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WorldDecember 2 2013

2013 review: the start of the US revival?

Many investors are confident that 2013 will be remembered as the year the US economy finally started its recovery. For other parts of the world, not least the eurozone and most major emerging markets, the memories are likely to be a lot gloomier. Paul Wallace reports.
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2013 review: the start of the US revival?

Monday, November 18, 2013, was a euphoric day on Wall Street, with the Dow Jones Industrial Average reaching 16,000 points for the first time. Outsiders could have been forgiven for thinking this was a sure sign of the US economy’s revival and that the series of financial crises since 2008 were finally going to be confined to the past.

But almost as soon as the Dow Jones hit that landmark, bearish investors warned that the US economy was not yet strong enough for the excitement to be justified. As if to prove their point, stocks started to fall soon afterwards.

In many ways, November 18 encapsulated the whole of 2013, a year in which markets and investors were more bullish about US economic prospects than in 2011 and 2012, but were still unsure whether a permanent recovery was at last upon them.

The change in stance by the US Federal Reserve over the course of the year testified to the uncertainty. On May 22, its chairman, Ben Bernanke, told Congress that “in the next few [Federal Open Market Committee] meetings, we could take a step down in our pace of purchases”. He was referring to the $85bn of monthly asset purchases that the central bank launched to stimulate the US economy and which resulted in a surge of capital to emerging markets.

Investors were jolted. Fearing that the era of cheap liquidity in global bond markets was at an imminent end, they heavily sold off US treasuries. Ten-year yields, which had been 1.6% in early May, soared to 2.75% just two months later. They continued to climb in the late part of the American summer, reaching almost 3% in early September, a level they had not touched since July 2011.

Tapering delayed

Yet expectations that a slowdown of quantitative easing (QE), or tapering, would soon begin were quashed after the Fed’s interest rate meeting in mid-September. Mr Bernanke said he was not convinced that unemployment was dropping quickly enough to enable fewer bond purchases (investors were subsequently relieved by the Fed’s delay, given that the US government entered a shutdown just over a week later, with about 800,000 federal employees being furloughed for about 15 days).

Bond markets became even more confused about the timetable for tapering after Janet Yellen, the incoming chair of the Fed, argued in mid-November that the US economy was falling “far short” of its potential. “It would seem there is little chance of the Fed starting to taper its QE programme any time in the foreseeable future,” John Rathbone, founder of UK advisory firm JC Rathbone Associates, said in a note in response to those comments.

Many others, however, believe the recent growth in the US will be sustained and that 2013 will be remembered as the year in which the country began to emerge from its slump. Some investors, pointing to the rise of the housing market and consumer demand, are confident that it is only a matter of time before expansion of gross domestic product (GDP) reaches 3%.

Tyler Dickson, Citi’s global head of capital markets origination, says there could even be a significant move out of fixed-income assets by investors who think that equities will pick up along with the economy. “Given increasing confidence in the US economy and the changing outlook for interest rates associated with tapering, many investors expect equities to outperform bonds,” he says.

Interest rate decoupling

If the Fed does taper in the next six months, then 2013 will also be remembered as marking the end of the close interest rate alignment between the US and the eurozone. The European Central Bank (ECB), in a sign of how far off Europe is from calling an end to its woes, moved in the opposite direction to the Fed in early November by cutting its benchmark interest rate to a record low of 0.25%.

Antonio Cacorino, managing principal at StormHarbour, an independent investment bank, says the chances of interest rates in the US and eurozone soon diverging are high. “In Europe, there are signs of export recovery, but domestic consumption is still subdued,” he says. “For the first time in about five years, there is a real risk of a decoupling between the US and the eurozone in terms of monetary policy. So far, there’s been coordination. But I think that the US will really struggle to maintain the size and pace of its quantitative easing. Inflation is still under control, but it’s definitely at a different point in the cycle compared to Europe.”

The eurozone crisis ceased to dominate gatherings of financial leaders in 2013. At the International Monetary Fund (IMF) and World Bank meetings in Washington, DC, in October, most attention was focused on the US shutdown and the troubles in major emerging markets.

But while it may have been the case that the eurozone’s existence in its current form was rarely called into question – unlike in the previous two years – Europe hardly had much to shout about. The ECB’s rate cut summed up how little progress was made economically during 2013. Third-quarter growth in the currency zone was a tiny 0.1%, a level which dented hopes that the second quarter figure of 0.3% was the start of a resurgence. And it was not just the usual suspects – Portugal, Spain, Italy and Greece – that struggled. France contracted by 0.1%, while Germany’s growth slowed.

More bailouts?

Few economists were of the opinion that this was a temporary blip. Several said the plight of the eurozone was such that the ECB’s November move was too little, too late, and that it would probably have to take the even more drastic measure of beginning quantitative easing.

Moreover, by late 2013 it seemed likely that the bloc’s big economies would soon be called on once again to help previously bailed-out countries. “Greece needs an extra €3bn to €4bn, Cyprus’s terms need reviewing, and Portugal needs to extend its existing bailout beyond mid-2014, given poor growth and obstacles to market funding,” says Neil Williams, chief economist at Hermes Fund Managers. “So, restructuring risk is not yet removed.”

One bailed-out eurozone country that did have a relatively good year was Ireland. It started off well – raising €2.5bn of debt in a better-than-expected bond auction in January – and continued to make progress. In November, it said it would not have to seek a precautionary credit line once its international bailout programme ends this month. That its bond yields hardly moved underscored just how far it had come.

Irish economic growth is expected to be negative or flat in 2013. But rating agencies have been impressed by the government’s fiscal consolidation and think its gross domestic product (GDP) will rise in 2014. “Ireland’s general government debt burden is likely to decline more rapidly, as a percentage of GDP, than we had previously expected,” said Standard & Poor’s when it upgraded the country’s outlook to positive in August. “Ireland’s economic recovery is under way. Given still-weak external demand and Ireland’s exports exceeding 100% of GDP, we expect growth to remain slow in 2013 and 2014. Nevertheless, Ireland’s domestic economy is showing signs of stabilising. Unemployment has started to decline while private sector employment numbers are improving.”

Osborne’s last laugh

UK chancellor of the exchequer George Osborne got a boost in October when the IMF, while downgrading the global economic outlook, upgraded the UK’s growth forecast for 2013 from 0.9% to 1.4%. This signalled an end to the Bretton Woods institution’s opposition to the chancellor’s austerity measures. Mr Osborne, who had not long before been accused by the IMF of “playing with fire”, could hardly contain his glee. “The UK has been singled out in a couple of the meetings I’ve been in as an example [of] the improving economic situation and I think there is a recognition that we’ve stuck to an economic plan that is delivering,” he said.

Another major development for the UK came on July 1, when it got its first ever foreign central bank governor. Canadian Mark Carney was treated like a rock star by the press when he started, such was the optimism that he would change the stuffy and opaque ways of the 319-year-old Bank of England. Among his first moves was to introduce forward guidance and link the cutting of interest rates to unemployment falling below 7%. “We need to provide as much clarity and as much certainty about the path of monetary policy [as possible],” he told the BBC.

But just how much clarity and certainty he was providing was questionable, given that he insisted on several caveats and said the 7% figure was a “way-station”, not a firm trigger-point.

The dangers of forward guidance further came to the fore in November, when the Bank of England, having just three months earlier said unemployment would not fall below 7% until the end of 2016, revised the date to the third quarter of 2015. “How to manage this embarrassing situation?” asked Mr Rathbone. “Well, it is now emphasised that the unemployment figure of 7% is not a target at all, but a ‘staging post’ at which point the [Monetary Policy Committee] would consider whether it should be adjusting monetary policy.

“The MPC now seems to have slipped into a position where the forward guidance is that rates are going to stay low and if any of the measures employed to judge the economy do not fit into line, then the MPC will just ignore them.”

Japan rises

Excitement about Japan reached fever pitch in the early part of the year after Shinzo Abe became prime minister for a second stint in December 2012. Investors hoped he would quickly start to fulfil his promises to kick-start the perennially slow-growing economy through monetary and fiscal stimulus. He duly obliged when on January 22 the Bank of Japan announced it was doubling its interest rate target to 2%.

Abenomics propelled a surge in Japanese equities. The Nikkei 225 climbed from 10,400 at the start of the year to more than 15,600 in late May. Investment bankers even say they are witnessing a growing international assertiveness among Japan’s biggest companies, many of which are flush with cash. “What we really anticipate over the coming years is Japanese corporates using their excess capital for cross-border merger and acquisition transactions,” says Ken Moelis, founder of Moelis & Company. “It’s not happened yet, but over the longer term it might.”

Yet, hammering home the point that Abenomics cannot work in the long term without deep structural reforms, the Japanese economy’s growth rate between July and September was 1.9% on an annualised basis, half the level for the previous quarter. The Nikkei reacted by falling from May’s peak.

It was a torrid year for many major emerging markets. From early May, as global portfolio investors began to take the prospect of tapering in the US seriously, many experienced a severe weakening of their currencies and a spike in their bond yields. Between then and early September, the Indian rupee tanked almost 20% versus the dollar, while the Brazilian real, South African rand and Turkish lira fell by almost as much. Emerging markets in general took a battering, but those with wide current account deficits and in need of bond inflows to plug them were particularly vulnerable.

Emerging market woes

India reacted by imposing extra capital controls on August 14, not to much avail. Several emerging market policy-makers – the finance ministers of Brazil and South Africa among them – called on the Fed to be clearer about its strategy on quantitative easing and take into account the effect of its actions globally.

Most analysts said that rather than blaming US monetary policy for their balance of payments problems, emerging markets needed to implement the structural reforms they have long promised but largely failed to deliver.

The evidence of a weakening in emerging markets was overwhelming. Brazil and South Africa’s growth slowed to 2%, far lower than what they managed in the 2000s; South Korea had to pass a $15bn supplementary budget in April to boost its economy; and India’s growth in the year to the end of March of 5% was its slowest in a decade. Even China, although still increasing its output quickly, was expected to cut its growth target from 7.5% to 7% as it tries to start its transition from an export-led to consumer economy.

Regulatory hell

For the world’s biggest investment banks, 2013 was again marked by a shifting regulatory environment. A lot of the changes have forced them to deleverage and have led to an increase in capital charges for some of the businesses, particularly in the fixed-income market, that were among their biggest money-spinners in the boom years before the 2008 crash. “The fixed-income market has been challenging in 2013,” says Zar Amrolia, Deutsche Bank’s co-head of fixed income and currencies. “There has been a huge amount of regulation to take into account. The industry is having to re-shape itself in response to that.”

Mr Moelis says the deluge of regulation is such that senior bankers at bulge-bracket firms are spending an inordinate amount of time on internal issues, rather than those of their clients. “The bankers that really want to be involved with their clients will come over to boutiques to ply their trade,” he says.

Even more worrying for investment banks was the onslaught of litigation they faced in 2013. Between July and September, JPMorgan made its first quarterly loss since 2004 after incurring a $9.2bn expense related to various investigations and potential lawsuits. The bank has been hit by more than $1bn-worth of fines for its $6bn London Whale trading loss in 2012, and is reported to be close to reaching an agreement to pay $13bn in penalties over the sale of subprime mortgages in the run up to the 2007 credit crunch.

European banks have not been immune. Deutsche’s third-quarter profits plunged after it added $1.65bn to its already large pot of about $4bn to cover legal proceedings. “Litigation issues came to the foreground for the industry and for us,” said Anshu Jain, the bank’s co-head.

Even firms hardly known for investment banking suffered. Holland’s Rabobank was fined $1bn in late October for manipulating Libor.

Few expect the barrage to stop in 2014. The next source of pain could be the foreign exchange markets, with several banks – including Barclays, Citi, Goldman Sachs, JPMorgan and Royal Bank of Scotland – being investigated by global regulators for the potential manipulation of foreign exchange rates. “It’s difficult for large investment banks, not least in terms of litigation,” says StormHarbour’s Mr Cacorino. “The regulators are either blaming them or trying to make them pay for some of the excesses during the boom years.”

Roll on 2014.

Changing world of central bankers 

Changing world of central bankers

When Ben Bernanke steps down as head of the US Federal Reserve in January and is replaced by Janet Yellen, the world’s major central banks will have gone through a widespread change in management that began in March this year when Haruhiko Kuroda became governor of the Bank of Japan. Since then, four other G-8 nations have replaced their central bank governors or, in the case of the US, are about to do so.

Moreover, having never previously possessed a female central bank governor between them, the G-8 countries will have two – Ms Yellen will join Elvira Nabiullina, who took over at the Bank of Russia in November. Her move followed that of Mark Carney, who became governor of the Bank of England in July and who was succeeded as head of Canada’s central bank by Stephen Poloz.

There were changes elsewhere, too. India got a new governor in September in the form of Raghuram Rajan, an ex-chief economist of the International Monetary Fund; Agus Martowardojo took charge of Bank Indonesia in May; and, after being without a governor for 112 days as politicians squabbled over who should replace Stanley Fischer, the Bank of Israel finally appointed Karnit Flug as its governor in November. She is the first woman to hold the post.

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