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February 23, 2023

German geopolitics, Japan’s bond investors, undervalued currencies

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Nicolas Tremel
Arnaud Lieugaut
Karl-Philip Nilsson
Patrick Malm
Usama Karatella
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Geopolitical risk perceptions depend on where you are sitting

In Germany, Russia’s war on Ukraine is perceived as the riskiest geopolitical crisis in 40 years. Americans are concerned, but Stateside, nothing compares to 9/11.

This chart uses measures of risk from Economic Policy Uncertainty, an academic group that measures news coverage to create indices relating to challenges ranging from infectious diseases to wars.

We used their data a year ago, after Russia invaded Ukraine. This is a different visualisation, which tracks a global geopolitical risk index against the perception of risk in nine major countries.

The “pulses,” or bubble size, reflect a deviation from the mean, i.e. the greater salience of geopolitical risk at a given moment. 

Germany is notable for how much its perception of risk surged. Europe’s biggest economy lost the source of energy that was key to its economic model and has had to pledge a military revamp as full-scale land wars return to the continent, not too far east of Germany’s borders.

Geopolitical risk index
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The Japanese are selling their foreign bond holdings

Japanese investors bought enormous quantities of foreign bonds over the last twenty years, seeking yield wherever they could find it. That trend has reversed.

During the period of very low – and sometimes negative – interest rates in Japan, the nation’s investors sought out the much steeper yield curves abroad. (Japan’s companies are also famously cash-rich, and had a limited need to issue corporate bonds.)

Key to this investing strategy was the ability to inexpensively hedge currency risk. Hedging is now more expensive (and local yields are higher) amid speculation that the Japanese central bank will abandon its yield control policy and let rates rise.

The bottom panel of our chart shows how Japanese investors have been reducing foreign government and corporate bond holdings for about half a year. The top panel of our chart shows the net position on a global basis; as the chart is in negative territory, the rest of the world now holds more Japanese debt than vice versa.

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Real Effective Exchange Rates

This Real Effective Exchange Rate is a weighted average of a country’s currency in relation to other major currencies, using weighting based on trade balances. When it rises, it means a country is losing trade competitiveness.

This chart shows nations’ deviation from their long-term average and five-year average REER to give a sense of which nations are benefiting from a devalued currency – Colombia and Turkey among them – or are suffering from an arguably overvalued one, as seems to be the case for the Czech Republic. 

On the right-hand side, the size of the bubbles reflect the impact on imports and exports. 

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Chinese equities await earnings surprises as the next leg of optimism

The Chinese stock market has jumped as the nation unwound zero-Covid policies. For the momentum to be sustained, watch out for positive earnings surprises.

The MSCI China Index is up about 40 percent since December. The top panel of our chart shows recent measures of inflation surprises (lower price increases than expected) as well as better-than-predicted economic news. 

However, the bottom panel shows that earnings per share are still expected to shrink 10 percent year-on-year, looking 12 months out. The 12-month forward price-earnings ratio for the index is 11.3, a discount to its long-term average of 11.6.  

Will the economic rebound lead to revised profit expectations?

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US inflation over the decades

Readers of a certain age will associate the 1970s with oil crises, disco and inflation. (And perhaps imagine the 1950s as a golden economic era of price stability.)

The 1980s, meanwhile, are known as the decade where central bankers conquered the inflation they had helped create with loose policy. But as our chart shows, it remains the second-most-inflationary decade in the postwar period. The Great Inflation (1965-82) persisted well into the first half of the decade. 

How will the 2020s be remembered? Some 36 months in, after the pandemic’s disruptions and hyper-stimulative monetary policy, and after the war in Ukraine upended commodity markets, we have experienced the most inflationary start to a decade since 1982-83.

What will be the ultimate shape of that 2020s line? It depends whether you are on “team transitory.” 

Chairman Powell has vowed to keep raising rates. Inflation is slowing, but remains far above the Fed’s 2% target.

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The dollar is whipsawing perceptions of central bank balance sheets

The weaker dollar is having some interesting macroeconomic effects. For one, it’s complicating the picture as we assess how much central banks are tightening monetary policy.

For most of 2022, central banks were shrinking their balance sheets to unwind the extraordinary stimulus of the pandemic. But in the fourth quarter, as the dollar started weakening, their combined balance sheets started to expand again in US dollar terms. 

This happened even though most of the major central banks were indeed shrinking their balance sheet as measured in their own currencies. In dollar terms, only the Fed, Bank of Canada and ECB have succeeded in shrinking their balance sheets. 

Our chart compares the expansion, contraction and rebound of the balance sheets in dollar terms with a hypothetical scenario – slower, but steadier balance sheet shrinkage – that held the dollar’s value constant as of Jan. 1, 2021 (before the “King Dollar” rally that began halfway through that year).

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Sticky inflation in Germany

This chart breaks down the components of a sticky period in German inflation. While other nations are seeing price increases ease, German inflation accelerated to 8.7 percent year-on-year in January.

The main contributor to the rebound, as our chart shows, is a grouping of some of the basic costs of living: “housing, water, electricity, gas and other fuel.”

Given this inflation picture – and some signs of a rebound in German growth, based on PMI figures and the ZEW survey – it’s no surprise that markets are starting to price in a more hawkish ECB this year. 

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Chinese traffic is a bullish signal

China’s roads are filling with traffic again, as you’d expect now that the zero-Covid policy has ended.

This chart tracks the seasonal course of congestion on Chinese roads, with the lulls from the Lunar New Year holiday period clearly visible during the first two months of the year. 

The purple line for the Covid years was well below the pre-Covid trend, in green. The trajectory for 2023 so far shows we are probably back to the old normal.

That would be consistent with the recent run of positive economic data from China, including a PMI figure that showed a swing back to growth. That’s bullish for the world economy.

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Transport stocks as a leading recessionary indicator

Transportation stocks have a track record of being a reliable leading economic indicator. And their relative performance recently gives cause for concern.  

This chart tracks year-on-year performance of the S&P 500’s transport index relative to its industrial index. 

Underperformance, in red, shows periods where there was a greater risk of recession. And this barometer is at a seven-year low. 

To be sure, there was no recession in 2016-17, and the red zone is far from the depths that anticipated the 2001 recession. 

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Watching the global heat map for recessionary red

This table is a heat map measuring quarter-on-quarter economic growth for nations in the G20. Green means expansion. Red means contraction.

One of the great debates of 2022 was whether the US entered recession, and indeed, there were two consecutive quarters of (barely) negative economic growth.

But the US is growing again and the proportion of red on the heat map appears to be shrinking, not spreading. China’s reopening might well result in more green on the map in 2023.

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