Technology Indices and Creative Destruction – When Might the Bubble Burst?

400dpiLogo

Macro Letter – No 33 – 10-04-2015

Technology Indices and Creative Destruction – When Might the Bubble Burst?

  • Publically traded technology stocks trade on modest multiples compared to 2000
  • Private sector overinvestment may, however, be cause for concern
  • European technology companies have outperformed US this year – it may not last
  • Technology and growth stocks remain highly correlated to the major indices

I adhere to the belief that technology and other such improvements in manufacturing are the key to delivering productivity growth, which thereby improves the quality of life for the greatest number. Of course, as Joseph Schumpeter so incisively illustrated, the process is often cathartic. For the technology investor this increases both the risk and potential reward.

Technology is affects all industries. In an attempt to be more specific, here is a table taken from a February 2015 report by Brookings – America’s Advanced Industries:-

Americas Advance Industries - Brookings

Source: Brookings

The report goes on to describe the scale and importance of these industries to the US economy:-

As of 2013, the nation’s 50 advanced industries employed 12.3 million U.S. workers. That amounts to about 9 percent of total U.S. employment. And yet, even with this modest employment base, U.S. advanced industries produce $2.7 trillion in value added annually—17 percent of all U.S. gross domestic product (GDP). That is more than any other sector, including healthcare, finance, or real estate.

At the same time, the sector employs 80 percent of the nation’s engineers; performs 90 percent of private-sector R&D; generates approximately 85 percent of all U.S. patents; and accounts for 60 percent of U.S. exports. Advanced industries also support unusually extensive supply chains and other forms of ancillary economic activity. On a per worker basis, advanced industries purchase $236,000 in goods and services from other businesses annually, compared with $67,000 in purchasing by other industries. This spending sustains and creates more jobs. In fact, 2.2 jobs are created domestically for every new advanced industry job—0.8 locally and 1.4 outside of the region. This means that in addition to the 12.3 million workers employed by advanced industries, another 27.1 million U.S. workers owe their jobs to economic activity supported by advanced industries. Directly and indirectly, then, the sector supports almost 39 million jobs—nearly one-fourth of all U.S. employment.

…From 1980 to 2013 advanced industries expanded at a rate of 5.4 percent annually—30 percent faster than the economy as a whole. 

…Workers in advanced industries are extraordinarily productive and generate some $210,000 in annual value added per worker compared with $101,000, on average, outside advanced industries. Because of this, advanced industries compensate their workers handsomely and, in contrast to the rest of the economy, wages are rising sharply. In 2013, the average advanced industries worker earned $90,000 in total compensation, nearly twice as much as the average worker outside of the sector. Over time, absolute earnings in advanced industries grew by 63 percent from 1975 to 2013, after adjusting for inflation. This compares with 17 percent gains outside the sector. Even workers with lower levels of education can earn salaries in advanced industries that far exceed their peers in other industries. In this regard, the sector is in fact accessible: More than half of the sector’s workers possess less than a bachelor’s degree.

The report is not an unalloyed paean of praise, however, they go on to emphasise the need for better education and training in order to maintain momentum.

The last great technology stock collapse was seen in the aftermath of the “Dotcom” bubble which burst in 2001:-

dot-com-bubble

Source: Kampas Research

During the early part of the last decade the growth in valuation of the technology sector returned to its long-term trend. Since 2008, however, central bank policies have changed the valuation paradigm for all stocks by reducing interest rates towards the zero-bound. Their quantitative easing policies (QE) have flattening government bond yield curves to unprecedented levels, especially given the absolute level of rates. Nonetheless, many of the signs of a bubble have begun to emerge as this December 2014 article from the Economist – Frothy.com – explains:-

In December 15 years ago the dotcom crash was a few weeks away. Veterans of that fiasco may notice some familiar warning signs this festive season. Bankers and lawyers are being priced out of office space in downtown San Francisco; all of the space in eight tower blocks being built has been taken by technology firms. In 2013 around a fifth of graduates from America’s leading MBA schools joined tech firms, almost double the share that struck Faustian pacts with investment banks. Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued—and has been largely ignored, just as her predecessor Alan Greenspan was when he urged caution in 1999.

Good corporate governance is, once again, for wimps. Shares in Alibaba, a Chinese internet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.

…Instead, today’s financial excess is hidden partly out of sight in two areas: inside big tech firms such as Amazon and Google, which are spending epic sums on warehouses, offices, people, machinery and buying other firms; and on the booming private markets where venture capital (VC) outfits and others trade stakes in young technology firms.

Take the spending boom by the big, listed tech firms first. It is exemplified by Facebook, which said in October that its operating costs would rise in 2015 by 55-75%, far ahead of its expected sales growth. Forget lean outfits run by skinny entrepreneurs: Silicon Valley’s icons are now among the world’s biggest, flabbiest investors. Together, Apple, Amazon, Facebook, Google and Twitter invested $66 billion in the past 12 months. This figure includes capital spending, research and development, fixed assets acquired with leases and cash used for acquisitions (see chart 1).

Tech spend - Economist

Source: The Economist, Bloomberg

That is eight times what they invested in 2009. It is double the amount invested by the VC industry. If you exclude Apple, investments ate up most of the cashflow the firms generated. Together these five tech firms now invest more than any single company in the world: more than such energy Leviathans as Gazprom, PetroChina and Exxon, which each invest about $40 billion-50 billion a year. The five firms together own $60 billion of property and equipment, almost as much as General Electric. They employ just over 300,000 people. Google says it is determined to keep “investing ahead of the curve”.

…The second area of technology froth is in private markets. Their exuberance was demonstrated on December 4th when Uber closed a $1.2 billion private funding round that valued the five-year old firm at $40 billion. Baidu, China’s biggest search engine, is set to buy a stake, too (see page 101). There are 48 American VC-backed firms worth $1 billion or more, compared with ten at the height of the dotcom bubble, according to VentureSource, a research outfit. In October a software firm called Slack was valued at $1.1 billion, a year after being founded. 2014 looks set to be the biggest year for VC investments since 2000 (see chart 2).

VC in US - Economist

Source: The Economist

Whilst this investment boom has centred around the giants of the technology industry and venture capitalists in the private sector, few large scale scientific research facilities have been developed without government grants or subsidies as this December 2014 FRBSF Economic Letter – Innovation and Incentives: Evidence from Biotech – makes abundantly clear:-

The adoption of biotech subsidies raises the number of star scientists in a state by 15% relative to that state’s pre-adoption number of stars. We find a similar effect from the adoption of R&D credits. These findings are important because of the role star scientists play on the local development and survival of U.S. biotech clusters. In addition, we find that most of the increase in the number of stars is due to their relocation to states that adopt incentives. Meanwhile, subsidies have only a limited effect on the productivity, measured by patenting, of incumbent scientists already in the state. We also find that the increase in star scientists happening after a state adopts a biotech incentive is entirely due to an increase in private/for-profit sector scientists, with no detectable increase in academic scientists.

The authors’ conclusions, however, are qualified:-

We found that, after states adopted incentives, they experienced significant increases in the number of star scientists, the total number of biotech workers, and the number of establishments, but limited effects on salaries and patents. We also uncovered significant spillover effects from biotech incentives to employment in other sectors that provide services in the local economy such as retail and construction.

In terms of policy implications, it is important to keep in mind that our finding that biotech subsidies are successful at attracting star scientists and at raising local biotech employment do not necessarily imply that the subsidies are economically justified. The economic benefits to a state of providing these incentives must be weighed against their fiscal costs—for instance, the loss of tax revenues and resulting loss of public services. Our research suggests that state incentives are successful at increasing the number of jobs inside the state. Nevertheless, our results do not suggest that the social benefit—either for that state or for the nation as a whole—is larger than the cost to taxpayers, nor that incentives for innovation are the most effective way to increase jobs in a state.

Government incentives may appear benign, but, as Michael Dell put it, in a November 2014 Op Ed for the Wall Street Journal – Going Private Is Paying Off for Dell:-

Yet we find ourselves in a world increasingly afflicted with myopia-governments that can’t see beyond the next election, an education system that can’t see beyond the next round of standardized tests, and public financial markets that can’t see beyond the next trade. This was what Dell faced as a public company. Shareholders increasingly demanded short-term results to drive returns; innovation and investment too often suffered as a result. Shareholder and customer interests decoupled.

My personal preference is for a free-market approach, despite the risk of underinvestment in the most capital intensive areas of research.

Valuation?

The valuation of growth stocks has always been fraught with uncertainty, especially when future cashflows are often deferred by several years and earnings forecasts, subject to significant variance. An even greater difficulty, as the chart above makes clear, is to assess, and hopefully anticipate, the herd behaviour of technology investors.

The chart below shows the differential performance of the STOXX Europe 600 Technology Index (FX8.Z) the global IXN Technology ETF and the Nasdaq Composite:-

Stox Tech Euro 600 Nasdaq IXN Global Tech ETF

Source: Yahoo Finance

The European dalliance with technology investment was shorter lived than in the US. So was the violence of the subsequent bust. The market had still not cleared by 2008 and achieved new lows for the decade. The subsequent recovery has been muted. The IXN appears to be roughly halfway between the two extremes. US investor perception of technology seems to be substantially rosier than that of the European investor.

The six month chart reveals a rather different picture. Since the equity market correction last November, European technology has out-performed both the US and other technology stocks globally:-

Tech stocks 6 months

Source: Yahoo Finance

Looks can be deceptive. This move has been broader based than simply the European technology sector. Led by Germany, most Eurozone stock markets have traded higher. This has largely coincided with the QE actions of the ECB and the steady weakening in the value of the Euro that this policy has abetted. The Euro Effective Exchange Rate has fallen from 100 to 90 over the same period.

Research carried out by LinkedIn sheds a unique perspective on global trends in technology industries. Their analysis focussed on migrating workers, identifying which countries and cities were net beneficiaries. This July 2014 article from Bruegal – Fact of the week: Not one European city in the top 10 for tech talenttakes up the story:-

In terms of skills uniquely identified in movers, Math, Science, Technology and Engineering seem to play a particularly important role. In terms of industries, movers are found to work mostly in media and entertainment; professional services; oil and energy; government, education and non-profit but most importantly, technology-software.

…Five out of ten cities attracting people with tech skills (especially IT infrastructure and system managements; Java development and web programming) are located in India, including the first four of the list. San Francisco only comes fifth, followed by two other US cities and two Australian.

No European city at all makes it to the list. For the 52 cities looked at in the study, the median percentage of new residents with tech skills was 16%, or just under 1 in 6; in many of the Indian cities, its more than double that figure. European cities are the real laggards: the percentage of new residents with tech skills was 18% in Berlin, 15% in Paris, 13% in Madrid and 11% in Paris.

The trend obviously mirror the Indian ongoing technology boom, in a still rather “virgin” environment. Kunal Bahl – founder of Snapdeal, a wannabe Indian Amazon – told USA Today in 2011 that India offers huge opportunity “because there are no mature companies, like Google and Microsoft, over there. The feeling is like in the U.S. in 1999.”

But there may be more to that.. Research by Vivek Wadhwa (Stanford) revealed that half of Silicon Valley start-ups were launched by immigrants, many of them educated in US top universities. But he also noticed that “for the first time, immigrants have better opportunities outside the U.S.” because, among other things, of rather strict immigration laws and California’s steep cost of living. Bahl himself, who studied in the US and spent some time working at Microsoft, reportedly wanted to initiate his company in the US but eventually went back to India because of visa problems.

And this is also why the tech industry – at the (by now almost) desperate search for engineers – is supporting the introduction of specific “start-up visa” for high-skilled workers in the US. The insights provided by this data is particularly important in the context of the recent discussions on the US immigration reform, but it is not without implications for Europe, which is at the bottom of the ranking as far as attracting tech talent is concerned.

This research suggests that the recent outperformance of the European technology sector may be short lived, yet, another article from November of last year by Bruegal – Brain drain, gain, or circulation? – indicates a somewhat more optimistic outcome for parts of Europe, specifically the UK and Spain:-

Quality of Scientists - OECD

Source: Bruegal, OECD

This chart benchmarks the median quality of scientists leaving or moving (for the first time) to a country between 1996-2011. The size of the bubble corresponds to total flows (inflows plus outflows). Countries in red are net contributors to the international market for scientists, those in blue net recipients.

Ideally, a country should want to be below or on the 45-degree line, indicating that the quality of the newcomers is just as high (or higher) as that of the leavers. Conditional on this, a country should also prefer a larger rather than smaller bubble, representing a sizeable flow of scientists and indicating a full exploitation of synergies gained from international cooperation. Finally, countries should aim to land in the top-right quadrant, indicating higher quality of both incoming and outgoing researchers. 

Over the long-term (pre-crisis) period analysed, Spain and the UK seemed the best placed at attracting high-quality scientists. France and Germany were broadly breaking even in terms of quality, although we note that they were facing significant net outflows of scientists, as was the UK.

All in all, in the sample here presented, while the US (unsurprisingly) comes out as the top performer in terms of net inflow of quality researchers, Italy ranks quite poorly. Not only the country is a net contributor of scientists, it also trades high quality researchers for lower quality ones. Time for a reform of the university system?

The EU Commission is seeking to address the deficiencies of innovation policy within its borders. At a Bruegal event last January in a speech entitled – The New European Research Agenda – Commissioner Moedas – outlined plans to improve the environment for innovation:-

First, create the framework conditions for a more productive exchange of research results, fundamental science and innovation. Things like:

Screen the regulatory framework in key sectors in order to remove bottlenecks

Accelerate the implementation of standardisation

Promote the public procurement of innovation and innovation in the public sector

Promote a venture capital culture

Reduce bureaucracy in science and innovation systems

Second, is to consolidate fundamental research as the flagship for Europe. As the essential foundation for a knowledge-based society. Working towards a single, open market for knowledge though open science.

Third: implement Horizon 2020 and the new Investment Plan to leverage the Europe economy towards a higher plane as a research and innovation-based area. Working towards a single, open market for knowledge though open science. It is better to focus on our potential than to dwell on illusions. We will always be different from other parts of the world. But that difference has many benefits!

These are stirring words, but in the EU turning words into deeds takes time. In unfettered, free-markets, resources are allocated more efficiently. Nonetheless, hope remains.

In terms of absolute valuation, US technology bulls point to the relatively undemanding PE ratio of the Nasdaq – around 24 times, vs 175 times during the zenith of the Dotcom frenzy. On the other hand, commentators such as Dent Research point to a flat-lining phase of the 45 year innovation cycle – this phase commenced around 2010 and will last until around 2032:-

It shows how clusters of powerful technologies increase productivity and move mainstream for about 22.5 years, like what we saw from 1988 into 2010.

Now we’re in the doldrums of this cycle and won’t move into the next upward swing again until after 2032. In short, the productivity revolution is over for the next two decades or so. That means less earnings and wage gains, regardless of demographic trends.

Interestingly, Dent then go on to wax lyrical about the potential for Bio-tech. In technology even the bears tend to be bullish about something.

We need to read Robert Gordon – Is US economic growth over? Faltering innovation confronts the six headwinds, to find a real bear. His CEPR paper was published in 2012 but these are ideas he has been developing for more than a decade. The premise is that the economic growth of the last 250 years is the exception rather than the rule:-

The ideas developed here are unorthodox yet worth pondering. They are applied only in the context of the US, because the worldwide frontier of productivity and the standard of living have been carved out by the US since the late 19th century. If growth of the US productivity frontier slows down, other nations may move ahead, or the slowing frontier could reduce the opportunities for future growth by all nations as the pace of productivity growth in the US fades out…

… The paper suggests that it is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR3, the follow-up process was much faster. Taking the inventions and their follow up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanisation itself.

The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the US economy, some of which are shared in common with other countries and others are uniquely American. Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99% of the income distribution will be even slower than that.

Gordon goes on to identify six headwinds buffeting the US economy – slowing the pace of GDP growth:-

  1. The disappearance of the demographic dividend
  2. Educational attainment
  3. Rising income inequality
  4. Outsourcing (especially due to technological development)
  5. Environmental constraints on energy pollution
  6. Combined household and government debt

These are important impediments to growth but I believe not all of them are as clear cut as Gordon suggests.

Firstly, the demographic dividend may be in decline but technology has made it easier for people to work until much later in life. Added to which, a more flexible labour market encourages greater participation. I wonder whether the decline in labour force participation is to some extent due to the improvement in welfare provision and not just a deficit of permanent “quality” jobs?

Despite the concerns of Gordon and Bruegal, education is in the process of being revolutionised by new technologies. Mass Open Online Courses (MOOCs) are but one aspect of this sea-change. The cost of providing education – which has risen inexorably over the last 50 years – could be reversed. Of course Gordon has cause for concern about educational achievement. Whilst technology will allow “the horse to be led to water” it is another matter “making it drink”. The Economist – Wealth without workers, workers without wealth – from October 2014, discusses this issue in the broader context of new technologies disruption of labour markets globally:-

The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income.

Income inequality is a popular economic theme and Gordon pays tribute to Emmanuel Saez – though not Thomas Piketty who has become its popular champion. From my interpretation of Piketty’s book, I believe that income inequality is a natural outcome of the long term benefits of peace. Reducing government intervention in the functioning of free markets is a better solution to this structural problem. Smaller government will not remove inequality but it will increase economic mobility, and, in the process, create faster economic prosperity – thereby more rapidly improving the standard of living for the greatest number of people. In freer markets, the technology entrepreneur, and creative risk takers in general, have a greater incentive to embrace opportunities.

Outsourcing is not new, David Riccardo observed its effects long ago. As rich countries adapt to concentrate on their comparative advantages – hopefully undistorted by government subsidy and protective tariff – the short-term headwind of lost domestic labour will be offset by the lower cost to the consumer of outsourced services. A greater proportion of a consumer’s income will then become available for investment. Once the investment has been allocated, the increased pool of available labour can then be retrained for employment in more productive enterprises. Frederic Bastiat – That Which is Seen and That Which is Not Seen makes this point much more eloquently than I could hope to do.

At the global level, man’s capacity to pollute his environment has not diminished but developing countries are less able to afford the luxury of conscience. Our best hope is technology. Yet technological discovery occurs by evolutionary leaps rather than steady increment. The lag between discovery and commercial application can also be long and variable. The collapse in the price of photovoltaic cells, making solar power dramatically more viable as an alternative to fossil fuel, is but one example. The tantalising potential of the development of tidal energy generation is another – especially given man’s predilection to inhabit the margins of the sea. Carbon sequestration technology – at present uneconomic – might be the next technological “leap”. I remain an optimist about man’s ingenuity. Since the Economist first published its Commodity Index in 1864 the price of commodities has been falling by roughly 1% per annum in inflation adjusted terms – punctuated by sharp price increases normally associated with war. Peace leads to investment and, as new technologies are adopted, prices begin to march lower once more.

This leaves Gordon’s concern about debt. Now, debt is a problem. It can be overcome, but the solution to excessive debt is not more debt. Deleveraging can be achieved by steady reduction or sudden default. Sadly, history favours the latter approach – I wonder whether Polonius’s advice to Laertes today would have been:-

Always a borrower never a lender be,

For loan oft loses both itself and bank,

And borrowing sure as hell beats husbandry.

Last September – Deleveraging, What Deleveraging? The 16th Geneva Report on the World Economy – discussed this global issue in detail:-

Contrary to widely held beliefs, the world has not yet begun to delever. Global debt-to-GDP is still growing, breaking new highs. Figure 1 shows the evolution of total debt (excluding the financial sector) for our global sample (advanced economies plus major emerging market economies). While there was a pause during 2008-09, the rise of the global debt-GDP ratio recommenced in 2010-2011.  Data in the report also show that debt-type external financing (leverage) continues to dominate equity-type financing (stock market capitalisation)

Global Debt to GDP

Source: CEPR

Perhaps surprisingly, the authors advise central banks to be cautious about interest rate increases in this environment:-

In such a context, and with still very high leverage, allowing the real rate to rise above its natural level would risk killing the recovery. Beyond pushing the economy into a prolonged period of stagnation, this would also put at risk the deleveraging process which is already very challenging.

Although there is a lot of uncertainty about such predictions, our call is for caution on interest rate rises. The case for caution in pre-emptively raising interest rates is reinforced by the weakness of inflationary pressures.

…The policy requirements for successful exit from a leverage trap are much broader than the appropriate conduct of monetary policy. The report addresses the fiscal challenges, the scope for macro-prudential policies and the restructuring of private-sector (bank, household, corporate) debt and sovereign debt.

The report also argues that – given the risks and costs associated with excessive leverage – more needs to be done to improve the resilience of macro-financial frameworks to debt shocks and to discourage excessive debt accumulation. Finally, we advocate enhanced international policy cooperation in addressing excessive global leverage.

I keep hearing the immortal words of Stan Laurel:-

Well, here’s another nice mess you’ve gotten me into.

Signs of fatigue

With all markets, I begin my analysis with technical patterns. This is a form of self-preservation; to paraphrase Keynes, I may be right in my fundamental analysis but the market is never wrong. On this basis I see no compelling reason to exit the technology sector, although there is a case to be made for rotation out of the Nasdaq and into technology stocks in Europe. I make the caveat, however, that European stocks have inherently less liquidity than US stocks and are therefore likely to exhibit greater volatility, especially on the downside.

The second stage of my analysis is to look at the change in the makeup of tech indexes. The constituents of the Nasdaq are a case in point. The table below shows the top 10 stocks by market capitalisation in 2000 and 2015:-

2000 2015
Microsoft MSFT Apple AAPL
Cisco CSCO Google GOOG
Intel INTC Microsoft MSFT
Oracle ORCL Facebook FB
Sun Microsystems JAVA Amazon.com AMZN
Dell Computer DELL Intel INTC
MCI WorldCom MCWEQ Gilead Sciences GILD
Chartered Semiconductor CHRT Cisco CSCO
Qualcomm QCOM Comcast CMCSA
Yahoo! YHOO Amgen AMGN

Source: Nasdaq

Several of the names have changed, added to which, many of today’s valuations, as measured by P/E ratios, are far less demanding – although Amazon (AMZN) at more than 700 times earnings, remains a notable exception. Looked at from another perspective, the technology promise of 2000 has delivered – today’s top tech companies are delivering real earnings. To understand whether the undemanding multiples are a harbinger of a period of “ex-growth” to come or represent an undervalued opportunity, we need to examine each individual stock in detail. This is beyond the macroeconomic analysis of this report, but one “macro” factor worth considering is the question of debt versus equity finance.

Equity versus Debt

At the risk of making a sweeping generalisation, technology companies are more likely to finance their projects via equity than debt – although established, large cap, technology companies make ample use of the capital markets. Technology projects often require long-lead times to deliver positive cashflows and the value created is invariably intellectual rather than physical. An Oil company with proven reserves may have to wrestle with the volatility in the price of crude oil, but it can mortgage those “reserves” – they have a fairly predictable future demand. Technology companies must endure the vicissitudes of disruptive innovation. Todays “must have” products can rapidly become tomorrow’s museum “curiosities”. To this extent, technology firms are better placed to weather a cycle of increasing interest rates because they carry less debt.

Here lies a dilemma. In the absence of the interest rate on debt to signal the riskiness of an investment, the availability of equity finance becomes critical. As the IPO market has become more active, venture capitalists have been pouring money into earlier and earlier investment opportunities to avoid having to pay too high a price for private equity – I’ve heard the phase “pre,pre-seed” which smacks of a lack of discrimination. Access to equity investment should be a signal about the validity of a project – in the current “overinvestment” environment, the informational value of this “signal” is dramatically diminishing.

Conclusions and Investment Opportunities

The current technology boom is very different from the dotcom bubble of 2000. The top companies in the sector have real earnings and trade at less demanding PE multiples. There are still early stage companies which have no cashflows but these are the much less prevalent today. At the risk of stating the obvious, look for companies with low debt to equity ratios, since these will weather the storm of rising interest rates more comfortably. Look for companies with growing earnings and, where possible, growing dividends. Keep a close watch on the price trend of the stock and have a stop-loss level in mind at which you will exit to preserve capital, regardless of your own opinions. Set a price target if you wish but remember that markets are prone to irrationality – I tend to let the “trend be my friend”.

For the present, technology stocks look set to continue rising, but it is important to remember that the correlation between equity indices tend to be high – The Nasdaq and the S&P500 have a one month correlation of more than 90%. Interest Rates may stay low for a protracted period, but the risk is asymmetric – not far to fall, a long way to rise – and conventional wisdom, which advocates investment in stocks because they are negatively correlated to bonds, may be severely tested as central bank interest rates normalise globally. For more on this topic the November 2013 paper from Pimco – The Stock-Bond Correlation is well worth investigation.

A final caveat concerning technology stocks. Most of the constituents of tech indices are growth stocks and therefore tend to have higher betas than the underlying index. This is a simple measure of their volatility – replete with Gaussian assumptions of “normality”. When constructing your investment strategy, keep the absolute level of volatility in mind, albeit is a measure of variance rather than risk. If this is a technology bubble, make allowance for it and you will weather its tempests, underestimate it and you will be forced to capitulate; the bull market isn’t over yet and the broader market will determine the timing of its demise.

German resurgence – Which asset? Stocks, Bunds or Real Estate

400dpiLogo

Macro Letter – No 32 – 20-03-2015

German resurgence – Which asset? Stocks, Bunds or Real Estate

  • German domestic consumption is driving GDP growth as wages rise
  • The effect of a weaker Euro has yet to be seen in exports
  • Lower energy prices are beginning to boost corporate margins
  • Bund yields are now negative out to seven years

Last month Eurostat released German GDP data for Q 2014 at +0.7%, this was well above consensus forecasts of +0.3% and heralded a surge in the DAX stock index. For the year German growth was +1.6% this compares favourably to France which managed an anaemic +0.4% for the same period. German growth forecasts are being, feverishly, revised higher. Here is the latest data as polled by the BDA – revisions are highlighted in bold:-

Institution Survey Date 2015 Previous 2015 2016
ifo ifo Institute (Munich) Dec-14 N/A 1.5  
IfW Kiel Institute Mar-15 1.7 1.8 2
HWWI Hamburg Institute Mar-15 1.3 1.9 1.7
RWI Rheinisch-Westf. Institute (Essen) Dec-14 N/A 1.5  
IWH Institute (Halle) Dec-14 N/A 1.3 1.6
DIW German Institute (Berlin) Dec-14 N/A 1.4 1.7
IMK Macroeconomic Policy Institute (Düsseldorf) Dec-14 N/A 1.6  
Research Institutes Joint Economic Forecast Autumn 2014 Oct-14 N/A 1.2  
Council of experts Annual Report 2014/2015 Nov-14 N/A 1  
Federal Government Annual Economic Report 2015 Jan-15 1.3 1.5  
Bundesbank Forecast (Frankfurt) Dec-14 N/A 1 1.6
IW Köln IW Forecast Sep-14 N/A 1.5  
DIHK German Chambers of Industry and Commerce (Berlin) Feb-15 N/A 0.8 1.3
OECD Nov-14 N/A 1.1 1.8
EU Commission Feb-15 1.1 1.5 2
IMF Oct-14 N/A 1.5 1.8

 

Source: Confederation of German Employers’ Associations (BDA), Survey Date: March 13, 2015

The improvement in German growth has been principally due to increases in construction spending, machinery orders and, more significantly, domestic consumption, which rose 0.8% for the second successive quarter. This, rather than a resurgence in export growth, due to the decline in the Euro, appears to be the essence of the recovery. That the Euro has continued to fall, thanks to ECB QE and political uncertainty surrounding Greece, has yet to show up in the export data:-

germany-exports 2008-2015

Source: Trading Economics

German imports have also remained stable:-

germany-imports 2008-2015

Source: Trading Economics

This may seem surprising given the extent of the fall in the price of crude oil – it made new lows this week. German Natural Gas prices, which had been moderately elevated to around $10.4/btu during the autumn have fallen to $9.29/btu, a level last seen in early 2011. That the improved energy input has not shown up in the terms of trade data may be explained by the fact that crude oil and natural gas imports account for only 10% of total German imports. Nonetheless, I suspect the benevolent impact of lower energy prices is being delayed by the effects of long-term energy contracts running off. Watch for the February PPI data due out this morning (forecast -1.9% y/y).

The ZEW Institute – Indicator of Economic Sentiment – released on Tuesday, showed a fifth consecutive increase, hitting the highest level since February 2014 at 54.8 – the forecast, however, was a somewhat higher 58.2. This is an extract from their press release:-

“Economic sentiment in Germany remains at a high level. In particular, the continuing positive development of the domestic economy confirms the expectations of the experts. At the same time, limited progress is being made with regard to solving the Ukraine conflict and the sovereign debt crisis in Greece. This has a dampening effect on sentiment,” says ZEW President Professor Clemens Fuest. The assessment of the current situation in Germany has improved notably. Increasing by 9.6 points, the index now stands at 55.1 points.

The good news is not entirely unalloyed (pardon the pun) IG Metall – the German metal workers union which sets the benchmark for other union negotiations – achieved a +3.4% wage increase for their 800,000 members in Baden Württemberg, starting next month. Meanwhile, German CPI came in at 0.09% in February after falling -0.4% in January. This real-wage increase is an indication of the tightness of the broader labour market. Nationally wages are rising at a more modest 1.3%, this is, however, the highest in 20 years. German unemployment fell to 4.8% in January, the lowest in 33years, despite the introduction of a minimum wage of Eur8.50/hour, for the first time, on 1st January.

One of my other concerns for Germany is the declining trend of productivity growth. Whilst employment has been growing, the pace of productivity growth has not. This 2013 paper from Allianz – Low Productivity Growth in Germany examines the issue in detail, here is the abstract:-

Since the labor market reforms implemented in the first half of the last decade, Germany’s labor market has been on a marked upward trend. In 2012, there were 2.6 million (+6.8%) more people in work than in 2005 and the volume of labor was up by 2.4 million hours (+4.3%) on 2005. But the focus on this economic success, which has also earned Germany a great deal of recognition on the international stage, makes it easy to overlook the fact that productivity growth in the German economy has continued to slacken. Whereas the increase in labor productivity per person in work was still averaging 1.0% a year between 1995 and 2005, the average annual increase in the period between 2005 and 2012 was only 0.5%. The slowdown in the pace of labor productivity growth, measured per hour worked, is even more pronounced. The average growth rate of 1.6% between 1995 and 2005 had slipped back to 0.9% between 2005 and 2012.

Allianz go on to make an important observation about the importance of capital investment:-

…the capital factor is now making much less of a contribution to economic growth in Germany than in the past, thus also putting a damper on labor productivity growth.

… Since the bulk of the labor market reforms came into force – in 2005 – the German economy has been growing at an average rate of 1.5% a year. Based on the growth accounting process, the capital stock delivered a growth contribution of 0.4 percentage points, with the volume of labor also contributing 0.4 percentage points. This means that total factor productivity contribute 0.7 percentage points to growth. So if the volume of labor and capital stock were to stagnate, Germany could only expect to achieve economic growth to the tune of 0.7% a year.

Although gross domestic product also grew by 1.5% on average during that period, labor productivity growth came in at 2.0%, more than twice as high as the growth rate for the 2005 – 2012 period. Between 1992 and 2001, the contribution to growth made by the capital stock, namely 0.9 percentage points, was much greater than that made in the period from 2005 to 2012; by contrast, the growth contribution delivered by the volume of labor was actually negative in the former period, at -0.4 percentage points, and 0.8 percentage points lower than between 2005 and 2012. This could allow us to draw the conclusion that the labor market reforms boosted economic growth by 0.8 percentage points a year. Although there is no doubt that this conclusion is something of a simplification, the sheer extent of the difference supports the theory that the labor market reforms had a marked positive impact on growth. In the period between 1992 and 2001, total factor productivity contributed 1.0 percentage points to growth, 0.3 percentage points more than between 2005 and 2012. This tends to suggest that the growth contribution delivered by technical progress is slightly on the wane.

The finding that the weaker productivity growth in Germany is due, to a considerable extent, to the insufficient expansion of the capital stock and, consequently, to excessive restraint in terms of investment activity, suggests that there is a widespread cause, and one that is not specific to Germany, that is putting a stranglehold on the German productivity trend.

The hope remains, however, that especially Germany – a country that has managed to get to grips with the crisis fairly well in an international comparison – will be able to return to more dynamic investment activity as soon as possible.  

The issue of under-investment is not unique to Germany and is, I believe, a by-product of quantitative easing. Interest rates are at negative real levels in a number of countries. This encourages equity investment but, simultaneously, discourages companies from investing for fear that demand for their products will decline once interest rates normalise. Instead, corporates increase dividends and buy back their own stock. European dividends grew 12.3% in 2014 although German dividend growth slowed – perhaps another sign of a return to capital investment.

German Bunds

Bunds made new highs again last week. The 10 year yield reached 19 bp. Currently, Bunds up to seven years to maturity are trading at negative yields. These were the prices on Wednesday after then 10 year Bund auction:-

Maturity Yield
1-Year -0.18
2-Year -0.225
3-Year -0.202
4-Year -0.173
5-Year -0.099
6-Year -0.065
7-Year -0.025
8-Year 0.053
9-Year 0.127
10Y 0.212
15-Year 0.38
20-Year 0.519
30-Year 0.626

 

Source: Investing.com

Wednesday’s 10 year auction came in at 0.25% with a cover ratio of 2.4 times, demand is still strong. The five year Bobl auction, held on 25th February, came with a negative 0.08% yield for the first time. Negative yields are becoming common-place but their implications are not clearly understood as this article from Bruegal – The below-zero lower bound explains – the emphasis is mine):-

The negative yields observed on some government and corporate bonds, as well as the recent move into further negative territory of monetary policy rates, are shaking our understanding of the ZLB constraint.

Matthew Yglesias writes… Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative.

Evan Soltas writes… economists had believed that it was effectively impossible for nominal interest rates to fall below zero. Hence the idea of the “zero lower bound.” Well, so much for that theory. Interest rates are going negative all around the world. And not by small amounts, either. $1.9 trillion dollars of European debt now carries negative nominal yields,

Gavyn Davies writes… the Swiss and Danish central banks are testing where the effective lower bound on interest rates really lies. Denmark and Switzerland are clearly both special cases, because they have been subject to enormous upward pressure on their exchange rates. However, if they prove that central banks can force short term interest rates deep into negative territory, this would challenge the almost universal belief among economists that interest rates are subject to a ZLB.

JP Koning writes that there are a number of carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn’t a zero bound, but a -0.5% bound (or thereabouts).

Evan Soltas writes that if people aren’t converting deposits to currency, one explanation is that it’s just expensive to carry or to store any significant amount of it… How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders… The data here suggest a conservative estimate is 2 percent annually.

Barclays writes… Coincidentally, the ECB has calculated that the social welfare value of transactions is 2.3%.

Brad Delong writes…In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it.

Whilst none of these authors definitively tell us how negative is too negative, it is clear that negative rates may have substantially further to go. The only real deterrent is the negative cost of carry, which is likely to make price fluctuations more volatile.

German Stocks

Traditionally Germany was the preserve of the bond investor. Stocks have become increasingly popular with younger investors and those who need yield. Corporate bonds used to be an alternative but even these issues are heading towards a zero yield. I have argued for many years that a well-run company, whilst limited by liability, may be less likely to default or reschedule their debt than a profligate government. Even today, corporates offer a higher yield – the only major concern for an investor is the liquidity of the secondary market.

Nonetheless, with corporate yields fast converging on government bonds, stocks become the “least worst” liquid investment, since they should be supported at the zero-bound – I assume companies will not start charging investors to hold their shares. Putting it in finance terms; whereas we have been inclined to think of stocks as “growth” perpetuities, at the “less-than-zero-bound”, even a “non-growth” perpetuity looks good when compared to the negative yield on dated debt. We certainly live in interesting, or perhaps I should say “uninteresting” times.

A different case for investing in stocks is the potential restructuring risk inherent throughout the Eurozone (EZ). Michael Pettis – When do we decide that Europe must restructure much of its debt? Is illuminating on this issue:-

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

while German institutions and policymakers are as responsible as those in peripheral Europe for the debt crisis, in fact it was German and peripheral European workers who ultimately bear the cost of the distortions, and it will be German households who will pay to clean up German banks as, one after another, the debts of peripheral European countries are explicitly or implicitly written down.

In many countries in Europe there is tremendous uncertainty about how debt is going to be resolved. This uncertainty has an economic cost, and the cost only grows over time. But because most policymakers stubbornly refuse to consider what seems to have become obvious to most Europeans, there is a very good chance that Europe is going to repeat the history of most debt crises.

For now I would argue that the biggest constraint to the EU’s survival is debt. Economists are notoriously inept at understanding how balance sheets function in a dynamic system, and it is precisely for this reason that we haven’t put the resolution of the European debt crisis at the center of the debate. But Europe will not grow, the reforms will not “work”, and unemployment will not drop until the costs of the excessive debt burdens are addressed.

If Pettis is even half-right, the restructuring of non-performing EZ debt will be a dislocating process during which EZ government bond yields will vacillate wildly. If the German government ends up footing the bill for the lion’s share of Greek debt, rather than letting its banking system default, then stocks might become an accidental “safe-haven” but I think it more likely that rising Bund yields will precipitate a decline in German stocks.

Here is how the DAX Index has reacted to the heady cocktail of ECB QE, a falling Euro and a deferral of the Greek dilemma:-

DAX Jan 1998 - March 2015 Monthly

Source: Barchart.com

The DAX has more than doubled since the dark days of 2011 when the ECB saved the day with rhetoric rather than real accommodation. From a technical perspective we might have another 1,500 points to climb even from these ethereal heights – I am taking the double top of 2000 and 2007 together with the 2003 low and extrapolating a similar width of channel to the upside – around 13,500. The speed of the rally is cause for concern, however, since earnings have yet to catch up with expectations, but, as I pointed out earlier, there are non-standard reasons why the market may be inhaling ether. The current PE Ratio is 21.5 times and the recent rally has made the market look expensive relative to forward earning. At 13,500 the PE will be close to 24.5 times. This chart book from Dr Ed Yardeni makes an excellent case for caution. This is a subscriber service if you wish to sign up for a free trial.

The domestic nature of the economic resurgence is exemplified most clearly by the chart below which shows the five year performance of the DAX Index versus the mid-cap MDAX Index, I believe it is time for the large cap stocks to benefit from the external windfalls of a weaker Euro and lower energy prices:-

DAX vs MDAX 2000-2015

Source: Finanzen.net

Real Estate

In Germany, Real Estate investment is different. Government policy has been to keep housing affordable and supply is therefore plentiful. This article from Inside Housing – German Lessons elaborates:-

Do you fancy a one-bed apartment in Berlin for £35,000 or a four- bed detached house in the Rhineland for £51,000?

In many parts of Germany house prices are a fraction of their UK equivalents – in fact, German house prices have decreased in real terms by 10 percent over the past thirty years, whereas UK house prices have increased by a staggering 233 percent in real terms over the same period. Yet German salaries are equal to or higher than ours. As a consequence Germans have more cash to spend on consumer goods and a higher standard of living, and they save twice as much as us, which means more capital for industry and commerce. Is it any surprise that the German economy is consistently out-performing ours?

There are a number of reasons for the disparity between the German and UK housing markets. Firstly, German home ownership is just over 40 percent compared to our 65 percent (there are stark regional variations – in Berlin 90 percent of all homes are privately rented) and the Germans do not worship ownership in the way we do. Not only is it more difficult to get mortgage finance (20 percent deposits are a typical requirement) but the private rented sector offers high quality, secure, affordable and plentiful accommodation so there are fewer incentives to buy. You can rent an 85 square metre property for less than £500 per month in Berlin or for around £360 per month in Leipzig. There is also tight rent control and unlimited contracts are common, so that tenants, if they give notice, can stay put for the long-term. Deposits must be repaid with interest on moving out.

In addition, Germany’s tax regime is not very favourable for property owners. There is a property transfer tax and an annual land tax. But the German housebuilding industry is also more diverse than ours with more prefabraction and more self-builders. The German constitution includes an explicit “right-to-build’’ clause, so that owners can build on their property or land without permission so long as it conforms with local codes.

But the biggest advantage of the German system is that they actively encourage new housing supply and release about twice as much land for housing as we do. German local authorities receive grants based on an accurate assessment of residents, so there is an incentive to develop new homes. The Cologne Institute for Economic Research calculated that in 2010 there were 50 hectares of new housing development land per 100,000 population in Germany but only 15 hectares in the UK. That means the Germans are building three times as many new homes as us pro-rata even though our population growth is greater than theirs. This means that German housing supply is elastic and can respond quickly to rising demand…

 

German rental protection laws – for the renter – are stronger than in other countries – this encourages renting rather than buying. From an investment perspective this makes owning German Real Estate a much more “bond like” proposition. With wages finally rising and economic prospects brightening, Real Estate is a viable alternative to fixed income. The table below was last updated in May 2014, at that time 10 yr Bunds were yielding around 1.5%:-

Apartment Location Cost Monthly Rent Yield
Berlin
45 sq. m. 108,225 500 5.55%
75 sq. m. 230,025 779 4.07%
120 sq. m. 489,360 1,362 3.34%
200 sq. m. 935,200 2,442 3.13%
Frankfurt
45 sq. m. 164,385 788 5.75%
75 sq. m. 308,025 1,182 4.60%
120 sq. m. 538,560 1,750 3.90%
200 sq. m. n.a. 3,066 n.a.
Munich
45 sq. m. 218,160 773 4.25%
75 sq. m. 463,275 1,172 3.00%
120 sq. m. 774,120 2,066 3.20%
200 sq. m. 1,850,000 3,562 2.31%

Source: Global Property Guide Definitions: Data FAQ

For comparison, commercial office space in these three locations also offers a viable yield: –

Office Location   Yield  
  2013 2012 2011
Berlin 4.7 4.8 4.95
Frankfurt 4.65 4.75 4.9
Munich 4.4 4.6 4.75

Source: BNP Paribas

I believe longer term investors are fairly compensated for the relative illiquidity of German Real Estate.

The Euro

For the international investor, buying Euro denominated assets exposes one to the risk of a continued decline in the value of the currency. The Euro Effective Exchange Rate is still near the middle of its long-term range, as the chart below illustrates, though since this chart ends in Q4 2014 the Euro has weakened to around 90:-

Euro_Effective_Excahnge_Rate_-_ECB_1993_-_2015

Source: ECB

Investors must expect further Euro weakness whilst markets obsess about the departure of Greece from the EZ, however, a “Grexit” or a resolution (aka restructuring/forgiveness) of Greek debt will allow the markets to clear.

Conclusion and Investment Opportunities

German Bunds continue to be the safe-haven asset of choice for the EZ, however, for the longer term investor they offer negligible or negative returns. German Real Estate, both residential and commercial, looks attractive from a yield perspective, but take care to factor in the useful life of buildings, since capital gains are unlikely.

This leaves German equities. A secular shift from bond to equity investment has been occurring due to the low level of interest rates, this has, to some extent, countered the demographic forces of an aging German population. Nonetheless, on a P/E ratio of 21.5 times, the DAX Index is becoming expensive – the S&P 500 Index is trading around 20 times.

At the current level I feel it is late to “arrive at the party” but on a correction to test the break-out around 10,000 the DAX looks attractive, I expect upward revisions to earnings forecasts to reflect the weakness of the Euro and the lower price of energy.

China versus India – Currencies, Reform and Growth

400dpiLogo

Macro Letter – No 31 – 06-03-2015

China versus India – Currencies, Reform and Growth

  • India announced a reformist budget, short on detail but market friendly
  • The PBoC cut interest rates again but are still behind the curve
  • Chinese and Indian Real-Estate prices continue to decline in real terms
  • INR/CNY exchange rate will move higher

Last month PWC – The World in 2050 – produced a long-term forecast for economic growth in which they predicted that India could become the second largest economy in the world by 2050 in purchasing power parity (PPP) and third largest in market exchange rate (MER) terms. Putting the scale of world economies in to perspective they say:-

China has already overtaken the US for the number one spot, and will remain as the world’s largest economy in 2050. India could narrowly overtake the US for the number two spot by 2050. However, the gap between the third largest economy and the fourth largest economy will widen considerably. In 2014, the third biggest economy (India) is around 50% larger than the fourth biggest economy (Japan). In 2050, the third biggest economy (the US) is projected to be approximately 240% larger than the fourth biggest economy (Indonesia).

The prospects from the BRIC economies are mixed. Russia is entangled in the geo-politics of the Ukraine and its economy has suffered from falling energy prices as this article from Chatham House – Troubled Times: Stagnation, Sanctions and the Prospects for Economic Reform in Russia explains. Meanwhile Brazil, still reeling from the stagnation of 2013, looks set to head into a fully-fledged recession exacerbated by high, wage-squeezing, inflation resulting from the near 30% decline in its currency. The prospects for India and China are much better.

India

Last week Arun Jaitley, India’s finance minister, announced a budget which he described as “a quantum jump”. Among other things, he intends to:-

  • Implement an RBI inflation target
  • Maintain a national government budget deficit of 4.1% of GDP in cash terms
  • Target a budget reduction to 3% of GDP in 2017-2018
  • Increase Spending on road construction and power generation
  • Streamline subsidies and accelerate the de-nationalization of state industries
  • Introduce a harmonised goods and sales tax, by April 2016, to replace state and federal levies – potentially adding 2% to GDP by creating an India-wide “common market”
  • Rationalise direct-taxation – cutting corporation tax but closing loopholes, abolishing a wealth tax in favour of an income tax surcharge on higher earners

This amounts to a decidedly reformist agenda, although the speech was light on detail. It removes several barriers to investment in India, although the issue of reform of land laws remains unresolved.

China

Meanwhile, last Saturday, the People’s Bank of China (PBoC) cut interest rates. This is the third accommodative move in as many months. Their motivation appears to be three-fold:-

  • Stimulate Credit Growth.
  • The fall in credit as measured by “total social financing” -13.5% y/y in January 2015 versus a +17.5% in January 2014. This may also allow SOEs and SMEs to service existing debt acquired during the indiscriminate credit expansion of 2009.
  • Alleviate Falling inflation.
  • The inflation rate has declined by 1.7% since Q4 2014. Lending rates are only 20bp lower over the same period. In other word a “real” tightening of 1.5% has occurred.
  • Stem Capital Outflows.
  • The capital and financial account deficit hit a decade high of $91.2bln in Q4 2014. This is a sharp deterioration, in 2013 the capital account surplus for the year was $326.2bln

This action may still not be sufficient to re-invigorate the Chinese economy. It fuels hopes for further accommodation later this year. This could take the form of lower interest rates, additional liquidity, reduction in bank reserve requirements or some form of fiscal stimulus. Last year the Chinese government budget deficit was 2.1% of GDP, there is plenty of room for manoeuver.

China and India as economic dynamos

Before delving into the details of monetary policy in each country, it is worth taking a broad overview of the Chinese and Indian economies from a global perspective.

The table below shows the major economic regions of the world ranked by population: –

Country GDP-YOY Interest Rate Inflation Rate Jobless Rate Debt/GDP C/A Population
China 7.30% 5.35% 0.80% 4.10% 22.40% 2 1360.72
India 7.50% 7.75% 5.11% 5.20% 67.72% -1.7 1238.89
EA 0.90% 0.05% -0.30% 11.20% 90.90% 2.4 334.57
USA 2.40% 0.25% -0.10% 5.70% 101.53% -2.3 318.86
Brazil -0.20% 12.25% 7.14% 5.30% 56.80% -4.17 202.77
Russia 0.70% 15.00% 15.00% 5.50% 13.41% 1.56 143.7
Japan -0.50% 0.00% 2.40% 3.60% 227.20% 0.7 127.02

 

Source: Trading Economics

India and China stand out as the engines of economic growth. They have a combined population of more than 3.5bln. On a GDP per capita basis both countries have far to go. Indian GDP/Capita is $1,165 and China $3,583, compared to Euro Area $31,807 and USA $45,863. However, as PWC say in their report, the gap between the rich and these relatively poor countries is likely to narrow in percentage terms significantly by 2050.

Here are some more statistics which help to show the similarities and differences between the two economies:-

Criteria China India
Age structure 0-14 years: 17.1% 0-14 years: 28.5%
15-24 years: 14.7% 15-24 years: 18.1%
25-54 years: 47.2% 25-54 years: 40.6%
55-64 years: 11.3% 55-64 years: 7%
65 years and over: 9.6%(2014 est.) 65 years and over: 5.8%(2014 est.)
Median age total: 36.7 years total: 27 years
male: 35.8 years male: 26.4 years
female: 37.5 years (2014 est.) female: 27.7 years (2014 est.)
Population growth rate 0.44% (2014 est.) 1.25% (2014 est.)
Birth rate 12.17 births/1,000 (2014 est.) 19.89 births/1,000 (2014 est.)
Death rate 7.44 deaths/1,000 (2014 est.) 7.35 deaths/1,000 (2014 est.)
Net migration rate -0.32 migrant(s)/1,000 (2014 est.) -0.05 migrant(s)/1,000 (2014 est.)
Urbanization – Urban 50.6% of total population (2011) 31.3% of total population (2011)
Rate of Urbanization 2.85% annual (2010-15 est.) 2.47% annual (2010-15 est.)
Major cities – population Shanghai 20.2mln                                                            BEIJING (capital) 15.6mln (2011) NEW DELHI (capital) 22.6mln                                        Mumbai 19.7mln (2011)
Infant mortality rate 14.79 deaths/1,000 live births 43.19 deaths/1,000 live births
Life expectancy at birth 75.15 years 67.8 years
Total fertility rate 1.55 children born/woman (2014 est.) 2.51 children born/woman (2014 est.)
Infectious diseases degree of risk: intermediate degree of risk: very high
Literacy – age 15 (can read and write) total population: 95.1% total population: 62.8%
male: 97.5% male: 75.2%
female: 92.7% (2010 est.) female: 50.8% (2006 est.)
School life expectancy 13 years 12 years
Education expenditures NA 3.2% of GDP (2011)
Maternal mortality rate 37 deaths/100,000 live births (2010) 200 deaths/100,000 live births (2010)
Children under weight <5yrs 3.4% (2010) 43.5% (2006)
Health expenditures 5.2% of GDP (2011) 3.9% of GDP (2011)
Physicians density 1.46 physicians/1,000 population (2010) 0.65 physicians/1,000 population (2009)
Hospital bed density 3.8 beds/1,000 population (2011) 0.9 beds/1,000 population (2005)
Adult Obesity 5.7% (2008) 1.9% (2008)

 

Source: Index Mundi

From a Chinese perspective the main elements which stand out in the table above are:-

  • Slower birth rate, aging population and lower fertility rate – according to the UN China’s working age population will decline by 16% between now and 2050
  • Higher literacy, especially female literacy
  • Lower mortality rate and higher health expenditure

For India, improvements in education, sanitation and healthcare are key factors.

Indian Monetary Policy

The Reserve Bank of India (RBI) cut their key Repo Rate in December 2014. Despite falling oil prices they have left this rate unchanged as the effects of the currency devaluation of 2013 work their way through the economy. This is an extract from the RBI Bulletin – February 2015:-

On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:-

  • keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 7.75 per cent;
  • keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL);
  • reduce the statutory liquidity ratio (SLR) of scheduled commercial banks by 50 basis points from 22.0 per cent to 21.5 per cent of their NDTL with effect from the fortnight beginning February 7, 2015;
  • replace the export credit refinance (ECR) facility with the provision of system level liquidity with effect from February 7, 2015;
  • continue to provide liquidity under overnight repos of 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
  • continue with daily variable rate term repo and reverse repo auctions to smooth liquidity

They go on to defend their hawkish stance on inflation:-

The upside risks to inflation stem from the unlikely possibility of significant fiscal slippage, uncertainty on the spatial and temporal distribution of the monsoon during 2015 as also the low probability but highly influential risks of reversal of international crude prices due to geo-political events. Heightened volatility in global financial markets, including through the exchange rate channel, also constitute a significant risk to the inflation assessment. Looking ahead, inflation is likely to be around the target level of 6 per cent by January 2016.

Their growth forecasts are also cautious:-

The outlook for growth has improved modestly on the back of disinflation, real income gains from decline in oil prices, easier financing conditions and some progress on stalled projects. These conditions should augur well for a reinvigoration of private consumption demand, but the overall impact on growth could be partly offset by the weaker global growth outlook and short-run fiscal drag due to likely compression in plan expenditure in order to meet consolidation targets set for the year. Accordingly, the baseline projection for growth using the old GDP base has been retained at 5.5 per cent for 2014-15. For 2015-16, projections are inherently contingent upon the outlook for the south-west monsoon and the balance of risks around the global outlook. Domestically, conditions for growth are slowly improving with easing input cost pressures, supportive monetary conditions and recent measures relating to project approvals, land acquisition, mining, and infrastructure. Accordingly, the central estimate for real GDP growth in 2015-16 is expected to rise to 6.5 per cent with risks broadly balanced at this point.

Since this report GDP data has surprised on the upside and the Indian Finance Ministry even suggested their own forecast could be revised to 8.5% – this is how the Wall Street Journal reported it, last week:-

India is in a “sweet spot,” the report said: Inflation has eased, international investors are bullish on India and the government in New Delhi has a strong mandate for change.

If the Modi administration continues improving the business environment and reducing government interference in the prices of food, fuel and other basic goods, the survey said, India’s GDP eventually could experience double-digit growth. That would give the country more resources to help its poor and provide opportunities for its young, growing middle class.

The combination of a relatively weak currency, declining inflation, accelerating growth and a structural reform package, from a government with a strong mandate from its electorate, are a heady cocktail. The RBI underpins these developments by holding back on interest rate cuts. The INR has taken this to heart as the chart below shows. It is still dangerous for the RBI to aggressively cut interest rates – the moderation in inflation needs to feed through to inflation expectations – but inward foreign direct investment could lead to a steady appreciation in the INR over the next couple of years. I wait for technical confirmation of this trend which could see at least a 61.8% correction of the 2011/2013 range (44-68) around USDINR 53:-

USDINR 5 yr

Source: Barchart.com

Chinese Monetary Policy

The Peoples Bank of China (PBoC) announced an interest rate cut last Saturday, lowering the one year rate to 5.35% from 5.6% previously. A PBoC official stated Deflationary risk and the property market slowdown are two main reasons for the rate cut this time,” The PBoC press release was somewhat drier:-

The one-year RMB benchmark loan interest rate and deposit interest rate will both be lowered by 0.25 percentage points, to 5.35 percent and 2.5 percent, respectively. At the same time, the upper limit of the floating range for deposit interest rates will be raised from 1.2 to 1.3 times the benchmark level in support of market-oriented interest rate reform. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities, and to deposit and loan interest rates on personal housing provident fund.

This is the second rate cut in four months. They also introduced a Standing Lending Facility to create better liquidity:-

To implement the decisions adopted at the Central Economic Work Conference as well as the requirements of the 2015 PBC Work Conference and PBC Money, Credit and Financial Market Work Meeting, to improve the central bank’s liquidity support channels for small and medium-sized financial institutions, to address seasonal liquidity fluctuations in the run-up to Spring Festival, and to promote stable functioning of the money market, the PBC has decided, based on the reproducible experience from the pilot Standing lending Facility (SLF) program participated by the branch offices in ten provinces (and municipalities), to introduce SLF operations in branch offices nationwide. As a result, the PBC branch offices will provide SLF on collaterals to four categories of local legal-entity financial institutions, i.e., the city commercial banks, rural commercial banks, rural cooperative banks, and rural credit cooperatives.

This followed on from a cut to Bank Reserve Requirements announced on February 5th:-

The PBC has decided to cut the RMB deposit required reserve ratio for financial institutions by 0.5 percentage points, effective from February 5, 2015. Furthermore, in order to enhance the capacity of financial institutions to support structural adjustment, and to beef up support to small and micro enterprises, the agricultural sector, rural area and farmer, and major water conservancy projects, the PBC has decided to cut the RMB deposit required reserve ratio for city commercial banks and non-county level rural commercial banks that have met the standards of targeted required reserve reduction by an additional 0.5 percentage points, and cut the required reserve ratio for the Agricultural Development Bank of China by an additional 4 percentage points.

The continued pegging of the RMB – within tight parameters – to the US$ means that China is a beneficiary of the rising US$, but this is something of a double-edged sword since the currency appreciation has been damaging for Chinese exporters. The slowing of the Chinese economy over the last few months and PBoC action has heralded a much needed weakening of the CNY rate as this chart shows:-

USDCNH Oct 2012-March 2015

Source: Barchart.com

The PBoC rate cut will probably not be the last action to stimulate economic activity, being pegged to a currency which has been steadily rising on a trade-weighted basis whilst maintaining a substantial interest rate differential is a difficult long-term operation even for an economy as closed to international capital flows as China. The BIS – Assessing the CNH-CNY pricing differential: role of fundamentals, contagion and policy released this week, discusses some of these issues in greater detail, here is the abstract:-

Renminbi internationalisation has brought about an active offshore market where the exchange rate frequently diverges from the onshore market. Using extended GARCH models, we explore the role of fundamentals, global factors and policies related to renminbi internationalisation in driving the pricing differential between the onshore and offshore exchange rates. Differences in the liquidity of the two markets play an important role in explaining the level of the differential, while rises in global risk aversion tend to increase the differential’s volatility. On the policy front, measures permitting cross-border renminbi outflows have a particularly discernible impact in reducing the volatility of the pricing gap between the two markets.

A weaker RMB would help China more than devaluations have aided other emerging market countries since most of China’s debt is denominated in their own currency, however, a major factor acting as a drag on economic growth is over-investment. At more than 50%, China has the highest level of investment as a percentage of GDP of any major economy – in the UK, by contrast, investment amounts to less than 20%.

Asset Markets

Indian Real-Estate

With relatively high short-term interest rates and uncertainty still hanging over the market due to the currency devaluation of 2013, Indian Real-Estate transactions have been sluggish. In 2014 residential sales were down 30% y/y across India’s seven major cities. A growing inventory of unsold properties is weighing on the domestic banks. Real-Estate accounts for around 13% of Indian bank lending. With non-performing loans on the rise, lower interest rates would be very welcome for the banking sector. The chart below shows the age of property for sale and the length of time these properties are taking to sell in the major cities – a region which accounts for around 70% of India’s property development:-

Unsold Indian Property - Frank Knight

Source: Knight Frank

The National Housing Bank – a subsidiary of the RBI – publishes an index of prices. With an inverted government bond yield curve (1yr 7.83% vs 10yr 7.68% – 4-3-2015) and a substantial over-hang of inventory, it is not surprising that prices are struggling to make much real upside even in the best areas:-

NHB - Price Data

Source: National Housing Bank

A new government initiative called the Smart Cities Project was launched last year with $1.2bln of funding for 2015. Long-term, this will help to deliver the housing and infrastructure India needs, but, near-term, Real-Estate is an asset class which remains supressed. Many apartment buildings stand empty and whilst real prices have not declined significantly, market activity remains very subdued. I do see value developing; there will be an opportunity to invest over the next couple of years as the economy responds to structural reforms.

Demand will emanate from urbanisation and an increase in high and middle income workers returning to India – after all, the “quality of life” for skilled workers returning home is compelling. A working paper from the Peterson Institute – The Economic Scope and Future of US-India Labor Migration Issues looks at the positive impact of both temporary and permanent Indian labour on US markets, they go on to raise concerns about recent US immigration policy:-

…but US immigration data show that India is by far the most important partner country for both permanent and temporary US employment-based migration: Indian nationals account for about half of all US employment-based permanent migration (e.g., green cards) in recent years.

…The prospects of a US-India totalization agreement for social contributions/taxation as part of an FTA are evaluated. A TA is likely to result in indirect economic losses to the United States from the loss of payroll taxes paid but never claimed by temporary Indian workers in the United States. The substantial political and economic quid pro quo that India would have to commit to in order to incentivize the United States to negotiate a TA would be daunting and seems likely to diminish the attractiveness of an FTA to India.

This 2012 paper from the Institute for European Studies – India’s Returning Elite Knowledge Workers is an excellent insight into the inward migration of skilled workers to the major cities of India’s North East. Here is a summary of the “Brain-Gain”:-

India’s rising independence in the last decade as an economic actor constitutes new issues in global governance for a large skilled workforce. What once constituted a ‘brain-drain’ for Indian actors that emigrated to the Global North (EU and US economic powers), is now resulting in a ‘brain-gain’ for the sending countries. India, as a representative power of the emerging Global South, has been a leader in creating cross-border social networks for entrepreneurship through ties between the Indian expatriate community and local entrepreneurs in industries that are enticing Western agents. 

This dissertation project investigates how the ‘brain gain’ of high-skilled entrepreneurs of Indian origin has transformed the landscape of infrastructure and social relations within emergent Global South cities in India based upon elite trans-migrant imaginaries of home. India’s growth as a global power attributed to cross border diasporic networks of Indian transnationals has given rise to a generation of permanently returning migrants to India’s cosmopolitan cities. This paper explores the movement of transnational Indian elites returning from the United States and Europe to postcolonial India. Through ethnographic interviews in Silicon Valley, California, I attempt to understand why social and technological entrepreneurs of Indian origin, those who see their return as a new venture or idea, are returning to accommodate a hybridized Western lifestyle within an Indian socio-cultural context. These entrepreneurs are transforming the peripheries of the cosmopolitan global city through the gated communities where they reside and Special Economic Zones where they work toward developing new business and change in India. By examining the narratives and everyday life of elite diasporic returners in their newfound ‘home’ spaces, I question (a) what are the principle motivations that guide entrepreneurs to return to India (b) whether the cosmopolitan Global South city can function as a hybrid ‘home’ and (c) in locating ‘home’ by transforming their spatial and temporal relationships, how are power relations constituted.

Chinese Real-Estate

Shanghai Real-Estate has risen by 650% since 2000 and by 85% since the last peak in 2007, although nationwide the increase in the period from 2008 to 2013 was a more moderate 20%. The driving force behind this price increase has been urbanisation. In the past 12 years 220mln people have move from rural to urban districts in China. A large number of these new, often unskilled, city dwellers have been employed in construction. It is estimated that 27% of urban Real-Estate is unoccupied. This explains the recent downturn in Chinese Real-Estate prices as this chart of newly built housing shows:-

china-housing-index

Source: Trading Economics and National Bureau of Statistics of China

In January the decline was -5.1% versus -4.3% in December and -3.7% in November 2014. Price drops were recorded in 64 of the 70 major cities, compared to 66 in December. Declines are not evenly distributed: the average price of new homes in the country’s four first-tier cities rose for the second consecutive month. The existing housing market is also more buoyant for first-tier cities, rising for the fourth month in a row. In second and third-tier cities prices continue to decline.

Writing in the FT – How addiction to debt came even to China Martin Wolf describes the problem overhanging the Chinese property market:-

China’s huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; “shadow banking” — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.

This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.

Despite this relatively sanguine appraisal of the prospects for the housing market it is worth pointing out that 75% of Chinese individual net worth is tied up in Real-Estate – by way of comparison, in the US the figure is 28%.

Chinese Real-Estate may recover at some point, probably in response to wage growth – currently running at around 8% in real terms, buoyed by state mandated minimum wage increases (13%) and strong growth in private manufacturing (12%). For the present I expect Real-Estate prices to continue to decline. This will eventually exert significant downward pressure on private domestic consumption – an impediment to the policy of “re-balancing”.

Indian Equities

Indian equities have performed strongly due to the currency devaluation, high inflation and relatively strong economic growth. Money supply has moderated in response to higher interest rates but is still sufficient to encourage asset market speculation. The chart below covers the period up to January 2014 but the double digit expansion has continued during the last year:-

India_Money_supply

Source: RBI

The currency devaluation of 2013 has fed through to higher inflation but the fall in oil prices has narrowed the current account deficit, whilst exports have held up well. This, among other factors, has supported a rise in stocks, despite the RBI’s hawkish stance:-

BSE_1yr

Source: Bigcharts.com

The SENSEX Index is trading on a current P/E ratio of 18.52. This is still in the lower half of the 5 year range (16.5 to 24). With growth prospects likely to be revised higher, I believe the market will continue to exhibit strong performance over the coming year.

Chinese Equities

The Shanghai Composite performed strongly in Q4 2014 as markets became cognizant of the PBoCs dovish policy shift. Government policy is also supportive, with the continued development of Free Trade Zones remaining high on their agenda. The Jamestown Foundation – “Hope” versus “Hype”: Reforms in China’s Free Trade Zones provides more detail and suggests they may fail to realize their early promise:-

After a year of the Shanghai pilot FTZ, three new FTZs are now being established in the major sea-port cities of Guangdong, Tianjin and Fujian (South China Morning Post, December 13, 2014). Fujian is the closest mainland province to Taiwan, Tianjin specializes in international shipping and related sectors and Guangdong is adjacent to Hong Kong and Macao and is close to Southeast Asia. However, the troubles of the Shanghai FTZ—despite the personal high-level support of Premier Li—suggest that these new FTZs will face an uphill battle in expanding the grounds of economic liberalization in China.

Most Promises Stand Unfulfilled

China’s slowing growth has led many foreign companies to consider scaling back their expansion plans, and the Shanghai FTZ has failed to deliver on the promises of reform that appear necessary to justify foreign companies’ high hopes for a better future business environment in China.

Bi-lateral Free Trade Agreements are also being contemplated. This paper from ECFR – The European interest in an investment treaty with China explores one with the EU:-

Like the EU, China is a global player. Trade and investment talks cannot be viewed in isolation of moves with third parties. Chinese economic agents – from SOEs turning into multilateral firms, to sovereign funds or more dispersed private actors – are in a decisive phase of capital internationalisation as China maintains a large current account surplus.

Recent trade data, however, paints a vulnerable picture in the near-term. This was the data for January, admittedly a notoriously volatile period as it precedes the Chinese New Year: –

  • Imports -19.9% – forecast -3.2%
  • Exports -3.3% – forecast +5.9%
  • Crude oil imports -41.8%
  • Iron ore imports -50.3%
  • Coal imports – 61.8%

Another factor impacting the stock market is credit and money supply growth, M2 grew 12.2% in December 2014 down from a high of 13.6% in 2013, however it has regained upward momentum in the last couple of months:-

China M2 - Cato

Source: Cato, John Hopkins University and PBoC

 

Unless it can be reversed, this declining trend will act as a drag on economic activity. Nonetheless, the stock market has surged ahead – note the dramatic increase in volume traded – anticipating the effect of the PBoC policy shift:-

Shanghai_Composite_1_yr

Source: Bigcharts.com

A longer-term chart shows that the market has some distance to go until it reaches its old highs:-

china-stock-market 8yr

Source: Trading Economics

The Shanghai Composite is trading on a P/E ratio of 16.33. This is undemanding but the risk of China unpegging and devaluing their currency is a significant risk for the international investor.

Conclusions and Investment Opportunities

Bonds

I have not made much mention of the government bond markets in China or India: it is not because one cannot invest in these markets but due to the relative difficulty of accessing them and their uneven liquidity. They both offer a real yield – China 2.63% and India 2.57% for 10 year (4-3-2015). Both markets are attractive.

Real-Estate

Both China and India are suffering from an overhang of unsold property but the overvaluation is more pronounced in China. India has the additional advantage that interest rates have more room to fall in the event of a sharp downturn in economic activity. India has a younger population and its skilled ex-patriot workers are returning in significant numbers. The Chinese market will take longer to clear. Neither market has finished correcting yet.

Equities

On a price to earnings basis the Shanghai Composite (16.33 times) offers better value than the Sensex (18.52 times) however there is a real risk that the “internationalisation” of the RMB leads to its decline against the US$. The Sensex is making new highs whilst the Shanghai Composite is trading higher after a major correction from the 2008 highs. This is not to suggest that India is trouble free, however, it has more room to grow given its per capita GDP, and less signs of over-investment. Corruption is an issue in both countries but the Chinese administration’s efforts to root out officials who have “feathered their nests” is likely to act as a drag on growth. Indian reform is principally concerned with reducing bureaucratic impediments to the functioning of free markets – closing tax loopholes, reducing state interference in competitive processes and so forth.

The key for growth in both China and India is the inward flow of foreign capital. On January 29th the UN – Global Investment Trends Monitor – announced that China had become the leading destination for FDI in 2014 ($128bln) for the first time since 2003, however, its growth rate was an incremental 3%. India, by contrast, saw FDI surge by more than 26% to $35bln – this follows a 17% rise in 2013. This trend will continue, accelerated by the reforming zeal of the incumbent regime.

Indian and Chinese interest rates will decline, but Indian rates have more room to fall. Chinese and Indian stocks will rise but, with the currency devaluation behind it, Indian stocks – despite their higher P/E ratio – look better placed to rise.

Currency

Risks for the RMB are on the downside whilst for the INR they are on the upside, the trend is underway:-

CNY-INR-2 yr

Source: Exchangerates.org.uk

Australia and Canada – Commodities and Growth

400dpiLogo

Macro Letter – No 30 – 20-02-2015

Australia and Canada – Commodities and Growth

  • Industrial commodities continue to weaken
  • The BoC and RBA have cut official rates in response to falling inflation and slower growth
  • The RBA has more room to manoeuvre in cutting rates, Australian Bonds will outperform

The price of Crude Oil has dominated the headlines for the past few months as Saudi Arabia continued pumping as the price fell in response to increased US supply. However, anaemic growth in Europe and a continued slowdown in China has taken its toll on two of the largest commodity exporting countries. This has prompted both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) to cut interest rates by 25 bp each – Canada to 0.75% and Australia to 2.25% – even as CAD and AUD declined against the US$.

In this letter I will look at Iron Ore, Natural Gas and Coal, before going on to examine other factors which may have prompted central bank action. I will go on to assess the prospects for asset markets over the coming year.

Iron Ore

The price of Iron Ore continues to make fresh lows, driven by weakness in demand from China and Japan and the EU.

Iron Ore Fines 6 yr

Source: Infomine.com

Iron Ore is Australia’s largest export market, significantly eclipsing Coal, Gold and Natural Gas. It is the second largest producer in the world behind China. 2013 production was estimated at 530 Mt. Canada, with 40 Mt is ranked ninth by production but is the fourth largest exporter. Needless to say, Iron Ore production is of significant importance to both countries, although for Canada Crude Oil comes first followed by vehicle and vehicle parts, then Gold, Gas – including Propane – and Coal. It is also worth noting that the two largest Steel exporters are China and Japan – both major Iron Ore importers. The health of these economies is vital to the fortunes of the Iron Ore industry.

Natural Gas

Natural Gas is a more difficult product to transport and therefore the price differential between different regions is quite pronounced. Japan pays the highest price of all the major economies – exacerbated by its reduction of nuclear generating capacity – closely followed by Singapore, Taiwan and South Korea. The US – Henry Hub – and AECO – Alberta – prices are broadly similar, whilst Europe and Japan pay a significant premium:-

Chart-4-Global-Natural-Gas-Prices11

Source: Federal Reserve, World Bank, CGA

Here is an extract from the International Gas Union report – IGU Wholesale Gas Price Survey Report – 2014 Edition:-

Wholesale prices can obviously vary significantly from year to year, but the top two regions are Asia Pacific followed by Europe – both with average prices over $11.00. OPE* remains the primary pricing mechanism in Asia Pacific and still a key mechanism in Europe.

*Oil Price Escalation – in this type of contract, the price is linked, usually through a base price and an escalation clause, to competing fuels, typically crude oil, gas oil and/or fuel oil. In some cases coal prices can be used as can electricity prices.

Canada has significant Gas reserves and is actively developing Liquefied Natural Gas (LNG) capacity. 13 plant proposals are underway but exports are still negligible. It also produces significant quantities of Propane which commands a premium over Natural Gas as this chart shows: –

Chart-5-Energy-Commodity-Prices10

Source: StatsCan, Kent Group, CGA

Australia, by comparison, is already a major source of LNG production. The IGU – World LNG Report – 2014 Edition:-

Though Australia was the third largest LNG capacity holder in 2013, it will be the predominant source of new liquefaction over the next five years, eclipsing Qatari capacity by 2017. With Pluto LNG online in 2012, seven Australian projects are now under construction with a total nameplate capacity of 61.8 MTPA (53% of global under construction capacity).

Coal

Australia is the fourth largest Coal producer globally. According to the World Coal Association, it produced 459 Mt in 2013. Canada did not feature in the top 10. However when measured in terms of Coking Coal – used for steel production – Australia ranked second, behind China, at 158 Mt whilst Canada ranked sixth at 34 Mt.

The price of Australian Coal has been falling since January 2011 and is heading back towards the lows last seen in 2009, driven primarily by the weakness in demand for Coking Coal from China.

Australian Coal Price - Macro Business 2012 - 2014

Source: Macro Business

This is how the Minerals Council of Australia describes the Coal export market:-

Coal accounted for almost 13 per cent of Australia’s total goods and services exports in 2012-13 down from 15 per cent in 2011-12. This made coal the nation’s second largest export earner after iron ore. Over the last five years, coal has accounted, on average, for more than 15 per cent of Australia’s total exports – with export earnings either on par or greater than Australia’s total agricultural exports.

Australia’s metallurgical coal export volumes are estimated at 154 million tonnes in 2012-13, up 8.5 per cent from 2011-12. However, owing to lower prices the value of exports decreased by almost 27 per cent to be $22.4 billion in 2012-13.

Whilst the scale of the Coal industry in Canada is not so vast, this is how the Coal Association of Canada describes Canadian Coal production:-

Production

Canada produced 60 million close to 67 million tonnes (Mt) of coal in 2012. 31 million tonnes was metallurgical (steel-making) coal and 36 million tonnes (Mt) was thermal coal. The majority of coal produced in Canada was produced in Alberta and B.C.

Alberta produced 28.3 Mt of coal in 2012

British Columbia produced 28.8 Mt (most was metallurgical coal) – 43% of all production

To meet its rapid infrastructure growth and consumer demand for things such as vehicles and home appliances, Asia has turned to Canada for its high-quality steel-making coal. As Canada’s largest coal trading partner, coal exports to Asia accounted for 73% of total exports in 2010.

Steel-Making Coal

Global steel production is dependent on coal and more and more the world is turning to Canada for its supply of quality steel-making coal.

The production of steel -making coal increased by 5.5% from 29.5 Mt in 2011 to 31.1 Mt in 2012.

Almost all of Canada’s steel-making coal produced was exported.

Thermal Coal

Approximately 36 million tonnes of thermal coal was produced in 2012.

The vast majority of Canadian thermal coal produced is used domestically.

Currency Pressures

Until the autumn of 2014 the CAD was performing strongly despite weakness in several of its main export markets as the chart below of the Canadian Effective Exchange Rate (CERI) shows:-

CAD CERI - 1yr to sept 2014

Source: Business in Canada, BoC

Since September the CERI index has declined from around 112 to below 100.

For Australia the weakening of their trade weighted index has been less extreme due to less reliance on the US. There is a sector of the RBA website devoted the management of the exchange rate, this is a chart showing the Trade Weighted Index and the AUDUSD rate superimposed (RHS):-

AUD_effective_and_AUDUSD_-_RBA

Source: RBA, Reuters

Taking a closer look at the monthly charts for USDCAD:-

canada-currency

Source: Trading Economics

And AUDUSD:-

australia-currency

Source: Trading Economics

These charts show the delayed reaction both currencies have had to the decline in the price of their key export commodities – they may fall further.

Central Bank Policy

The chart below shows the evolution of BoC and RBA policy since 2008. Australian rates are on the left hand scale (LHS), Canadian on the right:-

australia and canadian -interest-rate 2008 - 2015

Source: Trading Economics

To understand the sudden change in currency valuation it is worth reviewing the central banks most recent remarks.

The BoC expect Oil to average around $60/barrel in 2015. Here are some of the other highlights of the latest BoC monetary policy report:-

The sharp drop in global crude oil prices will be negative for Canadian growth and underlying inflation.

Global economic growth is expected to pick up to 3 1/2 per cent over the next two years.

Growth in Canada is expected to slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015.

Canada’s economy is expected to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016, with a return to full capacity around the end of 2016, a little later than was expected in October.

Total CPI inflation is projected to be temporarily below the inflation-control range during 2015 because of weaker energy prices, and to move back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.

On 21 January 2015, the Bank announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent.

…Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016.

The RBA Statement on Monetary Policy – February 2015 provides a similar insight into the concerns of the Australian central banks:-

…Australia’s MTP growth is expected to continue at around its pace of recent years in 2015 as a number of effects offset each other. Growth in China is expected to be a little lower in 2015, while growth in the US economy is expected to pick up further. The significant fall in oil prices, which has largely reflected an increase in global production, represents a sizeable positive supply shock for the global economy and is expected to provide a stimulus to growth for Australia’s MTPs. The fall in oil prices is also putting downward pressure on global prices of goods and services. Other commodity prices have also declined in the past three months, though by much less than oil prices. This includes iron ore and, to a lesser extent, base metals prices. Prices of Australia’s liquefied natural gas (LNG) exports are generally linked to the price of oil and are expected to fall in the period ahead. The Australian terms of trade are expected to be lower as a result of these price developments, notwithstanding the benefit from the lower price of oil, of which Australia is a net importer.

…Available data since the previous Statement suggest that the domestic economy continued to grow at a below-trend pace over the second half of 2014. Resource exports and dwelling investment have grown strongly. Consumption growth remains a bit below average. Growth of private non-mining business investment and public demand remain subdued, while mining investment has fallen further. Export volumes continued to grow strongly over the second half of 2014, driven by resource exports. Australian production of coal and iron ore is expected to remain at high levels, despite the large fall in prices over the past year. The production capacity for LNG is expected to rise over 2015. Service exports, including education and tourism, have increased a little over the past two years or so and are expected to rise further in response to the exchange rate depreciation.

…Household consumption growth has picked up since early 2013, but is still below average. Consumption is being supported by very low interest rates, rising wealth, the decision by households to reduce their saving ratio gradually and, more recently, the decline in petrol prices. These factors have been offset to an extent by weak growth in labour income, reflecting subdued conditions in the labour market. Consumption growth is still expected to be a little faster than income growth, which implies a further gradual decline in the household saving ratio.

…Prior to the February Board meeting, the cash rate had been at the same level since August 2013. Interest rates faced by households and firms had declined a little over this period. Very low interest rates have contributed to a pick-up in the growth of non-mining activity. The recent large fall in oil prices, if sustained, will also help to bolster domestic demand. However, over recent months there have been fewer indications of a near-term strengthening in growth than previous forecasts would have implied. Hence, growth overall is now forecast to remain at a below trend pace somewhat longer than had earlier been expected. Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained. In addition, while the exchange rate has depreciated, it remains above most estimates of its fundamental value, particularly given the significant falls in key commodity prices, and so is providing less assistance in delivering balanced growth in the economy than it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash rate, the Board judged at its February meeting that a further 25 basis point reduction in the cash rate was appropriate. This decision is expected to provide some additional support to demand, thus fostering sustainable growth and inflation outcomes consistent with the inflation target.

Real Estate

Neither central bank makes much reference to the domestic housing market. Western Canada has been buoyed by international demand from Asia. Elsewhere the overvaluation has been driven by the low interest rates environment. Overall prices are 3.1% higher than December 2014. Vancouver and Toronto are higher but other regions are slightly lower according to the January report from the Canadian Real Estate Association . The chart below shows the national average house price:-

 

 

Canada natl_chartA04_hi-res_en

Source: Canadian Real estate Association

The Australian market has moderated somewhat during the last 18 months, perhaps due to the actions of the RBA, raising rates from 3% to 4.75% in the aftermath of the Great Recession, however, the combination of lower RBA rates since Q4 2011, population growth and Chinese demand has propelled the market higher once more. Prices in Western Australia have moderated somewhat due to the fall in commodity prices but in Eastern Australia, the market is still making new highs. The chart below goes up to 2014 but prices have continued to rise, albeit moderately (less than 2% per quarter) since then:-

Australian House Prices 2006 - 2014

Source: ABS

This chart from the IMF/OECD shows global Price to Income ratios, Canada and Australia are still at the expensive end of the global range:-

House pricetoincome IMF

Source: IMF and OECD

The lowering of official rates by the BoC and RBA will not help to alleviate the overvaluation.

Bonds

This chart shows the monthly evolution of 10 year Government Bond yields since 2008 in Australia (LHS) and Canada (RHS):-

australia-canada-government-bond-yield

Source: Trading Economics

Whilst the two markets have moved in a correlated manner Canadian yields have tended to be between 300 and 100 bp lower over the last seven years. The Australian yield curve is flatter than the Canadian curve but this is principally a function of higher base rates. Both central banks have cut rates in anticipation of lower inflation and slower growth. This is likely to support the bond market in each country but investors will benefit from the more favourable carry characteristics of the Canadian market.

Stocks  

To understand the differential performance of the Australian and Canadian stocks markets I have taken account of the strong performance of commodity markets prior to the Great Recession, in the chart below you will observe that both economies benefitted significantly from the rally in industrial commodities between 2003 and 2008. Both stock markets suffered severe corrections during the financial crisis but the Canadian market has steadily outperformed since 2010:-

canada australian -stock-market 2000-2015

Source Trading Economics

This outperformance may have been due to Canada’s proximity to, and reliance on, the US – 77% of Exports and 52% of Imports. The Australian economy, by contrast, is reliant on Asia for exports – China 27%, Japan 17% – however, I believe that the structurally lower interest rate regime in Canada is a more significant factor.

Conclusions and investment opportunities

With industrial commodity prices remaining under pressure neither Canada nor Australia is likely to exhibit strong growth. Inflation will be subdued, unemployment may rise. These are the factors which prompted both central banks to cut interest rates in the last month. However, both economies have been growing reasonable strongly when compared with countries such as those of the Eurozone. Canada GDP 2.59%, Australia GDP 2.7%.

The BoC has little room for manoeuvre with the base rate at 0.75% but the RBA is in a stronger position. For this reason I believe the AUD is likely to weaken against the CAD if world growth slows, but the negative carry implications of this trade are unattractive.

Canadian Real Estate is more vulnerable than Australia to any increase in interest rates – although this seems an unlikely scenario in the near-term – more importantly, in the longer term, Canadian demographics and slowly population growth should alleviate Real Estate demand pressure. In Australia these trends are working in the opposite direction. Neither Real Estate market is cheap but Australia remains better value.

The Australian All-Ordinaries should outperform the Canadian TSX as any weakness in the Australian economy can be more easily supported by RBA accommodation. The All-Ordinaries is also trading on a less demanding earnings multiple than the TSX.

The RBA’s greater room to ease monetary conditions should also support the Australian Government Bond market, added to which the Australian government debt to GDP ratio is an undemanding 28% whilst Canadian debt to GDP is at 89%. The Canadian curve may offer more carry but the RBA ability to ease policy rates is greater. My preferred investment is in Australian Government Bonds. Both Canadian and Australian 10 year yields have risen since the start of February. The last Australian bond retracement saw yields rise 46 bp to 3.75% in September 2014. Since the recent rate cut yields have risen 30 bp to a high of 2.67% earlier this week. Don’t wait too long for better levels.

Where is the oil price heading in 2015?

400dpiLogo

Macro Letter – Supplemental – No 1 – 13-02-2015

Where is the oil price heading in 2015?

  • Growth in oil demand remains anaemic
  • Supply will gradually fall as contracts expire
  • Consolidation and declining volatility are the most likely outcome

The price of crude oil has rebounded strongly since the end of January. Is this the beginning of a new trend, a short-term correction prior to a further decline or the start of a period of consolidation?

Here is the price action for March 2015 WTI futures over the last four months:-

4month Mar15 WTI

Source: Barchart.com

Before jumping to any conclusions about the next trend it is worth taking a look at a longer term chart. This is the spot price chart for the period since 2005, it shows the period of the leveraged boom and the collapse during the Great Recession:-

10yr Oil

Source: Barchart.com

The collapse during the Great Recession was largely due to a reduction in demand as the world economy slowed dramatically. The price decline since the summer of 2014 has been driven by a combination of a delayed reaction to increased supply – specifically from the US – and a moderation in the rate of increase in demand associated with the slowing of Chinese growth and its policy of “rebalancing” towards domestic consumption. An additional factor has been the slowing of growth in Europe. An IEA report last December estimated that global oil demand had increased by only 0.75% between 2013 and 2014 – better, by 3.6%, than the 2009/2013 period but not excessive.

During 2013 and early 2014 geopolitical tension in the Middle East and Ukraine kept prices elevated amid expectations of supply disruptions. These disruptions failed to materialise. This coincided with an increase in US oil production. Finally the markets woke-up to the lack of geopolitical risk, the slowdown of growth in the EU and China, and the acceleration in US production. The price began to correct downwards taking out the 2012 lows. From here on it gathered momentum and, having taken out the majority of trading stop-losses, stabilised last month, not far from the 2009 lows.

Another look at the 10 year price chart shows the recovery in 2010/2011. At this stage the improvements in fracking and drilling technology were already becoming widely known, had it not been for geopolitical concerns the price would probably have begun to decline from this point – around $85. The widening price spread between Brent Crude and WTI shows the effect of increased US production:-

brent wti spread Goldman Sachs ZeroHedge

Source: Goldman Sachs and Zero Hedge

WTI begins to lag Brent Crude towards the end of 2010. Here is a chart of US versus World Oil production:-

US_vs_world_Oil_production

Source: EIA and Carpe Diem Blog

 

Price Prospects

What we have seen during the last six months is a delayed reaction to the increased supply of crude oil from the US. The recent decline has been very rapid and may have run its course, or may have further to fall. Either way, volatility is heightened and the price is likely to remain variable.

From a technical perspective I would expect the corrective rally to continue possibly to test the 2012 lows around $75/barrel. After such a rapid rise in the last few weeks, however, the price may retest the low first; there is an outside chance that the market takes out the January low to retest the 2009 bottom. The $75 level may be retested in the autumn as forward contracts expire and supply shortages appear. From this point a renewed decline is most likely, this phase will also be marked by declining volatility.

I have one concern with this technically bullish prediction – the steep contango in the futures market. At close of business on Wednesday 11th February the WTI futures settlements were as follows:-

Contract Last
CLY00 (Cash) 48.87s
CLH15 (Mar ’15) 50.43
CLU15 (Sep ’15) 57.15
CLH16 (Mar ’16) 60.14s
CLU16 (Sep ’16) 62.39s

 

Source: NYMEX and Barchart.com

The shape of the forward curve suggests that oil producers are not feeling quite as much pain as is implied by the spot price, the supply overhang may last into 2016.

Market views, as always, vary. At this week’s International Petroleum Week conference in London Igor Sechin – CEO of Rosneft predicted that oil prices may surge later this year due to supply shortages as a result of the precipitous decline. Meanwhile at the same conference Ian Taylor – CEO of Vitoil, questioned where oil demand would emanate from. His outlook was decidedly more bearish.

Moody’s research, published earlier this week, put a price target for 2015 is $55/barrel which makes sense if global growth slows: they see no boost to growth in China, Japan or the EU from a lower oil price but expect it to benefit India and the US.

I listened to a panel debate at the ICMA/JSDA – Japan Securities Summit on Wednesday where Takahiro Sato of the BoJ alluded to the positive impact lower oil prices might have on Japanese growth. He inferred that it would mean the BoJ undershot its inflation target. Here is a brief extract:-

On the price front, the inflation rates in major countries, including Japan, have been declining as a trend mainly due to the recent drop in crude oil prices. Under those circumstances, central banks in major countries have a common concern that major economies are trapped in a feedback-loop — the decline in the inflation rates would lead to a fall in people’s medium- to long-term inflation expectations, and it would result in a further decline in the actual inflation rates. That is why the Bank decided to expand the QQE last October.

As I cast a dissenting vote on that decision, I may not be an appropriate person to explain this policy.

The NY Times reported – KKR profits were down 89% in Q4 2014 due to turmoil in the US energy sector. New drilling has dried up in the last few months and concerns are growing about potential defaults by over-leveraged energy companies. This could slow US growth if the financial sector is wracked with contagion.

The prospects for the oil price is unclear; it will remain so for the next six months. For this reason I expect Moody’s price target of $55/barrel to be reasonably accurate even if their growth expectations prove wrong.

Obvious risk factors which could undermine my expectations include:-

  1. A dramatic slowdown in China
  2. An unravelling of the Eurozone currency union
  3. Russia and the US going head to head in the Ukraine

I think China is more likely to surprise on the upside if it does surprise at all. The Eurozone is still a difficult situation to predict but I think the Euro currency will survive and lower oil prices will aid Germany among other countries in the Euro area. The US may be performing well economically but its appetite for foreign conflict when the country is heading towards energy independence makes little strategic sense. They are likely to deploy their resources on dealing with ISIS first.

My 2015 outside range for WTI crude oil is $40 to $75 with an average of $55/barrel.

Swiss National Bank policy and its implications for currencies, assets and central banking

400dpiLogo

Macro Letter – No 29 – 06-02-2015

Swiss National Bank policy and its implications for currencies, assets and central banking

  • The SNB unpegged from the Euro and sustained balance sheet losses, they will survive
  • The Euro has been helped lower but rumours of a new SNB target are rife
  • The long run appreciation of the Swiss Franc (CHF) is structural and accelerating, the Swiss economy will adjust
  • If G7 central bank balance sheets expanded to Swiss levels, relative to GDP, QE would triple

On Thursday 15th January the Swiss National Bank (SNB) finally, and unexpectedly, threw in the towel and ceased their foreign exchange intervention to maintain a pegged rate of EURCHF 1.20. The cap was introduced in September 2011 after a 28% appreciation in the CHF since the beginning of the Great Financial Crisis (GFC) – from 1.68 to 1.20. After plumbing the depths of 0.85 the EURCHF rate settled at 0.99 – around 18% higher in a single day. This is a huge one day move for a G10 currency and has inflicted collateral damage on leveraged traders, their brokers and those who borrowed in CHF to finance asset purchases in other currencies. Citibank estimates that is has also cost the SNB CHF 60bln. Here is a 10 year chart of EURCHF: –

EURCHF_10_yr

Source: Bigcharts.com

The Swiss SMI stock Index declined from 9259 to 8400 (-9.2%) whilst the German DAX Index rose from 9933 to 10,032 (+1.1%). Swiss and German bond yields headed lower. Swiss bonds now exhibit negative nominal yields out to 15 years – the table below is from Wednesday 4th February:-

Maturity Yield
1 week -1.35
1 month -1.65
2 month -1.55
3 month -1.4
6 month -1.38
1 year -1.11
2 year -0.823
3 year -0.768
4 year -0.632
5 year -0.505
6 year -0.419
7 year -0.305
8 year -0.257
9 year -0.181
10 year -0.111
15 year -0.024
20 year 0.196

 

Source: Investing.com

Swiss inflation is running at -0.3% so the real-yields are fractionally better due to the mild deflation seen in the past couple of months. I expect this deflation to deepen and persist.

Thomas Jordan – Chairman of the governing board of the SNB – made the following statement at a press conference which accompanied the SNB decision:-

Discontinuation of the minimum exchange rate

The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it. The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.

Interest rate lowered

At the same time as discontinuing the minimum exchange rate, the SNB will be lowering the interest rate for balances held on sight deposit accounts to –0.75% from 22 January. The exemption thresholds remain unchanged. Further lowering the interest rate makes Swiss-franc investments considerably less attractive and will mitigate the effects of the decision to discontinue the minimum exchange rate. The target range for the three-month Libor is being lowered by 0.5 percentage points to between –1.25% and –0.25%.

Outlook for inflation and the economy

The inflation outlook for Switzerland is low. In December we presented a conditional inflation forecast, which predicts inflation of –0.1% for this year. Since this forecast was published, the oil price has once again fallen significantly, which will further dampen the inflation outlook for a time. However, lower oil prices will stimulate growth globally, and this will influence economic developments in Switzerland positively. Swiss franc exchange rate movements also impact inflation and the economic situation.

The SNB remains committed to its mandate of ensuring medium-term price stability while taking account of economic developments. In concluding, let me emphasise that the SNB will continue to take account of the exchange rate situation in formulating its monetary policy in future. If necessary, it will therefore remain active in the foreign exchange market to influence monetary conditions.

On Tuesday 27th January the CHF fell marginally after SNB Vice President Jean-Pierre Danthine told Swiss newspaper Tages Anzeiger – Die Presse war voller Spekulationen, that the SNB remains ready to intervene in the currency market. One comment worthy of consideration, with apologies for the “google-translate”, is:-

Q. Does the SNB did not develop a new monetary policy? Just as Denmark, which has tied its currency to the euro in 30 years? Or as Singapore, which manages its currency based on a trade-weighted basket of currencies?

A. Denmark is the euro zone financially and politically closer than Switzerland. The binding to Europe is a long standing. Means that this solution is for Switzerland hardly considered. The arrangement of Singapore is worthy of consideration. But what is decisive is the long-term. Apart from Switzerland and other small and open economies such as Sweden and Norway are done well over the years with a flexible exchange rate.

Rumours of a new unofficial corridor of EURCHF 1.05-1.10 are now circulating – strikingly similar to the level reached prior to the September 2011 peg.

Breaking the Bank

Another rumour to have surfaced after the currency move was that the SNB had become concerned about the size of their balance sheet relative to Swiss GDP. The chart below is from 2013 but it shows the relative scale of SNB QE:-

Central Bank Balance-of-percentage-GDP - source SNB

Source: SNB and snbchf.com

Estimates of the loss sustained by the SNB, due to the appreciation of the CHF, vary, but, rather like countries, central banks don’t tend to “go bust”. The Economist – Broke but never Bust takes up the subject (my emphasis in bold):-

…For one thing central banks are far bigger. Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs.

…Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree.

…With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

The Economist goes on to highlight the risk that going “cap in hand” to their finance ministries will weaken central banks’ “independence” and might prove inflationary. In the current environment inflation would be a nice problem for the SNB, or, for that matter, the ECB or BoJ to have. As for the limits of central bank balance sheet expansion, the SNB – at 80% of GDP – have blazed a trail for their larger peers to follow.

Is it the money supply?

A further unofficial explanation of the SNB move concerns the unusually large expansion of Swiss money supply since the GFC. In early January an article from snbchf.comThe Risks on the Rising SNB Money Supply discussed how the SNB might be thinking (my emphasis): –

Since the financial crisis central banks in developed nations increased their balance sheets. The leading one was the American Federal Reserve that increased the monetary base (“narrow money”), followed by the Bank of Japan and recently the ECB. Only partially the extension of narrow money had an effect on banks’ money supply, so called “broad money”. For the Swiss, however, the rising money supply concerns both narrow and broad money. Broad money in Switzerland rises as strong as it did in Spain or Ireland before the financial crisis.

They go on to discuss the global effects of QE:-

…The SNB had the choice between a stronger currency and, secondly, an excessive appreciation of the Swiss assets.  With the introduction of the euro floor, it opted for the second alternative and increased its monetary base massively in order to absorb foreign currency inflows. Implicitly the central bank helped to push up asset prices even further. Hence it was rather foreign demand for Swiss assets that helped to increase the demand for credit and money in the real economy.

…The SNB printed a lot of money especially in the years before and just after the euro introduction until 2003, to weaken the franc and the “presumed slow” Swiss growth. The money increase, however, did not affect credit growth more than it should have: investors preferred other countries to Switzerland to buy assets. Finally the central bank increased interest rates a bit and reduced money supply between 2006 and 2008. Be aware that in 2006/2007 there is a statistical effect with the inclusion of “Raiffeisen” group banks into M3. Since 2009, things have changed M3 is rising with an average of 7.7% per year, while before 2009 it was 3% per year. Banking lending to the private sector is increasing by 3.9% per year while it was 1.7% between 1995 and 2005.

…Since April 2014, money supply M3 has suddenly stopped at around 940 billion CHF. Before it had increased by 80 bln. CHF per year from 626 bln. in each year since 2008.  We explained before that Fed’s QE translated in higher lending in dollars, dollars that found their way into emerging markets. The same thing happens in Switzerland with newly created Swiss francs. Not all of them remained in the Swiss economy, but they were loaned out to clients from Emerging Markets. Hence the second risk does not directly concerns the Swiss economy and the euro, but the relationship between its banks and emerging markets and the risks of a strong franc for banks’ balance sheets.

 

Here is a chart of M3 and bank lending in Switzerland, the annotation is from snbchf.com:-

Swiss-M3-and-Lending-2014-Ireland

Source: SNB and snbchf.com

The SNBs decision to unpeg seems a brutal way to impose discipline on the domestic lending market and an unusual way to test increased bank capital requirements, however, I believe this was the least bad time to escape from the corner into which they had boxed themselves. The recent fall in M3 should put some upward pressure on the CHF – until growth slows and reverses the process.

The SNB said this about money supply and bank lending in their Q4 2014 Quarterly Bulletin (my emphasis):-

Growth in money supply driven by lending

The expansion of the money supply witnessed since the beginning of the financial and economic crisis is mainly attributable to bank lending. An examination of components of the M3 monetary aggregate and its balance sheet counterparts, based on the consolidated balance sheet of the banking sector, shows that approximately 70% of the increase in the M3 monetary aggregate between October 2008 and October 2014 (CHF 311 billion) was attributable to the increase in domestic Swiss franc lending (CHF 216 billion). The remaining 30% of the M3 increase was due in part to households and companies switching their portfolio holdings from securities and foreign exchange into Swiss franc sight deposits.

Stable mortgage lending growth in the third quarter

In the third quarter of 2014 – as in the previous quarter – banks’ mortgage claims, which make up four-fifths of all domestic bank lending, were up 3.8% year-on-year. Mortgage lending growth thus continued to slow, as it has for some time now, despite the fact that mortgage rates have fallen to a historic low. A breakdown by borrower shows that the growth slowdown has taken place in mortgage lending to households as well as companies.

This slower growth in mortgage lending may be attributed to various measures taken since 2012 to restrain the banks’ appetite for risk and strengthen their resilience. These include the banks’ own self-regulation measures, which subject mortgage lending to stricter minimum requirements. Moreover, at the request of the SNB, the Federal Council activated the countercyclical capital buffer in 2013 and increased it this year. This obliges the banks to back their mortgage loans on residential property with additional capital. The SNB’s bank lending survey also indicates that lending standards have been tightened and demand for loans among households and companies has declined.

…Growing ratio of bank lending to GDP

The strong growth in bank lending recorded in recent years is reflected in the ratio of bank loans to nominal GDP. After a sharp rise in the 1980s, this ratio remained largely unchanged until mid-2008. Since the onset of the financial and economic crisis, it has increased again substantially. This increase suggests that banks’ lending activities have supported aggregate demand. However, strong lending growth also entails risks for financial stability. In the past, excessive growth in lending has often been the root cause of later difficulties in the banking industry.

Switzerland’s banking sector is truly multi-national, deposits continue to arrive, despite penal “negative” rates, meanwhile, many CHF bank loans have been made to international clients. The sharp appreciation of the CHF will force the banking sector to make additional provisions for non-performing international loans. Further analysis of the effect of relative money supply growth, between Switzerland and the Eurozone (EZ) on the EURCHF exchange rate, can be found in this post by Frank Shostak – Post Mortem on the Swiss Franc’s Euro-Peg. He makes an interesting “Austrian” case for a weakening of the CHF versus the EUR over-time.

Swiss Francs in the long run

My first ever journey outside the UK was to Switzerland, that was back in 1971 when a pound sterling bought CHF 10.5. The Swiss economy has had to deal with a constantly rising exchange rate ever since. The chart below of the CHF Real Trade-Weighted value shows this most clearly: –

Real_Effective_CHF_Exchange_rate_EURCHF18_01_2013-

Source: Pictet

This chart only goes up to mid-2013, since then the USDCHF has moved from 0.88 and 0.99 by early January – after the unpegging the rate is near to its mid-point at 0.93. According to the Guardian – What a $7.54 Swiss Big Mac tells us about global currencies – the Swiss currency is now 33% overvalued. Exporters will be hit hard and the financial sector is bound to be damaged by commercial bank lending policies associated with pegging the CHF to a declining EUR. On Monday Bank Julius Baer (BAER.VX) announced plans to cut costs by CHF 100mln, domestic job cuts were also indicated – more institutions are sure to follow their lead. Meanwhile, there are bound to be emerging market borrowers which default. The Swiss economy will slow, exacerbating deflationary forces, but lower prices will improve the purchasing power of the domestic population. Switzerland’s trade balance hit a record high in July 2014 and came close to the same level in November:-

switzerland-balance-of-trade

Source: Trading Economics and Swiss Customs

In a recent newsletter – The Swiss Release the Kraken – John Maudlin quoted fellow economist Charles Gave in a tongue in cheek assessment of the SNB’s action:-

They [the SNB] didn’t mind pegging the Swiss franc to the Deutsche mark, but it is becoming more and more obvious that the euro is more a lira than a mark. A clear sign is the decline of the euro against the US dollar.

Mr. Draghi has been trying to talk the euro down for at least a year. This should not come as a surprise. After all, in the old pre-euro days, every time Italy had a problem, the solution was always to devalue.

But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity. The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy, and the need for savings to finance investments. How quaint!

Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers [not!]. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175…in favor of Switzerland.

And for most of that time Switzerland ran a current account surplus, a balanced budget, and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or central banker, since they have such limited power? And that all these marvelous results come from that one simple fact: their lack of power.)

The last time I looked, the Swiss population had the highest standard of living in the world – another disastrous long-term consequence of not having properly trained economists of the true faith.

Swiss unemployment has been trending higher recently (3.4% in December) and this figure may rise as sectors such as banking and tourism adjust to the new environment, however, this level of unemployment is still enviable by comparison with other developed countries.

The following charts give an excellent insight into the nature of trade in the Swiss economy. Firstly, exports:-

Swiss_ExportsByCountry

Source: snbchf.com

The importance of the EZ is evident (46.4% excluding UK) however the next chart shows a rather different perspective:-

Swiss_TradeBalanceByCountry

Source: snbchf.com

The relative importance of the USA is striking – 11% of exports but nearly half of the trade surplus – so too, is the magnitude of the deficit with Germany, in fact, within Europe, only Spain and the UK are export surplus markets.

A closer look at the break-down of Imports and Exports by sector provides an additional dimension:-

Swiss-Imports-Exports-by-Type

Source: snbchf.com

The SNB already highlighted the import of energy as a significant factor – Switzerland’s energy bill is now much lower than it was in July 2014. The export of pharmaceuticals has always been of major importance – many of these products are inherently price inelastic, the rise in the currency will have less impact on Switzerland than it might do on other developed economies.

Conclusion and investment opportunities

“The reports of my death are greatly exaggerated.” Mark Twain

Contrary to what several commentators have been suggesting, I do not believe the SNB capitulation marks the beginning of the end of central bank omnipotence – they were never that omnipotent in the first place. The size of the SNB balance sheet is also testament to the limits of QE – if the other G7 central banks expand to 80% of GDP the total QE would more than triple from $10.5 trln to $33.6 trln – and what is to say that 80% of GDP is the limit?

Swiss Markets

Switzerland will benefit from a floating currency in the longer term, although the recent abrupt appreciation may lead to a recession – which in turn should reduce upward pressure on the CHF. Criticism of the SNB for creating greater volatility within the Swiss economy is only partially justified, the excessive rise of the CHF effective exchange rate was due to external factors and the SNB felt it needed to be managed, the subsequent rise in the US$ has brought the CHF back to a more realistic level but the current environment of zero interest rate policy adopted by several major central banks has parallels with the conditions seen after the collapse of Bretton Woods.

I believe the SNB anticipates an acceleration in the long term trend rate of appreciation of the CHF. Swiss exports, even to the US, will be impaired but German imports will be cheaper – with a record trade surplus, this is a good time to start the adjustment of market expectations about the value of the CHF going forward. Swiss companies are used to planning within a framework which incorporates a steadily rising value of their currency – now they must anticipate an acceleration in that trend.

The money and bond markets will remain distorted and, in the event of another EZ crisis, the SNB may increase the penalties for access to the “safe-haven” Switzerland represents: and, as indicated, they may intervene again if the capital flows become excessive. 20 year, or longer, Confederation Bonds, alone, offer positive carry, buying call spreads on shorter maturities is a strategy worth considering.

The SMI Index is likely to lag the broader European market, but negative bond yields offer little alternative to stocks and domestic investors will exhibit a renewed cognizance of the risk of foreign currency investments. The SMI Index, at around 8550, is only 7.6% below the level it was trading prior to the SNB announcement. Swiss stocks will undoubtedly benefit from any export led European economic recovery. Meanwhile, the relative strength of the US economy appears in tact – the Philadelphia Fed Leading Indexes for December – released earlier this week – suggest economic expansion in 49 states over the next six months.

Eurozone Markets

The EZ has already been aided by the departure of its strongest “shadow” member; combined with the ECB’s Expanded Asset Purchase Programme (EAPP) this should drive the EUR lower. European stocks have already taken heart, fuelled by the new liquidity and international competitiveness.

European bond spreads continue to compress. Fears of peripheral countries exiting the single currency area will provide volatility but for the major countries – France, Italy and Spain – any weakness is still a buying opportunity, but at these, often negative real-yields, they should be viewed as a “trading” rather than an “investment” asset.

The prospects for the UK in 2015 – Stocks, Gilts and Sterling

400dpiLogo

Macro Letter – No 28 – 23-01-2015

The prospects for the UK in 2015 – Stocks, Gilts and Sterling

  • Unlike major Eurozone bond markets, UK 10 year Gilts have yet to make new highs
  • The FTSE has lagged both the S&P500 and the DAX
  • Sterling continues to appreciate against the Euro, but decline versus the UD$
  • UK election uncertainty will dominate and constrain markets until May

Last year the UK stock market trod water while other markets, often with weaker fundamentals, trended higher. Meanwhile UK Gilts headed back towards the multi-year low yields last seen during the Euro crisis in July 2012. UK growth still appears robust when compared to other EU countries; it has broadly kept pace with the US over the course of the last 18 months.

Annualised GDP
Country UK USA
Q1 2013 0.9 1.7
Q2 2013 1.7 1.8
Q3 2013 1.6 2.3
Q4 2013 2.4 3.1
Q1 2014 2.4 1.9
Q2 2014 2.6 2.6
Q3 2014 2.6 2.7

Source: Trading Economics

Earlier this month saw the publication of the Deloitte – Q4 CFO Survey. This influential report is based on a survey of 119 CFO, of which 32 represent FTSE 100 companies. They see a growing divide between good UK fundamentals and UK politics in the run up to the general election in May. The positive domestic environment is also at odds with a number of external risks including the collapse in commodity prices, slowing emerging market growth – especially in China – and the continued weakness and political uncertainty surrounding the Eurozone (EZ).

56% of CFO’s believe now is a good time to invest in their businesses – down from a record high of 71% in Q3. This is still well above the long-term average and the general expectation is that Capital Expenditure will increase 9% in 2015.

The Deloitte report underpins hopes for the return of real wage growth for the first time in six years. The UK employment report, released on Wednesday, may indicate the beginning of a trend: it reveals average weekly earnings rising 1.7% in November – down from 1.9% in October but the third consecutive month of above inflation wage growth. Headline unemployment was 5.8%, down from a previous 6%, but employment growth was muted and the activity rate has declined by 0.5% over the last six months. In other words, less people are participating in the labour market. The rate of private sector pay inflation actually slowed in November from 2.4% to 2.1% – real-wage growth may be distorted by temporary disinflationary factors such as falling energy prices. I think it is safe to suggest that UK living standards are stabilising after a painful period of adjustment.

Last week also saw the publication of UK inflation data. Following a trend seen in a number of other developed markets, it came in at 14 year low of +0.5% – well below the Bank of England (BoE) target of 2%. It is likely that Governor Carney will blame this divergence on external factors when he writes his first letter of explanation to the UK Chancellor. The excuses have already begun; this speech, given yesterday by external MPC member David Miles, opens:-

What can monetary policy be expected to do? My short answer comes in three parts: First, rather a lot less than many people who view inflation targets as too narrow seem to think; those who want to broaden the aims of monetary policy well beyond inflation to include targets for growth, financial stability and even income inequality may seriously over-estimate what policy can realistically achieve. Second, rather a lot more than is implied by many economic models which take a narrow view of the channels through which monetary policy affects behaviour and as a result make the ability of monetary policy to stabilise the economy precarious. Third, the success of monetary policy in achieving stable inflation (or prices) depends crucially on that being consistent with fiscal policy. Monetary policy cannot be expected to achieve price stability in isolation from things fiscal; monetary policy does not hold all the cards – it cannot trump everything.

The fall in inflation has been widespread, as the chart below shows, but this may not be an indication of economic malaise since external factors, such as the fall in oil prices and the continued decline in the Euro, are a significant influence. Nonetheless, as the Economic Research Council observe in their recent commentary, this is the first time on record that all four sub-sectors have experienced an inflation rate of 1% or less in a single month:-

UK_Inflation_-_ONS

Source: ONS and Economic Research Council

A more important gauge of corporate domestic conditions can be gleaned from the BoE – Q4 2014 Credit Conditions Survey – published on 6th January. Here are some of the highlights:-

…The overall availability of credit to the corporate sector was unchanged in Q4 according to lenders, and was expected to remain unchanged in Q1.

…While demand for credit from small businesses was reported to have decreased in Q4, demand from medium-sized companies increased significantly. Demand for credit from large corporates increased slightly in 2014 Q4.

…Spreads on lending to small businesses were unchanged in Q4, while spreads for medium-sized companies and large corporates narrowed significantly. These trends were expected to continue over the next three months.

…Default rates on corporate lending fell in Q4, particularly on lending to small businesses. Losses given default were unchanged in Q4 for small businesses, but fell for medium-sized companies and large corporates.

The minutes of the December MPC meeting showed a unanimous vote in favour of maintaining the stock of assets purchased during the period of QE from September 2009 to July 2012 – £375 bln – despite two members continuing to vote in favour of a 25bp rate increase. On Wednesday the January MPC minutes showed a unanimous accord to leave rates unchanged. Alert to the possibly temporary nature of the positive price shocks of lower oil and a declining Eur, Weale and McCafferty, the two MPC hawks, said their decision was “finely balanced”. The minutes went on to say:-

…the risks to CPI inflation in the medium term might have, if anything, shifted to the upside, but all members were also alert to the downside risk of current low inflation becoming entrenched.

At first sight the Deloitte CFO survey and the BoE Credit Conditions survey appear to be at odds, until one remembers the degree to which corporate sector demand for credit has been stifled by the unconventional monetary policy of the BoE and other central banks over the last few years. Negative real-interest rates distort the credit price discovery mechanism.

Corporates have chosen to issue special dividends or buy back stock rather than borrow at ostensibly attractive rates because of the uncertainty which surrounds the economic consequences of interest rate normalisation.

Nonetheless, in several respects, the UK economy looks robust, especially in comparison to most of the EZ. Six years of falling real wages – down 11% over the period – has allowed average working hours and private sector GDP to push well above the pre-crisis highs of 2007. Productivity, however, remains a problem, real GDP per hour barely moved, suggesting that “low wage – low skill” employment has taken up the slack. This has stimulated an influx of 1.5mln immigrant workers, and stoked divisive political debate, in the process. The economy may have grown but the standard of living of the average voter has not.

UK Public sector finances remain a concern as this chart from the Economic Research Council demonstrates:-

UK_Public_Sector_Finances_-_ERC

Source: Economic Research Council and ONS

Net government borrowing has improved, retreating from its zenith of 10% of GDP in 2009/2010 to less than 6% in 2013/2014, however the total Net Debt to GDP ratio continues to rise – the ERC are forecasting 83% during the 2014/2015 tax year. Ian Stewart – Chief Economist at Deloitte’s – put it succinctly in a weekly note back in November – Recession Over, Deficit Reduction Grinds On:-

The IMF reckons that the UK’s budget deficit will come in at 5.3% of GDP this year. In Europe, only Spain has a bigger deficit. Markets have worried a lot about public sector indebtedness in the euro area in recent years, but the ratio of borrowing to GDP in France, Italy and Greece this year is likely to be around half UK levels.

…Public sector deficits have been falling as a share of GDP in most countries since 2009.

Small nations which endured deep financial crises have been most aggressive in cutting public borrowing. Greece, Iceland, Ireland, Portugal and Latvia top the league table of deficit reduction since 2009. The US and UK also cut borrowing aggressively. But both, ironically, now have deficits which exceed those of Greece, Ireland and Iceland.

The best way of shrinking public deficits is to grow the economy. Yet while the UK has easily outpaced its peers this year progress in reducing the deficit has gone into reverse. In the first seven months of the 2014/15 financial year the deficit was 6% higher than in the same period a year earlier. The official forecast for a 12% reduction in the deficit in 2014/15 looks unattainable.

The long squeeze on public expenditure is actually on track. The problem is that tax revenues have lagged well behind expectations. Several factors are at work.

Much of the growth in UK employment in the last year has been in low wage work, dampening earnings growth and tax revenues. (The positive side of this is that the young and the unskilled are getting back into work. The proportion of young people not in work education or training is at the lowest level in ten years).

Stronger than expected growth in self-employment, where average earnings are below those in the rest of the economy, have also hit government revenues. The Office of National Statistics calculates that the median incomes for the self-employed fell by a whopping 22% between 2008-09 and 2012-13.

The Coalition’s decision to raise the tax free threshold to £10,000 has eaten further into revenues. Meanwhile, a lower oil price has hit North Sea revenues and a cooling housing market means less money for the Treasury from Stamp Duty.

The Coalition’s strategy has been to shrink the deficit mainly through cutting public expenditure. According to the Institute for Fiscal Studies spending cuts account for 71% of the planned fiscal consolidation, reduced interest payments 15% and tax rises just 12%.

Most planned tax rises have taken effect, but two-thirds of the planned cuts to spending on public services still have to take effect.

The UK is over five years through a ten-year programme of deficit reduction. Roughly half of the total planned tightening still lies ahead. The speed and composition of deficit reduction seem likely to remain a central issue in the next Parliament.

But that’s not how voters see things. A recent poll for the Financial Times by Populus found that 60% of voters do not believe that any further cuts in public spending will be necessary in the next Parliament.

Paradoxically, cutting budget deficits may be politically easier in a time of crisis than when the economy is growing. Voters’ concerns are already shifting away from the economy. Five more years of austerity is not a slogan that is likely to appeal to an electorate that has been through the deepest recession in generations.

The hope for whichever party or coalition wins the next election is that tax revenues pick up. Without such a recovery the next government would have to choose between pushing back the timetable for eliminating the deficit or piling on more austerity. The recession may be over, but much of the pain of deficit-reduction still lies ahead. 

The continued deterioration in government finances is one factor which is holding back UK growth, another is the rapid increase in private sector borrowing; primarily mortgages, helped by an extension of the Funding for Lending scheme, and credit cards. According to the Money Charity – January 2015 report:-

People in the UK owed £1.463 trillion at the end of November 2014.

This is up from £1.433 trillion at the end of November 2013 – an extra £591 per UK adult.

The average total debt per household – including mortgages – was £55,384 in November. The revised figure for October was £55,297.

Per adult in the UK that’s an average debt of £28,968 in November – around 115.0% of average earnings. This is up from a revised £28,922 in October.

…Outstanding consumer credit lending was £168.8 billion at the end of November 2014.

This is up from £158.8 billion at the end of November 2013, and is an increase of £199 for every adult in the UK.

These combined public and private sector trends helped to push the current account deficit to a 60 year high of £27bln – 6% of GDP – in Q3 2014, notwithstanding a record service sector surplus of 5.1%:-

current-account-quarterly-2000-2012

Source: economicshelp.org and OBR

The latest Ernst and Young’s ITEM Club forecast was released this week. This revised UK growth since their last estimate in October, from 2.4% to 2.9% for 2015. The revision is mainly due to lower oil prices. This also leads them to predict that inflation will average zero over the course of 2015. The clouds on this decidedly bright horizon are external factors, such as the dismal prospects for EZ growth, the continued slowing of a debt encumbered Chinese economy and the geo-political downside risks for Russia and its acolytes. All these factors would reduce growth but also, barring a dramatic increase in the price of energy, herald lower inflation.

Below is a chart showing annualised UK GDP data over the period 2007-2014:-

united-kingdom-gdp-growth-annual 2007-2014

Source: Trading Economics and ONS

The recovery looks robust until one realises that over the period 1993 to 2007 UK GDP averaged 3.3%. In the last three years it has only managed 0.9%.

I concur with the ITEM Club; BoE rates are unlikely to rise for some while yet – the money markets are not pricing in a rate rise until Q1 2016. As in many other developed countries, the economic recovery has been muted and protracted due to the overhang of debt and the “monetary engineering” of consumption.

Politics

May 7th is the date set for the general election; this event will dominate the political agenda for H1 2015. The latest ICM opinion poll published by The Guardian on Tuesday looks like this:-

ICM_Poll_Parties_200115

Source: Guardian and ICM

An article published last Sunday by British Future – 2015 A Year of Uncertaintysuggest that the election will be the most open in 40 years:-

We don’t even know how many parties will end up forming a government, let alone which ones. New ICM polling for this year’s State of the Nation 2015 report from British Future sheds some light on key issues surrounding the General Election campaign and beyond.

How people predict the outcome of the May 7 election depends very much on who they are, with most party supporters feeling that their team have a good chance: 88% of Conservatives think their party will be in government, while 78% of Labour supporters think theirs will. They can’t both be right. That two-thirds of UKIP supporters think Nigel Farage and co. will be part of the government and 49% of Lib Dems think they will, shows how open a contest it could be.

In an election that may well be dominated by questions about immigration and identity, not everyone is confident that we can emerge from the debate unscathed, with social and community cohesion intact. Our poll finds that only a quarter of Britons believe we can come through the 2015 election campaign with good community relations across our multi-faith and multi-ethnic society. A similar number worry that the tone of the election campaign will damage relations between different communities, while another group of voters wish the gloves would come off more.

…It is the job of politicians to articulate different views, but also to aggregate them. This has become more difficult as our fragmented politics show. But in a fractious society there will also be a greater appetite for politicians who can tell a broader story about what brings us together – one which can engage people in the cities and in coastal towns, across the generations, and build common cause across class, faith and ethnic lines in the Britain we all share.

Asset Market Direction

Uncertainty surrounding the general election will limit price moves for the UK stocks and Gilts until mid-year at the earliest; if anything, there may be capital outflows.

Gilts

Gilts offer higher yields than Bunds or Oats and yet, to a Euro based investor, the currency risk of Gilts, as opposed to the country risk of BTPs or Bonos, makes the carry-trade less than obvious in a UK election year. Here are a selection of 10 year Government bond yields from, post ECB QE announcement at 17:00 GMT on Thursday 22nd:-

Country 10 yr Yield Spread over Bunds
Switzerland -0.19 -0.64
Germany 0.45 0
Finland 0.46 0.01
Netherlands 0.48 0.03
France 0.62 0.17
Ireland 1.18 0.73
Spain 1.42 0.97
UK 1.51 1.06
Italy 1.62 1.17
Portugal 2.36 1.91
Greece 8.89 8.44

Source: Investing.com

The recent actions of the Swiss National Bank (SNB) whilst extreme, are an indication of the potential impact of currency risk both on the value of a bond and its yield. Meanwhile Gilts, like other government bonds continue their inexorable rise. Here is the monthly yield for 10 year Gilts since January 2007:-

united-kingdom-government-bond-yield 2007-2015

Source: Trading Economics

The absolute low in yield was seen in July 2012 at 1.40% during the depths of the last Euro crisis – at that juncture German Bunds were yielding around1.25% – a spread of around 15bp. I believe we will see fresh all-time highs in Gilts over the coming months, although I am not yet ready to short German Bunds against them, even for more than 100bp of positive carry. In absolute terms Gilt yields have halved in the last 13 months. For long-term investors a yield of 1.5% is hardly exciting, but that is what I said this time last year, only to watch fixed income markets have their best period of capital appreciation in many years.

Currency

The BoE decision to embrace aggressive QE early in the aftermath of the Great Recession – mainly during September and October 2009 – meant that the UK economy was the first to recover, however, as the chart below makes clear, the 40% depreciation of the GBP exchange rate versus its main trading partner created the conditions for a rapid export led recovery in economic fortunes:-

EURGBP Month Jan 2007 - Jan 2015

Source: Barchart.com

This month, prompted by the continued strengthening of the US$ and the unpegging of the CHF, has seen EUR/GBP break through the 61.8% retracement level (0.78). It is not inconceivable that the entire move will now be retraced. The 0.70 highs of 2005/2006 look like the next obvious level of support. This will hasten a further deterioration in the current account deficit and allow the EZ to export some of its deflation to the UK.

Against the US$, Sterling has been weakening, as international capital has flowed into the US markets. I expect continued weakness of Cable – it is likely to retest 1.42, a level last reached in May 2010 – together with further Sterling strength versus the Euro.

Stocks

Covering the period since 2010, here is a chart of showing the relative performance of FTSE versus DAX and EuroStoxx 50:-

FTSE EUROSTOXX DAX 5yr

Source: Yahoo Finance

What is clear is that German stocks have benefitted, from the receding of the Euro crisis, significantly more than either the UK or the broader European market. The DAX outperformance of FTSE, however, dates back to the early 2000’s Hartz reforms which have been key to German growth for more than a decade. As often happens, the UK stock market had already anticipated the resurgence in economic growth prior to 2012. In 2014 the FTSE marked-time as mining and commodity stock weakness was offset by stronger performance in other sectors – especially technology.

The continued weakness in GBP/USD may encourage inward capital flows into UK stocks. The upward momentum of the US economy – barring a major correction on the back of an energy sector related debt default – will also benefit UK stocks; the US is still “the Consumer of Last Resort”. The IMF – World Economic Outlook update cut its global growth forecast earlier this week from 3.8% to 3.5% but increased its US forecast from 3.1% to 3.6%. This is their introduction: –

Global growth will receive a boost from lower oil prices, which reflect to an important extent higher supply. But this boost is projected to be more than offset by negative factors, including investment weakness as adjustment to diminished expectations about medium-term growth continues in many advanced and emerging market economies.

Global growth in 2015–16 is projected at 3.5 and 3.7 percent, downward revisions of 0.3 percent relative to the October 2014 World Economic Outlook (WEO). The revisions reflect a reassessment of prospects in China, Russia, the euro area, and Japan as well as weaker activity in some major oil exporters because of the sharp drop in oil prices. The United States is the only major economy for which growth projections have been raised.

The distribution of risks to global growth is more balanced than in October. The main upside risk is a greater boost from lower oil prices, although there is uncertainty about the persistence of the oil supply shock. Downside risks relate to shifts in sentiment and volatility in global financial markets, especially in emerging market economies, where lower oil prices have introduced external and balance sheet vulnerabilities in oil exporters. Stagnation and low inflation are still concerns in the euro area and in Japan.

The FTSE is trading on a P/E of around 16 times earnings: this is not far above its long run average. The Shiller/Case CAPE – a measure of the price versus the last 10 years earnings – suggests the market is relatively cheap. Trading at around 15 times it compares favourably with the 27 times multiple of the US. The chart below shows the evolution over the last 40 years – it is from mid-October 2014 and the FTSE is around 300 points higher since then:-

PF-ftse-cape_3079144a

Source: Hargreaves Lansdown

This metric is underpinned by the following chart, again courtesy of the Economic Research Council, which shows the comparative profitability of the UK services and manufacturing sectors:-

UK_Company_profitability_-_ERC

Source: Economic Research Council and ONS

UK manufacturing sector profitability is hitting a 16 year high – lower energy prices can only help them improve margins further. This may be one of the factors influencing the investment intensions expressed in the Deloitte CFO survey. Perhaps demand for corporate credit might return in earnest after the election.

With politics overshadowing the market until May, I expect an out-performance by UK stocks to be delayed until H2 2015. Of the many external factors, the performance of the US stock market is probably the most important. The US market has outperformed the UK substantially since the mid-2012 Euro crisis:-

SPX vs FTSE 5yr

Source: Yahoo Finance

I envisage latent demand driving the UK stock market in the second half of the year. For those who are concerned that the US equity bull-market may be nearing the end its current cycle, long FTSE short S&P500 could be an interesting relative value play. Technically, however, the S&P500 is still trending higher whilst the FTSE should be bought on a convincing breakout above 6875.