Trade Insight April 2015

Currency volatility on the rise | EUR-USD heads for parity while equities climb

 

Executive Summary

 

Delta Economics’ Trade Corridor Index Assets (TCI-A) analysis for April suggests the following:

  • There will be continued optimism about European recovery in particular as the Purchasing Managers’ Indices rise.
  • The optimism in European growth will not boost the value of the euro. Quantitative Easing (QE) is already putting downward pressure on the euro which, combined with the political and financial consequences of Greece’s debt repayments, is pushing the value of the euro down further versus the US dollar.
  • As a result, the TCI-A is suggesting short positions on EURUSD. We expect the bearish trend to continue through the month and although there could be some resistance around €1.05:$1 in the middle of the month, the model suggests it could go as low as $1.01 by the end of the month with parity likely during May.
  • Meanwhile, we are bullish on the Dax and Eurostox 50, which are attracting capital inflows as a result of QE.
  • In the run-up to the general election in the UK we are expecting the value of sterling to fall against the US dollar. If Industrial Production results in the UK are weak, then we expect this to increase volatility in the value of sterling. This volatility is likely to continue as the general election nears as investors weigh up the business consequences of a Labour government versus the uncertainties of a referendum on European membership with a Conservative government.
  • The long positions we are taking on Asian equities reflect the fact that QE in Europe has increased capital availability and weakened the value of the euro.

 


Outlook for PMIs April 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level. They are constructed as follows:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S).
  • Correlation of the rate of change in that index (six-month moving average) with the Manufacturing PMI.
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

The full PMIs are expected to move generally in line with the Flash PMIs and consensus in April 2015. Overall, only very small movements in the PMIs are predicted, either by us or by the market. The PMI data has ceased to move markets substantially and the very similar results each month suggest that there will be little market volatility around these indicators this month.

 

Key points:

  • We are generally optimistic and in line with consensus about Europe’s PMIs. We are substantially more positive about French services than consensus, but the correlation is low so there is a high downside risk on this.
  • We are expecting a mild increase in the US Manufacturing PMI while consensus is predicting a mild downturn. However, the spread is very small between the two and, as this is an estimation of a survey, this could be within an error margin.Trade Corridor Index Asset Price Calls

2015-04-14_tradeInsight_fig01_v01

 

Figure 1 | PMI Outlook, April 2015
Source | Delta Economics analysis

 


Trade Corridor Index Asset Price Calls

 

Methodology

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against an asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 21 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength (which measures the percentage of trade corridors that are pointing to a long or short call) must be higher than 95%.
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5, indicating good or very good back-tested performance.
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns across the portfolio reflect the accuracy of the calls only. They are not optimised in any way, do not include transaction costs and are based on an equally-weighted portfolio across the asset calls that conform to the conditions above. There is no leveraging.

Key point | In March 2015 these paper returns were 1.9% suggesting that over the past 21 months, we have called the assets in a way that potentially produces an above-market performance of 1.4% per month.

 

2015-04-14_tradeInsight_fig02_v01

 

Figure 2 | Monthly Returns of TCI-A strategy (%) June 2013 – April 2015
Source | Delta Economics analysis


Commodities

We are calling metals long this month but our signal strengths and Information Ratios have deteriorated since February. This reflects continuing volatility in commodity prices; the price of oil, for example, is being influenced by uncertainties in the Middle East which, if they continue, could put strong upward pressure on prices.

 

2015-04-14_tradeInsight_fig03_v01

 

Figure 3 | Delta Economics TCI-A Based Strategy, Commodity Calls for April 2015
Source | Delta Economics analysis

 


Equities

QE in Europe and Japan alongside continuing uncertainty around any rate rise means that equity markets are likely to continue their bull run. Information Ratios continue to be weak suggesting that there is real volatility in the market, while the signal strengths on global (European and US) equities are much stronger than they are on EM equities. This is a product of capital movements into Europe post QE and continuing concerns about the depth of any Chinese slowdown. Of the Asia-Pacific markets the ASX 200 and BSE look to be the strongest performers in April.

 

2015-04-14_tradeInsight_fig04_v01

 

Figure 4 | Delta Economics TCI-A Based Strategy, Equity Calls for April 2015
Source | Delta Economics

 


Currencies

We return to a bearish stance on the euro versus USD for April and overall our calls suggest that the strength of the US dollar versus most currencies is likely to continue. The only exception is our bullish stance on the AUD which is based on a reasonable signal strength and strong Information Ratio.

 

2015-04-14_tradeInsight_fig05_v01

 

Figure 5 | Delta Economics TCI-A Based Strategy, Currency Calls for April 2015
Source | Delta Economics

 

Delta Economics Trade Insight April 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


 tradeInsight_TCI-BasedStrategy

Growth, currencies and interest rates

Four trade challenges to monetary policy  |  Short summary:

 

The Fed needs to be careful about the next monetary steps it takes because:

  1. The growth effects of Quantitative Easing (QE) in Europe are yet to be felt, if indeed they will be
  2. Neither China nor Korea’s trade surplus with the US is the Fed’s biggest concern in emerging Asia
  3. The weak yen is not boosting Japan’s exports to the US and is not responsible for its surplus
  4. Monetary policy is not the answer to trade and growth imbalances, but has unintended consequences

 

Context

In its bi-annual report to Congress, the US Department of the Treasury, International Affairs, assessed the macroeconomic policies of its major trading partners to see if inappropriate activities are being used to manipulate the balance of trade with the US. It urged the governments of Germany, China, South Korea and Japan to do everything in their power to eliminate global economic imbalances by focusing on reducing their trade surpluses with the US and halting practices of competitive devaluation against the US dollar. Against a backdrop of strong US growth and weaker growth elsewhere, the report argued that addressing these imbalances through structural reform, monetary and fiscal policy was the only way of ensuring that the G20 balanced global growth targets were met.

 

Four trade reasons why monetary policy alone can’t create real growth:

 

1  |  The growth effects of QE in Europe are yet to be felt, if indeed they will be

The immediate effect of QE has been to push European equity markets to new highs and push down the value of the euro against the USD. It is unlikely to create real, export-led growth since the correlation of the euro with Europe’s trade is positive (i.e. an increase in the value increases trade). Where it does have an effect on boosting trade, it is likely to be felt most strongly in Germany. This will potentially exacerbate the problem of its trade surplus, particularly with the US (Figure 1).

 

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Figure 1  |  Monthly Value of German Exports to the US (USDm), June 2001 – December 2015 vs. EUR-USD, Last Price Monthly, June 2001 – March 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The chart shows a positive correlation (0.67): in other words, as the value of the euro increases, so too do exports. This reflects the relative exchange rate inelasticity of trade between Germany and the US. Growth in exports from Germany to the US has been modest over the past two years and the sharp reduction in the value of the euro does not appear to be likely to make much difference to its trade balance with the US.

The weaker euro is unlikely to impact Europe’s or, more specifically, Germany’s trade surplus with the US. Indeed, it is also unlikely to lead to greater demand without an accompanying non-monetary policy in Europe, such as infrastructural spending and structural reform to boost both demand and competitiveness.

 

2  |  Neither China nor South Korea’s trade surplus with the US is the Fed’s biggest concern in emerging Asia

The yuan is kept within a 2% peg of the US dollar and, as such, has been increasing its value since the end of 2004 when the currency was first allowed to float. More recently, March 2015, the yuan has appreciated against the US dollar giving rise to speculation that the peg is about to be loosened or removed completely (Figure 2).

 

2015-04-14_growthCurrenciesInterestRates_fig02_v01

 

Figure 2  |  Monthly Value of Chinese Exports to the US (USDbn) vs. USD-CNY Spot Price, Last Price Monthly, June 2001 – December 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The impact of the appreciation of the yuan is to suggest that Chinese exports to the US may flatten slightly during 2015. This provides some cause for optimism around the size of its trade surplus with the US. Of greater concern from a US perspective may be Russia’s decision to price oil and gas deals with China in yuan. This suggests that the yuan’s role as a trade finance currency is growing and that there will be further strengthening of the currency. This is likely to be a result of both a loosening of the peg and the role of the yuan as a trade finance currency. The threat of a stronger yuan and the prospect of a future currency war may be more unpalatable than the trade surplus now.

The won is slightly different in that it is only very weakly correlated with South Korea’s exports to the US at -0.46. In other words, any devaluation by the Korean monetary authorities is unlikely to have much, if any, impact on its trade surplus with the US. Given the speed that the Kospi has picked up since QE in Europe has prompted greater liquidity, the US would do well to look at the consequences of capital outflows and rising dollar-denominated debt as Asia’s slowdown works through. Priced in local currencies, such as the won, the markets look buoyant; priced in dollars, the rises are less substantial and represent both a loss in earning and pose a threat when dollar-denominated debt has to be repaid.

 

3  |  The weak yen is not boosting Japan’s exports to the US and is not responsible for its surplus

Japan’s QE programme has resulted in a substantial devaluation of the yen against the US dollar. However, this has not had the desired impact of increasing all exports to the world or the US in particular (Figure 3). Export-led growth has not materialised despite substantial QE-induced devaluation since the onset of Abenomics.

 

2015-04-14_growthCurrenciesInterestRates_fig03_v02

 

Figure 3  |  Monthly Value of Japanese Exports to the US vs. USD-JPY Spot, Last Price Monthly, June 2001 – December 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

In fact, if anything, exports to the US from Japan have been falling ever since the start of the most recent phase of QE in Japan. Alongside this, Japan’s imports from the US have been increasing and could grow by nearly 5% in 2015 as a result of Japan’s greater external energy dependency after Fukushima.

 

4  |  Monetary policy is not the answer to trade and growth imbalances, but has unintended consequences

The US Fed is now in a bind: its challenge is not the monetary policy of its trading partners, it is the unforeseen consequences of its next monetary moves. The US dollar is strong and while some of this is because the US economy itself is doing well compared with other economies, its strength is more than partly due to the fact that markets are speculating on when the Fed will put up rates. Fuelled by both QE and uncertainty around the announcement of a rise in rates, it is likely that the USD and the euro will reach parity imminently, if not by the end of April then during May. Similarly, the yen is hitting new lows against the USD.

The euro and the yen’s values are already distorted by the effects of QE. Alongside this, any increase in interest rates will exacerbate the dollar’s strength against the currencies of all its major trade partners except China. While currencies weaken, equity markets including the Dax, Nikkei, the HSI and the Kospi continue bull runs that are the direct result of large amounts of liquidity made cheaper, not just by low interest rates, but also by weaker currencies. The result will undoubtedly be aggravated by a rise in US rates: a strong US dollar is not necessarily the best for the US in the long run if corporate earnings, confidence and exports falter.

Trade Insight February 2015

Currency wars and volatility

 

Executive summary

  • January 2015 was a volatile month with markets unsettled by the uncertainty generated at the beginning of the month over European Central Bank Quantitative Easing (QE). This uncertainty was compounded by the removal of the Swiss franc’s currency peg to the euro by the Swiss National Bank.
  • Both events have put significant pressure on the euro during the first month of 2015 which Delta Economics expects to continue throughout the year. We are forecasting that the euro and US dollar may well reach parity by the end of the year, if not earlier if current trends continue.
  • Delta Economics is expecting the PMIs published at the beginning of February to be broadly in line with consensus expectations. We expect China’s PMI to fall back while we are expecting PMIs in Europe to improve slightly. It is too soon to herald a recovery but this is a positive start to 2015.
  • The Delta Economics Asset Trade Corridor Index (TCI-A) reflects the underlying volatility in markets with Information Ratios largely negative for equities and currencies. The TCI-A has produced an average monthly paper return of 1.3% over the past 19 months. The average return on an equally weighted portfolio in January 2015 was 2.2%.
  • We expect oil prices and the value of the euro to fall during February. We expect other commodity prices to rise (against consensus), equities to rise and the US dollar to strengthen against most major Emerging Market currencies. However, the tightest strategy that we use suggests a strong downside risk to all these calls because of the underlying volatility reflected in the information ratios.

 


Greeks bearing gifts? The consequence of January for the euro in 2015

 

Delta Economics is of the view that the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continues. This is for several reasons:

First, Delta Economics considers the euro to have been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. It will not be helped by a lower-valued euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this; the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

  2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of Eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year.

 


 

Outlook for PMIs February 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Generally we are expecting manufacturing PMIs to move in line with consensus this month with very little movement on their December values. The only exception is French services where we are expecting a bigger increase in the service sector PMI compared to consensus. However, although the accuracy of the predictions has been reasonable over the past 12 months, the correlation is substantially lower.

The predictions are based on:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S)
  • Correlation of the rate of change in that index (6 month moving average) with the Manufacturing PMI
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

Outlook for PMIs February 2015  |  Outlook risk

  • The above information is based on the PMI tickers as listed.
  • The predictive capacity of the model is strong, but not perfect as they are based on correlations rather than causal relationships
  • Note – the correlations and values given are against the Tickers listed and not with the Flash PMIs although the Flash PMIs follow similar patterns
  • Note – forecast values are indicative of scale of change only and should not be seen as absolute values

 2015-02-04_tradeInsight_fig05_v01

 

Figure 5  |  PMI outlook, February 2015
Source  |  Delta Economics

 


 

Trade Corridor Index Asset Price Calls

 

Overview

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against and asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 19 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call: this must be higher than 95%
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5 (indicating good or very good back-tested performance)
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 2.2% in December 2014. This means that over the past 19 months, returns have averaged 1.3% per month with above average returns in 11 months.

 

2015-02-04_homepageGraph_v01

 

Figure 6  |  TCI-A returns, June 2013-January 2015
Source  |  Delta Economics

 

The calls for February 2015 reflect underlying volatility in markets with Information Ratios largely negative or mildly positive. Although the TCI-As across a portfolio of assets produced a return of 0.7% in October, this was against a similar backdrop of low or negative Information Ratios, which arguably underpinned the correction in the middle of the month. Because of these low, even negative, IRs our portfolio suggestions potentially have substantial downside risk attached to them.

 


 

Commodities

 

The short call on oil reflects continuing downward pressure on oil prices despite the mild rally at the end of January 2015. While the signal strength is low, the information ratio is high suggesting that this is a strong call. Similarly, the long call on Gold has weak information ratio but strong signal strength suggesting that Gold may continue its upward path as a hedge against deflation. Because of underlying uncertainties in the global economy and the fragility of commodity markets, the long calls on copper and steel appear contrary to market sentiment currently. However, our trade outlook for the world in 2015 is mildly more positive than it was during 2014 and Asia in particular is forecast to grow strongly. A long call on copper and steel suggests prices may start to increase during February as a lead indicator of manufacturing activity increases towards the end of Q1 2015.

 

2015-02-04_tradeInsight_fig07_v01

 

Figure 7  |  Delta Economics TCI-A based strategy, commodity calls for February 2015
Source  |  Delta Economics analysis

 


 

Equities

 

We are expecting all equity markets to increase this month, but the signal strengths are weak and the Information Ratios largely negative. A long position arguably reflects the sustained flight to equities following European QE, but the negative information ratios reflect volatility and substantial downside risk.

 

2015-02-04_tradeInsight_fig08_v01

 

Figure 8  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 


 

 

Currencies

 

The calls generally suggest that the euro will continue its weaker path against the US dollar this month. The information ratio on this call is strong, but the signal strength relatively weak. Other emerging market currencies similarly paint a picture of a strengthening dollar as expectations of an increase in US interest rates later this year versus perceived weakness in Europe and Japan continue to stoke up its value.

 

2015-02-04_tradeInsight_fig09_v01

 

Figure 9  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 

 

Delta Economics Trade Insight February 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


tradeInsight_TCI-BasedStrategy

China’s nerves of steel

Why January’s drop in exports may not be such bad news |  Chinese exports in January 2015 fell by 3.3% compared to a year earlier. Its imports fell by over 19%. Analysts had expected exports to grow by over 6% and the slowdown in imports to be less marked than it was. The Hang Seng Index (HSI), which has a high correlation with Chinese exports, dipped slightly on the news but had rallied by the end of the week.

Delta Economics views this rally as temporary: seasonal volatility in Chinese trade in January and February coupled with lower commodity prices means that we are likely to see a further drop in the value of China’s exports in February. Although the trend during the course of the year for the HSI is positive, lower trade could impact substantially on the value of the HSI until the end of Q1 2015 (Figure 1).

 

2015-02-16_nervesOfSteel_fig01

 

Figure 1  |  Monthly value of Chinese exports (USDbn) vs Hang Seng Index, LPM, June 2001-Dec 2015 (forecast)
Source  |  Delta Economics, Bloomberg

 

Of particular concern to analysts was the drop in imports in January. China’s trade is 83% correlated with oil prices and therefore the recent drop in oil prices goes some way to explaining the fall. Further, a more general drop in commodity prices would also have impacted on China’s import trade values for January: China’s trade is 61% correlated with steel prices for example. Given that we expect an increase of 5.8% in iron and steel trade in 2015, compared to 2.4% in 2014, it would be reasonable to conclude that seasonal effects and falling commodity prices are more likely to be responsible for January’s, and potentially February’s, drop in trade values rather than a drop in demand.

Iron and Steel trade is a good proxy for infrastructure development and economic growth within China. China is a net importer of Iron and Steel, the largest products within which are flat rolled alloy steel and hot rolled steel products. China’s exports predominantly go to emerging markets in Asia while China’s imports come from South Korea, Japan, Europe and the United States. China has a net trade deficit in iron and steel, yet to its key export partners, its market penetration is above average for the world.

 

2015-02-16_nervesOfSteel_fig02

 

Figure 2  |  Rebalancing of Iron and Steel trade
Source  |  Delta Economics, Bloomberg

 

The clearest indication of a reorientation of Chinese policy away from export and infrastructure-led growth in favour of demand-led growth can be found in its reimports of iron and steel. These are products that originate in China but are exported and then reimported from Chinese territories or Special Administrative Regions (such as Hong Kong, Macao or Taiwan). Over the past two years reimports have been slowing which suggests that China is utilising its internal resources less – arguably reducing its stockpiles.

Chinese trade, and particularly its iron and steel trade, matters for the rest of the world. But its importance is not as a proxy for the health of the Chinese economy. Instead, it matters because markets perceive it as a bellwether for the health of the Asian economy. For example, the HSI is 81% correlated with Chinese trade and 89% with the KOSPI. Similarly the Australian dollar’s correlation with Chinese iron and steel trade is 82%. While these do not reflect causality they do suggest that regional market sentiment and trade are strongly associated.

 

2015-02-16_nervesOfSteel_fig03

 

Figure 3  |  Monthly value of iron and steel trade (USDm) versus USD-CNY spot, Last Price Monthly
Source  |  Delta Economics, Bloomberg

 

Weaker trade data in the first part of 2015 is likely to result in a depreciation of the yuan (Figure 3). In recent months there has been a slight revaluation of the yuan but we see it depreciating further over the next two quarters as trade growth remains sluggish after it spikes in March. The correlation is negative at -82%: in other words, a currency depreciation will have a positive impact on iron and steel trade, because the currency elasticity of commodities is high.

This will have broader consequences for the rest of the world, not least by potentially aggravating trade relations between the USA and China by making US imports into China more expensive. It would also make European imports into China more expensive and, at a time when the European economy is looking to re-establish its growth, the importance of the Chinese market cannot be understated.

Once again this demonstrates the power that China has to manipulate its own performance and therefore to impact the economies of the rest of the world. Emerging markets equities are likely to react negatively to slower Chinese trade in the short term while the Australian dollar may well become weaker against the US dollar because it is so influenced by the performance of the Chinese economy generally and trade in particular.

If the yuan devalues further, this also has the potential to threaten any export-led growth that may be developing in Europe and the export-fuelled growth that the US is enjoying. The broader geopolitical risks of embarking on a currency war to protect China’s domestic interests as it restructures would stall trade negotiations at the very least. The hope is there will be no devaluation as China seeks to restructure its economy. The outlook for trade towards the end of 2015 and into 2016 for China is certainly brighter, but to get through the first quarter at least of 2015 markets and analysts will need to have nerves of steel.

Back to reality

Why Dollar-Euro parity is possible  |  Following a turbulent January in Europe, the once unthinkable is now becoming thinkable. Mario Draghi, as was widely trailed, launched €1.1 trillion of Quantitative Easing (QE) to September 2016. And following Syriza’s victory in the Greek election, the prospect of a Grexit is now actively being discussed.

So here’s another “unthinkable”: the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continue. Is this really unthinkable or is it simply a return to the reality that we saw in the early days of the euro?

First, the Delta Economics view is that the euro has been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

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Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. As with the eurozone more generally, it will not be helped by a lower value of the euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

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Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this: the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

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Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

All of which brings us back to reality with a harsh bump. The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

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Figure 4  |  Monthly value of eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year. Whether this will bring the eurozone “back to life” is uncertain, but we are certainly “back to reality”.

 

Back to reality: why Dollar-Euro parity is possible  |  Trade View Author  |  Rebecca Harding  |  CEO

Webcast 028 | Back to reality

Why Dollar-Euro parity is possible  |  January was a turbulent month in markets and politics. There was really only one story in town: European quantitative easing and the Greek election. What does this mean for trade and markets?

 

 

Webcast 028 Author  |  Rebecca Harding  |  CEO

Webcast 016 | Whisky and aspirin: is this the future of Europe?

In light of Delta Economics negative forecast for European growth, CEO Rebecca Harding and OMFIF Founder David Marsh explore the reasons behind the slowing in trade and how it is affected by, amongst other things, the recent slowing in Asian markets and uncompetitiveness. The discussion also examines the internal imbalances in the European economy, with particular emphasis on Germany and also looks at some of the fundamental differences between countries such as Greece and Spain with a view to understanding differences in trade growth patterns. This webcast also discusses the relatively positive trade growth in European periphery economies as well as they challenges they will face in the short and longer term.

 

Webcast 016 Author  |  Rebecca Harding  |  CEO

Lost interest?

What do England’s exit from the World Cup and a pending interest rate decision have in common?  |  Since Mark Carney hinted that UK interest rates might rise by the end of 2014 in his Mansion House speech on the 12th June, Sterling has strengthened, reaching a peak against the Dollar last seen in 2009. By the end of the week, Sterling had slipped back slightly and the debate had focused again on how this would affect the enduring problem of UK growth: that without a seismic shift in the productive, and hence export, capacity of the economy, any chance of sustainable recovery remains in the hands of Britain’s consumers. In essence, this is the same as leaving the chances of getting out of the group stages of the World Cup to Italy or Costa Rica. And we all know what happened there.

It is a mistake to think that interest rates changes are going to make much difference to exports at all. For example, the correlation of the USD-GBP spot with exports is only 0.41 while for the GBP-Euro rate it is 0.46. Similarly imports are only 0.38 correlated with the USD-GBP spot and 0.56 correlated with the GBP-Euro spot. In other words, don’t expect interest rates to make much difference to trade at all.

The mystery is why anyone should be surprised at this. Figure 1 shows the two currency spot rates (USD per Pound Sterling and Euro per Pound Sterling) against the one-month Libor rate.

 

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Figure 1  |  The USD-GBP and GBP-Euro spot price, Last Price Monthly, June 2001-May 2014

Source  |  Bloomberg

 

Over the time period, the volatility in base rates is relatively clear to see, as is the dramatic drop in interest rates to near zero as a reaction to the financial crisis. The substantial reduction in the value of Sterling against the dollar and the Euro between 2007 and 2009 can also be seen. And although there has been a slight improvement in the value of Sterling against both currencies over the past 12 months, this is both independent of interest rates, since these have not changed and, more importantly, in no sense a recovery to the pre-crisis levels. What is interesting about Figure 1, however is the fact that the relationship between interest rates and the value of Sterling against the Euro is much stronger at -0.80 compared to short term interest rates against the value of the US dollar against Sterling, where the correlation is 0.64. In other words, UK interest rates are more likely to provoke a sharper correction of Sterling against the Euro than they are against the dollar.

But whether or not this will impact trade is debatable. Figure 2 shows the historical relationship between short term interest rates and trade over the period since 2001.

 

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Figure 2  |  The Value of UK exports and imports (USDm) versus short term base rates, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

Mark Carney is clearly correct to think he can gamble on raising interest rates and it having a minimal effect on trade: the correlation of short-term base rates with exports over the period is -0.18 while for imports it is -0.25. While this is, of course, purely for illustrative purposes, it points to something that economists have suspected for a while of UK trade: that a change in interest rates that leads to a change in the value of the currency will have little or no impact on levels of trade. There has been a near 25% reduction in the value of Sterling since 2008; there has not been a commensurate increase in trade.

Figure 3 illustrates how the Terms of Trade have changed against the value of Sterling against the Euro and against UK base rates.

 

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Figure 3  |  UK Terms of Trade versus GBP per Euro spot, Last Price Monthly, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

There is a strong correlation over the period between the strength of the pound against the Euro and the terms of trade of 0.75. In other words, if Sterling strengthens, then the terms of trade over the period will also improve: exports will become more expensive relative to imports. This would almost be a truism were it not for the fact that the equivalent correlation with the Dollar is 0.18 – i.e. there is practically no relationship at all. So why would there be such a difference between the two exchange rates?

 

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Figure 4  |  Why UK trade with Europe is more vulnerable to a change in interest rates

Source  |  DeltaMetrics 2014

 

First, Europe accounts for 43% of UK goods trade and the US 10%. The UK’s top sectors are medicines, oil (crude and refined), cars and turbo-jet engines and turbines. The US is the biggest destination for both pharmacueticals and turbo jets engines and turbines, and the third and second largest destination for crude and refined oil respectively. Nevertheless, thirteen of the top 3 export destinations for Europe’s top five products are in Europe, helping to explain why the value of Sterling against the Euro is more important than it is against the dollar to UK trade.

Second, the USD-GBP rate is used more for speculation. Across the piece, its correlations with trade are weaker: the Euro is a trade-based currency so Sterling’s value against it is determined by trade rather than by speculation. This may make UK export trade itself more vulnerable should interest rates rise.

Relying on small-scale and incremental interest rate changes is likely to have little impact either on the value of Sterling or on the UK’s trade. The reason for putting up interest rates is usually to quell inflationary tendencies by making the cost of borrowing more expensive. In this case, the goal will be to dampen pressure on house prices which may create unsustainable growth in the UK economy.

But look again at Figure 2 and the trend in exports since September 2011. The values are actual historical values of trade and while the seasonal fluctuations in trade are clear, what is also obvious is a downward pressure on the value of UK exports in US Dollar terms. In other words, we are already seeing disinflationary tendencies affecting the value of UK exports. If interest rates do go up, this puts further negative pressure on inflation, which could create similar downward pressure on UK export prices in spite of a strengthening currency. The danger then would be of deflation brought on by the very instrument that was meant to be a cure: interest rates.

As a recent leader in the Financial Times* pointed out, the issue is one of a large productivity gap between the UK and the rest of the world, particularly the US and Germany. This weakens our manufacturing trade position and, arguably, makes UK exports uncompetitive not in price terms but in terms of the added value embodied in our high-end manufactured goods.

As was pointed out in a previous Trade View, the correlation between skills and UK trade is low at just 0.54 compared to figures of between 0.94 and 0.98 in the US, Germany and India and unless this gap can be closed, our progress towards global high-end competitiveness will be restricted by our productivity base. Like the post World Cup inquest, maybe we should be looking at the drivers of our own weak performance and not at the dominance of foreign players in our markets.

 

* Leader (June 13th 2014) | ‘Carney’s journey from dove to hawkFinancial Times

 

Trade Returns?

Why Obama was wrong to leave Japan without a deal | There is little doubt that President Obama’s visit to Asia was all about trade. The TransPacific Partnership (TPP) negotiations aim to enhance trade, economic integration and growth across the Asia-Pacific region particularly through the establishment of a free trade area (FTA) between the participants. That President Obama left Japan without an agreement is significant for the future of the TPP and his warnings to South Korea about its treatment of US exporters did nothing to reassure markets that the agreement was any closer.

However, at first glance, the relationship between inter-regional trade and key Asian markets and currencies would suggest that there is little for markets to be concerned about. US exports to and US imports from key countries within the region are strongly and negatively correlated with the Hang Seng Index (all above -0.72) and with the S&P 500 (again, all above -0.55). Similarly, Indonesia’s trade with the US is mildly but negatively correlated with the Rupiah’s value against the US dollar and India’s trade is mildly but again negatively correlated with the value against the US dollar of the Rupee. The only exception is Thailand: its exports to the US are highly and positively correlated with the Bhat’s value against the US dollar at 0.85.

If the links are so weak with currencies and strong but negative with key markets, why attempt to build a Free Trade Area? The conclusion from these largely negative correlations must surely be that Asia-Pacific is better served by intra-regional trade. The US, in this context has more to gain from the relationship than does Asia.

Japan-US trade is a proxy for countries elsewhere in the region and illustrates how the relationship between equity and currency markets and US-Asia trade has broken down since the financial crisis. For example, the relationship between Japanese and US trade was positively correlated with the Nikkei until July 2009. Although exports from Japan to the US continued to grow until September 2011, the correlation turned negative after that point and is particularly marked since the beginning of 2013, ironically, the start of President Abe’s tenure, as illustrated in Figure 1. While overall the correlation is negative at -0.55, much of this is accounted for by the post-crisis period.

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Figure 1 | Value of Japanese exports to the United States, June 2001-Dec 2014 (USDm) vs Nikkei Last Price Monthly, June 2001-March 2014

Figure 1 Source | DeltaMetrics 2014

Similarly, as with other economies in the region, there is also a weak, but negative correlation between Japan’s exports to the US and the value of the Yen against the USD (Figure 2).

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Figure 2 | Value of Japan’s exports to the US, June 2001-Dec 2014, USDm vs Yen per US Dollar, Last Price Monthly, June 2001-March 2014

Figure 2 Source | DeltaMetrics 2014

Again, the most marked post-crisis turning point in the relationship between exports to the US and the value of the Yen is at the start of Abenomics where the Yen has been depreciating against the dollar. This cannot be seen as anything to do with trade HGH since it is a deliberate policy choice, and the correlation, -0.29, reflects that. However, what is very clear from Figure 2 is that the currency depreciation is not having a marked effect on increasing exports to the US.

And again like other countries in the Asia-Pacific region, Japan is heavily dependent on intra-regional trade: some seven out of ten of its top export destinations are within the region. The correlation between Japan’s terms of trade (the value of exports in relation to the value of imports) and the value of its currency against the dollar is positive at 0.79 suggesting that the depreciation of the Yen is likely to be important in shoring up the value of its exports more generally.

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Figure 3 | Japan’s terms of trade (value of exports/value of imports), June 2001-Dec 2014 vs JPY per US Dollar, Last Price Monthly, June 2001-March 2014

Figure 3 Source | DeltaMetrics 2014

These negative correlations between trade and equity and currency markets are replicated across the region. Indian trade with China is negatively correlated with the value of the Rupee against the US Dollar, for example. But this should not be a surprise. Much of Asia is still emerging and all of Asia-Pacific is heavily dependent on trade with itself. The structure of trade is, even between advanced economies within the region and less advanced economies, dominated by commodities and intermediate manufacturing; the equity and currency values, in contrast, have been heavily driven by speculation in the post crisis period and while South-South trade remains set to grow by just 5.3% over the next year it will be some time before this type of hubris resumes (Figure 4).

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Figure 4 | USDbn value of North-North and South-South trade, June 2001-Dec 2015

Figure 4 Source | DeltaMetrics 2014

Neither the US nor Asia can afford to leave the negotiations in limbo, not just because of the importance of export-led growth in a sustainable global recovery. There are two reasons for this. First, an FTA in the Asia-Pacific region that extends beyond the South-East Asian nations (already represented through ASEAN) would create advantages from the reduction of costs of trade between nations and potentially help to shore up the south-south trade that was so much a feature of post-crisis recovery but that has waned since.

But second, the US would become a minority trading bloc accounting for just under 12% of world trade compared to the nearly 35% of world trade that the Asia-Pacific region accounts for and the just over 34% that the European Union accounts for including intra-regional trade. In the end, by leaving Asia without a trade deal, the US has weakened rather than strengthened its position: China is currently excluded from TPP but is critical to its trade structure. There is, potentially, more scope for an agreement between all nations in the region including China than there is between the region and the US if the US does not take a pragmatic approach to negotiations. President Obama and his team should be thinking about trade returns in every sense.

The Dog That Never Barked?

Why deflation may yet bite | Deflation has come back on to the agenda. It never really left – it is the dog that never barked in the wake of the downturn: the sheer scale of the fiscal stimulus around the world has meant that, with the notable exception of Japan, we have experienced dis-inflation, or falling price levels, rather than deflation, which is negative price levels. With recovery in Europe and North America apparently beginning to take hold, why would commentators and analysts start to fear its bite now?

The answer is that it is not just Europe that needs to worry about deflation. Chinese trend growth is falling and March’s declines in copper and iron ore prices underscore the over-capacity in the Chinese economy that are symptomatic of lower domestic demand and that raise the spectre of deflationary contagion for Asia and the rest of the world.

The similarities with Europe are striking. Lack of demand in Germany  keeps inflation low in the Eurozone. While this benefits the weaker economies in the Eurozone in terms of competitiveness, making their prices cheaper and giving their consumers some spending power, if German demand remains low, then its inflation remains low. Because it is a surplus nation, its over-production pushes down prices in peripheral countries too, putting further downward pressure on investments and increasing the cost of their debt.

The threat of deflation from China’s lack of demand is best seen through the lens of South-South trade, illustrated in Figure 1a and 1b. China’s demand is a major determinant of South-South Trade, and the two charts show clearly the inverse relationship between South-South trade and the strength or weakness of the currency.

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Figure 1a (left)  |  Real-USD and Zloty-USD Last Price Monthly versus monthly USDm monthly value of South-South trade, June 2001-Feb 2014

Figure 1b (right)  |  INR-USD versus monthly USDm monthly value of South-South trade, June 2001-Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg


The post-crisis recovery in trade continued until the beginning of Q2 2011 and the emerging currencies 
continued to strengthen. Since then, however, South-South trade has been volatile but with flat trend growth. The Real and the Rupee have deteriorated against the US Dollar. The Zloty has strengthened slightly, but this is because Poland is integrated into European supply chains, especially through Germany.

This points to two dangers: first, the fact that China’s trade is volatile and not increasing at the rate that it was between 2010 and the middle of 2011, meaning that South-South trade is relatively unpredictable and not as buoyant as it was either pre- or post-crisis. This will put downward pressure on prices in China and in other emerging economies. As prices fall, servicing debt becomes more difficult.

Second, the fact that emerging market currencies (here proxied by the Rupee and the Real in particular) are associated with South-South trade growth presents a further challenge for US denominated debt. Emerging market trade is slowing and the pressure on prices is downward. This puts downward pressure on the value of the currencies too, making dollar denominated debt more expensive – further exacerbating the debt challenges caused by any potential deflation.

Figure 2 looks at the problem on a global scale and shows how deflation may already be working its way into trade values and into lower metal prices.

 

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Figure 2  |  World Trade (USDm) versus Copper, Steel, Platinum and Gold Spot Last Price Monthly (June 2001-Feb 2014)

Source  |  DeltaMetrics 2014, Bloomberg

The first point from this chart is the clear flat-lining of trade values since March 2011 and a decline from May 2013 through to February 2014 in nominal value terms. Second, through the whole period, key metal prices are highly correlated with world trade, at above 0.79 for all metals. However, since August 2008 only Copper and Gold have been highly correlated (0.71 and 0.79 respectively) with world trade.

Both Copper and gold prices have fallen over the last 14 months but for quite different reasons. Copper is a proxy for economic development and manufacturing. In this context, its price will be strongly associated with economies that have strong manufacturing components to their trade, as illustrated in Figure 3.

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Figure 3  |  Copper Spot prices against the world’s largest exporters (value of exports USDm against Copper Last Price Monthly, June 2001-Feb 2014)

Source  |  DeltaMetrics 2014

 

The copper price is highly correlated (at above 0.85) for all these countries’ exports. However, since August 2008, China’s exports have exhibited the weakest correlation at 0.57. This may suggest that investors are already looking at stronger growth in Europe and the US in the near term while also expecting flatter manufacturing exports from China as a reflection of over-supply in Asia.

Gold prices, in contrast, are often used as a hedge against inflation and deflation. Theoretically, where deflation is a risk, gold, as a store of value during low or negative interest rates, would rise in price, although, as Figure 4 shows, the price of gold rose up to early 2008 despite sustained Japanese deflation. But Figure 4 also shows a marked decrease in the price between January 2008 and October 2008 and then from September 2012. These were periods of marked disinflation, as opposed to deflation.

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Figure 4  |  Gold Spot Last Price Monthly against Export Trade values for Germany, China, the US and Japan (June 2001-Feb 2014)

Source  |  DeltaMetrics 2014, Bloomberg

For the whole period, China, Germany, the US and Japan’s export trade has been highly correlated with Gold prices at 0.85 and 0.90 for China and Germany and 0.94 for Japan. Since the crisis, the correlation with Gold for Germany, the US and Japan has remained strong at 0.75, 0.79 and 0.86 but has weakened for China to 0.48. This is purely descriptive data but it suggests that investors have potentially been more concerned about the direct effects of deflation in developed economies until recently and have not regarded falling export prices in China as anything other than a competitive correction leading to disinflation rather
than deflation itself.

How worried to we need to be about either German or Chinese surpluses? There clearly is a deflationary trend globally manifesting itself through nominal trade values. But will this spill over into either the Eurozone or more widely across Asia?

 

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Figure 5  |  China and Germany’s Trade Ratio (exports/imports), June 2001-Dec 2014

Source  |  DeltaMetrics 2014

 

If the problem in either Germany or China is the balance of exports over imports, then Figure 5 is enlightening. Germany’s trade ratio has remained remarkably static since June 2001 suggesting that it is not Germany’s surplus that is causing new problems. Similarly, China’s trade ratio has tipped in favour of imports over exports since the downturn since it has declined overall since 2001. In other words, the challenges of over-production are not new for two economies that are export-driven or for their neighbours.

However, if there is an issue, it is that investors and commentators alike may yet talk themselves into a deflationary spiral based on what is, increasingly, compelling evidence that disinflation could turn into deflation.

 

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Figure 6  |  China and Germany’s trade balance, USDm against Gold Spot, Last Price Monthly, June 2001 – Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg

   

Figure 6 shows a high correlation between the Gold Price and Germany and China’s trade balances. It is the most recent months, where disinflation has been present, that both the trade balances and the gold price have declines most sharply. The only other time when the simultaneous decline was as strong was between July 2008 and January 2011. But while German trade is highly correlated since this point, suggesting investors have priced in European disinflation, the decline in gold prices appears to lead the Chinese trade surplus since September 2012. In other words, investors began to worry about Asian prices then but may not see this as a real issue of deflation since recent price rises are strongly associated with geo-politics rather than economics.

In the end, trade flows in nominal value terms provide evidence that disinflation is an issue in both China and Germany with obvious effects for Asia, South-South trade and Europe. Of particular concern is the size of the debt burden of peripheral countries in Europe and Dollar-denominated debt in Asian markets. Defaults alongside downward pricing pressures could make deflation really bite and this is what markets are currently nervous about. And, as Figure 7 shows, the correlation between World Trade and the S&P 500 was positive up until August 2013 but has been negative since suggesting some form of correction is perhaps overdue.

 

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Figure 7  |  World Trade Values (USDm) against S&P 500 Last Price Monthly, June 2001-Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg

However, whether or not the dog will start to bark will depend on recovery in Europe and the US. If this proves sustainable, then it is yet possible that deflation’s bark may be worse than its bite.