Should we buy Turkey for Thanksgiving?


Macro Letter – No 46 – 20-11-2015

Should we buy Turkey for Thanksgiving?

  • Erdogan’s AKP won an unexpected majority in this month’s election
  • The Turkish Lira (TRY) has fallen by 60% against the USD since 2008
  • Turkish stocks look inexpensive by several measures
  • Economic reform appears unlikely

Back in June the AKP failed to achieve a majority in this year’s first general election. Second time around they achieved a resounding victory – though not the “supermajority” required for constitutional reform. The main reason for the loss of confidence earlier in the year was the state of the Turkish economy. Now the AKP has an opportunity to embark on economic reform – this may be easier said than done.

They need to deal with rising unemployment which, having dipped to 9.3% in May, is on the rise again – August 10.1%. Labour participation has been steadily rising – from 43.6 in 2006 to 51.2 today, however it is still low by international standards and female participation is a rather dismal 29%. Youth unemployment has fallen from 28% in 2009 to 18.3% in August, but this does not bode well for their relatively young nation. Of the 77mln population, 67% are notionally working age – 15 to 64. Only 6% are over 64 years. Turks make up 75% of the population whilst Kurds already account for 18%; as this 2012 article from the IB Times – A Kurdish Majority In Turkey Within One Generation? makes clear, substantial cultural challenges lie ahead.

High unemployment has impacted consumer confidence which plunged to 58.52 in September – its lowest level since the global recession of 2009. October saw a rebound to 62.78.

Core inflation remains stubbornly high despite the fall in oil prices. During the summer it dipped below 8% but by October it was 9.3%. The chart below shows the core inflation rate over the last decade:-


Source: Tradingeconomics and Eurostat

High inflation is primarily due to the weakness of the TRY; the next chart shows USDTRY, but the BIS Effective exchange rate also declined from 100 in 2010 to 70.6 at the end of 2014. The last big TRY devaluation occurred between February and October 2001, the move since 2008 has been of a similar magnitude, albeit with less precipitous haste:-


Source: Tradingeconomics

Inflation might have been even higher had imports not fallen:-


Source: Tradingeconomics and Turk Stat

The decline in imports, principally from Russia (10.4%) China (10.3%) and Germany (9.2%) helped reduce the current account deficit to some extent but at -6% of GDP it remains, unhealthy:-


Source: Tradingeconomics and Central Bank of Turkey

Turkey is a big energy importer – for a more detailed discussion on energy security for Turkey (and the EU) this working paper from Bruegel – Designing a new Eu-Turkey Gas Partnership is worth perusal.

The current account deficit is matched by the government budget balance, this has remained negative for most of the decade, although the debt to GDP ratio is an undemanding 33%:-


Source: Tradingeconomics and Turkish Ministry of Economics

Meanwhile Turkey’s external debt continues to grow, it now equates to more than half of GDP:-


Source: Tradingeconomics and Turkish Treasury

Much of the external borrowing has been short-term and the private sector accounts for more than two thirds of the total. Since 2002 GDP has increased from $233bln to $800bln – during the same period external debt has tripled. Short-term debt to central bank reserves have doubled. The table below investigates this and other aspects of Turkey’s external debt:-

Turkish Debt

Source: Central Bank of Turkey and Turk Stat

In 2013 Morgan Stanley dubbed Turkey one of the “fragile five”, the others being Brazil, India, Indonesia and South Africa. These countries had high external debt, twin deficits, structurally high inflation and slowing growth. Turkish GDP has been recovering somewhat this year – 3.8% in Q2 2015 – but it remains below its 2002-2011 average of 5.2%:-


Source: Tradingeconomics and Turk Stat

Given the weakness of the currency it is surprising that economic recovery has not been more pronounced. This may be due to the parlous state in Turkey’s principal export markets, Germany (9.6%) has seen slow growth and Iraq (6.9%) has been in recession:-


Source: Tradingeconomics and Turk Stat

In March Morgan Stanley announced that India and Indonesia had made sufficient reforms to be removed from the “Fragile” category. Turkey remains, unreformed, especially in terms of its labour laws – a focal point if they are to reduce structural unemployment.

Turkey has demographic trends on its side but its productivity has been stagnant since the financial crisis. The OECD estimated GDP per hour for 2014 at 29.3 hours – in 2007 it was 28.9 hours.

Financial Markets

Short-term interest rates, which touched 10% last year, have fallen to 7.5%, despite inflation and TRY weakness, but the independence of the central bank has been questioned since Erdogan openly criticised their interest rate policy in March – with the AKP majority restored the problem of inflation may be deferred:-


Source: Tradingeconomics and Central Bank of Turkey

Reflecting market sentiment better, 10yr Turkish Government bonds, reached 10.78% in October, although they have recovered, in the wake of the election, to yield 9.72% today (Wednesday 18th) here is a five year chart:-

turkey-government-bond-yield 5yr

Source: Tradingeconomics and Turkish Treasury

From a technical perspective bond yields appear to have backed away from the 2014 highs, but considered in conjunction with the continued trend of the TRY, I lack the confidence to buy ahead of real economic reform package. Meanwhile, the US Federal Reserve look set to raise interest rates next month, putting further downward pressure on the TRY and driving short-term US$ financing costs higher.

The Turkish XU100 stock index rallied from 77,776 to 83,692 after the election – today (Wednesday 18th) it stands at 81,274. It has been buoyed by currency weakness:-


Source: Tradingeconomics and Istanbul Stock Exchange

The market valuation is relatively undemanding. A CAPE of 10.3 is higher than its emerging European neighbours, but on a straight PE basis (11 times) and dividend yield (3.4%) it is comparable. On a price to cost, price to book or price to sales basis, however, it is more expensive than Emerging Europe.

The largest stocks in the index are:-

Company Ticker Sector
Garanti Bankası GARAN Banking
Akbank AKBNK Banking
Turkcell TCELL Telecommunications
Koç Holding KCHOL Conglomerate
Türkiye İş Bankası ISATR Banking
Türk Telekom TTKOM Telecommunications
Enka İnşaat ENKAI Construction
Sabancı Holding SAHOL Conglomerate
Halk Bankası HALKB Banking
Efes Beverage Group AEFES Beverage
Vakıfbank VAKBN Banking
Turkish Airlines THYAO Transportation

Source: Istanbul Stock Exchange

Whilst the economy is 25% Agriculture, 26% Industry and 49% Services, the stock market is dominated by banks. At the end of 2013 the weights for the XU100 were 36% Banks, 17% Beverages and 8% Conglomerates – although the fragmented (30 companies) cement industry should be mentioned. It is the largest in Europe and fifth largest globally. Rising bond yields, even though they have fallen since the election, and the weakness of the TRY increase the risk of bank losses. Technically, one should remain long, but I’m not inclined to add aggressively at this stage.

An additional concern is Turkey’s political relations with the EU. According to a 3rd September article from Brookings – Why 100,000s of Syrian refugees are fleeing to Europe:-

Turkey’s is being deeply affected too, in spite of having the largest economy in the region and a strong state tradition. Its resources and public patience are wearing thin. The Syrian refugee issue certainly plays a role in the current political instability in the country. According to UNHCR, Turkey became the world’s largest recipient of refugees (total, including those from Iraq) in 2014. 

The EU’s inability to act on concert to address the migrant crisis, along with the imminent collapse of the Schengen Agreement, is likely to further strain relations. It may not stop existing trade but it is likely to slow new business developments.

Security remains a major issue for the new Turkish government as CFR – What Turkey’s Election Surprise Says About the Troubled Country explains:-

…Turkey now confronts simultaneous conflicts with the PKK and the Islamic State. After a year of intensive American diplomacy, Ankara’s decision last July to provide the United States and coalition forces access to air bases close to the Islamic State’s territory has made Turkey a target.

On a more positive note. The new government is likely to make good on its election promises by increasing fiscal stimulus. That 33% debt to GDP ratio must be burning a hole in Erdogan’s pocket. Stimulus is expected to be directed at infrastructure – the “three R’s”, roads, railways and real-estate. “Grand projects” include a third Airport and a mountaintop mosque for Istanbul, a third bridge and a tunnel across the Bosporus, a canal linking the Black Sea to the Sea of Marmara and a gigantic presidential palace in Ankara.

Conclusion – the currency is key

On balance I think it is too soon to buy Turkish bonds or stocks. The new government seems reluctant to embrace the economic reforms needed to drive productivity growth. External debt will have to be repaid, inflation, subdued and jobs created. Turkish stocks look relatively inexpensive and her bonds may be tempting to the carry trader, but an appreciating TRY is key – should the currency recover, stocks and bonds will follow.

Have technological advances offset the reduction in capital allocated to financial markets trading?


Macro Letter – No 45 – 06-11-2015

Have technological advances offset the reduction in capital allocated to financial markets trading?

  • Increases in capital requirements have curtailed financial institutions trading
  • Improved execution, clearing and settlement has reduced frictions in transactions
  • Faster real-time risk management systems have enhanced the efficiency of capital
  • On-line services have democratized market access

Liquidity in financial markets means different things to different participants. A sharp increase in trading volume is no guarantee that liquidity will persist. Before buying (or selling) any financial instrument the first thing one should ask is “how easy will it be to liquidate my exposure?” This question was at the heart of a recent paper by the UK Government – The future of computer trading in financial markets – 2012here are some of the highlights:-

…The Project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects. However, it is believed that policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets.

There will be increasing availability of substantially cheaper computing power, particularly through cloud computing: those who embrace this technology will benefit from faster and more intelligent trading systems in particular.

Special purpose silicon chips will gain ground from conventional computers: the increased speed will provide an important competitive edge through better and faster simulation and analysis, and within transaction systems.

Computer-designed and computer-optimised robot traders could become more prevalent: in time, they could replace algorithms designed and refined by people, posing new challenges for understanding their effects on financial markets and for their regulation.

Opportunities will continue to open up for small and medium-sized firms offering ‘middleware’ technology components, driving further changes in market structure: such components can be purchased and plugged together to form trading systems which were previously the preserve of much larger institutions.

The extent to which different markets embrace new technology will critically affect their competitiveness and therefore their position globally: The new technologies mean that major trading systems can exist almost anywhere. Emerging economies may come to challenge the long-established historical dominance of major European and US cities as global hubs for financial markets if the former capitalise faster on the technologies and the opportunities presented.

The new technologies will continue to have profound implications for the workforce required to service markets, both in terms of numbers employed in specific jobs, and the skills required: Machines can increasingly undertake a range of jobs for less cost, with fewer errors and at much greater speed. As a result, for example, the number of traders engaged in on-the-spot execution of orders has fallen sharply in recent years, and is likely to continue to fall further in the future. However, the mix of human and robot traders is likely to continue for some time, although this will be affected by other important factors, such as future regulation.

Markets are already ‘socio-technical’ systems, combining human and robot participants. Understanding and managing these systems to prevent undesirable behaviour in both humans and robots will be key to ensuring effective regulation…

While the effect of CBT (Computer Based Trading) on market quality is controversial, the evidence available to this Project suggests that CBT has several beneficial effects on markets, notably:

liquidity, as measured by bid-ask spreads and other metrics, has improved;

transaction costs have fallen for both retail and institutional traders, mostly due to changes in trading market structure, which are related closely to the development of HFT in particular;

market prices have become more efficient, consistent with the hypothesis that CBT links markets and thereby facilitates price discovery.

While overall liquidity has improved, there appears to be greater potential for periodic illiquidity: The nature of market making has changed, with high frequency traders now providing the bulk of such activity in both futures and equities. However, unlike designated specialists, high frequency traders typically operate with little capital, hold small inventory positions and have no obligations to provide liquidity during periods of market stress. These factors, together with the ultra-fast speed of trading, create the potential for periodic illiquidity. The US Flash Crash and other more recent smaller events illustrate this increased potential for illiquidity.

…Three main mechanisms that may lead to instabilities and which involve CBT are:

nonlinear sensitivities to change, where small changes can have very large effects, not least through feedback loops;

incomplete information in CBT environments where some agents in the market have more, or more accurate, knowledge than others and where few events are common knowledge;

internal ‘endogenous’ risks based on feedback loops within the system.

The crux of the issue is whether market-makers have been replaced by traders. This trend is not new. On the LSE the transition occurred at “Big Bang” in October 1986. The LSE was catching up with the US deregulation which prompted the formation of NASDAQ in 1971.

Electronic trading, once permitted, soon eclipsed the open-outcry of futures pits and traditional practices of stock exchange floors. Transactions became cheaper, audit trails, more accurate and error incidence declined. Commission rates fell, bid/offer spreads narrowed, volumes increased, in an, almost, entirely virtuous circle.

The final development which was needed to insure liquidity, was the evolution of an efficient repurchase market for securities – sadly this market-place remains remarkably opaque. Nonetheless, the perceived need for designated market-makers, with an obligation to make a two-way price, has diminished. It has been replaced by proprietary trading firms, which forgo the privileges of the market-maker – principally lower fees or preferential access to supply – for the flexibility to abstain from providing liquidity at their own discretion.

In the late 1990’s I remember a conversation with a partner at NYSE Specialist – Foster, Marks & Natoli – he had joined the firm in 1953 and sold his business to Spear, Leeds Kellogg in 1994. He told me that during his career he estimated the amount of capital relative to size of the trading portfolio had declined by a factor of five times.

Since the mid-1990’s stock market volumes have increased dramatically as the chart below shows:-


Source: NYSE

The recommendations of the UK Government report include:-

European authorities, working together, and with financial practitioners and academics, should assess (using evidence-based analysis) and introduce mechanisms for managing and modifying the potential adverse side-effects of CBT and HFT.

Coordination of regulatory measures between markets is important and needs to take place at two levels: Regulatory constraints involving CBT in particular need to be introduced in a coordinated manner across all markets where there are strong linkages.

Regulatory measures for market control must also be undertaken in a systematic global fashion to achieve in full the objectives they are directed at. A joint initiative from a European Office of Financial Research and the US Office of Financial Research (OFR), with the involvement of other international markets, could be one option for delivering such global coordination.

Legislators and regulators need to encourage good practice and behaviour in the finance and software engineering industries. This clearly involves the need to discourage behaviour in which increasingly risky situations are regarded as acceptable, particularly when failure does not appear as an immediate result.

Standards should play a larger role. Legislators and regulators should consider implementing accurate, high resolution, synchronised timestamps because this could act as a key enabling tool for analysis of financial markets. Clearly it could be useful to determine the extent to which common gateway technology standards could enable regulators and customers to connect to multiple markets more easily, making more effective market surveillance a possibility.

In the longer term, there is a strong case to learn lessons from other safety-critical industries, and to use these to inform the effective management of systemic risk in financial systems. For example, high-integrity engineering practices developed in the aerospace industry could be adopted to help create safer automated financial systems.

Making surveillance of financial markets easier…The development of software for automated forensic analysis of adverse/extreme market events would provide valuable assistance for regulators engaged in surveillance of markets. This would help to address the increasing difficulty that people have in investigating events

At no point do they suggest that all market participants – especially those with principal or spread risk – be required to increase their capital. This will always remain an option. An alternative solution, the reinstatement of designated market-makers with obligations and privileges, is also absent from the report – this may prove to be a mistake.

An example of technological emancipation

In this paper, Review of Development Finance – The impact of technological improvements on developing financial markets: The case of the Johannesburg Stock Exchange – Q3 – 2013 – the authors investigate how the adoption of the SETS trading platform transformed the volume traded on the JSE:-

The adoption of the SETS trading platform was supposed to represent a watershed moment in the history of the Johannesburg Stock Exchange. The JSE is more liquid after SETS. The JSE has nearly doubled its trading activity (volume), trading is cheaper, and there are more trades at JSE after SETS.

Overall, average daily returns are higher. We posit that this is mainly because the returns are increased to the levels demanded for the associated risk. With the new trading platform, it would also be expected that there would be improvements in market efficiency. Higher numbers of investors, more listed companies, faster trading and more trade (evidenced with trading activity and liquidity), all would imply more market efficiency. Contrary to our expectations, however, market-wide and individual-level stock returns are still somewhat predictable; this is a clear violation of market efficiency.

If market participants had been required to increase their capital in line with the increased volume, the transformation would have been far less dramatic. This is not to say that increased trading volume equates to increased risk. Technology has improved access, traders are able to liquidate positions more easily, most of the time, due to improved technology. At any point in the trading day they may hold the same open position size, but by turning over their positions more frequently they may be able to increase their return on capital (and risk) employed.

Federal Reserve concern

The Federal Reserve Bank of New York – Introduction to a series on Liquidity published eleven articles on different aspects of liquidity during the last three months, here are some of the highlights:-

Has U.S. Treasury Market Liquidity Deteriorated? …it might be that liquidity concerns reflect anxiety about future liquidity conditions, with a possible imbalance between liquidity supply and demand. On the demand side, the share of Treasuries owned by mutual funds, which may demand daily liquidity, has increased. On the supply side, the primary dealers have pared their financing activities sharply since the crisis and shown no growth in their gross positions despite the sharp increase in Treasury debt outstanding.

This seems to ignore the effect of QE on the “free-float” of T-Bonds. The chart below shows the growth of the Federal Reserve holdings during the last decade:-

T-Bonds at the Fed - St Louis Fed

Source: St Louis Federal Reserve

Liquidity during Flash Events…all three events exhibited strained liquidity conditions during periods of extreme price volatility but the Treasury market event arguably exhibited a greater degree of price continuity, consistent with descriptions of the flash rally as “slow-moving.”

Unlike the FX and equity market, the US government still appoint primary dealers who have privileged access to the issuer. This probably explains much of the improved price continuity.

High-Frequency Cross-Market Trading in U.S. Treasury Markets. Cross-market trading by now accounts for a significant portion of trading in Treasury instruments in both the cash and futures markets. This reflects improvements in trading technology that allow for high-frequency trading within and across platforms. In particular, nearly simultaneous trading between the cash and futures platforms now accounts for up to 20 percent of cash market activity on many days. Market participants often presume that price discovery happens in Treasury futures. However, our findings show that this is not always the case: Although futures usually lead cash, the reverse is also often true. Therefore, from a price discovery point of view, the two markets can effectively be seen as one.

For many years the T-Bond future was regarded as the most liquid market and was therefore the preferred means of liquidation in times of stress. The most extreme example I have witnessed was in the German bond market during re-unification (1988). The Bund future was the most liquid market in which to lay off risk. As a result, Bund futures traded more than 10 bps cheap to cash and cash Bunds offered a yield premium of 13bps to bank Schuldschein – unsecured promissory notes.

The introduction of electronic trading in T-Bond cash markets has created competing pools of liquidity which should be additive in times of stress. The increasing use of Central Counter Party (CCP) clearing has allowed new market participants to operate with a smaller capital base.

This evolution has also been sweeping through the Interest Rate Swap market, reducing pressure on the T-Bond futures market further still.

The Evolution of Workups in the U.S. Treasury Securities Market. The workup is a unique feature of the interdealer cash Treasury market. Over time, the details of the workup have changed in response to changing market conditions, with the abandonment of the private phase and the shortening of the default duration to 3 seconds. While some market participants may consider it an anachronism, given the increased trading activity in benchmark Treasuries and the tight link to the extremely liquid Treasury futures market, the workup has not only remained an important feature of the interdealer market; it has actually grown in importance, now accounting for almost two-thirds of trading volume in the benchmark ten-year Treasury note.

On the Frankfurt stock exchange each Bund issue is “fixed” at around 13:00 daily. This process creates a liquidity concentration. A similar “clearing” process occurs at the end of LME rings. For spread traders, the ability to “lean” against a relatively un-volatile market – such as during a workup – whilst making an aggressive market in the correspondingly more volatile companion, represents an enhanced trading opportunity. One side of the potential spread price is provided “risk-free”.

What’s Driving Dealer Balance Sheet Stagnation? …The growing role of electronic trading has likely narrowed bid-ask spreads and reduced dealers’ profits from intermediating customer order flow, causing dealers to step back from making markets and reducing their need for large balance sheets. The changing competitive landscape of market making, as manifested by the entry of nondealer firms since the early 2000s, may therefore also play a role in the post-crisis dealer balance sheet dynamics.  …The picture that emerges is that post-crisis dealer asset growth represents the confluence of several issues. Our findings suggest that business-cycle factors (the hangover from the housing boom and bust and subsequent risk aversion) and secular trends (electronification and competitive entry) should be considered alongside tighter regulation in explaining stagnating dealer balance sheets. 

I refer back to my conversation with Mr Foster, the NYSE Specialist; in asset markets – equities and to a lesser extent bonds – as volume increases during a bull-market, the number of market participants increases. In this environment “liquidity providers” trade more frequently with the same capital base. Subsequently, as volatility declines – provided trading volume is maintained – these liquidity providers increase their trading size in order to maintain the same return on capital. When the bear-market arrives, the new participants, who arrived during the bull-market, liquidate. The remaining “liquidity providers” – those that haven’t exited the gene pool – are left passing the parcel among themselves as the return on capital declines precipitously (the chart, some way below, shows this evolution quite clearly).

Has U.S. Corporate Bond Market Liquidity Deteriorated? …price-based liquidity measures—bid-ask spreads and price impact—are very low by historical standards, indicating ample liquidity in corporate bond markets. This is a remarkable finding, given that dealer ownership of corporate bonds has declined markedly as dealers have shifted from a “principal” to an “agency” model of trading. These findings suggest a shift in market structure, in which liquidity provision is not exclusively provided by dealers but also by other market participants, including hedge funds and high-frequency-trading firms.

Given the “quest for yield” and the reduction in T-Bond supply due to QE, this shift in market structure is unsurprising, however the relatively illiquid nature of the Corporate bond repo market means much of the activity is based around “carry” returns. Participants are cognizant of the dangers of swift reversals of sentiment in carry trading.

Has Liquidity Risk in the Corporate Bond Market Increased? …We measure market liquidity risk by counting the frequency of large day-to-day increases in illiquidity and price volatility, where “large” is defined relative to measures of recent liquidity and volatility changes (details are described here). We refer to the illiquidity jumps as “liquidity risk” and to the volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window shows that liquidity risk and vol-of-vol have declined substantially from crisis levels…

…Current metrics indicate ample levels of liquidity in the corporate bond market, and liquidity risk in the corporate bond market seems to have actually declined in recent years. This is in contrast to liquidity risk in equity and Treasury markets…

The Fed methodology is contained in a four page paper A Note on Measuring Illiquidity Jumps. It may be of interest to those with an interest in exotic option pricing. I’m not convinced that I agree with their conclusions about Liquidity Risk – it is difficult to measure that which is unseen.

Has Liquidity Risk in the Treasury and Equity Markets Increased? …While current levels of liquidity appear similar to those observed before the crisis, sudden spikes in illiquidity—like the equity market flash crash of 2010, the recent equity market volatility on August 24, and the flash rally in Treasury yields on October 15, 2014—seem to have become more common. Such spikes in illiquidity tend to coincide with spikes in option-implied volatility, in both equity and Treasury markets…

…we refer to these liquidity jumps as “liquidity risk” and volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window reveals a recent uptick in liquidity risk and vol-of-vol, and confirms the link between them… The evidence that liquidity risk in equities and Treasuries is elevated contrasts with our earlier post, which found no such increase for corporate bonds.

Our findings suggest a trade-off between liquidity levels and liquidity risk: while equity and Treasury markets have been highly liquid in recent years, liquidity risk appears elevated. This change has gone hand in hand with an apparent increase in the vol-of-vol of asset prices, so that illiquidity spikes seem to coincide with volatility spikes. Our findings further suggest that the increase in liquidity risk is more likely attributable to changes in market structure and competition than dealer balance sheet regulations, since the latter would also have caused corporate bond liquidity risk to rise. Moreover, evidence from option markets suggests that this seeming rise in liquidity risk is not reflected in the price of volatility.

Market liquidity in a given market is never constant, the trading volume may remain the same but the market participants, wholly different. In the 1980’s Japanese institutions were a significant influence on the US bond market, today it is the Federal Reserve. Changes, such as minimum price increments and exchange trading hours are significant; the list of factors is long and ever changing. The increase in Liquidity Risk has as much to do with the increase in systematic trading and the relative consistency of approach these traders take to risk management. These traders and their methods have become increasingly prevalent. Whilst cognizant of skewness they see the world through a Gaussian lense. They measure strategy success by Sharpe and Sortino ratio, assessing it by the minute or the hour and being “flat” by market close.

Changes in the Returns to Market Making. We show estimated returns to market making to be at historically low levels—a finding that seems inconsistent with market analysts’ argument that higher capital requirements have reduced market liquidity. The picture that emerges from our analysis is of a change in the risk-sharing arrangement among trading institutions. We uncover a compression in expected returns to market making in the corporate bond market, where dealers remain the predominant market makers, as well as the equity market, where dealers are less important. The compression of market making returns may be tied to competitive pressures, with high-frequency trading competition being important in the equity market.

High-Frequency Equity Market-Making Returns and VIX

Source: Reuters, Haver Analytics

The chart above looks at one minute reversals on the Dow. As long ago as 2003, the HFT customers I dealt with were operating on sub-second reversal time horizons. Nonetheless, the pattern of profitability may be broadly similar.

Redemption Risk of Bond Mutual Funds and Dealer Positioning. Mutual funds’ share of corporate bond ownership has increased sharply in recent years, while dealers’ share has declined substantially. Because mutual funds are subject to redemption risk, this shift in ownership patterns raises the concern that redemption risk might have increased. However, we find no evidence that the net flow volatility of bond funds has increased. Likewise, we uncover no evidence of contrarian behavior by dealers relative to bond fund flows. Therefore, even if we do observe large mutual fund redemptions in the future, our evidence does not suggest that reduced dealer positions will exacerbate the effects on corporate bond pricing and liquidity.

Since the Mutual Fund “Late Trading” scandal of 2003, arbitrage operators have maintained a low-profile. The “flight-to-quality” properties of T-Bonds should also mean mass-redemption is a much lower probability – “mass-subscription” is a higher risk.

The Liquidity Mirage. While low-latency cross-market trading has undoubtedly led to more consistent pricing of Treasury securities and derivatives, there is strong evidence that it has also resulted in a more complex and dynamic nature of market liquidity. Under the new market structure, it has arguably become more challenging for large investors to accurately assess available liquidity based on displayed market depth across venues. The striking cross-market patterns in trading and order book changes suggest that quote modifications/cancellations by high-frequency market makers rather than preemptive aggressive trading are an important contributing factor to the liquidity mirage phenomenon.

In the days of open-outcry trading on futures exchanges “local” traders would frequently cancel and replace bids and offers. These participants were visible, their reliability, or otherwise, was known to the market-place. In an electronic order book there is less transparency. Algorithmic trading solutions have developed, over the last twenty years, to enable efficient execution in this more opaque environment.

“Cost plus” pricing for equity and futures execution is still quite rare outside the HFT world but it has had a dramatic influence on stock market micro-structure and liquidity since the 1990’s.

In a recent speech by Minouche Shafik of the Bank of England – Dealing with change: Liquidity in evolving market structuressuggested that the changes in liquidity are a natural process:-

The reduction in the relative size of dealer balance sheets may also be a natural process of evolution as the market-making industry matures and emphasis is placed on using its warehousing capacity efficiently rather holding lots of inventory. Market making wouldn’t be the first industry to go through such a change: Just In Time management swept through manufacturing in the 70s and 80s with its focus on minimising waste, eliminating inventories, and quickly responding to changing market demand. More recently, supermarkets have reversed their once relentless expansion of retail space, and started moving away from inventory-intensive hypermarkets toward smaller retail units.

Indeed, moving toward smaller in-store inventories is not the only parallel between retailing and market making: both have also been dramatically changed by innovation. Just as the rise of internet shopping has given consumers access to a broader choice of shops and much easier means of price comparison, so has electronic trading facilitated new ways of matching buyers and sellers in financial markets, and added to the data generally available for price discovery.

The Deputy Governor goes on to remind us that the BoE acted as Market-Maker of Last Resort during the last crisis and would do so again.

Conclusion – Financial markets – for the benefit of whom

Financial markets evolve to allow investors to provide capital in exchange for a financial reward. Technology has increased the speed and reliability of market access whilst reducing the cost, however these benefits change the underlying structure of markets, be it co-location of servers in the last decade or block-chain technology in the next.

Politicians seek to encourage long-term investment; high frequency trading is a very short-term investment strategy indeed, but without short-term investors – shall we call them speculators – the ability to transfer of capital is severely impaired. Even the most jaundiced politician will admit, speculators are a necessary evil.

Innovation has democratized financial markets, it has enabled individual investors to create complex portfolios and implement strategies which were once the preserve of hedge funds and investment banks, however the experience has not been an unmitigated success, in the process it purportedly enabled one man from Hounslow to wipe $750bln off the value of the US stock market in May 2010. That this was possible defies credulity for many; I believe it indicates how technology has more than offset the decline in capital allocated to financial market trading, nonetheless, when it comes to financial market liquidity, I concur with Deputy Governor Shakif – “caveat emptor”.

What’s right with the Trans-Pacific Partnership?


Macro Letter – No 44 – 23-10-2015

What’s right with the Trans-Pacific Partnership?

  • The TPP may boost real-incomes by $285bln by 2025
  • US Congress should approve the TPP to avoid international political embarrassment
  • The TPP may be expanded to include South Korea, Taiwan and maybe even China
  • Many companies involved in auto, pharma, IT and agricultural should benefit

For Asia-Pacific, the Trans-Pacific Partnership (TPP) is the most substantial trade agreement in history. In this video Cato Institute – Putting the TPP in Perspective: 150 Years of U.S. Trade Policy in Less than 4 Minutes – remind us that this is a “Managed Trade Agreement” rather than a “Free Trade Agreement” (FTA).

The 12 TPP participating countries – Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, USA and Vietnam – represent almost 40% of output and 25% of exports of goods and services globally. This makes it the largest regional trade agreement in history.

After five years of “horse-trading” and “turf-wars” the agreement was finally signed on 5th October, yet, with US Congressional enactment still awaited in December, much media commentary has focussed on the weaknesses of the agreement. These include:-

  • Agriculture – Japanese resistance to the elimination of tariffs on agricultural imports, including rice, beef, pork, dairy, wheat, barley, and sugar. Japan’s average most-favoured nation (MFN) tariff for agricultural products is 16.6% – although some tariffs are as high as 700%. The US accounts for 25% of agricultural imports to Japan.
  • Intellectual property rights – Whilst all TPP members agree on high IP standards, the devil is in the detail. The period of data exclusivity for drug tests, protection of trade secrets, and liability of ISPs for transmitting illegal/pirated material all remain contentious.
  • State-owned enterprises – TPP members are committed to levelling the playing field in respect of preferential access to finance or new markets. Problems arise over the length of the transition period before the new rules must be adopted, standardisation of accounting practices, board governance and unbiased procurement processes.
  • Labour – Issues remain around the adoption of ILO Fundamental Principles, prohibiting workplace discrimination and upholding consistent child labour practices.
  • Investor-State Dispute Settlement – Investor-State Dispute Settlement provisions allow international investors to use dispute settlement proceedings against host governments if they believe their property has been expropriated without compensation or regulated in a discriminatory manner. TPP members disagree about the extent of carve-outs from Investor-State Dispute Settlements for health, safety, and environmental regulations.

According to the Independent – TPP trade agreement text won’t be made public for four years – so in the interim here is the USTR Summary.

The Guardian – Wikileaks release of TPP deal text stokes ‘freedom of expression’ fears – provides more details about Chapter 12, covering IP, yet it is not clear whether this is the final version of the document or not.

In attempting to assess the initial deal The Economist – Every silver lining has a cloud – said:-

First, there is the fact that the agreement has been so hard to sell in America. It took months, and several legislative setbacks, before Barack Obama won the authority to fast-track a congressional vote on TPP. The deal may still be voted down, in America or elsewhere. Those who would succeed Mr Obama as president know that TPP holds few votes. This week Hillary Clinton, the Democratic front-runner and once a promoter of TPP, came out against it. The beneficiaries of TPP—consumers, as well as exporters—are numerous, but their potential gains diffuse. By contrast, inefficient firms and farms, about to be exposed to greater foreign competition, are obvious and vocal. Canada, for example, limited the threat to its dairy farmers and doled out a big new subsidy. The saga is a reminder of how hard free trade is to champion.

Second, the TPP deal underscores the shift away from global agreements. The World Trade Organisation, which is responsible for global deals, has been trying, and largely failing, to negotiate one since 2001. Reaching agreement among its 161 members, especially now that average tariffs around the world are relatively low and talks are focused on more contentious obstacles to trade, has proved almost impossible. Regional deals are the next best thing, but, by definition, they exclude some countries, and so may steer custom away from the most efficient producer. In the case of TPP, the glaring outcast is China, the linchpin of most global supply chains.

Third, good news on TPP stands in contrast to bad news elsewhere. Cross-border trade today is as much about the exchange of data as it is the flow of goods and services: this week saw the annulment by a European court of a deal that had enabled American firms to transfer customer data across the Atlantic. Conventional trade faces even stronger headwinds. The volume of goods shipped in the first half of this year was just 1.9% higher than in the same period of 2014, far below its long-term average growth of 5%. This reflects not only China’s soggy demand for imports—a threat to the developing economies that supply it—but also the accumulation of minor measures that silt up global trade.

Deals like TPP are the most effective way to reverse this sorry trend, by reducing tariffs and other obstacles to trade. Optimists hope it can now be expanded, to include China and others. Sadly, experience suggests that will be hard.

Looked at from a more positive perspective, the TPP tops the US trade policy agenda, incorporating President Obama’s “Asia Pivot”. Signatory countries account for 36% of US trade in goods and services. US ratification of this agreement will upgrade a range of existing FTAs stretching back to NAFTA (1994).

With some exceptions – mostly in agriculture – the TPP aims to remove tariff barriers for goods and services. It will also address some “access” issues in areas such as competition policy, direct investment, labour and environmental standards.

Japan and the US will be the principal beneficiaries of the TPP (64% of GDP gains) but it has been estimated that the agreement could boost real incomes of member countries by $285bln by 2025, with exports increasing by $440 billion (+7%) assuming full-adoption.

The TPP could achieve even more since is allows for the future accession of new members. South Korea, possibly regretting its decision not to take part in the initial negotiations, has announced its interest, while Indonesia, the Philippines, Thailand, and Taiwan are evaluating the benefits. It might even form the framework for a bilateral FTA between the US and China. The chart below shows the potential benefit in GDP terms:-


Source: Economist and Peterson Institute

A brief history of free-trade



The liberal idea of free trade sprang from the earliest discoveries in the field of economics. It is the embodiment of the spirit of “comparative advantage” – David Riccardo’s observation that specialisation makes economic sense and that those agents with a natural economic advantage should specialise and trade, rather than attempting to produce all goods to meet their own needs.

There are difficulties in achieving genuine free trade. Consumer organisations are relatively weak in comparison with trade organisations: this iniquity is the flaw at the heart of so many FTAs. Consumers, if consulted, would vote unanimously in favour of cheaper goods. Inflation targeting might prove difficult for central banks but people’s standard of living would improve, all other things equal. This is the benign face of deflation; it is also the reason why productivity growth is critical to economic progress.

Since the time of Sumer, empire building has involved conquest, assimilation and trade. Artefacts of North African and Middle-Eastern origin uncovered at Roman archaeological sites in Britain, bears testament to the wide-spread distribution of goods throughout the Roman Empire.

The Spanish theologian, philosopher and jurist Francisco de Vitoria (1483 – 1546) developed the first ideas about freedom of commerce and freedom of the seas. A forerunner to FTAs, were the “most favoured nation” (MFN) clauses attached to international treaties during the European colonial era – many of these MFN clauses are still in use today – but it was the philosopher Adam Smith, along with Ricardo, who articulated what we would recognise as free-trade theory today.

William Huskisson (1770 – 1830) was appointed President of the Board of Trade and Treasurer of the Navy in 1823. He was part of the Canningite faction of the Tory party, led by George Canning, which formed a brief coalition government in 1827. Perhaps Huskisson’s greatest contribution to free-trade was his reform the Navigation Acts. This allowed other nations full equality and reciprocity of shipping duties, it repealed the labour laws, introduced a new sinking fund, reduced duties on manufactures and foreign imports, and repealed quarantine duties.

Huskisson had also been a member of the committee appointed to inquire into the causes of the agricultural distress of 1821 – this committee proposed a relaxation of the Corn Laws chiefly due to his strenuous advocacy. Sadly it was the potato famine in Ireland that eventually saw their repeal in 1846. It was the campaign to repeal the Corn Laws which eventually led to the next great clarion for free trade, the Cobden-Chevalier Treaty of 1860. The treaty reduced French duties on most British manufactured goods to around 30% and reduced British duties on French wines and brandy. During the next decade the value of British exports to France more than doubled whilst French wine imports increased by 100%.

Richard Cobden (1804 – 1865) had founded the Anti-Corn Law league in 1838. That the current TPP has taken just five years is therefore encouraging. Cobden is a giant in the annals of free-trade, to find out more about this extraordinary man and the relevance of his ideas today please visit The Cobden Centre. A recent post – No more “Free-Trade” treaties: it’s time for genuine free trade – is an excellent example of their important work:-

Murray Rothbard opposed NAFTA and showed that what the Orwellians were calling a “free trade” agreement was in reality a means to cartelize and increase government control over the economy. Several clues lead us to the conclusion that protectionist policies often hide behind free trade agreements, for as Rothbard said, “genuine free trade doesn’t require a treaty.”

The Cobden-Chevalier Treaty spawned a cascade of bilateral FTAs across Europe. By some estimates these agreements reduced tariffs in Europe by 50%. Sadly as the world economy entered a recession in 1873 the enthusiasm for free trade began to wane. The First World War saw the situation deteriorate further, whilst the great depression of the 1930’s heralded an increase in nationalism which went hand in hand with protectionism.

According to the World Trade Organisation (WTO) – established in 1995 in the wake of the NAFTA agreement of 1994 – the General Agreement on Tariffs and Trade (GATT) of 1947 was the starting point for multilateral FTAs, although it was originally agreed between just 23 countries. This followed in the wake of the 1944 Bretton Woods Agreement which had established the IMF, World Bank and Bank for Reconstruction and Development. By 1951 the European Coal and Steel Community had been founded – later to become the EEC (1957).

Many other bilateral and multilateral agreements followed. For a more detailed investigation of the history of free trade, this WTO – Historical background and current trends 2011 – article is worth investigating. One point the WTO make in conclusion is:-

…despite the explosion of PTAs in recent years, 84 per cent of world merchandise trade still takes place on an MFN (Most Favoured Nation) basis (70 per cent if intra-EU trade is included).

Viewed from this perspective, the ideal of “Free Trade” still has far to go.

Other perspectives on the TPP

In this recent article Bruegal – Trans-Pacific Partnership: Should the key losers – China and Europe – join forces? the authors anticipate a Chinese response which could benefit the EU-

The winners are obvious: Obama and Shinzo Abe, arguably also the US and Japanese economies. Obama can leave office with a strong demonstration of the US pivot to Asia, and Abe can finally argue that the third arrow of his Abenomics program is not empty.

The losers are also obvious: China and Europe. China not only has been left out of the deal, but it has been left out on purpose. If anybody had any doubt (at some point China was invited into the negotiations and some still expect China to continue discussing membership in the future), Obama’s official statement on TPP yesterday makes it very clear: “when more than 95 percent of our potential customers live outside our borders, we can’t let countries like China write the rules of the global economy”. For China the issue is not only losing access to the US market but also the fact that its most important trading partners are in the deal, with the notable exception of Europe.

The fact that TPP has not yet being ratified by national parliaments still offers room for doubt as to TPP’s actual economic significance (exemptions from its coverage could spring out in every jurisdiction) but there is no doubt that it will be economically relevant. TPP covers 40 per cent of global trade and spans 800 million people. Not only will trade barriers be reduced to the minimum in virtually every sector (including generally protected ones such as agriculture) but also common standards will need to be used by all participants, be it for investment, environment or labour. In this regard, the primacy of the protection of brand names over the protection of geographical indications of agricultural products, or the priority of the protection of trade secrets over press freedom are cornerstones of the US success in its negotiations with TPP partners, which also shows the price that a country like Japan are willing to pay for US-led security. In the same vein, the high price to pay (in terms of US supremacy on the negotiation table) makes it all the more unlikely for China to seriously consider joining the bloc in the near future: the treatment of state-owned enterprises and data protection are two stumbling blocks. The latter is also a key deterrent for Europe’s TTIP negotiations.

They see a window of opportunity to the EU to negotiate a deal with China.

From a geo-political standpoint Chatham House – For the West, the Trans-Pacific Partnership Must Not Falter – see the TPP providing benefits which go well beyond economics:-

But the economic benefits are only one upside of the deal. While it is by no means assured, there could also be a significant geostrategic impact. The TPP was not the only Asian trade agreement of choice. China, for example, had been supporting an alternative Regional Comprehensive Economic Partnership. But the 12 TPP participants – the US, Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam –  sent a clear message regarding the kind of standards and rules they believe are best placed to provide the greatest benefit to their populations – from greater transparency and anticorruption to more free and open markets.

Western leadership

The TPP now sets the bar. If successful, in time other states will hopefully join including, most significantly, India, China and South Korea. But this will take time and the TPP has to prove itself first. Prospective member states will have to make extremely tough political choices in order to join and they and their populations will need to see meaningful tangible benefits first. But the door has been left open and if the TPP turns out to realize some of its potential, others could come knocking on the door.

This podcast from CFR – Trans-Pacific Partnership Trade Deal – gives a good global overview from both an economic and political perspective:-

…If you look at the U.S. negotiations with Europe—the Transatlantic Trade and Investment Partnership—if those come to fruition—and they’re on a somewhat slower track—you’re going to reach a position for the United States where two-thirds of its trade is covered under free trade arrangements of some sort of another.

…you’ve had a stalemate in the Doha Round for more than a decade now between the advanced economies—primarily the United States, Europe, Japan to some extent—and the big emerging economies—China, India, and Brazil. And they’re just at loggerheads over a whole series of issues, from, you know, farm subsidies in the U.S. and Europe to the pace of opening up manufacturing markets in the developing countries.

…The Europeans are always very conscious about not losing their relative trade advantages, and the possibility of Japan, and then if Korea docks on to the TPP as well—the possibility of those countries having better access to the U.S. market than European companies would enjoy, I think that will be a spur to action at the—at the U.N.

…Peterson Institute, for example, thinks that Japan is going to gain upwards of $119 billion in absolute gains from TPP.

…TPP is an instrument of Abenomics, the broader structural reorganization inside Japan, and it leverages for Abe all kinds of transformations that would be difficult to accomplish by a Japanese government on its own.

…There’s some loud minority voices of criticism. But overall, the opinion polling in Japan has really embraced this notion of TPP participation.

…The LDP has long been the protector and party that has advocated on behalf of Japan’s farmers. It is now leading this agricultural reform, largely because Japan’s farmers are aging. They’re getting older. And there’s a demand from within the agricultural sector for these reforms and a more competitive-oriented agricultural policy.

Nonetheless, in some parts of Japan Abe’s party still is seen as betraying some of the core interests of its postwar conservative protections, and so he’ll have to tread a little bit carefully to make sure that he can pay off or make sure that the farmers will not be mistreated.

…Initially the rhetoric out of the Chinese government was reasonably hostile to TPP. That has softened in recent months. But clearly, to make the sorts of reforms that would be necessary to join the TPP would be a very big lift for China.

…if Congress rejects the TPP, that’s a slap in the face to 11 other countries, including close allies like Mexico, Canada, Japan, Australia, and New Zealand that have made difficult decisions domestically in order to be able to conclude the deal. So the thinking has always been, at the end of the day, Congress is going to be very reluctant to do that.

Countering the enthusiasm of Chatham House, The Diplomat – Could the TPP Actually Divide Asia? – cautions that there are geopolitical risks that the TPP will increase tensions in the region.

Firstly, South Korea:-

U.S.-Korea free trade agreement (KORUS) came into effect in March 2012. South Korea is undoubtedly a strong candidate to join the group, given that KORUS is seen as a gold standard for free trade deals. Nevertheless, the U.S.-Korea free trade pact largely exempted the politically sensitive Korean rice market. That alone will undoubtedly be a major political issue for all member countries should Korea negotiate entry into the pact, and it will certainly be a source of contention with Japan, a founding member of the TPP that was forced to make concessions on its equally politically sensitive rice market. 

Then, Taiwan:-

The Taiwanese government has made clear that it hopes to be one of the first entrants to the TPP, not only to further its position as a global exporter, but also to encourage domestic reform that is critical if Taiwan is to remain competitive. Given its experience in joining the World Trade Organization, whereby it had to wait until China was ready for accession in 2001 so that it could join at the same time, there is growing concern that Taipei would have to wait again for Beijing to be ready. The frustration of being unable to join a group that is seen as key to Taiwan’s growth will undoubtedly strain cross-Strait relations.

And finally, the undermining of existing agreements:-

The Regional Comprehensive Economic Partnership (RCEP) includes not only all 10 ASEAN countries, but also China, Japan, South Korea, India, Australia, and New Zealand. Critics of the RCEP have been quick to dismiss the pact as aiming at lower standards compared to the TPP, and as focused too heavily on relatively unambitious tariff barrier reductions. Moreover, it is seen as a Chinese-led initiative that does not include the United States. Yet the fact that RCEP brings hitherto unlikely partners such as Burma and Cambodia into the fold of regional trade agreements in itself should be heralded as a significant development that has already achieved what is one of the major longer-term goals of TPP, namely to encourage nations to adopt internationally developed rules and standards. 

To round off the arguments for and against here is Mish Shedlock – Hillary Clinton, Dead Rats, Toilet Paper Politics – he’s definitively unimpressed:-

Every country is a firm believer in free trade for exports, but no country wants free trade for imports. Obviously, that cannot work mathematically, which is precisely why the deal had to be negotiated in secret and has taken five years to produce questionable results. …The New York Times reports “Trans-Pacific Partnership Seen as Door for Foreign Suits Against U.S.“. WikiLeaks analysis explains that this lets firms “sue” governments to obtain taxpayer compensation for loss of “expected future profits.” This agreement is a lawyer’s fantasyland dream come true. Corporations will be suing governments left and right over “expected future profits.” For example, Australia would not sign the deal unless it obtained a waiver for health warnings on cigarette packages that are more stringent than elsewhere. Apparently, all other lawsuits are fair game. And it will be taxpayers who pay the bill. Imagine the lawsuits over GMOs (genetically modified organisms). Monsanto will be suing every country that blocks its GMO products.

…I propose TPP will create a nightmare of worldwide lawsuits at taxpayer expense, while doing nothing that will genuinely advance free trade. Mish Free Trade Proposal As I have stated numerous times, I am in favor of free trade. An excellent free trade agreement would consist of precisely one line of text: “All tariffs and all government subsidies on all goods and services will be eliminated effective immediately”. I maintain that the first country that does that will be the beneficiary, regardless of what any other country does!

Conclusions and investment opportunities

The TPP has 30 chapters to be analysed. It will probably under-deliver as Shedlock indicates, however, perception that large scale, multilateral free-trade negotiation is back on the agenda, after such a long absence – NAFTA was back in 1994 – is likely to be supportive for markets

Country level benefit to financial markets

  • Japan will benefit from the external assistance it lends to the policies of Abenomics. Japanese agriculture will be negatively affected but internal subsidies will mitigate its impact. The TPP should have a strong positive influence on the Nikkei. This will help support JGB yields but is unlikely to cause a significant increase in the JPY if the BoJ continues with its QQE policy..
  • Singapore should benefit, providing goods and services to its Asian neighbours. The Straits Times Index should be supported and the SGD is likely to appreciate.

Sectoral stock market effects

  • US, Canadian, Australian and New Zealand agricultural businesses should reap significant benefits over time – especially Australian sugar refineries – whilst agro-business in Japan will be impaired.
  • Vietnam’s apparel manufactures should have improved terms of trade, as will Malaysian Palm Oil producers.
  • Companies in the Japanese and US auto-industry will benefit.
  • US pharmaceutical companies will benefit.
  • IT companies, especially from the US but also Japan, will benefit.

In the long run, other countries, including South Korea, Taiwan and perhaps even China, may join the TPP. Uncertainty still revolves around final approval of the treaty by the US, but, as more information begins to emerge, investment flows will start to influence equity prices across certain sectors and, more broadly, on a country specific basis.

Brazil – Good buy or Goodbye?


Macro Letter – No 43 – 09-10-2015

Brazil – Good buy or Goodbye?

  • The Bovespa is down 35% in US$ terms this year
  • Government bond yields are back to levels last seen during the crisis of 2009
  • The BRL has declined by 45% against the US$ during 2015
  • Bond agency downgrades and government inaction exacerbate the sense of crisis

When I last gave a speech about the Brazilian economy and stock market prospects, back in March 2014, I was optimistic. During the summer of that year the Bovespa rallied, USDBRL improved and Brazilian government bond yields declined, but by early September these nascent trends had lost momentum. The table lower shows the evolution:-

Market 28-Mar 29-Aug 28-Dec 05-Oct
Bovespa 50415 61288 48512 47033
10yr Bond 12.8 11.21 12.33 15.23
USDBRL 2.27 2.23 2.69 3.92


The charts below show these markets over the last 10 years:-

brazil-stock-market 10 yr - Trading Economics

Source: Trading Economics

brazil-government-bond-yield 10yr - Trading Economics

Source: Trading Economics

brazil-currency 10yr - Trading Economics

Source: Trading Economics

For good measure, and since Brazil’s economy is sensitive to the price of commodities here is the Goldman Sachs Commodity Index over the same period:-

GSCI 10 yr

It is worth remembering that, despite the importance of commodities – and Coffee made fresh lows for the year in September – the largest contributor to Brazilian GDP is services (67%).

During the second half of 2014, inflation remained broadly stable at around 6.75%, but, as the BRL weakened, inflation picked up sharply forcing the Bank of Brazil to raise interest rates, meanwhile the government primary budget surplus evaporated:-

Brazil Budget Balance Inflation and Policy Rate - Economist

Source: Economist

This 2nd September Economist article – Brazilian waxing and waning – sums up the range of negative forces besetting the Brazilian economy:-

In the past few years Brazil’s economy has disappointed. It grew by 2.2% a year, on average, during President Dilma Rousseff’s first term in office in 2011-­14, a slower rate of growth than in most of its neighbours, let alone in places like China or India. Last year GDP barely grew at all. It contracted by 1.6% in the first quarter, compared to the same period last year, and is expected to shrink by as much as 2% in 2015. Household consumption registered the first drop, year-on-year, since Ms Rousseff’s left-wing Workers’ Party (PT) came to power in 2003. At the same time, public spending has surged. In 2014, as Ms Rousseff sought re-­election, the budget deficit doubled to 6.75% of GDP. For the first time since 1997 the government failed to set aside any money to pay back creditors. Its planned primary surplus, which excludes interest owed on debt, of 1.8% of GDP ended up being a 0.6% deficit. Brazil’s gross government debt of 62% may look piffling compared to Greece’s 175% or Japan’s 227%. But Brazil’s high interest rates of around 13% make borrowing costlier to service.

…As the government loosened fiscal policy, the Central Bank prematurely slashed its benchmark interest rate in 2011-­12. This pushed up inflation, which is now above the bank’s self­-imposed upper limit of 6.5%, and way above its 4.5% target. The interest-rate cut has since been reversed. On June 3rd the Bank’s monetary policy-makers raised the rate once more, boosting it to 13.75%, more than a percentage point higher than before the decision to cut.

…In the past ten years wages in the private sector have grown faster than GDP (public­-sector workers have done even better). That allowed consumers to borrow more, which encouraged still more spending. Now the virtuous circle is turning vicious. Real wages have been falling since March, compared to a year earlier, mainly because Brazilian workers’ productivity never justified the earlier rises.

…unemployment, which has long been falling and dipped below 5% for most of 2014, increased to 6.4% in April. Economists expect it to reach 8% this year.

…the government is cutting spending on unemployment insurance (which had risen even when the jobless rate was falling) and on other benefits. Taxes, including fuel duty, are going up. So, too, are bills for water and electricity.

…Consumer confidence has fallen to its lowest level since Fundação Getulio Vargas, a business school, began tracking it in 2005. The government has no money to boost investment. Petrobras, the state-­controlled oil giant and Brazil’s biggest investor, is in the midst of a corruption scandal that has paralysed spending: the forgone investment may reduce GDP growth this year by one percentage point. It is hard to see where growth will come from. 

Worst of all, Ms Rousseff’s policy levers are jammed. She cannot loosen fiscal policy without precipitating a downgrade of Brazil’s credit rating. In fact, her hawkish finance minister, Joaquim Levy, has slashed 70 billion reais off the discretionary spending planned for this year (on top of the modest welfare reforms). Nor can the Central Bank ease monetary policy. That would once again undermine its credibility—and weaken the currency. A depreciating real, which is oscillating around a 10-year low, pushes up inflation; it also makes Brazil’s $230 billion dollar-denominated debt dearer by the day.

This chart, courtesy of the Peterson Institute, highlights the relative predicament facing Brazil’s government:-

EM debt and tax balance - IMF

Source: IMF

On September 9th – one week after the Economist article was published – S&P cut Brazil’s bond rating to BB+ – this is “Junk Bond” status. It followed Moody’s downgrade to Baa3 on August 11th. There seems little reason to “Buy Brazil”, but it is when markets look most dire that one should pay the most attention.

In May 2015 I wrote about the prospects for Brazil and Russia here – once again, I was anticipating the rebound in commodity prices coming to the aid of these commodity exporters – yet again, I was premature. The economic slowdown in China continues, commodity exporting countries remain under pressure and, from a technical perspective, the GSCI appears to be heading back to test the 2009 lows.

My conclusions about Brazilian Real-Estate have become slightly more negative since May. The recent increase in domestic inflation, combined with a rise in unemployment, makes rental yields – ranging from 4 to 6% – less attractive. Real yields have grown more negative whilst rental arrears and defaults rise.

Government bonds also lack their previous allure; short term rates rose again from 13.75% to 14.25% at the end of July. Back in March 2014 the SELIC rate was 10.75% whilst 10yr government bonds yielded 12.80% – 205bp of positive carry. Today the yield pick-up is worth a mere 48bp. My analysis of value, back in May, was based on the expectation that the currency had weakened sufficiently and commodity markets were forming a bottom – both these expectations proved erroneous. Since the currency has weakened further, corporate bonds are likely to come under additional pressure due to the large outstanding US$ issuance:-

EM Bonds - USD Exposures - Bloomberg

Source: Bloomberg and Strategas Research Partners

The IMF – May 2015 Brazil – selected report 15/122 – suggests that the situation is not quite so dire as the table above suggests, nonetheless, I would expect to see a rise in the number of high-profile defaults over the coming months:-

Petrobras accounts for some 13.5 percent of total NFC FX debt. It hedged 70 percent of its FX exposure through both domestic and global derivative markets despite ample FX income.9

Other exporting companies account for 36 percent of FX debt.

Non-exporting companies with at least 80 percent of their FX debt hedged in domestic derivatives markets account for 17 percent of FX debt.

Non-exporting companies (both foreign-owned and domestic firms) with hedge for less than 80 percent of their exposures account for 33.5 percent of NFC FX debt,10 or about 10 percent of total debt (Financial Stability Report, September 2014).

The solitary ray of hope has been the Bovespa, it is substantially lower than in May though not far from where it ended 2014. The table below looks at the CAPE – Cyclically Adjusted Price Earnings Ratio, PE, PC – Price to Cashflow, PB – Price to Book, PS – Price to Sales and DY – Dividend Yield:-

Russia 4.8 8.8 3.7 0.8 0.7 4.30%
Hungary 7.9 23.4 4.1 1 0.5 2.50%
Brazil 8.2 19.4 5.8 1.3 1.1 3.70%
Poland 10.3 14.1 9.5 1.3 0.8 3.40%
Turkey 10.3 11 8 1.4 1 3.40%
Czech 10.7 14.3 6.2 1.4 1.1 6.10%
Korea (South) 12.2 12.9 6.3 1 0.6 1.40%
China 13.8 6.2 4.1 0.9 0.6 4.90%
Malaysia 15.6 16.1 10.8 1.7 1.9 3.40%
Thailand 15.7 17 10 2 0.9 3.20%
Indonesia 17 17.9 12.3 3.1 2.2 2.60%
Israel 17.4 16.5 11.1 1.8 1.4 2.80%
Taiwan 17.8 11.5 7.3 1.7 0.9 4.10%
India 18.5 21.5 13.7 2.6 1.5 1.50%
South Africa 19.2 14.6 8.5 2.2 1.3 3.60%
Mexico 21.2 26.9 11.9 2.6 1.5 1.90%
Philippines 22.3 19.5 12.7 2.4 2 1.90%


I’ve ranked these markets by CAPE to look at valuation from a longer-term perspective. Remember, however, the Bovespa index has only a 14% exposure to Energy and 14% to Commodities; domestic consumption will drive growth for many Brazilian companies – the consumer is likely to be in cyclical retreat as wages and benefits fall. Exporters should thrive due to the currency devaluation but for the broader index these effects will take time to manifest themselves in higher stock prices. My longer-term enthusiasm from May remains undimmed, but I was clearly too early calling the bottom. With China still slowing, the headwinds facing Brazil have yet to fully abate.

Emerging markets in general, are under pressure. Back in January 2014 the World Bank Global Economic Prospects stated:-

…if markets react sharply to the continued tapering, then capital flows to developing countries could decrease by as much as 80 percent, destabilizing current account balances, leading to disorderly depreciations of regional currencies, and quite possibly, increasing imported inflation.

They estimated that 60% of all capital flows to emerging markets, since the financial crisis, have been a by-product of QE.

The IMF – WEO – Financial Stability Report – October 2015 – reviews the situation:-

Corporate debt in emerging market economies has risen significantly during the past decade. The corporate debt of nonfinancial firms across major emerging market economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014. The average emerging market corporate debt-to-GDP ratio has also grown by 26 percentage points in the same period, but with notable heterogeneity across countries.

EM Debt to GDP now stands at roughly 70%.

The Institute of International Finance estimate that investors sold $40bln of EM assets during Q3 2015. Brazil topped their list for asset outflows in Q3 – a 27% decline – closely followed by Indonesia and China:-

The marked decline in EM bond and equity in fund allocations amounted to some 80% of the drop seen during the worst of the taper tantrum in Q2 2013. This has left fund allocations to EM bonds and equities nearly 1.5 percentage points below end-June levels–at just 11%, EM allocations are at their lowest since early 2009. The decline in global investors’ appetite for emerging market stocks has been particularly striking, with EM equity funds suffering more than EM bond funds. Large fund outflows, falling asset prices and marked losses in EM currencies against the U.S. dollar have all contributed to lower allocations.

The IIF go on to state that this year EM countries will witness a capital outflow of $541bln for 2015 vs a net inflow of $32bln for 2014. These are the first EM outflows since 1988.

No way out?

In a recent Bloomberg Op-Ed – The Anatomy of Brazil’s Financial Meltdown – Mohamed El-Erian proposes official “Circuit-Breakers” to stop the vicious cycle. Peterson InstituteA Non-Circuit Breaker Agenda for Brazil – disagree:-

What are the options for Brazil? With interest rates at 14.25 percent, there is unfortunately little room for further rate hikes. With short-term domestic rates at these levels and global interest rates at close to zero, one would be hard pressed to argue that remedies used in the 1990s—specifically abrupt interest rate hikes of a high order of magnitude—would make a big impact on reversing capital outflows. If market pressures continue unabated and exchange interventions are ineffective, Brazil might well need to resort to capital controls. A further credit downgrade might follow, and the stage would be set for the type of inevitable crash that many economists imagined they would no longer see. While a crisis cannot be fully avoided—arguably, it is already happening—the government could still take some action to instill confidence. A strong commitment to prudent fiscal management over the medium term might help attenuate market turbulence even if the government’s hands are tied in the short run by political dysfunction. Instituting debt limits as discussed above would be a good start; Poland’s experience is testament to how fiscal credibility can be enhanced through their adoption. In Brazil’s case, debt limits have an additional advantage: They would send the right medium-term signals without being as overtly unpopular as the other measures and reforms the country desperately needs.

“Circuit-Breaker” policy proposals and the spectre of capital controls are unlikely to stem capital flight in the near-term, but with EM exposures already back to 2009 levels, I believe we’re nearer the end than the beginning of the repatriation process.

Conclusions and Investment Opportunities

For investment to return to Brazil, repatriation of existing investment needs to run its course, corporate bond defaults need to peak and begin to improve, unemployment needs to rise and then begin to decline and the government needs to prove it has the resolve to adhere to a policy of real austerity.


The BRL is the weakest it has been in more than 20 years, it last approached these levels back in October 2002. Foreign Exchange reserves remain high, I would expect the markets to test the central bank’s resolve. Further currency weakness certainly cannot be ruled out.


The full impact of recent currency weakness on Brazilian US$ denominated bonds has yet to run its course. Default rates should rise, the Serasa Experian Corporate Default Index rose 13.3% in the period January to August 2015, meanwhile, corporate delinquencies for the month were 16.1% higher than in August 2014.


According to Blackrock investors outflows from EM ETFs in September exceeded $3.2bln, albeit, sentiment has improved over the past week. The chart below shows EM stock market performance for the year to 6th October, Brazil has suffered more than every country except Greece:-

EM Stocks in USD - 2015

Source: Reuters

For the contrarian investor this may present an opportunity to buy – personally, I would prefer to see some indication of government resolve to tackle the countries difficult domestic economic issues first. Next year Brazil will host the Olympic Games – this is an opportunity to push through unpopular policies and showcase all the reasons to invest in Brazil. It is always darkest before the light – I shall be watching closely.







Will Europe benefit economically from the migrant crisis?


Macro Letter – No 42 – 25-09-2015

Will Europe benefit economically from the migrant crisis?

  • The EU is expecting to receive 750,000 asylum applications in 2015 – it may be more
  • Net EU immigrant numbers fell from 748,000 to 539,000 between 2010 and 2013
  • By 2030 the EU will need more than 50mln extra workers to maintain the participation rate
  • Massive infrastructure investment is needed and EU government debt is likely to rise

Last week I met a friend at a café on Hanbury Street, beyond Brick Lane. This is the old East End of London, beyond Spitalfields. I was last there in 1988 – it bears testament to the success of London that an area which was once down at heel, is now clearly on the rise. The ethnic mix is extraordinary, but with a strong Asian bias.

This journey set off a train of thought about the demographic needs of the UK – along with many other European countries – and the current immigrant crisis. Added to this eclectic web of inter-connections are some ideas I’ve been forming about the future of education and healthcare.

The UK – an historical perspective on Refugees and Immigrants

The word refugee was coined during England’s first “refugie” crisis, when Protestant French Huguenots escaped persecution in Catholic France. The “exodus” – clearly this wasn’t the first refugee crisis in history – gathered momentum after Louis XIV revoked the Treaty of Nantes in 1685. As early as October 1681, The Protestant Mercury – a pamphlet distributed in London during the period – reported 600 Huguenots fleeing La Rochelle in four crammed boats. The map below shows the destination of the Huguenot diaspora over the period:-

Hugenot diaspora

Source: The Huguenot Society

The great trading nations of the Netherlands and England, took the lions share (50%).

Of the Protestant Huguenots who came to England, more than half settled in London. Their arrival caused social tension but they had an advantage in that Londoners were, for the most part, fiercely anti-Catholic. The Proceedings of the Old Bailey contains an interesting short history of the period:-

The traditional and virulent anti-Catholicism of Londoners, in combination with propaganda depicting the atrocities committed against Protestants in France, ensured that the refugees had a surprisingly warm welcome. Despite threatened riots against French weavers in the East End in 1675, 1681 and 1683, and vocal opposition to the creation of a new French church at St Martin Ongars, there appears to have been little physical violence directed against the French refugees. More positively, particularly after the Glorious Revolution in 1688 and the accession of William and Mary, Huguenots received a remarkable level of charitable support. At the end of the seventeenth century, for example, some £64,713 was raised by royal brief for their relief, while William and Mary donated £39,000 to help Huguenot resettlement between 1689 and 1693 alone.

At the same time, the concentration of French speaking immigrants in well defined communities ensured the survival of a distinctive culture and identity for several generations. Both their language and fashions set the French apart, and there were complaints about their unfamiliar diet. But they acquired a certain respectability. Even in 1738, William Hogarth could contrast the clothing and behaviour of a French Protestant congregation leaving church with the poverty, squalor and sexual immorality of other Londoners. And many prospective English gentlemen about to set off on the Grand Tour made an initial visit to the East End to polish their language skills.


Source: William Hogarth collection

If you are interested in the life and times of William Hogarth, I recommend a visit to the small Hogarth Museum, next to Chiswick House, in west London.

I was struck by the length of time it took for the Huguenot’s to become integrated in society. More than 50 years after the revocation of the Treaty of Nantes they still formed a distinct minority – much like the Bangladeshi community today.

Fresh from the Huguenot influx, England rose to the challenge again. In 1709 during the reign of Queen Anne, the Poor Palatines arrived – more than 13,000 – although many were en route to the New World. Towards the end of the 19th century more than 120,000 Jews arrived in Britain, fleeing persecution in Tsarist Russia and Eastern Europe – many settled in the area of London originally inhabited by the Huguenots. In fact the L’Eglise de l’Artillerie near Spitalfields, originally a site of Huguenot worship, built 1766, has been a Synagogue since 1840. This article from the Jewish Museum contains a concise history: –

Between 1881 and 1914 over 2 million Jewish people left Russia, Poland and the Hapsburg Empire. While the majority went to the United States, around 150,000 settled in Britain, mainly in areas near the docks where they had arrived, in the East End of London and in regional centres such as Manchester, Leeds, Glasgow and Liverpool.

Between the first and second world wars, Britain accepted a further 70,000 Jews, fleeing persecution. After 1945, more than 250,000 displaced Europeans became British citizens. From 1968 to 1974 the UK witnessed the arrival of 70,000 Asians, mainly of Kenyan and Ugandan origin. Many of these Asians, together with those from India, Pakistan and Bangladesh, now inhabit distinct areas around Greater London.

One building which epitomises London’s approach to immigration is the Brick Lane Mosque. It is a tribute to the success with which the UK, and our European neighbours, can deal with a constant influx of immigrants – the perennial pattern of, at least, the last 300 hundred years. The building that houses this Mosque was previously the Spitalfields Great Synagogue, however, it was built originally in 1743 as a French Protestant Church. Sadly Europe has an, at best, chequered record on assimilation and acceptance of ethnic minorities.

At the risk of being incendiary, the economic benefits of immigrant workers are always mixed. On average, immigrant workers are more ambitious – they had the courage to leave their home countries in search of a better life. They are inclined to work harder, will encourage their children to achieve more academically and economically: and they value the benefits offered by the government of their new domicile more highly than the indigenous population – theirs’ is not generally a culture of entitlement. All these aspects benefit society as a whole, but, immigrants also bring their own culture which, whilst additive in terms of diversity, may be at odds with the traditions of their adopted country. Immigrants are also more likely to take the jobs of the indigenous population – especially more menial roles. In the short-term they may impose a burden on their adopted country, yet in the long-run they repay the host countries investment with interest.

Carefully planned government policy is essential to minimise the economic and social tensions created by the boon of migrant workers, however, history is littered with examples of failure. For example, the Huguenots became prominent in silk weaving, but as China began to export fine quality cloth, during the second half of the 18th century, the British government passed in the Spitalfields Acts, this article from the Von Mises Institute takes up the story: –

The Spitalfields Act of 1773 mandated that local magistrates in designated silk-manufacturing districts, but not in the country, set the “wages and prices of work” masters could offer journeymen. In practice it actually controlled the piece-rate price of goods produced by labor. The exact rate masters could pay journeymen was set, with no leeway. Paying above or below the price subjected the master to severe fines. Work done with machines was paid at the same rate. One could only have two apprentices, (presumably to keep down the number of workers paid apprentice wages).

I shall leave it to the Von Mises Institute to rail against price controls – suffice to say the Spitalfields Acts, whilst reducing social tension in the short term, heralded the demise of the entire silk weaving industry in the long run. The acts were finally repealed in 1824.

The European Asylum Crisis of 2015

Today’s refugee crisis is the largest Europe has faced since 1945. The Economist – Europe’s migrant acceptance rates – described it thus:-

Not since the second world war has Europe faced refugee flows of such complexity and scale as this summer’s migrant crisis. The protests reported on September 1st involving hundreds of migrants at a railway station in Budapest—after Hungarian police barred their ongoing travel into Europe—were just the latest in a series of recent flashpoints from Calais to the Macedonian border.

The chart, which accompanied this article, says much more about the impact on a country by country basis. The data is from 2014 – this year Germany is expected to receive a four-fold increase.

EU-Asylum acceptance rates

Source: Economist

The map below – from Mish Shedlock – shows the potential number of immigrant/refugees displaced by the Syrian civil war, of whom may be heading for the EU:-

Displaced Refugees Mercury Corp

Source: UNHCR, Global Economic Trend Analysis

Europe’s Demographic Cliff

Many books have been written over the past decade about the ageing of western society. Medical science continues to extend our “three score years and ten” whilst redistributive taxation, combined with house price inflation, among other factors, has helped to discourage procreation. 2013 saw the publication of The Demographic Cliff by Harry Dent – this 2013 Business Insider interview provides a precis:-

Young people cause inflation because they “cost everything and produce nothing.” But young people eventually “begin to pay off when they enter the workforce and become productive new workers (supply) and higher-spending consumers (demand).”

Unfortunately, the U.S. reached its demographic “peak spending” from 2003-2007 and is headed for the “demographic cliff.” Germany, England, Switzerland are all headed there too. Then China will be the first emerging market to fall off the cliff, albeit in a few decades. The world is getting older.

…The worst economic trends due to demographics will hit between 2014 and 2019.

“The everyday consumer never came out of the last recession.” The rich are the ones feeling great and spending money, as asset prices (not wages) are aided by monetary stimulus.

The U.S. and Europe are headed in the same direction as Japan, a country still in a “coma economy precisely because it never let its debt bubble deleverage,” Dent argues. “The only way we will not follow in Japan’s footsteps is if the Federal Reserve stops printing new money.”

“The reality is stark, when dyers start to outweigh buyers, the market changes.” It all comes down to an aging population, Dent writes. “Fewer spenders, borrowers, and investors will be around to participate in the next boom.”

The U.S. has a crazy amount of debt and “economists and politicians have acted like we can just wave a magic wand of endless monetary injections and bailouts and get over what they see as a short-term crisis.” But the problem, Dent says, is long-term and structural — demographics.

Businesses can “dominate the years to come” by focusing on cash and cash flow, being “lean and mean,” deferring major capital expenditures, selling nonstrategic real estate, and firing weak employees now.

The big four challenges in the years ahead will be 1) private and public debt 2) health care and retirement entitlements 3) authoritarian governance around the globe and 4) environmental pollution that threatens the global economy.

Germany has announced that it will take up to 800,000 Syrian refugees this year and is in a position to receive a further half-million per year thereafter. This is not unalloyed altruism, Germany has the fastest ageing population in Europe. Its workforce – 20 to 65 years – will fall from 61% of the total population this year, to 54% by 2030. During the same period her overall population is expected to fall from 82mln to 78mln, whilst life expectancy will rise from 81 to 83 years for men and 83 to 85 years for women. In other words, Germany needs at least 5.5mln people of working age between now and 2030 to make up the shortfall, and her entire workforce need to retire two years later.

The Table below is from 2014 and shows the demographic breakdown of Asylum applicants to the EU-28:-


Source: Eurostat  

Germany stands out in terms of numbers, however, only 67% of these asylum seekers are of working age. For the EU-28 the working age component is 74%, but it must be assumed that a significant proportion of women will not be actively seeking work. At 20mln, non-EU immigrants account for just 4% of the total and 5% of the working age population. This June 2015 document from the EC – Migration in the EU – has a selection of other information which is worth reviewing.

This 2012 article from the Economist – All about taking part – points to some positive trends among the Pakistani and Bangladeshi communities in the UK, but it is now more than 30 years since their arrival in the UK.

Asian Women labour market activity rate UK

Source: ONS, Economist

According to World Bank data, Syrian female labour force participation rates are low at 13%, the second largest source of asylum seekers, Afghanistan, is not much higher at 15%. The table below shows the labour participation rate for females, between 15 and 64, for a selection of countries which have a significant diaspora domicile within the EU:-

Country %
Afghanistan 16
Albania 45
Algeria 15
Bangladesh 57*
Egypt, Arab Rep. 24
India 27
Jordan 16
Lebanon 23
Libya 30
Macedonia, FYR 43
Moldova 38
Montenegro 43
Morocco 27
Pakistan 25
Saudi Arabia 20
Serbia 45
Sri Lanka 35
Syrian Arab Republic 14
Tunisia 25
Turkey 29
United Arab Emirates 47
West Bank and Gaza 15
Yemen, Rep. 25

Source: World Bank

*Bangladesh female participation is high due to agro-micro-finance and the garment industry – see this ILO report

By my rather unscientific estimate, only about 45% of the current influx of immigrants will participate in the labour force – at least initially. The table below shows the main countries of origin of EU asylum seekers in thousands for 2013 and 2014; –

Country 2013 2014
Syrian Arab Republic 50 122
Afghanistan 26 41
Serbia 22 31
Pakistan 21 22
Albania 11 17
Iraq 11 15
Bangladesh 9 12
Iran, Islamic Rep. 13 11
Macedonia, FYR 11 10
Algeria 7 7
Sri Lanka 7 5

Source: Eurostat

Germany would need to accept 800,000 immigrants per annum to address their demographic deficit. These need not – indeed, will not – be exclusively asylum seekers. The gloomiest forecast I’ve encountered, from the U.S. Census Bureau, estimates the EU will experience a 14% decrease in its workforce by 2030 – more than 50mln people – meanwhile the total population of the EU-28 is forecast to grow by 10mln to reach 518mln by 2030. The demographic dividend of immigrants is self-evident, as this Eurostat chart makes clear:-

Immigrants to EU 2013

Source: Eurostat

Sadly the greatest benefit is derived from the addition of female non-residents – the female participation rate of Syria (13%) and Afghanistan (15%) is sub-optimal.

This article from Eurostat – Being young in Europe today – demographic trends – provides more detail on the opportunities and challenges facing the young across the EU.

Messrs. Mauldin and Gartman chimed in this week – in Thoughts From the Front Line – Merkel Opens the Gates – Mauldin writes:-

Merkel’s immigration plan presents huge problems, given Germany’s generous retirement benefits and social programs. For every baby boomer that stops working, the country needs at least one person to start working. The US is in better shape only because we have enough legal immigrants to keep the demographic pipeline flowing. Even so, we will hit the wall at some point unless more and more potential retirees keep working.

Germany is in much deeper trouble on this point, and Merkel knows it. I suspect she wants to bring in quite a few million immigrants, somehow make good Germans out of them, and keep the economy humming.

My good friend Dennis Gartman wrote about this in his September 15 daily report:

But there is a very real demographic reason why Germany is so willing to take a surfeit of these refugees: German’s demographics demand it. Simply put, Germany’s population… and especially its indigenous… population is imploding swiftly and certainly.

Already there are very real shortages of young, skilled workers, and many German companies openly and regularly complain that they cannot hire enough workers to fill job vacancies because there are not enough workers available for those jobs.

Further, Germany needs younger workers to fill those jobs because it needs their salaries for the social welfare programs that Germany is so renowned for. Simply put, there are not enough workers paying into the social programs to pay for them at present, and this problem shall become worse, not better, unless Germany’s population swells measurably in the coming years and decades.

So, Ms. Merkel has a clear ulterior motive for her seeming generosity: she wants the present welfare system in Germany that benefits now and will even more greatly benefit more in the future her normal constituency. If Germans are going to retire they shall need either newly born Germans to take their place and pay into the social security systems or Germany shall need to “import” foreign workers. For now, it is the latter that Ms. Merkel is embracing.

The numbers seeking asylum in the EU rose from 431,000 in 2013 to 626,000 in 2014 – this year it will be higher still – but the total number of immigrants arriving in the EU declined from 748,000 in 2010 to 539,000 in 2013. The table below, from Eurostat, shows the main country origin of migrants to the EU in 2013:-

Country 000s
Morocco 47
China 42
Russia 28
Ukraine 26
India 26
USA 21
Syria 19
Pakistan 18
Brazil 18
Afghanistan 15
Somalia 15
Philippines 14
Turkey 14
Albania 14
Bangladesh 14

In total, emigrants from Turkey and Morocco top the Eurostat list of EU immigrant residents:-

Country 000s
Turkey 1,631
Morocco 1,374
China 737
India 653
Ukraine 608
Russia 562
Albania 521
Pakistan 421

According to the CIA Factbook the average age of the population of Turkey is 29.6, for Morocco 28.1, Syria is younger still at 23.3 whilst in Afghanistan it is 18.1 years. The EU-28 average age is 42.2 years. Turkey, with a population of 75mln, first applied to join what was then the EEC in 1987, the most recent negotiations took place in 2013. Her accession would solve the majority of the EU’s demographic problems, but Turkey’s integration would be a far from simple political and cultural process.


Whilst Europe’s demographic problems could be solved by immigration policy, an unskilled, uneducated workforce will not create the productivity growth required to insure social cohesion. Education is key, as this essay from the European Parliamentary Research Serivce – Higher education in the EU: Approaches, issues and trends – points out. The cost of education in the EU is lower for students than in the US – sadly the cost to the tax payer is higher, and the number of tax payers looks destined to fall unless immigrants fill the gap. The US spends 2.8% of GDP on higher education – the OECD average is 1.6%. Only 36% of US expenditure comes from public sources – the OECD average is 68%. Technology provides a tangible answer to the problem of affordable provision:-

In spite of the fact that the United States is still the global leader with 17% of international students, the EU is increasingly popular with the United Kingdom, France and Germany accounting respectively for 13%, 6%, and 6% of world students.

… While EU universities took more time to develop Massive Open Online Courses (MOOCs), they now account for approximately one quarter of MOOCs in the world and the numbers are constantly rising.

The accompanying March 2015 paper – Higher Education in the EU – provides some fascinating insights. Within the EU, Germany and Sweden have increased educational spending between 2008 and 2014 by more than 10% while the UK, Italy and Spain (among others) have cut expenditure by more than 10% – overall EU spending has declined in inflation adjusted terms. The cost of higher education in the US has surged 1120% over the past 35 years, four times faster than CPI.

Open Educational Resources – the forerunner to MOOCs – began to appear as early as the 1980’s and in 2001 MIT introduced their first free online content. Platforms such as Coursera, developed by Stanford University and eDx, funded by MIT and Harvard University, began to appear in 2011. There are now more than 2,400 MOOCs available, offered by over 400 Universities globally.

In 2013 a Harvard paper by Sergiy Nesterko – Evaluating Geographic Data in MOOCs – produced this registration data:-

Country Registrants
USA 42.30%
India 9.47%
Canada 3.81%
Australia 2.18%
Nigeria 2.11%
Brazil 1.97%
Spain 1.85%
Philippines 1.76%
Pakistan 1.66%
UK 1.41%

Coursera has 36% of the MOOC market – the map below – also from 2013 – shows how the global impact of MOOCs is evolving:-


Source: Cartography Lab

Gary Matkin – UC Irvine presentation at the Open Education Global 2015 conference shows how rapidly technology is transforming the way we learn. He shows that in the two years since 2013 the percentage of US student enrolling in MOOC’s has dropped to 34%, Europe has risen to 26% (with a wider range of language options encouraging enrolment) whilst Asia now accounts for 21% of the total. As of March 2015, Coursera had 249,000 students enrolled in Career Readiness courses and a further 683,000 enrolled in Undergraduate courses. The annual MOOC market, by extrapolation, is already 2.6mln students – and this assumes students take only one MOOC course per annum. This April 2014 article from Forbes – Moore’s Law Touches Education At Last — To Techies’ Delight – suggests I may be overly cautious, they estimate that 7.4mln student enrolled in more than 20mln classes between 2011 and April 2014. At that time only 100 universities were involved, that number has quadrupled in 18 months.

Having taken four of Coursera courses in the last two years, I have been amazed at the incredible diversity of the students enrolled, both in terms of geographic location, ethnic background and level of education – especially students from China, the Middle East and Africa.

MOOCs and other forms of online education have a long way to go in terms of structure and interactivity – they remain a pale substitute to traditional teaching methods, however, the total global market for higher education is forecast to double by 2025 to 262mln. Technology provides an affordable, scalable solution.

Conclusion and Investment Opportunities

In attempting to make predictions about the investment opportunities which will flow from a reversing of the demographic deficit, I see long-term growth in equities and real-estate. Nonetheless, between now and 2030 Europe needs to attract more than 50mln new workers. The challenge this entails is colossal and it is unlikely that the process will be smooth. I call my Macro Letter service “In the Long Run”, nonetheless the investment opportunities below are very long term in nature and I believe, after the recent, interest rate driven, bull-market, there will be better levels to invest over the next decade or so – there’s no rush.

Most commentators expect negative demographic trends in the EU to continue until at least 2060, with the associated economic costs that will involve. Whilst this may happen I believe two strong economic counter-trends are underestimated. Firstly, people will choose to work longer, especially as labour markets become more flexible, and secondly, immigrants will fill the declining workforce void.

Government finances will be stretched far more than is currently predicted. Housing must be provided – which in Germany may be relatively simple, but, for the rest of Europe, will require substantial changes to planning laws. Hospitals and schools will vie for public money more fiercely than in the past. Home schooling will become more common in the primary and secondary sector whilst MOOCs will evolve to fill the gap between university and the workplace. Technology will also help to reduce the cost of healthcare as this article by Stephen Duneier – Doctoring Deflation – explains – I quoted this article quite recently, I make no apology for quoting it again:-

In America, there are roughly 200,000 primary care physicians, plus 56,000 nurse practitioners and 31,000 physician assistants who work to support them. That adds up to 287,000 diagnosticians. They take in information through samples and questionnaires, run the results through their encyclopedic minds, which were developed through years of medical school and on the job experience, and spit out their findings. They then prescribe a course of action, many of which are ignored, and/or medication. For clarity’s sake, let me rephrase that. Primary care physicians and their colleagues collect data, run correlation analyses and present results. Sound like a job typically done by something other than a doctor?

Yes, I’m implying that as a diagnostician, the primary care physician’s role is very similar in nature to that of a computer. Here’s the catch though. Ironically, the very thing that once allowed doctors to add value and charge commensurate fees, namely their encyclopedic knowledge, is now their greatest shortcoming.

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Europe is heading inexorably into a pensions and healthcare crisis, public borrowing will balloon and developed nation QE will be required to keep these economies from imploding under the burden of debt and interest payments. The prospect is alarming to anyone of a Puritanical bias like myself, but, in these Macro Letters, I write about what I think will happen rather than what I think should.


As European governments’ tax base is eroded, they will be forced to borrow more. The ECB will be required to purchase a far larger proportion of the increased issuance. The yield curve may steepen during times of uncertainty, but the Euro will act as the main instrument of economic adjustment for the region. Asian currencies will tend to rise against the Euro and Germany, in particular, will benefit from the competitive advantages of a permanently weak currency. However, Germany will need to continue footing the bill for the profligacy of the rest of Europe – plus ça change. Debt will dampen growth and domestic inflation. Long-term returns will be disappointing, yet there will be plenty of tactical trading opportunities both long and short.


Near-term – at least the next 15 years – the demographic headwinds will remain unfavourable. Pensioners will draw-down on savings and divest themselves of assets. The young will continue to be discouraged from starting a family because of the escalating cost of childcare and burden of student loans, combined with the excessive cost of housing (excepting Germany) resulting from the artificially low level of interest rates and planning constraints. Finally, after retiree asset repatriation has run its course, currency depreciation will foster import price inflation, meanwhile wages will start to rise relative to capital as the absolute number of people in the workforce declines. Pensioners, having divested themselves of their more liquid stores of wealth, will begin to draw-down on property assets to supplement their inadequate pensions. In 15 to 25 years, depending upon the success of the EU immigration offensive, this demographic dynamic should begin to change.

The official retirement age across the EU will have to rise. More flexible part-time work will become far more prevalent. Retirees will defer asset liquidation for longer. The immigrant community, meanwhile, will begin acquiring assets, saving for their retirement and consuming as they start their own families. Equities will be supported by low interest rates in the near-term – 15 years – and offer value long-term as saving and investment finally rebounds.

What are the bond markets telling us about inflation, recession and the path of central bank policy?


Macro Letter – No 41 – 11-09-2015

What are the bond markets telling us about inflation, recession and the path of central bank policy?

  • Since January US Government bond yields have risen across the yield curve
  • Corporate bond yields have risen more rapidly as stock markets have retreated
  • China, Canada and Mexico have seen their currencies weaken against the US$

For several years some commentators have been concerned that the Federal Reserve is behind the curve and needs to tighten interest rates before inflation returns. To date, inflation – by which I refer narrowly to CPI – has remained subdued. The recent recovery in the US economy and improvement in the condition of the labour market has seen expectations of rate increases grow and bond market yields have risen in response. In this letter I want to examine whether the rise in yields is in expectation of a Fed rate increase, fears about the return of inflation or the potential onset of a recession for which the Federal Reserve and its acolytes around the globe are ill-equipped to manage.

Below is a table showing the change in yields since the beginning of February. Moody Baa rating is the lowest investment grade bond. Whilst the widening of spreads is consistent with the general increase in T-Bond yields, the yield on Baa bonds has risen by 30bp more than Moody BB – High Yield, sub-investment grade. This could be the beginning of an institutional reallocation of risk away from the corporate sector.

Bond       Spread over T-Bonds    
08-Sep 02-Feb Change 08-Sep 02-Feb Change
10yr US T-Bond 2.19 1.65 0.54 N/A N/A N/A
Baa Corporate 5.28 4.29 0.99 3.09 2.64 0.45
BB Corporate 5.55 4.86 0.69 3.36 3.21 0.15


Source: Ycharts and

The chart below shows the evolution of Baa bond yields over the last two years:-

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

The increase in the cost of financing for the corporate sector is slight but the trend, especially since May, is clear.

Another measure of the state of the economy is the breakeven expected inflation rate. This metric is derived from the differential between 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities:-

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

By this measure inflation expectations are near their lowest levels since 2010. It looks as if the bond markets are doing the Federal Reserve’s work for it. Added to which the July minutes of the FOMC stated:-

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

This is hardly hiking rhetoric.

The International perspective

The table below looks at the largest importers into the US and their contribution to the US trade deficit as at December 2014:-

Country/Region Imports Deficit
China $467bln $343bln
EU $418bln $142bln
Canada $348bln $35bln
Mexico $294bln $54bln
Japan $134bln $68bln

Source: US Census Bureau

The TWI US$ Index shows a rather different picture to the US$ Index chart I posted last month, it has strengthened against its major trading partners steadily since it lows in July 2011; after a brief correction, during the first half of 2015, the trend has been re-established and shows no signs of abating:-

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

A closer inspection of the performance of the Loonie (CAD) and Peso (MXN) reveals an additional source of disinflation:-

CAD and MXN vs USD 2yr

Source: Yahoo Finance

Focus Economics – After dismal performance in May, exports and imports increase in June – investigates the bifurcated impact of lower oil prices and a weaker currency on the prospects for the Mexican economy:-

Looking at the headline numbers, exports increased 1.2% year-on-year in June, which pushed overseas sales to USD 33.8 billion. The monthly expansion contrasted the dismal 8.8% contraction registered in May. June’s expansion stemmed mainly from a solid increase in non-oil exports (+6.8% yoy). Conversely, oil exports registered another bleak plunge (-41.0% yoy).

Should the U.S. economy continue to recover and the Mexican peso weaken, growth in Mexico’s overseas sales is likely to continue improving in the coming months.

Mexico’s gains have to some extent been at the expense of Canada as this August 2015 article from the Fraser Institute – Canada faces increased competition in U.S. market – explains:-

There are several possible explanations of the cessation of real export growth to the U.S. One is the slow growth of the U.S. economy over much of the period from 2000-2014, particularly during and following the Great Recession of 2008. Slower real growth of U.S. incomes can be expected to reduce the growth of demand for all types of goods including imports from Canada.

A second possible explanation is the appreciation of the Canadian dollar over much of the time period. For example, the Canadian dollar increased from an all-time low value of US$.6179 on Jan. 21, 2002 to an all-time high value of US$1.1030 on Nov. 7, 2007. It then depreciated modestly to a value of US$.9414 by Jan. 1, 2014.

A third possible explanation is the higher costs to shippers (and ultimately to U.S. importers) associated with tighter border security procedures implemented by U.S. authorities after 9/11.

Perhaps a more troubling and longer-lasting explanation is Canada’s loss of U.S. market share to rival exporters. For example, Canada’s share of total U.S. imports of motor vehicles and parts decreased by almost 12 percentage points from 2000 through 2013, while Mexico’s share increased by eight percentage points. Canada lost market share (particularly to China) in electrical machinery and even in its traditionally strong wood and paper products sectors.

There is fundamentally only one robust way for Canadian exporters to reverse the recent trend of market share loss to rivals. Namely, Canadian manufacturers must improve upon their very disappointing productivity performance over the past few decades—both absolutely and relatively to producers in other countries. Labour productivity in Canada grew by only 1.4 per cent annually over the period 1980-2011. By contrast, it grew at a 2.2 per cent annual rate in the U.S. Even worse, multifactor productivity—basically a measure of technological change in an economy—did not grow at all over that period in Canada.

With an election due on 19th October, the Canadian election campaign is focused on the weakness of the domestic economy and measures to stimulate growth. While energy prices struggle to rise, non-energy exports are likely to be a policy priority. After rate cuts in January and July, the Bank of Canada left rates unchanged this week, but with an election looming this is hardly a surprise.

China, as I mentioned in my last post here, unpegged its currency last month. Official economic forecasts remain robust but, as economic consultants Fathom Consulting pointed out in this July article for Thomson Reuters – Alpha Now – China a tale of two economies – there are many signs of a slowing of economic activity, except in the data:-

With its usual efficiency, China’s National Bureau of Statistics released its 2015 Q2 growth estimate earlier this week. Reportedly, GDP rose by 7.0% in the four quarters to Q2. We remain sceptical about the accuracy of China’s GDP data, and the speed with which they are compiled. Our own measure of economic activity — the China Momentum Indicator — suggests the current pace of growth is nearer 3.0%.

…although policymakers are reluctant to admit that China has slowed dramatically, the recent onslaught of measures aimed at stimulating the economy surely hints at their discomfort. While these measures may temporarily alleviate the downward pressure, they do very little to resolve China’s long standing problems of excess capacity, non-performing loans and perennially weak household consumption.

Accordingly, as China tries out the full range of its policy levers, we believe that eventually it will resort to exchange rate depreciation. Its recent heavy-handed intervention in the domestic stock market has demonstrated afresh its disregard for financial reform.

The chart below is the Fathom Consulting – China Momentum Indicator – note the increasing divergence with official GDP data:-


Source: Fathom Consulting/Thomson Reuters

A comparison between international government bonds also provides support for those who argue Fed policy should remain on hold:-

Government Bonds 2yr 2yr Change 5yr 5yr Change 10yr 10yr Change 30yr 30yr Change
08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb
US 0.74 0.47 0.27 1.52 1.17 0.35 2.19 1.65 0.54 2.96 2.23 0.73
Canada 0.45 0.39 0.06 0.79 0.61 0.18 1.48 1.25 0.23 2.24 1.83 0.41
Mexico 5.01* 4.13* 0.88 5.29 4.89 0.4 6.15 5.41 0.74 6.81 6.1 0.71
Germany -0.22 -0.19 -0.03 0.05 -0.04 0.09 0.68 0.32 0.36 1.44 0.9 0.54
Japan 0.02 0.04 -0.02 0.07 0.09 -0.02 0.37 0.34 0.03 1.41 1.31 0.1
China 2.59 3.22 -0.63 3.2 3.45 -0.25 3.37 3.53 -0.16 3.88 4.04 -0.16

*Mexico 3yr Bonds


Canada and Mexico have both witnessed rising yields as their currencies declined, whilst Germany (a surrogate for the EU) and Japan have seen a marginal fall in shorter maturities but an increase for maturities of 10 years or more. China, with a still slowing economy and aided by PBoC policy, has lower yields across all maturities. Mexican inflation – the highest of these trading partners – was last recorded at 2.59% whilst core inflation was 2.31%. The 2yr/10yr curve for both Mexico and Canada, at just over 100bps, is flatter than the US at 145bp. The Chinese curve is flatter still.

A final, if somewhat tangential, article which provides evidence of a lack of inflationary pressure comes from this fascinating post by Stephen Duneier of Bija Advisors – Doctoring Deflation – in which he looks at the crisis in healthcare and predicts that computer power will radically reduce costs globally:-

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Conclusions and investment opportunities

The bond yield curves of America’s main import partners have steepened in train with the US – Canada being an exception – whilst stock markets are unchanged or lower over the same period – February to September. Corporate bond spreads have widened, especially the bottom of the investment grade category. Corporate earnings have exceeded expectations, as they so often do – see this paper by Jim Liew et al of John Hopkins for more on this topic – but by a negligible margin.

The FOMC has already expressed concern about the momentum of GDP growth, commodity prices remain under pressure, China has unpegged and the US$ TWI has reached new highs. This suggests to me, that inflation is not a risk, disinflationary forces are growing – especially driven by the commodity sector. Major central banks are unlikely to tighten but corporate bond yields may rise further.


Remain long US$ especially against resource based currencies, but be careful of current account surplus countries which may see flight to quality flows in the event of “risk off” panic.


At the risk of stating what any “value” investor should always look for, seek out firms with strong cash-flow, low leverage, earnings growth and comfortable dividend cover. In addition, in the current environment, avoid commodity sensitive stocks, especially in oil, coal, iron and steel.


US T-Bonds will benefit from a strengthening US$, if the FOMC delay tightening this will favour shorter maturities. An early FOMC tightening, after initial weakness, will be a catalyst for capital repatriation – US T-Bonds will fare better in this scenario too. Bunds and JGBs are likely to witness similar reactions but, longer term, both their currencies and yields are less attractive.

An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?


Macro Letter – No 40 – 28-08-2015

An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?

  • The FOMC rate increase may be delayed
  • An equity market correction is technically overdue
  • Long duration bonds offer defensive value
  • The US$ should out-perform after the “risk-off” phase has run its course

It had been a typical summer market until the past fortnight. Major markets had been range bound, pending the widely-anticipated rate increase from the FOMC and the prospect of similar, though less assured, action from the BoE. The ECB, of course, has been preoccupied with the next Greek bailout, whilst EU politicians wrestle with the life and death implications of the migrant crisis.

What seems to have changed market sentiment was the PBoC’s decision to engineer a 3% devaluation in the value of the RMB against the US$. This move acted as a catalyst for global markets, commentators seizing on the news as evidence that the Chinese administration has lost control of its rapidly slowing economy. As to what China should do next, opinion is divided between those who think any conciliatory gesture is a sign of weakness and those who believe the administration must act swiftly and with purpose, to avoid an inexorable and potentially catastrophic deterioration in economic conditions. The PBoC reduced interest rates again on Wednesday by 25bp – 1yr Lending Rate to 4.6% and 1yr Deposit Rate to 1.75% – they also reduced the Reserve Ratio requirement from 18.5% to 18%. This is not exactly dramatic but it leaves them with the flexibility to act again should the situation worsen.

Markets, especially equities, have become more volatile. The largest bond markets have rallied as equities have fallen. This is entirely normal; that the move has occurred during August, when liquidity is low, has, perhaps, conspired to exacerbate the move – technical traders will await confirmation when new lows are seen in equity markets during normal liquidity conditions.

Has anything changed in China?    

The Chinese economy has been rebalancing since 2012 – this article from Michael Pettis – Rebalancing and long term growth – from September 2013 provides an excellent insight. The process still has a number of years to run. Meanwhile, pegging the RMB to the US$ has made China uncompetitive in certain export markets. Other countries have filled the void, Mexico, for example, now appears to have a competitive advantage in terms of labour costs whilst transportation costs are definitely in its favour when meeting demand for goods from the US. This April 2013 article from the Financial Times – Mexican labour: cheaper than China elaborates:-


Source: BofA Merrill Lynch

China’s economy continues to slow, a lower RMB is not unexpected but how are the major economies faring under these conditions?

US growth and lower oil prices?

I recently wrote about the US economy – US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment? My conclusion was that US stock earnings were improving. The majority of Q2 earnings reports have been released and the improvement is broad-based. This article from Pictet – US and Europe Q2 Earnings Results: positive surprises but no game changer which was published last week, looks at both the US and Europe:-

US earnings: strong profit margins and strong financials

Almost all S&P500 (456) companies published their Q2 results. At the sales level, 46% of companies beat their estimates; meanwhile, the corresponding number was 54% at the net profit level. Companies beat their sales and net profit estimates by 1.2% and 2.2% respectively, thus demonstrating strong cost control. Financials were big contributors as sales and net profit surprises came out at +0.5% and 1.5% respectively excluding this sector. Banks (37% of financials) beat sales estimates by 9% sales surprises and 8.4% at the net profit level. This sector’s hit ratio was especially impressive with 92% of reporting companies ahead of the street estimates. Oil and gas companies, which suffered from very large downgrades in 2015, reported earnings in line with expectations. Sales of material-related sectors (basic resources, chemicals, construction materials) suffered from the decline in global commodity prices, but those companies were able to post better than expected net profits. While positive, these numbers were not sufficient to alter the general US earnings picture. Thus the 2015 expected growth remains anaemic at 1.6% for the whole S&P500 and at 9.1% excluding the oil sector.

Q2 GDP came out at 2.3% vs forecasts of 2.6%, nonetheless, this was robust enough to raise expectations of a September rate increase from the FOMC.

European growth – lower oil a benefit?

The European Q2 reporting season is still in train, however, roughly half the earnings reports have now been published; here’s Pictet’s commentary:-

European earnings: positive surprises, strong banks but no substantial currency impact

A little more than half of Stoxx Europe 600 constituents published their numbers. Sales and net earnings surprises came out at 4% and 4.3% respectively. Excluding financials, the beat was less impressive with 0.8% at the sales level and 2.7% at the net income level. Banks had a strong quarter on the back of a rebound in loan volumes and improvements in some peripheral economies. This sector’s published sales and net income were thus 33% and 11% higher respectively than estimates. One of the key questions going into the earnings season was whether the very weak euro would boost European earnings. Unfortunately, this element failed to impact Q2 earning in a meaningful way. Investors counting on the weaker currency to boost European companies’ profit margins were clearly disappointed as this process remains very gradual. Thus, European corporates’ profit margins remain well below their US counterparts (11% versus 15%).

The weakness of the oil price doesn’t appear to have had a significant impact on European growth. This video from Bruegel – The impact of the oil price on the EU economy from early June, suggests that the benefit of lower energy prices may still feed through to the wider European economy, however they conclude that the weakening of prices for industrial materials supports the view that the driver of lower oil prices is a weakening in the global economy rather than the result of a positive supply shock. The views expressed by Lutz Kilian, Professor of Economics at the University of Michigan, are particularly worth considering – he sees the oil price decline as being a marginal benefit to the global economy at best.

When attempting to gain a sense of how economic conditions are changing, I find it useful to visit a country or region. The UK appears to be in reasonably rude health by this measure, however, mainland Europe has been buffeted by another Greek crisis during the last few months, so my visit to Spain, this summer, provided a useful opportunity for observation. The country seems more prosperous than last year – albeit I visited a different province – despite the lingering problems of excess debt and the overhang of housing stock. The informal economy, always more flexible than its regulated relation, seems to be thriving, but most of the seasonal workers are non-Spanish – mainly of North African descent. This suggests that the economic adjustment process has not yet run its course – unemployment benefits are still sufficiently generous to make menial work unattractive, whilst unemployment remains stubbornly high:-

spain-unemployment- youth unemployment rate

Source: Trading Economics

Euro area youth unemployment remains stubbornly high at 22% – down from 24% in 2013 but well above the average for the period prior to the 2008 financial crisis (15%).

If structural reforms are working, Greece should be leading the adjustment process. Wages should be falling and, as the country regains competitiveness, and employment opportunities should rise:-

greece-german unemployment-rate

Source: Trading Economics

The chart above shows Greek vs German unemployment since the introduction of the Euro in 1999. Germany always had structurally lower unemployment and a much smaller “black economy”. During the early part of the 2000’s it suffered from a lack of competitiveness whilst other Eurozone countries benefitted from the introduction of the Euro. Between 2003 and 2005 Germany introduced the Hartz labour reforms. Whilst average earnings in Germany remained stagnant its economic competitiveness dramatically improved.

During the same period Greek wages increased substantially, the Greek government issued a vast swathe of debt and unemployment fell marginally – until the 2008 crisis. Since 2013 the adjustment process has begun to reduce unemployment, yet, with youth unemployment (see chart below) still above 50% and migrants arriving by the thousands, this summer, it appears as though the economic adjustment process has barely begun:-

greece-german youth-unemployment-rate

Source: Trading Economics

Japan – has Abenomics failed?

Japanese Q2 GDP was -1.6% y/y, Q1 was revised to an annualised +4.5% from 3.9% – itself a revision from 2.4%, so there may be room for some improvement in subsequent revisions. The weakness was blamed on lower exports to the US and China – despite policies designed to depreciate the JYP – and a weather related lack of domestic demand. The IMF – Conference Call from 23rd July urged greater efforts to stimulate growth by means of “third arrow” structural reform:-

In terms of the outlook for growth, we project growth at 0.8 percent in 2015 and 1.2 percent in 2016, and potential growth over the medium term under current policies we estimate to be about 0.6 percent. Although this near-term growth forecast looks modest, we would like to emphasize that it is above potential and, therefore, we think that the output gap will be closing by early 2017.

Still, we need to emphasize that the risks are on the downside, including from external developments, weaker growth in the United States and China, and global financial turbulence that could lead to safe haven appreciation of the yen, which would take the wind out of the recovery to some degree.

The key domestic risks include weaker than expected real wage growth in the short term and weak domestic demand and incomplete fiscal and structural reforms over the medium term. These scenarios could result in stagnation or stagflation and trigger a jump in JGB yields.


Conclusions and investment opportunities

I want to start by reviewing the markets; here are three charts comparing equities vs 10yr government bonds – for the Eurozone I’ve used German Bunds as a surrogate:-

Dow - T-Bond 2008-2015

Source: Trading Economics

Eurostoxx - Bunds - 2008-2015

Source: Trading Economics

Nikkei - JGB 2008-2015

Source: Trading Economics

With the exception of the Dow – and its pattern is similar on the S&P500 – the uptrend in stocks hasn’t been broken, nonetheless, a significant stock market correction is overdue. Below is a 10 year monthly chart for the S&P500:-

S&P500 10yr


US Stocks

Looking at the chart above, a retest of the November 2007 highs (1545) would not be unreasonable – I would certainly view this as a buying opportunity from a shorter term trading perspective. A break of the October 2014 low (1821) may presage a move towards this level, but for the moment I remain neutral. This is a change to my position earlier this year, when I had become more positive on the prospects for US stocks – earnings may have improved, but the recent price action suggests doubts are growing about the ability of US corporates to deliver sufficient multi-year growth to justify the current price-multiples in the face of potential central bank rate increases.

US Bonds

T-Bonds have been a short term beneficiary of “flight to quality” flows. A more gradual move lower in stocks will favour Treasuries but FOMC rate increases will lead to curve-flattening and may completely counter this effect. Should the FOMC relent – and the markets may well test their mettle – it will be a reactive, rather than a proactive move. The market will perceive the rate increases as merely postponed. Longer duration bonds will be less susceptible to the vagaries of the stock market and will offer a more attractive yield by way of recompense when a new tightening cycle begin in earnest.

Europe and Japan – stocks and bonds

Since the recent stock market decline and bond market rally are a reaction to the exogenous impact of China’s economic fortunes, I expect correlation between the major markets to increase – whither the US so goes the world.

The US$ – conundrum

Finally, I feel compelled to mention the recent price action of the US$ Index:-

US Dollar Index


Having been the beneficiary of significant inflows over the past two years, the US$ has weakened versus its main trading partners since the beginning of 2015, however, the value of the US$ has been artificially reduced over multiple years by the pegging of emerging market currencies to the world’s reserve currency – especially the Chinese RMB. The initial reaction to the RMB devaluation on 12th August was a weakening of the US$ as “risk” trades were unwound. The market correction this week has seen a continuation of this process. Once the deleveraging and risk-off phase has run its course – which may take some weeks – fundamental factors should favour the US$. The FOMC is still more likely to raise rates before other major central banks, whilst concern about the relative fragility of the economies of emerging markets, Japan and Europe all favour a renewed strengthening of the US$.