Has Bitcoin come of age?

Has Bitcoin come of age?

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Macro Letter – No 81 – 21-07-2017

Has Bitcoin come of age?

  • Bitcoin (BTC) has tripled and then halved since late March
  • Even at BTCUSD 2000 total issuance amounts to $33bln
  • Historic volatility is high (80%) but implied volatility is higher (97%)
  • The introduction of derivatives and an interest rate curve suggest financial deepening

Bitcoin (BTC) came into existence in January 2009. It was not the first ‘cryptocurrecny’ and there are now an estimated 950 competitors, with new ICO’s ‘Initial Coin Offerings’ appearing almost daily.

BTC’s closest rival in terms of coins in circulation is Ethereum (ETH). The chart below shows how these currencies % of total market capitalisations has waxed and waned:-

Cryptocurrency_Market_Cap_-_Coinmarketcap_com

Source: coinmarketcap.com

I want to concentrate on BTC since it remains the market leader with a total circulation of $33bln (reference BTCUSD 2000) whilst the outstanding issuance of its nearest rival ETH is $16bln.

Below is a four month chart of BTCUSD, its price has fallen by almost one third in just over a month:-

Bitcoin_chart_since_March_2017_-_Bitcoincharts_com

Source: Bitcoincharts.com

The recent price action needs to be seen in a broader context. The price has increased from less than BTCUSD 1000 in late March. On April 1st the Japanese authorities officially recognised BTC for the first time: perhaps, this was the catalyst for its spectacular rise.

The subsequent precipitous decline in price may be related to a proposed software change to be introduced on 21st July, known as SegWit, which is discussed in Cryptocurrency Value: Growing Pains or Something More? By Ryan Shea – here’s the rub:-

SegWit2x software, which introduces SegWit while doubling the block size to 2MB, will be released on July 21. More than 80% of the network hash rate has agreed to run the SegWit2x code, which suggests that the solution to increasing bitcoin’s scalability will be enacted smoothly.

However, it is also possible that the hard fork required to increase the block size leads to a bifurcation of bitcoin into two separate currencies –something that would unquestionably trigger a sharp price correction by undermining the bitcoin brand. (The key date by which a split can be avoided is August 1 when BIP148 activates – this represents the last opportunity for miners to accept Segwit2x and thereby avoid a chain split resulting in the creation of two parallel bitcoins.)

There have been victories and defeats during the evolution of BTC, as it has evolved from an obscure novelty to a serious contender for investors seeking a store of value. The price volatility reflects these uncertainties but it is not demonstrably different from the volatility seen in several commodity markets.

Financial deepening

For a security, commodity or a currency to gain credence, among financial market operators, it needs to offer a store of value, liquidity and convertibility. If can achieve these attributes it should have collateral value, by which I mean, BTC should be capable of being borrowed or lent. This is already happening. Some cryptocurrency exchanges are offering a rate of interest on term deposits and others offer the opportunity for holders of BTC to lend their currency to traders who wish to borrow it, primarily to sell the currency short. Whilst there is not really a ‘risk-free rate’ for BTC an interest rate term structure is beginning to emerge as the table below, derived from a number of exchanges, shows:-

Bitcoin_Interest_Rates_-_July_2017

There may well be other exchanges offering a variety of differing interest rates. but this, I hope, provides a snapshot of the current environment.

The other aspect of financial deepening which will help BTC come of age is the development of a derivatives market. I believe the arrival of exchanges for BTC futures and options is a very positive signal.

The futures exchanges include Okex, CryptoFacilties, BitMEX, BitVC, Coinut and Deribit which also offers options – there may be several others. Today (Monday 17th July) I have taken some snap shots of the futures and options pricing from Deribit.

With the BTCUSD spot price at 2027, the July future (expiration 28th July) traded at a discount of $12 ($2015) this is known in futures parlance as a backwardation. The September contract (expiration 29th September) was, by contrast, trading at a premium, or contango ($2070). Because of high demand from leveraged traders to borrow US$ to buy BTC the forward/futures price of BTCUSD normally trades at a premium (contango). The current environment is unusual, the forced liquidation which has fuelled the recent collapse in the price has led to, what is likely to be a temporary, backwardation. John Jansen – CEO of Deribit – explained the anomaly during a recent interview:-

…when the market is bullish, US$ interest rates spike up and BTC interest rates go down: uses want to borrow USD to buy BTC. In other words, short USD and go long BTC…there is an overall tendency for speculators to be long, therefore, the arbitrage traders are short BTC (lending out their USD) or short the future. USD interest rates are, therefore, normally higher than BTC rates which explains the contango in BTCUSD futures prices.

…on BTC platforms, annualized interest rates on US$ are on average maybe 20%…which would imply that the future should trade at a 20% annualized contango. Arbitrage traders take the other side of the trade…but get paid for their trouble.

Over time I expect the BTC market to become more efficient and the natural relationship for BTC futures should (other things equal) eventually become a small backwardation, reflecting the 1.5% differential between lower US$ and higher BTC interest rates. There are a number of arbitrage opportunities for those who want to dig deeper, but remember credit risk, both in terms of counterparties and exchanges, together with risks surrounding convertibility are nuanced. It may not be the free-lunch you perceive it to be.

This brings me to the BTC option market. The prices in the table below are again from Deribit:-

Deribit_-_Bitcoin_Options_prices_-_17-7-2017_-_Spo (1)

Source: Deribit

I regret the resolution this table is less than I’d like but it shows some important features. Firstly, implied volatility is trading at a substantial premium to historic volatility. The chart below shows the evolution of historic volatility and the BTC price over the last three months:-

Bitcion_price_and_vol_3month_-_Deribit

Source: Deribit

The July option series expires on 28th but the mid-market implied volatility for the September 29th expiration is not significantly lower – implied call volatility stands at 97%, for puts it is 85%. At this stage in the development of the BTC options market, I suspect the majority of the buyers are speculative traders rather than desperate hedgers, but option market-makers are wise to build in a margin of safety given the tendency of the underlying market price to gap lower or higher: delta and gamma hedging is challenging with these price swings. The bid/offer spreads on the options are also wide, another reflection of the nascent nature of the marketplace.

A final measure of immaturity – or perhaps I should say, opportunity – which the option market reveals, may be found in the shape of the volatility surface. The chart below is extrapolated from the mid-market implied volatilities in the table above:-

Bitcoin_Options_Vol_Smile_-_Deribit

Source: Deribit

In a liquid options market one would normally expect the lowest implied volatility to be at-the-money – around the $2000 strike price. In the chart above the nadir of volatility is around the $1900 strike, a level breached briefly last weekend.

Conclusions and investment opportunities

Cryptocurrencies have captured the imagination of many new participants, from geeks to gold bugs, but, as BTC achieves greater legitimacy, the market will deepen and mature. The adoption of scalable technology to deal with the exponential increases in trading volume is a part of this process. The acceptance of distributed ledger technology across other parts of the financial services sector will also be supportive.

From a technical perspective the price of BTC has corrected by around 50% – since March it has risen from under $1000 to $3000 and is now back around $2000 (Monday 17th July). In absolute terms it has fallen by just over one third. This is a healthy price correction, typical of the price action witnessed from time to time in more liquid and established commodity markets: US Natural Gas springs to mind.

As an investment, the argument for holding BTC is more tenuous. It is a currency with no government or central bank to underwrite its value, however, the expansion of the BTC monetary base is strictly controlled, making it more like a hard currency, such as we had during the Bretton Woods era, as opposed to the endlessly debased fiat currencies we are inveigled to consider of value today.

Currencies have no implicit yield but BTCUSD currently offers a theoretical positive carry of around 1.5%. As mentioned above, this relationship is currently distorted by the demand to borrow US$ to buy BTC by leveraged traders. Any investment in an asset which has no earnings and pays no dividend/coupon/interest must by its nature be a trading asset. However, strategies such as high frequency, robotic, liquidity provision and long term, trend following, are among a number of exciting trading opportunities for the active BTC operator.

The fundamentals driving BTC investment revolve around: investor distrust in fiat currencies, loathing of government intervention in asset markets and belief in the tenability of cryptocurrencies as a lasting store of value both from a technical and regulatory perspective. These fundamental drivers of valuation have, in the past and will in the future, cause sudden repricing’s. Outside of these seismic episodes, the price of BTC will be driven by capital flows. With liquid currency pairs like EURUSD, the economic fundamentals of both geographic regions are of equal importance. This is unlikely to be the case for BTC for the foreseeable future. BTC volatility eclipses the majority of its developed currency peers; its true value, whilst it is becoming gradually clearer, will remain ephemeral for some time to come.

The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

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Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.

Central Bank balance sheet adjustment – a path to enlightenment?

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Macro Letter – No 79 – 16-6-2017

Central Bank balance sheet adjustment – a path to enlightenment?

  • The balance sheets of the big four Central Banks reached $18.4trln last month
  • The Federal Reserve will commence balance sheet adjustment later this year
  • The PBoC has been in the vanguard, its experience since 2015 has been mixed
  • Data for the UK suggests an exit from QE need not precipitate a stock market crash

The Federal Reserve (Fed) is about to embark on a reversal of the Quantitative Easing (QE) which it first began in November 2008. Here is the 14th June Federal Reserve Press Release – FOMC issues addendum to the Policy Normalization Principles and Plans. This is the important part:-

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

On the basis of their press release, the Fed balance sheet will shrink until it is nearer $2.5trln versus $4.4trln today. If they stick to their schedule that should take until the end of 2021.

The Fed is likely to be followed by the other major Central Banks (CBs) in due course. Their combined deleveraging is unlikely to go unnoticed in financial markets. What are the likely implications for bonds and stocks?

To begin here are a series of charts which tell the story of the Central Bankers’ response to the Great Recession:-

Central_Bank_Balance_Sheets_-_Yardeni_May_2017

 Source: Yardeni Research, Haver Analytics

Since 2008 the balance sheets of the four major CBs have grown from around $6.5trln to $18.4trln. In the case of the People’s Bank of China (PBoC), a reduction began in 2015. This took the form of a decline in its foreign exchange reserves in order to support the weakening RMB exchange rate against the US$. The next chart shows the path of Chinese FX reserves and the Shanghai Stock index since the beginning of 2014. Lagged response or coincidence? Your call:-

China FX reserves and stocks 2014 - 2017

Source: Trading Economics

At a global level, the PBoC balance sheet reduction has been more than offset by the expansion of the balance sheets of the Bank of Japan (BoJ) and European Central Bank (ECB), however, a synchronous balance sheet contraction by all the major CBs is likely to be of considerable concern to financial market participants globally.

An historical perspective

Have CB balance sheets ever been as large as they are today? Indeed they have. The chart below which terminates in 2011, shows the evolution of the Fed balance sheet since its inception in 1913:-

Federal_Reserve_Balance_Sheet_-_History_-_St_Louis

Source: Federal Reserve, Haver Analytics

The increase in the size of the Fed balance sheet during the period of the Great Depression and WWII was related to a number of factors including: gold inflows, what Friedman and Schwartz termed “precautionary demand” for reserves by commercial banks, lack of alternative assets, changes in reserve requirements, expansion of income and war financing.

For a detailed review of all these factors, this paper from 2016 – How was the Quantitative Easing Program of the 1930s Unwound? By Matthew Jaremski and Gabriel Mathy – makes fascinating reading, here’s the abstract:-

Outside of the recent past, excess reserves have only concerned policymakers in one other period: The Great Depression of the 1930s. This historical episode thus provides the only guidance about the Fed’s current predicament of how to unwind from the extensive Quantitative Easing program. Excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed banks to naturally reduce their excess reserves. Excess reserves fell rapidly in 1941 and would have unwound fully even without the entry of the United States into World War II. As such, policy tightening was at no point necessary and likely was even responsible for the 1937-1938 recession.

During the period from April 1937 to April 1938 the Dow Jones Industrial Average fell from 194 to 100. Monetarists, such as Friedman, blamed the recession on a tightening of money supply in 1936 and 1937. I don’t believe Friedman’s censure is lost on the FOMC today: past Fed Chair, Ben Bernanke, is regarded as one of the world’s leading authorities on the causes and policy errors of the Great Depression.

But is the size of a CB balance sheet a determinant of the direction of the stock market? A richer data set is to be found care of the Bank of England (BoE). They provide balance sheet data going back to 1694, although the chart below, care of FRED, starts in 1701:-

BoE_Balance_Sheet_to_GDP_since_1701_-_BoE_and_FRED

Source: Federal Reserve, Bank of England

The BoE really only became a CB, in the sense we might recognise today, as a result of the Banking Act of 1844 which granted it a monopoly on the issuance of bank notes. The chart below shows the performance of the FT-All Share Index since 1700 (please ignore the reference to the Pontifical change, this was the only chart, offering a sufficiently long history, which I was able to discover in the public domain):-

UK-equities-1700-2012 Stockmarket Almanac

Source: The Stock Almanac

The first crisis to test the Bank’s resolve was the panic of 1857. During this period the UK stock market barely changed whilst the BoE balance sheet expanded by 21% between 1857 and 1859 to reach 10.5% of GDP: one might, however, argue that its actions were supportive.

The next crisis, the recession of 1867, was precipitated by the end of the American Civil War and, of more importance to the financial system, the demise of Overund and Gurney, “the Bankers Bank”, which was declared insolvent in 1866. Perhaps surprisingly, the stock market remained relatively calm and the BoE balance sheet expanded at a more modest 20% over the two years to 1858.

Financial markets became a little more interconnected during the Panic of 1873. This commenced with the “Gründerzeit” or “Founders” crash on the Vienna Stock Exchange. It sent shockwaves around the world. The UK stock market declined by 31% between 1873 and 1878. The BoE may have exacerbated the decline, its balance sheet contracted by 14% between 1873 and 1875. Thereafter the trend reversed, with an expansion of 30% over the next four years.

I am doubtful about the BoE balance sheet contraction between 1873 and 1875 being a policy mistake. 1873 was in fact the beginning of the period known as the Long Depression. It lasted until 1896. Nine years before the end of this 20 year depression the stock market bottomed (1887). It then rose by 74% over the next 11 years.

The First World War saw the stock market decline, reaching its low in 1917. From juncture it rallied, entirely ignoring the post-war recession of 1919 to 1921. Its momentum was only curtailed by the Great Crash of 1929 and subsequent Great Depression of 1930-1931.

Part of the blame for the severity of the Great Depression may be levelled at the BoE, its balance sheet expanded by 77% between 1928 and 1929. It then remained relatively stable despite Sterling’s departure from the Gold Standard in 1931 and only began to expand again in 1933 and 1934. Its balance sheet as a percentage of GDP was by this time at its highest since 1844, due to the decline in GDP rather than any determined effort to expand the balance sheet on the part of the Old Lady of Threadneedle Street. At the end of 1929 its balance sheet stood at £537mln, by the end of 1934 it had reached £630mln, an increase of just 17% over five traumatic years. The UK stock market, which had bottomed in 1931 – the level it had last traded in 1867 – proceeded to rally for the next five years.

Adjustment without tightening

History, on the basis of the data above, is ambivalent about the impact the size of a CB’s balance sheet has on the financial markets. It is but one of the factors which influences monetary conditions, the others are the availability of credit and its price.

George Selgin described the Fed’s situation clearly in a post earlier this year for The Cato Institute – On Shrinking the Fed’s Balance Sheet. He begins by looking at the Fed pre-2008:-

…the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks’ legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed’s balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed’s immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could  influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Then comes the era of QE – the sea-change into something rich and strange. The purchase of long-term Treasuries and Mortgage Backed Securities is funded using the excess reserves of the commercial banks which are held with the Fed. As Selgin points out this means the Fed can no longer use the federal funds rate to influence short-term interest rates (the emphasis is mine):-

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions’ demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target “range,” because most of the limited trading that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base.

Selgin goes on to describe this as Confiscatory Credit Control:-

…Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases.

The good news is that the Fed can adjust its balance sheet with relative ease (emphasis mine):-

It’s only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills.  Were it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions’ demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks’ own demand for such reserves, both policies are expansionary. They don’t alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks’ capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

Selgin expands, suggesting that if the Fed decide to announce a fixed schedule for adjustment (which they have) then they may employ another tool from their armoury, the Term Deposit Facility:-

…to the extent that the Fed’s gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed’s federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks’ excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.

With unemployment falling and economic growth steady the Fed are expected to tighten monetary policy further but the balance sheet adjustment needs to be handled carefully, conditions may look benign but the Fed ultimately holds more of the nation’s deposits than at any time since the end of WWII. Bank lending (last at 1.6%) is anaemic at best, as the chart below makes clear:-

Commercial_Bank_Loan_Creation_US

Source: Federal Reserve, Zero Hedge

The global perspective

The implications of balance sheet adjustment for the US have been discussed in detail but what about the rest of the world? In an FT Article – The end of global QE is fast approaching – Gavyn Davies of Fulcrum Asset Management makes some projections. He sees global QE reaching a plateau next year and then beginning to recede, his estimate for the Fed adjustment is slightly lower than the schedule announced last Wednesday:-

Fulcrum_Projections_for_tapering

Source: FT, Fulcrum Asset Management

He then looks at the previous liquidity injections relative to GDP – don’t forget 2009 saw the world growth decline by -0.8%:-

Fulcrum CB Liquidity Injections - March 2017 forecast

Source: IMF, National Data, Haver Analytics, Fulcrum Asset Management

It is worth noting that the contraction of Emerging Market CB liquidity during 2016 was principally due to the PBoc reducing their foreign exchange reserves. The ECB reduction of 2013 – 2015 looks like a policy mistake which they are now at pains to rectify.

Finally Davies looks at the breakdown by institution. The BoJ continues to expand its balance sheet, rising above 100% of GDP, whilst eventually the ECB begins to adjust as it breaches 40%:-

Fulcrum Estimates of CB Balance sheets - March 2017 

Source: Haver Analytics, Fulcrum Asset Management

I am not as confident as Davies about the ECB’s ability to reverse QE. They were never able to implement a European equivalent of the US Emergency Economic Stabilization Act of 2008, which incorporated the Troubled Asset Relief Program – TARP and the bailout of Fannie Mae and Freddie Mac. Europe’s banking system remains inherently fragile.

ProPublica – Bailout Costs – gives a breakdown of cost of the US bailout. The policies have proved reasonable successful and at little cost the US tax payer. Since initiation in 2008 outflows have totalled $623.4bln whilst the inflows amount to $708.4bln: a net profit to the US government of $84.9bln. Of course, with $455bln of troubled assets still outstanding, there is still room for disappointment.

The effect of TARP was to unencumber commercial banks. Freed of their NPL’s they were able to provide new credit to the real economy once more. European banks remain saddled with an abundance of NPL’s; her governments have been unable to agree on a path to enlightenment.

Conclusions and Investment Opportunities

The chart below shows a selection of CB balance sheets as a percentage of GDP. It is up to the end of 2016:-

centralbankbalancesheetgdpratios

SNB: Swiss National Bank, BoC: Bank of Canada, CBC: Central Bank of Taiwan, Riksbank: Swedish National Bank

Source: National Inflation Association

The BoJ has since then expanded its balance sheet to 95.5% and the ECB, to 32%. With the Chinese economy still expanding (6.9% March 2017) the PBoC has seen its ratio fall to 45.4%.

More important than the sheer scale of CB balance sheets, the global expansion has changed the way the world economy works. Combined CB balance sheets ($22trln) equal 21.5% of global GDP ($102.4trln). The assets held are predominantly government and agency bonds. The capital raised by these governments is then invested primarily in the public sector. The private sector has been progressively crowded out of the world economy ever since 2008.

In some ways this crowding out of the private sector is similar to the impact of the New Deal era of 1930’s America. The private sector needs to regain pre-eminence but the transition is likely to be slow and uneven. The tide may be about to turn but the chance for policy mistakes, as flows reverse, is extremely high.

For stock markets the transition to QT – quantitative tightening – may be neutral but the risks are on the downside. For government bond markets there are similar concerns: who will buy the bonds the CBs need to sell? If interest rates normalise will governments be forced to tighten their belts? Will the private sector be in a position to fill the vacuum created by reduced public spending, if they do?

There is an additional risk. Yield curve flattening. Banks borrow short and lend long. When yield curves are positively sloped they can quickly recapitalise their balance sheets: when yield curves are flat, or worse still inverted, they cannot. Increases in reserve requirements have made government bonds much more attractive to hold than other securities or loans. The Commercial Bank Loan Creation chart above may be seen as a warning signal. The mechanism by which CBs foster credit expansion in the real economy is still broken. A tapering or an adjustment of CB balance sheets, combined with a tightening of monetary policy, may have profound unintended consequences which will be magnified by a severe shakeout in over-extended stock and bond markets. Caveat emptor.

Trade and Protectionism post globalisation

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Macro Letter – No 78 – 02-06-2017

Trade and protectionism post globalisation

  • Protectionism is on the increase among developed nations
  • The benefits of free-trade have been most evident in developing countries
  • Short-term effects on financial markets may be reversed in the long run
  • The net impact on global growth will be negative

The success of free-trade and globalisation has been a boon for less developed countries but, to judge by the behaviour of the developed world electorate of late, this has been at the expense of the poorer and less well educated peoples of the developed nations. Income inequality in the west has been a focus of considerable debate among economists. The “Elephant Chart” below being but one personification of this trend:-

world-bank-economist-real-income-growth-1988-2008

Source: Economist, World Bank

If the graph looks familiar it’s because I last discussed this topic back in November 2016 in – Protectionism: which countries have room for fiscal expansion? This is what I said about the chart at that time:-

What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

It can be argued that this chart is not a fair representation of the reality in the west. This excellent video by Johan Norberg – Dead Wrong – The Elephant Graph – makes some important observations but, as a portfolio manager, friend of mine reminded me recently, when considering human action one should not focus on absolute change in economic circumstances, but relative change. What did he I mean by this? Well, let’s take income inequality. The rich are getting richer and the poor are…getting richer less quickly.

In the dismal science, as Carlyle once dubbed economics, we often take a half-empty view of the world. Take real average income. Since 2008 people have become worse-off as the chart below for the UK shows:-

wages-inflation

Source: Economicshelp.org

However, in the long-run we have become better-off for generations. What really drives prosperity, by which I mean our quality of life, is productivity gains: our ability to harness technology to improve the production of goods and services.

Financial markets are said to be driven by fear and greed. Society in general is also driven by these factors but there is an additional driver: envy. Any politician who ignores the power of envy, inevitably truncates his or her career.

The gauntlet was thrown down recently by the new US administration: their focus was on those countries with trade surpluses with the US. Accusations of trade and currency manipulation play well to the disenfranchised American voter.

Well before the arrival of the new US President, however, a degree of rebalancing had already begun to occur when China adopted policies to increase domestic consumption back in 2012. A recent white paper entitled – Is the Global Economy Rebalancing? By Focus Economics – looks at the three countries with the largest persistent current account surpluses: China, Germany and Japan. As they comment in their introduction, a current account surplus may be derived by many different means:-

Decades of conflicting perspectives over the causes and effects of global trade imbalances have been thrust back into the spotlight in recent months by Donald Trump’s brazen criticism of almost every country with a significant current account surplus with the U.S. His controversial accusation that big exporter countries are deliberately weakening their currencies to gain a competitive advantage taps into an issue that has perplexed and divided economists and policymakers ever since the mid-1990s. At that time, countries such as the U.S. were starting to build up large current account deficits, while others such as China, Germany and Japan were accumulating large surpluses.

Put simply, a country’s current account balance measures the difference between how much it spends and makes abroad. Trade in goods usually—but not always—accounts for most of the current account, while the other components are trade in services, income from foreign investment and employment (known as ‘primary income’), and transfer payments such as foreign aid and remittances (known as ‘secondary income’).

A current account surplus or deficit is not necessarily in and of itself a good or bad thing, since a number of considerations must be factored in—for example, in the case of deficit countries, whether they make a return on their investments that exceeds the costs of funding them. A large current account surplus can be considered a desirable sign of an efficient and competitive economy if it comprises a positive trade balance generated by market forces. And yet such competitiveness can also be falsely created to an extent by policy decisions (e.g. a deliberate currency weakening), or may alternatively be a sign of overly weak domestic demand in a highly productive country. Therein lies the crux of the controversy, or at least one of many. 

Global imbalances were a critically important contributing factor to the financial crisis, although they did not in themselves cause it. Even if the precise nature of that connection has sparked different interpretations, there is at least more or less agreement on the fundamentals of the part played by trade relations between the U.S. and China, the two countries traditionally responsible for the lion’s share of global imbalances. Credit-fueled growth in the U.S. encouraged consumers to spend more, including on products originating in China, thereby further increasing the U.S. trade deficit with China and prompting China to “recycle” the dollars gained by buying U.S. assets (mostly Treasury notes). This, in turn, helped to keep U.S. interest rates low, encouraging ever greater bank lending, which pushed up housing prices, caused a subprime mortgage crisis and ultimately ended in a nasty deleveraging process.

Services and investment balances can be difficult to measure accurately; trade data is easier to calculate. Here are the three current account surplus countries in terms of their trade balances:-

china-balance-of-trade

Source: Trading Economics, Chinese General Administration of Customs

Interestingly, China’s trade balance has declined despite the recent devaluation in the value of the Yuan versus the US$.

germany-balance-of-trade

Source: Trading Economics, German Federal Statistics Office

The relative weakness of the Euro seems to have underpinned German exports. On this basis, the weakening of the Euro, resulting from the Brexit vote, has been an economic boon!

japan-balance-of-trade

Source: Trading Economics, Japanese Ministry of Finance

The Abenomics policy of the three arrows whilst it has succeeded in weakening the value of the Yen, has done little to stem its steadily deteriorating trade balance. The Yen has risen ever since the ending of Bretton Woods, it behoves Japanese companies to invest aboard. The relative strength of the current account is the result of Japanese investment abroad.

Trade data is not without its flaws, even in a brand dominated business such as automobiles the origin of manufacture can turn out to be less obvious than it might at first appear. According to the Kogod – Made in America Auto Index 2016 – at 81% the Honda Accord ranks fifth out of all automobiles, in terms of the absolute percentage of an entire vehicle which is built in the USA, well above the level of many Ford and General Motors vehicles.

Conclusions and Investment Opportunities

The financial markets will react differently in each country to the headwinds of de-globalisation and the rise of protectionism. The US, however, presents an opportunity to examine the outcome for a largest economy in the world.

The US currency’s initial reaction to the Trump election win was a significant rise. The US$ Index rallied from 97.34 on the eve of the election to test 103.81 at the beginning of January. Since then, as the absolute power, or lack thereof, of the new president has become apparent, the US$ Index has retraced the entire move. Protectionism on the basis of this analysis is likely to be UD$ positive. In the long run protectionist policies act as a drag on economic growth. The USA has the largest absolute trade deficit. Lower global economic growth will either lead to a rise in the US trade deficit or a strengthening of the US$, or, perhaps, a combination of the two.

Interest rates and bonds may be less affected by the strength of the US currency in a protectionist scenario, but domestic wage inflation is likely to increase in the medium term, especially if border controls are tightened further, closing off the flow of immigrant workers.

US stocks should initially benefit from the reduction in competition derived from a protectionist agenda but in the process the long run competitiveness of these firms will be undermined. The continual breaching to new highs which has been evident in the S&P 500 (and recently, the Nasdaq) is at least partially due to expectation of the agenda of the new administration. These policies include the lowering of corporation tax rates (from 35% to 15%) to bring them in line with Germany, infrastructure spending (in the order of $1trln) and protectionist pressure to “Buy American, Hire American”. Short term the market is still rising but valuations are becoming stretched by many metrics, as I said recently in Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train:-

Pro-business US economic policy will continue to drive US stocks: the words of Pink Floyd spring to mind…we call it riding the gravy train.

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

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Macro Letter – No 71 – 24-02-2017

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

  • In 2006 NATO partners agreed to spend at least 2% of GDP on defence
  • Germany’s defence spending shortfall since 2006 equals $281bln
  • Retrospective adjustment is unlikely, but Europe needs to increase spending substantially
  • A minimum of $64bln/annum is required from Germany, France, Italy and Spain alone

Given the mutual relationship of the NATO treaty it could be argued that, for many years the US has been footing the lion’s share of the bill for defending Europe. Under the new US administration this situation is very likely to change.

The July 2016 Defence Expenditures of NATO Countries (2009-2016) presents the situation in clear terms. At the Riga summit back in 2006 NATO members agreed to raise defence expenditure to 2% of GDP. In that year only six countries met the threshold – Bulgaria, France, Greece, Turkey, the UK, and the US. Eight years later, at the NATO meeting in Wales, members renewed their commitment to this target. Last year only five members achieved the threshold – Estonia, Greece, Poland, the UK, and, of course, the US.

The original NATO treaty was signed on 4th April 1949 by 12 countries, it was expanded in 1952 to include Turkey and Greece and in 1955 to incorporate Germany. In 1982, after reverting to a democracy, Spain also joined. Further expansion occurred in 1999, again in 2004 and most recently 2009.

Back in 1949 Europe was still recovering from the disastrous social and economic impact of WWII. Today, in the post-Cold War era, things look very different and yet, whilst defence spending has waxed and waned over the intervening years, the US still spends substantially more on defence, both in absolute terms and as a percentage of GDP, than any of its treaty partners. The table below reveals the magnitude of the current situation:-

nato_expenditure_-_geopolitical_futures

Source: Geopolitical Futures, Mauldin Economics

US defence spending last year amounted to $664bln which equates to 3.61% of US GDP based on current estimates.

Setting aside the political debate about whether we should be spending more or less on defence, it would appear that the US continues to do more than its fair share, in economic terms, in defence of its NATO allies.

The next table looks at the budgetary implications of making the NATO budget equable. Firstly, all NATO countries committing 2% of GDP to defence (which would dramatically reduce the total NATO budget) or, secondly, maintaining the current level of spending, which would imply all countries contributing 2.58% of GDP. In both scenarios the US is a clear winner in economic terms:-

nato_expenditure_as_percentage_of_gdp_-_analysis-1

Source: NATO, UN, IMF

I have excluded the smaller, mainly Eastern European, countries from this analysis – their combined contribution is less than $13bln/annum. I do not wish to appear disparaging, on a percentage of GDP basis many of these countries contribute more than their larger European neighbours. My purpose in this analysis is to look at the relative increases or decreases under each scenario. Below are the Budget to GDP and Debt to GDP ratios before and after adjustment to the less demanding 2% defence expenditure target:-

nato_budget_and_debt_to_gdp_after_adjustment_to_2_

Source: NATO, UN, IMF, Trading Economics

The Maastricht Treaty incorporated certain criteria in order to satisfy Germany, along with other cautious countries, of the fiscal rectitude of all countries seeking to join the Eurozone. Although they were never really taken seriously by politicians, these fiscal restrictions included a maximum Government debt to GDP ratio of 60% and a Budget deficit to GDP ratio of less than 3%. Applying these arcane criteria, only three countries – Denmark, Norway and Turkey – are in the enviable position of being able to undertake the required defence spending increases with equanimity.

The burning question going forward is how the largest countries in Europe will react to the US compliant that they have failed to increase spending since 2006. As George Friedman of Geopolitical Futures – The Evolving NATO Alliance succinctly explains:-

…the US accounts for about 50% of NATO members’ total GDP and 32% of their total population—and yet the US makes up about 72% of defense spending.

… Western European countries (excluding the UK) account for 31% of NATO members’ GDP and 33%  of their population, and yet they contribute 16%  to NATO members’ total defense spending.

Eastern European countries, which account for 4.2% of NATO members’ GDP and 12.7% of their population, are much poorer and smaller than Western European countries. Eastern Europe contributes 2.7% to defense spending. In effect, Eastern Europe contributes closer to its share than its far wealthier and stronger neighbors to the west.

According to SIPRI Milex data for 2015, Russia spent 5.4% of GDP on defence. Other notable defenders of their realms include Pakistan (3.4%) and India (2.3%).

At the Munich Security Conference which took place last weekend, the prospect of Germany finding an extra Eur20bln per year for defence spending was raised, but, being an election year, little more was heard on the topic. The conference was fascinating however, here are some of the key quotes:-

A stable EU is as much in America’s interest as a united NATO – Ursula von der Leyen – Minister of Defence – Germany.

American security is permanently tied to European security – James Mattis – Secretary of Defence – USA.

The role of Germany in Europe is always to be a bridge – between North and South and East and West – Wolfgang Schauble – Minister of Finance – Germany.

Make no mistake, my friends. You should not count America out – John McCain – Chairman of Senate Committee on Armed Services – USA.

Let us not forget that NATO is the backbone of our value system – Jeanine Hennis-Plasschaert – Minister of Defence – Netherlands.

NATO is not an obsolete organisation. It is an organisation to which additional mandates should be added – Fikri Isik – Minister of National Defence – Turkey.

The United States of America strongly supports NATO and will be unwavering in our commitment to this Transatlantic alliance – Michael Pence – Vice President – USA.

Europe’s defence requires your support as much as ours – Michael Pence – Vice President – USA.

Things look very different if we add up our defence budgets, our development aid budgets and our humanitarian efforts all around the world – Jean-Claude Juncker – President – European Commission

The post-war generation rose to their challenge, we must rise to ours – Jens Stoltenberg – Secretary General – NATO.

The European Union is much stronger than we European’s realise – Federica Mogherini – Vice President – European Commission – High Representative for Foreign Affairs and Security Policy – EU.

No one has any clue what the foreign policy of this administration is – Christopher Murphy – Member of the Senate Committee on Foreign Relations.

From a negotiating perspective it would not be entirely unreasonable for the US to demand that the 2006 commitment of 2% spending be honoured retrospectively, in addition to the 2% commitment going forward. The table below shows how NATO members have performed in this respect since 2005, apart from the US, only Greece and the UK have been above target over the entire period. American frustration with its NATO partners is hardly surprising:-

nato_defense_expenditure_as_percentage_of_gdp_-_ge

Source: NATO, Geopolitical Futures

The tone of US comments at the Munich conference appear slightly more conciliatory than of late. Europe’s defence ministries have, nonetheless, been seriously shaken by the change in attitude which has accompanied the change of US administration.

According to commentators, who purport to have more of a clue than Christopher Murphy, US defence spending is likely to rise by between $500bln and $1trln under the new administration. This is no “Get Out of Jail Free” card for NATOs parsimonious majority, Europe will be pressured to defence spending at a time when budgets are already uncomfortably bloated. They have had more than a decade to comply with the Riga commitment.

Looking at the bigger picture for a moment, this sudden rise in spending is a small uptick in a downward trend. Defence budgets have been falling in all the major NATO countries, as the chart below indicates. In 1989 excluding the UK and US the average budget to GDP across NATO countries was 2.9% by 1998 it had fallen to 2% but since then it has steadily declined to an average of 1.4% today. This may be good from an economic perspective – as Frederic Bastiat argued most eloquently in relation to the cost of a standing army in his essay What Is Seen and What Is Not Seen:-

A hundred thousand men, costing the taxpayers a hundred million francs, live as well and provide as good a living for their suppliers as a hundred million francs will allow: that is what is seen.

But a hundred million francs, coming from the pockets of the taxpayers, ceases to provide a living for these taxpayers and their suppliers, to the extent of a hundred million francs: that is what is not seen. Calculate, figure, and tell me where there is any profit for the mass of the people.

Nonetheless, the economic burden of defence spending borne by the US is undoubtedly going to shift, or else, NATO will cease to be tenable going forward:-

defence_spending_as_a_pecentage_of_gdp_since_1949_

Source: SIPRI

Conclusion

I believe it is likely that Germany, France, Italy and Spain will find an additional $64bln/annum for Defence and Aid budgets. They may also have to pick up part of the bill for the smaller countries to their East.

Will this impact European bond markets? It seems like a drop in the ocean beside the Asset Purchase Program of the ECB. President Draghi announced in January that they will be reducing the monthly purchases from Eur 80bln per month to Eur 60bln starting in April. I suspect the impact will be limited but it might prolong the Asset Purchase Program somewhat.

The implications for defence contractors and their stock market valuations will be more direct. Here are some of the largest listed names in Europe. Not all of them have been darlings of the stock market of late:-

areospace_and_defence_companies-1

Source: Investing.com, LSE, NYSE Euronext

For those who, like myself, who prefer to analyse the sector rather than individual stocks, the STOXX Europe TMI Aerospace & Defense (SXPARO) may appeal; here is a three year chart:-

stoxx_-_europe_tmi_aerospace_defense

Source: STOXX

The combination of increased military spending by the US and the pressure being brought to bear on Europe, should see the defence sector outperform over the longer term. During the last 12 months the SXPARO has risen 15%. Its US equivalent, the iShares US Aerospace & Defense ETF (ITA) is up by 20% over the same period, whilst the Euro has declined by around 3% against the US$. As a general rule I prefer to buy Leaders rather than Laggards, but the logic of buying European if European governments are forced to honour their defence obligations remains compelling.

The impact of household debt and saving on long run GDP growth

The impact of household debt and saving on long run GDP growth

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Macro Letter – No 70 – 10-02-2017

The impact of household debt and saving on long run GDP growth

Neither a borrower nor a lender be;

For loan oft loses both itself and friend,

And borrowing dulls the edge of husbandry.

Hamlet I, iii – Shakespeare

  • BIS research indicates that household debt to GDP ratios above 80% reduce growth
  • But higher household savings do not appear to lead to higher investment
  • Counter-cyclical fiscal stimulus and fractional reserve lending are much more powerful growth factors than household savings or even household debt

Last week saw the publication of a fascinating working paper by the BIS – The real effects of household debt in the short and long run –the conclusions of the authors were most illuminating, here is the abstract:-

Household debt levels relative to GDP have risen rapidly in many countries over the past decade. We investigate the macroeconomic impact of such increases by employing a novel estimation technique proposed by Chudik et al (2016), which tackles the problem of endogeneity present in traditional regressions. Using data on 54 economies over 1990‒2015, we show that household debt boosts consumption and GDP growth in the short run, mostly within one year. By contrast, a 1 percentage point increase in the household debt-to-GDP ratio tends to lower growth in the long run by 0.1 percentage point. Our results suggest that the negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds 60%. For GDP growth, that intensification seems to occur when the ratio exceeds 80%. Finally, we find that the degree of legal protection of creditors is able to account for the cross-country variation in the long-run impact.

The chart below shows the growing divergence between the household debt of developed and emerging market economies:-

household_debt_-_bis

Source: BIS

Of the emerging markets, South Korea has the highest household debt ratio, followed by Thailand, Malaysia and Hong Kong: all have ratios above 60%. Singapore is on the cusp of this watershed, whilst all the remaining emerging economies boast lower ratios.

Part of the reason for lower household debt in emerging economies is the collective market memory of the Asian financial crisis of 1997. Another factor is the higher savings rate among many emerging economies. The table below is incomplete, the data has been gathered from multiple sources and over differing time periods, but it is still quite instructive. It is ranked by highest household savings rate as a percentage of GDP. On this basis, I remain bullish on the prospects for growth in the Philippines and Indonesia, but also in India and Vietnam, notwithstanding the Indian Government debt to GDP ratio of 69% and Vietnam’s budget deficit of -5.4% of GDP:-

em_household_debt_table

There are other countries who household sector also looks robust: China and Russia, are of note.

Last month I wrote about The Risks and Rewards of Asian Real Estate. This BIS report offers an additional guide to valuation. It helps in the assessment of which emerging markets are more likely to weather the impact of de-globalising headwinds. Policy reversals, such as the scrapping of the TPP trade deal, and other developments connected to Trump’s “America First” initiative, spring to mind.

Savings and Investment

When attempting to forecast economic growth, household debt is one factor, but, according to the economics textbooks, household savings are another. Intuitively savings should support investment, however, in a recent article for Evonomics – Does Saving Cause Lending Cause Investment? (No.)Steve Roth shows clear empirical evidence that a higher savings rate does not lead to a higher rate of investment. Here is a chart from the St Louis Federal Reserve which supports Roth’s assertions:-

household_savings_fred

Source: St Louis Federal Reserve Bank

Personal savings represents a small fraction of GDP especially when compared to lending and investment. Roth goes on to analyse the correlations:-

correlations-saving-and-investment-steve-roth-evonomics

His assessment is as follows:-

Of course, correlation doesn’t demonstrate causation. But lack of correlation, and especially negative correlation, does much to disprove causation. What kind of disproofs do we see here?

Personal saving and commercial lending seem to be lightly correlated. The correlation declines over the course of a year, but then increases two or three years out. It’s an odd pattern, with a lot of possible causal stories that might explain it.

Personal saving and private investment (including both residential and business investment) are very weakly correlated, and what correlation there is is mostly negative. More saving correlates with less investment.

Commercial lending has medium-strong correlation with private investment in the short term, declining rapidly over time. This is not terribly surprising. But it has nothing to do with private saving.

Perhaps the most telling result here: Personal saving has a significant and quite consistent negative correlation with business investment. Again: more saving, less investment. This directly contradicts what you learned in Econ 101.

The last line — commercial lending versus business investment — is most interesting compared to line 3 (CommLending vs PrivInv). Changes in commercial lending seem to have their strongest short-term effects on residential investment, not business investment. But its effect on business investment seems more consistent and longer-term.

This is a fascinating insight, however, there are international factors at work here. This data looks at the US, but the US is a far from closed economy; the current account deficit tells you that. Setting aside cross border capital flows there are even larger forces to consider.

Firstly, in general, when an economy slows, its government increases fiscal spending and its central bank reduces interest rates. Secondly, when short term interest rates fall, banks are incentivised to borrow short and lend long. They achieve this using a fraction of their own capital, lending depositors’ money at longer maturity and profiting from the interest rate differential.

Once fiscal stimulus has run its course and banks have leveraged their reserves to the maximum, the importance of household savings should, in theory, become more pronounced, but if interest rates are low investors are likely to defer investment. If government fiscal pump-priming has failed to deliver an economic recovery, investors are likely to be dissuaded from investing. Despite Roth’s empirical evidence to the contrary, I do not believe that the household savings rate is an unimportant measure to consider when forecasting economic growth, merely that it is overshadowed by other factors.

Conclusion

Household savings may have little impact on GDP growth but Household debt does. In the UK the savings Ratio was 6.6%, whilst the Household debt to income ratio was 152% at the end of 2015. By comparison, at the end of 2014 the US the savings ratio was 5% and household debt to income a more modest 113%. The ratio of the ratios is broadly similar at around 23 times.

With interest rates still close to the lowest levels in centuries and real interest rates, even lower, debt, rather than savings, is likely to be the principal driver of investment. That investment is likely to be channelled towards assets which can be collateralised, real estate being an obvious candidate.

I began this letter with a quote from Hamlet. I wonder what advice Polonius would give his son today? The incentive to borrow has seldom been more pronounced.

The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

  • Shanghai house prices increased 26.5% in 2016
  • International investment in Asian Real Estate is forecast to grow 64% by 2020
  • Chinese and Indian Real Estate has underperformed US stocks since 2009
  • Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed AssetLocation is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country Weight
Japan 32.94%
Hong Kong 26.40%
Australia 19.81%
China 9.62%
Singapore 6.30%
Other 4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and  ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

 

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

  • There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
  • Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
  • Geographic constraints – lack of space drives prices higher.
  • Planning restrictions – limitations on development and redevelopment drive prices higher.
  • Economic growth – this can be at the country level or on a per-capita basis.
  • Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
  • Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
  • Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
  • Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region 2017 Change
ASEAN* 4.90% -0.20%
India 7.20% -0.40%
China 6.50% 0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index Performance – March 09 – December 16 Performance in US$ Current Yield
S&P500 207% 207% 2%
FHFA House Price Index (US) 9.70% 9.70% 2.20%
Shanghai Composite (China) 50% 49.20% 4.20%
Shanghai Second Hand House Price Index 74% 72.85% 3.20%
S&P BSE Sensex (India) 204% 135.25% 1.50%
National Housing Bank Index (India) 58%* 38.45% 3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

india_-_national_housing_bank_-_house_price_index

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country Price/Income Ratio Rental Yield City Price/Rent Ratio City Mortgage As % of Income GDP f/c 2017
Malaysia 9.53 4.07 24.6 72.87 4%
Taiwan 12.87 1.54 64.91 78.76 1.80%
South Korea 12.38 2.04 49.1 85.47 2.40%
India 10.28 3.08 32.44 123.44 7.40%
Singapore 21.63 2.75 36.41 134.33 1.60%
Pakistan 12.09 4.08 24.51 156.97 5.10%
Philippines 16.91 3.75 26.69 162.87 6.60%
Bangladesh 12.89 3.25 30.81 181.3 6.80%
China 23.29 2.23 44.83 189.71 6.40%
Mongolia 15.77 9.78 10.22 203.47 1.80%
Thailand 24.43 3.8 26.29 212.03 3.30%
Hong Kong 36.15 2.25 44.35 224.85 1.80%
Sri Lanka 17.49 4.91 20.38 238.64 4.80%
Indonesia 21.03 4.67 21.41 247.68 5.10%
Vietnam 26.76 4.52 22.1 285.55 6.60%
Cambodia 24.32 7.44 13.44 292.43 7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager Asian AUM $Blns Total AUM $Blns
UBS Global Asset Management 9.33 64.89
Global Logistic Properties 9.26 20.14
CBRE Global Investors 8.56 91.27
LaSalle Investment Management 8.05 55.75
Blackstone Group 7.58 121.88
Alpha Investment Partners 7.48 8.70
Blackrock 7.32 22.92
Pramerica Real Estate Investors 6.84 59.17
Gaw Capital Partners 6.64 9.16
Prologis 6.08 29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.