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$. The FOMC is still more likely to raise rates before other major central banks, whilst concern about the relative fragility of the economies of emerging markets, Japan and Europe all favour a renewed strengthening of the US$.

Which way now – FTSE, Gilts, Sterling and the EU referendum?


Macro Letter – No 39 – 03-07-2015

Which way now – FTSE, Gilts, Sterling and the EU referendum?

  • Uncertainty is bad for business and the UK will struggle ahead of the referendum
  • Gilt yields have been around 150bps higher than Bunds over the last 25yrs
  • The DAX has substantially outperformed FTSE over the same period
  • Higher productivity is key to UK growth but, in the long run, demographics will help

Last week the UK Prime Minister began to debate EU treaty reform with his European counterparts. He has a long way to go. The deadline for a UK referendum on EU membership is the end of 2017 but an up-hill battle is likely because all EU countries must ratify treaty changes – the referendum will come before EU treaty changes have been agreed. In this letter I will review the history of UKs, uncomfortable, membership of the EU and previous renegotiations, compared with today’s proposals. I will then go on to consider the implications for Sterling, Gilts and UK Stocks should the UK decide to stay or go.

A brief history of the UK and the EU

The last time the UK voted on EU, or as it was then called, European Economic Community (EEC) membership, was in 1975. At that time the “yes” vote won by 67.5%. This took place only two years after first joining, previous attempts to join in 1961 and 1967 having been vetoed by French President de Gaulle.

British scepticism about the political ambitions of the Schuman declaration of May 1950 meant the UK failed to join the European Coal and Steel Community – established at the Treaty of Paris in 1951 – but spent much of the decade debating EEC membership. When the EEC was finally established in 1958, the UK opted out for two principal reasons: concern about its relationship with the Commonwealth and other international alliances, and its preference for free-trade over economic organisation and sectoral policies. At that time the UK was torn between two foreign policy strategies, one focused on the European Free Trade Area, the other on the General Agreement on Tariffs and Trades – the predecessor to the World Trade Organisation (WTO).

The 1974 treaty renegotiation, just a year after joining the EEC, was driven by three factors: free-trade versus political integration, the effects of the collapse of Bretton Woods and subsequent inflation on the UK economy – Sterling had been considered a quasi-reserve currency up to this point – and the size of UK contributions to the EEC budget which the UK government considered to be excessive.

The table below lists the 1974 UK government demands for renegotiation and the outcomes:-

Changes to CAP so as not to undermine free-trade None
Fairer financing of EEC budget Correcting mechanism
Withdrawal of UK from EMU Accepted
Retention of UK powers over regional, industrial and fiscal policy Creation of Regional Development fund supported by Ireland and Italy
Agreement on capital movement to protect UK jobs and balance of payments None
No harmonisation of VAT Never planned anyway
Access to Commonwealth goods Minor concessions

The next major test of the UK relationship with the EU came during Margaret Thatcher’s first Conservative government (1979-1983) although an agreement with the EEC was not reached until her second term in 1984. On this occasion the issue was simply a question of how much the UK was paying in to the EU budget given that 80% of that budget was then spent on maintaining the Common Agricultural policy (CAP). The UK “rebate” was sanctioned because at that time the UK was the second poorest of the ten member EEC.

UK demands for treaty change 2015

The current UK renegotiation of EU membership is concerned with the following issues:-

Restrictions to freedom of movement within the EU
Sovereignty of Sterling
Structural reform of the EU bureaucracy
Reclaiming of powers from Brussels to protect UK interests

On the latter point, this takes two principal forms: the ability to block EU legislation where it may be detrimental to UK interests and the ending of a commitment to “ever closer union” in respect of UK membership.

The Sovereignty of Sterling is a relatively uncontentious issue, whilst structural reform of the EU bureaucracy is an ideal to which all European governments will accede, at least in principal; the problems arise over restrictions on free-movement of people – enshrined in Article 48 of the Treaty of Rome:-

1.Freedom of movement for workers shall be secured within the Community by the end of the transitional period at the latest. 2. Such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the Member States as regards employment, remuneration and other conditions of work and employment. 3. It shall entail the right, subject to limitations justified on grounds of public policy, public security or public health: (a) to accept offers of employment actually made; (b) to move freely within the territory of Member States for this purpose; (c) to stay in a Member State for the purpose of employment in accordance with the provisions governing the employment of nationals of that State laid down by law, regulation or administrative action; (d) to remain in the territory of a Member State after having been employed in that State, subject to conditions which shall be embodied in implementing regulations to be drawn up by the Commission. 4. The provisions of this Article shall not apply to employment in the public service.

This leaves, the reclaiming of powers from Brussels. “Ever closer union” is probably negotiable since EU member states have always moved at different rates, both economically and culturally. Allowing the UK to pick and choose which aspects of EU legislation it accepts, however, is like joining an exclusive club and then ignoring the rules. Under normal circumstances you’d be asked to leave.

One of the associated problems for the EU – that of, when to stop expanding – is discussed in this essay by Tim Price – Let’s Stick Together. He reviews the work of Leopold Kohr, in particular his seminal work “The Breakdown of Nations”:-

It all comes down to scale. As Kirkpatrick Sale puts it in his foreword to ‘The Breakdown of Nations’,

“What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.”

Kohr showed that there are unavoidable limits to the growth of societies:

“ problems have the unfortunate tendency to grow at a geometric ratio with the growth of an organism of which they are a part, while the ability of man to cope with them, if it can be extended at all, grows only at an arithmetic ratio.”

In the real world, there are finite limits beyond which it does not make sense to grow. Kohr argued that only small states can have true democracies, because only in small states can the citizen have some direct influence over the governing authorities.

What’s in it for the UK

In the interests of levity I’ve included a link to this summation of UK foreign policy with regard to Europe from the satirical TV programme Yes, Minister – this episode was first aired in 1980.

In the intervening 35 years, trying to decipher what is best for the UK has not become any easier. I’ve chosen just two organisations to represent the views for and against EU membership: Business for New Europe and Better off Out. Here’s how Business for New Europe make the case for staying in:-

As a member of the European Union, our companies can sell, without barriers, to a market of 500 million people. The Single Market means that exporters only need to abide by one set of European regulations, instead of 28 national ones. Europe is our biggest trading partner- it buys 45% of our exports. If we left the EU, companies would face tariffs and regulatory barriers to trade.

The free movement of capital means that EU companies can invest here in Britain freely. This investment, by companies like Siemens, creates jobs and grows our economy. 46% of all the foreign investment in Britain came from EU countries.

The EU provides funding for businesses to all regions of Britain, particularly those with the greatest need. From 2014 until 2020, £8 billion of EU money will go from Brussels to the UK. The biggest winners from this process are Cornwall, Wales, the Scottish Highlands, Northern Ireland and the North of England.

EU research funding helps universities and firms innovate to create the technologies of the future. Britain will receive £7 billion from the EU’s Horizon 2020 fund, and our small businesses receive more funding for hi-tech research than those of any other EU country. EU membership is vital to rebalancing the British economy.  

Better off Out – sponsored by the Freedom Association – counter thus:-

10 Reasons to Leave

1.Freedom to make stronger trade deals with other nations. 2. Freedom to spend UK resources presently through EU membership in the UK to the advantage of our citizens. 3. Freedom to control our national borders. 4. Freedom to restore Britain’s special legal system. 5. Freedom to deregulate the EU’s costly mass of laws. 6. Freedom to make major savings for British consumers. 7. Freedom to improve the British economy and generate more jobs. 8. Freedom to regenerate Britain’s fisheries. 9. Freedom to save the NHS from EU threats to undermine it by harmonising healthcare across the EU, and to reduce welfare payments to non-UK EU citizens. 10. Freedom to restore British customs and traditions.

They go on to highlight 10 Myths about the risk of leaving – not all are economic so I’ve paraphrased their opinions below;-

Britain would lose 3mln jobs if we left the EU – Under the terms of the Lisbon Treaty the UK would enter into an FTA with the EU. The WTO obliges them to do so too. Of more importance the UK trade balance will the EU is in increasing deficit – the other member states have more to lose.

Britain will be excluded from trade with the EU by Tariff Barriers – EU has FTAs with 53 countries with a further 74 countries pending. In 2009 UK charged customs duty of just 1.76% on non-EU imports. The EU Common Market is basically redundant already.

Britain cannot survive economically outside the EU in a world of trading blocs – Japan does and it’s not a member. The EU’s share of world GDP is forecast to be 15% in 2020, down from 26% in 1980. Norway and Switzerland export more, per capita, to the EU than the UK does. Britain’s best trading relationships are with the USA and Switzerland. The largest investor in the UK is US.

The EU is moving towards the UK’s position on cutting regulation and bureaucracy – EU directives are subject to a ‘rachet’ effect – once in place they are unlikely to be reformed or repealed. 80% of the UK’s GDP is generated within the UK so should not be subject to EU laws. In 2010, Open Europe estimated EU regulation had cost Britain £124 billion since 1998.

If we leave, Britain will have to pay billions to the EU and implement all its regulations without having a say – The UK has 8.4% of votes. The Lisbon Treaty ensured the loss of Britain’s veto in many more policy areas.

Swiss Case Study: The Swiss pay the EU less than CHF600mln a year for access to the EU market. They estimate the cost of full membership would be CHF3.4bln.

Norway Case Study: In 2009 Norway’s total financial contributions to the EEA (European Economic Area) agreement was Eur340mln Britain pays £18.4bln per annum.

The EU has a positive impact on the British Economy – Fishing (115,000 jobs lost) farming, postal services and manufacturing have been devastated by EU membership. Unnecessary red tape, aid contributions, inflated consumer prices (due to CAP etc.) are indirect costs.

Britain will lose vital foreign investment as a consequence of leaving the EU – The 2010 Ernst and Young survey on UK’s attractiveness to foreign investors, found Britain still the number one Foreign Direct Investment (FDI) destination in Europe owing largely to the City of London and the UK’s close corporate relationship with the US. Key factors, in order of importance:-

Culture and values, English language, Telecommunications infrastructure, Quality of life, Stable social environment, Transport and logistics infrastructure.

Britain will lose all influence in the world by being outside the EU – Britain has a substantial ‘portfolio of power’ including membership of the G20 and G8, a permanent seat on the UN Security Council and seats on the IMF and WTO. The British Commonwealth has 54 nations which is being discriminated against by EU policy. London is the financial capital of the world and Britain has the sixth largest economy. The UK is also in the top ten manufacturing nations in the world.

Legally, Britain cannot leave the EU – A single clause Bill passed at Westminster can repeal the European Communities Act 1972 and its attendant Amendment Acts.

Having dealt with the main arguments for remaining in the EU, Better off Out do point out that creating an FTA with the EU may take time.

Greenland established a precedent when it left the EEC in 1985, this followed a referendum in 1982 and the signing of the Greenland Treaty in 1984. It had joined, as part of Denmark in 1973 but after it had achieved home rule in 1979 the importance of its fishing industry became a major economic incentive for it to leave the forerunner to the EU.

Greece may leave as early as next week and, as this March 2015 article from ECFR – The British problem and what it means for Europe makes clear, a Brexit will not be good for the EU either:-

An EU without Britain would be smaller, poorer, and less influential on the world stage. The UK makes up nearly 12.5 percent of the EU’s population, 14.8 percent of its economy, and 19.4 percent of its exports (excluding intra-EU trade). Furthermore, it runs a trade deficit of £28 billion, is home to around two million other EU citizens, and remains one of the largest net contributors to the EU budget (responsible for 12 percent of the budget in total).

Meanwhile the Confederation of British Industry claim that being a member of the EU is worth £3,000 per household whilst Business for Britain estimate that the UK would save £933 per person from cheaper food if they left. In a report last week S&P chimed in, saying 30% of foreign direct investment (FDI) into the UK – representing 17% of GDP – was directed to financial services and insurance. 50% of this FDI emanated from other EU countries – this could be at risk if the UK should leave. So the debate rumbles on.

How is the UK economy evolving?

UK manufacturing has been in decline since the start of the millennium, whilst this decline was initially a reaction to the strength of Sterling it has yet to benefit from the subsequent weakness of the currency:-


Source: ERC, IMF, UN

Total factor productivity is near the heart of this conundrum:-


Source: ERC, ONS

The UK is lying 6th out of the G7 in terms of output per hours worked, and since 2007, has underperformed the G7 average. The dotted line shows where productivity would have been had the recession not hit. The UK had been lagging its peers during the 1990’s so the predicted outperformance would merely have brought it back into the fold.

In a speech given last week the BoE’s Sir John Cunliffe – Pay and productivity: the next phase made a number of observations about the future:-

Between 2000 and 2007, the average worker in the UK automotive manufacturing industry produced 7.7 vehicles a year. Over the past seven years he/she averaged 9.8 vehicles a year. Productivity – output per worker – in car manufacturing has increased by 30% since the onset of the great financial crisis. Britain has become the fourth-biggest vehicle maker in the EU and is more efficient than bigger producers such as Germany and France.

Unfortunately productivity in the UK has not followed the lead of the car industry. Indeed, the opposite is true. In 2014 labour productivity in the UK was actually slightly lower than its 2007 level. In the seven years between 2000 and 2007 labour productivity grew at an average annual rate of about 2% a year. In the seven years that followed, our annual productivity growth averaged just below zero.

Or to look at it another way, the level of labour productivity – output per hour worked – in the UK economy is now 15% below where it would have been if pre-crisis trends had continued.

…It is true that the average output per hour of the rest of the G7 advanced economies is only around 5% above its pre-crisis level. But as I have noted, in the UK it has not even recovered to that level. And in 2013 output per hour in the UK was 17 percentage points below the average for the rest of the G7 – the widest gap since 1992.

In the 10 years prior to the crisis, growth in the hours worked in the UK economy, accounted for 23% of the UK’s overall economic growth. The mainstay of our economic growth, the other 77%, came from growth in productivity. Since 2013 only 9% of our annual economic growth has come from productivity improvement. The remaining 91% has come from the increase in the total hours worked.

As a result, employment in the UK is now around its highest rate since comparable records began in 1971. Over 73% of people aged 16-64 are working. There are now over 31 million people in work in the UK.   Unemployment has fallen at among its fastest rate for 40 years and is now very close to its pre-crisis level – over the past two years over 1 million jobs have been created.

Productivity growth can be divided into two sorts of change: the change in productivity inside individual firms and the changes between firms. The first, the changes within firms, happens as firms increase their efficiency. The second happens as labour and capital are reallocated between firms, from the less productive ones to the more productive.

After collapsing in the crisis, productivity began to increase again within firms two years ago. We expect that to continue. As the economy grows, spare capacity is used up. The real cost of labour increases relative to the cost of investment. Firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.

In contrast, productivity growth due to the reallocation of resources in the economy remains weak. We can see this in the divergence of rates of returns across firms which remain remarkably and unusually high and the change in capital across sectors which has been particularly low. When the reallocation mechanism is working, the transfer of capital and labour from the less productive to the more productive pulls up the level of productivity in the economy and reduces the divergence between firms. The high degree of divergence between firms at present implies that this reallocation mechanism is working significantly less powerfully now than before the crisis. This can also be seen in the proportion of loss-making firms which stands at around 20% higher than its long-run average. Company liquidations also remain low. So there is still more than a hint of ‘zombiness’ in the corporate sector.

For more on productivity issue this working paper BoE – The UK productivity puzzle 2008–13: evidence from British businesses is full of interesting insights.

The UK service sector continues to grow, although its share of exports to the EU remains smaller than that of goods – 37% vs 49%. Services exports to the rest of the world are the driver of UK export growth.

Conclusion and Investment Opportunities


In search of a surrogate for the uncertainty surrounding the UK referendum, the chart below shows the impact on Sterling of the sudden realization that the Scottish might vote to leave the Union in 2014:-


Source: Oanda and ERC

Should the population of the UK vote to forsake the EU, the relative stability of the GBPEUR exchange rate is likely to become structurally more volatile, the move against the USD from 1.72 to 1.61 is but a foretaste of what we should anticipate. However, the 40% appreciation in the UK effective exchange rate between 1995 and 2000 – see the earlier chart above – and reversal between 2000 and 2009, suggests that membership of the EU has not led to the stability in exchange rates one might have expected.

Between the breakdown of Bretton Woods in March 1973 and the establishment of the European Exchange Rate Mechanism (ERM) In March 1979 (which the UK chose not to join until October 1990) was a period of intense currency volatility – exacerbated by significant interest rate differentials. During this period the GBP effective exchange rate actually moved less than it has since 2000. Nonetheless, higher daily volatility will impose a modicum of additional cost on UK businesses. This 2004 paper from the FRBSF – Measuring the Costs of Exchange Rate Volatility looks at the subject in more detail:-

The main quantitative finding is that the welfare effects of exchange rate volatility are likely to be very small for many countries. When numbers are chosen to permit the model to reproduce basic characteristics of the U.S. economy, the model indicates that the loss of utility is equal in size to only about 0.1% of annual consumption; that is, people would be willing to exchange only about 0.1% of their annual consumption level to eliminate the exchange rate volatility in the economy.


The UK has exhibited structurally higher inflation than much of the Eurozone (EZ) since the collapse of Bretton Woods. That, combined with the relative asynchronicity of the UK and German economic cycles, made it difficult for the UK to operate inside the ERM – it lasted less than two years, from October 1990 to September 1992. The chart below shows German and UK 10yr Government bond yields during this period, Bunds, with lower yields, on the right hand scale:-

united-kingdom-and german government-bond-yield 1990 - 1992

Source: Trading Economics

Germany was struggling during this period and the Hartz labour market reforms occurred shortly thereafter.

germany-UK-government-bond-yield 1990 - 2015

Source: Trading Economics

As the chart above shows UK Gilts have traded at a higher yield than German Bunds for most of last 25 years. I think it would be reasonable to assume Gilt yields, had the UK remained in the ERM and joined the Euro, would have been between those of Germany and France during this period. In other words, the cost of UK government financing has been around 150bp higher than it might have achieved had it joined the EZ.

UK inflation over the same period has been significantly higher than Germany’s, in real-terms Bunds have offered vastly superior returns. This differential may also be due to the UK government running a substantially larger budget deficit during the period. I regret the data in the chart below only goes back to 1996. The UK balance is shown on the right hand scale:-

germany-UK government-budget 1996-2015

Source: Trading Economics


The chart below shows the relative performance of the FTSE100 vs Germany’s DAX40 since 1990. The German market (right hand scale) has increased from 2,000 to 12,000 whilst the UK market has risen from 2,000 to 7,000. Germany has been the clear winner of this race:-

united-kingdom-German stock-market 1990-2015

Source: Trading Economics

Would the UK stock market have fared better inside the EZ and would the UK departure from the EU be detrimental or positive to stock performance going forward? Here is the 1990-2015 comparison between FTSE100 and the French CAC40 index:-

united-kingdom-france stock-market

Source: Trading Economics

Germany appears to be something of an exception, France, Italy and the Netherlands have underperformed the UK during the same period: although Spain has delivered German-like returns. It is worth mentioning that Germany has run a balance of trade surplus for the entire period 1990 – 2015 whilst, excepting a brief period between 1991 and 1997, the UK has run a continuous trade deficit.

I don’t believe UK membership of the EU has much influence over the value of UK stocks in aggregate. Certain companies benefit from access to Europe, others are disadvantaged.

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign. The chart below shows UK GDP by sector since 2008. Services stand out both in terms of their resilience to the effects of the recession and continued growth in its aftermath, it is now 8.5% higher than before the recession, all the remaining sectors languish below their 2008 levels. Improving total factor productivity is key:-


Source: ERC and ONS

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

Longer term the demographic divergence between the UK and other countries of Europe will become evident. By 2060 the working age population of the UK is projected to increase from 37.8mln (2013) to 41.8mln whilst in Germany the same population will decline from 49.7mln to 35.4mln. The EC – Ageing Report 2015 – has more details. The UK can benefit from staying in the EU and continuously negotiating. However, it must become much more involved in the future of the EU project, including “ever closer union”. It can also benefit from “Brexit”, directly flattering the government’s bottom line. The worst of both worlds is to remain, as the UK has since 1950, sitting on the fence –decisiveness is good for financial markets and the wider economy.

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?


Macro Letter – No 38 – 19-06-2015

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?

  • Last year’s oil price falls are still feeding through to the wider economy
  • Oil producing states have remained resilient despite the continued lower price of WTI
  • The wider economy has rebounded after the slowdown in Q1
  • Stock earnings growth is regaining upward momentum

At the end of last year I became cautious about the prospects for the US stock market. The principal concern was the effect a sustained decline in the price of oil was likely to have on the prospects for employment and economic growth.

The Texan Experience

Oil rich Texas represents a microcosm of the effect lower energy prices may be having on employment and growth. This article from December 2014 by Mauldin Economics – Oil, Employment, and Growth – neatly sums up my concerns at the end of last year:-

…we need to research in depth as we try to peer into the future and think about how 2015 will unfold. In forecasting US growth, I wrote that we really need to understand the relationships between the boom in energy production on the one hand and employment and overall growth in the US on the other. The old saw that falling oil prices are like a tax cut and are thus a net benefit to the US economy and consumers is not altogether clear to me. I certainly hope the net effect will be positive, but hope is not a realistic basis for a forecast. Let’s go back to two paragraphs I wrote last week:

Texas has been home to 40% of all new jobs created since June 2009. In 2013, the city of Houston had more housing starts than all of California. Much, though not all, of that growth is due directly to oil. Estimates are that 35–40% of total capital expenditure growth is related to energy. But it’s no secret that not only will energy-related capital expenditures not grow next year, they are likely to drop significantly. The news is full of stories about companies slashing their production budgets. This means lower employment, with all of the knock-on effects.

As we will see, energy production has been the main driver of growth in the US economy for the last five years. But changing demographics suggest that we might not need the job-creation machine of energy production as much in the future to ensure overall employment growth.

…The oil-rig count is already dropping, and it will continue to drop as long as oil stays below $60. That said, however, there is the real possibility that oil production in the United States will actually rise in 2015 because of projects already in the works. If you have already spent (or committed to spend) 30 or 40% of the cost of a well, you’re probably going to go ahead and finish that well. There’s enough work in the pipeline (pardon the pun) that drilling and production are not going to fall off a cliff next quarter. But by the close of 2015 we will see a significant reduction in drilling.

Given present supply and demand characteristics, oil in the $40 range is entirely plausible. It may not stay down there for all that long (in the grand scheme of things), but it will reduce the likelihood that loans of the nature and size that were extended the last few years will be made in the future. Which is entirely the purpose of the Saudis’ refusing to reduce their own production. A side benefit to them (and the rest of the world) is that they also hurt Russia and Iran.

Employment associated with energy production is going to fall over the course of next year. It’s not all bad news, though. Employment that benefits from lower energy prices is likely to remain stable or even rise. Think chemical companies that use natural gas as an input as an example.

I am, however, at a loss to think of what could replace the jobs and GDP growth that the energy complex has recently created. Certainly, reduced production is going to impact capital expenditures. This all leads one to begin thinking about a much softer economy in the US in 2015.

Last month’s employment report suggests we may have avoided the downturn from cheaper oil, but uncertainty remains. Earlier this month the Dallas Fed – Robust Regional Banking Sector Faces New Economic Hurdles whilst focusing on the health of the banking sector, worried that the effect of lower oil prices, combined with higher interest rates, may yet wreak havoc in the Eleventh District. Here are some of the highlights:-

Not only have district banks achieved greater profitability than their counterparts nationwide, but their loan portfolios also have grown twice as fast. District banks returned to lending sooner than banks in the rest of the country and experienced more rapid loan growth due to the region’s economic strength.

…Possibly reflecting banks’ quest for yield in a low-interest-rate environment, the so-called three-year asset/ liability gap has been growing, particularly for district banks. This measure subtracts liabilities with maturities greater than three years (certificates of deposit, for example) from loans and securities with maturities greater than three years and divides the difference by total assets. A bigger gap means that banks would be hurt by rising interest rates because their assets are tied up for a longer time relative to their liabilities. Consequently, when interest rates rise, banks’ funding costs could rise while interest income remains stagnant, squeezing profitability.

…The other big concern is potential fallout from recent dramatic oil and gas price declines, which affects Texas banks in particular. In July 2014, the West Texas Intermediate (WTI) spot price exceeded $105 a barrel; by March, it had tumbled to below $50 before bouncing back to near $60 at the start of May. The size and rapidity of the decline raised concerns about the impact on the Texas economy and Texas banks, especially given the experiences of the energy and financial collapses of the 1980s. While the state’s economy has become more diverse and thus less reliant on the oil and gas industry, the price drop has still negatively affected the Texas economy and labor market. Some pockets of the state remain heavily dependent on the energy sector, making local industries vulnerable to spillover effects. And because of community banks’ close ties to the areas they serve, they are more exposed than large banks.

…One measure of potential distress is the so-called Texas ratio, the book value of an institution’s nonperforming assets as a percent of its tangible equity capital and its loan-loss reserves. Essentially, the Texas ratio compares an institution’s bad assets to its available capital. A Texas ratio above 1 (expressed as 100 percent) indicates that probable and potential losses exceed an institution’s immediate loss-absorbing cushion, putting it at greater risk of bankruptcy. There have been two instances of dramatic oil price declines since 1980; one gives rise to concern and the other to hope.

Between June 1980 and September 1986, the WTI price declined 74 percent in real (inflation-adjusted) terms. Roughly 20 percent of all Texas institutions had a Texas ratio greater than 100 percent by year-end 1988. A staggering 706 Texas banks and thrifts failed—including nine of the 10 largest banking institutions—between September 1986 and year-end 1990.9

A more recent oil price decline, in the second half of 2008 and early 2009, was also dramatic, but in a different way. Over a nine-month period beginning in June 2008, the price fell more than 71 percent. Yet less than 1 percent of Texas banks had a Texas ratio exceeding 100 percent and only seven failed in 2008–09. The slight pickup in bank troubles in 2010 is likely attributable to generally difficult financial and economic conditions that year.

From June 2014 through March 2015, the price of WTI fell 58 percent. Nevertheless, not one Texas bank had a Texas ratio greater than 100 percent as of the first quarter and only one bank had failed as of March.

The bottom line: The persistence of low oil prices seems to matter more for banks than the magnitude of falling prices. A precipitous, but short-lived, decline is likely to have only a minor impact on the banking industry. Even a longer-term decline similar to that seen in the 1980s is unlikely to provoke the same scope of disruption now as it did then.

…Mitigating factors also make Texas banks better able to weather falling oil prices. Memories of the 1980s crisis linger, and the 2008–09 financial crisis is also fresh in the minds of bankers and regulators. Apart from regulatory changes, Texas bankers manage their risks more prudently, using better risk diversification. The Shared National Credit (SNC) program is one example. Generally, large loans are held by multiple institutions through the SNC program, allowing individual institutions to spread the risk of large credit exposures. While the SNC program has been around since 1977, it has grown in importance and coverage. SNC industry trends by sector show that commodities credits, including those tied to the oil and gas industry, increased from $395 billion in 2002 to $798 billion in 2014. Regulatory filings and investor conference calls suggest that energy exposure at the larger banks in Texas is now predominantly through these shared credits.

…The low-interest-rate environment and a flat yield curve with relatively little difference in interest rates across various maturities have pressured bank earnings over the past five years. Banks have responded by extending their maturity profile in an attempt to generate more robust returns. As interest rates normalize, regulators will need to monitor banks’ ability to restructure their maturity profiles and adapt to the new environment.

The impact of recent oil price declines on banks also bears watching, particularly in Texas. While banks appear to be managing their energy exposure well—and a relatively short spell of low energy prices is not expected to have a severe, adverse effect on local banks—the importance of energy in certain regions points to the possibility of relatively large localized disruptions. The banking system has navigated a post crisis path to recovery. Conditions have improved markedly, but the industry must remain vigilant to potential risks to its financial health and stability.

According to the Dallas Fed – Texas Economic Indicatorspublished on 4th June, the region is showing mixed performance:-

Region Employment Growth
Austin 7.70%
Dallas 2.20%
El Paso 3.30%
Houston 0%
San Antonio -0.50%
Southern New Mexico -0.90%

Source: Dallas Federal Reserve

For the state as a whole, April employment was 1% higher versus the US +1.9%. The largest fall was seen in Oil and Gas Extraction (-14.4%) followed by Manufacturing (-4%) and Construction (-2.6%). Leisure and Hospitality led employment increases (5.3%) Information (4.6%) Education and Health (2.6%) and Trade, Transportation and Utilities (2.3%).

The importance of Oil and Gas to Texas, from an employment perspective, is small– only 2.5% of the workforce – but the sector’s impact on the rest of the region’s economy is much greater. Many ancillary sectors, including manufacturing, banking and finance rely on energy. The most encouraging aspect of the data above is the 2.3% increase in Trades, Transportation and Utilities. As an employer this sector amounts to 20.2% of the total. For this sector, lower energy prices are like the tax cut John Mauldin alluded back in December.

The Energy Complex and US growth

The recent energy technology boom has increased the oil and gas sector’s importance – please revisit Manhattan Institute – New Technology for Old Fuels – my personal favourite essay on this subject. The share of oil and gas in total employment peaked in the early 1980s at 0.8% it’s now back to 0.5%. Its share of GDP followed a similar path, falling from 4% in the 1980’s to less than 1% at the start of the millennium; it’s now back around 2%. Energy self-sufficiency remains elusive – the US is still a net oil importer and therefore benefits from lower oil prices. The Energy Information Administration (EIA) estimates a $700 per household saving from the decline in gasoline prices in 2015. This should also spur an increase in capital investment. The traditional estimate of a halving of output has increased dramatically; meanwhile energy efficiency has significantly improved. The fall from $105 to $60 – assuming the market remains around the current level – will probably add 0.4% to GDP.

As one might expect, the direct impact of cheaper oil on the energy sector has been negative. The US rig count fell by 850 between December 2014 and March 2015. Many energy exploration firms have reduced headcount and cut capital expenditure. I don’t believe the benefits of technology have been exhausted by the energy exploration firms, especially the shale-industry. The Manhattan Institute – Shale 2.0 – takes up the story and go on to make some policy recommendations:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

The shale industry is unlike any other conventional hydrocarbon or alternative energy sector, in that it shares a growth trajectory far more similar to that of Silicon Valley’s tech firms. In less than a decade, U.S. shale oil revenues have soared, from nearly zero to more than $70 billion annually (even after accounting for the recent price plunge). Such growth is 600 percent greater than that experienced by America’s heavily subsidized solar industry over the same period.

Shale’s spectacular rise is also generating massive quantities of data: the $600 billion in U.S. shale infrastructure investments and the nearly 2,000 million well-feet drilled have produced hundreds of petabytes of relevant data. This vast, diverse shale data domain—comparable in scale with the global digital health care data domain—remains largely untapped and is ripe to be mined by emerging big-data analytics.

Shale 2.0 will thus be data-driven. It will be centered in the United States. And it will be one in which entrepreneurs, especially those skilled in analytics, will create vast wealth and further disrupt oil geopolitics. The transition to Shale 2.0 will take the following steps: 1.Oil from Shale 1.0 will be sold from the oversupply currently filling up storage tanks. 2. More oil will be unleashed from the surplus of shale wells already drilled but not in production. 3. Companies will “high-grade” shale assets, replacing older techniques with the newest, most productive technologies in the richest parts of the fields. 4. And as the shale industry begins to embrace big-data analytics, Shale 2.0 begins.

Further, if the U.S. is to fully reap the economic and geopolitical benefits of Shale 2.0, Congress and the administration should: 1. Remove the old, no longer relevant, rules prohibiting American companies from selling crude oil overseas. 2. Remove constraints, established by the 1920 Merchant Marine Act, on transporting domestic hydrocarbons by ship. 3. Avoid inflicting further regulatory hurdles on an already heavily regulated industry. 4. Open up and accelerate access to exploration and production on federally controlled lands.

Nonetheless, in the near-term, states which benefitted from $100+ crude oil and the energy related innovations it spawned, are now feeling the effects of what appears to be a sustained period of lower energy prices. The EIA predicts WTI crude will average $60 over the course of 2015.

The CFR – Energy Brief – October 2013 – predicted that a 50% oil price fall would affect the employment prospects of eight states in particular:-

State Fall in Employment
Alaska -1.70%
Louisiana -1.60%
North Dakota -2%
New Mexico -0.70%
Oklahoma -2.30%
Texas -1.20%
West Virginia -0.70%
Wyoming -4.30%

Source: Council for Foreign Relations

So far, if Texas is any guide, the negative effects of the oil price decline have failed to materialise.

The effect of a 25% rise in crude oil prices is also worth considering:-

State Employment Change State Employment Change
Wisconsin -0.74 Ohio -0.61
Minnesota -0.73 Missouri -0.6
Tennessee -0.72 Illinois -0.59
Rhode Island -0.71 Massachusetts -0.59
Florida -0.71 Delaware -0.58
New Hampshire -0.7 South Dakota -0.57
Idaho -0.69 New York -0.57
Nevada -0.69 California -0.56
Arizona -0.68 Alabama -0.56
Indiana -0.68 DC -0.5
Nebraska -0.67 Kentucky -0.48
Vermont -0.66 Pennsylvania -0.47
Iowa -0.66 Utah -0.38
New Jersey -0.65 Kansas -0.35
Washington -0.64 Mississippi -0.35
Maryland -0.64 Arkansas -0.34
Georgia -0.64 Montana -0.31
Michigan -0.64 Colorado -0.15
Virginia -0.64 New Mexico 0.36
South Carolina -0.64 West Virginia 0.36
Oregon -0.64 Texas 0.6
Connecticut -0.63 Louisiana 0.78
Maine -0.62 Alaska 0.87
North Carolina -0.62 North Dakota 1.01
Hawaii -0.61 Oklahoma 1.16
Wyoming 2.14

Sources: CFR, U.S. Bureau of Labor Statistics and the Wall Street Journal

The effect on the US as a whole is estimated at -0.43%. In other words, a fall in crude oil is good for employment and should also act as a cathartic stimulus to GDP growth.

A final measure of the vulnerability of the US economy to the recent oil price decline is shown by the next table. This shows the substantial diversification away from the energy sector seen in every one of the major oil producing states since the 1980’s:-

Share of Oil and Gas Extraction as a % of GDP
1981 2000 2010
Alaska 49.5 15.1 19.1
Louisiana 35.5 11.1 9.7
New Mexico 26.1 5.2 5.1
North Dakota 20.3 0.9 4.3
Oklahoma 21.6 4.8 9.1
Texas 19.1 5.8 7.8
West Virginia 2.4 1 1.5
Wyoming 37.1 9.8 18.5

Source: CFR, U.S. Bureau of Economic Analysis

Looking at how unemployment has changed across the 51 states over the last 12 months:-

State April April 12-month net change
2014 2015
Alabama 7.1 5.8 -1.3
Alaska 6.9 6.7 -0.2
Arizona 6.9 6 -0.9
Arkansas 6.3 5.7 -0.6
California 7.8 6.3 -1.5
Colorado 5.4 4.2 -1.2
Connecticut 6.8 6.3 -0.5
Delaware 5.9 4.5 -1.4
DC 7.8 7.5 -0.3
Florida 6.4 5.6 -0.8
Georgia 7.3 6.3 -1
Hawaii 4.5 4.1 -0.4
Idaho 4.9 3.8 -1.1
Illinois 7.4 6 -1.4
Indiana 6 5.4 -0.6
Iowa 4.4 3.8 -0.6
Kansas 4.5 4.3 -0.2
Kentucky 7 5 -2
Louisiana 5.7 6.6 0.9
Maine 5.8 4.7 -1.1
Maryland 5.9 5.3 -0.6
Massachusetts 5.8 4.7 -1.1
Michigan 7.5 5.4 -2.1
Minnesota 4.2 3.7 -0.5
Mississippi 7.8 6.6 -1.2
Missouri 6.3 5.7 -0.6
Montana 4.7 4 -0.7
Nebraska 3.4 2.5 -0.9
Nevada 8.1 7.1 -1
New Hampshire 4.5 3.8 -0.7
New Jersey 6.7 6.5 -0.2
New Mexico 6.7 6.2 -0.5
New York 6.5 5.7 -0.8
North Carolina 6.4 5.5 -0.9
North Dakota 2.7 3.1 0.4
Ohio 5.9 5.2 -0.7
Oklahoma 4.7 4.1 -0.6
Oregon 7 5.2 -1.8
Pennsylvania 6 5.3 -0.7
Rhode Island 8.1 6.1 -2
South Carolina 6.1 6.7 0.6
South Dakota 3.4 3.6 0.2
Tennessee 6.5 6 -0.5
Texas 5.2 4.2 -1
Utah 3.8 3.4 -0.4
Vermont 4 3.6 -0.4
Virginia 5.3 4.8 -0.5
Washington 6.2 5.5 -0.7
West Virginia 6.8 7 0.2
Wisconsin 5.5 4.4 -1.1
Wyoming 4.3 4.1 -0.2

Source: Bureau of Labor Statistics

Only Louisiana (+0.9%) North Dakota (+0.4%) and West Virginia (+0.2%) of the top oil producing states, have witnessed increased levels of unemployment. South Dakota (+0.2%) and South Carolina (+0.6%) were the only other states in the union to see unemployment rise. This is not the picture of a faltering economy.

The Federal Reserve Leading Index, whilst it hit a low point of +0.9% in January – down from +2% in July 2014 – has rebounded – April +1.12% – and has remained in positive territory since August 2009. The Conference Board Leading Economic Index increased 0.7% in April to 122.3, following a +0.4% in March, and a -0.2% February. The Conference Board commented:-

April’s sharp increase in the LEI seems to have helped stabilize its slowing trend, suggesting the paltry economic growth in the first quarter may be temporary. However, the growth of the LEI does not support a significant strengthening in the economic outlook at this time. The improvement in building permits helped to drive the index up this month, but gains in other components, in particular the financial indicators, have been somewhat more muted.

The outlook appears steady rather than robust but this has been the pattern of the economic recovery ever since the first round of quantitative easing (QE) in November 2008.

Conclusion and Equity Investment Opportunities

The US economic recovery remains intact. The long run economic benefits of structurally lower energy prices and energy security are slowly feeding through to the wider economy. This is good for the US and, as long as the US continues to run a trade deficit with the rest of the world, it’s good for the US main trading partners too.

After a sharp correction in October 2014 the S&P500 recovered. Since its January lows the market has ground slowly higher:-

S&P500 - 1yr


The table below shows a series of additional valuation measures:-

Indicator Ratio Date Start of Data
Trailing 12 month P/E 20.53
Mean 15.54
Min 5.31 Dec 1917
Max 123.73 May 2009 1875
Shiller Case P/E 27.1
Mean 16.61
Min 4.78 Dec 1920
Max 44.19 Dec 1999 1885
Price to Sales 1.81
Mean 1.4
Min 0.8 Mar 2009
Max 1.81 Jun 2015 2001
Price to Book 2.89
Mean 2.75
Min 1.78 Mar 2009
Max 5.06 Mar 2000 2000


On most of these metrics the market looks relatively expensive but the current level of interest rates is unprecedented. JP Morgan Asset Management predict average corporate earnings to grow by 4% in 2015 – stripping out energy stocks this rises to 11%. They also remind investors that the S&P has seen 10 bear markets since 1926. Eight occurred as a result of economic recessions or commodity price shocks (price increases not decreases) and extreme valuations were a contributing factor only on four occasions. They go on to refute the idea that interest rate increases by the Federal Reserve will derail the bull market, pointing to the positive correlation between rising interest rates and rising equity prices when interest rates start from a low point. They make the caveat that the initial reaction to interest rate increases is negative but in the longer term stocks tend to rise.

At the risk of uttering that most dangerous of phrases – “this time it’s different” – I believe the majority of the rise in equity prices was a function of the reduction in the level of interest rates since 2008. This had two effects; investors switched from interest bearing securities to equities, hoping that capital appreciation would offset the declining income from bonds: and corporations, faced with negative real interest rates, decided to raise dividends and buy back stock, rather than make capital investments when interest rates were artificially low. The chart below shows US 10yr Government Bond yields since 1790:-

US 10 yr Bond Yield Global Financial Data

Source: Global Financial Data

The chart ends in 2013, since when yields have plumbed new depths. Ignoring the inflation shock of the 1970’s and 1980’s it would be reasonable to expect US Treasuries to yield around 3% but that was before the Federal Reserve moved from a stable price target – i.e. around zero – to a 2% inflation target. I think it is reasonable for corporates to assume a long-term cost of finance based on a 3% real yield for US Treasuries plus an appropriate credit spread. Is it any wonder that corporates continue to buy back stock?

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

US stocks are not cheap, but Q1 earnings declines have been reversed and, whilst growth is muted, the longer term benefits of lower energy prices are just beginning to feed through. At the beginning of the year I was cautious and considering reducing exposure to the US market. Now, I am still cautious, but, if earnings start to improve, today’s valuations will prove justified and further upside may be well ensue. The US bond market is doing the Fed’s work for it – 10yr yields have risen from a low of 1.64% in January to 2.30% today. Whilst the first rise in official rates is likely to act as a negative for stocks, the market will recover as long as the momentum of earnings growth remains positive and energy prices remain subdued.

Nigeria and South Africa – what are their prospects for growth and investment?


Macro Letter – No 37 – 06-06-2015

Nigeria and South Africa – what are their prospects for growth and investment?

  • The IMF forecast South Africa to grow by only 2% in 2015 and 2.1% in 2016
  • Whilst Nigeria is forecast to grow by 4.8% in 2015 and 5% in 2016
  • Both countries are succeeding in diversifying away from resources
  • Corruption remains the greatest political challenge to their prosperity

To begin my analysis of the two largest economies in Africa here is a table of statistics:-

Indicator Nigeria South Africa
GDP 523 USD Billion – Dec 13 351 USD Billion – Dec 13
GDP y/y 3.96 percent – Feb 15 2.1 percent – Feb 15
GDP per capita 1098 USD – Dec 13 5916 USD – Dec 13
GDP per capita PPP 5676 USD – Dec13 12106 USD – Dec 13
Unemployment Rate 23.9 percent – Dec 11 26.4 percent – Feb 15
Population 174 Million – Dec 13 54 Million – Dec 14
Inflation Rate 8.7 percent – Apr 15 4.5 percent – Apr 15
Food Inflation 9.48 percent – Apr 15 5 percent – Apr 15
Interest Rate 13 percent – May 15 5.75 percent – May 15
Foreign Exchange Reserves 4118713 NGN Million – May 15 470400 ZAR THO Million – Apr 15
Balance of Trade 1145749 NGN Millions – Dec 14 (2513) ZAR Million – Apr 15
Current Account ($158 USD Million) – Nov14 (198000) ZAR Million – Nov 14
Gold Reserves 21.37 Tonnes – Nov 14 125 Tonnes – Nov 14
Crude Oil Production 2520 BBL/D/1K – Jan 14 3 BBL/D/1K – Dec 14
Foreign Direct Investment 1030 USD Million – Nov14 1684 ZAR Billion – Nov 14
Government Budget (1.8) percent of GDP – Dec 13 (3.8) percent of GDP – Dec 14
Government Debt to GDP 11 percent – Dec 13 46.1 percent – Dec 13
Capacity Utilization 60.3 percent – Nov 14 81.5 percent – Nov 14
Corporate Tax Rate 30 percent – Jan14 28 percent – Jan 14
Personal Income Tax Rate 24 percent -Jan14 41 percent – Apr 15
Sales Tax Rate 5 percent – Jan 14 14 percent – Jan 15
Population below poverty line 33.1% (2013 est.) 26.2% (2011 est.)
Labour force 48.57 million (2011 est.) 17.89 million (2012 est.)
Labour force by occupation services: 32%; agriculture: 30%; manufacturing: 11% agriculture: 9%, industry: 26%, services: 65% (2007 est.)
Main industries crude oil, coal, tin, columbite, uranium; palm oil, peanuts, cotton, rubber, wood; hides and skins, textiles, cement and other construction materials, food products, footwear, chemicals, fertilizer, printing, ceramics, steel, small commercial ship construction and repair, entertainment, machinery, car assembly mining (world’s largest producer of platinum), gold, chromium, automobile assembly, metalworking, machinery, textiles, iron and steel, chemicals, fertiliser, foodstuffs, commercial ship repair
Ease-of-doing-business rank 131st 39th
Exports $97.46 billion (2012 est.) $101.2 billion (2012 est.)
Export goods petroleum and petroleum products 95%, cocoa, rubber, machinery, processed foods, entertainment gold, diamonds, platinum, other metals and minerals, machinery and equipment
Main Export Partners  India 12.8%  China 14.5%
   United States 11.1%  United States 7.9%
   Brazil 10%  Japan 5.7%
   Spain 7.1%  Germany 5.5%
   Netherlands 7%  India 4.5%
   Germany 5.1%  United Kingdom 4.1% (2012 est.)
   France 4.7%
   United Kingdom 4.5%
   South Africa 4.2% (2013 est.)
Imports $70.58 billion (2012 est.) $106.8 billion (2012 est.)
Import goods machinery and equipment, chemicals, transport equipement, manufactured goods, foodstuffs machinery and equipment, chemicals, petroleum products, scientific instruments, foodstuffs
Main import partners  China 20.8%  China 14.9%
   United States 11.2%  Germany 10.1%
   India 4.5% (2013 est.)  United States 7.3%
   Saudi Arabia 7.2%
   India 4.6%
   Japan 4.5% (2012 est.)
Gross external debt $10.1 billion (2012 est.) $47.66 billion (31 December 2011 est.)
Public debt 18.8% of GDP (2012 est.) 43.3% of GDP (2012 est.)
Credit Rating (S&P) B+ (Domestic) BBB+ (Domestic)
  B+ (Foreign) BBB- (Foreign)
  B+ (T&C Assessment) BBB+ (T&C Assessment)
  Outlook: Stable Outlook: Stable
Foreign reserves $42.8 billion (2012 est.) $54.98 billion (31 December 2012 est.)

Source: Trading Economics, CIA Factbook, IMF, World Bank, S&P

One additional factor to mention from the outset is the importance of China, and not just as an import partner, although South Africa also exports more to China than it does to any other country. Chinese companies have been aggressively bidding for infrastructure projects across the continent, partly in response to over-investment at home. These companies have also been acquisitive, especially in the resource sector, for several years. Across the continent China now accounts for 20% of infrastructure investment. This has grown from next to nothing in 2002. It has been concentrated in transportation – railways, roads and airports – and, to a lesser degree, in energy; although the decline in commodities prices since 2009/2010 has reduced China’ resource security concerns.

Looking ahead, Chinese investment in Africa has the potential to dramatically improve the prospects for large swathes of the continent. Brookings –   Are Chinese Companies Retooling in Africa? elaborates.

Another major investment trend across Africa has been the growth of private participation in infrastructure (PPI) which now accounts for around 50% of the $30bln per annum – up from $5bln in 2003. This investment is concentrated in telecommunications – 64%, electricity – 18.6% and seaports – 9.8%. Nonetheless, the estimated infrastructure investment gap – $93bln – remains a significant impediment to productivity growth.


Nigeria has just emerged from a general election, the most credible since its return to constitutional government in 1999. The new president, Buhari and his APC party, secured a substantial victory on an anti-terrorist and anti-corruption mandate; it’s worth noting that Muhammadu Buhari is a devout Muslim, his campaign slogan was “new broom”.

The country has overcome some challenges but, as this article from Brookings – Nigeria’s Renewed Hope for Democratic Development – makes clear, there is much still to be done:-

…there is an extensive list of challenges awaiting Buhari and the APC government. They include: ending the Boko Haram insurgency; promoting the socio-economic advance of the largely Muslim and impoverished northern region; overhauling the criminalized petroleum sector; improving the core infrastructures of electricity, water supply, and public transport; drastically reducing corruption in state institutions; and rapidly increasing jobs in agriculture, agro-processing, and light industry.

Chatham House – Nigeria’s New President Pits Hope Against Harsh Realities, takes up the theme:-

This would-be economic powerhouse and Africa’s biggest crude oil producer is running low on fuel. While Nigeria exported around 2.08 million barrels of oil a day in the first quarter of 2015, its three refineries operate at 20 per cent capacity at most. So Nigeria imports its petrol to run cars and diesel to power private generators for homes and businesses. National grid power generation is negligible relative to demand. 

The traders that import refined products are paid by government in cash or crude oil via the byzantine Nigerian National Petroleum Corporation (NNPC). Most foreign suppliers had long stopped supplying on credit as they are owed $1.5 billion in arrears dating back to 2011. Local traders and wholesalers claim to be owed N200 billion in subsidies and are withholding supplies pending some form of settlement.

…In a country that remains dependent on crude exports for fiscal revenue and product imports to function, the cabal-controlled opaque deals that keep the economy running are perhaps at the heart of the corruption that makes people’s lives unnecessarily harsh every day in Nigeria.

But given the parlous state of the economy after crude oil prices halved in six months in 2014, the depreciation of the national currency, the erosion of foreign reserves to under $30 billion, (perhaps four months of external payments), and the political and popular sensitivities around fuel importation and the fuel subsidy, the new government may not have chosen the fuel traders and how to reform the NNPC as the first challenge to tackle. But the traders have forced the issue.

…With ambitions including economic diversification, institutional reform and improving welfare to millions of Nigeria’s poorest, President Buhari and the APC will see their efforts stymied in 2015 by empty state coffers.

Yet it is not the availability of money but the management of it that may effect change in Nigeria. Years of high oil prices and strong GDP growth have not translated into the development, job creation and poverty reduction that they should have. Instead Nigeria is one of the fastest-growing markets for luxury aircraft and champagne, while it ranks 152 out of 187 countries in the Human Development Index.

Back in April 2014 the Nigerian Statistics Office rebased GDP for the first time in 20 years, the result was a near doubling of the size of their economy, as this article from the Atlanitic – How Nigeria Became Africa’s Largest Economy Overnight, expalins:-

In computing its GDP all these years, Nigeria, incredibly, wasn’t factoring in booming sectors like film and telecommunications. The Nigerian movie industry, Nollywood, generates nearly $600 million a year and employs more than a million people, making it the country’s second-largest employer after agriculture. As for the telecom industry, consider that there are now some 120 million mobile-phone subscribers in Nigeria, out of a population of 170 million. Nigeria and South Africa are the largest mobile markets in sub-Saharan Africa, and cell-phone use has been exploding in the country:

Nigeria mobile subsribers

Nigerian Communications Commission (Datawrapper)

Incorporating the film and telecom industries into Nigeria’s GDP made a huge difference in the services sector, rendering the country’s economy not just bigger but more diversified:

Nigeria GDP estimate

 National Bureau of Statistics (Datawrapper)

This is not the first time an African country’s GDP has risen after rebasing, Ghana saw a 60% increase in 2010. The World Bank and IMF estimates for growth in many frontier markets may prove self-fulfilling prophesies if other frontier economies rebase in a similar manner. Nonetheless, these countries are growing rapidly and present a plethora of investment opportunities in the process.

Between 2000 and 2008 African GDP growth averaged 4.9%, twice the pace of the previous decade. Last August, ahead of the US-Africa Summit, saw the publication of the Cato Institute – Sustaining the Economic Rise of Africa – they gave an excellent summation of the state of the region:-

 …between 1990 and 2010, the share of Africans living at $1.25 per day or less fell from 56 percent to 48 percent, while the continent’s population almost doubled in size. If the current trends continue, Africa’s poverty rate will fall to 24 percent by 2030. Since 1990 the per-capita caloric intake in Africa increased from 2,150 kcal to 2,430 kcal in 2013. Between 1990 and 2012, the proportion of the population of African countries with access to clean drinking water increased from 48 percent to 64 percent. Many African countries have also seen dramatic falls in infant and child mortality. Since 2005, some African countries, such as Senegal, Rwanda, Uganda, Ghana, and Kenya, have seen child mortality decline by an annual rate exceeding 6 percent.

Nonetheless, the continent still lags significantly behind the rest of the world in its income levels and also in many indicators of human well-being. For example, Africa scored a mere 0.502 on the United Nation’s 2014 Human Development Index, measured on a scale from 0 to 1, with higher values denoting higher standards of living. By comparison, the United States scored 0.914, Latin America 0.74, and China 0.719.

The extent of trade protectionism, for example, is large, especially when compared with other regions in the world. Average applied tariffs in Africa remain comparatively high, and the extent of trade liberalization on the continent has not matched that experienced in the rest of the world. While between 1988 and 2010, the average applied tariff in high-income countries in the Organization for Economic Cooperation and Development fell from 9.5 percent to 2.8 percent, Africa saw a reduction from 26.6 percent to 11 percent. That is not a negligible decrease but it still leaves the continent with unnecessarily high tariff protection, which hinders trade.

Cato went on to highlight what Africa needs:-

Needs Examples
The Rule of law Land title, commercial contact enforcement
Improvement in governance Oversight of government contracts
Reduction of red tape Regulatory reforms
Infrastructure investment Electricity generation, transportation
Regional Economic integration Free-trade agreements

Here are the IMF – Selected Issues papersDecember 2014 – South Africa and April 2015 – Nigeria  – which look in more detail at several of these issues.

Whilst Nigeria is not exactly a paragon of virtue when it comes to corruption – ranking 136th out of 175 countries on Transparency International’s Corruption Perceptions Index – this 2011 article from the Economist – Africa’s hopeful economiespoints to real signs of progress, both in Nigeria and across the continent as a whole:-

Her $3 billion fortune makes Oprah Winfrey the wealthiest black person in America, a position she has held for years. But she is no longer the richest black person in the world. That honour now goes to Aliko Dangote, the Nigerian cement king. Critics grumble that he is too close to the country’s soiled political class. Nonetheless his $10 billion fortune is money earned, not expropriated. The Dangote Group started as a small trading outfit in 1977. It has become a pan-African conglomerate with interests in sugar and logistics, as well as construction, and it is a real business, not a kleptocratic sham.

…Severe income disparities persist through much of the continent; but a genuine middle class is emerging. According to Standard Bank, which operates throughout Africa, 60m African households have annual incomes greater than $3,000 at market exchange rates. By 2015, that number is expected to reach 100m—almost the same as in India now.

…Since The Economist regrettably labelled Africa “the hopeless continent” a decade ago, a profound change has taken hold. Labour productivity has been rising. It is now growing by, on average, 2.7% a year. Trade between Africa and the rest of the world has increased by 200% since 2000. Inflation dropped from 22% in the 1990s to 8% in the past decade. Foreign debts declined by a quarter, budget deficits by two-thirds.

…Africa’s population is set to double, from 1 billion to 2 billion, over the next 40 years. As Africa’s population grows in size, it will also alter in shape. The median age is now 20, compared with 30 in Asia and 40 in Europe. With fertility rates dropping, that median will rise as today’s mass of young people moves into its most productive years. The ratio of people of working age to those younger and older—the dependency ratio—will improve. This “demographic dividend” was crucial to the growth of East Asian economies a generation ago. It offers a huge opportunity to Africa today.

Dangote Group may not be a “kleptocratic sham” but it is protected from foreign competition by import tariffs which enable it to make a 62% margin on domestic sales. The Economist article goes on to apply a string of caveats – after all, every silver-lining must have its dark cloud, especially for those trained in the “dismal science”- the authors conclude:-

Africa is not the next China. It provides only a tiny fraction of world output—2.5% at purchasing-power parity. It is as yet not even a good bet for retail investors, given the dearth of stockmarkets. Mr Dangote’s $10 billion undeniably makes him a big fish, but the Dangote Group accounts for a quarter of Nigeria’s stockmarket by value: it is a small and rather illiquid pond.

For corporations wishing to succeed in Africa, Nigeria remains a key market. With roughly 20% of Sub-Saharan Africa’s 930 mln people and population growth of 2-3% per annum, this is a market one can’t ignore. The Economist – Business in Nigeria – takes up the story:-

In 2001 MTN, a fledgling telecoms company from South Africa, paid $285m for one of four mobile licences sold at auction by the government of Nigeria. Observers thought its board was bonkers. Nigeria had spent most of the previous four decades under military rule. The country was rich in oil reserves but otherwise desperately poor. Its infrastructure was crumbling. The state phone company had taken a century to amass a few hundred thousand customers from a population of 120m. The business climate was scarcely stable.

MTN took a punt anyway. The firm’s boss called up colleagues from his old days in pay-television and found they had 10m Nigerian customers. He reasoned that if they could afford pay-TV they could stump up for a mobile phone. Within five years MTN had 32m customers. The company now operates across Africa and the Middle East. But Nigeria was its making and remains its biggest single source of profits.

In the 1980’s, after an oil price collapse threatened to under-mine government finances, I ended up doing business in Nigeria with a subsidiary of Unilever (ULVR). Outside of the Oil and Mining sector, it was one of a very few multi-nationals still operating in the country, however, there had been an, almost catastrophic, deterioration in the operations of the division with which I dealt. This decline had taken place over the two decades since Nigerian independence: it reflected the endemic problems of doing business in the country. Managers privately told me, the principal reason they had not closed down was because this was the only practical way to recoup losses sustained in lending the government money.

Finally Unilever, along with a handful of other firms, are reaping the benefit of their long term investment. According to UN forecasts the population of Nigeria will overtake the population of the US by 2045, as soon as 2020, according to research from Oxford Economics, the population will have topped 200mln making Nigeria the fifth largest country in the world, overtaking Pakistan and Brazil – they should have a very bright future.

Near-term growth has slowed as a result of weaker GDP – 3.96% in Q1 2015 vs Q4 2014 at 5.94%, Q3 2014, 6.23% and Q2 2014 of 6.54%. The marginal effect of a falling oil price is still substantial – especially for the export market 95% of which is in petroleum and petroleum products.

The construction sector has remained robust, growing at around 10% – lower than in 2013 but still impressive. Information and Communications has also shown stability, growing at 8% per annum.

South Africa

South Africa has triple Nigeria’s per capita GDP, it is also endowed with better developed institutions. This does not, however, guarantee prosperity. This article from last week’s South African Independent on Sunday – South Africa’s triple challengemakes that clear:-

We are frequently reminded by the political establishment of South Africa’s triple challenge of poverty, inequality and unemployment. This weighs heavily on the social, political and economic fabric of the country.

This is why the unemployment and economic growth data just released points to South Africa sinking into crisis. Official unemployment, at 26.4 percent, rose to a 12-year high. Growth slumped to 1.3 percent for the first quarter this year, below expectation.

The official unemployment rate is one of the highest in the world. The measure masks a low economic participation rate and excludes discouraged work-seekers. In other words, people who want work but have stopped looking for work due to being discouraged are not counted among the unemployed. If a higher participation rate was factored in and discouraged work-seekers were included in the data, the unemployment rate would be nudging towards 50 percent.

…The economy is not big enough to absorb everyone into it. The solution is a bigger economy. For that, the economy needs growth. Not difficult. But growth has ground down to 1.3 percent and looks set to slow further. At the recent Monetary Policy Committee meeting, the SA Reserve Bank warned the inflation risks were to the downside but the risks to economic growth were on the downside.

The combination of weak economic prospects, along with higher inflation, means unemployment is set to rise even further.

… The underperformance of South Africa has been self-inflicted. It struggles under its triple triple.

First Triple: poverty, inequality and unemployment.

…if South Africa had full employment, then poverty and unemployment would be dramatically diminished as issues. However, by not emphasising this perspective, policy is focused on inequality and poverty but is not resolving unemployment.

The national budget is a case in point where the “rich” (success) are penalised through a very “progressive” tax take. Inequality is reduced by pulling down the top end of earners (in reality right down to the working class).

Poverty is tackled through a very aggressive redistribution spending policy. Through this whole process, unemployment is neglected and perpetuated. Policy focus on poverty alleviation has the effect of transferring economic resources to consumption, which is in complete contrast to poverty reduction that transfers resources to investment.

…This shift of resources to consumption has resulted in the second triple, which has become a major constraint and stumbling block to resolving the first triple.

Second Triple: the triple deficit.

The budget deficit in recent years has led to a multiple downgrade of the credit rating. On the face of it, the government “needs” more taxes to balance its books. Yet households, the core of the tax base, are also in deficit. The cost pressures in recent years and availability of credit has led to households spending more than they have earned. The ability to meet a higher tax bill is simply not there. The tax base is both narrow and shallow.

The high unemployment rate also places pressure in a higher dependency ratio on each salary and wage earner. And the government has very ambitious spending plans and faces at least four expenditure threats where each one can take South Africa to a solvency crisis. These are: the public sector wage bill; National Health Insurance; State Owned Enterprises’ need for capital; and the nuclear deal. So far, indications are that the government is going to commit to all four.

The third deficit is the current account deficit. This has been widening to record levels, especially since 2008. Of particular concern is that the current account deficit has been widening while the economy has been slowing and the currency has been weakening. This is a major concern as it means the country is losing competitiveness at an alarming rate.

Part of the reason for the loss of competitiveness comes down to the third triple:

Third Triple: the triple mistake.

The first mistake is labour unrest. No one invests in labour unrest, and investment is essential to grow the economy. South Africa must find a way to resolve labour disputes without unrest. Labour relations is where South Africa languishes near the bottom of the World Economic Forum’s Global Competitiveness survey. The unemployment crisis needs attraction of investment into labour, not away from it.

The second major mistake is the regulatory tsunami that has hit the business sector. The economy is being attacked by policymakers not nurtured. Companies trying to contain costs in a low growth environment have resources diverted to compliance, leaving less to grow their businesses. The biggest problem is that the regulatory burden requires economies of scale in order to be compliant. This is manageable by big business but debilitating for the SME sector. And it is the SME sector that is the engine of job creation. South Africa should be seeking to make South Africa an easier place to invest and do business not more difficult.

…The third mistake South Africa is making is in taxes. Economic expansion cannot happen without investment. Investment cannot be sustained without savings. The investment rate is currently 19 percent of GDP. This will buy a long-term growth rate of 2 to 3 percent.

Excessive debt, both public and private, a low savings rate and a low investment to GDP ratio – it sounds remarkably like the problems of many developed economies. Before dismissing the above article as a little localised hyperbole it’s worth considering this leader from last week’s Economist – Africa’s second-largest economy is in a huge mess:-

There is little in the way of bright news about South Africa’s economy—and not just because power cuts are plunging neighbourhoods into darkness several times a week. According to figures released on May 26th, annual GDP grew by a mere 1.3% in the first three months of this year, a crawl compared with the 4.1% achieved in the fourth quarter of 2014. Unemployment is soaring. Even using a narrow definition, it stands at 26.4%, the highest since 2003.

“The numbers are saying ‘something has to be done, and done quickly’,” says Pali Lehohla, South Africa’s statistician-general. But where to begin? Power shortages under Eskom, the failing state utility, have dampened manufacturing, drought has hit agriculture and tourism, a rare boon, has been hampered by much-criticised new visa requirements. Rating agencies have warned that South Africa is dancing dangerously close to junk status, though no immediate downgrade is likely.

…Strikes are hurting mining. Talks between unions and gold-mine bosses are due to begin in early June. But with unions opening the bargaining by demanding that basic pay for unskilled mineworkers be doubled, prospects of an early settlement seem poor. Last year similar demands at platinum mines sparked five months of labour unrest. A strike by 1.3m public-sector employees has been averted, but only at the cost of a 7% wage increase, with the money coming from emergency funds.

The weak economy is stoking social unrest and public violence. Foreigners, seen as competition for scarce jobs, were targeted in a recent spate of xenophobic attacks that left at least seven people dead. The IRR, a think-tank in Johannesburg, says that protests have nearly doubled since 2010. Many relate to the provision of basic services such as water and electricity. Inequality remains high. A report by the Boston Consulting Group, a consultancy, placed South Africa 138th of 149 countries for its ability to turn the country’s wealth into well-being for its people.

So far the government of President Jacob Zuma has shown little sign of being able to improve matters. The African National Congress, the ruling party, is bogged down in internal political battles, not least over whether to pursue capitalist or socialist economics. The government’s much-touted National Development Plan, a market-friendly strategy to encourage investment and growth, is largely ignored. Even by the ANC’s own standards, it is failing: only 2% growth is expected in 2015 when the economy needs to expand by at least 5% a year to reduce unemployment.

The country doesn’t score that well on corruption either, ranking 67th out of 175 countries on the Corruption Preceptions Index.

Likewise the Deliotte’s CFO Survey is less than encouraging. Many South African CFO’s expressed anxiety about the future. New investment is overwhelmingly directed towards expanding into other, higher-growth, parts of the continent. Of those companies with no presence elsewhere in Africa, 80% said they wanted to build such a presence within the next year – West and east Africa were their favoured destinations.

Capital Markets and Investment Opportunities

Africa is largely dependent on private capital flows as this May 2015 article explains – Brookings – Private Capital Flows, Official Development Assistance, and Remittances to Africa: Who Gets What?:-

The data also show that private capital flows to sub-Saharan Africa over the period of 2001-2012 have mostly benefited two countries—South Africa and Nigeria—which accounted for 45 percent and 13 percent of total private flows to sub-Saharan Africa, respectively. These two countries have attracted the most flows in part because they are the largest in sub-Saharan Africa, together making up more than half of the region’s GDP.

…Portfolio flows have also been increasing recently, though they remain concentrated in South Africa: That country received 96 percent of the portfolio flows to the region in 1990-2000. However, in 2001-2012, the issuance of sovereign bonds by a number of countries and increased interest by investors has led to a more diversified recipient base for portfolio flows. South Africa’s share of the total fell to 59 percent, whereas Nigeria’s increased to 24 percent, and other countries like Mauritius (14 percent) emerged on the scene.

…From 1990 to 2000, half of total FDI to sub-Saharan Africa went to South Africa (29 percent) and Nigeria (21 percent). This trend has not changed: Between 2001 and 2012, the top 10 recipient countries received 85 percent of the total FDI inflows to the region.

…In terms of volume, Nigeria was the largest recipient of remittances in the region from 1990 to 2012.

I want to turn my attention to more liquid opportunities.

Bonds – South Africa

The SARB – Quarterly Bulletin – March 2015 – sums up the recent price action in South African government bonds:-

South African bond yields moved generally lower from early 2014, in line with US bond yields. Local yields receded further in January 2015, supported by an improved inflation outlook and abundant international liquidity following the announcement of an expanded asset-purchase programme by the ECB and continued quantitative easing out of Japan. Bond yields edged higher in early March 2015 as a reversal in the oil price, the announcement of higher levies on fuel and rand depreciation impacted on inflation expectations. Most money-market interest rates have displayed little movement since the middle of 2014, remaining well-aligned with the repurchase rate of the South African Reserve Bank (the Bank) that had been held steady over this period.

The SARB has left base rates unchanged at 5.75% since July 2014 as a result of the stabilisation of the Rand and falling oil prices. Inflation expectations had been on the downside but as SARB Governor Lesetja Kganyago stated in the 21st May MPC statement:-

The challenges facing monetary policy have persisted, and, as expected, the downward trend in inflation which was mainly attributable to the impact of lower oil prices, has reversed. Headline inflation is expected to breach temporarily the upper end of the target range early next year, and thereafter remains uncomfortably close to the upper end of the target band for most of the forecast period. The upside risks have increased, mainly due to further possible electricity price increases. The exchange rate also continues to impart an upside risk to inflation as uncertainty regarding impending US monetary policy continues. Domestic demand, however, remains subdued while electricity constraints continue to weigh on output growth and general consumer and business confidence.

As the chart below suggests, 10yr Bond yields have risen from their January lows. The upward trend appears to be established, the current 10yr yield is 8.51% which is not far from the January 2014 high of 8.8%. I suspect this level will be breached but not to a substantial extent because the rising interest rate environment will undermine, already weak, growth expectations. If yields approach 9.25% I think this offers a buying opportunity. For the present, remain short. For most retail investors this means using South African bond index futures, but remember, only your P&L will be exposed to currency fluctuations.

Bonds – Nigeria

Nigerian 10yr Government bonds have behaved in a very different manner to South Africa over the last seven years, as the chart below reveals:-

south-africa-nigeria government-bond-yield

Source: Trading Economics, Central Bank of Nigeria and South African Treasury

A portfolio of these two bonds would offer an attractive Sharpe ratio. Short South Africa and Long Nigeria 10yr might be another strategy to consider, you may get positive carry, but Nigerian inflation has been substantially higher over this period. Here is a chart:-

south-africa-nigeria inflation-cpi

Source: Trading Economics, National Bureau of Statistics Nigeria and Statistics South Africa

The Central Bank of Nigeria – MPC May 2015 Communique 101 – provides a wealth of information, here are some highlights:-

The Committee expressed concern about the weakening economic momentum but recognized the relative similarity in the condition to the evolving economic environment in virtually all oil exporting economies, suggesting the need for acceleration of various ongoing initiatives to diversify the economic base of the country.

The Committee noted that the uptick in inflationary pressures, year-to-date, was largely traceable to transient factors such as high demand for transportation, food and energy, especially in the period around the general elections as well as the Easter festivities. It also noted the roles played by system liquidity and the pass-through effects of the recent depreciation of the naira exchange rate. When the transient causes are isolated, the Committee observed the decline in month-on-month inflation across all the measures in April as headline inflation moderated to 0.8% from 0.9% in March; core inflation moderated to 0.6% from 0.8% and food inflation moderated to 0.9% from 1.0%.

The Committee reiterated its commitment to price stability noting that given the already tight stance of monetary policy and the transient nature of the incubators of the current inflationary trend, which are outside the direct control of monetary policy, the space for maneuver remains constrained, necessitating the intervention of fiscal and structural policies to stimulate output growth.

…the Committee stressed the need for proactive measures to protect the reserve buffer to safeguard the value of the domestic currency and engender overall stability of the banking system. It was, however, noted that monetary policy is gradually approaching the limits of tightening and would, therefore, require complementary fiscal and structural policies.

…Consequently, the MPC voted to:

(i) Retain the MPR at 13 per cent with a corridor of +/- 200 basis points around the midpoint;

(ii) Retain the Liquidity Ratio at 30 per cent; and

(iii) Harmonize the CRR on public and private sector deposits at 31.0 per cent.

10yr Bond yields have fallen from more than 17% in mid-February to 13.7% today. I believe that the hawkish policy of the Central Bank of Nigeria will insure that inflation falls further. Now the election is over, bond yields will continue to decline as foreign capital flows into the country. As recently as July 2014 yields were at 12% – I think they will go lower even than this despite yield curve inversion. The one major risk to this otherwise promising scenario is a rating agency downgrade. S&P downgraded Niara bonds to +B as recently as March, the election result helps but the new government need to deliver on their promises of reform.

To access the Nigerian bond market you need to contact one of the primary dealers – here is the link to the Nigerian Debt Management Office. You will have to deal with the issues of exchange controls, an alternative would be to be a fixed rate receiver through a Niara interest rate swap. The list of dealers may be a place to start but I suspect this is a strictly institutional option.

Stocks – South Africa

The SARB – Quarterly Bulletin – March 2015 – describes recent developments in South African equities:-

Despite the subdued growth in the economy over the past year, domestic share price entered 2015 on a positive note, recovering from the losses incurred in the second half of 2014 to reach all-time-high levels in March 2015. The domestic share market benefited from sustained accommodative monetary policies in the advanced economies, while lower international oil prices and the depreciation of the rand also boosted some share prices. Corporate funding through the issuance of shares in the primary share market rose considerably in 2014, consistent with the high level of share prices and rising number of companies listed on the JSE Limited.

…The performance of equity funding on the JSE was strong in 2014. Equity capital raised in the domestic and international primary share markets by companies listed on the JSE amounted to R153 billion in 2014, which was 65 per cent higher than the amount raised in 2013. Equity capital raising activity was concentrated in companies listed in the financial and industrial sectors, which dominated equity funding in 2014 with shares of 35 and 41 per cent respectively. Dividing the industrial sector further, as shown in the accompanying graph, more than half of the industrial sector’s equity funding in 2014 was accounted for by companies in the consumer goods subsector. Proceeds were utilised mostly for acquisitions, both abroad and domestically.

Robust funding in the primary share market was consistent with the high level of share prices and rising number of companies listed on the JSE, as new listings exceeded delistings in 2014 for the first time since 2008. The number of company listings came to 329 on the main board at the end of February 2015, while 60 were listed on the Alternative Exchange (AltX) and 3 on the development and venture capital boards. The most prominent method of raising capital was the waiver of pre-emptive rights where shares were issued for cash to the general market or specific investors. Equity financing amounted to R43 billion in the first two months of 2015.

Secondary market trading has remained stable but the P/E ratio, at around 18 times, is above its long term average (1990-2015) of 14.4. The P/E ratio has only broken above 20 once, back in 2010, during the rebound from the global recession – though it came close to these levels in 1993.

The Johannesburg (JSE) and the Nigerian Stock Exchange (NSE) are currently working towards developing a partnership that would benefit both exchanges. In this collaboration, among other things, South African companies would be able to list on the NSE and Nigerian companies on the JSE.

South Africa has the most sophisticated financial markets in Africa, it also acts as a conduit for foreign investment to the rest of the continent. The main stock index – the FTSE/JSE 40 – has traded steadily higher since 2009:-


Source: Trading Economics and JSE

However, this does not take account of the currency risk of investing in the Rand. An alternative is the iShares MSCI South Africa ETF – EZA. Here are the top 10 components:-

Company Symbol % Assets
Naspers Ltd Class N NAPRF.JO 19.44
Mtn Group Ltd MTNOF.JO 9.83
Sasol Ltd SASOF.JO 6.51
Standard Bank Group Ltd SBGOF.JO 5.27
Firstrand Ltd FSR.JO 4.81
Steinhoff International Holdings Ltd SNHFF.JO 4.41
Sanlam Ltd SLMAF.JO 3.46
Aspen Pharmacare Holdings Ltd APNHF.JO 3.43
Remgro Ltd RMGOF.JO 3.28
Bidvest Group Ltd BDVSF.JO 2.63

Source: Yahoo Finance

iShares MSCI South Africa

Source: Yahoo Finance

It is clear from the chart above that South Africa’s main stocks are struggling due to the difficult domestic economic situation, which has led to continuous bouts of currency weakness and bond rating agency downgrades.

For domestic or hedged investors the market trend remains positive, but for international investors the carry costs of hedging undermines the attraction of this market.

Stocks – Nigeria

Nigerian stocks have recovered from weakness earlier this year. The Central Bank put most of the recent performance down to improvements in earnings, sentiment and the successful conclusion of the election.

nigeria-stock-market 2010 - 2015

Source: Trading Economics and NSE

Given the heavy weighting to Dangote in this index (25%) perhaps a more diversified investment would be the Global X MSCI Nigeria ETF (NGE) here are the top 10 constituents:-

Nigerian Breweries PLC 16.41
Guaranty Trust Bank PLC 11.54
Zenith Bank PLC 8.93
Nestle Nigeria PLC 7.06
Ecobank Transnational Inc 4.72
Lafarge Africa PLC 4.66
First Bank Of Nigeria PLC 4.64
Dangote Cement PLC 4.63
Guinness Nigeria PLC 4.48
Stanbic IBTC Holdings PLC 4.37

Source: Yahoo Finance and MSCI

The advantage of the ETF is that you don’t have to deal with the problem of Nigerian exchange controls, however you should keep a close eye on the currency which continues to depreciate against the US$. The technical picture is unclear, I have no direct exposure to Nigeria but it remains on my list of stock markets with significant long-term potential. The current P/E ratio is around 16 times, not cheap like China last year, but worth watching.

NGE 2 yr chart

Source: Yahoo Finance


The South African Rand (ZAR) is a freely traded international currency. Daily turnover is roughly 1.1% of the global total – mostly traded in London. The Nigerian Niara (NGN) is subject to exchange controls. It is possible to trade non-deliverable forwards, but liquidity reflects the relative lack of tradability. The chart below compares the two currencies against the US$ since 2007:-

ZAR and NGN vs USD - 2007-2015

Source: Trading Economics

Since H2 2011 the ZAR/USD rate has been weakening. This trend looks set to continue. This is how its recent movements are described in the SARB – Quarterly Bulletin – March 2015 – they highlight the developments during 2014:-

The nominal effective exchange rate of the rand declined, on balance, by 2,8 per cent in 2014, compared with a decline of 18,6 per cent in 2013. The trade-weighted exchange rate of the rand increased, on balance, by 0,3 per cent in the fourth quarter of 2014 following a decline of 2 per cent in the third quarter. The rand did, however, regain some momentum, rebounding by 4,0 per cent in October 2014 supported by a positive Medium Term Budget Policy Statement and portfolio investment inflows. The domestic currency weakened by 0,3 per cent in November 2014 amid South Africa’s credit rating downgrade from Baa1 to Baa2 by Moody’s rating agency as electricity challenges became more acute. In December 2014, the trade-weighted exchange rate of the rand weakened further along with other emerging-market currencies and declined by 3,2 per cent. Sentiment towards emerging-market currencies, including the rand, was generally weighed down by the persistent weakness of the euro area, a slowing Chinese economy and an unexpected Japanese recession.

The USD/NGN has been declining by steps as the Central Bank of Nigeria, in a futile attempt to halt the depreciation, depletes its gross reserves. These have fallen to $28bln from more than $50bln in less than two years. Now that the elections are behind them the currency should be less vulnerable. During mid-April overnight rates hit 90% but have since returned to a more normal range – still a volatile series. It’s unlikely they will drop below 9% with the current hawkish MPC. This makes Long NGN Short ZAR an attractive trade – carry will be around 300bp. However, this should be viewed as a trading position. The Central Bank of Nigeria will probably have to defend the NGN again, when they fail the USD/NGN rate will rapidly head for 230.