Japan's Current Account Fallacy?

The bigger-than-expected rise in Japan’s current account during April underlines the limits to Yen depreciation in driving the economic recovery. Specifically, the income surplus rose to Y1.9tr, the highest since current records began in January 1985. Japan’s large holding of external assets has amplified the (positive) impact of the fall in the Yen on the current account. At the end of 2012, net external total assets were a record 62.3% of GDP. The possibility that the Fed will taper asset purchases is currently viewed as the main driver behind the bounce in the Yen. However, the rise in Japan’s current account surplus will prove to be a more important and durable obstacle to Yen depreciation.

Nonetheless, this constitutes a potential moral hazard. The persistent external surpluses have effectively been the flipside to Japan’s ability to largely self-finance its budget deficits. Larger current account surpluses may encourage the Japanese government to push the limits of fiscal policy. Indeed, the misguided response since 1990 and the exaggerated reliance upon fiscal policy to address deflation show how the ‘successful’ export-led model has fuelled an alarming complacency vis a vis the public debt burden. Indeed, with the Upper House elections taking place next month, Mr Abe’s backpedalling on fiscal policy has the hallmark of previous government mistakes. Indeed, the recent drop in his approval ratings may increase the temptation of a populist short term (fiscal) ‘fix’.


Euroland's Tentative Recovery

The modest uptick in the manufacturing PMI recorded for May from 46.7 to 48.3 still implies that the Euroland economy is contracting. Nevertheless, the PMI matched similar improvements in the European Commission survey: some peripheral countries have turned the corner. The manufacturing PMIs reached 24 and 23 month highs for Spain (48.1) and Greece respectively (45.3). The six month change for unemployment in Spain (Ministry of the Economy and Finance) has dropped dramatically from 281k in May last year to -17k. And there has been a notable turnaround in sentiment in Greece. The economic sentiment index has risen in six out of the last seven months. Construction confidence is another important barometer, but there have been mixed signals. In Greece, there has been a significant rise since January, from -58.6 to -35.0, despite the persistent decline in private sector lending. In Spain, it has fallen heavily again in the last two months from -49.4 to -65.3. However, this is lagging the turnaround in the Ministry of Housing’s house price index. For Q1, house prices were unchanged (s.a.). This marks a big turnaround from 2012, where the average q/q decline was 2.4% (annualised 10.1%). This was the first quarter since Q1 2008 where house prices have not fallen. Critically, the portfolio balance effect could be starting to take hold in Spain.


Stock Market Corrections Accelerate

The late sell-off in US equities on Friday has brought the S&P 500 decisively back within the rising channel established following the low point of November 15th 2012 (1353.3). The key support will be the mini-high of 1593.4 reached on April 11th this year. The FOMC will need to judge carefully how the market trades in the coming days and weeks, to see if this support holds. As we have seen in Japan, losing control of bond yields can be very damaging. For the record, we would reiterate last week’s commentary: the lack of commitment to controlling the budget deficit remains the biggest flaw with Abenomics.

The US by contrast, has engaged upon fiscal tightening rather by accident than design, but the results, are striking. It is very likely that the Federal deficit will fall below 4.0% of GDP this year and perhaps 2.5% in FY2014. The US is not relying upon a weaker currency to drive a recovery either, while inflation pressures continue to ease, with the core consumption deflator falling to 1.05% y/y in April. The importance of these numbers in the context of the FOMC’s ability to contain any further sell-off in Treasuries should not be underestimated. Of course, benign ‘inflation’ will have to be counterbalanced by the second of the FOMC’s targets and Friday’s payroll report will be interesting. After falling 101k in the second week of April, continuing claims rose 63k last week. Nevertheless, averaging these two weeks shows that the decline in continuing claims has continued and may have accelerated. If the jobless rate does fall again in May, the onus will be on FOMC to emphasise a broader pespective of the labour market, rather than the narrow target (6.5%) set at its December 2012 meeting.

Either way, the FOMC has an alternative strategy to bond purchases, which it used to good affect from August 11th 2011 onwards. It can - and arguably should - be reactivated or given greater prominence to help control rate expectations. The 3-month implied rate for eurodollars has risen to 0.89% for June 2015, up 35 b.p. since the low reached on May 2nd this year. The housing market may well be enjoying a robust upturn. But the FOMC’s task of ensuring a recovery from the 2008 debacle remains incomplete. It will need to reassert the pre-eminence of the labour market in its dual policy targets and perhaps consider cutting the 6.5% threshold. Only then will the US stock market stabilise.