Will technology change the prospects for emerging market growth?

Will technology change the prospects for emerging market growth?

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Macro Letter – No 75 – 21-04-2017

Will technology change the prospects for emerging market growth?

  • The challenge to low-cost manufacturing in emerging markets is from technology
  • Some industries will benefit but many jobs will be displaced globally
  • The mercantilist model of emerging market growth will need to adapt
  • Technology will solve some of the demographic challenges of the developed world

In July 2016 the International Labor Organisation (ILO) released a report entitled – ASEAN in Transformationin the preface it relates the apocryphal story of a 1950’s conversation between Henry Ford, Chairman of Ford Motor Company, and Walter Reuther, Leader of the United Automobile Workers Union.

Ford asked, “Walter, how are you going to get those robots to pay your union dues?” to which Reuther responded, “Henry, how are you going to get them to buy your cars?” It reminds us that disruptive technology is not new. As the latest wave of innovation begins to disrupt employment globally, it makes sense to reassess the prospects for some of the world’s fastest growing economies.

The ILO report goes on to focus on the impact of technology on ASEAN countries, a region with 632mln people. This is an under-researched topic. They highlight the industries which are most likely to be affected and suggest ways countries can adapt to minimise the impact of automation on employment. This is their conclusion:-

Considerable opportunities for growth exist within ASEAN. Importantly, the local domestic market is expanding, and ASEAN’s middle class is expected to grow to 125 million by 2025. This represents a massive and emerging regional market.

However, threats remain, and in some cases, are intensifying. In particular, a range of labour-intensive sectors in a number of less developed countries are susceptible to major technological disruption, leading to potential large-scale job displacement. The consequences for these countries could be profoundly negative if they are unprepared to adapt.

We are witnessing the emergence of new markets, the potential relocation of production, the rise of new hiring trends and the displacement of lower skilled jobs. Supplying workers with the appropriate skills and competencies remains a major challenge. Overall, concerted efforts are required from all ASEAN stakeholders. They should act now to build a future of innovation and growth shaped with better employment opportunities.

The World Bank Development Report 2016 – Digital Dividends provides a global perspective. Here are a couple of graphs which illuminate the challenging landscape:-

World_Bank_-_Impact_of_Automation_on_employment_20

Source: World Bank

If the unadjusted percentages indicated in the graph above are realised the social and political stability of many countries maybe undermined, however, the next graph shows which occupations are likely to be most at risk. It also shows which occupations can be expected to benefit from the productivity enhancing impact of new technology:-

World_Bank_-_probability_of_being_computerised_and

Source: World Bank

Educational challenge

Be an expensive complement (stats knowhow) to something that’s getting cheaper (data).

—Hal Varian, Chief Economist, Google, 2014

Going back to the ILO report, the key to creating workers with the correct skills is designing appropriate education. According to Asian Nation:-

50.5% Asians, age 25 and older, who have a bachelor’s degree or higher level of education. Asians have the highest proportion of college graduates of any race or ethnic group in the country and this compares with 28 percent for all Americans 25 and older.

This graph shows the educational attainment across ASEAN:-

ASEAN_Student_Survey_-_ILO

Source: ILO

Singapore scores highly but so does Cambodia, however, it is the low skilled worker who will suffer; the retraining challenges, for Asia and elsewhere, will be substantial. More than 60% of salaried workers in Indonesia and 73% in Thailand are at risk from automation. The highest risk group are employed in Textiles, Clothing and Footware.  More than 9mln people are employed in this sector across ASEAN and the ILO estimate that 64% are at risk in Indonesia, 86% in Vietnam whilst in Cambodia that figure rises to 88%.

Business Process Outsourcing (BPO) is another industry which is ripe for automation. There is a heavy concentration of BPO in the Philippines where more than 1mln salaried working are employed. The ILO estimate that 89% are at risk from automation.

Earlier this year I discussed the demise of China as a low-cost manufacturing hub in – Low cost manufacturing in Asia – The Mighty Five – MITI V – Malaysia, India, Thailand, Indonesia and Vietnam. I concluded:-

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Over the next few years I remain confident about these economies but the headwinds of technology will blow through these markets, nonetheless. Low cost manufacturing has to be set alongside, efficient inventory management and transit costs. In the apparel industry, where trends change in a rapid and unpredictable fashion, the advantage of fast design to production lead times makes the benefits of robotic production, geographically close to the consumer, much more alluring.

In a fascinating post on LinkedIn – Robots Take Over – The Apparel Production – Susanna Koelblin – discusses the decision by Adidas to transfer a part of the production of their sports shoes back to Germany for the first time in more than 20 years. Another “Speed factory” will open in the US later this year. Here are some of her observations:-

It took 50 years for the world to install the first million industrial robots. The next million will take only eight. Importantly, much of the recent growth happened in particular in China, which has an aging population and where wages have risen…

German robot maker Kuka, acquired last year by China’s Midea, estimates a typical industrial robot costs about 5 euros an hour. Manufacturers spend 50 euros an hour to employ someone in Germany and about 10 euros an hour in China. Rather than seek out an even cheaper source of labor elsewhere – in another emerging Asian economy, say – Chinese manufacturers are choosing to install more robots, especially for more complex tasks. China isn’t getting rid of the work, just the workers…

It is in fact China which is leading the world in terms of the installation of industrial robots, but relative to the size of its workforce these concentrations are still relatively low. China boasts 4.9 robots/1,000 workers while Germany tops the world ranking at 30.1/1,000. That is almost twice the concentration of the US and four times that of the UK.

The current level of earnings in manufacturing still favours the work force of the MITI V but as the cost of automation continues to fall and average earnings in, lower cost Asia, rises, an inflection point will be reached:-

Wage_costs_-_inflation_and_currency_MITI_V_-_Tradi

Source: Trading Economics

Manufacturing wage inflation has been high in Indonesia partly in response to earlier currency depreciations – over 10 years the Rupiah has declined by 46% against the US$ whilst manufacturing wages have increased by 164%. All these emerging economies maintain a manufacturing cost advantage relative to robotic automation, however, for countries like Malaysia, which has seen its currency decline by 46.7% over the last five years, whilst manufacturing wages have only risen by 37.6%, the competitive advantage versus robotic automation is narrowing. Malaysia now has a manufacturing wage cost which is slightly higher than China’s.

Interestingly, India has seen a real-terms improvement in export competitiveness. Its currency has fallen 21.4% over five years but manufacturing wages have only risen by 14.6%. Vietnam and Thailand have seen export competitiveness decline, yet in both cases they have had considerable room for manoeuvre.

I am in agreement with Dr. Jing Bing Zhang, Research Director of IDC Worldwide Robotics, we should not be worried about automation derailing the emerging market growth model over the next decade. This is what he said in a recent interview with the Diplomat:-

There are different schools of thought…  From my research, I don’t see it. Maybe we will be less dependent on human labor. But there is no way this will eliminate the need for people in the next 15-20 years. We are entering high speed growth for robotics but in 2014 global density for robotics was still very low at 66 per 10,000 employees, 36 in China, 57 in Thailand, and close to none in India.

The uptake of robots does not appear to have damaged employment in Germany where unemployment recently dipped below 4%, the lowest level since 1981. One can argue that demographic forces are at work here but Germany has the highest concentration of robots relative to workers globally.

Chatham House – Robots and pensioners to the rescue – examines a different aspect of automation and demographics, focussing on Japan:-

Bleak demographics saddle Japan with a potential growth rate of less than 1 per cent, economists say, unless there are aggressive moves to accept more immigrants, boost the role of women in the workforce and overhaul workplace inefficiencies to increase productivity.

Yet despite its real and chronic problems, Japan may arguably be faring better than the image often projected of a country on the brink of an abyss. Japan still feels safe, prosperous and dazzlingly futuristic. While the overall economy has stagnated, GDP per head has outperformed most of the developed world, including Germany and France, according to World Bank figures − partly a consequence of the population crunch…

Most importantly, a shrinking population fosters innovation to boost productivity. Writing in the Financial Times, Michael Lind, a senior fellow at New America, a Washington think-tank, argued that a labour shortage can be a blessing rather than a curse: ‘Where labour is scarce and expensive, businesses have an incentive to invest in labour-saving technology,’ he wrote, ‘which boosts productivity growth by enabling fewer workers to produce more.’

That is precisely what is happening in today’s Japan, with investment pouring into robotics, industrial automation and artificial intelligence. Furuta notes that a similar phenomenon took place in 18th-century Japan, under the Tokugawa shoguns, when sharp population declines due to famine and natural disaster spurred an age of innovation in science, the arts and agriculture. Such thinking has prompted Prime Minister Abe to embrace the idea that Japan’s population crunch may have a silver lining: ‘Japan may be losing its population. But these are incentives,’ Abe said in a speech last year. ‘Japan’s demography, paradoxically, is not an onus, but a bonus.’

In my previous Macro Letter – No 72 – Low cost manufacturing in Asia – The Mighty Five – MITI VI reproduced the latest Deloitte Global Manufacturing Competitiveness Index, here it is again:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deloitte

The MITI V are all expected to rise up the competitiveness ranking over the next three years – with the exception of Thailand which remains unchanged in 14th place.

I remain optimistic about emerging market growth, but keep in mind the industries which will benefit from technology and those which will be harmed. For example, the software developers of India look well placed to thrive; the garment workers of China may not.

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

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Macro Letter – No 74 – 07-04-2017

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

  • With 30yr Swap yields below T-bond yields arbitrage should be possible
  • Higher capital requirements have increased the cost of holding T-bonds
  • Central clearing has reduced counterparty risk for investors in swaps
  • Maintaining swap market liquidity will be a critical role for Central Banks in the next crisis

Global investors are drawn to US fixed income markets, among other reasons, because of the depth of liquidity. The long term investor, wishing to match assets against liabilities would traditionally purchase US Treasury bonds (T-bonds). This pattern of investment has not changed, but the yield on longer dated Treasuries has become structurally higher than the yield on interest rate swaps (IRS).

In a normally functioning market the lowest yield for a given maturity is usually the yield on government bonds – the so called risk free rate – however, regulatory and monetary policy changes have undermined this relationship.

Writing in March 2016 for Forbes, Darrell Duffie of Stanford University – Why Are Big Banks Offering Less Liquidity To Bond Markets?  described the part of the story which relates to the repo market:-

The new Supplementary Leverage Ratio (SLR) rule changes everything for the repo market. For the largest U.S. banks, the SLR, meant to backstop risk-adjusted capital requirements, now requires 6% capital for all assets, regardless of their risk. For a typical large dealer bank, the SLR is a binding constraint and therefore pushes up the bank’s required equity for a $100 million repo trade by as much as for any other new position of the same gross size, for example a risky real estate loan of $100 million. This means that the bank’s required profit on a repo trade must be in the vicinity of the profit on a risky real estate loan in order for the repo trade to be viable for shareholder value maximization. That profit hurdle has become almost prohibitive for repo intermediation, so banks are providing dramatically less liquidity to the repo market. As a result, the spread between repo rates paid by non-banks and by banks has roughly tripled. The three-month treasury-secured repo rates paid by non-bank dealers are now even higher than three-month unsecured borrowing rates paid by banks, a significant market distortion. Trade volume in the bank-to-non-bank dealer market for U.S. government securities repo is less than half of 2012 levels.

Other factors that are distorting the Bond/Swap relationship include tighter macro prudential regulation and reduced dealer balance sheet capacity. Another factor is the activities of companies issuing debt.

Companies exchange floating rates of interest for fixed rates. When a company sells fixed-rate debt, it can use a swap to offset the payment of a bond coupon and pay a lower floating rate. Heavy corporate issuance can depress the spread between swaps and bonds. This can be exacerbated when dealers are swamped by sales of T-bonds. A combination of heavy company issuance being swapped and higher dealer inventories of Treasury debt, might explain why swap spreads turn negative over shorter periods.

Back in 2015, when the 10yr spread turned sharply negative, Deutsche Bank estimated that the long term fair value for swaps was 3bp higher than the same maturity T-bond. But negative spreads have continued. A side effect has been to raise the cost of US government financing, but Federal Reserve buying has probably more than compensated for this.

The declining volume of transactions in the repo market is one factor, the declining liquidity in the T-bond market is another. The quantitative easing policies of the Federal Reserve have lowered yields but they have also lowered liquidity of benchmark issues.

The final factor to consider is the demand for leveraged investment. One solution to the problem of matching assets versus liabilities is to leverage one’s investment in order to generate the requisite yield. This does, however, dramatically increase the risk profile of one’s portfolio. The easiest market in which to leverage a fixed income investment remains the IRS market but, as a white paper published last May – PNC – Why are swap rates trading below US Treasury Rates? highlights, the cost of leverage in the swap market has, if anything, increased more than in the bond repo market:-

The regulatory requirement for central clearing of most interest rate swaps (except for swaps with commercial end users) has removed counterparty risk from such swap contracts. Regulatory hedging costs and balance sheet constraints have also come into effect over the past few years. These rules have significantly reduced the market-making activity of swap dealers and increased the cost of leverage for such dealers. This is evidenced in the repo rates versus the Overnight Interest Swap* (OIS) basis widening. This basis widening strips rate expectations (OIS) from the pure funding premium (repo) rates. Swaps and Treasuries are less connected than in the past. The spread between them is a reflection of the relative demand for securities, which need to be financed, versus derivatives, which do not.

*The LIBOR-OIS Spread: The difference between LIBOR and OIS is called the LIBOR-OIS Spread and is deemed to be the health taking into consideration risk and liquidity. (An Overnight Index Swap (OIS) is a swap where the floating payments are based on the overnight Federal Funds Rate.)

For a more nuanced explanation, the publication, last month by Urban J. Jermann of the Wharton School, of a paper entitled – Negative Swap Spreads and Limited Arbitrage – is most insightful. Here are his conclusions based on the results of his arbitrage model:-

Negative swap spreads are inconsistent with an arbitrage-free environment. In reality, arbitrage is not costless. I have presented a model where specialized dealers trade swaps and bonds of different maturities. Costs for holding bonds can put a price wedge between bonds and swaps. I show a limiting case with very high bond holding costs, expected swap spreads should be negative. In this case, no term premium is required to price swaps, and this results in a significantly lower fixed swap rate. As a function of the level of bond holding costs, the model can move between this benchmark and the arbitrage-free case. The quantitative analysis of the model shows that under plausible holding costs, expected swap spreads are consistent with the values observed since 2008. Demand effects would operate in the model but are not explicitly required for these results.

My model can capture relatively rich interest rate dynamics. Conditional on the short rate, the model predicts a negative link between the term spread and the swap spread. The paper has presented some empirical evidence consistent with this property.

The chart below, which covers the period from 1999 up to Q3 2015, shows the evolution before and after the Great Financial Crisis. It is worth noting that the absolute yield may be an influence on this relationship too: as yields have risen in the past year, 30yr swap spreads have become less negative, 5yr and 10yr spreads have reverted to positive territory:-

US Swap Spreads Zero Hedge Goldman Sachs

Source: ZeroHedge, Goldman Sachs

This table shows the current rates and spreads (6-4-2017):-

Bond_-_Swap_Spread_6-4-17

Source: Investing.com, The Financials.com

Conclusion and investment opportunity

The term “Risk-Free Rate” has always been suspect to my mind. As an investor, one seeks the highest return for the lowest risk. How different investors define risk varies of course, but, in public markets, illiquidity is usually high on the list of risks for which an investor would wish to be paid. If longer dated US T-bonds trade at a structurally higher yield than IRS’s, it is partly because they are perceived to lack their once vaunted liquidity. Dealers hold lower inventories of bonds, repo volumes have collapsed and central counterparty clearing of swaps has vastly reduced the counterparty risks of these, derivative, instruments. Added to this, as Jermann points out in his paper, frictional costs and uncertainty, about capital requirements and funding availability, make arbitrage between swaps and T-bonds far less clear cut.

When the German bond market collapsed during the unification crisis of the late 1980’s, it was Bund futures rather than Bunds which were preferred by traders. They offered liquidity and central counterparty clearing: and they did not require a repurchase agreement to set up the trade.

Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.

At its heart, the Great Financial Crisis revolved around a drying up of liquidity in multiple financial markets simultaneously. Tightening of regulation and increases in capital requirements since the crisis has permanently reduced liquidity in many of these markets. Meanwhile, increasingly sophisticated technology has increased the speed at which liquidity provision can be withdrawn.

It behoves the Federal Reserve to become an active participant in the IRS market. Control of the swap market is likely to be the key to maintaining market stability, come the next crisis. IRS’s, replete with their leveraged investors, have assumed the mantle which was once the preserve of the US Treasury market.

In previous crises the “flight to quality” effect was substantial, in the next, with such a small free float of actively traded T-bonds, which are not already owned by the Federal Reserve, the effect is likely to be much greater. The latest FOMC Minutes suggest the Fed may turn its attention towards reducing the size of its balance sheet but the timing is still unclear and the first asset disposals are likely to be Mortgage Backed Securities rather than T-bonds.

Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.

Can a multi-speed European Union evolve?

Can a multi-speed European Union evolve?

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Macro Letter – No 73 – 24-03-2017

Can a multi-speed European Union evolve?

  • An EC white paper on the future of Europe was released at the beginning of the month
  • A multi-speed approach to EU integration is now considered realistic
  • Will a “leaders and laggards” approach to further integration work?
  • Will progress on integration enable the ECB to finally taper its QE?

At the Malta Summit last month German Chancellor Angela Merkel told reporters:-

We certainly learned from the history of the last years, that there will be as well a European Union with different speeds that not all will participate every time in all steps of integration.

On March 1st the European Commission released a white paper entitled the Future of Europe. This is a discussion document for debate next week, when members of the EU gather in Rome to celebrate the 60th anniversary of the signing of the Treaty of Rome.

The White Paper sets out five scenarios for the potential state of the Union by 2025:-

Scenario 1: Carrying On – The EU27 focuses on delivering its positive reform agenda in the spirit of the Commission’s New Start for Europe from 2014 and of the Bratislava Declaration agreed by all 27 Member States in 2016. By 2025 this could mean: Europeans can drive automated and connected cars but can encounter problems when crossing borders as some legal and technical obstacles persist. Europeans mostly travel across borders without having to stop for checks. Reinforced security controls mean having to arrive at airports and train stations well in advance of departure.

Scenario 2: Nothing but the Single Market – The EU27 is gradually re-centred on the single market as the 27 Member States are not able to find common ground on an increasing number of policy areas. By 2025 this could mean: Crossing borders for business or tourism becomes difficult due to regular checks. Finding a job abroad is harder and the transfer of pension rights to another country not guaranteed. Those falling ill abroad face expensive medical bills. Europeans are reluctant to use connected cars due to the absence of EU-wide rules and technical standards.

Scenario 3: Those Who Want More Do More – The EU27 proceeds as today but allows willing Member States to do more together in specific areas such as defence, internal security or social matters. One or several “coalitions of the willing” emerge. By 2025 this could mean that: 15 Member States set up a police and magistrates corps to tackle cross-border criminal activities. Security information is immediately exchanged as national databases are fully interconnected. Connected cars are used widely in 12 Member States which have agreed to harmonise their liability rules and technical standards.

Scenario 4: Doing Less More Efficiently – The EU27 focuses on delivering more and faster in selected policy areas, while doing less where it is perceived not to have an added value. Attention and limited resources are focused on selected policy areas. By 2025 this could mean A European Telecoms Authority will have the power to free up frequencies for cross-border communication services, such as the ones used by connected cars. It will also protect the rights of mobile and Internet users wherever they are in the EU.A new European Counter-terrorism Agency helps to deter and prevent serious attacks through a systematic tracking and flagging of suspects.

Scenario 5: Doing Much More Together – Member States decide to share more power, resources and decision-making across the board. Decisions are agreed faster at European level and rapidly enforced. By 2025 this could mean: Europeans who want to complain about a proposed EU funded wind turbine project in their local area cannot reach the responsible authority as they are told to contact the competent European authorities. Connected cars drive seamlessly across Europe as clear EU-wide rules exist. Drivers can rely on an EU agency to enforce the rules.

There is not much sign of a multi-speed approach in the above and yet, on 6th March the leaders of Germany, France, Italy and Spain convened in Versailles where they jointly expressed the opinion that allowing the EU to integrate at different speeds would re-establish confidence among citizens in the value of collective European action.

There are a couple of “general instruments”, contained in existing treaties, which give states some flexibility; ECFR – How The EU Can Bend Without Breaking suggests “Enhanced Cooperation” and “Permanent Structured Cooperation”(PESCO) as examples, emphasis mine:-

Enhanced cooperation was devised with the Amsterdam Treaty…in 1997, and revised in successive treaty reforms in Nice and Lisbon. Enhanced cooperation is stipulated as a procedure whereby a minimum of nine EU countries are allowed to establish advanced cooperation within the EU structures. The framework for the application of enhanced cooperation is rigid: It is only allowed as a means of last resort, not to be applied within exclusive competencies of the union. It needs to: respect the institutional framework of the EU (with a strong role for the European Commission in particular); support the aim of an ever-closer union; be open to all EU countries in principle; and not harm the single market. In this straitjacket, enhanced cooperation has so far been used in the fairly technical areas of divorce law and patents, and property regimes for international couples. Enhanced cooperation on a financial transaction tax has been in development since 2011, but the ten countries cooperating on this have struggled to come to a final agreement.

PESCO allows a core group of member states to make binding commitments to each other on security and defence, with a more resilient military and security architecture as its aim. It was originally initiated at the European Convention in 2003 to be part of the envisaged European Defence Union. At the time, this group would have consisted of France, Germany, and the United Kingdom. After disagreements on defence spending in this group and the referendum defeat for the European Constitution which meant the end of the Defence Union, a revised version of PESCO was added into the Lisbon treaty. This revised version allows for more space for the member states to decide on the binding commitments, which of them form the group, and the level of investment. However, because of its history, some member states still regard it as a top-down process which lacks clarity about how the groups and criteria are established. So far, PESCO has not been used, but it has recently been put back on the agenda by a group of EU member states.

These do not get the EU very far, but the ECFR go on to mention an additional Schengen-style approach, where international treaties of EU members can be concluded outside of the EU framework. These treaties can later be adopted by other EU members.

As part of their research the ECFR carried out more than 100 interviews with government officials and experts at universities and think-tanks across the 28 member states to discover their motivation for adopting a more flexible approach. The chart below shows the outcomes:-

ECFR FutureEU_MotiviationFlexibility

Source: ECFR

Interestingly, in two countries, Denmark and Greece, officials and experts believe that more flexibility will result in greater fragmentation. Nonetheless, officials and experts in Croatia, Finland, Germany, Italy, Latvia, and Spain are in favour of embracing a more flexible approach. Benelux and France remain sceptical. Here is how the map of Europe looks to the ECFR:-

ECFR206_THE_FUTURE_SHAPE_OF_EUROPE_-_CountryMap

Source: ECFR

The timeline for action is likely to be gradual. President Juncker’s plans to develop the ideas contained in the white paper in his State of the Union speech in September. The first policy proposals may be drafted in time for the European Council meeting in December. It is envisaged that an agreed course of action will be rolled out in time for the European Parliament elections in June 2019.

Can Europe wait?

Two years is not that long a time in European politics but financial markets may lack such patience. Here is the Greek government debt repayment schedule prior to the European Parliament Elections:-

Greece_-_Repayment_Schedule_-_WSJ

Source: Wall Street Journal

This five year chart shows the steady rise in total Greek government debt:-

greece-government-debt

Source: Tradingeconomics, Bank of Greece

Greek debt totalled Eur 326bln in Q4 2016, the debt to GDP ratio for 2015 was 177%. Italy’s debt to GDP was a mere 133% over the same period.

ECB dilemma

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016. The chart below shows the evolution of Eurozone long-term interest rates between October 2009 and November 2016:-

Long-term_interest_rates_(eurozone) Oct 09 to Nov 16 - ECB

Source: ECB

In 2011 the Euro Area debt to GDP ratio was 86%, by 2015 it had reached 91%. The table below shows the highest 10yr yield since the great financial crisis for a selection of Eurozone government bonds together with their ratios of debt to GDP. It goes on to show the same ratio at the end of 2015. Only Germany is in a stronger position today than it was during the Eurozone crisis in terms of its debt as a percentage of its GDP:-

Bond_yields_and_debt_to_GDP (1)

Source: Trading Economics

Since these countries bond markets hit their yield highs during the Eurozone Crisis, Greece, Italy and Spain have seen an improvement in GDP growth, but only Spain is likely to achieve sufficient growth to reduce its debt burden. If the ECB is to cease killing the proverbial fatted calf, a less profligate fiscal approach is required.

Euro Area GDP averaged slightly less than 1.8% per annum over the last two years, yet the debt to GDP ratio only declined a little over 1% from its all-time high. Further European integration sounds excellent in theory but in practice any positive impact on economic growth is unlikely to be evident for several years.

EU integration has been moving at different speeds for years, if anything, the process has been held back by attempts to move in unison. There are risks of causing fragmentation with both approaches, either within countries or between them.

Conclusions and Investment Opportunities

Another Eurozone financial crisis cannot be ruled out this year. The political uncertainty of the Netherlands is past, but France may yet surprise. Once Germany has voted in September, it will be time to focus on the endeavours of the ECB. Their asset purchase programme is scheduled to end in December.

I would expect this programme to be extended once more, if not, the stresses which nearly tore the Eurozone asunder in 2011/2012 are likely to return. The fiscal position of the Euro Area is only slightly worse than it was five years ago, but, having flirted with the lowest yields ever recorded, bond markets have considerably further to fall in percentage terms than in during the previous crisis.

Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero. German Bunds are always likely to act as the safe haven in a crisis and their yields have risen substantially in the past year, yet at less than ½% they are 300bp below their “safe-haven” level of April 2011.

The Euro is unlikely to rally in this environment. The chart below shows the Euro Effective Exchange Rate since 2005:-

Euro_Effective_Exchange_Rate_-_ECB (1)

Source: ECB

The all-time low for the Euro is 82.34 which was the level is plumbed back in October 2000. This does sound an outlandish target during the next debacle.

Euro weakness would, however, be supportive for export oriented European stocks. The weakness that stocks would initially suffer, as a result of the return of the Euro crisis, would quickly be reversed, in much the same manner that UK stocks were pummelled on the initial Brexit result only to rebound.

Low cost manufacturing in Asia – The Mighty Five – MITI V

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Macro Letter – No 72 – 10-03-2017

Low cost manufacturing in Asia – The Mighty Five – MITI V

  • Low cost manufacturing is moving away from China
  • Malaysia, India, Thailand, Indonesia and Vietnam will continue to benefit
  • Currency risks remain substantial
  • Stock market valuations are not cheap but they offer long term value

The MITI V is the latest acronym to emerge from the wordsmiths at Deloitte’s. Malaysia, India, Thailand, Indonesia and Vietnam. All these countries have a competitive advantage over China in the manufacture of labour intensive commodity type products like apparel, toys, textiles and basic consumer electronics. According to Deloitte’s 2016 Global Manufacturing Competitiveness Index they are either among, or destined to join, the top 15 most competitive countries in the world for manufacturing, by the end of the decade. Here is the Deliotte 2016 ranking:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deliotte

The difficulty with grouping disparate countries together is that their differences are coalesced. Malaysia and Thailand are likely to excel in high to medium technology industries, their administrations are cognizant of the advantages of international trade. India, whilst it has enormous potential, both as an exporter and as a manufacturer for its vast domestic market, has, until recently, been less favourably disposed towards international trade and investment. Vietnam continues to benefit from its proximity to China. Indonesia, by contrast, has struggled with endemic corruption: its economy is decentralised and this vast country has major infrastructure challenges.

The table below is sorted by average earnings:-

MITI_V_-_Stats

Source: World Bank, Trading Economics

India and Vietnam look well placed to become the low-cost manufacturer of choice (though there are other contenders such as Bangladesh which should not be forgotten when considering comparative advantage).

Another factor to bear in mind is the inexorable march of technology. Bill Gates recently floated the idea of a Robot Tax, it met with condemnation in many quarters – Mises Institute – Bill Gates’s Robot Tax Is a Terrible Ideaexamines the issue. The mere fact that a Robot Tax is being contemplated, points to the greatest single challenge to low-cost producers of goods, namely automation. Deliotte’s does not see this aspect of innovation displacing the low-cost manufacturing countries over the next few years, but it is important not to forget this factor in one’s assessment.

Before looking at the relative merits of each market from an investment perspective, here is what Deliotte’s describe as the opportunities and challenges facing each of these Asian Tigers:-

 

Malaysia

…has a low cost base with workers earning a quarter of what their counterparts earn in neighboring Singapore. The country also remains strongly focused on assembly, testing, design, and development involved in component parts and systems production, making it well suited to support high-tech sectors.

…is challenged by a talent shortage, political unrest, and comparatively low productivity.

India

Sixty-two percent of global manufacturing executives’ surveyed rank India as highly competitive on cost, closely mirroring China’s performance on this metric.

…highly skilled workforce and a particularly rich pool of English speaking scientists, researchers, and engineers which makes it well-suited to support high-tech sectors. India’s government also offers support in the form of initiatives and funding that focus on attracting manufacturing investments.

…challenged by poor infrastructure and a governance model that is slow to react

…As 43 percent of its US$174 billion in manufacturing exports require high-skill and technological intensity, India may have a strong incentive to solve its regulatory and bureaucratic challenges if it is to strengthen its candidacy as an alternative to China.

Thailand

When it comes to manufacturing exports (US$167 billion in 2014), Thailand stands slightly below India, but exceeds Malaysia, Vietnam, and Indonesia. This output is driven largely by the nation’s skilled workforce and high labor productivity, supported by a 90 percent national literacy rate, and approximately 100,000 engineering, technology, and science graduates every year.

…highly skilled and productive workforce creates relatively high labor costs at US$2.78 per hour in 2013.

…remains attractive to manufacturing companies, offering a lower corporate tax rate (20 percent) than Vietnam, India, Malaysia or Indonesia. Already well established with a booming automotive industry, Thailand may provide an option for manufacturers willing to navigate the political uncertainty that persists in the region.

Indonesia

Manufacturing labor costs in Indonesia are less than one-fifth of those in China.

…The island nation’s overall 10-year growth in productivity (50 percent) exceeds that of Thailand, Malaysia, and Vietnam,

…manufacturing GDP represents a significant portion of its overall GDP and with such a strong manufacturing focus, particularly in electronics, coupled with the sheer size of its population, Indonesia remains high on the list of alternatives for manufacturers looking to shift production capacity away from China in the future.

Vietnam

…comparatively low overall labor costs.

…has raised its overall productivity over the last 10 years, growing 49 percent during the period, outpacing other nations like Thailand and Malaysia. Such productivity has prompted manufacturers to construct billion-dollar manufacturing complexes in the country.

Deliotte’s go on to describe the incentives offered to multinational corporations by these countries:-

(1) numerous tax incentives in the form of tax holidays ranging from three to 10 years, (2) tax exemptions or reduced import duties, and (3) reduced duties on capital goods and raw materials used in export-oriented production.

Forecasts for 2017

In the nearer term the MITI V have more varied prospects, here are Focus Economics latest consensus GDP growth expectations from last month:-

Malaysia Economic Outlook 2017 GDP forecast 4.3%

…GDP recorded the strongest performance in four quarters in Q4, expanding at a better-than-expected rate of 4.5%.

…acceleration in fixed investment and resilient private consumption. Exports also showed a significant improvement, growing at the fastest pace since Q4 2015, thanks to a weaker ringgit and rising oil prices. However, the external sector’s net contribution to growth remained stable as imports also gained steam. Government consumption, which contracted for the first time since Q2 2014, was the only drag on growth in Q4, reflecting the government’s commitment to its fiscal consolidation agenda for 2016.

India Economic Outlook 2017 GDP forecast – 7.4%

Economic activity is beginning to firm after demonetization shocked the economy in the October to December period. The manufacturing PMI crossed into expansionary territory in January and imports rebounded.

…Despite the backdrop of more moderate growth, the government stuck to a market friendly budget for FY 2017

…which was presented on 1 February, pursues growth-supportive policies while targeting a narrower deficit of 3.2% of GDP…

…five states will conduct elections in February, with results to be announced on 11 March. The elections will test the electorate’s mood regarding the government after the economy’s tumultuous past months and ahead of the 2019 general vote.

Thailand Economic Outlook 2017 GDP forecast 3.2%

Growth decelerated mildly in the final quarter of 2016 due to subdued private consumption and a smaller contribution from the external sector. The economy expanded 3.0% annually in Q4, down from 3.2% in Q3.

…January, consumer confidence hit a nearly one-year high, while business sentiment receded mildly. On 27 January, the government announced supplementary fiscal stimulus of USD 5.4 billion for this year’s budget, which ends in September. The sum will be disbursed specifically in rural areas in a bid to close the growing inequality between urban and rural infrastructure and income. This shows that the military government is set to continue providing fiscal stimulus to GDP this year, which should spill over in the private sector via higher employment and improved economic sentiment.

Indonesia Economic Outlook 2017 GDP forecast 5.2%

…economy lost steam in the fourth quarter of last year as diminished government revenues caused public spending to fall at a multi-year low.

…household consumption remained healthy and the recent uptick in commodities prices boosted export revenues.

…for the start of 2017…momentum firmed up: the manufacturing PMI crossed into expansionary territory in January and surging exports pushed the trade surplus to an over three-year high.

…poised for a credit ratings upgrade after Moody’s elevated its outlook from stable to positive on 8 February. All three major ratings agencies now have a positive outlook on Indonesia’s credit rating and an upgrade could be a catalyst for improving investor sentiment.

Vietnam Economic Outlook 2017 GDP forecast 6.4%

…particularly strong performance in the external sector in 2016. Despite slower demand from important trading partners, merchandise exports, which consist largely of manufactured goods, grew 9.0% annually. The manufacturing sector is quickly expanding thanks to the country’s competitive labor costs, fueling manufacturing exports and bolstering job creation in the sector.

…industrial production nearly stagnated in January, it mostly reflected a seasonal effect from the Lunar New Year, which disrupted supply chains across the region.

…manufacturing Purchasing Manager’s Index, though it inched down in January, continues to sit well above the 50-point line, reflecting that business conditions remain solid in the sector. Moreover, the New Year festivities boosted retail sales, which grew robustly in January.

Currency Risk

The table below shows the structural nature of the MITI V’s exchange rate depreciation against the US$. The 20 year column winds the clock back to the period just before the Asian Financial Crisis in 1997:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

Looking at the table another way, when investing in Indonesia it would make sense to factor in a 4% annual decline in the value of the Rupiah, a 2.2% to 2.4% decline in the Ringgit, Rupee and Dong and a 1.3% fall in the value of the Baht.

The continuous decline in these currencies has fuelled inflation and this is reflected to the yield and real yields available in their 10 year government bond markets. The table below shows the current bond yields together with inflation and their governments’ fiscal positions:-

MITI_V_-_Bonds_Inflation_Fiscal

Source: Trading Economics

Indonesian bonds offer insufficient real-yield to cover the average annual decline in the value of the Rupiah. Vietnam has an inverted yield curve which suggests shorter duration bonds would offer better value, its 10 year maturity offers the lowest real-yield of the group.

Whilst all these countries are running government budget deficits, Malaysia, Thailand and Indonesia have current account surpluses and Indonesia’s government debt to GDP is a more manageable 27% – this is probable due to its difficulty in attracting international investors on account of the 82% decline in its currency over the past two decades.

Stock Market Valuations

All five countries have seen their stock markets rise this year, although the SET 50 (Thailand) has backed off from its recent high. To compare with the currency table above here are the five stock markets, plus the S&P500, over one, two, five, ten and twenty years:-

MITI_V and US_Stocks_in_20yr

Source: Investing.com

For the US investor, India and Indonesia have been the star performers since 1997, each returning more than six-fold. Thailand, which was at the heart of the Asian crisis of 1997/98, has only delivered 114% over the same period whilst Malaysia, which imposed exchange controls to stave off the worst excesses of the Asian crisis, has failed to deliver equity returns capable of countering the fall in its currency. Finally, Vietnam, which only opened its first stock exchange in 2000, is still recovering from the boom and bust of 2007. The table below translates the performance into US$:-

MITI_V_-_Stock_performance_in_US_20yr

Source: Investing.com

Putting this data in perspective, over the last five years the S&P has beaten the MITI V not only in US$, but also in absolute terms. Looking forward, however, there are supportive valuation metrics which underpin some of the MITI V stock markets. The table below is calculated at 30-12-2016:-

MITI_V_PEs_etc

Source: Starcapital.de, *Author’s estimates

Conclusion and Investment Opportunities

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Thailand and Malaysia look less expensive from a price to earnings perspective, than India and Indonesia. Their dividend yields also look attractive relative to their bond yields, perhaps a hangover from the Asian Crisis of 1997.

Technically all five stock markets are at or near recent highs:-

MITI_V_-_stocks_-_distance_to_high

Source: Investing.com

The Vietnamese VN Index is a long way below its high and on a P/E, P/B and dividend yield basis it is the cheapest of the five stock markets, but it is worth remembering that it is still regarded at a Frontier Market, It was not included in the MSCI Emerging Markets indices last year. This remains a prospect at the next MSCI review in May/June.

Given how far global equity markets have travelled since the November US elections, it makes sense to be cautious about stock markets in general. Technically a break to new highs in any of these markets is likely to generate further upside momentum but Vietnam looks constructive both over the shorter term (as it makes new highs for the year) and over the longer term (being well below its all-time highs of 2007). In the Long Run, I expect these economies to the engines of world growth and their stock markets to reflect that growth.

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.