News: MXN Up Big on Fitch Upgrade

The Mexican Peso sharply appreciated this afternoon after Fitch raised the nation's sovereign credit rating one notch to BBB from BBB-.  The rating house cited progress on the internal security front, macro-economic and political stability, and the Pena Nieto's ambitious reform agenda which has already passed sweeping education reform and now is looking to tackle the telecom and oil monopolies.  The Peso surged nearly 1000 pips on the news, strengthening to a near two year high to 11.97 per USD.  This also marks the first time USD/MXN has been under 12 since 2011.  The techs are now salivating for chance to retest  the 2011 low of 11.48.  CTFC long/short data shows that speculators have already built up a huge net long position for MXN, while corporations have largely maintained their equally large short MXN position, presumably to hedge MXN denominated receivables.  MXN is technically a mixed bag, but the fundamentals remain excellent.  Therefore, USD/MXN is a sell on rallies.  I maintain my 2-3 year target of 10, and expect this pair trade in the 11.10-11.25 range by year end.  

Meanwhile, Governor Carstens of the Banco de Mexico may be regretting his calls for the rating houses to upgrade Mexico.  Last Spring, when the Peso was tumbling with all EM currencies as the Grexit seemed inevitable, Carstens had hoped that an upgrade in light of Mexico's sound finances may help shore up MXN amidst terrified markets selling off nearly everything but USD and JPY.  Today, the Bank is warning of 'hot money' inflows which may drive up the exchange rate short term but could cause a sudden crash should they stop or reverse.  The recent upgrade should only further stoke foreign demand for MXN denominated securities, which is already at an all time high, thus exacerbating the 'hot money' problem.  On monetary policy, the Bank faces a tough choice.  Inflows from abroad typically drive inflation up because firms find cheaper financing as foreign investors pour money into local bond markets.  However, any rate hikes make it only that much more attractive for investors to park money in Mexico. 

Mexico is projecting an aura of vigilance.  It is loathe to suffer the same fate as Brazil and Costa Rica, whose local money markets were flooded with foreign deposits as world investors chased yield.  The result was high inflation that the central bank felt powerless to contain, lest it encourage even more short-term inflows.  A key theme for MXN going forward will be how the central bank signals its policy as to what it may do if it determines that inflows have reached "critical mass."   As long as Mexico continues its strong growth and maintains healthy public finances, the inflows remain largely in line with the fundamentals, for now.             

Trade Idea: Buy USD/ZAR

Okay, so for those of you here to make money and not analyze my philosophical musings, here's my idea to play the strong NFP data.  Buy USD/ZAR.  ZAR rallied on the news to make new multi-week highs against the dollar.  This appears to be the return of risk on, risk off sentiment that drove the Rand last summer.  When markets realized that South African fundamentals had deteriorated, ZAR sold off, plummetting on October 5th, despite the strong NFP data that day.  The Rand's recent rally seems to be driven entirely by post jobs euphoria.  As such, trader conviction should be light, and selling the news on the Rand looks like nice short-term play.  I jumped in around 8.93, and will target 9, though longterm I see USD/ZAR at 10.    

Preview: Post War Trends in US Employment

Rather than dissect the market gyrations from the latest jobs report, I thought it might be more insightful to share an except from a larger project I am working on about the US economy and capitalism.  The following is a chapter on post-war employment and labor trends. 

Preface

Work and daily occupation is a cornerstone of society, as well as a key component of our political economy. In order to share in the social surplus, one must earn his piece by working. Work and labor is undoubtedly an economic input. Labor is a required ingredient to many productive processes which create the commodities and services modern consumers demand. Somewhat strangely however, workers are rarely paid based on productivity or output, and labor unions have often resisted piece-work schemes or performance based pay. Firms are often reluctant to lay-off surplus workers when times are good and profits are relatively stable.

Therefore, modern work is as much a political and social construct as an economic phenomenon. This reality helps to explain why firms don't lay off in mass, even when doing so might maximize profits. It also explains things such as vacation pay and severance packages, and employer-based healthcare. Furthermore, it might also explain while socially pleasant but incompetent workers often not only retain their jobs, but receive promotions.

A Permanent Shortage of Aggregate Demand

Centuries of capital investments and savings have given us an economy which can produce many times what it can consume. This supply and demand mismatch would normally lead to divestment and contraction, and in particular industries this has certainly been the case. The overbuilding of houses caused a bust in the construction industry in recent years, and forecasters have seen recent upticks in construction employment as a sign that the economy is healing. However, in the broader economy, the reality is that the difference between supply and demand is absorbed by debt and waste.

This is somewhat true on the household level, as families racked up credit card and housing debt during the the last business cycle, only to aggressively pay down this debt after the collapse. However, consumers, by their very nature are fickle, and households have trouble maintaining spending during lean times. Therefore, the most important borrower and spender has been the US government.

Agricultural subsidies, much bemoaned by many on the left and right, continue to provide nearly 20 percent of income for farms. Decades of farm subsidies have created incentives for tremendous increases in efficiencies in farming. The result is that the US is one of the worlds largest per capita food exporters with a relatively small number of workers in the farm sector. The European Union, which also heavily subsidizes agricultural also posts similarly impressive figures.

While on the surface it appears that the government is simply paying farmers to produce crop surpluses, these subsidies (financed via government debt) are really investments which have produced and sustained a large and highly efficient food system capable of feeding the world with relatively few workers. In a world where hunger is still a problem, this system is an invaluable asset both in terms of easing human suffering and raising general living standards.

Similar stories have played out not just in farming, but also high-tech industries like aviation. For fiscal year 2014, the government will spend nearly 40 billion dollars on new aircraft. Even though this figure represents a 12 percent year on year reduction since 2013, it still accounts for nearly 25 percent of all new aircraft orders for 2014. Although policy makers at the Defense Department say that many of these procurements are unnecessary, Congress has forced Defense to go through with these slated orders anyway. The political explanation is that many Congressman have corporate and natural person constituents highly dependent on government contracts and orders. However, economically, these orders, again financed largely through debt, have built up a huge high tech industry which has revolutionized life for the average American. Let us not forget that the internet comes to us courtesy of investments made by the US military.

Recessions Drive Restructurings via “Shock Therapy.”

These high levels of capital investments are also in line with massive exodus of labor from capital intensive industries into the service sector. The following figures show the amazing reality that while manufacturing jobs have been lost in the US, manufacturing output has soared. As evidence in Figure 1, it's almost as if the more people manufacturers lay off (and replace them with machines) the higher output rises.

Figure 1: Indices of manufacturing output(red), employment(blue), and investment in machines and software(green). Employment has tends to stay steady but roughly fall during recessions, never to recover. Output rises sharply during boom times, falls during recessions, only to robustly recover. Fixed investment rises steadily, regardless of the business cycle.

Another interesting feature is that firms only tend to lay off during recessions, or as a last resort in order to survive. From 1992 to 2000, manufacturers added few jobs while output soared. Then the 2001 recession resulted in huge layoffs and a drop in output. However, output quickly recovered while layoffs continued through the 2000s. Technology advances rapidly, however, such a marked change in business model over a single year can hardly be accounted for by technological progress. The fact that men could be replaced by machines was probably largely true several years earlier in the 1998, during the internet boom. It is also worth noting that investments in equipment (green line) did not break their upward trends during the past few recessions. Finally, some sudden technological innovation would entail a spike in capital spending as manufacturers rushed to bring the newest most efficient machines online. Instead we see a steady rise in capital spending, which occurs regardless of cuts in labor costs.

Conclusions we can draw from this data are that manufacturers tend to lay off only as a last resort, not to maximize profits. Recessions act as 'shocks' which force firms to lay off in mass, after which manufacturers quickly realize that most of the labor let go during the layoffs can be replaced by machines and retained employees. Indeed, investment in equipment has risen steadily even through recessions. Unit labor costs, or the labor costs per unit of output, also tend to fall during recessions, reflecting that retained employees tend to raise their productivity after layoffs.

In sum, the unwillingness of firms to gradually adjust to changing fundamentals adds instability to the economy and probably prolongs downturns. Rather than waiting to be forced to layoff workers in mass, firms should replace workers with fixed capital as it becomes more profitable. This would avoid the mass flood of workers onto the labor market during downturns as firms layoff workers as a last resort. It would also allow the broader economy more flexibility in absorbing excess workers, a theme we will explore in the next section.

Ironically, at least in the manufacturing sector, data suggests that hiring and firing decisions during boom years are not based on profit maximization. Other factors, such as loyalty, social cohesion, and satisfaction with being an employer may cause firms to retain many otherwise unnecessary employees.

The Service Sector Absorbs Excess Labor, For Now

Thanks to the dynamism of the US economy, labor formerly employed in the manufacturing sector has largely been absorbed by the service sector. In recent years, this has been reflected by the strong growth in food service and healthcare jobs. Furthermore, as shown in figure 2, the losses of jobs in manufacturing have been a continuation of the post-war trend, beginning around 1950.  

Figure 2: The relative composition of the total workforce by sector. Services(red), manufacturing(blue), government(green)

So largely, losses in the manufacturing sector have be off-set by gains in the service sector. Modest gains in the public sector, on the order of about 5 percent as a relative share of the total workforce, have also eased the transition. Furthermore, there is little evidence that machines will replace workers in the broader, service oriented economy. Thus, the service sector has acted as a safety valve to redirect displaced manufacturing labor. Indeed, unlike manufacturing, in the broader economy, investment in human labor (wage growth) continues to outstrip investment in fixed capital. (office computers and software, buildings, ect.) Figure 3 illustrates.

Figure 3: Labor and capital investments in the broader economy. Wages (red) continue to outpace growth in capital investments (blue). Unlike in manufacturing, capital investment moves with the business cycle. This suggests that service industries are not as easily able to save labor costs through up front capital purchases.

It therefore is evident that the broader economy is much more dependent on hiring to increase output. So long as this remains the case, labor can continue to shift from manufacturing into to service, albeit with great disruption to many households.

Modern employment trends started nearly 60 years ago. The same post-war mechanisms of recession induced layoffs in manufacturing, and job growth recovery coming in the service sector, are at work today. Fixed capital investment in manufacturing has remained robust and surprising strong even in business contractions. This is consistent with the steady replacement of man with machine in the manufacturing sector. The service sector remains the key absorber of excess labor unemployed in manufacturing. Furthermore, service sector wage growth continues to outpace capital investments in service oriented industries. This suggests that machines will not replace humans any time soon in the service sector. Advancement in technology may someday cause the service sector to go through the same revolution that manufacturing has undergone in the past 60 years. This would clog the key safety valve which has historically soaked up excess labor. The result of such a “service sector revolution” would be foreshadowed by large capital investments in service industries, followed by layoffs during recessions. These workers would not be rehired, but replaced by further capital investments. Some futurists envision much service work being done by intelligent machines. This would result in permanently high structural unemployment, because at this moment, unlike the times of industrial mechanization, no obvious absorber of excess workers exists. The economic and sociological implications of this hypothetical are profound. But that is a subject for another book.

 

Commentary: Can No News Be Good News?

As widely expected, Banco de México held its target rate for overnight interbank loans at 4 percent.  The real news toady was the shift in bias from the governing board from slightly dovish to a markedly neutral tone.  The bank signalled no further rate cuts, or rate increases.  It it reaffirmed its view that transitory supply shocks were driving the above target inflation of recent months.  Specifically, high agricultural prices were passing through in the form of increased food costs for the consumer.  The bank noted that core inflation was coming in on target at 3.02 percent, and predicted a drop in the general inflation index by August.  

On the FX front, the bank discussed substantial capital flows into Mexico, which has both reduced borrowing costs for firms but also resulted in a marked appreciation of the peso.  At the same time, the bank opposes capital controls, and called the peso's appreciation from last year's record lows as "important" for helping to keep inflation in check. Other recent publications of the bank have warned of downside risks of sudden stops or reversals of capital flows which time after time have devastated emerging market economies.

Today's statement was generally somber, stressing slow growth observed in advanced economies and the threat this poses to growth in emerging markets.  The bank seems to recognize that the performance of the Mexican economy has been generally good.  The bank did not stoke market euphoria nor discourage further foreign investment.  The bank's seems to have gotten its message across.  The peso was little changed this morning, trading around 12.14 per dollar as of 8:04 PM GMT.      

Commentary: MXN's Medium Term Future Tied to Banco De México Policy Statement

This Friday, Banco de México issues its first monetary policy decision after cutting its key policy for the first time since 2009.  For nearly all of 2012, and especially through the height of the Eurozone crisis last June, the central bank kept a firmly hawkish bias with two related themes.  The slightly above target inflation observed in the general index was due to 'transitory shocks' in commodity prices, which tended to push up food and energy costs.  Core inflation continued to be on target, registering around three percent.  Despite stable core inflation, the bank communicated its committent to achieving its inflation target in nearly all its policy announcements last year.  Paraphrasing from the Spanish, "Despite the transitory nature of the shocks causing elevated inflation, rate increases may be necessary to anchor inflation expectations and prevent the contamination of the mechanism of price transmission in the broader economy."  In sum, the bank was not about to let external factors derail its policy objective of low and stable inflation, even if acting meant slower growth.  

By 2013, inflation had slowed in both the core and non-core indices.  Growth had also slightly moderated.  Therefore, the central bank shifted its bias.  Inflation had been tamed, so now "a rate reduction may be advisable to help the economy adjust to slower growth and constrained inflation."  In March of this year, Banco de México acted by cutting the overnight interbank lending rate by fifty basis points to all time low of 4 percent.   
  
Since then, the Mexican peso has continued to appreciate, mainly because of Mexico's excellent fundamentals and a promise by the bank that the cut was a one-off and not the beginning of an "easing cycle." Today, inflation stands at 4.25 percent, or 1.25 percentage points off the central bank's three percent objective.  More troubling, core inflation stands at 3.02 percent, while non-core inflation is a whopping 8.25 percent.  In other words, the transitory shocks, which seemed to have abated earlier this year, have returned.  The board must now decide whether stable and low core inflation is good enough, and reaffirm its intentions to cut rates should growth slow, or if it must meet its inflation target at all costs, even it means sacrificing growth, and fighting external shocks.  Meanwhile, all time high net longs for the Mexican peso and record foreign bond buying demonstrate the incredibly bullish investor sentiment towards the Latin American giant.  Signalling the possibility of more easing may cost the central bank credibility, since only six weeks ago in promised it would not cut further.  On the other hand, a reassertion of a hawkish tone may well send  USD/MXN into sub ten territory given the market's current euphoria.  In general, Banco de México has been very open to peso appreciation, but policy makers never like to see currencies rise too far too fast.  Therefore, the formulation of the exact wording of the policy statement will be a careful dance for the central bank.  The future Mexico's currency hangs in the balance.   

News: Risk Off in Asia as JPY and USD Rally

More risk off in Asia as the Yen and US dollar rally.  USD/JPY was trading at 98.86 as of 3:52 AM GMT, after closing at 99.40 in New York.  EUR/USD was also dinged, and looks poised to retest the 1.30 handle, at least in the short term.  USD/MXN was back above 12.30.  USD/MXN had spiked to as high as 12.35 from 12.28 during the US session, before plunging down back down to 12.25.  MXN looks to be extremely well bid, as evidenced by this whipsaw action.  As such, selling USD/MXN on rallies remains the preferred strategy.  I have my offer in at 12.35.  I booked profits on a short deal which got filled at 12.30 this morning.  I ended up exiting at 12.26, in light of the awesome volatility.  That said, I have maintained a core position in anticipation of a further leg downward.  Patience is necessary with MXN.  Bouts of risk aversion beat this currency up, but the excellent fundamentals mean that longterm it will appreciate.  Be willing to ride out short term losses, rake in carry, and look for MXN to make multi-year highs.  

Back on the JPY outflow story, the wires are a buzz with JPY funded carry trade ideas.  Aside from MXN, many names seem to like TRY.  As far as very high yielding currencies go, Turkey's lira looks to be the best bet.  Though Turkey is running a current account deficit of 6.6 percent of GDP, it is making progress on this front.  Last year the current account deficit was approaching ten percent of GDP. Turkey's current account woes come from the unfortunate fact that it must import nearly all of its fossil fuels. The fiscal deficit is relatively modest, coming in at 2.8 percent of GDP.  Finally, a recent sovereign upgrade means that Turkey really shouldn't have trouble finding the external financing to plug either of these holes.  This contrasts nicely with other high yielding currencies such as ZAR and INR.  Both 'yield' over six percent, but South Africa and India both face widening current account and fiscal deficits in the five percent of GDP range.  India is on notice of a possible downgrade, and South Africa was already downgraded earlier this year. Growth is slowing in all three of these countries, with quarterly GDP well below potential.    In sum, TRY looks to be the best bet for carry trades.  TRY has a nice yield, as is probably faces little risk of depreciation in the medium term.  ZAR and INR yield more, and will appreciate if these countries get their acts together.  However weak fundamentals coupled with deteriorating sovereign credit worthiness means that these currencies could face sharp and sudden depreciation on any sort of bad news.  I certainly was on board the long TRY/JPY trade from 47 to 53, missing the latest jump higher to the 55 levels we see now. If I decide to establish a position again I will try to buy a dip, and target 60 in the long term.  

 

Japan's Largest Life Insurer Plans and other Flows

Japan's Largest Life Insurer Plans and other Flows 

A major post on some Japanese outflows from Marc Chandler.  Click the link above to check out Marc's blog!