One of the considerations for MP is financial stability issues

a.       Don't fully understand the linkages with MP

b.      MP is too blunt of a tool - SF Fed study showed that in order for the Fed to pop the 2000s housing bubble, would have had to raise FFR 800bps

12.   Yield curve is forecasting very low future FFR, lower than Fed's forecasts

a.       Risk premiums on long bonds are very low and maybe even negative

                                                               i.      Permanent reasons: less fears of inflation, safe haven demand, portfolio preferences

                                                             ii.      Temp reasons: inflation beta may change, hedge value goes down, global savings glut diminishing (China selling tsys, Europe becoming less of a net saver)

                                                            iii.      Negative risk premiums occur when dangers of deflation/disinflation are high, high hedge value for bonds

                                                           iv.      Higher risk premiums will help mkt forecast converge with the Fed's

b.      If the YC flattens or reverts, this is bad news, I hope this doesn't happen


Mkt action in Sept 2013 (vertical line is the Fed meeting)


White is S&P 500

Orange is TLT, the long bond etf

Yellow is UUP, the bullish USD etf