Investment Research 31 October 2014 Strategy Bank of Japan adds to pressure on the ECB In one of the most surprising moves in a very long time, the Bank of Japan (BoJ) stepped on the gas further this morning and increased asset purchases in its quest to push inflation up to its 2% target. It increased the target for the annual expansion of the monetary base to JPY80trn, from JPY60-70trn (see Flash Comment: Japan – BoJ expands QE programme in surprise easing move for details). The timing was surprising because Japanese economic data has improved lately but with this move the Bank of Japan is showing a very clear commitment to reaching its 2% target by the end of fiscal year 2015. Inflation has eased recently to 1.0% (excluding VAT effects) in September, from a peak of 1.5% in April. The move is also significant because the Bank of Japan was already printing a significant amount of money, so the new stimulus is taking policy easing to even higher levels. Apart from increasing global liquidity further, it also adds more pressure on the ECB – as if the pressure was not high enough already. The difference between the two central banks is striking: Japan has inflation of 1.0%, the euro area has 0.4%. The output gap has been closed in Japan, the euro area has an output gap of 3-4% (OECD estimates). Finally, the Japanese economy is recovering, while the euro economy is still slowing down. Apart from the psychological pressure, the ECB will also feel the effect through a stronger currency versus the yen if it does not go down the same route. It seems more and more likely that Mario Draghi will have to take the final battle with the German hawks in early 2015 and push through a broader based QE programme. For now though, we believe the ECB wants to get past the results of the TLTRO in December before taking any further decisions on policy easing. For risk assets the Bank of Japan move is clearly a positive. Stock markets reacted promptly, showing new gains, and the news is likely to provide more fuel to the recovery in stocks and credit bonds that started a couple of weeks ago. Not least, Japanese stocks are getting a lot of tailwind now from both a recovering economy and another shot in the arm from the BoJ. The next key thing to watch for overall risk markets will be how much the US economy slows down in coming quarters and how the Fed reacts to a continued faster decline in unemployment than it projects in its own forecasts. Next week releases for ISM and non-farm payrolls will be important inputs to this equation (see Market movers later in this document). We remain positive on risk assets in the medium term but expect volatility to stay high short term, while US growth is slowing and yearend is approaching. Key points  Surprise Bank of Japan move gives support to risk assets  Pressure rising on the ECB to follow – but it takes time for it to act  Hawkish Fed and dovish Bank of Japan give new fuel to USD/JPY  Focus turns to US next week – ISM to give more clues to US slowing Bank of Japan already the most aggressive of all central banks Source: Macrobond Financial Even though Japan has closed the output gap (according to OECD) Source: Macrobond Financial Chief Analyst Allan von Mehren +45 45 12 80 55 [email protected] Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com Strategy US economy in tug of war in the short term As we wrote in Strategy: How much will the US slow?, 24 October, the US economy is set for a tug of war in coming quarters. The economy is facing headwinds from a stronger USD, financial uncertainty and some softening in demand from consumers and exports on the one hand but has also received new tailwinds from a decline in both oil prices and bond yields on the other. This tug of war was also reflected in this week’s data. Consumer confidence rose to a new seven-year high boosted by the very sharp decline in gasoline prices recently. However, at the same time, weekly chain store sales weakened further and durable goods orders show signs of levelling off following the very strong growth pace over the summer. The latter confirms the moderation in demand growth that we expect to slow the US economy over the next couple of quarters. With ISM for both manufacturing and services being at very high levels, we continue to look for moderation in these in the short term. Our models also point to a decline in the US OECD leading indicator in coming months. Tighter US financial conditions causing headwind Source: Macrobond Financial Lower US unemployment increases medium-term inflation pressure… The Fed’s compass is the labour market If there was any uncertainty over how the Fed weighs the balance of risks between inflation and employment, this week’s statement left a clear message: the Fed compass is the labour market. It is ultimately seen as the main determinant of future inflation. The more hawkish Fed statement this week was thus linked purely to jobs: the Fed now sees ‘solid job gains’ and that ‘underutilisation of labour resources is gradually diminishing’ rather than being ‘significant’. This explains why the Fed continues to consider the ‘likelihood of inflation running persistently below 2% has diminished somewhat since early this year’ despite a sharp decline in energy prices, a stronger USD, lower inflation expectations and momentum in core inflation currently being the lowest since 2010. Although we expect growth to slow in coming quarters, trend growth in the US has fallen to 2.0-2.5% as productivity growth is suffering from the very low investment activity following the financial crisis. Hence, even with growth around 2.5-3.0% over the next two quarters, we look for the unemployment rate to hit the Fed’s long run unemployment level of 5.4% as soon as early Q2 15. Despite all the financial noise and still low inflation today, the Fed is steering its ship with a firm hand and focusing on what is on the horizon rather than on the waves it is hitting on the way. It did not mention the rise in global uncertainty and financial turmoil at all in its statement this week. The Fed is following its job market compass and it is leaving it on track for a rate hike in Q2 next year. We moved our forecast from an April hike to a June hike this week based on a more subdued inflation outlook. However, there is still a risk that the Fed pulls the trigger in early Q2 if the financial situation is stable and the growth outlook still positive at that point. Source: Macrobond Financial …making short-term decline in inflation less significant Source: Macrobond Financial Euro banks easing credit standards Euro area credit shows signs of thawing but inflation stays low While euro area activity continues to be weak in the short term, we are getting more positive signs that the credit market may be slowly thawing. The ECB lending survey for Q3 showed further easing in lending standards and an increase in demand (see Flash Comment: Euro area – loan demand continues to increase, 29 October). In particular, the supply of credit has been a constraint and it is good news that lending standards continue to improve. With the Asset Quality Review and stress tests out of the way, there is hope that the supply of credit can increase further next year. Hard data on credit and money are also moving in the right direction, as new data this week showed a rise in money growth and that the decline in credit flows is easing. 2| 31 October 2014 Source: Macrobond Financial www.danskeresearch.com Strategy While the improving credit conditions are positive for the medium term, the shortterm picture is still one of weakness. Judging from PMI data, inventory levels are too high, which is likely still to weigh on production in coming months. However, we continue to look for improvement in H1 15, as real wage growth is robust, the euro is weakening substantially and credit conditions are improving. On the inflation front, the headache for the ECB is not getting better. While inflation rose to 0.4% y/y as expected in October, from 0.3% in September, this was due mainly to base effects in energy and food prices. Core inflation declined to 0.7% y/y, from 0.8% y/y. We expect inflation to stay low in coming months and continue to challenge the ECB. Combining the weak growth picture in PMI and the low inflation, we have constructed a nominal PMI (see chart). It clearly illustrates how the euro area has failed to recover in nominal terms over the past few years. Downward pressure on bond yields to persist in euro area The ECB is struggling with low nominal growth in the euro area Source: Macrobond Financial Downward pressure on German yields to continue While the US bond curve saw some repricing with higher yields following the hawkish Fed statement, German yields have stayed low. With rising expectations of QE from the ECB, continued low inflation and easing growth in the US, we expect the pressure on German bond yields to continue to be on the downside. The move by the Bank of Japan also means the world is even more awash with cash and European pension funds are growing, so significant amounts of liquidity are likely to support euro area bonds for a long time, in our view. Peripheral bond markets remain nervous even though volatility has come off the peak seen in mid-October. The news from the Bank of Japan is giving support to bonds in the peripheral countries but otherwise investors have become more cautious as year-end is approaching, yield levels have come down and liquidity proved to be quite thin during the October sell-off. The latter has caused some reluctance to run too big positions in peripheral bond markets. However, in the medium term, new money will come into play with the start of a new year in 2015 and a QE programme next year would add liquidity and demand to the market. Hence, we retain a moderately positive stance on peripheral bonds, especially in short maturities, where holding bonds to maturity gives a nice pickup to German bonds trading at negative yields. Source: Macrobond Financial More of the same in the currency market – USD strength resumed Stronger policy divergence to support USD The central bank news this week underlines the strong divergence in monetary policy: the Fed delivered a more hawkish statement than expected, while the Bank of Japan is stepping on the gas further. This is giving more fuel to the long USD/JPY trade. The Bank of Japan needs a weaker currency to lift inflation further and it is likely to achieve that with today’s move. The added pressure on the ECB should work in the same way and reinforce the downward pressure on EUR/USD. 3| 31 October 2014 Source: Macrobond Financial www.danskeresearch.com Strategy Global market views Asset class Main factors Equities Very po sitive o n 3m ho rizo ng, mo derately po sitive o n 12m ho rizo n Sho rt term: Expect high vo latility, but with limited risk to the do wnside M edium term: Stro ng US gro wth, mo derate Chinese gro wth, a dro p in the o il price o f 28% since June high and the co ntinued easing bias at ECB , B o J and P B o C is suppo rtive o f equities. In additio n equities are still attractive versus bo nds and the US earnings seaso n so far lo o ks very pro mising Bond market Do wnward pressure o n yields rest o f year, lo nger term mo derate rise M o deratio n in US gro wth, ECB QE expectatio ns building, inflatio n to stay lo w US-Euro spread: Wider 2-5y, stable lo nger maturities P o licy divergence drives sho rt-end spread wider, lo nger-end spread stable as clo se to histo rical highs P eripheral spreads to co ntinue gradual tightening Vo latility to remain higher into year-end. Neg. po licy rate and impro ving fundamentals suppo rt search fo r yield. Credit spread to remain stable, but with bo uts o f vo latility A dded liquidity fro m ECB , stable fundamentals and search fo r yield FX EUR/USD - Lo wer sho rt- and medium-term Lo wer o n 0-6 mo nths o n diverging gro wth and mo netary po licy USD/JP Y - higher USD/JP Y to break sharply higher o n B o J easing and pensio n refo rms EUR/SEK - lo wer Lo wer fo llo wing Riksbank o n Swedish gro wth o utperfo rmance, valuatio n EUR/NOK - Co nso lidatio n and then lo wer EUR/NOK to fall o n stabilizing o il prices, gro wth o utperfo rmance Commodities Oil prices - weakness rest o f the year, reco ver in 2015 OP EC o verpro ductio n and glo bal gro wth co ncerns to weigh near-term. Limited risk o f supply disruptio ns M etal prices sideways befo re trending up in 2015 Chinese gro wth co ncerns a near-term negative facto r, supply side risks. Go ld prices to co rrect lo wer still Trending do wn as first Fed hike draws clo ser. Geo po litical co ncerns a suppo rtive facto r. A gricultural risks remain o n the upside Near term stabilizatio n, extreme weather is key upside risk. Source: Danske Bank Markets 4| 31 October 2014 www.danskeresearch.com Strategy Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of the research report is Allan von Mehren, Chief Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. 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