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Investment Quarterly
April 2015
China National People’s
Congress (NPC)
Macroeconomic charts
Financial market charts
Market Data
Executive Summary
US dollar strength: a welcome
long term guest?
Lower oil prices: the implications
of the ‘Big Drop’
A deflationary wave has arrived
in the Eurozone, but it is not
the next Japan
Different directions
2
Contents
Executive Summary
US dollar strength: a welcome long term guest?
Lower oil prices: the implications of the ‘Big Drop’
A deflationary wave has arrived in the Eurozone, but it is not the next Japan
China National People’s Congress (NPC)
Macro and Investment Strategy team
Important Information
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6
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17
24
31
32
3
Executive Summary
Overview
Global economic growth is becoming more balanced
and less dependent on the US. Economic growth in
the US slowed in the first quarter of 2015, though
partly because of temporary factors. China’s growth
is also slowing and its current trajectory suggests it
could fall below the official target of 7%. In contrast,
other major economies have picked up, most notably
the Eurozone, leaving global growth stable overall.
Slowing growth in the US has also resulted in a more
moderate expectation for rate increases this year and
next.
This ‘lower for longer’ prospect has been a boon for
risk assets. Equities have set new all-time or multi-
year highs in the US, Europe and Japan in the last
quarter. Diminishing prospects for US rate rises have
softened the pace of appreciation of the US dollar,
but it still remains strong and a concern for more
vulnerable Emerging Market (EM) currencies. After
six months of falling prices, crude oil seems finally to
have found some sort of floor. However,
overproduction continues and the swelling glut of
inventory has yet to diminish, suggesting prices could
remain low for some time. This seems likely to keep
inflation in check for the next couple of quarters and
enable lower policy rates globally. However, as we
get to the end of the year, the favourable base effects
from low oil prices will unwind, pushing inflation
higher.
Euro weakness and Quantitative Easing (QE) have
helped create some impressive equity returns in the
first quarter. For example, the German DAX was up
22% in Q1 in local currency terms and was even up
an impressive 10% in US dollar terms. Equally,
stimulus in Japan has pushed Japan’s Nikkei up
10.5%. Asian markets also outperformed with the
Hong Kong Hang Seng China Enterprise Index
(HSCEI) up 17%. Latin America (LATAM) fared
worse, with some equity gains in local terms that
were however outstripped by currency losses. Core
government bond markets also performed well with
many markets hitting record low yields such as
Switzerland, where 10-year yields went negative and
Germany where 10-year Bunds ended Q1 at 0.18%;
the exception was Japan which moved sideways.
The best performer in periphery markets was
Portugal which rallied 100bp after they announced
they intended to repay their International Monetary
Fund (IMF) loans early.
US
The US Federal Reserve (Fed) removed the word
“patience” from its 18 March monetary policy
statement, providing flexibility for a rate hike.
However, it also acknowledged that economic growth
has moderated in recent months and signalled a
more gradual approach to monetary tightening.
Indeed, the Fed significantly revised down its
economic forecasts for both growth and inflation and
also lowered its estimate of the long-run equilibrium
unemployment rate. Furthermore, the Fed’s
expectations for appropriate policy rates over the
next couple of years have dropped significantly,
suggesting a more dovish stance than at the end of
2014. The median forecast for Fed policy rates at the
end of 2015 is now 0.625%, down from 1.125% last
December. This suggests that, on average, the Fed
is expecting between one and two interest rate rises
this year. The downward revisions to the Fed’s
interest rate forecasts also brought the projections
more in line with how financial investors view the
trajectory of policy rates going forward, as implied by
futures and swap markets.
Europe
The Eurozone is enjoying a strong cyclical upswing.
For example, the Markit Eurozone Composite PMI
survey increased for the fourth consecutive month in
March, while money supply and industrial production
growth both accelerated in January. Additionally,
data is consistently surprising to the upside of
consensus expectations. These recent developments
have been reflected by the European Central Bank
(ECB) in their macroeconomic projections, as they
upgraded their forecasts for Eurozone Gross
Domestic Product (GDP) growth from 1.0% to 1.5%
for 2015 and from 1.5% to 1.9% in 2016, citing the
favourable effect of lower oil prices, a weaker euro
and the impact of the ECB’s large scale asset
purchase programme. However, the Eurozone still
remains in deflationary territory, with headline
Consumer Price Index (CPI) inflation recorded at -
0.3% year-on-year (yoy) in February. Although the
effect of lower oil prices is likely to wash out of
headline inflation by the end of 2015, inflation is
expected to remain below the ECB’s target of 2%
until at least 2016 given the spare capacity within the
region.
Julien Seetharamdoo, Chief Investment Strategist
4
China
Growth in China continues to slow and risks
undershooting official targets. The risk of a hard
landing remains, although this is not our central
scenario. For example, monthly activity data for Q1
came in much weaker than expected across the
board with domestic investment and manufacturing
particularly weak. Retail sales growth was also below
consensus expectations and down from 2014 growth
rates. The property sector also continues to show
signs of softness. Local government financing
constraints, the reining in of Local Government
Financing Vehicles (LGFV), the decline in land sales
and the on-going anti-corruption campaign likely also
curbed local infrastructure investment. Government
policies have turned increasingly supportive of
growth recently, in line with the overall tone on macro
policy from the National People’s Congress (NPC),
including accelerated fiscal spending, monetary
policy easing, property policy relaxation, and
measures to help local government refinancing.
However, we think the government will need to step
up policy measures, in order to deliver their growth
target of ‘about 7%’ for this year and to create a
stable macro environment for reforms. We explore
these themes at more length in our article, ‘China
NPC: Growth stabilisation and economic
restructuring are two policy priorities in 2015’.
US dollar strength
While the Fed’s new lower growth and interest rate
projections have taken the edge off dollar strength
temporarily, the secular trend remains for a stronger
dollar. In our piece in the next section, “US Dollar
Strength: a welcome long-term guest?”, we examine
how interest rate and growth differentials have been
driving a stronger dollar. We examine the extent to
which this has been a boon or problem for different
markets and the extent to which a stronger dollar has
and could generate headwinds for the US economy.
For example, in theory a stronger dollar should be a
negative for US equities as it chokes exports, but in
practice they have outperformed in historic periods of
dollar strength.
A combination of falling commodity prices and a
strong dollar hit the commodity currencies very hard
during Q1. This was particularly true of the oil-
correlated Russian rouble (RUB) where Ukraine-
orientated sanctions helped create a run on the
currency. This hit crisis levels in December and
January but has eased off considerably since then.
Other commodity currencies fared equally badly with
Brazil, Colombia, Mexico, Nigeria, Malaysia and
South Africa struggling with weakening currencies.
The improvement in the current account due to the
United Sates’ increasing oil independence through
the ‘shale gas revolution’ has strengthened the dollar
and driven oil prices lower, which is the topic of our
next article.
Implications of lower oil prices
The more than 50% fall in oil prices since June 2014
has primarily been supply-driven, although demand
from China has fallen too. Though this balance hasn’t
changed in the first quarter, West Texas Intermediate
(WTI) Crude has stabilised in a USD45-55 per barrel
range. Structural excess supply suggests that lower
crude prices will be with us for a while. While the rig
count is falling, this has yet to feed through and US
production remains high. Department of Energy non-
strategic Cushing inventories, currently around 56
million barrels haven’t been this high since the
1930s. Despite the risk of conflict in Yemen and Iraq,
production in the region has actually expanded as
Iraq and Libyan production volumes have surprised
to the upside. In our article ‘Lower oil prices: the
implications of the Big Drop’ we look at the impact on
global growth and inflation of this dramatic
adjustment in energy prices. We argue that it
provides a net boost to global growth (although there
will be winners and losers) and is largely positive for
risk assets and fixed income in the medium to long-
term.
Eurozone deflation
The oil price drop has been one of the major
influences behind global deflation. Falling consumer
prices have opened the door for easing by over 30
central banks so far this year, especially in Emerging
Market (EM). In our inflation article, ‘A deflationary
wave has arrived in the Eurozone but it is not the
next Japan’, we explore the risk of deflation
becoming entrenched in various global economies as
it did in Japan. We also examine the effect of current
monetary policies, such as QE, on inflation and how
a weak currency can help lift inflation and what the
repercussions would be on financial markets.
Executive Summary
5
Conclusions
If current indications for a more balanced global
economy are accurate – with slower growth in the US
versus improving growth in Europe – then this should
be relatively supportive for risk assets. Much faster
US growth with unbalanced global growth, higher
short-end rates and a much stronger dollar could
create headwinds for equities and especially for EM.
As it is, moderate growth and rate expectations, low
inflation and globally accommodative monetary
policies should extend the current, relatively benign,
environment or ‘fragile equilibrium’.
Indeed, the Fed seems more preoccupied with
growth failing to meet expectations. Challenges for
policy normalisation have been pushed back towards
the second half of 2015 and into 2016, but will still
remain as growth starts to pick up and low energy
prices work their way out of inflation data.
A slow steady recovery also suggests lower
correlations between securities and asset classes, as
fundamental drivers assert themselves, presenting
greater opportunities for alpha generation within
portfolios.
Risks to this benign view remain, however. As well
as the risk that eventually the US Fed will have to
raise rates more aggressively than currently
expected, China looks like it might miss its growth
target – though not severely as more stimulus is
likely. Conflicts in Ukraine and the Middle East still
have the potential to deliver surprises to assumptions
about the lower costs of energy. Equally,
negotiations between Greece and its creditors still
look precarious.
Executive Summary
6
US dollar strength A welcome long-term guest? Michael Hampden-Turner, Senior Macro and Investment Strategist
Summary
The US dollar has strengthened on the back of
increasingly divergent global growth rates; this
creates policy implications. For example, the US
will soon be exiting from a long period of
extraordinary stimulus just as Europe and Japan
step-up theirs
A stronger dollar is also a product of structural
changes such as growing US oil independence
which has been shrinking the current account
deficit
Historically, periods of dollar strength have lasted
for more than five years. On a trade-weighted
basis the dollar has been much stronger than it is
now. It is also close to fair value against the euro
and yen. These factors suggest there are no
particular constraints on further dollar strength
Dollar strength has several impacts on the US
economy. A first-round effect is to weaken US
GDP through lower net exports. However, it also
has a deflationary effect which acts like a tax cut
for consumers and enables the Fed to persist with
lower rates for longer than it would otherwise. The
falling prices of crude oil add a similar tailwind
Elsewhere, a weak euro and yen are set to
provide a crucial boost to competitiveness.
Historically, a strong dollar has been bad for EM
economies, attracting foreign investment away
from EM and to the US. The dynamics may be
different this time
In theory, a strong dollar should increase
competitiveness and be a boost for non-US equity
but in practice domestic stocks have
outperformed in periods of dollar strength.
Different sectors and company-types face
different sorts of headwinds and tailwinds from a
strong dollar
A strong dollar has historically been associated
with a flattening of the yield curve, especially in
the period around the first rate hike. There has
also been a weak correlation between rates and
credit spreads
Higher rates are bad for precious metals as higher
treasury yields and a stronger dollar make holding
metals like gold less attractive. A strong dollar is
typically bad for commodities but, later in the
cycle, demand for industrial commodities tends to
pick up
Why has the US dollar strengthened?
Although the US dollar has strengthened 20% in the
last nine months on a trade-weighted basis, it has
been much stronger historically. Trends of dollar
strength can last for several years, as can be seen in
Figure 1. Expectations for the relative performance of
the US economy are already high, but if they are
exceeded then conditions will be in place for further
dollar strength in 2015. These conditions are: further
US economic growth outperformance, increasingly
divergent global economic policies and growing oil
independence. Let’s look at these in turn.
Global growth rates have become increasingly
divergent, with the US significantly ahead of many
developed economies. Bloomberg consensus
forecasts expect US GDP to grow 3.0% yoy in 2015
and 2.8% in 2016. In contrast, European growth is
only expected to be 1.3% and 1.6% in the same time
periods while in Japan 1% and 1.4% are expected.
This divergent economic growth outperformance
leads directly to divergent policy rates and
government bond yields. The Fed has signalled that
it is ready to raise rates in 2015 (although this has
Figure 1: US Dollar Trade Weighted Index is rising but still
low by historical standards
Note: Plaza accord= Plaza Agreement . Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
Figure 2: USD strength has been driven by relative rate
expectations as central bank monetary policies diverge
Note: LHS= Left Hand Side; RHS= Right Hand Side. Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
7
US dollar strength
recently been moderated to a reduced rate
trajectory). In contrast, Europe is only just starting
quantitative easing (‘QE’), and rates are near zero
and expected to remain low for the foreseeable
future. QE increases the monetary base and is
expressly designed to weaken the currency. There is
a similar monetary policy story in Japan which is also
embarking on a fresh round of QE. The mismatch in
timing of these policies has weakened both the euro
and yen relative to the dollar.
The shale gas ‘revolution’ has had a significant
impact too. The US were the first to exploit this
resource and estimated global reserves will make a
lasting change to energy supply and cost. The US
current account deficit has been shrinking over the
last decade as US energy independence has grown.
This has a long-lasting strengthening effect on the
dollar. In 2005, the US imported 60% of its oil
requirements while in 2013 this dropped to a third.
Looking back at Figure 1 we can see that periods of
relative dollar strength or weakness have lasted
seven or eight years on average from peak to trough.
Periods when the dollar is up to 20% stronger than
average for years at a time are not uncommon. On a
trade-weighted basis the dollar was strongest in the
1980s, prompting central banks to use the Plaza
agreement to engineer a weaker dollar.
However, further dollar strength from here would
require either further US outperformance relative to
current expectations or for the difference between
US, European and Japanese rates to be greater than
expected. We estimate that the USD is now at fair
value, based on relative (GDP-adjusted) PPP,
compared to the EUR and JPY. Hence, further USD
strength from here against the EUR and JPY is most
likely to be driven by relative macro fundamentals
rather than an additional valuation adjustment.
Negative effect on the US economy
What about the impact on the US economy? In this
cycle, as in others, dollar strength is usually
associated with growth and a tightening of
conditions. In a stronger dollar scenario, US goods
become less competitive for foreign buyers and
imported goods cheaper domestically. Therefore, the
first-round effect of a stronger dollar is to weaken US
GDP through lower net exports. The Organization for
Economic Co-operation and Development (OECD)
rule of thumb suggests a 10% appreciation in the
trade-weighted USD subtracts about 0.5% from GDP
growth and 0.3% from CPI inflation in the first year1.
Given that the USD has rallied 18% on a trade-
weighted basis since June 2014 this would suggest
90bp off GDP and 50bp off inflation.
However, these effects are offset by the fact that
lower growth and inflation expectations enable
monetary policy to be looser for longer. The
disinflationary pressure also provides support for
consumers’ real income, acting as a tailwind for
consumer spending and domestic demand.
Macroeconomic Advisers estimate this might add
back as much as 60 basis points (bp) to GDP2.
Of course, an end to easy money and low rates
creates a substantial headwind for business
development and a drag on areas such as real estate
growth. However, with rates still currently low these
effects are very much secondary.
The other coincident move is the positive effect from
lower commodity prices, particularly oil. Lower
energy and commodity prices act like a tax cut for
households and businesses, boosting real incomes.
When combined with low inflation both in the US and
globally it potentially enables the Fed to keep interest
rates lower for longer. It also has a positive, if
uneven, impact on the attractiveness of US
investments, as we shall see further on.
1Michala Marcussen, Societe Generale, “World Economy Stuck in
the Mud” November 2014.
Figure 3: A stronger dollar should weaken growth
through lower net exports
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
Figure 4: A stronger dollar should weaken growth through
lower net exports
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
2 Macro Advisers, data as at October 2014.
http://www.macroadvisers.com/2014/10/impact-of-a-rising-dollar-on
-the-u-s-economy/
8
US dollar strength
Impact of a strong dollar in Europe
Europe is deliberately pursuing a strong dollar / weak
euro policy to help pull it out of deflation and to
stimulate growth. In the same way as a strong dollar
will create headwinds for US corporates, a weak
Euro will provide tailwinds for Eurozone businesses.
Zero rates and quantitative easing make goods more
competitive abroad; the opposite of the effect
described above. It should add to Eurozone GDP in
the same way a strong dollar subtracts from US
GDP.
Europe is also going through a period of low inflation
which has a feedback loop with a weak currency. For
example, the ECB indicate a 10% change in the
currency can generate a 0.4-0.5% change in
inflation. The other key element here, as discussed
earlier, is lower commodity prices which also have a
deflationary effect.
The scenario is very similar in Japan, although the
country has been in a low growth phase for much
longer.
Emerging market economies in a strong
dollar environment
Historically, emerging markets have not fared well in
a strong dollar market. The last prolonged period of
dollar strength was in the late 1990s and it helped
spark the 1997 Asian ‘Financial Crisis’ and the 1998
default in Russia. However, conditions are quite
different now and a strong dollar / rising rate
environment doesn’t necessarily imply a repeat of
these extreme stresses.
At the time, the US Fed sought to fight inflation by
raising rates and allowing the US dollar to
strengthen. This attracted foreign investment to (and
back to) the US, away from EM. This sudden
movement of capital led to the rapid deflation of an
economic bubble that had developed over many
years.
There are several key differences today. In the
1990s, many countries maintained fixed or pegged
exchange rates; now many are floating. Equally, the
amount of internal, regional and local investment was
much smaller than it is today. The economy was
more leveraged, with levels of credit at seemingly
unsustainable levels before the additional burden of
currency moves. Also, the proportion of dollar-
denominated debt held in EM was much higher than
it is today. Finally, current account deficits are
narrower.
Some emerging markets are more vulnerable than
others to currency moves so talking about them
generically is misleading. In this context, it is hard to
separate lower commodity prices from a stronger
dollar. Countries with a combination of large levels of
debt relative to GDP, a substantial percentage of
dollar relative to local currency debt and a high level
of dependence on commodity exports have been the
hardest hit. Chile, Russia and Nigeria are commodity
exporters that have suffered in this environment.
The heatmap in Figure 5 illustrates the vulnerability
of different countries depending on how much hard
currency debt they have and their relative valuations.
If the majority of their debt is hard currency, and the
amount outstanding is large relative to their GDP,
then a strong dollar makes this much less affordable
and adds an additional burden to their economy. In
the heatmap Turkey and Malaysia look vulnerable by
this measure whereas Indonesia and the Philippines
look more resilient to dollar strength.
However, vulnerability is not the only part of the
investment equation. The key is the extent to which
investors are compensated for risks or, to put it
differently, how much of the vulnerability is already
priced into the investment.
Figure 5: EMs with large amounts of hard currency
external debts are vulnerable to a stronger dollar
Note: REER= Real Effective Exchange Rate. Source: World Bank, BIS, Bloomberg, HSBC Global Asset Management Note: External Debt data from World Bank, data as at September 2014, except Venezuela data (December 2013). Nominal GDP data from World Bank as at 2013. Real effective exchange rate data sourced from Bank of International Settlements (BIS), data as at 31 December 2014. For illustrative purposes only.
External Debt
(USD m)
External Debt
(% of GDP)
Valuation
(REER, 5-
year)
Vulnerability
Rank
Turkey 396,800 48.3 -0.3 1
Malaysia 226,398 72.3 -0.2 2
Mexico 418,777 33.2 -0.8 3
Venezuela 118,758 27.1 3.1 4
Peru 60,639 30.0 0.5 5
Bulgaria 49,334 90.6 -1.0 6
Chile 137,416 49.6 -1.9 7
South Africa 142,314 40.6 -1.3 8
Russia 679,422 32.4 -5.2 9
India 455,929 24.3 -0.9 10
Indonesia 292,286 33.7 -0.6 11
Philippines 57,730 21.2 2.1 12
Brazil 540,434 24.1 -1.6 13
Argentina 148,361 24.3 -1.2 14
9
US dollar strength
Investment implications: is a strong
dollar bad for US equities?
In theory a strong dollar should be a boost for non-
US equity in local currency terms; in practice US
equity has historically outperformed in strong dollar
periods, especially in dollar terms.
In local currency terms the outperformance is less
dramatic than Figure 6 suggests, however.
Valuations will also be a key driver of long-term
returns in our view.
While in theory a strong dollar should act as a
headwind for US equities the relationship is not
straightforward. Firstly, as we mentioned earlier,
dollar outperformance is a symptom of growth
outperformance, i.e. growth is a prerequisite for a
strong dollar in the first place. Secondly, some stocks
are more exposed to exports than others and
therefore more exposed to a strong dollar.
Within equities the mix between different sectors
and types of business means that some face
much stronger headwinds than others. This is
most complex for US multinational giants with sales
and costs spread globally. According to S&P,
overseas sales accounts for about 50% of the
combined revenue of the 30 companies represented
in the Dow Jones Industrial Average. This figure
drops to 16% of the S&P Smallcap 600 index.
This isn’t evenly spread between sectors either.
Figure 7 illustrates that those sectors that are most
dependent on foreign sales, such as Information
Technology (IT) and Energy, are theoretically most
vulnerable. In contrast, highly domestically-focused
sectors such as financials and consumer staples are
likely to benefit from a stronger USD relative to the
broader market.
There are some areas where vulnerability to the
dollar has been key. Materials and Energy have been
some of the worst performers in the last few cycles of
dollar strength. This is illustrated in Figure 8, which
demonstrates the negative correlation between the
Materials sector and dollar strength. It is far from
consistent, however, while the IT sector is the most
vulnerable, it has also been the best performer in
periods of dollar strength such as the late 90s and
2011-15.
The key takeaway is that periods of dollar strength
are much better correlated with cyclical
outperformance. IT, Consumer Discretionary,
Industrials and Financials outperformed in 1997-2000
and 2011-2015, while Utilities, Energy, Materials and
Staples underperformed.
Figure 6: S&P 500 has outperformed when the USD
Index (DXY, weighted basket of currencies) is strong.
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns. S&P 500 and Stoxx 600 in USD terms.
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns.
Source: Bloomberg, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
Figure 7: Sector breakdown of S&P 500 foreign sales
as a % of total sector turnover
Figure 8: Materials sector tend to underperform in
periods of USD strength. DXY vs relative performance
of materials
10
US dollar strength
Developed market equities
A weak currency against the dollar is a mixed
blessing for developed market equities. It provides a
critical boost for earnings by making exports cheaper
but is a major negative for investors from stronger
currency areas. US, Chinese and Gulf based
investors are going to be wary of potential currency
loss.
Let’s take Japan as an example, where the currency
has devalued by more than 15% since mid-2014
relative to the dollar. This has tempered the
otherwise impressive over 25% gain in the Nikkei
225 in yen terms (Data as at 31 March 2015).
A weak currency is partially a product of Quantitative
Easing (QE) and it is this factor that is likely to
dominate in weak currencies such as the yen and the
euro. The size of the Fed’s balance sheet and the
positive performance of the S&P have been highly
correlated, as can be seen Figure 9, even taking into
account associated dollar weakness during the same
period. This provides constructive guidance on the
considerable tailwind for European and Japanese
equities as they begin their QE programmes.
A stronger dollar is typically created by higher US
rates, or at least an expectation of higher rates,
relative to other major currencies. So a strong dollar
should be characterised by fixed income
underperformance. However, this characteristic is
more typical of late phases of the cycle once growth
outperformance has really taken hold. Early in the
cycle, treasuries tend to rally until the first rate hike.
This has especially been the case in this cycle with
the addition of QE.
Mixed for US Corporate Bonds
The link between a strong dollar and credit spreads
mostly has to do with the credit cycle. Following a
bust corporates deleverage, repair their balance
sheets and start to make profits. Credit starts to look
quite attractive at this point and spreads compress,
causing corporate bonds to rally. Corporates then
start to engage in capex, Merger & Acquisition (M&A)
etc and at some point Earnings Before Interest,
Taxes, Depreciation and Amortization (EBITDA)
stops expanding and they become more leveraged
and less credit worthy, even if still attractive from an
equity/earnings perspective. Historically, this tends to
carry on until another credit bust occurs and the
process repeats.
A strong dollar period tends to correspond with that
initial growth period, i.e. when credit is initially
attractive but becomes less so as the Fed raises
rates to combat increased borrowing and leverage.
Mixed effects for industrial commodities
Historically, a strong dollar has been bad for
commodity prices in the first phase of the cycle and
better for them as growth gets into full swing.
As can be seen in Figure 10, industrial metals and
crude declined in the late 90s until the end of 1998
when growth really took off after the end of the Asian
Financial Crisis.
Figure 9: US equities rallied in periods of QE
Note: TR= Total Return. Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns.
Figure 10: Goldman Sachs Commodity Index (GCSI) and sub
indices sold off and then rallied in a strong dollar
environment
Source: Bloomberg, data as at March 2015. For illustrative purposes only. Past performance is not indicative of future returns.
11
Higher rates bad for precious metals
A strong dollar has historically been negative for gold
as it is associated with higher treasury yields. As an
asset class, precious metals tend to react badly to
perceived ‘risk-free’ assets such as treasuries
offering more attractive yields. In 2011, gold
achieved record prices in a crisis and at a time when
it seemed likely that US yields would remain low for a
very long time. As the current period of dollar
strength has progressed, and expectations for rate
rises have increased, gold prices have fallen. Even
precious metals such as palladium, that have
industrial uses, tend to lose value in a strong dollar
environment.
US dollar strength
Figure 11: Correlation between gold and US treasuries
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
12
Lower oil prices The implications of the ‘Big Drop’ Shaan Raithatha, Macro and Investment Strategist
Summary
The over 50% fall in oil prices from June 2014 to
January 2015 was primarily supply-driven, though
weak demand also played a part. Oil prices have
stabilised somewhat in the first quarter of 2015
Lower oil prices should provide a net boost to
global growth, though there will be winners and
losers. Inflation, particularly across the developed
world, has already fallen considerably, though a
rebound is expected later in 2015 assuming oil
prices remain relatively stable
With the exception of the energy sector, equities
proved to be fairly resilient to falling oil prices.
Historically, defensive stocks such as healthcare
and utilities appear to outperform relative to the
broader market index when oil prices are falling
Within fixed income markets, nominal developed
market government bond yields have fallen,
driven by deteriorating inflation expectations,
while US high yield spreads have widened
The net boost to global growth should be
supportive of risk assets. An attractive entry point
for high yield credit may also arise should oil
prices remain relatively stable, or even rebound,
given the observed spread widening
Falling oil prices have led to perceived safe-haven
developed market government bonds becoming
increasingly less attractive, given that yields have
fallen considerably since June. However, the
recent bouts of market volatility and increased risk
aversion highlight the need to construct a well-
diversified portfolio
Why have oil prices fallen?
From June 2014 to January 2015, oil prices tumbled
by over 50%, with both WTI and Brent crude oil
falling by around USD60 per barrel. However, oil
prices have stabilised somewhat in the first quarter of
2015 (Figure 1).
The ‘Big Drop’ in oil prices was driven primarily by a
surge in supply, though weak demand has also
played a part. Since June, oil produced by
Organisation of the Petroleum Exporting Countries
(OPEC) members has accelerated considerably.
This is partially due to Iraq being able to meet its
production targets, despite escalating geopolitical
tensions, and a better-than-expected recovery of
Libyan oil production. In addition, non-OPEC oil
supply has continued to grow at a strong rate, driven
by the US shale revolution.
On the demand side, weaker global economic growth
expectations also exerted downward pressure on oil
prices. Despite the US experiencing robust growth in
the second half of 2014, the Chinese economy
continued to slow, growth in the Eurozone was
stuttering and Japan briefly entered recession.
The cyclical growth outlook between regions has
changed slightly in recent months, with economic
data suggesting US growth slowed in the first quarter
of 2015. However, this was offset by a pick-up in
growth momentum within the Eurozone, supported
by a weaker euro and ‘ultra-loose’ monetary policy.
It is important to note that weaker demand has also
contributed to considerable falls in other commodity
prices, such as coal, copper and steel.
Figure 1: Oil prices collapsed by over 50% from June
2014 to January 2015, but have stabilised since
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
Figure 2: The fall in oil prices was primarily
driven by a surge in global supply
Source: Energy Intelligence Group, HSBC Global Asset Management, data as at February 2015. For illustrative purposes only.
13
Although global supply and demand forces had been
pointing to an oil supply glut for many months, oil
prices were supported by the belief that OPEC would
react by cutting their production targets, as they have
done in the past. However, at the November OPEC
meeting, the oil cartel decided to take no action,
thereby maintaining its aggregate production target
of 30 million barrels per day. Indeed, Saudi Arabia’s
oil minister stated that it was “not in the interest of
OPEC producers to cut their production” given that at
current lower prices their market share is likely to
increase. The outcome of the meeting caught the
market off guard and triggered a steep sell-off in oil
prices.
As a result of recent developments, financial market
participants have revised down their oil price
forecasts significantly, both in the short and long
terms. Interestingly, the current prices of crude oil
futures contracts imply that lower oil prices are
expected to persist. Futures prices are currently
suggesting that West Texas Intermediate (WTI)
crude oil will remain below USD60 per barrel for the
next twelve months (Figure 3). This likely reflects an
expectation that global oil supply will remain
relatively high, with both OPEC and the US unlikely
to cut production soon, while global demand is
expected to remain subdued, particularly as China
attempts to rebalance its economy and make it less
commodity-intensive. However, market expectations
and implied futures prices can change rapidly,
especially in the face of a significant supply shock
such as a sudden escalation of geopolitical risk or a
cancellation of oil projects as producers react to
lower oil prices.
Macroeconomic implications
Lower oil prices should provide a net boost to
global growth, though there will be winners and
losers
A fall in oil prices will likely provide a net boost to
global economic growth, primarily through higher
consumption as real household incomes rise, and
through lower input costs. Indeed, a recent
simulation conducted by the International Monetary
Fund (IMF) estimates that global GDP growth in
2015 will increase by 0.3-0.7% compared to a
scenario without the drop in oil prices. Although the
global economy is likely to benefit in aggregate, there
will be a significant distribution of wealth from oil
producers to oil consumers. Oil consumers, such as
the US, Eurozone, Japan and China, are likely to
benefit from lower oil prices through a boost to real
household disposable income, lower manufacturing
input costs and improved current account positions.
Of course, the strength of these effects will vary
across countries. For example, China and India are
likely to benefit the most from the real income effect
given they have a large share of oil consumption as a
percentage of GDP. Similarly, US consumers are
likely to benefit more than UK consumers due to the
lower level of fuel taxes in the US than in the UK,
though there may be potential job losses in the US
shale energy sector.
However, the effect of falling oil prices on oil
producers will undoubtedly be negative and will
detract from economic growth through falling oil
Figure 4: Oil producing countries that have high
fiscal breakeven prices are the most vulnerable
Figure 3: Crude oil futures currently suggest that
the recent fall in oil prices is likely to persist
Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.
Source: IMF, HSBC Global Research, Ecuador Finance Ministry, data as at 31 March 2015. For illustrative purposes only.
Lower oil prices
14
Lower oil prices revenues and profits. The economies that are most
vulnerable are likely to be those that have high fiscal
break-even prices, that is, the price of oil at which
governments of oil-exporting countries are able to
balance their government budgets. These notably
include Venezuela, Nigeria and Saudi Arabia (Figure
4). Russia is also particularly vulnerable given that
energy accounts for 70% of its exports and half of
government revenues.
Headline inflation has fallen considerably across
the developed world, though the effect of lower
oil prices is expected to be transitory
Falling oil prices have already translated into lower
inflation within developed market economies. Indeed,
the decline in oil prices drove the Eurozone into
deflationary territory from December 2014 and even
the US experienced negative inflation in January
2015, though it has bounced back since. Inflation
amongst the OECD economies has fallen from 2.1%
yoy in June 2014 to 0.6% in February 2015 (Figure
5).
Within Emerging Markets (EM), falling oil prices have
so far had a mixed impact on inflation. In China, CPI
inflation fell to a low of 0.8% yoy in January 2015, but
has bounced back. In India, inflation actually
increased in the first two months of the year as a
result of a sharp rise in food prices, but has since
fallen. Moreover, in both Brazil and Russia, inflation
has increased sharply, but this has been driven by
sharp depreciations in the Brazilian Real (BRL) and
Russian Rouble (RUB) respectively. Nevertheless,
lower oil prices are still expected to act as a drag on
EM inflation in the coming months.
However, assuming oil prices remain relatively stable
for the rest of 2015, as they have done in Q1, the
drag of lower energy prices will wash out of headline
inflation completely by early 2016. Figure 6 illustrates
this for US inflation, assuming that WTI crude oil
remains at around USD50 per barrel.
What has the impact been on other asset
classes?
Although falling oil prices have triggered bouts of
volatility and increased investor risk-aversion over
recent months, developed equity markets have
proven to be fairly resilient. Indeed, the MSCI World
index excluding the energy sector has posted gains
of almost 10% in local currency terms since 20 June
2014, while energy stocks have fallen over 20%
during the same period (Figure 7). Within emerging
markets, it is noticeable that Asian equity markets,
which are majority oil consumers, have outperformed
their Latin American counterparts, who are generally
highly reliant on commodity exports, including oil. For
example, since 20 June 2014, the MSCI EM Asia
index has outperformed the MSCI Latin America
Index by over 14% in local currency terms. (Data as
at 31 March 2015)
Figure 7: Developed market equities excluding energy
have rallied despite falling oil prices
Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only and does not constitute any investment recommendation. Past performance is not indicative of future returns.
Figure 5: OECD inflation has fallen significantly,
driven by falling oil prices
Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only.
Figure 6: Assuming oil prices remain at current
levels, the energy contribution to inflation will
wash out completely by early 2016
Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only.
15
Over the last 30 years, we have identified three
previous occasions when the oil price has fallen by
over 50% in the space of a few months (Figure 8).
Interestingly, the two supply-driven oil price collapses
identified (in 1985-1986 and 1990-1991) coincided
with equity market rallies. For example, from
November 1985 to March 1986, the over 60% fall in
the oil price, triggered by Saudi Arabia ramping up its
production to full capacity in order to defend its
market share, facilitated a 14% rally in the MSCI
World index in local currency terms during the same
period. Developed market equities have not
experienced as strong a rally this time around, with
the MSCI World Index returning just over 2% in local
currency terms from 20 June 2014 to 30 January
2015.
However, during this period, there were large
differences between regions. Japan’s Nikkei 225
rose over 15% as the Bank of Japan provided further
monetary stimulus, while US stocks were weighed
down by a stronger USD and concerns over the
normalisation of monetary policy. European equities
were also held back by concerns over growth
momentum and disinflationary pressures, though
they have subsequently rallied strongly on the back
of the European Central Bank’s (ECB) sovereign QE
programme, a weaker euro and a more optimistic
growth outlook. Emerging market equities also
experienced differences within regions, with
commodity-consumers broadly outperforming
commodity-producers. Looking forward, equity
markets should be supported by a falling oil price if it
translates into a much-needed boost for the global
economy, benefitting energy consumers the most.
Within sectors, energy stocks have significantly
underperformed since June, as expected. However,
across other equity market sectors, the impact of
falling oil prices has been more varied. Defensive
stocks such as healthcare and utilities appear to
outperform relative to the broader market index as oil
prices fall, while materials and industrials
underperform. Indeed, these sector trends appear to
be fairly consistent over time, as illustrated in Figure
9.
Within fixed income markets, yields on developed
market government bonds have fallen since June,
reflecting deteriorating inflation expectations. Both
10-year US Treasury and German Bund yields fell by
around 100bps to 1.64% and 0.30% respectively
from 20 June 2014 to 30 January 2015. Since the
end of January, US 10-year Treasury yields have
picked up to 1.92%, while German 10-year Bund
yields have fallen further to 0.18% as the ECB began
its sovereign QE programme (as at 31 March 2015).
The fall in “safe-haven” government bond yields is
consistent with what has been observed through time
– developed market government bond yields have
fallen in each of the three previous occasions
identified where the oil price has fallen by over 50%,
again driven by falling inflation expectations.
In contrast to the strong performance of developed
market government bonds, the US high yield market
experienced significant spread widening between
June 2014 and January 2015 (Figure 10).
Figure 9: Historically, defensives such as healthcare
and utilities have outperformed as oil prices fall
Figure 8: Previous occasions when oil prices have fallen by over 50%
Note: MSCI World Index expressed in local currency terms.
Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only.
Past performance is not indicative of future returns.
Source: Bloomberg, HSBC Global Asset Management, data as at February 2015. For illustrative purposes only. Past performance is not indicative of future performance.
Start End Dynamics No. Months
Start Price
(WTI,
USD/bbl)
End Price
(WTI,
USD/bbl)
Price fall (%) Change in MSCI World Index (%)
Change in US Treasury 10Y
Yield (bps)
Change in Barclays
US HY Spread (bps)
1 Nov-85 Mar-86 Supply-driven 4 31 12.3 -60.3 14.0 -189 -
2 Oct-90 Feb-91 Supply-driven 5 39.7 17.9 -54.9 16.4 -91 1260
3 Jul-08 Dec-08 Demand-
driven 5 145.3 33.9 -76.7 -30.0 -185 1274
4 Jun-14 Jan-15 Supply-driven 7 107.3 48.2 -55.0 2.1 -96 260
Lower oil prices
16
This is driven by the fact that energy companies have
significantly increased their share of the US high
yield benchmark, with a weight of approximately 15%
in 2014, compared to less than 5% ten years ago.
Looking back to the previous periods of large oil price
falls identified, US high yield spreads also widened
substantially. However, the spread widening
observed in both 1990-91 and 2008 was each time
associated with recessions and rising default rates,
which is not the case today.
Lower oil prices
Investment Implications
Assuming oil prices remain at or around current
levels, the global economy should receive a net
growth boost over the coming months, which should
be supportive of risk assets such as equities. An
attractive entry point for high yield credit may also
arise should oil prices remain relatively stable, or
even rebound, given the observed spread widening.
Perceived safe-haven developed market government
bonds have become increasingly less attractive given
yields have fallen considerably since June, driven by
deteriorating inflation expectations. However, the
recent bouts of market volatility and increased risk
aversion highlight the need to construct a well-
diversified portfolio, including this asset class.
Moreover, the anticipated transfer of wealth from oil
producers to oil consumers will likely cause
differences in performance between regions, with the
US, Eurozone, Japan and China all likely to benefit
from a boost to real household disposable income
and improved current account positions.
With the exception of the energy sector, equities
have proven to be fairly resilient to falling oil prices.
Historically, defensive stocks such as healthcare and
utilities appear to outperform relative to the broader
market index when oil prices are falling, while
materials and industrials tended to underperform.
Figure 10: US high yield spreads experienced
significant widening as oil prices tumbled
Source: Bloomberg, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only. Past performance is not indicative of future returns.
17
A deflationary wave has arrived in the Eurozone but it is not the next Japan Rabia Bhopal, Macro and Investment Strategist
Summary:
Low oil prices drove Eurozone inflation into
negative territory in December 2014
The current outlook for deflation is not necessarily
dangerous, as it is mainly driven by the oil price
drop, which only has a temporary impact on
energy price inflation
However, low core inflation could continue as
wage growth will remain weak due to a large
amount of slack in the labour market
The ECB’s QE programme reduces headwinds to
inflation through a weaker currency
By the end of 2015, we expect inflation to pick up
in Europe as there is a positive base effect from
the decline in the oil price in 2014
What is deflation and why is it so bad?
Deflation in the Eurozone is a “protracted fall in
prices across different commodities, sectors and
countries. In other words, it is a generalised
protracted fall in prices, with self-fulfilling
expectations”. This is the definition of deflation that
ECB President Mario Draghi gave in the summer of
2013. At the time, Draghi said that the Eurozone was
just on a disinflationary trend (falling inflation rates),
while risks of deflation (falling prices) were, however,
subdued. Nearly two years later, inflation in the
Eurozone has turned negative. This report looks at
what forces are dragging down inflation, mainly in
Europe, but also elsewhere. Is prolonged deflation a
real threat for the Eurozone?
Most consumers would, of course, regard falling
prices as good news, given the boost to their
spending power. After all, the burst of deflation in
2009 arguably contributed to the subsequent global
recovery by boosting consumer spending. What’s
more, it is reasonable to distinguish between
deflation due to some favourable external shock or
supply-side development, such as the slump in oil
prices, and a more general decline in the prices of
goods and services due to weak demand. The former
is sometimes described as ‘good’ deflation, which
may simply increase the amount of money that
people have to spend on other items. But even where
falling prices are a symptom of weakness in
domestic demand, sometimes described as ‘bad’
deflation, the resulting boost to real incomes may still
mean that deflation is part of the cure.
What is going on in the Eurozone?
High levels of spare capacity across the developed
world, in addition to deleveraging forces, have
exerted downward pressure on global consumer
prices. The recent tumble in commodity prices has
exacerbated this trend. In the US and Eurozone,
inflation has already dipped below zero while the UK,
Japan and most of Asia are experiencing
disinflationary trends. The Federal Reserve and the
Bank of England are likely to ‘look through’ a period
of deflation and begin raising rates. However, a
phase of falling headline consumer prices has
opened the door for easing by over 30 central banks
so far this year, particularly in emerging markets.
It is worth highlighting that the Eurozone has been in
deflation before. As Figure 1 shows, having remained
remarkably steady and close to the ECB’s 2% ceiling
in the first eight years of the euro’s life, inflation
climbed sharply above 4% in 2008, before dropping
equally sharply and entering negative territory in
2009. That bout of deflation lasted only five months,
however, and inflation then rose quickly back to 3%
before embarking on its latest long descent.
In December 2014, Eurozone inflation turned
negative to -0.2% yoy for the first time since October
2009, falling further in January (-0.6% yoy). However,
figures show February’s headline inflation at -0.3%
yoy. In line with the recent drop in oil prices, the main
drag came from energy price inflation (-7.9% yoy).
Core inflation (defined as headline excluding energy,
food, alcohol & tobacco) was stable at 0.7% yoy in
February. The breakdown showed that the decline in
headline inflation was broad-based across the
Eurozone, with 16 out of 19 countries reporting a
negative inflation rate. Only Malta (+0.6% yoy), Italy
(+0.1% yoy) and Austria (+0.5% yoy), listed a
positive inflation rate.
Figure 1: Eurozone headline CPI inflation entered
deflationary territory in December 2014
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
18
A deflationary wave has arrived in the Eurozone but it is not the next Japan
What has caused the fall in Eurozone
inflation and will the latest bout of
deflation be just as brief as the last one?
A key issue here is what has caused the fall in
Eurozone inflation. The chart below sheds light on
this by showing the contributions to annual inflation
of the three key components that are energy, food,
and core. It shows that the 2009 bout of deflation was
very strongly driven by a deeply negative contribution
from energy prices, reflecting the sharp drop in oil
prices from over USD 130 per barrel in mid-2008 to
just USD40 per barrel by the end of that year.
With oil prices doubling in 2009, however, the
negative impact on inflation quickly went into reverse
and with core price pressures remaining more
robust, the headline inflation rate rebounded sharply.
Indeed, only 12 months after troughing at -0.6% in
July 2009, inflation was back close to the ECB’s 2%
ceiling and its subsequent further climb towards 3%
even prompted the ECB to raise interest rates twice
in 2011.
Of course, falling oil and energy prices have also
played an important part in the latest drop in inflation
and it is worth noting that core and food price
inflation are low from a historical perspective. During
the summer of 2014, food price inflation turned
negative for the first time since the financial crisis,
while core inflation has balanced around its new
historical low of 0.6% since September.
Deflationary pressures are already
broader
Although energy effects have been the primary
downward force, deflationary pressures are generally
broader than they were in 2009. Not only is core
inflation lower than it was then (+0.7% versus a low
of +0.8%) but more components of the CPI have
entered negative territory. Key components such as
household goods, communication, and recreation &
culture all have low or negative inflation.
Inflation expectations have fallen
markedly which could give rise to
prolonged deflation
Another rather less comforting development is the
fact that the drop in inflation appears to have caused
inflation expectations to become distinctly detached
from the ECB’s 2% target. For example, as the chart
below shows, the implied market expectations for
consumer price inflation has fallen markedly over the
past year.
Figure 2: Main contributions to Eurozone
headline inflation
Source: Eurostat, data as at March 2015. For illustrative purposes only.
Figure 3: Eurozone inflation by key sectors –
June 2009 and December 2014
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
Figure 4: Eurozone inflation expectations have
deteriorated significant since mid 2014
19
A deflationary wave has arrived in the Eurozone but it is not the next Japan
Admittedly, the chart also shows that the same
measure dropped equally sharply back in 2009, only
to rebound just as quickly when inflation itself picked
up again. But if deflation lasts longer this time – if
only because energy effects are not so quickly
reversed – it will create a risk of prolonged deflation
where the danger of a more permanent shift in
inflation expectations could feed back into lower
wage growth and a delay in consumer spending
could presumably increase.
So what are the risks of prolonged
deflation in the Eurozone?
If there is a severe negative economic shock, the risk
of prolonged deflation in the Eurozone could rise and
past experiences of deflation suggest prolonged
deflation may significantly harm economic activity.
There are three potential risks if deflation becomes
entrenched:
1. The cost of servicing existing debt rises as
inflation falls. Falling inflation leads to higher real
interest rates as nominal rates are often fixed. So
rather than simply boosting spending power, falling
prices may lead to outright declines in nominal
incomes – including wages, profits and government
revenues. This means that the current low rates of
inflation in the Eurozone are increasing the
importance of member countries’ already high public
and private debt levels. Rising debt service costs
may in turn reduce consumer spending and business
investment.
2. The second risk is that a surge in debt defaults
drives asset prices lower, particularly property and
other assets used as collateral, further increasing the
fragility of the financial system. This in turn, could
lead to an even more catastrophic decline in
economic demand.
3. The third risk is that expectations of ever-falling
prices become entrenched and a debt-deflation
spiral develops. This could encourage households to
delay spending, in the hope that they will eventually
be able to buy goods more cheaply. It could also
prompt companies to cut back on investments, for
fear that future returns will be lower. This sort of
deflationary spiral was avoided in 2009 partly
because major central banks responded with bold
monetary easing to boost inflation expectations and
keep real interest rates positive. But with nominal
interest rates now near zero, they have much less
room for manoeuvre
Who is most at risk in a prolonged
Eurozone deflationary environment?
Not all Eurozone countries are expected to face the
same issues in a prolonged deflationary
environment. Heavily-indebted economies with high
unemployment, low-trend real growth and already
low expectations of inflation are particularly
vulnerable to deflationary spirals as well as countries
that have a large output gap. To create a list of the
countries most likely to be impacted, the IMF in its
World Economic Outlook October 2014 publication,
selected the Eurozone countries that have a budget
deficit larger than 3.0%. The forecast output gap in
2014 for those countries was also noted. The IMF
then ranked the countries for both variables, and
added the two results to rank the countries again
based on this combined score. That final ranking was
thus based on an unweighted average of the other
two ranked scores.
Those most susceptible to lowering prices were
generally the peripheral countries that are currently
working to recover from the crisis and to regain
competitiveness relative to the core countries, as
shown in Figure 6. But one of the core countries,
France, also made the list. Taking into account the
weak economic growth in France and Italy over the
first half of 2014, these two are especially likely to
face further disinflationary pressure.
Source: Bloomberg, data as at March 2015. For illustrative purposes only.
Figure 5: Falling prices make debt burdens
harder to service
20
A deflationary wave has arrived in the Eurozone but it is not the next Japan
Deflation is rare
Persistent deflation, with prices falling over many
years, is an exceedingly rare phenomenon, at least
in the post-World War II era. There have been only
14 occurrences of deflation in the past 54 years, of
which only three (including Japan) occurred in
developed economies. With the exception of Japan –
which has had two separate periods of deflation
since the late 1990s – all of the remaining examples
of deflation were in countries operating fixed
exchange rate regimes.
This shows just how harmful entrenched deflation
can be for an economy. Following the bubble’s
bursting, Japanese corporations held high levels of
debt, which remained the same in nominal terms.
Then, as prices fell, the real value of corporate debt
increased. To avoid further increases in debt, these
firms reduced investment which in turn lowered
growth, deepening the economic downturn,
increasing unemployment and widening the output
gap. Japan’s greatest weakness was the policy
response to its economic woes, including
unsuccessful experiments in quantitative easing.
Japan is still suffering from effects of the ‘Lost Two
Decades’. Economic indicators finally seem to be
returning to healthier levels as Abenomics sets in,
with its ’three-arrowed’ reform programme (fiscal
stimulus, monetary easing and structural reform) to
address chronically low inflation, decreasing worker
productivity, and an ageing population. However, the
implementation of structural reform has been
delayed.
There are some similarities in the causes of deflation
in Japan and the recent experience in parts of
Europe. Like Spain and Ireland, Japan saw a
significant property bubble that, when it burst, threw
the economy into recession. However there has not
been a Europe-wide property bubble. Like Japan,
European banks were slow to write off bad loans,
and credit growth has stagnated.
However in Europe, the stock market bubble was not
as large and its bursting was part of an international
phenomenon in the wake of the Lehman collapse.
Furthermore, in the absence of exchange rate
devaluations, crisis-hit countries reacted with a raft of
reforms to regain competitiveness, including wage
and price moderation and, where possible, a shift
from labour taxes to consumption taxes. This so-
called “internal devaluation” aims to depreciate the
real effective exchange rate by realigning labour
costs with productivity, thereby restoring
competitiveness and, as a result, unwinding current
account deficits, a first step toward a sustainable
growth path for these economies. Countries in which
the internal devaluation has been the most
successful are generally those where structural
reforms have also been readily implemented such as
Ireland, Portugal, Spain, and, to some extent,
Greece. By contrast, France and Italy have fallen
behind in the reform race.
Overall, the fact that Japan is the only relevant
(modern) example provides some reassurance that
deflation is not something that occurs easily or
frequently in developed countries.
Figure 6: Vulnerability rankings
Source: IMF World Economic Outlook, data as at October 2014. For illustrative purposes only.
Overall
Rank Country
Fiscal
balance
2014 (% of
GDP)
Output gap
2014 (% of
GDP)
1 Spain -5.7 -5.0
2 Portugal -9.2 -3.5
3 Cyprus -5.0 -3.4
4 Greece -3.6 -9.4
5 Italy -3.3 -4.3
6 France -4.0 -2.8
7 Ireland -4.7 -2.5
8 Slovenia -4.0 -3.3
Figure 7: Deflation is unusual in advanced
economies
Lessons from Japan
Japan’s case was characterised by a series of
negative and mutually reinforcing factors, some,
but not all, of which are shared by the Eurozone.
At the end of the 1980s, Japan saw an asset price
bubble, prompting the Bank of Japan (BoJ) to step
in with sharp monetary tightening. This caused the
stock market to crash, asset prices to plummet
and the economy to fall into recession.
Consequently, non-performing loans increased
dramatically and credit became extremely
constrained. In the absence of an expansionary
monetary policy from the Bank of Japan, deflation
set in a couple of years after the crash.
Developed Market (DM) Emerging Market (EM)
Hong Kong Argentina
Japan (x2) Bahrain (x2)
Malta Libya (x2)
Niger
Saudi Arabia (x2)
Senegal
Syria Source: OECD and IMF. Deflation definition: 3years or more of negative inflation. For illustrative purposes only.
Sample 1960-2013 (54 years), 180 countries, annual CPI inflation
21
A deflationary wave has arrived in the Eurozone but it is not the next Japan
What about core Eurozone inflation?
Where will core inflation go?
Just how deep deflation becomes and how long it
lasts will depend most importantly on the behaviour
of core inflation. A quick look at the past behaviour of
core inflation would appear to provide some
reassurance. As the chart below shows, it has
tended not surprisingly to be more stable than the
headline rate, fluctuating in a much narrower band
and at a record low of -0.6% yoy in January 2015; it
is already at the bottom of that band.
This might suggest that the general stickiness of
prices in the Eurozone will prevent core inflation from
falling any further over the coming months. This is
also supported by our own Core Inflation Leading
indicator model (based on the output gap, trade-
weighted euro and a survey measure of inflation
expectations), which expects core inflation to remain
stable. If that is the case, deflation will remain an
energy-driven and relatively short-lived phenomenon.
Indeed, it could readily be classified as “good
deflation” insofar as it will boost private consumption
through higher real wage growth and could therefore
help to revive the Eurozone’s flagging economic
recovery. Added to this, low core inflation primarily
reflects low inflation in non-energy industrial goods,
while service price inflation, which is highly
dependent on labour as an input and closely related
to wage growth, has remained relatively stable.
Spare capacity has also exerted
downward pressure on core inflation
High levels of spare capacity have also exerted
downward pressure on consumer prices in the
Eurozone. Eurozone core inflation (the ECB has little
control over food and energy prices) is highly
correlated with the output gap, which is the difference
between how much an economy is producing and
how much the economy could produce. A lot of spare
capacity in factories or a lot of unemployed workers
discourages firms from raising prices because their
competitors can use their idle capacity or labour to
produce more and undercut them. The output gap is
notoriously hard to measure but an expanding output
gap has usually pushed core inflation down, and a
narrowing output gap has pushed core inflation up.
Therefore, to avoid a prolonged period of deflation,
the output gap needs to close and GDP growth to
pick up. Based on estimates from the OECD, the
Eurozone’s output gap was quite large at -3.3% in
2014, which means that core inflation could pick up if
the ECB’s QE programme succeeds in boosting
growth and closing the output gap.
Figure 8: Japan CPI and Core CPI inflation
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
Figure 9: Eurozone CPI and Core Inflation, ECB
target
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
Figure 10: Eurozone core goods and services
inflation
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
22
A deflationary wave has arrived in the Eurozone but it is not the next Japan
Wage pressures have been subdued in the
Eurozone. While Eurozone unemployment remains
high, the fact that the unemployment rate has
stopped rising and even fallen modestly over the last
year suggests wages could soon start to pick up from
recent very low levels, with corresponding potential
upward effects on headline inflation.
Even a quick look at the Eurozone’s monetary
dynamics might suggest that disinflationary pressure
may soon ease. The chart below shows the
relationship between broad (M3) money growth and
CPI inflation with the recent pick-up in M3 growth
pointing to rising inflation ahead. Furthermore, this
might become clearer if the ECB’s quantitative
easing (QE) programme results in a further pick-up in
money supply growth.
Other factors also suggest that the Eurozone could
avoid a prolonged downward slide into deflation. For
instance Eurozone business and consumer
confidence has picked up since the dip in September
while household savings as a proportion of gross
disposable income have continued to edge lower
since the start of the year, suggesting that spending
could be set to rise in the coming months and boost
aggregate demand.
The largest Eurozone banks also appear to be in
better shape than expected, with capital shortfalls
identified by the ECB’s latest asset quality review
coming in at the lower end of expectations. No
French or German banks were required to source
more capital.
How can low inflation be addressed?
The tricky part is determining how to fight low
inflation and avoid prolonged deflation. With interest
rates already close to zero, standard monetary policy
virtually ceases to be effective. Over the last months,
the ECB has tried hard to ease financial conditions,
using various non-standard monetary policy
measures, such as providing ultra-cheap loans
targeted to those banks that lend to small and
medium-sized enterprises, and purchasing private
sector assets (covered bonds and asset backed
securities).
Finally, as an antidote to deflation, the European
Central Bank (ECB) rolled out its aggressive QE
program in March 2015. The package includes
injecting EUR1.1 trillion through the purchases of
government bonds and private sector assets, worth
EUR60 billion a month, until at least the end of
September 2016 or when the inflation rate shows
signs of improvement towards its target. But QE in
the Eurozone has arrived late. The US is winding
down the QE programme it embarked on 6 years ago
when low inflation rates first started to raise alarm.
The ECB’s QE programme reduces
headwinds to inflation
The ECB’s QE programme is expected to lift inflation
through various channels:
Figure 11: Output gap and 12-month change in
core CPI inflation
Source: Bloomberg, data as at March 2015. For illustrative purposes only.
Figure 12: Eurozone inflation and M3
Source: Bloomberg, data as at 24 March 2015. For illustrative purposes only.
23
A deflationary wave has arrived in the Eurozone but it is not the next Japan
The first channel is the currency. On a trade-
weighted basis, the euro depreciated significantly in
2014 (-6.0%) and this decline has accelerated since
the beginning of 2015 (an additional -6.4%), following
the ECB’s announcement that it would purchase
sovereign bonds and increase its balance sheet
further. Euro depreciation should put upward
pressure on inflation. The lower exchange rate has
already raised manufactured import prices in H2
2014 by 1.9%, according to Eurostat, and these are
expected to increase further in Q1 2015. This
increase alone should help lift core goods price
inflation in the first half of the year. The weaker EUR
will also lift food-price inflation this quarter and
dampen the impact of lower oil prices.
The second channel at play is inflation
expectations. The ECB’s QE programme should
support inflation expectations as it signals the ECB is
committed to its mandate of maintaining price
stability. Hence, the current monetary easing should
support wage growth if the stimuli convinces wage
earners that they should expect 2% inflation. Related
to this, easing should limit second-round effects and
the risk of a dangerous kind of deflation, where
wages follow inflation lower.
The last channel is the growth outlook. The ECB
expects GDP to grow by 1.5% in 2015 (up from 1%
in the December projections), 1.9% in 2016 (up from
1.5%) and 2.1% in 2017, and QE poses upside risks
to this view.
Investment Implications
The obvious question is: will QE make a difference,
especially as government bond yields in Europe are
already so low? There is certainly scope for bond
yields in peripheral Europe to fall further, and for
those lower interest rates to feed through to the real
economy via the banking system. However, we feel
that the ECB’s QE programme will eventually benefit
the Eurozone economy by reducing the risk of
prolonged deflation and that the main impact will
come through from the weaker euro. This should
make European exporters more competitive
internationally and provide a boost to GDP and
corporate earnings growth, and therefore be a
positive for risk assets such as European equities.
Looking ahead, we expect oil prices to eventually
increase from current very low levels. We are not
there yet, but if they rebound eventually over the
coming year as they did in 2009/10, then it is likely
that headline inflation will also rise again quickly and
the current burst of deflation might prove to be just as
brief as the last one. Even if the oil price does not
increase but remains at its current level, headline
inflation should turn positive towards the end of this
year. However, the price dynamics will continue to be
limited by a large negative output gap, high
unemployment and the absence of wage pressures.
Furthermore, with Eurozone inflation already in
negative territory, investors could remain sensitive to
any negative exogenous shocks, for example from
Greece or from the situation in Ukraine and Russia,
that may put further pressure on the outlook for
inflation and growth.
Over the long-term, we continue to favour riskier
assets, such as equities, over perceived safe-haven
developed market government bonds. The ECB’s QE
programme supports the view that the world’s major
developed market central banks are ready and willing
to provide monetary stimulus if necessary to support
their economies and to ward off entrenched deflation.
24
China National People’s Congress (NPC) Growth stabilisation and economic restructuring are two policy priorities in 2015 Renee Chen, Senior Macro and Investment Strategist
Summary:
Chinese Premier Li Keqiang delivered the
Government Work Report at the National People’s
Congress on 5 March, outlining the
macroeconomic and policy targets and reform
agenda for 2015
The macroeconomic and policy targets for 2015
reflect the balancing act between growth
stabilisation and economic restructuring, the two
priority policy objectives, and are broadly in line
with expectations
The lower “about 7%” growth target for 2015, in
our view, likely reflects the government’s
awareness of the “new normal” of growth on the
back of economic rebalancing and restructuring
The overall tone on macro policy sounds more
supportive of growth, with the mention of more
flexibility in monetary policy and more
expansionary fiscal policy. The government has
also loosened property policies
Allowing local governments to swap existing Local
Government Financing Vehicles (LGFV) debt with
municipal bonds marks a major step in
restructuring local government debt. It could help
lower funding costs for local governments, credit
risk for banks, and the systemic financial risks
Premier Li covered a wide range of key reform
areas for 2015, including financial, fiscal/tax,
State-Owned Enterprises (SOE) and hukou
reforms and opening up, etc. and laid out key
growth strategies. He also addressed key topics
such as the fight against pollution and anti-
corruption
The government’s strong intent to maintain a
stable growth and its focus on reforms could help
ease concerns about China’s growth outlook,
earnings prospects and credit risk, and support
the financial markets in the near term, amid a
more supportive macro policy backdrop
‘New normal’ growth targets
Chinese Premier Li Keqiang delivered the
Government Work Report (“the Report”) at the Third
Session of the 12th National People’s Congress
(NPC), the nation’s parliament, on 5 March, outlining
the macroeconomic and policy targets and reform
agenda for 2015.
The government has set a growth target of “about
7%” and CPI inflation target of “around 3%” for 2015,
lower than “about 7.5%” and “around 3.5%,”
respectively, for 2014. The actual 2014 GDP growth
was 7.4% and inflation was 2.0%. The growth goals
for foreign trade, fixed asset investment (FAI) and
retail sales have also been reduced to 6%, 15% and
13% for 2015 from 7.5%, 17.5% and 14.5%,
respectively, for 2014. However, the 2015 target for
retail sales growth is still higher than the actual rate
of 12% in 2014 while the target for FAI is lower than
the 2014 actual rate of 15.7%. This could imply the
government’s goal to restructure and rebalance the
economy, in our view.
Other specific economic and social targets include
keeping the target for urban job creation at 10 million
for 2015 (the 2014 actual figure was 13.2 million) and
ensuring that personal income growth keeps pace
with overall economic growth. In 2014, the nation-
wide disposable income per household increased by
8% in real terms, faster than real GDP growth
(+7.4%).
Figure 1: Selected key economic targets for 2015
Source: Government Work Report, data as at March 2015. For illustrative purposes only. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets
2015 Target 2014 Target 2014 Actual
GDP (% yoy) ~7.0 ~7.5 7.4
CPI (% yoy) ~3.0 ~3.5 2.0
Fixed asset investment
(% yoy) 15.0 17.5 15.3
Retail sales (% yoy) 13.0 14.5 12.0
Trade (% yoy) 6.0 7.5 3.4
Urban job creation (mn) 10.0 10.0 13.2
Urban unemployment
rate (%) <=4.5 <=4.6 4.1
Budget deficit (CNYtrn) 1.62 1.35 1.13
Budget deficit % of GDP -2.3 -2.1 -1.8
M2 (% yoy) 12.0 13.0 12.2
25
China National People’s Congress (NPC)
Premier Li said that the “about 7%” growth target takes
into consideration what is needed and what is possible.
We think the growth target reflects the government’s
awareness of the “new normal” of slower growth for the
economy, its intent to maintain stable growth to ensure
employment, and its resolve to push forward structural
reform. The government views “about 7%” growth to be
consistent with stable employment conditions, as the
service sector becomes larger, the number of small
and micro businesses grows and the economy gains in
size.
The lower inflation target – which tends to mean an
upper limit – for this year is unlikely to become a
binding constraint, given the current low inflation
environment. The Chinese economy faces
disinflationary pressure from lower energy/commodity
prices, sluggish demand conditions and overcapacity in
some industries. This would open room for factor-input
pricing reform and monetary policy easing, if
necessary.
The government’s work for 2015 will focus on: (1) to
ensure continuity in and make improvements to
macroeconomic policies; (2) to strike a fine balance
between ensuring steady growth and making
structural adjustments; and (3) to foster new drivers
for economic and social development. The Report
highlighted increasing provision of public goods and
services as well as innovation and entrepreneurship
as two new growth sources.
Macro policy stance
Premier Li reiterated the stance of a proactive fiscal
policy and prudent monetary policy for 2015.
However, he also called for a more “forceful and
effective” fiscal policy and an “appropriate” and more
flexible monetary policy to help stabilise growth. The
tone for property policies appears to be more
supportive than in 2014.
Recent economic data showed weakness in China’s
growth momentum, particularly still sluggish
domestic demand (investment). Industrial activity
continued to be constrained by overcapacity, an
uncertain demand outlook, and environmental
concerns. We think local government funding
constraints, higher real interest rates/costs of capital,
deflationary expectations, and the ongoing anti-
corruption campaign likely also weighed on domestic
activity (and hence prompted the rate cut in March).
1. Prudent monetary policy with more flexibility
The government has lowered the broad money
supply M2 growth target for 2015 to 12%, from 13%
for 2014 (2014 actual: 12.2%), but Premier Li said
the actual figure may be slightly higher than 12%
depending on the needs of economic development.
We do not interpret a lower M2 growth target as a
signal of policy tightening, but we view it as a realistic
adjustment to lower economic growth and inflation
targets.
The Report states that the People’s Bank of China
(PBoC) will use various monetary policy tools,
including open market operations, interest rates,
reserve requirement ratio (RRR) and re-lending, to
maintain the stable growth of money supply/bank
loans/total social financing, lower funding costs for
the real economy and prevent any sharp deceleration
in growth. Li said monetary policy measures should
focus on fine-tuning and targeted adjustment,
indicating no intention for big stimulus measures. We
expect monetary policy to remain accommodative
and supportive of growth in the near term. Further
Figure 2: Selected activity indicators
Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
Figure 3: Inflation trajectory
Note: PPI= Producer Price Index; CPI= Consumer Price Index.
Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
26
China National People’s Congress (NPC)
policy easing is likely, both to lower (real) financing
costs for corporates and to ensure sufficient liquidity.
The timing and magnitude of policy moves will be
data-dependent.
2. A more “forcefully” proactive fiscal policy
The government has set the 2015 fiscal deficit target
at CNY1.62 trillion (2.3% of GDP), compared with the
target of CNY1.35 trillion (2.1% of GDP) for 2014.
The actual deficit for 2014 was CNY1.1 trillion (1.8%
of GDP). The 2015 target includes CNY1.12 trillion
deficit for the central government (versus CNY950
billion for 2014) and CNY500 billion (versus CNY400
billion for 2014) for local governments. In addition to
a quota of CNY500 billion for local government bond
issuance to fund new projects this year, the
government will also allow local governments to
issue special-purpose bonds (CNY100 billion) to roll-
over debts and fund existing projects.
However, the actual fiscal policy could be more
expansionary than the budget plan or the 2.3% GDP
deficit target indicate, taking into account the
CNY112.4 billion of unspent funds carried over from
the previous year and funding from special-purpose
bond issuance. Finance Minster Lou Jiwei estimated
that the actual fiscal deficit could be 2.7% of GDP for
2015, if the two items are included, compared with
2.1% of GDP in 2014.
Meanwhile, the Ministry of Finance (MOF) has
granted a CNY1 trillion debt-issuance quota to local
governments to allow them to convert their existing
higher-interest debt scheduled to mature this year
into lower-yielding municipal bonds. The existing
debt largely includes debt issued by local
government financial vehicle (LGFV) entities, and
borrowing from banks and the shadow banking
sector (e.g. trust loans). The funds raised can only be
used to repay the debt that the National Audit Office
(NAO) identified as debt for the repayment of which
the local governments have direct responsibility. The
2013 NAO Report estimated that there is CNY1.86
trillion of such debt maturing this year, so the CNY1
trillion quota covers about 53.8% of the debt
maturing in 2015.
The debt-swap scheme marks a major step forward
in restructuring local government debt. It will
introduce more oversight, transparency and
discipline over debt issuance by local governments. It
could lower funding costs and the interest burden for
local governments, extend their debt maturities, and
ease their refinancing and liquidity risk in the near
term. The MOF estimated that the refinancing could
reduce local governments’ interest payments on
existing debt by around CNY40-50 billion a year. The
savings from the lower interest burden could be
spent on other expenditure areas such as
infrastructure investments. The debt-swap scheme
could also help reduce the credit risk of banks’ LGFV
portfolios in the near term and help reduce banks’
direct LGFV exposure if the existing debt was
refinanced away from bank loans. Consequently, this
could free up funds for bank lending to more
productive sectors, and lower the systemic financial
risks in the economy. The scheme could be
expanded later, if needed.
However, we are also cautious that the debt-swap
scheme does not cover the portion of the debt local
governments do not have direct responsibility to
repay and debt issued after June 2013. While the
scheme reduces immediate risks around the
refinancing of the debt maturing in 2015, the impact
on longer-term sustainability remains to be
addressed. The risk of excessive local government
indebtedness also remains unaddressed as the debt
stock continues to be rolled over.
Despite a larger fiscal deficit target and more local
government bond issuance this year, local
governments will likely still face financing constraints
given weaker land sales revenues and tightened
rules over LGFV borrowing. Reform of the
investment and financial mechanism is important,
including more private sector participation [(e.g. the
public-private partnership (PPP)] and the disposal of
local state assets, etc. However, it remains unclear
how quickly the PPP will be effectively launched.
Figure 4: Bank lending rates vs. inflation
Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
27
China National People’s Congress (NPC)
Finance Minister Lou Jiwei said that for local
government projects that could generate some profits
or stable cash flows, part of the debt could be repaid
via fee collections while some could be restructured
into corporate debt via the PPP. Another option is to
restructure local government debts by refinancing
some upcoming projects through bank loans.
3. Supportive signals in property policies
The overall tone for the property market this year in
the Report sounds more supportive at the margin
compared with 2014. The government pledges to
support stable “housing consumption” and promote a
stable and healthy development of the real-estate
market. The government will adhere to differentiated
guidance in setting policies, supporting home
ownership and increasing demand for housing and
allowing local governments to set property policies
based on local market conditions. The social housing
construction target is set at 7.4 million units this year,
of which 5.8 million units were shanty town re-
development, an increase of 1 million units from
2014. This could also provide some cushion against
a significant slowdown in real-estate investment this
year.
The authorities on 30 March announced measures to
support the property market, including loosening
housing mortgage policies and shortening the
holding period for business-tax exemption. The
down-payment requirement for second home
mortgages will be lowered to 40%, from 60% and
above previously. For mortgage borrowing from the
Housing Provident Fund, the down-payment for first-
time home buyers will be cut to 20% (from 20-30%
previously) and, for second-home buyers who have
fully paid down their first mortgages, will be lowered
to 30% (from 60% previously).
Regarding housing transactions in the secondary
market, the MOF also shortened the minimum
holding period to 2 years from 5 years for sales of
ordinary housing to get the business-tax exemption.
For luxury properties, the tax will be imposed on the
net revenue (i.e. resale value minus the purchase
cost) if resale occurs more than two years after the
purchase. If resale occurs within two years, the tax
will be imposed on the entire resale value. These
easing measures were largely expected by the
market, on the back of further weakness in property
market activities in January-February.
These policies should provide some support to
increasing demand for housing and bolstering
sentiment in the property market in the short term,
especially in upper-tier cities. These should help slow
the pace of property market adjustments and limit the
downside to property sales and investment growth.
However, we do not expect these measures to lead
to a strong rebound in the property market
nationwide or to boost real-estate investment much
in the near term given the severe over-supply and
inventory overhang in tier-3 or 4 cities. Meanwhile,
the mortgage policy easing also showed the
government’s determination to stabilise growth this
year, as the housing market correction remains one
of the key drags on domestic demand/activity.
Figure 5: Gauge of capital flows
Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
Figure 6: Selected property market indicators
Note: FAI= Fixed Asset Investment.
Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.
28
China National People’s Congress (NPC)
Reform plans for 2015
Premier Li pledged to deepen reform and economic
opening up. Li laid out a wide range of reform areas,
although he made no mention of the timetable for
implementation. These include pricing, fiscal and tax,
the investment and financing mechanism, financial,
state-owned enterprise (SOE) and household
registration (hukou) reforms, among others.
Below are some highlights in selected reform areas:
Reform of the investment and financing-
mechanism.
• To significantly reduce the number of investment
projects that require government approval and
delegate more powers of review to lower-level
governments.
• To loosen entry restrictions for private investment
and encourage the use of private capital to set up
equity investment funds.
• To deepen reform of railway investment and
financing by making good use of railway
development funds.
• To promote the PPP scheme to fund infrastructure
projects.
Resource pricing reform.
• To significantly reduce the scope of government
pricing.
• The government to stop setting prices for most
pharmaceuticals.
• To delegate to lower-level governments the power
to set prices for certain basic public services.
• Pricing reform of electricity, water and energy to
be more conducive to environmental protection.
Fiscal/tax reform.
• To implement a comprehensive and transparent
budgeting system.
• To increase the percentage of funds transferred
from the budgets for state capital operations to
general public budgets.
• To reform the transfer payments system and to
clearly define spending responsibilities and make
appropriate adjustments to the division of revenue
between the central and local governments.
• To complete work to replace business tax with a
value-added tax (VAT) across the board.
• To adjust and improve policies on consumption
tax.
• To extend price-based resource taxes to cover
more types of resources.
Financial and capital-market reform.
• To promote the establishment of small and
medium-sized financial institutions by private
capital.
• To establish a deposit insurance scheme.
• To further liberalise interest rates.
• To increase two-way flexibility in the CNY
exchange rate while keeping it relatively stable at
an appropriate and equilibrium level.
• To continue efforts to expand the CNY’s global
use while gradually opening up the capital
account.
• To launch the Shenzhen-Hong Kong Stock
Connect on a trial basis at an appropriate time.
• To reform the IPO system from approval-based to
registration-based.
• To encourage the securitisation of credit assets,
the expansion of corporate bond issuance and the
development of the financial derivatives market.
• To promote tax-deferred pension insurance.
The PBoC on 31 March officially introduced the
deposit insurance scheme, to be implemented on 1
May. The scheme will cover all deposit-taking
financial institutions in China (except for foreign
banks’ branch offices). The maximum level of
protection is CNY500,000 per depositor per financial
institution, with more than 99% of depositors to be
covered. The introduction of deposit insurance marks
an important step toward full interest rate
deregulation and market-based capital allocation.
The scheme is seen as a prelude to the removal of
the deposit rate ceiling, which is currently capped at
130% of the benchmark rate, by ensuring that savers
are protected (up to the maximum insured amount)
even if increased competition for deposits leads to
excessive risk-taking and bank failure. The scheme
also removes the government’s implicit full deposit
guarantee and, at least in theory, could lead to better
pricing of risks by banks and depositors, given the
shift in perception over the government’s bailout
promise which could increase differentiation between
strong and weak banks by market forces. With
deposit insurance in place, the government could
also move on introducing bankruptcy rules or an exit
framework for failed financial institutions, and
accelerating capital market liberalisation, as the
government expands the financial safety net.
SOE reform.
• To push forward with targeted reform of SOEs on
the basis of having clearly defined their functions.
• To accelerate carrying out the trials on setting up
state capital investment companies and operating
companies.
• To take systematic steps to introduce mixed
ownership of SOEs.
• To encourage and regulate equity investments
made by private capital in SOE investment
projects.
29
China National People’s Congress (NPC) Opening-up.
• To transform and upgrade China’s foreign trade.
• To speed up the implementation of the “go global”
strategy, encourage Chinese companies to
participate in overseas infrastructure projects, and
broaden the use of FX reserves.
• To develop the New Silk Road and the 21st
Century Maritime Silk Road (the “One Belt One
Road” strategy).
• To actively develop pilot free-trade zones (FTZ) in
Shanghai, Guangdong, Tianjin and Fujian and to
extend these pilot FTZ to the rest of the country.
• To strengthen investment and trade connections
with neighbouring countries.
The “One Belt One Road” initiatives aim to boost
trade, investment and economic relations, as well as
financial and infrastructure connectivity with the rest
of Asia, Africa, Europe and the Middle East with
more roads, railways, ports, power grids, oil and gas
pipelines, and other projects.
Hukou reform, a key to promote a new type of
people-oriented urbanisation.
• To reform the hukou system and relax controls
over the transfer of hukou.
• To grant migrant workers who live in urban areas
but have yet to gain urban residency access to
basic public services on the basis of their
residence certificates.
• To link the transfer payments of cities to their
performance in granting urban residency to
eligible migrant workers.
Rural land reform.
• To prudently carry out pilot reforms related to: (1)
rural land acquisition, (2) putting rural collective
land designated for business-related construction
on the market; (3) the system of land use for rural
housing; and (4) the rural collective property rights
system.
In addition to the new type of urbanisation, the
Report also highlighted the growth strategy in other
areas, through encouraging consumption,
increasing effective investment in public goods,
modernising agriculture, and promoting
industrial upgrading.
The government will encourage consumption in a
wide range of services, including elderly care, health,
leisure and tourism, information, education, and
housing, etc. To support major public investment
projects in areas such as social housing, transport
(railway, roads and waterway), oil and gas pipelines,
and clean energy, etc., the central government will
increase its budgetary investment but also
encourage private participation. Railway investment
should exceed CNY800 billion in 2015 (versus a
target of CNY800 billion in 2014).
The government will support industrial innovation and
upgrading through fiscal subsidies and accelerated
amortisation and will support industrial consolidation
in over-capacity industries. Initiatives such as “Made
in China 2025” and “Internet Plus” will be promoted
to support emerging industries, focusing on scientific
and technological innovation and green development.
“Internet Plus” includes promoting cloud computing,
online banking, mobile Internet, along with logistics to
help e-commerce expansion. The government will
also deepen the reform and opening up of the
services sector.
The Report also covers other social issues and
reforms ranging from education, the medical and
healthcare system, social security, environmental
protection, energy conservation, and anti-
corruption, among others. In terms of the social
security system/ pensions, the basic pension benefits
for enterprise retirees will be increased by 10%, and
the monthly basic pension benefits for rural and non-
working urban residents will be raised to CNY70 from
CNY55 per person. In the area of the medical and
healthcare system, the government plans to increase
subsidies for basic medical insurance and roll out
serious illness insurance across the country. The
annual government subsidy for basic medical
insurance will increase to CNY380 per person (from
CNY320). The government will also work toward a
national pooling system for basic pensions and
increase portability of its healthcare insurance.
Investment Implications
The Report showing the government’s strong intent
to maintain stable growth and implying a more
supportive macro policy should help ease investor
concerns about a sharp slowdown in the Chinese
economy and the implication for corporate earnings
growth (prospects) and default risks. The debt
swapping also suggests that the government is
taking a more moderate and gradual approach in
China’s deleveraging process, to prevent the
economy from falling off a cliff. While concerns about
macro headwinds and debt overhang will likely
remain, we believe the Chinese authorities have
deep tool kits to cushion the downside risk to the
economy and contain financial stability risks.
Overall, there is little surprise in the Government
Work Report. The lower growth and inflation targets
are in line with our and market expectations, given
the ongoing economic rebalancing and restructuring
and the current low inflation environment. The Report
emphasizes that growth stabilisation and economic
restructuring remain the two priority policy objectives
in 2015, and the government will try to strike a
balance between them.
30
China National People’s Congress (NPC)
Supportive policies and reform initiatives are near-
term positives for Chinese equity and credit markets.
For example, SOE reform could help improve
transparency, governance and efficiency of the SOE
sector, providing support for potential earnings
revisions and driving the market’s re-rating potential.
Policy/regulatory efforts (e.g. the repo rule, margin
trading and umbrella trusts) to contain speculation on
the market could tighten liquidity in the near term, but
they are positive for improving risk pricing and a
healthier market development in the longer term.
The local government debt-swap scheme could be
positive for banks from a credit risk perspective.
Lower financing costs on the back of an
accommodative monetary policy could help highly-
leveraged companies and the property sector at the
margin in the near term. The property sector could
also get support from the recent policy relaxation and
the government’s pledge to maintain a stable
property market. The government’s emphasis on
environmental protection, the fight against pollution
and for energy conservation could support the
alternative and clean energy sector. The “Internet
Plus” strategy could support the e-commerce/
logistics sector. We continue to like sectors and
stocks with strong earnings growth prospects, those
that stand to gain from reforms, and those that offer
high and stable dividend yields. There could also be
selective opportunities from a comprehensive plan
for the deepening healthcare reform, the “One Belt
One Road” initiatives, the new urbanisation (and the
hukou and land reforms), a stock connect between
Shenzhen and Hong Kong and China’s capital
market opening-up. The “One Belt One Road”
initiatives could be positive, in the long term, for the
Engineering and Construction (E&C) sectors with a
stronger overseas franchise, larger overseas
exposure and higher absolute margin levels.
An overall macro backdrop of tepid growth
momentum and low inflation coupled with lower
financing costs on the back of a more supportive
monetary policy should be positive for the Chinese
fixed income market in the near term. The risk
premium in the China credit complex due to concerns
over economic and financial risks could narrow if the
government continues to demonstrate that it remains
in control. We see the debt swap scheme as the start
of local government debt reforms. In the near term,
an anticipated sharp increase in local government
bond supply, to an estimated CNY1.6 trillion in gross
issuance in 2015 (from CNY400 billion last year) has
pushed up onshore bond yields. However, we think
the debt-swap scheme is a positive for China’s
sovereign credit profile and should help reduce the
risk premium priced in Chinese bonds due to
leverage concern in the medium term, as it reduces
local government’s near-term refinancing risk and
overall liquidity and credit risk.
However, financial markets will likely remain highly
volatile in the near term. Earnings growth, corporate
fundamentals, policy initiatives to manage risks, and
effective reform implementation are key to the
medium-term outlook for Chinese financial markets.
31
Macro and Investment Strategy team
Julien Seetharamdoo
Chief Investment Strategist Julien Seetharamdoo is Chief Investment Strategist
within HSBC Global Asset Management’s Macro
and Asset Strategy team where he provides analysis
and research on the key issues facing the global
economy and asset markets. Prior to joining HSBC,
Julien has worked for Coutts & Co, RBS and Capital
Economics. He holds a first-class degree in
Economics from Cambridge University and a PhD in
Economics from the Management School, Lancaster
University focusing on the implications of the
European Monetary Union.
Renee Chen
Senior Macro & Investment Strategist Renee Chen joined HSBC Global Asset
Management as Macro and Investment Strategist in
April 2012. Prior to this role, she held Economist
roles at Macquarie Capital Securities, Nomura and
Citigroup and has over 14 years’ experience in
economic and policy research. Renee holds a
master’s degree in International Affairs and
Economic Policy Management from Columbia
University, New York and an MBA in Finance and
Investment from George Washington University,
Washington DC.
Herve Lievore
Senior Macro & Investment Strategist Hervé Lievore is a Senior Macro and Investment
Strategist based in Hong Kong. Before joining
HSBC, he spent five years at AXA Investment
Managers in London and Hong Kong as an
economist and strategist, covering Asia and
commodities. He was also involved in the firm’s
tactical asset allocation committees. He started his
career 18 years ago at Natixis in Paris, where he
mostly covered Asian markets.
Michael Hampden-Turner
Senior Macro & Investment Strategist Michael Hampden-Turner is a Senior Macro
and Investment Strategist based in London
having recently joined HSBC Asset Management
in December 2014.
He previously held global macro, asset allocation,
fixed income and credit strategy roles at Citigroup
and RBS over a twenty year career both as a
publishing top down strategist and a desk
analyst. He studied at Trinity College, Cambridge
and Harvard University.
Rabia Bhopal
Macro & Investment Strategist Rabia Bhopal is a Macro and Investment
Strategist and provides analysis and research on
the key issues facing the global economy and
asset markets, with particular focus on Frontier
Markets. Rabia has been working in the industry
since 2003. Prior to joining HSBC in 2012, Rabia
held Economist roles at Standard & Poor¹s,
Lloyds TSB Corporate Markets, Financial
Services Authority and the Economist Intelligence
Unit. She holds a degree in Economics from
Brunel University in London.
Shaan Raithatha
Macro & Investment Strategist Shaan is a Macro and Investment Strategist
within HSBC Global Asset Management’s Macro
and Investment Strategy team. Prior to this role,
he spent 18 months on the HSBC Global Asset
Management Graduate Programme working as
an analyst on both the Global Emerging Markets
Equity and Equity Quantitative Research teams.
Shaan holds a bachelor of arts degree in
economics from the University of Cambridge.
32
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