GavekalResearch
The Gavekal Monthly
A Possible
Return Of US Inflation
November 2015
The Gavekal Monthly – November 2015
Overview
Louis’s Take
Watch Out For Inflation’s Return
Louis-Vincent Gave
3
US Growth
The False Recession Alarm
Will Denyer/Tan Kai Xian
Europe
More Easing On The Way
François-Xavier Chauchat 16
China
Will Construction Ever Recover?
Rosealea Yao
Key Calls
12
20
Dashboard
Our Views In Brief Economies, Markets, Themes
24
Indicators
27
Growth, Risk, Inflation, QE
GavekalResearch
2
Louis’s Take
Watch Out For Inflation’s Return
Louis-Vincent Gave
lgave@gavekal.com
GavekalResearch
3
When the Fed worries, worry about something else
• After a tempestuous summer, October was a strong month for most risk
assets with the S&P 500 delivering its best monthly performance in four
years. This performance was all the more impressive since October tends
to be a challenging month for risk assets.
• Several factors contributed (see our last monthly for details), but perhaps
most important was the Fed’s dovish decision to “wait and see” before
hiking rates. This stalled the US dollar’s rise, which in turn gave breathing
room to stressed emerging markets. This brings us back to the old adage
that “when the Fed worries about something, it is time to worry about
something else”.
• The Fed was clearly worried about China: a possible devaluation, potential
financial contagion, and greater stress in emerging markets.
• We believe worries about a Chinese financial market contagion are
overblown; and most macro and financial data in the past month have
confirmed our view. China concerns are becoming “so summer 2015.”
• A more profitable thing to worry about now is a return of inflation in
the G
US.
4
avekalResearch
The ‘China Panic’ has abated: four steps to
financial stabilization
Step 1: Central bank data shows that the contraction in reserves is abating and
was mostly the result of foreigners panicking rather than Chinese people quitting
on the renminbi.
Step 3: The difference between the onshore (CNY) and offshore (CNH)
renminbi dwindles to meaningless territory, highlighting the lessening of financial
stress:
GavekalResearch
Step 2: Local bond markets make new highs and spreads collapse,
highlighting lack of domestic financial stress. The dim sum bond market
starts to follow and hits new highs.
Step 4: Domestic equity markets move higher once again on strong
volumes, without government intervention. Particularly telling is the all-time
volume high in the ChiNext small cap exchange. Animal sprits have yet to be
broken!
5
Commodities may have found a floor
With every passing week, the collapse in commodity
prices recedes further into the rearview mirror. Oil is
particularly important: starting around NovemberDecember, the annual base effect of the oil price
collapse on global consumer price indexes will
start seriously abating.
GavekalResearch
Of course, commodities could easily take another step
down. China keeps slowing, growth across the
western world remains anemic, and so on. Having
said that, this information has now been processed
well by the market. So the more likely scenario is that
in the coming months, the stabilization of commodity
prices no longer drags CPI readings lower.
6
The US dollar has topped out
The US dollar is basically trading at the same level as
it was on August 11, the renminbi’s “devaluation
day”—despite a meltdown in emerging market
currencies, a very dovish European Central Bank,
capital outflows from China, etc.
GavekalResearch
Unless the dollar takes another leg up soon, we
should see the annual change in the US import price
indices move back towards zero, or even positive
territory. After all, back-to-back -5% contractions in
quarterly import prices usually only occur when
something big happens (Asian Crisis, TMT bust, 2008
GFC). Looking ahead, it seems likely that import
prices will start contributing positively to inflation.
7
Wages and rents are rising
From Walmart, to FedEx, to NetJets, anecdotal
evidence keeps coming in that wages are moving
higher. Several recent earnings disappointments (e.g.
Walmart) were laid at the feet of rising labor costs.
So far this anecdotal evidence has yet to filter through
to the monthly data on wages. This could change now
that the US$ is no longer rising: a rising dollar keeps
wages in check through the threat of offshoring.
GavekalResearch
Rents are another inflationary factor: since 2010 the
number of homes for rent in the US has shrunk by
1.4mn units and is now barely above the year 2000’s
level. Meanwhile, the population of young renters has
grown by 9.5mn individuals since 2000.
Already, anecdotal evidence shows that rents are
shooting higher in many US cities: San Francisco,
New York, Seattle, Los Angeles.
8
Inflation could be the hot-button issue of 2016
In sum, if the next few
months see a
combination of a stable
dollar, stabilizing
commodity prices,
rising US wages, and
rising rents, then it is
hard to see how US
inflation will stay low.
That is a big set of ifs, of
course. Yet interestingly,
one of our favorite
gauges of inflation, the
Cleveland Median CPI, is
already hovering at postGFC highs.
GavekalResearch
9
If inflation picks up, the ‘pain trade’ will continue
US + Chinese
consumers keep on
consuming
Cyclicals everywhere
outperform
US trade balance
deteriorates
Foreign central bank
reserves rise again
EM equities outperform
in US$ and local
currency terms
EM currencies start
to stabilize
China devaluation fears
abate and the renminbi
rises on short covering
Dim sum and EM bond
yields come down
The PBOC slashes interest
rates without a fall in the
renminbi
GavekalResearch
The “pain trade” began in
September (see Is The
Bull Market Over? (II)).
The stalling of the dollar
bull market, and the
easing of the China
panic, started a rally in
EM, beaten-up cyclicals
and industrials.
A pickup in US inflation
would amplify the “pain
trade.” Stable US growth
stocks and other “volume
monetizers” would derate; the outlook for
“price monetizers”
(cyclicals, EM) would
brighten.
North Asia tends to do
well when US inflation
picks up. Asia is the
obvious place to offshore
production when costs
rise at home. And most
companies in Asia are
price monetizers.
10
Inflation bounce would likely lead to outperformance
in North Asia
GavekalResearch
11
US Growth
The False Recession Alarm
Will Denyer and Tan Kai Xian
wdenyer@gavekal.com, ktan@gavekal.com
GavekalResearch
12
US Growth The False Recession Alarm
What’s happening
What it means
• Consensus: growth is faltering and rate hikes will be delayed
The US payrolls report for until the middle of next year.
• Our view: largely due to a tightening labor market (less low
the month of September
came in surprisingly weak hanging fruit); hawkish stance indicates that the Fed holds
similar view; wage growth also remains supported.
Data continues to point to
zero US manufacturing
growth, but the service
sector remains robust
• Under the weight of a strong US dollar and weak global growth,
US manufacturing is no longer growing.
• The rise in inventory/sales ratios is particularly worrying.
• Yet the direct economic impact is arguably small, given
that manufacturing is just 12% of GDP and 9% of payrolls.
• The much larger service sector is holding up—being less
exposed to the currency and benefiting from the tighter labor
market.
US 3Q GDP slowed to
1.5% QoQ annualized,
with consumption being
the only bright spot
• US GDP is likely to continue to muddle through due to
widespread inventories build-up, weakening net exports and
slower capex.
• But the bottom line is that despite the softness in many
indicators, the return on invested capital for US firms is still
solidly above the cost of capital. So long as this holds, we
probably will not see a recession.
GavekalResearch
13
US Growth The False Recession Alarm
The US is experiencing numerous developments often
associated with recessions. But sometimes these
ominous signals flash and no recession occurs.
Examples include 1985, 1998, and, we think, today.
In all three cases, the US dollar rose to uncompetitive
levels. In turn, US manufacturing activity slipped and
inventories piled up.
GavekalResearch
And yet no recession occurred in 1985/86 nor in
1998/99. The service sectors continued to expand—
being less exposed to an uncompetitive dollar and
foreign competition. Moreover, in1998 the service
sector benefited from a US consumer strengthened by
low unemployment and wage growth accelerating in
fits and starts. We appear to be in the same position
today.
14
US Growth The False Recession Alarm
Corporate profits contracted in 1985 and 1998, as
today. And as a result, in 1985, 1998 and today
equities temporarily sold off and credit spreads
jumped. Indeed, with so many things going in the
wrong direction today, it is tempting to sell everything
and brace for recession.
But 1985 proved to be the middle of the cycle. After
the October 1998 pull-back, equities rose for more
than a year, and it was more than two years until the
2001 recession.
GavekalResearch
So how do we know when the situation is bad enough
for a proper downturn? We suggest watching our new
Wicksellian spreads, which measure the gap between
corporations’ cost of capital and their return on
invested capital. These spreads are narrowing, but are
still quite positive. So long as this holds, recession is
not around the corner (see A New Look At Capital:
Reassessing Cost And Return).
15
Europe
More Easing On The Way
François-Xavier Chauchat
fchauchat@gavekal.com
GavekalResearch
16
Europe
More Easing On The Way
What’s happening
What it means
• On a continent where immigration issues are increasingly
Hundreds of thousands of shaping politics, the migrant crisis is creating new political risks.
• The good news is that Germany and Sweden will loosen
migrants from Syria and
fiscal policy by 1% of GDP to address the issue.
other Middle Eastern
• The rise of the German population since 2010 has already
countries are heading to
surprised demographers, on the back of immigration from
Europe
Eastern and Southern Europe. More to come with the migration
from Syria.
Volkswagen admitted that
its installed “cheatware”
on 11mn vehicles in order
to pass emissions tests
• For now the shock seems manageable as VW announced that
modified software will cost the company €200 per vehicle. But
class action lawsuits could eventually lead to much higher costs.
• In the worst case scenario, the VW scandal could lead to a soft
patch in the German economic cycle, but given Germany’s huge
margins for maneuver, pessimism does not look justified.
On October 22 ECB
president Mario Draghi
hinted at further monetary
policy easing from
December
• Eurozone domestic demand remains resilient, but slower world
growth and a higher euro vs EM currencies are making the ECB
even more nervous about the risk of an anchoring of “lowflation”.
• The ECB will likely expand QE and possibly cut its deposit
rate further into negative territory, with positive
consequences for the domestic economy and for asset
prices.
GavekalResearch
17
Europe
More Easing On The Way
With its largest export champion in crisis—Volkswagen
lost -50% on the stock market since the emission
scandal started—and hundreds of thousands of Syrian
migrants crossing its borders, Germany suddenly
looks vulnerable.
Germany benefits from the best financial situation any
G7 country has ever enjoyed in modern times: a
current account surplus of 8.5% of GDP, and a fiscal
surplus. Even if the migrant crisis and the VW scandal
leads Germany to spend 3% of its GDP next year, it
But even if the VW crisis worsens, leading the German will still remain the safe haven of the G7. The main
risk is not on the economic front but rather the
government to bail the company out and finance the
political: are the German people ready for the
largest car-scrapping scheme in history, the worst
immigration shock?
case scenario remains easily manageable.
GavekalResearch
18
Europe
More Easing On The Way
Although not yet very strong, eurozone domestic
demand has continued to improve on the back of
lower oil prices and better credit conditions.
Still, the ECB cannot afford to be passive if it wants to
be credible in its fight against “lowflation.” Additional
deflationary pressures coming from a stronger euro
The ECB’s QE has already succeeded in considerably and from even lower commodity prices could lead to
reducing financial fragmentation. Bank interest rates in inflationary expectations anchored lower than target.
Italy and Spain have now converged on French and
In December the ECB is thus likely to announce
German levels, and banks are showing more and
further monetary easing: QE extension and probably
more willingness to lend.
another rate cut. This should ensure further gains in
domestic growth.
GavekalResearch
19
China
Will Construction Ever Recover?
By Rosealea Yao
ryao@gavekal.com
GavekalResearch
20
China
Will Construction Ever Recover?
What’s happening
What it means
Property sales have
picked up sharply since
May…
• Property sales rebounded strongly in response to multiple rate
cuts and other easing measures.
• Yet given the traditional two-year cycle, housing sales will
almost certainly be weaker in 2016.
…but unlike in past
cycles, construction has
not followed suit
• Historically, strong sales translate into construction and
investment, with a lag of 3-6 months. But sales and
construction have decoupled in 2014-15. Construction starts
fell -13% YoY in Jan-Sep and land sales fell -34%. Crude steel
use fell -5% YoY in Jan-Sept.
• The culprit is inventory overhang. Developers have no
appetite for new investment before inventory draws down
sufficiently.
Inventories are peaking
but have much farther to
fall
• City-level data shows inventories in Tier 1 & 2 cities fell quickly,
but inventories in smaller cities fell less. Our own broader
estimates show national inventories are just peaking, with
highest inventory levels in the smaller cities.
• This means more pain in construction is very likely in
2016. A recovery in construction activity is unlikely to occur until
2017.
GavekalResearch
21
China
Will Construction Ever Recover?
Construction overshot
sales in past years and
will have to undershoot
the demand trend. When
it will rebound depends
on how quickly inventory
can normalize.
In 2015, policymakers
essentially took a handsoff attitude toward the
supply side, letting the
decline in starts continue
but being supportive on
the demand side.
Inventory levels peaked.
GavekalResearch
Expect the same policy
stance in 2016. This
means construction
starts will fall for at least
another year, with some
recovery in 2017 to
match the trend in sales
(see When Will
Construction
Rebound?).
22
China
Will Construction Ever Recover?
Assuming all housing starts will eventually turn into
sales, the difference between the cumulative starts
and amount of sales at any given time will therefore
be the inventory held by developers.
Various indicators show a supply-side correction is
deepening and has yet to end. A bigger proportion of
housing demand has been and will continue to be met
by inventory de-stocking.
This difference was about 2.6bn sqm, or 30 months
of sales in 2014, but is on pace to decline to 2.5bn
sqm and 25 months in 2015. Clearly more correction
is needed in 2016 to reach the normal inventory level
of 20 months.
The expected weak construction in 2016 will, by
extension, mean continued pain in the whole complex
of industries that depends on it: steel, metals, coal,
etc. And as construction goes, so goes the economy.
GavekalResearch
23
Our Views In Brief Economies
Region
World
China
US
Eurozone
Emerging Asia
Analyst
View
Read more
Charles Gave/Pierre
Gave
Sustained low interest rates
increase the risk of recession
in the US and other rich
countries
Gauging The Chances Of
A US Recession; A
Worrying Set Of Signals
Andrew Batson/Chen
Long
Growth keeps slowing and
divergence widens between
weak industry and stronger
services
The Diverging Fortunes
Of The Two Chinas; The
Next Step Down In
Growth
Will Denyer/ Tan Kai
Xian
Watch out for a return of US
inflation
Position For A Pick-Up In
US Inflation; Does
Slower Job Growth
Signal Recession?
François-Xavier
Chauchat
Rising intra-EZ financial flows
are creating a sustained
recovery
Animal Spirits And The
Revival Of European
Finance; A British-Style
Recovery For France?
Joyce Poon
Growth is constrained by high
leverage and limits on
monetary easing due to
weaker currencies
Emerging Asia’s
Leverage Problem; China
And North Asia’s
Deflation Syndrome
GavekalResearch
24
Our Views In Brief
Market
Analyst
Markets
View
Read more
Equities
Louis-Vincent Gave
The top of the US$ and the end of Is The Bull Market
the China panic signal a “pain
Over? (II); The Birth Of
trade” favoring cyclicals and EMs A Pain Trade
US dollar
Will Denyer/ Tan Kai
Xian
US$ unlikely to strengthen further
due to relative competitiveness
shift
The Rising Supply Of
‘Earned’ US Dollars;
Drop The Dollar Hedge
Will Denyer
Buy tomorrow’s winners (US
homebuilders and those
producing outside the US); avoid
bonds
Portfolio Construction
Towards The End Of
The Cycle
François-Xavier
Chauchat
“Pan-European” stocks offer the
best value; balance with
peripheral bonds
Tantrum II And
European Portfolios;
Who Benefits From The
Fall Of Europe’s Export
Champions?
Chen Long
Once the worst of capital-outflow
pressures is past, the PBOC will
likely allow another -2% to -3%
depreciation this year
The Three Options For
RMB Policy; CrossBorder Flows And The
RMB
Joyce Poon
Good earnings and improved
corporate governance will keep
the bull market going
The Next Phase Of
Japan’s Bull Market;
Japan’s ROE
Revolution
US equities
Europe
equities
Renminbi
Japan equities
GavekalResearch
25
Our Views In Brief
Topic
Oil: lower for
longer
The low-rate
fallacy
China policy
uncertainty
Europe’s
Thatcherite
Keynesianism
US long-run
growth
Renminbi
internationalization
GavekalResearch
Analyst
Themes
View
Read more
Anatole Kaletsky
Abundant supply means
US$50 is a ceiling not a
floor
Oil: Lower For Longer;
Oil At Its Ceiling, Not Its
Floor
Charles Gave
Zero rates are destroying
productivity and leading to a
deflationary recession
The Untimely Demise Of
US Productivity; The
Myth Of Secular
Stagnation
Andrew Batson
Nationalist politics make
policy choices less
predictable
Expect The Unexpected;
The Nationalist Style Of
Economic Reform
François-Xavier
Chauchat
Combination of monetary
support and supply-side
reforms strengthens
eurozone
Europe’s Thatcherite
Keynesianism; Greece,
Europe & The Equity
Market
Will Denyer
The long-run growth rate will
New Century, New
be 2-2.5%, thanks to
Structural Growth Rates
weaker demographics
Louis-Vincent Gave
Beijing’s drive to globalize
its currency is the biggest
macro event of 2015
The Crocodile Mouth
About To Close; The
New Way To Think About
China
26
IndicatorsOur growth indicators are still depressed
Our growth indicators are still pointing to a
deceleration in economic activity. Part of this can be
explained by the fact that these indicators are biased
towards “old” style activity (like manufacturing) which
has in fact been quite weak.
As such, one could argue that global growth is
perhaps on a stronger footing than our indicators
would imply.
Nevertheless, we still find it unsettling that the most
volatile part of the economy (industrial production) is
The indicators do a less good job in capturing changes clearly struggling. The fact that the most stable part of
in the service part of the economy, which has been far the economy (services) remains, well, stable does not
more solid.
do enough to shake our uneasiness.
GavekalResearch
27
IndicatorsRisk appetite is back with a vengeance
Risk appetite bounced back strongly last month. After
it became clear that the Chinese were not playing the
devaluation game, investors felt increasingly confident
to dip back in to risk assets.
And after the ECB came out on the dovish side, the
trickle towards risk became a flood and the world
MSCI ended up by 7.9% for the month, the best
monthly performance since October 2011.
GavekalResearch
The VIX, which had been hovering at multi-year highs,
collapsed back to the very low trading we saw
between 2012 and mid-2015.
Unless something unexpected happens, the stage
does appear to be set for a very solid end of the year
for risk assets (as is very often the case).
28
Indicators
No sign yet of inflation
But while spirits run high on the markets, the same
cannot be said for inflationary expectations.
The Fed held off hiking rates in September, hinting at
worries on the international scene (i.e. China).
Notwithstanding the argument made by Louis at the
front of this report, most of our price indicators imply
that we are dipping towards new lows. Inflation is still
very clearly missing in action.
Now that global financial markets have calmed and
risk appetite is bouncing, will the Fed raise in
December, despite a dismal inflation reading?
GavekalResearch
Right now, the market expectations of a December
hike have been reined in, but we think there is fair
chance the Fed will raise rates.
29
IndicatorsIs the ECB pushing on a string?
Obviously, policymakers are still more worried about
the state of the economic recovery than the potentially
destabilizing risk of rising asset prices.
The ECB was again the leader of the pack as Draghi
highlighted his continued willingness to err on the side
of more easing.
GavekalResearch
Already, the ECB balance sheet is rising at 40% YoY
and is rapidly approaching the levels of 2012.
Part of the reason that the ECB seems so willing to go
the extra mile is that precious little of this new liquidity
has actually led to a rebound in bank lending.
This is somewhat worrying and highlights the
challenges associated with a solely monetary
response.
30
GavekalResearch
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