The Eurozone economy has weakened in 2016 slipping into deflation with both manufacturing and services PMIs turning south in January and February. After disappointing the market in December 2015 with a mere 6 month extension of the existing QE the ECB will be expected to do more to spur demand and head off deflation.

The market will expect the following:

1. 20 basis point rate cut to take the deposit rate to -0.5%.

2. Additional 10 billion EUR monthly budget for bond purchases.

3. Program extension from Mar 2017 to Sep 2017

4. Additional TLTRO

What might not be effective:

1. A rate cut is not likely to be effective. The problem is not willingness to lend but willingness to borrow. Banks will not be able to pass on the lower rates while incurring costs on their reserves on deposit. They might well raise interest rates to make up for the additional costs.

2. The bond purchases are allocated according to the capital key which means 25.6% of the budget goes to German bunds, 20.1% to OATs, 17.5% to Italian bonds and 12.6% to Spanish bonds. Deflation is worst in Italy, Spain and France. Germany has zero price growth. The money is not going to where it is needed most.

3. TLRO take up has been disappointing.

4. Most of what the ECB can do, the market expects the ECB to do. There is no latitude for shock and awe left.

What might the ECB do to surprise the market?

1. Moving away from the capital key and allocating the budget to the countries which need stimulus most and trying to bring rate convergence between countries’
   bond yields could be more effective and would be taken positively by the market.

2. Currently the ECB buys 8% of the budgeted bond purchases, while the National Central Banks buy a further 12% under a risk sharing program. The other 80% is not commingled and each NCB bears the default risk of their own government’s bonds. The ECB could make all purchases risk-shared. This would pull peripheral and core spreads together bringing down interest rates in Italy, Spain and Portugal.

3. Removing limits on buying debt yielding less than the deposit rate. If the ECB cuts rates by 20 basis points, this point would be academic.

What might get in the way?

1. On Feb 25, 2016, Jens Weidmann, President of the Bundesbank, argued that his Eurozone counterparts are putting too much emphasis on recent weak data. The Bundesbank’s own prognosis for the Eurozone economy was less gloomy. This could be a signal that the Bundesbank, the largest capital contributor to the ECB, is unwilling to do more.

2. Draghi himself might decide that doing more of the same is not rational given that the initial program has not been effective. As long as the ECB was strenuously fighting deflation, governments would be less inclined to pursue fundamental reform.

Speculation.

1. If the ECB simply meets market expectations, it is likely the market will be disappointed.

2. The ECB has little room to surprise the market since the market is expecting a lot.

3. Draghi may, if he so chooses, openly speculate about going off the capital key, or commingling the NCB’s risk, to present the Bundesbank a fait accompli at the Apr 21 meeting.

Trades:

1. The EUR is fundamentally weak,  recent strength being related to the risk of a disappointing ECB announcement. The EUR remains a good short, however, the degree of uncertainty surrounding the Mar 10 ECB meeting recommends moderating this exposure.

2. Under TARGET2, countries are essentially risk-shared and as such peripheral bonds should trade tighter to German and French government bonds. Convergence trades are still rational. Again the uncertainty around the possible outcomes leads us to defer this trade until we have more visibility.

• The world is engaged in a trade war which hits manufacturing and industry more than services and consumption. The composition of the Chinese economy makes it vulnerable. The Chinese are a proud people and will claim that the rebalancing is an intentional project rather than a phenomenon forced upon them.
• China’s markets are still closed albeit becoming more open. A financial crisis in China will have less contagion effects than a financial crisis in a more open economy.
• China’s contagion risk lies in the real economy through trade. But world trade is already stagnating and the world becoming more insular. Also, the weakness in the Chinese economy is over 5 years old and not new. Its effects have already been felt.
• China’s nominal output is some 10 trillion USD per annum. To expect even a balanced economy to grow at 6% is very optimistic. For an economy plagued with overcapacity in heavy industry and state owned enterprises to grow at 6.5%-7.0% will require more stimulus.
• The central bank has been stimulating the economy with Open Market Operations (repo operations), interest rate cuts and reserve ratio cuts. This will accelerate. Even so, monetary policy will be insufficient given the examples of the Bank of Japan and the European Central Bank. The Chinese government recognizes this and will engage fiscal policy, budgeting for a 3% deficit, officially, but in fact more, to boost demand. Other countries may learn from the Chinese experience, positive or negative, as their policy unfolds.
• China’s debt stands at over 2.5X GDP. Government debt is circa 40% of GDP and is not a problem. The bulk of China’s debt is corporate debt and raised in local currency. Being mostly in local currency, China’s debt is less sensitive to exchange rate fluctuations. However, most of the debt was raised by unproductive SOEs and heavy industry and will face increasing defaults. The government has the financial ability to bail out or to absorb debt write-downs on behalf of the banking system and domestic investors without depleting its foreign reserves.
• The government has been encouraging refinancing of USD debt in local currency, with extended maturities, and lowered debt costs by changing collateral rules and capital requirements for specific assets such as municipal bonds and LGFV debt. The total debt may rise before it falls.
• China’s non-manufacturing economy is healthy. Despite declining, non-manufacturing PMI’s hold above 50, whereas manufacturing PMI’s have now been below 50 for close to a year. There are good sectors, industries and companies in China. Unfortunately, investing in China is a very risky endeavour. 90% of capital accounts are owned by retail investors leading to a highly sentiment and technically driven market often subordinating fundamental factors such as earnings and cash flow.
• The macroeconomic conditions in China imply a weakening RMB. The weakness in RMB has not been entirely due to capital flight. The government’s efforts to get corporate China to refinance USD debt in RMB must result in capital outflows and a reduction in foreign reserves, which we have seen. The solution to private capital flight is a sharply weaker RMB which the PBOC is unwilling to allow.

Beware negative interest rates. The intention of central banks imposing negative rates upon an economy is to stimulate growth. But if 10 years of falling rates have done little to stimulate demand, 7 of those at close to zero interest rates, why would negative rates encourage more demand? Taken in the extreme, negative interest rates will encourage owners of money to change the relationship with their depository institutions from one of debtor to custodian. The result would be a withdrawal of money from the money market into a custodian network. There will of course be custody expenses but these are limited and such expenses are, at least for now, beyond the influence of central banks. Negative interest rates could therefore trigger a contraction of the money supply which would maintain the zero bound in market rates of interest while liquidity would overflow out of the money markets. The provision of liquidity to the system will have become waterboarding.

The FOMC meets March 16, the ECB March 10, the BoJ March 15. Confidence in central banks is waning resulting in more volatility surrounding signals they send whether hawkish or dovish. It certainly appears that central banks have reached the limits of policy and that efforts to boost growth will have to be even more innovative, if in fact growth needs boosting. Given the dogmatic pursuit of growth apparently beyond the natural metabolic rate of the global economy, it would not be surprising if fiscal policy were engaged.

In some ways, fiscal policy will be more effective than monetary policy. For all the magnitude of QE, it only supplies credit to the economy, it does not directly increase demand. QE policies assume that there is always demand for credit, but this is clearly not the case. If governments insist on pushing the economy towards a higher target growth rate, in the absence of private demand, it may have to spend. It cannot finance this spending out of taxes as that would sterilize the fiscal expansion. Instead, government would need to run a deficit and monetize it. When economists speak about ‘helicopter cash’, this is what they mean.

There is another way, which is to tax and spend, but to do it in a tax neutral and redistributive way. Imagine a wealth tax of 100% for all wealth over 100m USD. Put aside the practicalities and politics of such a tax for a moment and see what can be done with this. By one estimate (by Boston Consulting Group), this wealth totals 10 trillion USD, basically equal to the current nominal annual output of China. The marginal propensity to consume of these ultra-high net worth people is presumably quite low. Imagine if this, expropriation, to put it candidly, were ‘spent’ by distributing it to the bottom tenth of the global population, a group of households who could not save their income because they might be living below the poverty line, the boost to global output would be substantial. This is an absurd limiting case of course, but it illustrates the cost of inequality.

Economic orthodoxy will not easily relax the need for fiscal rectitude and austerity. Monetary policy has clearly hit a wall. Fiscal policy will eventually need to be engaged, and again, I qualify that this is if we target growth at a level beyond the natural metabolic rate of the real economy. Then countries will begin to tax and spend. Around the world, the people have already signaled their political choices, and it leans that way. Perhaps the masses know something the economists don’t.

2016 began with very weak equity and credit markets. Markets reacted strangely and counterintuitively to data and central bank policy. So, how does one invest in times like this? Ideally, one invests in precisely the same way one invests in calm markets. When the herd is panicking, calm is the scarce resource and therefore valuable. A few principles are worth remembering.

Find the exit before the entry. This is true whether one is investing or indeed doing anything. It is a most general concept. It is fine if the exit is expected to be a tricky one. Recognizing it as such prepares one for the eventuality and advises the enthusiasm of the entry. Sometimes, the exit requires that the market comes to its senses, and sometimes the exit is structurally established. Relying on the rationality of other investors is a risky endeavor, judging by one’s own rationality or lack of it. Relying on a structural or contractual exit is better, but the returns are usually commensurately smaller.

There is no return without risk. If there appears to be such an opportunity, then one has failed to identify the source of risk. Risks are not limited to market risk. General conditions can change altering the fortunes of companies and countries. Laws and regulations can change or be open to interpretation. Contracts are not always honored or enforceable.

Compounding is powerful. It is difficult to compound a volatile investment. An investor should realize that losses are inevitable. The nature of compounding is such that you want your profits to compound, that is to grow exponentially, and your losses to be linear. The only way to do that is to limit your losses. The downside to this strategy is that you will leave a lot of profits on the table, which is still preferable to sustaining losses which take too much time to recoup.

Managing losses comes with experience. Investors who have never lost money are either economical with the truth, or have yet to make a loss and are therefore inexperienced in dealing with it and at risk of sustaining a bigger loss than one practiced in the art of losing. Lose often, not big. But not too often for that is when embarrassment takes over.

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, said the great Warren Buffet. This needs some qualification. The market isn’t always greedy or fearful, most of the time its just mildly manic depressive. In these in-between states, it pays to be with the herd. How can you tell when there is fear? It’s when you yourself are fearful and selling. You will feel awful and feel like selling everything. Until you get there, it’s not fear. You must be acutely opposed to buying when you buy.

Managing one’s own emotions is at least as important as the cold rational decisions one is supposed to make. Completely removing emotions from investment decisions is almost impossible to do unless one delegates the decisions to a trading algorithm. The patchy performance of such algorithms implies that there are elements of our emotions which are useful in investment decisions, or that algorithms are inherently incomplete. A few rules might be necessary to mitigate emotional biases, such as having stop losses, independent risk managers, diversification rules and time outs.

Don’t overdo it. When a great investment idea comes along, do it, but don’t overdo it. Wall Street is great at coming up with great ideas but overdoing them, that’s why they almost always end in tears. CDOs, CLOs, SIVs, CDS, portfolio insurance, risk parity. At the more practical level, this applies to sizing your investments. You will never have enough of a winning position so make sure you don’t for if you do, you might have too much of a losing position. Best to always go away slightly hungry.

Leverage is not a bad thing, it makes good things better and bad things worse. Most importantly, far more important than the multiplier effect, leverage transfers control over an investment strategy away from the sponsor or equity to the senior lender. Structure leverage and use it with care.

We are not smarter than everyone else. It is natural to believe in our own intellectual superiority, but in fact we are the average. To avoid turning investing into a game of pure chance we need a sensible process and discipline. Genius is rare and cannot be confirmed.

China’s growth is evidently slowing and investors are concerned. China is the second largest economy in the world, and it is a manufacturing hub importing commodities and intermediate goods and exporting finished goods. More recently, China has extended its connectivity beyond trade in material goods but has sought participation in and sometimes led the establishment of significant clubs in the international arena. The establishment of the Asian Infrastructure Investment Bank, and the inclusion of the RMB in the IMF Special Drawing Rights are examples of how China seeks to engage and be part of the world. However, it is feared that its current and future position makes it a nexus for economic and financial contagion. To understand the potential for this it is useful to understand why China is slowing and if that rate of deceleration is a cause of concern or not.

Since 2008, the world has been in a Cold War in trade. As countries exhausted domestic consumption, their financial markets stopped funding business investment and their governments exhausted reserves in rescuing their banking and financial systems, trade became the only viable source of growth. A currency war was fought under the cover of financial system desperation’ it continues in fits and starts today. Weak economic data has become a relief as it justifies more monetary analgesic and currency debasement. New battlefronts have opened in the form of re-shoring in the case of Western economies previously happy to outsource manufacturing to foreign shores. The evidence lies in the stagnation of global trade since 2012. For an economy designed to export like China, a trade war is damaging. Exports as a share of GDP have fallen from 36% in 2006 to 22.6% at the end of 2014.

A related theme is the balance between manufacturing and services in the economy. Globally, services are growing whereas manufacturing is in decline. This is another consequence of the Cold War in trade. Manufacturing is more export sensitive than services so as global trade slows more than global growth, manufacturing must slow relative to services. This is a phenomenon measured from Asia to Europe to the US. As manufacturing capacity is re-shored, countries like China must experience a surge in excess capacity, even if GDP does not actually shrink. In the case of China, because manufacturing was the larger contributor to output, its relative weakness translates into weakness in aggregate growth.

It is illuminating of the culture that the shift from investment and exports to consumption and services is portrayed as an intentional strategy when fact it is a phenomenon which China cannot avoid.

Then there is the matter of simple mathematics. Economies are expected to grow exponentially even though this is not realistic. Economists expect constant growth rates or use this as the basis of their calculations even when they don’t expect constant growth rates. When growth rates are high, the path of nominal GDP levels, not growth, is exponential. When growth rates are lower, constant growth rates approximate linear growth in the level of nominal GDP. Technically, the higher powers of the polynomial can be ignored when the growth rate is small, and the linear component is sufficient to capture the growth. When China’s GDP was 3.5 trillion USD, it was easy to grow at 10% per annum. China’s GDP is some 11 trillion USD in nominal terms. If China adds 700 billion USD of nominal output every year, that is it grows linearly, growth this year, 2016, would be 6.4% and growth in 2017 would be 6.0%.

While China’s slowdown is understandable, it cannot and will not simply passively accept its fate. China recognizes that as the world evolves it too needs to keep up with it. It has to address a number of issues.

As China opens up as it evolves it has to adopt international standards and norms consistent with a free and enlightened society. The complexity of managing an economy without arbitrary control over the populace is risky both economically as well as socially. To diversify its risk, the Chinese Communist Party recognizes that rule of party poses to itself an existential risk, a risk which can be mitigated by embracing rule of law. This is already well underway as evidenced by the focus on the constitution and the anti-corruption campaign.

China is engaging the world by joining and creating economic and political coalitions such as the AIIB. It continues to engage in trade as buyer even if its export competitiveness has been eroded. China’s adventures in the South China Sea are most probably a device to appease the nationalists at home who tend to have a bit of a persecution complex and see China’s engagement in the context of weakness.

China is spending more on R&D than ever before and has overtaken the US, Japan and Germany in terms of patents filed. Not all of this frantic patent filing will be productive but China is reacting to the charge that it has a poor record of generating intellectual property and is more adept at stealing it or buying it.

Change has direct monetary as well as opportunity cost. Rebalancing an investment and industrial heavy economy to consumption and services is costs in growth. China has stated that it wishes to maintain growth near current levels, impossible without central bank largesse. The PBOC has been busy providing liquidity to the economy to compensate for the slowdown associated with restructuring costs. We have seen the debt accumulation post 2008 as China first reacted to the new reality in international trade. This will continue. The PBOC, however, knows it can only deal with one problem at a time and it has chosen to allow debt to pile up, as it must, but tackle the more immediate issue of debt service. Enter targeted open market operations and debt restructurings, particularly of local government debt, to reduce the debt burden on the more indebted corners of the economy, the local governments and SOEs. At the same time it is directing credit towards SMEs and households. Unlike developed world central banks who pull 2, maybe 3 levers, interest rates, size of balance sheet and maturity schedule of balance sheet assets, the PBOC has many more levers and behaves like a creditor committee working to maintain the going concern of its massive economy.

China is full of opportunity but it has never rewarded the macro investor who buys equity index exposure, not for long anyway. Investing in China requires an understanding of businesses, their prospects, the behavior of management and of the government who continues to direct capital where it is needed and siphon it away from where it isn’t. China is a stock pickers market but fundamentals are but one small part of the analysis. Policy, frustratingly opaque and seemingly arbitrary, play an important part also, in determining price discovery in this fascinating market.