Money Matters Dec 21st, 2016

Frequent readers will know of our great interest in the plethora of reforms announced by the Modi government in India since 2014 – and of our positive assessment of the economy over the next few years. The most controversial policy, amongst the raft of changes, has been demonetisation. 86% of cash has been removed from circulation in order to help formalise the economy and increase tax revenue (only 1% of Indians pay income tax). Whilst this has created a significant short-term drag on activity, the policy has remained popular and we see consistent evidence that the negative effects will be transitory, with permanent long-term benefits.
Following the Indian example, on the 11th December, Venezuela attempted a similar exercise. President Maduro announced the 100 bolivar note (worth about 15 USD cents and used for 77% of transactions) would cease to be legal tender within 72 hours. However, unlike the Indian example, the measure has descended into farce. New replacement notes were not ready for circulation and there have been riots and looting across the country (which has the highest rate of inflation and one of the highest rates of violent crime in the world). The exchange has now been delayed until the 2nd January.
UNITED STATES

S&P 2,258 -0.06%, 10yr Treasury 2.57% +12.41bps, HY Credit Index 361 +1bps, Vix 12.20 +0.45Vol
As expected, the FOMC announced a 25bps point rate hike (0.50-0.75% range) at their December meeting. However, three items mean the outcome was more hawkish than anticipated:
1) The Median FED voter now predicts three rate hikes in 2017 vs. 2 prior (specifically 11 out of 17 expect 3 or more and the remainder 1 or 2).
2) The FED are starting to “internalise” the potential effects from fiscal policy.
3) Yellen backed away from her “high-pressure economy” statement.
With respect to the FED’s new forecast for an extra hike in 2017 this, in itself, is of marginal importance. Given recent history, the committee has lost credibility and the market will not necessarily be swayed by its guidance. Indeed, the messaging was not internally consistent as growth and inflation forecasts were little changed. Moreover, although futures now price 2.5 hikes, an FT survey over the weekend suggests sell-side economists still expect only two increases.

The other items, revealed by Yellen during the post-meeting press conference, are more significant.

First, although caveating that it is “far too early” to understand the impact of so called “Trumponomics”, Yellen stated that “some of the participants…did incorporate some assumption of a change in fiscal policy into their projections.” This is to say rates will rise faster to the extent fiscal stimulus is forthcoming.

Second, and related, Yellen appeared to back away from an October speech in which she had discussed the benefits of running a “high-pressure economy with robust aggregate demand and a tight labour market”. She said the focus of this discussion was to stimulate academic work and that “I didn’t draw any policy conclusions from that…I was not recommending a substantially easier policy.” Further, she commented “I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.”

The FED’s stance speaks to a view that the market has got ahead of itself with respect to the potential boost from Trump. Although there will be short-term gains, the longer term relies on positive multipliers and an interaction with monetary policy that shifts the growth regime back to the pre-crisis norm. We think this is unlikely.
After the FED meeting, the USD dollar trade-weighted index hit a 14 year high and the 10-year Treasury touched its highest yield since September 2014.
EUROPE
Eurostoxx 3,250 +1.02%, German Bund 0.33% -5.10bps, Xover Credit Index 292 -17bps, EURUSD 1.046 +1.05%
Despite moves on the other side of the pond, most European bonds rallied last week. This came on mixed data with weak industrial production but strong PMI and French and German business surveys.
In Italy, Monte Paschi’s tightrope walk continued with the regulator approving an extension of a debt-to-equity swap to retail bondholders. The bank will now pursue the exchange this week, alongside a share offering. If there is not sufficient interest, the firm will be nationalised. Elsewhere, Unicredit announced a sweeping restructuring and capital raising (amounting to EUR 13bn), which was taken positively by the market.
In groundhog day style, Greek Parliament’s decision to give a year-end bonus to pensioners prompted European partners to suspend debt relief negotiations. Greek bonds underperformed as a consequence.
In the UK, the MPC voted unanimously to leave policy unchanged (base rate at 0.25%) as expected. The minutes revealed a neutral tone – “a slowdown in growth remained likely, but there had been little news since the time of the November inflation report about domestic activity and, although the near-term global outlook had improved, this was counterbalanced by more elevated risks.” The SNB in Switzerland also left policy on hold, whilst the Riksbank in Sweden meets this week.
ASIA
HSCEI 9,377 -4.12%, Nikkei 1,939.00 +0.10%, 10yr JGB 0.09% +0bps, USDJPY 117.330 +2.26%
China’s economic data for November was largely positive versus consensus. A turnaround in manufacturing and trade were the key positive surprises, with trade growth turning positive for the first time since September 2011 on the back of a weaker RMB and higher commodity prices. Retail sales also accelerated to 10.8% YoY (versus 10.0% in October). On the downside, infrastructure investment slowed down to +14.6% YoY. This is partly seasonal, with a ramp up in spending expected after Chinese New Year. The property market also softened, with both sales and investment weaker, on the back of recently introduced tightening measures. These tightening measures are scheduled to be reviewed by the government in Q1, which could lead the sector to return to its previous upward trajectory established earlier this year.
India’s consumer price index fell to the lowest level in two years, falling to 3.6% YoY in November versus 4.2% in October. This was lower than market expectations.
There are a number of moving parts here. India’s inflation rate has been on a downward trajectory for over two years now, with the lower oil price playing a key role, along with the central bank’s inflation targeting renaissance in effect since 2013. On a more temporary basis, Modi’s demonetisation programme appears to have had a disinflationary impact. This is intuitive both on a conceptual level (monetarist view of inflation: increasing [decreasing] the supply of money causes inflation to increase [decrease]) and when considering behaviour at the household level (less cash with which to transact, spend less, demand-pull disinflation). The Reserve Bank of India also acted to prevent one channel through which demonetisation could have created inflationary pressure, increasing the cash reserve requirement ratio to 100% on incremental deposits in order to prevent excessive lending growth and risk taking from the banking sector.
The Bank of Korea kept interest rates at 1.25%, in line with expectations. The accompanying statement showed that the monetary policy committee see downside risks to growth and inflation on the horizon. Given that over the last 12 months Korea’s current account surplus has been equivalent to 7% of GDP, there is likely room for Korean monetary policy to diverge from the US without incurring external balance issues.
Bank Indonesia also left rates on hold, at 4.75%, in line with expectations. The central bank spoke of external global risk factors and the delayed impacts of previous rate cuts yet to come through, as reasons for the pause.



LATIN AMERICA

MSCI Lat Am 2,243 -4.40%
Brazil is making further progress in passing structural reforms. Last week, the fiscal ceiling was definitively voted in the Senate in its initial version. This constitutional amendment will cap government spending in real terms over the next 20 years, reducing progressively the Debt/GDP level to a more sustainable level and trajectory. Also last week, the social security reform cleared its first vote in congress, the amended version will go for vote in the Senate and the definitive version is expected to be adopted in 2017.
The Brazilian government announced a new package of reforms aiming to remove economic obstacles and inefficiencies. This set of measures tackles the cost of dismissal, tax arrears, securitisation, reducing bank spreads and reducing red tape in general.
Although we don’t have many details yet on those measures and they are less structural, it is a step in the right direction.
Banxico in Mexico hiked its benchmark rate by 50bps to 5.75%, surprising the market that expected only 25bps. Inflation expectations are overshooting the central bank’s target of 3% due to the lagged impact of the MXN depreciation and the 9.6% minimum wage increase for 2017 announced earlier this month.
Peruvian President Kuczynski encountered his first challenge from the opposition-dominated congress. His close allay Jamie Saavedra, the highly regarded education minister, was removed from office by a congress vote after he was implicated in a corruption case. More generally, Kuczynski will have to deal with a Fujimojist congress to get reforms passed.
Overall this should have a limited impact on reforms. Peru is accustomed to operating with fragmented leadership as it has consistently elected minority governments since 2000. So far Fuerza Popular, the party led by Keiko Fujimori, has not obstructed the law-making process: a dozen decrees have already been issued without major objections and they even granted the government authority for 90 days to legislate in five priority areas. More recently, congress approved the 2017 budget, the 2017 borrowing law and an amendment to the fiscal responsibility law.
Chile’s central bank kept rates unchanged at 3% but adopted a much more dovish stance. According to the board, domestic economic growth, lower inflation expectations particularly in the short-term and high external volatility and uncertainty, among other factors are building the case for a rate cut next meeting.
AFRICA
MSCI Africa 725 -4.32%
Nigerian inflation rose for the 13th month in a row, reaching 18.5% in November.
It is difficult to see the light at the end of the tunnel for the Nigerian economy, based on all economic indicators, companies’ results and messages from independent analysts. IMF intervention and oil price increasing back above USD 100/barrel appear to be the only 2 options.
South African inflation accelerated to 6.6% YoY in November, from 6.4% a month before. Food and transportation prices were the main contributor to the highest print in the last 9 months. Retail sales also fell 0.2% YoY in October.
Botswana’s central bank kept the lending rate unchanged at 5.5%
Information taken from Alquity The Global Market Update now takes a break for 2 weeks, returning on the 9th January. This week there is a Bank of Japan meeting, with results due on Tuesday.