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Broadgate: Weekly Briefing 12/11

12 November 2013

China – China’s service sector grew at its fastest pace in a year in October, the latest sign of a recovery in the world’s second-largest economy.

The non-manufacturing Purchasing Managers’ Index (PMI) rose to 56.3 in October from 55.4 in September. The report comes just days after data showed that China’s manufacturing PMI also rose to an 18-month high in October.

China’s service sector, which includes construction and aviation, accounts for nearly 43% of its overall economy. The PMI is a key gauge of the sector’s health and a reading above 50 indicates expansion.

“The non-manufacturing sector should continue to develop at a stable rate over the next few months, though there still needs to be more market training and promotion to further release the service sector’s potential,” said Cai Jin, vice-president of the China Federation of Logistics and Purchasing.

U.S. – The Dow Jones Industrial Average closed at a record high on Wednesday.

The index was helped by a 4% gain for shares in Microsoft, which rose following a report that the company has narrowed its search for a new chief executive.

Overall the Dow Jones Industrial Average closed 128 points or 0.8% higher at 15,746. The S&P 500 closed 0.4% higher at 1,770 – just one point short of its record.

“The markets are going to slowly drift up higher, unless there is something to keep it from happening,” said Randy Frederick, from stock broker Charles Schwab.

Traders are also betting that the US Federal Reserve (the Fed) is unlikely to end its stimulus programme in the near future. Currently it is pumping $85bn into the economy every month by buying government bonds, which is helping to keep interest rates extremely low.

Late on Tuesday the president of the San Francisco Federal Reserve Bank said the Fed should wait for more solid evidence of economic growth before phasing out that effort.

“What’s seeping into the market is the increasing likelihood [the Fed] will keep zero percent interest rates for 18 months longer than they had signalled previously,” said Steven Einhorn from the hedge fund Omega Advisors.

Industries – One-fifth of the world’s biggest banks may be broken up or sold as part of a “radical course correction” to boost shareholder returns, according to McKinsey& Co.

The number of global universal banks may drop to fewer than 10 from about 25 as they narrow their focus on products or regions, the consulting firm said in an annual review of the industry this week. Ninety global lenders are generating higher returns by following one of five distinct strategies described by McKinsey, according to the report.

“It’s not as if it can’t be done,” Fritz Nauck, a director at the consulting firm and a co-author of the report, said in an interview. “It’s about how do the other banks get there or how does this consolidation start to bring the overall industry up in terms of performance.”

Global banks’ return on equity climbed to 8.6% in 2012 from 7.9% a year earlier, still below the 10% to 12% average cost of equity, a measure of the minimum return required by shareholders, McKinsey said in the report.

Commodities – Gold held gains after the biggest advance in almost two weeks as investors await reports that may show the U.S. economy lost momentum last quarter and employers added fewer workers, boosting the case for sustained stimulus.

Bullion for immediate delivery was at $1,318.78 an ounce on Thursday, when prices climbed 0.5%, the most since Oct. 24.

Europe – The European Commission has said the European economy has reached a “turning point”, but the eurozone will grow less quickly than previously expected. The Commission said there were “signs of hope” that had started to turn into “tangible positive outcomes”.

Although in the eurozone, the 18 nations that use the euro, it predicted growth of just 1.1% next year. This is the second downward revision of 2014 eurozone growth this year, after it was cut from 1.4% to 1.2% in May.

Jonathan Loynes, chief European economist at Capital Economics, said the subdued forecasts reflected the “general sluggishness” of the eurozone economy.

Spotlight on: Japanese Equities, from Chris Taylor of Neptune

Chris Taylor, manager of the Neptune Japan Opportunities fund (the underlying asset to the HIL Neptune Japan Opportunities fund, MC133, available in HIL), assesses the outlook for Japan.

Japanese Prime Minister Shinzo Abe’s, and his deputy Taro Aso’s, intentions for Japan are best understood after appreciating their family histories and the fiscal time bomb facing Japan.

Both their families have over 150 years of history in providing both ministers and prime ministers to successive Japanese governments which, combined with the country’s savings being insufficient to fund the burgeoning national debt within five to seven years, means both men see it as their deep-rooted duty to rescue the country from an otherwise inevitable bankruptcy. They also see Japan’s economic resurgence as a prerequisite to re-establishing Japan’s position in the world.

Their recent electoral successes should ensure governmental stability, with Japan having endured 15 prime ministers over the last 25 years. This time Abe has a clear majority in both houses of parliament, strong electoral support and most importantly dominates his own party, the LDP (Liberal Democratic Party). Prior infighting within the LDP was the main cause of the historic prime ministerial turmoil.

Abenomics

The current administration has both the political will as well as the political power to pursue the required dramatic policy shifts. These entail aggressive monetary easing to stimulate loan growth, substantially higher government infrastructure and defence spending to kick-start the economy, and deregulatory measures to make more efficient use of resources such as men, money and materials.

In the short term, this means taking on greater budget deficits and outstanding national debt to finance the recovery which, once it has taken hold, will eventually lead to improved tax receipts that reverse the fiscal deterioration.

Yen weakness: the unintended consequence

The intended doubling of the money supply in two years compared to a relatively static economy should undermine the yen and see it fall substantially, aided by further fiscal deterioration.

The yen’s fall is merely an “unintended consequence of their domestic policies”. Compared to the US, the sum of money involved in easing is greater than all three QE fundings, acting on an economy less than a third of the size and in two years rather than five.

This means the Japanese efforts are over ten times as cash, time and GDP intensive as the US actions. This illustrates the dramatic nature of Abe’s policies to rescue Japan.

The intended yen weakness is crucial to the success of Abe’s policy measures. The currency’s fall would lift the yen value of the overseas derived profits, which would then be repatriated to fund increased full-time employment, higher base wages and renewed capital investment. These in turn will lift domestic GDP and tax receipts.

Currently, 85% of employed Japanese pay no income tax, as well as 35% of the workforce not enjoying full-time employment. The average wage of ¥4m puts most individuals below the tax threshold, which is also why the authorities have become increasingly dependent upon indirect taxes i.e. why the consumption tax is being increased next year. However, the latter’s potential negative economic impact will be offset by equivalent supplementary budget expenditure.

Japanese multinationals

Yen depreciation should not be seen as a ‘competitive’ devaluation, as Japan’s multinationals no longer export all they produce from Japan as they did over 30 years ago when a cheap yen was essential to their success.

They now make and sell substantially more outside of the country than within it. Nissan, for instance, exports only 14% of its entire worldwide production from Japan, while 72% of all its vehicles are already made abroad, so a cheaper yen is of no major benefit. Instead, the impact is translational, lifting only the yen value of its overseas derived earnings.

The adopted 2% inflation target is aimed principally at mobilising Japan’s huge savings pool to be spent and boost the economy via ending the prevailing deflationary mentality through a price hike shock.

Japanese individuals behaved rationally while prices fell by saving and putting off purchases, which helped raised their potential spending power but shrank the economy.

Now they will have to deploy these savings or see their spending power whittled away by inflation. Their resultant likely sale of Japanese government bonds (JGBs) will be absorbed by the Bank of Japan’s annual quantitative easing (QE) program of ¥50trn ($500bn equivalent), which is roughly half the size of QE 3 in the US but acting on an economy a third the size, so 50% more aggressive.

In practice, expenditure to-date has averaged almost ¥70trn and has peaked at over ¥90trn, so greatly larger than the US’s QE 3 maximum purchases.

Japan version 2.0

In summary, Shinzo Abe’s polices are not aimed at political reform or an ‘old versus new Japan’ environment. It is largely about rejuvenating the country by improving the way it operates.

Japan version 1.0 worked well from the 1950s to the 1980s but then become obsolete. Abe’s ‘reboot’, or Japan version 2.0, involves pursuing quick, aggressive and very substantial policy changes to avoid the otherwise inevitable national bankruptcy i.e. Japan version 0.0.

BWB

The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.

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