Macro Strategy Review: Insights on Monetary Policy, Economics and Markets

Forward Markets: Macro Strategy Review
Macro Factors and Their Impact on Monetary Policy,
the Economy and Financial Markets
The following is a recap of the analysis I provided in the monthly
Macro Strategy Review (MSR) starting in January 2014 through
May 2015. I think you’ll see why it can be a valuable resource as
you navigate the current challenging investment environment.
My approach combines fundamental and technical analysis,
which is unusual since most economists and financial advisors
rely almost exclusively on fundamental analysis, which focuses
on economic growth, monetary policy, equity valuations and the
outlook for corporate earnings. While fundamental analysis is
important, combining it with technical analysis can provide a
more complete view since it incorporates market prices.
Changes in the technical trend of a market have often led changes
in the underlying fundamentals. A perfect example of the
interplay between fundamental and technical analysis was
provided in 2014.
In March 2014, European Central Bank (ECB) president Mario
Draghi expressed concern about the low level of inflation and
noted that the 15% increase in the value of the euro since July
2012 had shaved 0.4% off the European Union’s rate of inflation.
Since the ECB had already lowered interest rates to 0% and wasn’t
close to being able to launch a quantitative easing (QE) program,
I concluded that the only stimulus left was for Draghi to lower
the value of the euro. A decline in the euro would reverse its
deflationary effects, boost growth by making exports cheaper and
help make countries like Spain, Italy and France more competitive
due to their higher cost of production. During the week of May 9,
2014, the euro experienced a weekly key reversal, which often
signals an important change in a price trend. Since the euro
represents 57% of the dollar index, I concluded that the dollar was
likely to rally 20%–25% and ultimately reach 100.00–102.00.
I believed a dollar rally of this magnitude would have a negative
effect on emerging market (EM) currencies and equity markets and
prove a headwind to future growth in those countries that have a
current account deficit, a budget deficit and an elevated inflation
rate. For advisors with exposure to emerging markets, this proved
a valuable insight. I also believed that the rally in the dollar would
pressure commodity prices in general, which proved prescient
as oil, copper and numerous other commodities subsequently
suffered large price declines. In March 2015, the dollar reversed
lower after reaching 100.39. This suggested that the dollar was
likely to pullback to 92.60–94.70, likely leading to a rally in the euro
to 111.00–115.00, oil to $55.00–$59.00 a barrel and EM currencies
and equity markets overall.
When prices fall below or rise above critical levels, technical
analysis helps me quantify when I’m wrong so I can help advisors
and investors do a better job of managing risk. Keeping losses
small supports my philosophy that the best way to make money
is to limit losses, and technical analysis can do that in real time.
In my experience, fundamental analysis too often follows market
reversals and by the time the “news” comes out, keeping losses
small is more difficult.
Over the years I’ve received great feedback from advisors and
investors who have found my analysis to be timely and insightful.
Thanks in advance for taking the time to review this summary.
Jim Welsh
Macro Strategy—Portfolio Manager
2014 – 2015

Macro Strategy Review www.forwardinvesting.com2
Table of Contents
Macro Perspective—U.S. Economy_______________________________ 3
Eurozone______________________________________________________ 9
Emerging Markets_____________________________________________ 16
Japan__________________________________________________________ 19
China__________________________________________________________ 21
U.S. Economy___________________________________________________ 27
Treasury Bonds________________________________________________ 32
U.S. Stocks_____________________________________________________ 34
Oil_____________________________________________________________ 38

Macro Perspective—U.S. Economy
October 2014: Reaching the Limits of Monetary Policy
Economics has often been called “the dismal science” for good
reason. President Harry Truman became so frustrated with
the equivocations of his economists that he said, “Give me a
one-handed economist! All my economists say, ‘…on the one
hand…on the other.’”1
As the world was mired in the Great
Depression in 1936, John Maynard Keynes wrote The General
Theory of Employment, Interest and Money, which offered
a theory for dealing with recessions. When private demand
slackened due to a recession, Keynes advocated for intervention
by the government and central bank to rejuvenate demand in
the economy. This entailed the central bank lowering interest
rates and the government launching infrastructure projects to
inject government spending into the economy, which would
then increase demand and create jobs. The deficit created by
government spending during a recession would be funded by the
issuance of government bonds. Once the economy returned to
a path of steady growth, government surpluses would be used
to pay off the bonds issued during the recession. The logic and
common sense of Keynes’ theory made it easy to embrace. Any
time a recession developed after World War II, Keynes’ game plan
of lower rates and deficit spending was always implemented.
For the most part this economic prescription worked well. In seven
of the 15 years after World War II the government actually ran a
surplus, and in the 27 years between 1946 and 1972 economic
growth averaged 4.15%. There was one problem, however: in the
300 months from 1957 to 1982 there were 64 months of recession.
During these recessions, the unemployment rate spiked before the
therapeutic effect of lower interest rates and fiscal stimulus turned
the economy around. A recession caused the unemployment rate
to zoom from 2.6% to 5.8% in 1954 and from 4.0% to 7.4% in 1958.
Between 1968 and 1976 it soared from 3.4% to 8.9%. This pattern
was unacceptable to the political system since elections could be
lost if they occurred during a recession. To address this problem,
Congress passed the Full Employment and Balanced Growth Act,
which was signed into law by President Jimmy Carter on October
27, 1978. In addition to the Fed’s primary mandate of stable prices,
the act would order that the Fed also conduct policy to ensure a low
unemployment rate was maintained.
Labor costs make up approximately 65% of the cost of goods sold.
Historically, full employment meant there was very little slack in
the labor market, which often led to higher wages as companies
bid up wages to keep or attract workers. Rising labor costs result
in higher prices as companies are forced to raise the prices of their
goods and services to cover higher labor costs. Wage inflation is
far more intractable than inflation caused by higher food prices
due to a drought or a temporary shortage. For the Fed to pursue a
policy that would achieve full employment, it risked undermining
its mandate for price stability. The contradictory nature of the two
mandates wasn’t as important as passing legislation at a time of
high unemployment with the words “full employment” in the title.
For Congress, the notion of policies that are contradictory is almost
perfection, since half the voters will be satisfied and the other half
ripe for campaign contributions to fix the new problem.
Normally, people or organizations wouldn’t be given any
additional responsibilities unless they had handled their original
tasks well. Prior to 1979, the Federal Reserve had one policy
mandate, which was to conduct monetary policy so prices
remained stable. In 1965, the Consumer Price Index (CPI) rose a
scant 1%. By 1975 it exceeded 12%, on its way to 14% in 1980.
There were mitigating circumstances: the Organization of
Petroleum Export Countries (OPEC) cut back on oil production and
oil prices soared from $3.00 to $12.00 a barrel in 1974. Even with
this concession, no one considered Fed chairmen Arthur Burns or
G. William Miller as maestros of monetary policy. By any standard,
the Federal Reserve did not do a good job of accomplishing
their stable price mandate. This poor performance, however,
did not dissuade Congress from giving the Fed the potentially
contradictory second mandate of full employment.
Ironically, the tide of history was about to change after Paul Volker
became Fed chairman in August 1979. Volker increased the federal
funds rate to 18% in 1981 to break the back of inflation, which
resulted in a secular bull market in bonds and stocks. In the 300
months between 1983 and 2007 there were only 16 months
that the economy was in recession. By comparison, there were
64 months of recession in the 300 months from 1957 to 1982, as
stated previously. The recessions during this 25-year period were
more frequent and deeper than the shallow recessions in 1991 and
2001, which each lasted eight months. Between 1983 and 2007, the
CPI spent most of its time range bound between 2% and 4%, much
more under control than it had been in the 1970s. After peaking
at 10.8% in November 1982, the unemployment rate consistently
trended lower until it was back under 4% in 2000—returning to
levels of the 1950s (see the U.S. Unemployment Rate chart on page
1). On the surface it appeared that manipulating monetary and
fiscal policy had achieved the economic holy grail of full
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
U.S. Unemployment Rate
Source: Bureau of Labor Statistics, period ending 08/31/14

employment, relatively low inflation and decent economic growth.
If the business cycle hadn’t been completely eliminated, it had at
least been tamed.
The apparent success of monetary and fiscal intervention did result
in a number of unintended consequences. The economic stability
encouraged more risk-taking and a greater use of leverage. For
instance, hedge fund manager Long-Term Capital Management
L.P. (LTCM) had two Nobel Prize winners for Economic Sciences on
its board and was levered 100 to 1. After the LTCM hedge fund
imploded in the summer of 1998, the Fed stepped in to stabilize
the financial system and provide a floor under the stock market.
This intervention and memories of the Fed’s intervention after the
1987 stock market crash provided investors confidence that the Fed
would always intervene, which became known as the “Greenspan
put.” This assurance fueled the dot-com bubble and a 378% increase
in the Nasdaq’s composite from its low in October 1998 to its high
in March 2000. While speculation ran rampant and valuations
reached the sky, the Fed saw no bubble and took no action.
In 2004, investment banks petitioned the Securities and Exchange
Commission (SEC) to increase their balance sheet leverage from 12
to 30 times their capital. Since the volatility of the business cycle
had been low for a long time, the SEC granted the request and
the investment banks proceeded to leverage their balance sheets
on the “safest” investment of all. Home values had not declined
since the depression, so what could go wrong? After 2002, lending
standards disappeared, liar loans became the norm and median
home values rose 50% above their historical norm of 3.5 times
median income. Despite a plethora of warning signs, including
TV ads in 2004 and 2005 promoting mortgage loans of 125% of a
home’s value, the Fed saw no housing bubble and exercised zero
supervision over home lending.
The second and more important unintended consequence was
an enormous increase in debt between 1982 and 2007. In 1982,
household debt was 44% of gross domestic product (GDP), but by
2007 it had climbed to 98% of GDP. Homeowners levered up on the
rise in home prices and used increases in their home equity as a
personal ATM. Based on analysis by Federal Reserve Board members
Alan Greenspan and James Kennedy, mortgage equity withdrawal
was responsible for more than 75% of the growth in GDP from 2003
to 2006. In other words, rising home values and housing market
speculation made the extraction of home equity possible and
was far more important than the increase in personal income in
powering economic growth during the housing boom. This made
the economy far more vulnerable to a decline in home values and
the commensurate cessation of home equity extraction.
Household debt escalation was only part of the widespread debt
increases in response to low interest rates and ample liquidity
provided by the Fed. Total credit market debt, which includes
-2%
0%
2%
4%
6%
8%
10%
1982
1986
1990
1994
1998
2002
2006
2010
2014
CPI (Year-Over-Year): 1982 - 2014
Past performance does not guarantee future results.
0%
2%
4%
6%
8%
10%
12%
14%
16%
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
CPI (Year-Over-Year): 1964 - 1981
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
U.S. Federal Funds Effective Rate
Source: Federal Reserve Bank of New York, period ending 09/19/14
1100
1600
2100
2600
3100
3600
4100
4600
5100
5600
01/1998
07/1998
01/1999
07/1999
01/2000
07/2000
01/2001
07/2001
01/2002
07/2002Nasdaq Composite
Source: Bloomberg, period ending 12/31/02

private and public debt, was 165% of GDP in 1982 and reached
370%, or $3.70 for each $1.00, of GDP in 2007. Although the Fed
increased the federal funds rate from 1% in June 2004 to 5.25% in
2006, it never really tightened credit availability. Spreads between
Treasury bonds and corporate bonds continued to narrow until mid-
2007, even with the rate increase. This provided clear evidence that
risk-taking and liquidity remained available despite the increase in
the cost of short-term money rates.
From 1982 until 2007, monetary and fiscal policy was manipulated
to ward off recession and keep unemployment rates down while
debt grew as if on steroids. Even though the debt funded an
increase in demand, economic growth actually slowed. Between
1946 and 1972, GDP growth averaged 4.16%, 28% faster than the
3.23% average from 1982 through 2007. The enormous increase
in debt borrowed demand from the future, but really didn’t help
the economy grow faster. In effect, each additional dollar of debt
between 1982 and 2007 increasingly generated less than a dollar
of GDP growth. Since debt as a percentage of GDP rose from 165%
in 1982 to 370% in 2007, the value of each additional $1.00 of debt
only generated $0.44 of GDP in 2007.
At the end of the first quarter this year, debt as a percentage of
GDP receded from 370% to 347%, primarily because household
debt has declined as a result of homeowners defaulting on
mortgages. The decline in household debt has been mostly offset
as government deficit spending soared during the recession. Total
public debt as a percentage of GDP soared from 63% in 2007 to
112% as of June 30, 2014, and has skyrocketed from less than $6
trillion to $17.63 trillion.
Of course, the Fed can’t take all the credit (pun intended) for
the massive debt buildup since Congress has been an active
coconspirator for decades. Keynes’ economic theory depended on
fiscal policy being a counterweight to swings in private demand.
When private demand slumped and a recession developed,
fiscal deficits were a useful tool to pump up demand through
government spending. The resulting deficits were financed
through the issuance of government bonds and then paid off as
economic growth generated government surpluses. The strength
of Keynes’s theory is its simplicity. What Keynes did not appreciate,
however, was that its success over time depended on the discipline
of Congress not to spend surpluses and instead use them to pay
down accumulated government debt. After the end of World War
II, government debt as percentage of GDP was 121.7%, but by
1972 was less than 40%. Between 1946 and 1960, the government
posted a budget deficit in seven out of 15 years. However, from
1961 through 1972 the only year of surplus was 1969. The main
contributor to the decline in debt as a percentage of GDP came
from economic growth, which averaged 4.16% between 1946 and
1972. It really is simple math: if GDP grows faster than the growth
of debt, debt as a percentage of GDP falls; when debt grows faster
than GDP, the ratio rises, as it did between 1982 and 2007.
250%
300%
350%
400%
450%
500%
550%
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Ratio of Median Home Price to Median Household
Income (5-Year Average)
Source: Nat'l Association of Realtors and the U.S. Census Bureau, period ending 06/30/14
100%
150%
200%
250%
300%
350%
400%
1948
1954
1960
1966
1972
1978
1984
1990
1996
2002
2008
2014
Total Credit Market Debt as a Percentage of GDP
Source: Federal Reserve and Bureau of Economic Analysis, period ending 07/31/14
40%
50%
60%
70%
80%
90%
100%
1982
1986
1990
1994
1998
2002
2006
2010
2014
Household Debt as a Percentage of GDP
Source: Federal Reserve and Bureau of Economic Analysis, period ending 06/30/14
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
1946 - 1972 1982 - 2007
Source: Bureau of Economic Analysis, period ending 12/31/07
U.S. Real GDP
Year-Over-Year Average Comparison: 1946-1972 & 1982-2007

In 2007, federal debt as a percentage of GDP was 64.5%—almost
double 1982’s ratio of 32.5%. This increase occurred because the
federal government ran a budget deficit in every year except four:
1998, 1999, 2000 and 2001. Capital gains tax revenues from the
dot-com bubble were one of the primary reasons for the surplus
years. Thus when the stock market declined in 2001 and 2002,
those surpluses vanished. When it comes to government deficits,
we are agnostic. A deficit is a deficit: whether it is the result of
government spending or tax cuts, either way, future generations
are on the hook to pay for them. This is one case where the means
(liberal or conservative ideology) does not justify the net result.
Both parties would, of course, argue this point. Ironically, each
party is the opposite side of the same coin, which is currently
valued at more than $17 trillion of debt.
A prominent Nobel Prize winning economist has argued that
the reason the current recovery is so lackluster is because the
government stimulus plan was too small. In other words, if the
government had increased outstanding debt since 2009 by $8
trillion or $10 trillion instead of $6 trillion, the country would be
better off. This argument totally ignores the fact that since 1982
each additional one dollar of debt has increasingly produced less
than one dollar of GDP growth. Hopefully this economist has lots
of children, grandchildren and great grandchildren so they can pay
for his ideological largesse. A 3% annual budget deficit is commonly
accepted as good by the majority of mainstream economists. This is
like saying going broke is not a good thing, but if we’re going to go
broke, it is better to do it slowly. But, according to the U.S. Office of
Management and Budget, the average annual deficit from
1946 through 2013 was 2.09%, which has led to $17.6 trillion in
federal debt.
A May 2012 ABC 20/20 news report entitled “Losing it: The Big Fat
Trap” reported that Americans spend $20 billion a year on weight
loss programs and diets with disappointing results. Losing weight
is fairly straightforward—eat smaller portions, eat less fattening
food and be more active. Getting our fiscal house in order is also
straightforward—no more deficits and use surpluses to pay off
prior debt. With each political party pitching their formula of
spending or tax cuts to voters who, on balance, spend more time
focused on sports, reality TV and social media, the odds of fiscal
discipline breaking out anytime soon are slim. As we discussed in
the June MSR section “Economic Enervation,” Congress could also
reduce the number of its regulations, which have likely contributed
to slower economic growth since 1982. Since both political parties
use regulations as a primary fundraising tool, we don’t expect a
“let’s roll back regulation” movement to sweep the nation. Nor do
we anticipate that Congress and the Federal Reserve will abandon
their multidecade unsuccessful attempt to tame the business cycle.
There is a natural ebb and flow for everything on this planet,
from ocean tides to seasons of the year. Recessions are a natural
part of the business cycle, just as night follows day. In a practical
sense, periodic recessions cleanse the economy and financial
system of excesses, such as unneeded inventories or overleveraged
companies. In this way, a balance is maintained between the supply
and demand for raw materials, labor and credit, which ensures
the underpinnings of the economy remain sound. The business
cycle has been in existence as long as there has been something
to sell and willing buyers. The notion the business cycle could be
suppressed or eliminated with the ministrations of monetary and
fiscal policy should have been deemed preposterous. Instead,
hubris trumped common sense. In the pursuit of minimizing
increases in unemployment and reelection, politicians embraced
fiscal stimulus to ward off recessions but scorned the discipline to
pay for the stimulus. The Fed has aided and allowed debt to grow
faster than GDP, and in the process printed their way into a blind
alley. With $3.47 of debt for every $1.00 of GDP, how much can the
Fed raise rates without interest expense becoming a significant
headwind for the economy and federal budget? At the September
2014 Federal Open Market Committee (FOMC) meeting, the
median forecast for the 2017 federal funds rate was 3.75%. We
suspect the Fed will be as correct on the federal funds rate forecast
as their projections for 3%+ GDP growth in each of the past four
years. The Fed has trained investors to be so dependent on an
accommodative monetary policy that markets are fixated on when
the Fed will remove the phrase “considerable period” from the
FOMC statement. There will come an “uh-oh” moment when the
global financial markets realize that central bank monetary policy
is tapped out and perception can no longer trump economic reality.
In the meantime, global markets can find comfort in the fact that
the ECB will probably launch their version of quantitative easing by
early 2015, the Bank of Japan will continue to debase its currency
and the Fed won’t increase rates for a considerable period.
0
10
20
30
40
50
60
70
80
90
100
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
InThousands
Federal Register Pages Published Annually
Source: Federal Register, period ending 12/31/12
0
2
4
6
8
10
12
14
16
18
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
InTrillions($)
U.S. Total Public Debt Outstanding
Source: U.S. Treasury, period ending 08/31/14

January 2015: Monetary Policy and Business Investment
The Federal Reserve has kept short-term interest rates barely above
0% for six years and has expanded its balance sheet from $900
billion in 2007 to $4.4 trillion in 2014 through quantitative easing.
The suppression of interest rates and bond purchases by the Fed
has made it possible for corporations to borrow cheaply. Issuance
of investment-grade and junk bonds has soared from $953 billion
in 2009 to $1.31 trillion in 2012, $1.41 trillion in 2013 and $1.39
trillion through November 2014. Borrowing at lower interest rates
has saved corporate America several hundred billion dollars in
interest expense in recent years, which is a good thing. However,
an increasing number of companies have used debt to buy back
their stock. In the 12 months through the end of November, 374
companies in the S&P 500 Index spent $567.2 billion on share
buybacks, up 27% since November 2013. Over the last four years,
corporations have spent more than $2.2 trillion on stock buybacks.
Between 2003 and 2012, of the 449 companies publicly listed in
the S&P 500, 54% of earnings were used to buy back stock and 37%
were used to pay dividends. According to Barclays, the proportion of
cash flow used for stock buybacks has almost doubled over the last
decade. With such a large percentage of earnings being used to buy
back stock, the proportion of cash flow used for capital investments
has declined. One driver behind the shift toward more stock
buybacks has come from the increase in executive compensation
derived from stock options and stock awards. In 2012, the 500
highest-paid executives named in proxy statements of U.S. public
companies received an average of $30.3 million. Of this total, 42%
came from stock options and 41% from stock awards. What’s
more astonishing than the level of compensation is the obvious
conflict of interest. Some executives recommend to their firm’s
board of directors that a better use of the company’s earnings is
buying back more stock, or worse, that they should borrow money
for the buybacks. The fact that stock buybacks somewhat directly
enrich executives is overlooked by the board, whose focus is
supposedly on the long-term interests of the company. A mutual
fund portfolio manager who buys a stock for his personal account
before purchasing it for the fund runs afoul of security laws. A
company, however, can buy its stock all day, every day based on
a recommendation from the firm’s executives to the board of
directors and the Securities and Exchange Commission sees no
conflict of interest.
Cheap money has incentivized companies to increase earnings
by using more of their cash flow and borrowed money to reduce
their share count through stock buybacks rather than investing
in their business and future. In addition to skimming capital
investments for buybacks, corporations have kept their hiring and
wage increases to a bare minimum. On the surface this looks like
a winning business plan since after-tax profits as a percentage of
GDP are at an all-time high. But upon further review, there is a less
promising message: employee compensation as a percentage of
GDP has been trending lower for decades and is at the lowest level
since recordkeeping began in 1947.
Earnings juiced by stock buybacks and financial engineering
along with the suppression of wages and quality jobs may make
the S&P 500’s price-earnings (P/E) ratio appear reasonable. But
these earnings are not the same quality of earnings derived from
intelligent research and development (R&D) investment, new
products and solid revenue growth. Henry Ford became famous
for implementing the assembly line, which lowered the amount of
time to build one car from 12 hours to just 93 minutes. The increase
in the production of cars lowered the cost of each car produced,
making them affordable. His real genius though may have been
deciding to pay his workers enough so they could buy the cars his
assembly lines produced.
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
1947
1953
1959
1965
1971
1977
1983
1989
1995
2001
2007
2013
Proﬁts as a Percentage of GDP
Source: Federal Reserve Bank of St. Louis, period ending 07/01/14
40%
42%
44%
46%
48%
50%
52%
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
2013
Wages as a Percentage of GDP
Source: Bureau of Economic Analysis, period ending 01/01/13

May 2015: Global Debt, Growth and Future Central Bank Policies
The global economic pie is shrinking relative to the growth rates
of the past and that’s a problem. According to the International
Monetary Fund’s (IMF) World Economic Outlook database,
worldwide GDP growth during 2013–2014 averaged 3.10%,
compared to 2006–2007, which averaged 5.15%. While GDP growth
has declined, the chasm between growth in advanced economies
and developing countries has not changed much. GDP growth in
advanced economies has slowed -47.37% from 2.85% in 2006–2007
to just 1.50% in 2013–2014 while growth in developing countries
has downshifted -45.06% from 8.10% to 4.45%, respectively. As this
data indicates, the worldwide slowdown in growth has been evenly
distributed and not merely concentrated in either advanced or
developing countries.
The widespread impression that the global economy has
deleveraged in the wake of the financial crisis is a fallacy—it is
more leveraged now than it was prior to the financial crisis, based
on the ratio of total global debt to GDP. In February, the McKinsey
Global Institute published an extensive review of debt levels in
22 developed and 25 developing countries. The McKinsey analysis
found that global debt had increased from $142 trillion in 2007
to $199 trillion in 2014. The $57 trillion increase in global debt
represents a surge of 40%, far exceeding the 23% gain in global GDP
during the same period. The global debt-to-GDP ratio rose from
269% at the end of 2007 to 286% as of June 30, 2014. The title of
the McKinsey study was apt: “Debt and (not much) deleveraging.”
Although total global debt has increased 40% since 2007, the
McKinsey Global Institute did find a couple of silver linings. The
growth rate in global household debt slowed from 8.5% during the
period of 2000–2007 to 2.8% in 2007–2014. Lax mortgage lending
standards contributed to the excessive addition of mortgage debt
prior to 2007 while tighter standards after the financial crisis curbed
growth. The net result is that household debt is now growing in
line with global GDP growth as compared to the debt binge prior
to 2007. When household debt grows in line with GDP growth,
household incomes are more likely to grow fast enough to prevent a
rise in defaults on mortgage, credit card and auto debt. The increase
in debt and leverage by banks prior to 2008 was a major contributor
to the financial crisis. A number of U.S. investment banks increased
their leverage ratio from 12-to-1 in 2004 to almost 30-to-1 in 2007.
A number of large European banks had leverage ratios of almost 40-
to-1 just prior to the financial crisis. When home values fell in many
countries, the excessive leverage decimated bank balance sheets
and threatened the global financial system. Financial institutions
have significantly lowered the growth rate of debt since 2007 from
9.4% to 2.9%. The deleveraging of bank balance sheets in the wake
of the financial crisis is a strong indication that the global financial
system is in far better shape than it had been and is capable of
handling the next business cycle downturn and any unanticipated
economic shock.
The same cannot be said about government debt and leverage.
In response to the financial crisis, governments around the world
increased spending to offset the decline in private demand
as unemployment soared, consumers stopped shopping and
businesses slashed spending. Much of the increase in government
spending was financed with debt, which grew 60% faster in
the seven years following the crisis than the precrisis level (9.3%
versus 5.8%). The growth rate in government debt poses a perilous
challenge for the global economy in coming years since the current
level of government debt is already high enough to impair its
capacity to deal with the next economic slowdown. Faced with
another recession, we have no doubt that politicians around the
world will respond with another round of deficit spending to
minimize its impact—as that’s how they have repeatedly responded
every time a recession threatened their reelections. Mae West
famously said too much of a good thing could be wonderful, but we
don’t think debt is one of those things. We don’t know how much
debt is too much, but the economic engine of the global economy
is certainly more at risk now than it was 30 years ago, even though
global interest rates were far higher back then.
Most governments consider a deficit of 3% of GDP to be healthy,
but the flaw in this perspective is it ignores the impact of “healthy”
deficits over time. Total debt as a percentage of GDP doubles
in just 24 years if a country maintains a “healthy” 3% annual
deficit, meaning the long-term threat from continually running
Global Stock of Debt Outstanding
Compound Annual Growth Rate
2000 – 2007 2007 – 2014
Total 7.3% 5.3%
Household 8.5% 2.8%
Corporate 5.7% 5.9%
Government 5.8% 9.3%
Financial 9.4% 2.9%
*47 nations, including 22 developed and 25 developing countries
Source: McKinsey Global Institute, as of 06/30/14
Global Slowdown Compounds the Debt Challenge
Growth Rate
2006 – 2007
Growth Rate
2013 – 2014
Change in
Growth Rate
World Average 5.15% 3.10% -39.81%
Advanced Economies 2.85% 1.50% -47.37%
Developing Countries 8.10% 4.45% -45.06%
USA 2.40% 2.05% -14.58%
Eurozone 2.80% 0.20% -92.86%
Source: International Monetary Fund, as of 12/31/14
Economic Growth Hasn’t Kept Pace With Debt
2007 2014
Global Debt* $142 T $199 T
Global Debt/GDP 269% 286%
*47 nations, including 22 developed and 25 developing countries
Source: McKinsey Global Institute, as of 06/30/14

“healthy” annual deficits is that cumulative debt reaches a level
that can hardly be described as healthy. However, any slowdown in
government deficit spending will dampen growth in the short term
unless household and corporate spending picks up the slack. That’s
not likely in the short run since the global economy is suffering
from a lack of demand due to a combination of high unemployment
and underemployment, weak wage growth and excess capacity
that has depressed business investment.
The Congressional Budget Office has estimated that a 1.0% increase
in Treasury yields across the maturity spectrum would add $150
billion in interest expense to the annual U.S. government budget.
Debt-to-GDP ratios in Europe and Japan are far higher than in the
U.S., so their budgets and economies are even more vulnerable to
higher interest rates. Any meaningful rise in global interest rates in
coming years could accelerate budget deficits to well above 3% of
GDP as interest expense on the mountain of accumulated sovereign
debt soars—one reason central banks, especially in advanced
economies, will find it extraordinarily difficult to normalize interest
rates in coming years. This situation exposes an inherent conflict of
interest between fiscal and monetary policy that has never been so
pronounced and has the potential to further compromise central
banks’ independence.
The level of GDP growth impacts the amount of cash flow
generated in the form of personal income, corporate profits and
government tax revenue. As economic growth accelerates, the
ability to service debt becomes easier and the risk of defaults on
mortgages, auto loans, corporate bonds and bank loans declines.
Debt levels are higher now than in 2007 while global economic
growth has slowed significantly and is only expected to reach
3.50% in 2015, according to the IMF. Even with that improvement
in growth compared to the last two years, it will still be more than
30% slower than in 2007. In this respect the leverage in the global
economy is more precarious than in 2007.
In the next few years, the global economy will be vulnerable to
either a slowing from current growth levels or an increase in
interest rates. Navigating these issues amounts to the economic
equivalent of threading the needle since even a modest increase
in interest rates is likely to disproportionately weigh on future
growth as a larger share of cash flow will be needed to service debt.
Any slowdown in the global economy would push central bankers
even deeper into the uncharted territory of negative interest rates,
unlimited quantitative easing (QE) and currency depreciation. The
risk of deflation will continue to lurk in the shadows until the ratio
of global debt to GDP actually declines.
Even though interest rates, especially in advanced economies,
have spent years at their lowest levels in history, economic growth
has fallen far short of historical norms. Big deficits and cheap
money have failed to engender sustainable growth. This economic
reality provides an insight into just how difficult it will be for the
Fed, ECB and Bank of Japan (BoJ) to ever “normalize” short-term
interest rates. Any increases are likely to be modest and stretched
out over an extended period of time. Beginning in June 2004, the
Fed increased the federal funds rate at 17 consecutive meetings.
Nothing close to that will happen in this cycle. The pace of central
bank rate increases in the next few years is likely to make a tortoise
look like the Road Runner. The BoJ may never increase rates in
our lifetime and the first increase the ECB effects will be to raise
rates from below zero percent to zero percent. Welcome to the
brave new world of modern monetary policy that is more
effective in distorting market outcomes than generating actual
economic growth.
Eurozone
February 2014: Eurozone
One of the ongoing challenges of the European Union (EU) is the
disparity in productivity among its members. In the wake of the
financial crisis, the least productive countries experienced a deeper
and more prolonged contraction, resulting in far higher rates
of unemployment that persists into 2014. Although the overall
unemployment is 12.1% for the EU, it is 11% in France, 12.7% in
Italy, 26.7% in Spain and 27.4% in Greece. In contrast, Germany’s
unemployment rate is just 5.2%, hence the friction within the EU.
Prior to the formation of the EU in 1999, the productivity gap
between countries could be closed through the depreciation of
an individual country versus the currency of trading partners. For
instance, if Italy wanted to improve its export competitiveness,
it would lower the value of the Italian lira by 5%–10% or more.
A decline in the lira would lower the cost of Italian exports and
make Italian exporters more competitive with exporters around
the world. Lowering the cost of exports through the depreciation
of its currency, rather than cutting wages, kept Italian domestic
demand stable, as a weaker currency lifted exports. However,
with the establishment of a common currency for the members
of the EU, the only way to improve export competitiveness is
through productivity improvements or lower labor costs, which is
far more painful since lower incomes weaken domestic demand
and GDP. For those countries whose productivity has lagged
Germany over the last decade, the path to increased productivity
will primarily be through labor market reforms. In the short run,
labor market reforms will be politically unpopular in countries
like France and Italy, and if enacted, will likely result in higher
unemployment and slower GDP growth.
France’s core problem is that wages have been growing faster than
productivity for years. In 2000, the socialists in France instituted
the 35-hour workweek, so French workers have been producing less
in less time too. Unemployment is 11% and youth unemployment
is 26%. The minimum wage is now 62% of median income, versus
38% in the U.S. Anyone who has worked more than 28 months can
receive up to 75% of their old salary for 24 months. The employer
payroll tax can reach 48%, which means an employee paid $1,000 a
month actually costs the employer $1,480 per month. Needless to
say, private sector job growth has been almost nonexistent.
Welfare spending, including programs for youth, the unemployed
and the elderly is set to reach 31% of GDP, the highest of the 34

OECD nations. Instead of reducing government spending, France
increased spending so that government spending is now 57% of
GDP, and debt as a percent of GDP jumped from 60% in 2007 to
92% in 2013.
Whether it was the result of its credit downgrade, Draghi’s
comment, or recent polls which show that 74% of the French
think France is on the decline and 83% view President Francois
Hollande’s reform policies as ineffectual, Hollande appears to
have experienced an epiphany. In a speech on January 14 he said,
“How can we run a country if entrepreneurs don’t hire? And how
can we redistribute if there’s no wealth?”2
Acknowledging that
socialist redistribution does not create wealth and relies instead
on entrepreneurs must have been an out-of-body experience for
Hollande. Proof came when Hollande proposed cutting government
spending to fund a $48 billion annual tax cut so companies won’t
have to pay for France’s generous family welfare programs by 2017.
It’s unlikely that one small program will pull the French economy
out of a malaise that took decades to grow.
According to the OEDC, of its 34 participating countries, Italy’s
output has grown the least over the last decade. This poor
performance is partially due to the lack of currency flexibility, but
is also due to government spending, high taxes and inflexible
labor market regulations. Government spending is 50.7% of GDP
and relies on high payroll taxes to fund its spending. According
to the OECD, 33% of Italian salaries support Italy’s pension fund,
compared to 13% in the U.S.’s Social Security system. Labor costs
are higher than in Spain, but Italian workers have less disposable
income after taxes are deducted. This is a bad combination since
high labor costs suppress hiring, and low take-home pay mutes
economic growth since workers have less money to spend. The
lack of growth has resulted in chronic budget deficits, which has
increased Italy’s debt to GDP ratio to 130%. Within the EU, only
Greece has a higher debt to GDP ratio.
According to PricewaterhouseCoopers (PwC), European banks are
sitting on $1.7 trillion in nonperforming loans, which are loans on
which no payments have been made in 90 days. In order to comply
with Basel III regulations, European banks will need to increase
capital by at least $240 billion to as much as $380 billion, depending
on how much each bank restructures its balance sheet assets,
according to PwC. A weak economy, bad loans and looming Basel
III regulations have led many banks to shrink their balance sheets
and lending. The annual change in eurozone loans to nonfinancial
corporations has not improved and was still negative in November
at -2.3%. In early November, the ECB announced stress tests for
128 systemically important banks that should be completed by
the fourth quarter of 2014. The ECB will assume direct supervision
over the largest eurozone banks in 2014. With the ECB conducting
its stress tests and assuming a more active supervisory role over
the largest banks, lending throughout Europe is likely to remain
constrained in 2014 and well into 2015. Many banks may choose to
write off bad loans before the stress test is completed so they look
better, as Deutsche Bank did when it announced a fourth quarter
loss of $1.35 billion. As long as credit growth is weak, economic
growth is unlikely to exceed 1% in 2014.
There are few instruments left for the ECB to use to spur growth
and offset low inflation. The ECB’s refinancing rate was lowered
from 0.50% to 0.25% in November. The ECB can lower it further,
but another 15 basis points probably won’t make a big difference
in spurring bank lending in the EU, or help speed up the structural
reforms needed in France or Italy. The ECB can launch another
long-term refinancing operation (LTRO) program, but pushing more
money into the European banking system is not likely to encourage
more lending while banks are undergoing a stress test, economic
growth is almost nonexistent and bad loans weigh on bank balance
sheets. One step the ECB could take is lowering the value of the
euro, which would improve the export competitiveness for every
EU member. A cheaper euro would especially help those countries
whose productivity has lagged behind Germany. Since a lower value
of the euro could increase the cost of imports, like oil, which are
priced in dollars, inflation may also rise.
Eurozone
April 2014: Eurozone
In the face of an ongoing contraction in bank lending, weak
economic growth and potentially dangerously low inflation, what
can the ECB do to boost growth and inflation in coming months
when their refinancing rate is already at an all-time low of 0.25%?
In the December 2013 MSR, we suggested the ECB might pursue a
lower euro in 2014 to spur growth since their refinancing rate was
already low (0.25%) and other policy options were limited. In the
February 2014 MSR, we noted that a lower euro would improve
the export competiveness of every EU member, especially the
southern countries (Italy and Spain) whose productivity has lagged
Germany’s over the last decade. A lower euro would increase the
cost of imports and contribute to an increase in inflation, which
could lessen deflation concerns. After ECB President Mario Draghi
stated that the ECB would do “whatever it takes” to stem the
sovereign debt crisis on July 24, 2012, the euro has rallied more than
15% versus the dollar.3
The initial rebound in the euro was welcome
and a sign that international confidence in the sustainability of the
eurozone was increasing. The strengthening euro was a helpful
tailwind, which brought borrowing costs down for the countries
most affected by the sovereign debt crisis–Greece, Portugal, Spain
and Italy. Lower borrowing costs helped their economies stabilize
and narrow budget deficits over the past 18 months. With the
eurozone’s economy on the mend, the euro’s strength has shifted
from being a tailwind to a headwind. In February, the CPI was up
0.8% versus a 1% increase in core inflation, since the CPI includes
energy prices. Both measures of inflation were well below the ECB’s
target of 2.0%. The ECB has been concerned that the low rate of
inflation makes the eurozone vulnerable to deflation, especially
if economic growth faltered. Some of the downward pressure
on inflation over the past year has come from a decline in energy
prices. However, the strength of the euro has also caused inflation
to be lower. At the ECB’s monthly news conference on March 6,

Mario Draghi said that the strength in the euro since July 2012
had shaved 0.4% off annual inflation. Draghi went on to state,
“The strengthening of the euro exchange rate over the past one
and a half years has certainly had a significant impact on our low
rate of inflation, and, given current levels of inflation, is therefore
becoming increasingly relevant in our assessment of price stability.”4
Draghi has consistently argued that the risk of a Japan-style
deflation was low. However, on March 6, Draghi acknowledged that
the longer inflation in the European monetary block remained low,
the higher the risk that deflation would increase. Although the ECB
has forecast that inflation will rise to 1.7% in 2016, Draghi’s March
6 comments imply the ECB may not be comfortable with that
timetable, since it means that inflation will remain under the ECB’s
target of 2% for at least another two years.
Our expectation that the ECB would take steps to lower the euro
in 2014 appears on track and seems increasingly likely. We have
no idea what actions the ECB might take to reverse the euro’s
uptrend or when, but the ECB’s success in bringing down sovereign
yields in 2012 may provide a clue. In conjunction with Draghi’s
“whatever it takes” statement in July 2012, the ECB announced
plans for its Outright Monetary Transactions (OMT) program. Under
the OMT program, the ECB would be able to buy sovereign bonds
of EU members in the secondary market. There were no limits
established on the amount of a country’s outstanding bonds the
ECB could buy, as long as that country stuck to the agreed plan for
deficit reduction. The ECB didn’t want its OMT program to lessen a
country’s commitment to fiscal austerity. Knowing the ECB would
step in to backstop any rise in bond yields for EU countries, hedge
funds and international money managers bought sovereign bonds
aggressively. Within six months, bond yields had come down
dramatically and the ECB didn’t have to spend a dime in achieving
their goal. Given this prior success, all the ECB may need is for
Draghi to state the desire for a lower euro as well as a willingness
from the ECB to sell euros if necessary. Currency traders likely would
be happy to accommodate the ECB’s wishes, since they could sell
the euro short knowing they were doing so with the blessing of the
ECB and with almost zero chance the ECB would intervene. The ECB
wouldn’t have to sell a single euro to achieve their goal.
The 50% retracement of the decline from 160.50 in July 2008 to
the low in June 2010 at 118.79 is 139.64, and not much above the
March 13 high of 137.87.
Eurozone
June 2014: Eurozone
Eurozone GDP grew 0.8% in the first quarter, with Germany and
Spain up 3.2% and 1.5%, respectively, while France was flat, Italy
was down 0.5%, and GDP in Portugal was off by -2.8%. We do
not expect GDP growth in the eurozone to exceed 1% by much
in 2014, so the first quarter was in line. Since banks provide 80%
of the credit creation in the eurozone, a solid recovery is not likely
until lending and credit availability improves. A recent report by
the ECB noted that the credit squeeze throughout the eurozone
had eased modestly in recent months, but has a long way to go.
New bank loans are still only half of their pre-crisis level. Since
small- and medium-size businesses represent two-thirds of all jobs,
unemployment is not likely to come down quickly in many eurozone
countries until credit availability improves materially. The ECB
report also noted that 60% of businesses in Greece, 52% in Italy
and 43% in Portugal still face a real problem in gaining access to
credit. When they can obtain a loan, they are often paying rates
two to three times higher than German businesses. The lack
of access and cost of credit will make it especially difficult for
businesses in Southern Europe to not fall further behind Germany
in terms of productivity.
Entering 2014, we expected the ECB to engineer a decline in the
value of the euro. As we discussed in the April 2014 MSR, the
simplest way for the ECB to lift inflation and further support
growth would be to communicate a desire for the euro to decline.
The ECB has estimated that the 15% rise in the euro over the last
18 months has shaved 0.4% off eurozone inflation. Since imported
goods will cost more and add to inflation, a weaker euro should
alleviate some of the downward pressure on inflation. A weaker
euro would also likely make exports from every EU country
cheaper for the rest of the world to buy, which would likely lead
to an increase in exports and GDP growth. A cheaper euro would
especially help Italy, Spain and France, which have higher labor and
production costs than Germany. After the ECB’s meeting on May 8,
ECB President Mario Draghi stated that the ECB’s governing
council is “comfortable with acting next time” and easing policy
at their meeting in early June. He also reiterated the connection
between the euro and the low rate of inflation. “The strengthening
of the exchange rate in the context of low inflation is a cause for
serious concern.”5
It appears currency traders have gotten the message since the
euro peaked on May 8 at 139.93. As we discussed in April, the 50%
retracement of the decline from the July 2008 high of 160.38 to
the low in June 2010 at 118.77 was 139.57. The May 8 peak was
just 0.46 from a perfect 50% retracement, which technically is
significant. During the week of May 9, the euro posted a weekly
key reversal when it made a higher high, lower low than the
previous week, and closed lower. In fact, the May 9 weekly reversal
encompassed the three prior weeks, which adds to its importance.
1.15
1.20
1.25
1.30
1.35
1.40
01/2012
04/2012
07/2012
10/2012
01/2013
04/2013
07/2013
10/2013
01/2014
Euro to U.S. Dollar
Whatever It Takes


This is another technical indication that the trend in the euro versus
the dollar has turned down. This is one of those times when the
fundamentals and the technicals are aligned, which should increase
the probabilities that our forecast of a decline in the euro is on
target. As we wrote in the May 2014 MSR, “Shorting the euro has
the potential to result in a profitable trade over the next year.” From
a risk management point of view, a stop on a short trade should be
either just above the May 8 high or pennies below it.
Eurozone
September 2014: Eurozone
After its GDP fell -0.1% in the second quarter, France avoided
fulfilling the classic definition of recession (two consecutive
quarters of negative GDP) only because GDP was unchanged in
the first quarter. The unemployment rate rose to an all-time high
of 10.2% in July, and, absent labor market reforms, it is unlikely
to improve much in coming quarters. France holds the dubious
distinction of having twice as many companies with exactly 49
employees as companies with 50 or more employees. You probably
won’t be surprised to learn that the less-than-invisible hand of
government regulation is responsible. When a company takes on
a 50th employee, it becomes subject to almost three dozen labor
laws prescribed by France’s 3,200 page labor code. A 2012 study by
the London School of Economics and Political Science showed that
the cost of additional rules for companies with 50-plus employees
in France added 5% to 10% to labor costs. The study concluded,
“There is a strong disincentive to grow.”6
Italy’s GDP fell in the first quarter and the second quarter (by
-0.8%), so it is in a recession for the third time in five years. Italy’s
debt-to-GDP ratio reached 135.2% in the first quarter and will
continue to rise unless GDP growth returns. Like France, Italy has
labor market rules that have protected one group of workers
over another. In Italy’s case older workers are protected at the
expense of younger workers. In an attempt to help young people
get jobs in the 1980s and 1990s, Italy encouraged short-term
labor contracts, which made it easier for companies to hire and
fire employees. In 1998, 20% of workers younger than 25 were
temporary workers, compared to more than 50% now, according
to Eurostat. A 2013 Bank of Italy study found that entry level
wages for young workers under temporary contracts fell almost
30% between 1990 and 2010. This created a large income gap
between older workers, whose jobs and incomes are protected by
labor laws, and young workers. The temporary contracts allowed
young workers to be let go when the financial crisis struck, so
young workers were disproportionately affected. According to
Eurostat, since 2007 the employment rate for those under 40 has
fallen 9%, while it rose 9% for workers between 55 and 64 years
old. In June, the unemployment rate for workers under 25 rose
to a record of 43.7%. Unless Italy changes its labor laws, a whole
generation of young workers will clearly have a lower standard of
living than their parents.
The conundrum facing Mario Draghi and the ECB is that proactive
monetary policy can alleviate some of the pressure on countries like
France and Italy to make the structural changes needed to improve
economic growth over the long term. In the short term, weak
economic growth and low inflation will win out over doing nothing,
which is why the ECB is likely to implement quantitative easing
before year-end.
Eurozone
October 2014: The Return of the Almighty Dollar and Deflation
Since 2010, a vocal chorus has proclaimed that hyperinflation
and a crash in the dollar was right around the corner once the Fed
became a serial advocate of quantitative easing in the wake of
the financial crisis. Since 2008, the Fed has expanded its balance
sheet from $900 billion to more than $4.2 trillion in 2014. Although
neither a crash in the dollar or hyperinflation has reared its ugly
head, it hasn’t diminished warnings from proponents like Peter
Shrill (fictitious name), who in a recent CNBC interview reassured
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
14.0%
2007
2008
2009
2010
2011
2012
2013
2014
Eurozone Unemployment Rate

1.15
1.20
1.25
1.30
1.35
1.40
01/2012
05/2012
09/2012
01/2013
05/2013
09/2013
01/2014
05/2014
Euro to USD
Whatever
it
takes

Key
Weekly

Reversal

viewers that the plagues of hyperinflation and the dollar’s demise
are still on their way. He’s just been a bit early. As we have discussed
previously, there are a number of reasons why hyperinflation and
a collapse in the dollar has not happened and likely won’t for some
time. A stronger dollar is usually bearish for commodities and
increases the deflationary threat from excessive debt.
The classic definition of inflation is too much money chasing too
few goods. Although the Fed has greatly expanded its balance
sheet since 2008, most of the money has not made its way into
the economy. Free reserves held at the Federal Reserve by U.S.
banks totaled $2.71 trillion as of September 19, 2014. One of the
reasons the current recovery has been mediocre is because there
is too little demand, not just in the United States, but globally.
Capacity utilization rates around the world are low, which has kept
business investment weak and inflation rates low. The U.S. Federal
Reserve, ECB and Bank of Japan have been far more concerned
about deflation and have strenuously tried to revive inflation with
the greatest amount of monetary accommodation ever attempted.
Most of the money created by central banks though is not coursing
through domestic economies but sitting dormant. Although bank
lending has modestly picked up in the U.S., it is still contracting in
Europe, with banks more focused on strengthening their balance
sheets than lending into a weak economy.
The velocity of money measures how fast each dollar of M2
money supply is turning over. When consumers and businesses
are confident, the turnover of M2 rises as consumers spend
more and business investment increases. The increase in velocity
results in faster GDP growth and fosters a virtuous cycle of better
job creation, business investment, wage growth and more bank
lending. When they are cautious, consumers spend less, businesses
hold back on new investments, banks reduce lending and GDP
growth slows. As you can see, the velocity of money is at its lowest
rate in more than 50 years and has continued to slow precipitously
irrespective of the increase in the Fed’s balance sheet. This is
another reason why GDP growth has remained stalled around 2.5%
during the last three years despite the efforts of the Fed. Those
forecasting hyperinflation and a dollar crash are likely going to need
even more patience.
On February 18, 2001, Treasury Secretary Paul O’Neill said, “We
are not pursuing, as often said, a policy of a strong dollar. In my
opinion, a strong dollar is the result of a strong economy.”7
With
his comments, O’Neill appeared to distance himself and the
Bush administration from Robert Rubin’s insistence when he was
treasury secretary in the Clinton administration that a strong
dollar was in the best interest of the United States. The dollar
index topped out five months later in July 2001 at 121.29 and then
declined in earnest in 2002. When the Bush administration failed
to offer even token support, currency traders shorted the dollar
with impunity. The dollar lost 42% of its value between July 2001
and March 2008, when it bottomed at 70.69. As the financial crisis
erupted in the fall of 2008, international investors poured money
into the dollar as a safe haven, and by March 2009 it had risen
27%. As the stock market recovered and financial market volatility
calmed down, the dollar entered a broad trading range during 2009,
2010 and 2011, fluctuating between 73.00 and 89.00.
As discussed in the April 2014 MSR, we thought the dollar was
on the cusp of a solid rally after trading in a very narrow range in
2012 and 2013: “The euro represents 57.6% of the dollar index, so a
decline of 7.5% to 9.2% in the euro versus the dollar would add 4.3-
5.3% to the dollar index. With the dollar index trading near 80.00,
the decline in the euro would add 3.4-4.2 points to the dollar index,
and easily enable the dollar to trade above near-term resistance
at 81.30. Once above 81.30, the next level of resistance is 84.30 to
84.50, the highs in May and July last year.” In the May 2014 MSR,
just days before the peak in the euro, we wrote, “Shorting the euro
has the potential to result in a profitable trade over the next year.”
On September 19, the dollar index traded as high as 84.78 and the
euro fell to €128.30. In the September 2014 MSR our downside
target for the euro was €128.25-128.75. The dollar and euro have
reached our targets, and the dollar is overbought while the euro is
quite oversold. This suggests that the potential for a two or three
month rebound in the euro is probable, which should usher in a
modest decline and consolidation of the recent gains in the dollar.
This respite from dollar strength could allow commodities like oil
and gold, which have been trending down and are also oversold, to
experience oversold technical rallies. Although a bounce in the euro
and pullback in the dollar is overdue, the long-term technical trends
seem clear.
Between July 2001 and March 2008, the dollar index fell 50.6 points
from 121.29 to 70.69. Using a common Fibonacci ratio to measure
the rebound from a large decline, a 38.2% retracement of this
decline would be 19.33 points, which targets a rally to 90.02. This
target is just above the highs of 89.25 in November 2008, 89.71
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
Velocity of M2 Money Stock (Seasonally Adjusted)
Source: Federal Reserve Bank of St. Louis, period ending 04/01/14
65
75
85
95
105
115
125
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
U.S. Dollar Index Spot Rate

in March 2009 and 88.80 in June 2010, so we expect the index
to hit within the price range of 88.80 to 90.00 in coming months.
Should the dollar index reach this range as we expect, the odds of
it breaking out above the range are good. The dollar has already
tested this zone three times, so a breakout after a fourth attempt is
very probable. A 50% retracement of the dollar’s 50.6 point plunge
from 2002 to 2008 would create a target of 95.99 while a 61.8%
rebound (another common Fibonacci rebound from a large decline)
would suggest a possible high of 101.97. We think the higher
target more likely as after breaking through serious resistance at
89.00-90.00, a rally to just 95.99 seems too small, whereas a pop to
100.00-101.97 would be a more appropriate follow through. Finally,
if we are correct about the eurozone’s extended economic malaise,
the euro will decline significantly from current levels.
The euro almost doubled from its low of €82.30 in October 2000
to its high in July 2008 of €160.08, an increase of €77.78. A 50%
retracement of this huge rally would have been achieved with a
decline to €121.19. The euro bottomed at €118.70 in June 2010
and again at €120.00 in July 2012. The overshoot of the €121.19
target is understandable since Greece was imploding in June 2010
and concerns whether the European Union would hold together
were rampant in July 2012, prior to ECB President Mario Draghi’s
“whatever it takes” comment. Since the July 2008 top, each
euro rally has made a lower high, which is a sign of longer term
diminishing strength. The lows in 2010 and 2012 near €120.00 will
likely be retested, and probably result in a decent short covering
rally. We suspect this short covering rally will not represent “the
pause that refreshes,” but rather a failing dead cat bounce, which
will set up an unsettling plunge well below €120.00. A decline of 40
points from the high of €139.93 in May would be consistent with
the 40 point fall from €160.00 to €120.00, so we see €100.00 as
one possible target.
A decline from the September 19 close of €128.52 to €100.00 would
represent a 22.2% decline. Since the euro represents 57.6% of the
dollar index, the dollar would receive a boost of 12.8% from the
euro’s decline, lifting the dollar to 95.58 from its September 19 close
of 84.73. Since we expect additional weakness in the Japanese yen
and a number of emerging market currencies, it is easy to see how
the dollar index could reach 100.00-101.97 over the next nine to
18 months. Although these targets for the euro and dollar indices
may seem a bit extreme, the fundamentals and chart analysis are
aligned, which raises our confidence.
Eurozone
December 2014: Deflation Battle Becoming Currency War
In the 1930s as the growth of the global economic pie slowed
and contracted, trade barriers and tariffs to protect domestic
producers and jobs were enacted, unfortunately led by the United
States. On June 17, 1930, the Smoot-Hawley Tariff Act was passed
and raised tariffs on over 20,000 imported goods to the highest
level in more than a century. European countries didn’t appreciate
America’s “Beggar-Thy-Neighbor” trade policy and responded
with retaliatory tariffs of their own. Between 1929 and 1934,
U.S. exports plunged 70% and imports from Europe into the U.S.
sank 66%. World trade collapsed 66% between 1929 and 1934.
Although trade barriers were a consequence of the Depression and
not a cause, they certainly contributed to its depth, longevity and
greatness. No doubt the authors of the Smoot-Hawley Tariff Act
and their European counterparts felt a degree of pride that their
trade protections were so successful back then. However, history
has judged their actions far more harshly, and the lesson learned
is that protectionism is bad economic policy for everyone involved.
Unfortunately, desperate men do desperate things and decades of
bad policy has led policymakers in Japan and Europe to engage in a
modern day form of protectionism.
As we discussed in the June 2013 MSR section entitled “Japan –
Winning in a Zero-Sum Growth World,” there isn’t much difference
between a country that cheapens its currency by 20-25% and
a country that slaps import tariffs of 20-25% on products from
competing countries. In one way, currency devaluation is worse
since it affects every good or service offered by a competing
country rather than targeted products like the tariffs of the 1930s.
The Keynesian tools of fiscal and monetary policy that policymakers
have relied on since World War II to end every recession and foster
economic growth have failed in Japan and Europe. This is due in
part to problems beyond the scope of monetary or fiscal policy.
Political leaders have had many years to address their internal
structural problems but have lacked the leadership skills and
courage to make necessary changes. Ironically, labor laws erected
to “protect” some workers at the expense of other workers within
Japan and many EU countries are a form of internal protectionism.
Labor market inertia has led to slower economic growth that has
persisted despite unprecedented monetary and fiscal stimulus.
Given the political realities in these countries, central bankers have
opted for currency devaluation in a desperate attempt to rescue
their economies at the expense of global trade. While equity
markets cheer central bankers, it appears to us that we’re on a
slippery road to perdition.
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Euro to U.S. Dollar

Eurozone
December 2014: Currency War Beneficiary: The U.S. Dollar
When asked to explain the dollar’s strength, most strategists point
to better U.S. growth compared to Europe and Japan as the primary
reason. This has led strategists to conclude that the U.S. economy
is strong enough to “go it alone.” This analysis, however, overlooks a
couple of salient points. In a global economy there is no such thing
as one economy decoupling from the rest of the world. Economic
growth in the U.S. has been outpacing the recession-plagued
European Union and Japan for years. The trigger for the dollar’s rally
was not U.S. growth but Draghi’s strong hints that the ECB wanted
the euro to decline in March and April. This led to a reversal in the
euro’s uptrend in early May and its subsequent fall from 139.93
to below 124.00 on November 21. In the first estimate of third
quarter GDP, the Department of Commerce reported that U.S. GDP
expanded by 3.5% with trade representing more than 1% of the
total. The 12% rally in the dollar is likely to exert downward pressure
on exports in coming quarters, which will lower its contribution to
GDP growth. This drag will be mostly offset by the decline in
energy prices that are causing consumers’ disposable income to
increase. As some of this newfound wealth is spent, it will help
support the economy, especially in the short run. The dark side
of lower energy prices won’t materialize for some time, unless oil
drops to $60 a barrel.
Eurozone
April 2015: Euro – Technical
In the May 2014 MSR we suggested the following: “Shorting the
euro has potential to result in a profitable trade over the next year.”
At that time, the euro was trading near 1.380 and almost no one
was talking about the coming decline in the euro that we expected.
As the decline in the euro accelerated after the ECB commenced
with its QE program on March 9, 2015, a number of forecasts
surfaced projecting a decline in the euro to 0.820 or 0.850. It has
been our experience that when extreme forecasts are made after
something has either rallied or declined by a large percentage, it
is time to expect a counter-trend move. The Fed’s dovish outlook
for the U.S. economy initiated a surge of short covering in the euro,
which had become a very overcrowded trade. In coming months,
the euro has the potential to rally to 1.12–1.14 before the longer-
term downtrend resumes. Additional short covering may be
spurred by economic reports reflecting improvement in the
eurozone. From a money management perspective, we think it
reasonable to cover a portion of the short position we suggested
last May if the euro drops under 1.065. As we noted in the March
2015 MSR, Germany is likely to benefit disproportionately from
any improvement since it is the most productive economy in the
eurozone; it generates 50% of its GDP from exports, so the decline
in the euro would prove a boon. Longer term, we expect the euro
to decline after any bounce since wealthy Europeans will want to
protect their purchasing power by moving assets out of the euro
and into other currencies like the dollar.
Eurozone
May 2015: Eurozone
Charles Plosser, president of the Federal Reserve Bank of
Philadelphia, said in an interview with the New York Times in
early February, “If monetary policy…is distorting what might be
normal market outcomes…” In the March 2015 MSR we wrote that
we found this statement to be exceedingly disingenuous as the
purpose of the Fed’s monetary policy since the financial crisis has
been the intentional manipulation of Treasury yields and inflating
the wealth effect of the stock market. It would be fair to say that
65.0
75.0
85.0
95.0
105.0
115.0
125.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
The U.S. Dollar Index Spot Rate
Euro Reversal
65.0
75.0
85.0
95.0
105.0
115.0
125.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
U.S. Dollar Index Spot Rate
Euro Reversal

the ECB has taken the distortion of market outcomes to a new
level through its QE program launched on March 9. As of April
22, more than half of eurozone government bonds have negative
yields, according to Bank of America Merrill Lynch. In other words,
investors that purchase a seven-year German bund will pay the
German government 0.07% a year for the privilege, or they will
pay the government of Spain 0.116% for owning a one-year
Spanish bond.
Negative interest rates are forcing banks throughout Europe
to rebuild computer programs, update legal documents and
reconstruct spreadsheets to account for negative rates. The Euro
Interbank Offered Rate, or Euribor, is the base interest rate used
for many banks loans in Spain, Italy and Portugal. More than 90%
of the 2.3 million mortgages outstanding in Portugal have variable
rates linked to Euribor. Portugal’s central bank recently ruled that
banks would have to pay interest on existing loans if Euribor or any
additional spread falls below zero percent. Spanish-based Bankinter
has been forced to pay some customers interest on mortgages by
deducting that amount from the principal the borrower owes.
While the unusual effects of the ECB’s QE program are making
headlines for distorting normal market outcomes, the improving
health of the banking system in Europe may provide the bigger
economic punch. The ECB’s second quarter survey of bank lending
showed that the net percentage of banks expecting a rise in loan
demand reached 39%, up from 17% in the first quarter. Banks
expect a small net easing of their credit standards to businesses
during the second quarter but a further tightening of their credit
standards for mortgages. Since banks provide more than 70% of
credit creation in the eurozone (compared to 35% in the U.S.), the
improvement in lending in coming months will put more money
to work in the real economy, which should lift GDP growth to
1.5% or so in 2015. Not great, but certainly better than the 0.9%
increase in 2014 and contraction in 2012 and 2013. In our opinion,
the coming improvement in bank lending is more important than
the ECB’s QE program.
Eurozone
May 2015: Euro – Technical
In the May 2014 MSR, when the euro was trading above 1.380, we
suggested shorting the euro. In the April 2015 MSR, we said that
from a money management perspective, it seemed reasonable to
cover a portion of that short position if the euro dropped under
1.065, and on April 13 and 14 the euro did trade under 1.065. As this
is being written on April 24, the euro is trading at 1.086. We expect
the euro to rally to 1.110–1.150 in coming months as the timing
of the first Fed rate increase is pushed back and better economic
news from the eurozone spurs some short covering by the legion of
traders expecting the euro and the dollar to reach parity. In recent
weeks the euro has been under pressure by another episode in
the ongoing Greece drama/comedy. The fact that the euro has not
made a new low despite the headlines suggests any “resolution”
could ignite a new wave of short covering.
Emerging Markets
February 2014: Emerging Economies
We discussed the economic fundamentals of China, Brazil, India and
Indonesia in detail in the November 2013 MSR, and concluded that
these emerging economies were unlikely to return to prior growth
rates in 2014 and beyond. We noted that China, Brazil, India and
Indonesia had provided a significant share of the increase in global
growth following the financial crisis. Much of the growth, however,
was fueled by an unsustainable increase in credit. We expected
credit growth to slow and with it economic growth. Although
the Fed’s decision to postpone tapering at their mid-September
meeting provided a respite, we expected countries with current
account deficits (for instance, Brazil, India, Indonesia, Turkey and
Mexico) would experience another test once the Fed decided to
scale back its quantitative easing (QE3) purchases. The lead financial
story in 2014 has been the upheaval in emerging market currencies,
especially those with current account deficits.
Based on Shiller’s cyclically adjusted price-earnings (CAPE)
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
2008
2009
2010
2011
2012
2013
2014
2015
Eurozone Lending to Private Sector
Source: European Central Bank, period ending 02/28/15
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Euro to U.S. Dollar
Support

method of valuation, Tobin’s Q Ratio and the U.S. market
capitalization as a percentage of GDP, the valuation of the S&P
500 is far more expensive than indicated by its price -to-earnings
(P/E) ratio. Comparing the valuation of EM to the S&P 500’s
valuation may not be a great idea, given how expensive U.S.
equities appear. In addition, the MSCI Emerging Market Index had
a P/E ratio of 3.5 in the late 1990s, versus its current multiple of
11.3 times earnings. Investors in emerging markets should favor
those countries with current account surpluses and use technical
chart analysis to manage risk.
Emerging Markets
October 2014: Emerging Markets
The iShares MSCI Emerging Markets Index (EEM)8
recently failed
to break above the trendline that connects the highs in 2007 and
2011, then fell below intermediate support at $43.25. This failure
suggests equity markets in emerging countries could be vulnerable
to a decline of more than 10% since EEM could decline below $39.00
before reaching trend support. Combined with our stronger dollar
outlook, it seems timely to review. EM economies will be buffeted
if the dollar index climbs to 89.00-90.00 and especially impacted if
it reaches 100.00-101.97. The impact will vary and will depend on
a number of factors, including domestic current account deficit,
domestic budget deficit as a percentage of GDP, dependency on
imports of food and energy and domestic subsidies of food and
energy purchases for the poor. Barring shortages, a stronger dollar
is likely to weigh on commodity prices, which will be painful for
countries like Brazil, Australia and Indonesia that rely on the export
of commodities. Since most commodities are priced in U.S. dollars,
those countries whose currency declines relative to the dollar will
experience more inflation.
The factors that most contribute to a currency’s direction are GDP
growth, current account surplus or deficit, fiscal budget surplus or
deficit and the rate of inflation. In general, a country with good GDP
growth, a current account and budget surplus and low inflation
is more likely to have a stable or rising currency. Conversely,
countries with weak or negative GDP growth, current account
and budget deficits and higher inflation are more likely to have a
weaker currency. Countries with current account deficits are more
dependent on the kindness of strangers since those deficits must
be funded by international inflows. We ranked 12 EM countries by
combining these four variables using data provided in a September
8 J.P. Morgan Securities report entitled “Emerging Markets and
Outlook Strategy.” As the nearby table shows, the best-performing
countries have solid GDP growth, positive current account
surpluses, positive or only modestly negative fiscal balances and
low inflation. The reverse is true for those countries at the bottom.
Emerging Markets
December 2014: Currency War Beneficiary: The U.S. Dollar and Emerging Markets
As we discussed in the October 2014 MSR, a strong dollar was likely
to buffet the currencies of emerging economies as it approached
the 89.00-90.00 range. Japan announced they were ramping up
their QE program on October 31. Since then, the South Korea won
has dropped about 5% and is at its lowest versus the dollar since
August 2013. A governor of the Bank of Korea said, “Efforts are
necessary to prevent the weakening yen from moving sharply.”9
Simple translation: the Bank of Korea is willing to see the won fall
so it doesn’t become uncompetitive with Japanese exporters. The
Singapore dollar has sunk to its lowest level in almost three years
and the New Taiwan dollar recently reached its lowest point in
more than four years. A Taiwan central bank official told the Wall
Street Journal on November 19, “We are closely watching foreign
exchange movements.”10
Countries are accepting a weakening
of their currency to protect their export business, which only
adds to dollar strength and fosters a vicious cycle of even more
GDP
Growth
Cur. Acct
Balance
% of GDP
Fiscal
Balance
% of GDP
Inflation
Net
Composite
Singapore 3.3% 18.9% 5.0% 1.4% 25.8%
Taiwan 3.8% 11.0% -2.0% 1.9% 10.9%
Korea 3.6% 5.8% 1.0% 1.8% 8.6%
China 7.3% 1.8% -1.9% 2.6% 4.6%
Malaysia 5.8% 4.7% -3.5% 2.5% 4.5%
Hong Kong 2.0% 1.7% 1.0% 4.4% 0.3%
Indonesia 4.9% -3.0% -2.5% 4.5% -5.1%
Mexico 2.7% -1.9% -3.5% 4.1% -6.8%
India 5.3% -2.3% -4.1% 8.5% -9.6%
Turkey 3.0% -5.1% -2.1% 9.0% -13.2%
Brazil 0.2% -3.5% -3.7% 6.2% -13.2%
So. Africa 1.4% -5.5% -4.2% 6.2% -14.5%
Source: J.P. Morgan September 2014 Emerging Markets Outlook and Strategy
15
20
25
30
35
40
45
50
55
60
2006
2007
2008
2009
2010
2011
2012
2013
2014
Emerging Markets Vulnerable
iShares MSCI Emerging Markets Index (EEM)

dollar strength. According to the International Monetary Fund,
$650 billion has flowed into emerging markets as a result of
quantitative easing by the Federal Reserve. There is a significant
risk that some of this money will flow out of emerging economies
as their currencies depreciate. A rush for the exit has the potential
of igniting a currency crisis as affected central banks are forced to
defend their currency through direct intervention or interest
rate increases.
According to the Bank for International Settlements, more than
two-thirds of the $11 trillion in cross-border bank loans are
denominated in dollars and an unknown amount is not hedged.
This has the potential to be a big problem since nonhedged dollar
debt becomes more expensive as the dollar rises. For instance, if the
dollar rises by 12%, which it has since May, a $100 million loan that
is nonhedged may now be effectively $112 million if the currency
of the loan holder has fallen 12%. This is another aspect of why
the depreciation of the yen and euro amounts to those countries
exporting the very deflation they are attempting to ward off in
their own economies. The volatility in the currency market that the
BOJ and ECB have initiated is likely to intensify in coming months.
If it does, it is easy to see how it could spill over into global equity
markets, which have greeted every central bank intervention by
lifting stock valuations.
Emerging Markets
February 2015: U.S. Dollar and Foreign Currency
In the April 2014 MSR we wrote, “The collateral damage that might
flow from a weaker euro and stronger dollar could include renewed
weakness in emerging market [EM] currencies with current account
deficits and another decline in gold and a range of commodities,
since a stronger dollar is likely to increase deflationary pressures in
the global economy. There is a lot of debt denominated in dollars
and most commodities are priced in dollars.” The euro experienced
a three week key reversal the week of May 9, 2014, which we
discussed in the June 2014 MSR. The technical key reversal in the
euro coincided with the beginning of the rally in the dollar. Based on
the J.P. Morgan basket of emerging market currencies (EMCI), dollar
strength has translated into a decline of 13.3% as this is written on
January 26. Since May 2014, the S&P Goldman Sachs Commodity
Index (GSCI) has declined by 41.5%. Certainly, a large portion of the
loss was due to the drop in oil, but many other commodities have
fallen, just less dramatically. Copper has declined -17.3% after falling
from $3.05 a pound last May to $2.52. As noted in previous MSRs,
we expected gold to break below its support at $1,180 as the dollar
strengthened. Gold bottomed on November 7, 2014, at $1,132
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
11/02/1201/02/1303/02/1305/02/1307/02/1309/02/1311/02/1301/02/1403/02/1405/02/1407/02/1409/02/1411/02/14
South Korea Taiwan Singapore China
U.S. Dollar vs. South Korea Won, Taiwan Dollar,
Singapore Dollar and China Yuan
Past
performance
does
not
guarantee
future
results.

75
80
85
90
95
100
105
110
01/2011
07/2011
01/2012
07/2012
01/2013
07/2013
01/2014
07/2014
01/2015
J.P. Morgan EM Currency Index
Source: J.P. Morgan, period ending 01/22/15
Taper Talk
Dollar Rally
350
400
450
500
550
600
650
700
750
01/2012
07/2012
01/2013
07/2013
01/2014
07/2014
01/2015
S&P GSCI
Source: Standard & Poor's, period ending 01/23/15
Dollar Rally

Emerging Markets
April 2015: Emerging Economies
Since 2009, the amount of dollar loans in EM countries has soared
50% to $9.2 trillion as of September 2014, according to the Bank for
International Settlements (BIS). According to the IMF, $650 billion
has flowed into emerging markets as a result of U.S. quantitative
easing. As we noted in December 2014, there was a significant risk
that some of this money would flow out of emerging economies as
their currencies depreciated, thus causing further depreciation.
In 1997–1998, the Asian and emerging market financial crisis was
precipitated by a decline in EM currencies, especially for those
countries that were carrying a high proportion of debt held by
foreigners. What may not be fully appreciated by global investors
is that the amount of foreign-owned debt is up significantly since
1997–1998 in a number of EM countries, according to data from
the BIS. Of the 15 countries listed in the nearby table, 12 had more
foreign debt as a percentage of GDP than they did in 1996. In 1996,
the average foreign debt was 14.8% of GDP versus 18.4% as of
September 30, 2014—an increase of 24.3%. The three countries that
have seen an improvement in their foreign debt exposure (South
Korea, Indonesia and the Philippines) were all key players in the
crisis and obviously learned their lesson. Thailand, which was the
first domino to fall in 1997, has lowered its foreign debt exposure
from 59.1% to 19.7%, which is still above the average.
The Asian debt crisis was triggered on February 5, 1997, when a
property developer in Thailand failed to make a scheduled interest
payment. Within months, the Thai baht had plunged, leading to its
devaluation on July 2. Days later, Malaysia was forced to intervene
to support the ringgit and the Philippines devalued the peso on
July 11. In the following months, the Singapore dollar came under
pressure, Indonesia abandoned its defense of the rupiah and, on
October 10, 1997, the Hong Kong stock market plunged 10.4%
after bank rates were raised to 300%. Eventually the currency
market weakness spread to Latin America and then to Russia, which
announced it would default on its foreign debt in August 1998.
In December 1998, the World Bank estimated that the Asian
currency crisis had shaved 2% off global GDP growth. Between July
20 and October 8 of 1998, the S&P 500 plunged 22.45% in less than
three months.
Although an emerging market debt default is unlikely to have the
same impact as it did in 1997–1998, the higher level of dollar-
denominated debt and volatility in EM currencies will likely have an
impact that extends beyond the individual countries most affected
by the volatility in the currency market before the end of 2015.
Japan
August 2014: Japan
Japan’s economy has pretty much followed the path we laid out
in the February 2014 MSR: “Demand will be pulled forward into
the first quarter, as consumers buy before the April 1 increase in
the sales tax from 5% to 8% in order to save 3% on their purchases.
First-quarter GDP will be lifted by the surge in consumer demand,
only to be weakened in the second quarter by the double whammy
of lower demand and higher taxes.” First-quarter GDP jumped a
whopping 5.9%, but consumer spending has since fallen 4.6% in
April and 8.0% in May. Orders for machinery plunged 19.5% in May,
which indicates that demand from businesses was also pulled
forward into the first quarter. As noted in the February 2013 MSR,
Japan produces only 16% of its energy needs, and is the largest
importer in the world of natural gas, second largest importer
of coal and third largest importer of oil, according to the Energy
EM External Debt Levels % of GDP
Country Q4 1996 Q3 2014
Chile 19.9% 31.7%
Malaysia 27.7% 27.8%
Taiwan 8.7% 23.8%
Turkey 13.7% 23.6%
Brazil 10.5% 20.5%
South Africa 10.9% 19.9%
Korea 24.2% 18.7%
Russia 12.5% 16.5%
Peru 10.5% 18.2%
Mexico 14.0% 14.3%
India 6.5% 13.2%
Philippines 16.9% 12.3%
China 9.3% 12.1%
Columbia 10.5% 11.8%
Indonesia 26.0% 11.5%
Average 14.8% 18.4%
Source: Bank for International Settlements
-3%
-2%
-1%
0%
1%
2%
3%
4%
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Japan Trade Statistics (Percent of GDP)
Cheaper Yen Not Lifting Exports Yet
Sources: Ministry of Internal Affairs and Economic and Social Research Institute, period
ending 03/31/14

Information Administration. Since these commodities are priced in
dollars, we expected the decline in the yen to increase the cost of
these imports, resulting in more inflation and a larger trade deficit.
In May, Japan’s Consumer Price Index (CPI) was 3.7% higher than in
May 2013. As of March 31, 2014 (latest data available), Japan’s trade
deficit as a percentage of GDP was the largest in decades. Prime
Minister Shinzo- Abe has succeeded in reversing deflation, but he
may have succeeded too well since the cost of living is rising faster
than the increase in wages. This may hurt future consumption,
resulting in slower GDP growth in coming quarters. If Japan’s
economy does not shows signs of recovering from the tax increase
before year-end, the Bank of Japan may instigate another round of
QE to cheapen the yen further and boost Japan’s stock market.
Japan
December 2014: Japan
Japan’s newest round of quantitative easing, tax cuts and currency
devaluation was triggered by a -1.6% decline in third quarter GDP
after its economy contracted -7.3% in the second quarter. The
weakness in the second quarter was prompted by an increase
in Japan’s sales tax from 5% to 8% on April 1. As we noted in the
November 2013 MSR, “As consumers rush to buy before April
in order to save 3% on their purchases…first quarter [2014] GDP
will be lifted by the surge in consumer demand, only to weaken
significantly in the second quarter. This will be the first real test of
the durability of Abenomics.” While the first quarter strength of
6.7% and second quarter weakness was predictable, the contraction
in the third quarter illustrates how fragile the Japanese economy
remains. In the August 2014 MSR we wrote, “If Japan’s economy
does not show signs of recovering from the tax increase before
year-end, the Bank of Japan may instigate another round of QE to
cheapen the yen further and boost Japan’s stock market.”
With the contraction in the second and third quarters, Japan has
entered its fourth recession since 2007. The BOJ vote to increase
its QE program was a close 5 to 4, however, since some members
are concerned about the precariousness of Japan’s long-term fiscal
health. As Japan’s total debt-to-GDP ratio is a mind-blowing 640%,
their concern is more than justified.
Real household income, which adjusts for inflation, has declined for
15 consecutive months and has dropped from an increase of almost
3% in the first half of 2013 to -6.0% as of September 30, 2014.
Although wages rose for the seventh straight month in September
and were up 0.5% from September 2013, the improvement in
wages still lagged the 3.2% increase in Japan’s consumer price index
(CPI) in September. The purchasing power of the average Japanese
worker continues to worsen. In fact, a BOJ survey released in
October found that only 4.4% of households said they were better
off than a year ago. As consumers account for about 65% of Japan’s
GDP, their finances and outlook are important.
-3
-2
-1
0
1
2
3
4
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Japan CPI (Year-Over-Year Change)
Rising Faster Than Incomes
Source: Ministry of Internal Affairs, period ending 05/31/14
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
03/31/07
09/30/07
03/31/08
09/30/08
03/31/09
09/30/09
03/31/10
09/30/10
03/31/11
09/30/11
03/31/12
09/30/12
03/31/13
09/30/13
03/31/14
09/30/14
Japan GDP Growth (Year-Over-Year)
Source: Economic and Social Research Institute, period ending 09/30/14
500%
520%
540%
560%
580%
600%
620%
640%
660%
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Japan Debt Oustanding as a Percentage of GDP
Source: Morgan Stanley Research, period ending 06/30/14
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
01/01/07
07/01/07
01/01/08
07/01/08
01/01/09
07/01/09
01/01/10
07/01/10
01/01/11
07/01/11
01/01/12
07/01/12
01/01/13
07/01/13
01/01/14
07/01/14
Japan Household Income (Year-Over-Year)
Source: Ministry of Internal Affairs, period ending 09/30/14

Japan
March 2015: Japan
The Bank of Japan has become so concerned about the decline
in real wages that it decided in early February to postpone any
additional quantitative easing that might result in a further decline
in the yen. This decision may have been partially due to local
elections in April but also to await the results of the annual wage
talks between corporations and labor groups. The negotiations,
known as Shunto, have been a tradition since the 1950s when
agreements by large manufacturers and unions set the wage
pace for other industries. This year’s negotiations are critical if
Japan is going to finally escape the grip of deflation and 20 years
of subpar growth. Japanese Prime Minister Shinzo Abe and BoJ
Governor Haruhiko Kuroda have been pressuring public companies
to pass on more of their record profits to their workers. Japanese
public companies have greatly benefited from the doubling in the
Japanese stock market and the yen’s decline since November 2012.
It is hoped that higher wages will spur consumer spending and
Japan’s economy. Japan Business Federation, which includes 1,309
companies and is also known as Keidanren, supports an increase
of at least 2.2%. The Japan Trade Union Confederation is seeking a
raise of at least 4%, the largest request since 1998. Since the sales
tax was increased from 5% to 8% in April 2014, consumer spending
has been weak and would surely benefit from a meaningful
increase in wages. Last year’s increase of 2.2% by the Keidanren
was the first increase above 2% since 2001 and obviously wasn’t
enough. If wage increases prove insufficient, we have no doubt
that the BoJ will embark on another round of QE. Abenomics is
an exercise in desperation and the BoJ has no choice but to keep
throwing Hail Mary passes until one is completed or the whistle
blows signaling the game is over.
China
February 2014: China
We first discussed the potential for banking problems in China in
our November 2012 MSR, and concluded that China is likely to be
beset by its own banking problems in 2013 or 2014. In June 2013,
we wrote, “At some point (perhaps 2014 or 2015) China could prove
vulnerable to large capital outflows that undermines its growth
story, creates liquidity problems for China’s state-run banking
system and potentially deflates the credit bubble that has been
expanding in China since 2008.”
Despite efforts by the People’s Bank of China (PBOC) to rein in credit
growth in 2013, the three-month average of overall bank lending
was up 27.9% through November, according to UBS. This increase
includes traditional bank loans at 16.3% and nontraditional lending.
The nontraditional or “shadow” banking system includes banks’
off-balance-sheet lending arms, trust companies, leasing firms,
insurance firms and pawn brokers. According to JPMorgan Chase
& Co., between 2010 and 2012, shadow lending doubled to $5.9
trillion or 69% of GDP at the end of 2012. UBS estimates that during
the same period, traditional bank lending grew by more than 18%
annually. An official audit released on December 30, showed that
China’s local government debt reached $2.9 trillion as of June 30,
2012, up 67% from December 31, 2010. China’s debt to GDP ratio
was set to reach 218% by the end of 2013, up 87% since 2008,
according to Fitch Ratings, a global rating agency. Although the
debt to GDP ratio is not excessive, the rate of increase is concerning
since it has occurred while economic growth decelerated. Since the
end of 2010, GDP growth has slowed from 10.4% to 7.7% in 2013,
which means each new dollar of debt has been contributing less
and less to economic growth. Excessive credit growth in five years
has proved problematic for other countries during the past 30 years
as the nearby graphic illustrates. We don’t know if China’s credit
binge will end in a crisis, but we are confident it will result in slower
growth in coming years as the PBOC reduces credit availability from
traditional banks and the shadow banking system. Policymakers at
the PBOC have been worried about credit growth and have taken
modest steps to slow it. Last June, the PBOC allowed the seven-day
interbank rate to jump from under 4% to 11% on June 20, and to
8.8% on December 23. In both instances, the tightening amounted
to a tap on the brakes, since the PBOC quickly injected liquidity to
bring rates down.
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Nikkei-225
0%
50%
100%
150%
200%
250%
2003
2007
2003
2007
1986
1990
1994
1998
2009
2013E
U.S. U.K. Japan S. Korea China
Debt as a Percent of GDP
Sources: PBC, IMF, Fitch, WSJ, as of 01/06/14

Macro Strategy Review: Insights on Monetary Policy, Economics and Markets

Macro Strategy Review: Insights on Monetary Policy, Economics and Markets

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