Lessons from QE in four charts

Why nothing should be taken for granted  |  March 2015 marks the start of Quantitative Easing (QE) in Europe. The much anticipated programme will inject €1.1tn into the eurozone’s coffers up to September 2016 at a rate of €60bn per month from next month. The European Central Bank will be purchasing national government bonds from member states and, in so doing, it will have become the “lender of last resort” in Europe at last ceding to demands that it provides a backstop to Europe’s fragile sovereign nations in the wake of the financial crisis.

While this has created an uneasy truce between markets and Europe, there is still a long way to go. With QE, systemic risk from sovereign default is avoided and the immediate impact has been to boost equity markets and weaken the value of the euro. Theoretically, this should boost confidence and exports. However, the volatility in markets at present is a product of the broader uncertainty around the effectiveness of QE. Markets need to be convinced that it was the right strategy in the first place, not least because of the broader uncertainties around European geopolitics at present, and are in a mood to test European policy makers in any way they can.

One of the principles of QE is that it reduces the value of the currency and thereby supports real economic growth through exports. Here are the lessons from that trade perspective in four charts:


Chart 1  |  US QE – market correction overdue




Figure 1  |  Monthly Value of US exports (USDbn) versus S&P 500, last price monthly
Source  |  DeltaMetrics 2015, Bloomberg


The chart shows the close correlation between monthly movements in trade and the S&P 500 at 0.715. Each horizontal line shows the start of a QE programme: December 2008, November 2010 and latterly September 2012. US exports during that time have grown modestly, while the S&P 500 has increased in value substantially faster than its pre-crisis rates, particularly since QE3 in 2012. It appears that one effect of QE has been to worsen the disconnect between asset values and the real economy up to the start of this year.


Chart 2  |  Abenomics and the paradox of the yen




Figure 2  |  Monthly value of Japanese exports versus JPY per USD spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


Japan’s relationship with QE has been a long one and has produced a bizarre result: except for the period between October 2004 and May 2007, the relationship between the strength of the yen and exports has been the reverse of what would be expected. As the value of the yen strengthened between June 2001 and October 2004, exports increased. Similarly, as the value of the yen decreased shortly before the implementation of Abenomics in 2012 through to Shinzo Abe’s final asset purchases in October 2014, export trade actually fell. This is a lesson for the developed world economies: exports are currency inelastic and therefore depreciation is unlikely to have much impact on export-led growth.


Chart 3  |  UK QE and the export mystery


The purpose of UK QE was arguably to protect against systemic risk and loosen up the supply of credit in the banking system to enable bank-to-bank lending. It did not have as its primary focus either exports or real growth. However, as the rest of the world started to pull out of the downturn in the wake of the financial crisis, the question of why sterling had depreciated so much without any impact on exports took on renewed importance. The Conservatives, elected in 2010, set export-led growth as its target and set a goal to double UK exports between 2010 and 2020 to a value of £1 trillion.




Figure 3  |  Monthly value of UK exports (USDbn) vs EURGBP spot (value of 1 euro in sterling), June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


UK QE started in September 2009 and was boosted further in October and November 2009. In October 2011 an additional £75bn in QE was announced followed by £50bn each in February and July 2012. Rather than causing the value of sterling to drop, the immediate market reaction was for it to strengthen. Interestingly, the terms of trade are negatively correlated with the value of sterling at -0.754. In other words, exports will grow in value in relation to imports as the value of the currency depreciates. This is exactly as it should be. Yet the facts demonstrate a very weak correlation (0.466) between the value of sterling and exports. QE has strengthened rather than weakened sterling, as in the US, especially against the euro but even so, sterling has not returned to its levels against the euro of 2001 and has therefore depreciated over the whole period, as have exports.


Chart 4  |  QE in Europe – a combination of both?


Previous trade views have expressed scepticism at the impact on trade of any reduction in the value of the euro. Like Japan, the eurozone’s trade is highly currency inelastic and, as a result, the depreciation of the euro is unlikely substantially to increase exports and therefore provide a much-needed boost to growth.




Figure 4  |  Monthly value of eurozone exports (USDbn) vs Dax Index, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


However, it is likely that the value of European stock markets could increase substantially. The Dax has reached all-time highs since QE was announced and this creates as substantial a disconnect between economic fundamentals and equities in Europe as there has been in the US and the UK. But this QE-induced asset boost, unlike in the US, comes without an accompanying boost to the real economy in the form of infrastructure spending. Instead, it may well come with restrictions on real growth if sovereign responsibility is tied to austerity rather than structural reform and long-term growth.

Policy makers in Europe now have to ask which lessons they want to learn, and from which chart.

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).




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.




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.




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.

Damned if they do…?

Why QE will not be enough for Europe  |  It is easy to view the Swiss National Bank (SNB)’s decision to drop its cap on the value of the Franc against the Euro as a harbinger of chaos to come. The immediate market reaction, pushing the Swiss Franc up by nearly 30%, arguably makes the currency case to support exporters less compelling for Quantitative Easing (QE). QE was always likely to depreciate the Euro, so if it has already depreciated, can it be justified on currency grounds?

We will probably never know whether the SNB’s decision was a Machiavellian one prompted by conversations held behind closed doors on the scale of QE to be undertaken by the ECB; nor will we know if it was insider knowledge of a concession to Germany: that individual sovereigns would be made responsible for their own debt. Heaven forbid, but the move could simply have been the SNB formulating policy on the basis of pure national interest. It would be possible to imagine a thought process that ran something like this: “If there is substantial QE, then there will be a run on the Euro. That will make it very expensive for us to maintain the cap and it will be better to have clarity now by instigating the drop in the Euro under Swiss-controlled conditions rather than leave it up to European policy makers.”

Who knows? But whatever prompted the move, it has done two things: first, it has thrown markets into confusion ahead of the ECB’s decision. In essence, unless the ECB introduces “substantial” QE, of say €1 trillion or more, the Euro could go into free-fall (if last week wasn’t free fall already). With this €1 trillion may well come conditions – Germany will not support QE if it means it is liable for others’ sovereign debt as the Eurozone’s paymaster and is likely to insist on the “concession” that sovereigns take responsibility for their own debt. A large announcement with strings attached is as bad for markets as a smaller announcement but with no strings attached: damned by markets if they do introduce QE.

But second, and more importantly for longer term Eurozone competitiveness, the move has also prompted more serious conversation on whether or not QE is the right thing to do for the Eurozone. It is not likely to be inflationary, not only because there is no evidence from the Bank of Japan (or indeed the Fed) that QE is inflationary, but also because oil prices have fallen so steeply that we are already in the throes of deflationary pressures if not outright deflation. While this may actually help producers, the fact is that it is arguably the perception of a threat of deflation that inhibits decision-making, not deflation itself.

What is clear is that the Eurozone needs to boost its demand urgently. Delta Economics is forecasting that intra-Eurozone trade will fall by 3.7% during 2015. This extends beyond oil prices because intra-European trade is predominantly in high-end sectors like automotives, pharmaceuticals, electronics & machinery. Markets know this and the Euro is therefore highly correlated over time with its trade at 0.84. In other words, month-by-month, if the value of the Euro appreciates against the US Dollar, trade in the short term will rise; if its value depreciates against the US Dollar trade will decrease (Figure 1).



Figure 1  |  Monthly value of Eurozone exports, USDbn vs USD per Euro, last price monthly, June 2001-December 2015
Source  |  DeltaMetrics 2015


The strong association between trade and the value of the currency is counter-intuitive and needs some interpretation. Normally, a drop in the value of the currency would suggest a rise in exports, but in the case of the Eurozone since 2001, the reverse appears to be the case. Rather than a Euro depreciation improving trade prospects, it actually diminishes them. While this is not causal, what it clearly demonstrates is the relationship between the markets and the Eurozone: the Euro is a currency that is traded on the basis of the strength of the Eurozone as a trading bloc. Where the Eurozone looks weaker, so the value of the currency falls.

This does not augur well either for the prospects of growth in the Eurozone or for the value of the currency. It certainly leads to the conclusion that more is required to boost Eurozone demand than simply purchasing government debt, indeed that QE may well be too little, too late. Falling oil prices may well provide a boost to companies by reducing producer prices but without strong demand in Eurozone there is little that producers can do to take advantage of low prices and low borrowing costs.

The days ahead of the announcement will be dominated by uncertainty and volatility for markets and businesses: that much is clear. Ahead of the announcement it is likely we will see further depreciation of the Euro to test the tensions between Germany and the ECB on further austerity measures. Alongside further drops in oil prices and perception of a deflationary threat, the uncertainties that this creates for business are manifest.

And this is the real paradox of ECB policy at the moment: if it instigates wholesale QE then it will prompt further depreciation of the Euro – whether it is unconditional or not. With conditions if the rumours prove true, the run on the Euro may start earlier. And yet, if the ECB decides to go for a smaller-scale QE or no QE against market expectations but to spend money on infrastructure instead, then there will also be a run on the Euro: damned if they do, and damned if they don’t.


Damned if they do…?: Why QE will not be enough for Europe  |  Trade View Author  |  Rebecca Harding  |  CEO

Demanding times

Why Europe urgently needs to focus on long term competitiveness  |  The Eurozone has a problem, but not the one that policy makers thinks it has. On the face of it, prices falling by 0.1% between October and November, growth at 0.2% in Q3 and unemployment at 11.5% is quite enough to concentrate minds as ECB policy makers sit down at their next meeting on the 4th December. The ECB is coming under increased pressure to stimulate demand across the Eurozone in order to stave off disinflationary pressures that may result in deflation and hence raise the spectre of the Eurozone becoming like Japan: negative price increases alongside near-to-zero growth.

But the problem is not disinflation, nor even deflation as such. It is long term competitiveness and the policy paradoxes that have taken the Eurozone, and, indeed the whole world to the brink of a low inflation, low growth normality as oil prices continue to tumble.

Within Europe the problem is not the willingness to boost investment through Quantitative Easing (QE) and low interest rates. The ECB is already committed to sovereign Bond purchases for peripheral nations if those nations commit to structural reform, which, while contested by Germany and its Constitutional Court, represents a statement of intent. Alongside the promise for corporate bond and asset backed security purchases, the ECB is clearly in the market for some form of QE alongside negative interest rates if necessary.

The policy paradox is this: the solutions that are currently under discussion are aimed at the monetary side of the Eurozone economy while having the effect of contracting the real, demand, side of the economy. By definition, monetary instruments are being used to shore up the banking sector, to inject financial stability into the system and to reflate the economy by increasing the money supply. The hope is that by creating a financially stable system, credit conditions will loosen and, alongside structural reforms and austerity at a national level, will naturally generate growth over the long –term. But the austerity packages and national structural reforms alongside this flatten demand and therefore the capacity for the policies to work over the long term.

One measure of just how flat demand and of how important the drive for greater competitiveness should be is trade. The picture for Europe does not look good: the value of European exports is forecast to decline outside of the EU by 0.5% in 2015 which is a long way from the robust export-led growth that the region needs. Within European EU28 trade is forecast to decline by 3.5% and Eurozone trade by 3.7% over the next year, as shown in Figure 1 which illustrates imports trade within Europe and into Europe from non-EU countries.



Figure 1  |  Monthly value of intra and extra EU and Eurozone imports (USDbn)
Source  |  DeltaMetrics 2014


Imports from outside of the EU are forecast to drop by 1.45%. Much of the drop in imports from non-EU countries has to do with the falling oil prices (Figure 2). 7 out of the top 10 oil importers into Europe are not in the EU28 and as 30% of the EU’s imports in value terms are oil and gas, the link between falling import values and the reduction in oil prices is clear. There is a 94% correlation between EU imports from non-EU countries and the oil price: the flat trade forecast for 2015 therefore, suggests that there may be some small upward correction in oil prices but nothing substantial until the end of Q1.



Figure 2  |  Monthly value of EU imports from non-EU countries, June 2001-Dec 2015 (USDbn) vs NYSE Arca Oil Spot, Last Price Monthly, June 2001-Nov 2014
Source  |  DeltaMetrics 2014, Bloomberg


In theory, this helps the EU and the Eurozone because it reduces producer costs and, hence, arguably prices as well. Disinflation, which is simply falling prices, is catalysed by lower oil prices but does not in itself represent anything negative.

Of more concern is the forecast drop in intra regional trade between EU28 and Eurozone countries, which is forecast to fall by 3.5% and 3.7% respectively. Much of this trade is dominated by high-end manufactured goods, for example, automotives, consumer electronics, pharmaceuticals and machinery. If demand for these products is falling (Figure 3) then it suggests a deeper malaise within the system that is triggered by disinflation but leads ultimately to lower demand.



Figure 3  |  Europe’s demand problem
Source  |  DeltaMetrics 2014


Europe clearly has a problem: it’s demand for the higher end products that have defined its consumption patterns in the past is falling: demand for cars will fall by around 5% in 2015 and demand for medicines by 2.4% and 0.6% respectively. This matters for the world because, if demand is falling, then Europe has the potential to transmit its lower demand through the trade system to the rest of the world since it accounts for 44% of medicines, 34% of cars and 26% of computer imports across the world.

So if Europe is demanding less, then, accordingly, other countries will see their aggregate demand affected by the drop in trade to Europe as net exports drag further on global GDP. This is reflected in the forecast for European car and medicines exports, both top ten trade sectors for the world, which are set to fall by around 1% in 2015. As EU produced Pharmaceuticals account for 64% of all world exports, and cars for 50%, this suggests a tough year ahead.

All is not lost and the highest end, research-led exports from Europe, aircraft and biopharmaceuticals are set to grow significantly. In other words, the challenge for European policy makers is to ensure that Europe remains competitive at the highest end of the manufacturing supply chain where it already dominates global exports.

It is unlikely that the ECB will consider QE on Thursday and most economists expect any European QE to happen in Q1 2015 at the earliest. Delta Economics is of the view that European long term competitiveness is now a more pressing issue than addressing issues of disinflation. A substantial boost to European and domestic infrastructures, particularly to support high end manufacturing industry, is a necessary counterpart to any austerity measures to bring wayward budgets under control. Any QE at any point will be potentially necessary to stabilise international markets but not sufficient to fuel long term growth.

From Russia with love

Why the collapse of the Rouble matters  |  It might well be that President Vladimir Putin needed more sleep, as he said, and therefore left the G20 Summit early in order to rest on the long plane flight home. The Russian economy’s growth in the third quarter of 2014 was just 0.7% and the Delta Economics forecast for trade growth in 2015 is 3.5% – half the level seen in 2014. Some of the drop in trade values may well be due to lower oil prices but this does not explain the fact that imports are forecast to fall from over 9% growth to 4% growth in 2015. If this were not enough, imports of cars have been flat this year and are likely to shrink by 3.5% next. For so long car imports were a proxy for demand for luxury from a burgeoning middle class; so now, even a long plane flight may be too short to recover from the sleepless nights that President Putin may be facing (Figure 1).


Figure 1  |  President Putin’s sleeplessness explained
Source  |  Delta Economics


The collapse in the value of the Rouble cannot be helping Russian policy makers with their insomnia either. The correlation between trade and the value of the Rouble is very low at just 12% suggesting that the currency’s value is unrelated to trade and economic fundamentals but instead has a strong speculative component. When the Rouble was allowed to free-float in November, the result was an immediate devaluation – suddenly connecting it both with the real economy and with the fact that sanctions are making investors nervous.

In contrast, the value of the Moscow MICEX is highly correlated with trade (Figure 2), which helps explain its relative resilience to the battering that the Rouble is currently receiving. Russian export growth, this year at least, remains relatively strong and while this is the case, it can be expected that the MICEX will remain strong too.



Figure 2  |  Monthly value of Russian exports (USDm) vs MICEX,
June 2001-October 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg


Unsurprisingly, Russian exports are 94% correlated with the price of oil (Figure 3). This fact points to two dangers for the world economy.



Figure 3  |  Monthly value of Russian exports (USDm) vs NYSE Arca Oil Spot,
June 2001-October 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg


First, the decline in oil prices itself will cause the value of Russian exports to fall further which at least in part explains our lower trade forecast for 2015. This is bound to have a weakening effect on the Russian economy. Even the effects of strong oil and gas deals with China, which amount to a doubling of trade over the next five years cannot negate lower prices. More than this, China’s growth in mineral fuel imports is forecast to slow from above 11% in 2014 to just above 8% in 2015 and 2016. Russia’s trade growth is increasingly dependent on Chinese imports of fuels – and if these are growing more slowly, then this does not augur well for Russia.

Second, if Russia’s demand for luxury goods is declining then it is bound to have a negative effect on Europe. Figure 4 shows the effects of the fall in Russia’s demand for cars generally on Germany’s exports of cars in particular.



Figure 4  |  Monthly value of German exports of cars to Russia, USDm, vs DAX Index,
June 2001-Oct 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg


So any demand crisis in Russia comes back to affect Europe: the fall in German exports is forecast to continue after a brief respite at the end of Q1 2015 well into Q2 and Q3 of 2015 and, as German car exports to Russia are more than 83% correlated with the value of the DAX Index, this has the potential to create greater instability on European, indeed global, markets The Euro may also experience some fallout as well: German car exports to Russia are 60% correlated with its value.

From a Russian perspective it made sense to form deals with China given the vulnerability both of its own economy and of its relationship with Europe in the wake of the Ukraine crisis. However, there is a perfect storm brewing: a drop in oil prices and a drop in Chinese demand for mineral fuels which could threaten the Russian economy even further than it is currently threatened by sanctions.

There was very little panic on markets around the drop in the value of the Rouble. This is not surprising –the rouble has not been connected with economic fundamentals and it is now so some correction could be expected. But a weaker Russia matters for Europe because of the risks of contagion: the German export engine is being damaged by lower demand for cars and this has a compounded effect both on the value of the Euro and on the value of key European markets, specifically the DAX.

In Abe-yance

Why trade still holds the key to Japan’s growth  |  The decision by the Bank of Japan to boost the Japanese economy by around $712bn at the end of October was Quantitative Easing (QE) on such as scale that it took markets by surprise. It signals the determination of Japan’s policy makers to “do whatever it takes” to boost Japan’s sluggish economy, to increase the value of the Yen against the US Dollar and to prevent latent deflationary pressures from taking hold yet again. Boosting the Yen will import some inflation while it is hoped the QE will halt the contraction of Japan’s economy of 7.1% seen in Q2 this year.

Shinzo Abe is now faced with a decision: does he raise the sales tax introduced in April 2014 from 8% to 10%? That there should even be a question around this is remarkable.

As Figure 1 shows, Japan’s imports were not impacted immediately by the sales tax and in fact rose between April 2014 and September 2014. However, we are forecasting a marked drop in imports from October, which, even with a brief spike in March 2015, will still represent a negative trend to the end of Q1. There is little sense in damaging what is at best a fragile recovery and this policy should be put on hold for the time being.




Figure 1  |  Monthly value of Japanese imports (USDbn) versus JPY-USD spot, June 2001-September 2014
Source  |  DeltaMetrics 2014, Bloomberg (currency data)


Japan’s imports since April alongside a marked depreciation in the value of the Yen point to one of the persistent paradoxes of Abenomics: why has trade failed to pull Japan out of its economic torpor?

Delta Economics is of the view that, since the Fukushima disaster in 2011, Japan’s policy makers have had relatively little influence over trade through manipulation of the Yen’s value. This is quite clear from Figure 2, which shows Japanese Terms of Trade in relation to the value of the Yen against the US Dollar.



Figure 2  |  Japan’s terms of trade (value of exports in terms of value of imports) in relation to Yen per USD Last Price Monthly, June 2001-September 2014
Source  |  Delta Economics analysis


The depreciation in the Yen against the Dollar pre-dates Abenomics by six months and, despite a mild pick-up in the terms of trade between July 2012 and April 2013, the impact of the currency depreciation since has been, perversely, for the terms of trade to deteriorate further. In other words, export values have not increased relative to import values, which might have been the result of an expected boost to exports from a currency devaluation.

This has less to do with fact that the relationship between the currency and trade has broken down (the so-called J-curve effect) and more to do with the fact that Japan’s dependency on energy imports has increased in the wake of the Fukushima disaster. Japan’s terms of trade deteriorated by nearly 9% between the disaster in March 2011 and the real start of currency depreciation in July 2012; over the same period, energy imports rose by nearly 14% (Figure 3).



Figure 3  |  Monthly value of Japanese imports (total and energy), June 2001- June 2015
Source  |  DeltaMetrics 2014


The figure shows two things: first, Japanese imports generally have fallen in value since the immediate post-crisis recovery and, in real terms will only be at the value they were immediately pre-crisis by June 2015. Insofar as Japan’s imports reflect its demand, this is a sharp reminder of the fact that the economy is still sluggish. Second, although energy imports in 2014 represent nearly 37% of Japan’s imports compared to just under 30% at the end of 2010, the fact that growth is also forecast to be sluggish into Q2 2015 suggests that industrial as well as consumer demand is likely to remain flat for some time.



Figure 4  |  Japanese trade – full of paradoxes
Source  |  DeltaMetrics 2014


Japan’s demand is likely to improve slightly in 2015 as witnessed by the mild pick up in imports that we are predicting for 2015. Exports, which have been sluggish globally as well as in Japan, will pick up. Electronics exports, for example, may well recover from the contraction in growth of 3% this year to flat or slightly negative growth in 2015. Similarly we are predicting a slight slow-down in the contraction of automotive exports in 2015.

The fact that flagship sectors, like cars and electronics are likely to see negative trade growth even into next year may suggest that Japan’s economy itself is no longer competitive. However, this is too simplistic. In an era of global supply chains, it is a mistake to suggest that the decline in exports represent the declining competitiveness of a whole country: global corporations locate globally to take advantage of competitive strengths elsewhere and Japan’s companies do this as much as their German, American or South Korean counterparts.

In a sense, then, it is imports that are of more interest because they illustrate some of the underlying patterns of demand within an economy. Japan’s policy makers have had their foot on the economic accelerator and brake at the same time, arguably since the Fukushima crisis rather than the beginning of Abenomics. Deliberate currency depreciation and fiscal stimulus alongside a sales tax has done little to boost exports or stimulate domestic demand. And because of the greater energy component of imports, falling oil prices now mean that Japan will be as prone to the disinflationary pressures seen in Europe and Asia. There is little that further currency depreciation can do to prevent this and while falling energy prices may help, if every country has falling energy prices, then it does little to boost comparative advantage.

Similarly, increasing the sales tax by a further 2% now may not have much of an effect on an already fragile start into 2015 that Delta Economics sees. It could well have a further negative effect in Q2 2015 and this is something to be avoided at all costs.

What goes up…

Why markets should recover but uncertainty will remain |  For almost all of this year, Delta Economics has been arguing that global equities are long overdue a correction. The reason for this is simple: there is a high correlation between trade values and the global markets (68% for the FTSE and S&P 500 and 85% for the Dax). There is an even higher correlation between trade and emerging market equities at over 90% for the Kospi. If the Delta Economics forecast for trade growth is flat, then it should stand to reason that markets will also underperform.

But, as Figure 1 shows, what goes up appears to be going up forever. Since the bull-run began, trade has been relatively flat while markets have reached unprecedented heights. Even the putative crisis in emerging markets at the beginning of 2014 failed to have a lasting impact on equities generally despite ever-more negative news about trade.




Figure 1  |  Value of World Trade (USDbn) vs S&P 500, Last Price Monthly, June 2001-Dec 2014
Source  |  DeltaMetrics, 2014, Bloomberg


As markets do not consider trade data as market-leading, this should not be a surprise. What appeared to happen during the second week of October was that market analysts reacted to suspicions that interest rates might rise and that Quantitative Easing might stop in October. Simultaneously they realised that the Ebola crisis in Africa could have an economic impact while tumbling oil prices raised a spectre of disinflation and poor German data put the Eurozone crisis back in the spotlight.

So is this the moment where Delta Economics steps back and says, “We told you so”? The short answer is no, not yet. We are expecting markets to continue to recover their lost ground in October, but for volatility to remain high. We are forecasting a seasonal pick-up in trade, which means that Purchasing Managers’ Indices may well show some sign of recovery at the end of the month. This could spur equities if not to new heights, then at least to reverse the correction earlier this month (Figure 2).



Figure 2  |  Eurozone PMI (normalised value) versus Eurozone Delta Trade Corridor Index (Sentiment) change (June 2001-Dec 2014)
Source  |  Delta Economics analysis


The Delta Trade Corridor Index-Sentiment (TCI-S) measures the change in a country’s or region’s trade against its PMI. For the Eurozone, the correlation is 86% thus the slight pick-up we expect to see in trade this month is likely to be accompanied by a similar increase in the value of the Eurozone’s PMI. Similarly, we expect the PMI to improve for China and the US as well.

This is nothing more than a seasonal fluctuation and it is always a mistake to react to one month of data. Instead, it is more useful to look at the macroeconomic momentum. This is precisely what the TCI-S measures: the way in which trade is changing over time. What is clear from Figure 2 is that the Eurozone trend is downwards; the same is the case for the Global Manufacturing PMI, as measured in Figure 3.



Figure 3  |  Global manufacturing PMI normalised values vs Global Delta TCI-S change
Source  |  Delta Economics analysis


Figure 3 presents a more worrying picture of momentum: that well into Q2 next year will be the earliest we see any pick-up in our TCI-S or trade more generally. After an increase this month, the next five are likely to be weaker with the TCI-S turning negative.

The reason for this has as much to do the uncertainty caused by geopolitical risks as it does with macroeconomics; these risks will affect emerging markets in particular. While conditions remain uncertain, investment will be held back and it is likely that Africa will suffer first. Since March 2014 we have seen a year-on-year decline of 8% in West Africa’s trade. Further, we are expecting Chinese imports from West Africa to halve (from over 16% to 8% growth) in 2014. With falling oil and commodity prices generally, this represents a perfect storm for investment in Africa.




Second, Turkey is likely to suffer substantial economic fallout from the Iraq crisis. Turkey’s trade with Iraq alone is worth some USD11.6bn. Much of this trade is in oil and, although Iraq’s oil reserves are largely in the South rather than the ISIS-controlled North, we are still forecasting a 21% reduction in its imports from Iraq to January 2015. We also expect a 23% reduction in its trade with Syria over the same period.

Finally, oil prices have not risen as a result of the crises in the Middle East or in Ukraine although this may have been expected. Instead, prices have fallen as Saudi Arabia has increased its oil supply and as the USA, now the world’s largest oil producer has loosened its restrictions on exports. Trade values and oil prices are 94% correlated and our forecast of 0.56% trade growth in 2014 suggests that oil prices are set to fall further (Figure 4).



Figure 4  |  Value of world trade (USDbn) vs NYSE ARCA oil spot, Last Price Monthly, June 2001-Dec 2014
Source  |  DeltaMetrics, 2014, Bloomberg


The falling price of oil is a double-edged sword: while it lowers costs, it also raises the spectre of deflation, which is increasingly causing concern amongst analysts. If prices turn negative then it threatens global economic growth – as witnessed in the latest downgrading of IMF economic and trade forecasts.

Delta Economics is of the view that the IMF and WTO forecasts for trade growth, at over 3.1%, have still not sufficiently factored in the effects of falling oil prices. Based on data produced by the CPB Netherlands Bureau’s World Trade Monitor, the Delta Economics forecast still appears to be closer to actual trade than that of either the IMF or the WTO (Figure 5).



Figure 5  |  World Trade Organisation and Delta Economics World Trade Forecasts versus actual
Source  |  Delta Economics analysis


We are expecting a temporary increase in world trade in October that could well boost markets for the remainder of the month. However, we are also expecting trade to drop back considerably into the first quarter of 2015. The immediate reaction to the return of volatility in the early part of August must surely have been, “What goes up must come down” and over the longer term, we expect continued uncertainty to fuel volatility in markets. The potential for a major correction before the year end cannot be discounted. However, in the very short term, the reverse might well be the case: what goes down must surely come up again.



Under the same Umbrella

Why Hong Kong protests will not have a lasting economic impact  |  Hong Kong’s so-called Umbrella Revolution will worry markets and strategists around the world while it continues; it may even deter a few tourists. There is a potential risk that once a largely younger generation has started to express its counter-establishment feelings, more protests might follow. All of this creates a degree of uncertainty and, in turn, potential for market volatility and reduced trade.

Delta Economics does not see the Umbrella revolution as having a lasting impact on trade or Hong Kong’s role as a financial centre. There has been a downward correction in the Hang Seng since July, although this is more likely to be because of wider economic conditions in Asia than specifically the protests in Hong Kong (Figure 1).



Figure 1  |  Value of Hong Kong’s exports (USDm 2001-2015) vs. Hang Seng Index,
Last Price Monthly, June 2001-September 2014
Source  |  DeltaMetrics 2014, Bloomberg


The correlation between the Hang Seng Index and Hong Kong’s exports is 0.823. This is very high and given a forecast decline in monthly trade export values up to 2015, suggests that the correction that we are currently seeing may have some way to go. However, as can be seen quite clearly from the chart these corrections are cyclical. Delta Economics expects exports in November 2014 will be 1.3% below their 2013 values. By January and February 2015 they will be similar to their levels 12 months earlier – unimpressive growth, but growth nevertheless.
The reason why the protests will have little impact on trade is the very reason why there are protests in the first place: the Umbrella Revolution’s purpose is to point out to the world generally, but China in particular, that it has the right to democracy as a counterpart to the free market and free trade system that it has built. It is not questioning the symbiotic economic and trade relationship with China, merely saying that the logical political consequence of a free market economy is the existence of a democracy.

Hong Kong’s exports to the United States, its second-largest export partner, are just 12% of the US$294bn it is expected to export to China in 2014; while exports to China will grow modestly in 2014, at just under 5%, they are forecast to fall to the US by nearly 3%. This point is reinforced by the fact that it is not just Hong Kong’s exports that are highly correlated (0.817) with the Hang Seng Index (Figure 2), but Hong Kong’s total trade with China as well (0.813).



Figure 2  |  Value of China’s exports to the world and value of Hong Kong’s trade with China (USDm),
June 2001-September 2015 vs. Hong Kong Index, Last Price Monthly, June 2001-September 2014
Source  |  DeltaMetrics 2014, Bloomberg

The Hang Seng moves proportionately with both China’s exports and bilateral trade between China and Hong Kong. Although the correlation is marginally weaker for Hong Kong’s trade with China than it is for either Hong Kong’s or China’s total exports to the world, it is still apparent that the Hong Kong Index appears more dependent on the trade relations between the two countries in the longer term than it does on political relations.

Hong Kong’s export trade is only mildly and negatively correlated with the Hong Kong dollar at -0.525. The Hong Kong Dollar is pegged to the US Dollar and is traded within upper and lower limits (Figure 3). However, a depreciation in the value of the Hong Kong Dollar at present appears to be aligned not just with the protests, but also with broader downward trends in trade (Figure 3).




Figure 3  |  Value of Hong Kong’s exports (USDm), June 2001-September 2015,
vs. USD-HKD Last Price Monthly, June 2001-September 2014
Source  |  DeltaMetrics, 2014, Bloomberg


The correlation between China’s exports and the value of the Hong Kong dollar is 1 per cent stronger, which underscores the fact that the dependency between the two countries works both ways. There is very little correlation between the value of the Shanghai Composite index and either Hong Kong or China’s trade (less than 0.34 in both cases) suggesting that the Shanghai Composite is more of a speculative market that the Hang Seng. However, the correlation between both China and Hong Kong’s exports and the value of the Yuan is extremely high at 0.885 and 0.941 respectively suggesting that China’s currency manipulation may have positive spillover effects for Hong Kong’s trade as well as China’s (Figure 4).



Figure 4  |  Value of Hong Kong and China’s exports (USDbn), June 2001-September 2015 vs. USD-CNY spot,
Last Price Monthly, June 2001-September 2014
Source  |  DeltaMetrics 2014, Bloomberg


Thus far the revolutionary impact of the protests has been limited. Indeed, there are signs that the numbers of protestors are dwindling. However, they have been successful in raising global awareness of the issue of democracy in Hong Kong and there is no guarantee that these protests will be an isolated event.

The protests highlighted the issue of how important Hong Kong is to Chinese and world finance. Markets were unsettled by events and investor confidence was knocked, however briefly. However, it is unlikely that there will be a lasting impact on long-term confidence, a weakening in the rule of law, or even a threat to the free-market and trade traditions of Hong Kong. After all, in the end the two countries are, economically at least, under the same umbrella.

United Kingdom, but the problems are the same

Why interest rates will stay on hold for at least 9 months |  UK markets started to rise as soon as the opinion poll gap between the “yes” and the “no” votes in the Scottish referendum widened. This was as much out of a sense of relief as anything else. A more considered, if slightly glib, response when the final votes were counted came from a BBC interview with a bond trader, his view was that it would be business as usual: markets would start looking back at “fundamentals” and price in a rise in interest rates early next year.

Delta Economics does not see a rise in interest rates as likely in the next 9 months. This is because the macro-economic fundamentals, specifically trade, are too weak for this to be an option for the foreseeable future. The reassurance that the United Kingdom will remain intact as a currency union may initially play well with market sentiment; however, over a longer time period of time the spectre of falling prices and the performance of real economy in the form of exports cannot be excluded from the Bank of England’s thinking on interest rates. Add to this three things: first, there will be a Westminster election in May 2015; second, between now and then Scotland’s membership of the UK is to be renegotiated; third, if there is a Conservative government after May 2015 then there will be a Referendum on EU membership in 2017. All of this creates enough uncertainty around investment decisions to render an increase in UK interest rates extremely inadvisable.

But leaving the politics on one side, the first reason for suggesting that the UK cannot raise interest rates is that there is evidence of disinflation in recent historical export trade figures. Nominal values of trade have been on a downward trend since October 2011 and the UK’s annual export growth in 2013 was just 0.3%. In current prices, Delta Economics is forecasting negative export growth in 2014 (-0.65%) and 2015 (-0.1%) as illustrated in Figure 1.



Figure 1  |  Value of UK exports, June 2001-August 2015, USDbn versus Euro per GBP, June 2001-August 2014
Source  |  DeltaMetrics 2014, Bloomberg

As Figure 1 also shows, there is a low correlation between trade and the value of sterling against both the dollar and the Euro. This indicates that there are no advantages to be gained from altering interest rates. Higher rates would not be a powerful tool to make imports cheaper and, as there are disinflationary pressures anyway, lower import prices may be something that policy makers should avoid. Similarly, higher interest rates may push up the value of sterling but could damage exports and will exacerbate deflation.

In any case, sterling’s value has risen against the Euro and the dollar over the last 18 months and it would be dangerous to accelerate the process too quickly. Illustrated in Figure 2 are the UK terms of trade (i.e. the value of exports in relation to the value of imports), which have been improving gradually since early 2013 when sterling first started to strengthen. A gradual process allows UK exporters to become more competitive through quality and productivity rather than focusing simply on price. A hike in interest rates would distort this and make exports artificially expensive thereby lessening the impact of any productivity improvements by widening the gap again.



Figure 2  |  UK terms of trade vs Euro per GBP, last price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

Second, the sustained uncertainty around the global economy, European and Asian demand is affecting global trade. As Trade Views have noted successively, actual trade in 2014 is substantially below IMF expectations but, with the IMF and the OECD now reducing their forecasts for growth in 2014 and suggesting that Q4 may see a slowdown, it is likely that the manufacturing and export Purchasing Managers Indices (PMI) will suffer over the next 6 months. Our Trade Corridor Index – Sentiment (TCI-S) for the UK certainly suggests that the key PMI sentiment indicator is currently disproportionately high compared to export performance.

The correlation between changes in the Delta TCI-S and the PMI is over 70% and the flat outlook for UK trade is reflected in the TCI forecast; it is likely that the PMI will drop over the next few months reflecting the inherent weakness in underlying trade conditions and reducing the likelihood of a rate rise.




Figure 3  |  Delta TCI-S changes against changes in the PMI, June 2001-December 2016 (forecast)
Source  |  Delta Economics analysis

Third, the trade of key innovative exports sectors like cars and pharmaceutical products is highly correlated with the last price monthly value of sterling against the Euro (70% and 79% respectively). Both have been falling over the last few months as sterling has strengthened. Substantial policy effort has been put behind stimulating export growth in both of these sectors and particularly to China. Given that both are forecast to grow substantially over the next two years it is unlikely that the Bank of England will raise interest rates. This is because the effect of a rise in interest rates would be to strengthen sterling too far, too fast. This could potentially jeopardise any embryonic export-led growth outside of Europe.



 Figure 4  |  Value of UK exports of private cars to China (USDbn) vs Euro-GBP Last Price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014




Figure 5  |  Value of UK exports of medicines to China
Source  |  DeltaMetrics 2014

Fourth, trade is currently a drag on GDP. This is illustrated by the UK’s net trade openness: in other words the UK’s net exports as a proportion of GDP. The fact that this is falling means that the increases in GDP are forcing a rise in the deficit. This is creating the biggest drag on GDP since the financial crisis.



Figure 6  |  UK net exports as a proportion of GDP vs Euro per GBP, Last Price Monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

The disconnect between rising GDP and net exports has, as a consequence, created an asset bubble. The correlation between FTSE 100 and economic fundamentals trade has weakened since October 2011; the FTSE has risen while nominal trade values have been on a downward trend suggesting markets are no longer pricing in macro fundamentals such as trade. Disinflation, as evidenced by nominal export values and falling volumes (the forecast in current prices) means that this over-valuation is unsustainable. However, without a gradual correction, a rise in interest rates would exacerbate this detachment and pose the risk of a greater correction in Q4.



Figure 7  |  Value of UK exports (USDbn) vs FTSE 100 Last Price Monthly, June 2001- August 2015
Source  |  DeltaMetrics 2014

There are manifest reasons why a rise in interest rates is inadvisable in the current situation. In essence they boil down to the fact that national and global geo-political and economic uncertainties are too great to make a rise in interest rates probable in the next 9 months. A cynic might say that, in any case, there is a UK general election in 2015 and interest rates will not rise before then, but the weight of economic evidence suggests that there is no forecast pick up in the real economy or improvement in productivity. The economic problems remain the same and the process of building competitiveness through high value exports would be damaged by any increase in the value of sterling as a result of a rise in rates.


The invisible hand

Why Argentina needs free trade more than ever  |  There is little doubt that Argentina needs a miracle, or at least a helping hand. No, this is not another reference to football: just a simple statement of fact.

It has until the 30th July to find USD 1.3bn in order to avoid default. Argentina’s trade performance has suffered as a result of poor economic and trade tariff management since 2011. Trade declined in 2012 by over 4% and while it grew in 2013 and is expected to return to growth of around 7% this year, this will only take it back to the levels of exports last seen in the middle of 2011. Policy makers have focused instead on attracting inward investment to develop the large shale gas reserves, taking their eye of the trade ball. Yet even this policy has stalled: Delta Economics is forecasting that Foreign Direct Investment levels will increase in 2014 but this will again only take them just above the 2011 levels. Put simply: if Argentina is to stave off the permanent threat of default and encourage enduring FDI, it will have to bring the invisible hand back into its trade markets.

At first glance, it does not appear that trade matters unduly to the Argentinian economy. It still runs a trade surplus, although not as substantial as it was and this is reflected in its positive terms of trade (the value of exports in relation to the price of imports). Yet there appears to be very little correlation (-0.37) between its terms of trade and the value of the Argentinian Peso (ARS), as illustrated in Figure 1.


2014-07-07_the InvisibleHand_fig01

Figure 1  |  Argentina’s terms of trade vs ARS per USD, Last Price Monthly, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg


This matters in so far as countries with high correlations between trade and their currency values are less prone to speculative attacks on their currency. The Peso has weakened by around 50% since the financial crisis: the last time the deterioration in its value was as substantial, Argentina was gripped by its last sovereign debt crisis. While the decline in value has been over a longer period of time, it does suggest that traders are speculating against Argentina being able to re-pay its debt.

If this is the case, then it is more than worrying. Argentina needs to default on its debt a bit like its football team needs the Netherlands to score 2 goals in the first fifteen minutes of the game on Wednesday. If it defaults, then it will find it very difficult to raise the external capital/inward investment that it needs to begin the process of extracting shale gas. But as Figure 2 shows, Argentina is no longer a net exporter of oil and gas, so, in order to restore its self-sufficiency urgently needs this inward investment.


2014-07-07_the InvisibleHand_fig02

Figure 2  |  Value of Argentina’s oil and gas trade (USDm) versus ARS per USD, Last Price Monthly, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg


The Peso is barely correlated with oil and gas exports (-0.42), although it is correlated with its imports (0.72) suggesting that as the currency weakens (values are in Peso per USD), it is more likely to import oil which is worrying because it suggests that oil imports are plugging a structural weakness in Argentina rather than a response to imported oil being proportionately cheaper. And as the correlation with exports is so weak, it reinforces the view that the currency is more closely correlated with its economic condition than with its trade position.

So what is the scale of the challenge ahead? What does the Argentinian government need to do if it is indeed to create substantial economic growth through the inward-investment associated with shale gas production? Figure 3 presents the specific six-digit subsectors within natural gas that represent shale.


2014-07-07_the InvisibleHand_fig03

Figure 3  |  Value of Argentina’s natural gas imports and exports (USDm), 2001-2026 (forecast)

Source  |  DeltaMetrics 2014


Other things being equal, that is, if inward investment continues at the pace we are currently seeing it and if policy and the economic climate remain unchanged, then the picture is not rosy for Argentina’s shale gas revolution. Our model suggests that imports are already outstripping exports and that trend will continue to grow over time. The chance of a trade surplus is remote, as is the chance of self-sufficiency in gas.

It is not the intention to enter a debate on shale in Argentina, still less to suggest that this is the only way out of the current crisis. Instead, just take a look at where policy really can have an influence: trade. Argentina’s openness, in other words its trade as a proportion of GDP has grown from just under 30% in 2001 to over 60% now. The economy is more dependent on trade as a result since it is so important in relation to GDP.

Yet oil and gas is not the sector, arguably, where it should be focusing in the short term. There are two reasons for this. First, the normalised revealed comparative advantage of oil and gas has deteriorated from a position where it was competitive in 2001 (0.39) to a position where it is uncompetitive now (-0.51). We are expecting its position to deteriorate still further to -0.60 by 2020. In contrast, Automotives were uncompetitive in 2001 (-0.12) but are competitive now (0.32) and will be more so by 2020 (0.38).

Second, there appears to be a much stronger correlation between automotive trade and the value of the currency suggesting that some of the speculation may dissipate if the manufacturing side of the economy can be allowed to flourish as Figure 4 shows.


2014-07-07_the InvisibleHand_fig04

Figure 4  |  Value of Argentina’s automotive exports overall and to Brazil (USDm) vs ARS per USD, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg


If Argentina can grow its manufacturing sector then it stands a chance of creating real export-led growth, particularly if it focuses on the regional automotive supply chain to Brazil since the correlation between it and its currency is particularly high for that trade route. As the currency has weakened, this has strengthened the position of Argentina’s automotive sector in relation to Brazil and has provided a platform for growth.

This is where policy makers should focus to address the challenges of growth and currency stability in the long run and to provide a clear message to markets and arguably the US Supreme Court to stave off default in the short run. Trade suffered between 2001 and 2012 when tariffs were first imposed and Argentina can in no sense afford to make this mistake again. Free trade is as key – otherwise the “hand of God” may well start to look like an Argentina own goal.