Is the “flight to quality” effect breaking down?

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Macro letter – No 61 – 16-09-2016

Is the “flight to quality” effect breaking down?

  • 54% of government bonds offered negative yields at the end of August
  • Corporate bond spreads did not widen during last week’s decline in government bonds
  • Since July the dividend yield on the S&P500 has been higher than the yield on US 30yr bonds
  • In a ZIRP to NIRP world the “capital” risk of government bonds may be under-estimated

Back in 2010 I switched out of fixed income securities. I was much too early! Fortunately I had other investments which allowed me to benefit from the extraordinary rally in government bonds, driven by the central bank quantitative easing (QE) policies.

In the aftermath of Brexit the total outstanding amount of bonds with negative yields hit $13trln – that still leaves $32trln which offer a positive return. This is alarming nonetheless, according to this 10th July article from ZeroHedge, a 1% rise in yields would equate to a mark-to-market loss of $2.4trln. The chart below shows the capital impact of a 1% yield change for different categories of bonds:-

zerohedge_-_100bp_move_in_yields

Source: ZeroHedge

Looked at another way, the table above suggests that the downside risk of holding US Treasuries, in the event of a 1% rise in yields, is 2.8 times greater than holding Investment Grade corporate bonds.

Corporate bonds, even of investment grade, traditionally exhibit less liquidity and greater credit risk, but, in the current, ultra-low interest rate, environment, the “capital” risk associated with government bonds is substantially higher. It can be argued that the “free-float” of government bonds has been reduced by central bank buying. A paper from the IMF – Government Bonds and Their Investors: What Are the Facts and Do They Matter? provides a fascinating insight into government bond holdings by investor type. The central bank with the largest percentage holding is the Bank of England (BoE) 19.7% followed by the Federal Reserve (Fed) 11.5% and the Bank of Japan (BoJ) 8.3% – although the Japanese Post Office, with 29%, must be taken into account as well. The impact of central bank buying on secondary market liquidity may be greater, however, since the central banks have principally been accumulating “on the run” issues.

Since 2008, financial markets in general, and government bond markets in particular, have been driven by central bank policy. Fear about tightening of monetary conditions, therefore, has more impact than ever before. Traditionally, when the stock market falls suddenly, the price of government bonds rises – this is the “flight to quality” effect. It also leads to a widening of the spread between “risk-free” assets and those carrying greater credit and liquidity risk. As the table above indicates, however, today the “capital” risk associated with holding government securities, relative to higher yielding bonds has increased substantially. This is both as a result of low, or negative, yields and reduced liquidity resulting from central bank asset purchases. These factors are offsetting the traditional “flight to quality” effect.

Last Friday, government bond yields increased around the world amid concerns about Fed tightening later this month – or later this year. The table below shows the change in 10yr to 30yrs Gilt yields together with a selection of Sterling denominated corporate bonds. I have chosen to focus on the UK because the BoE announced on August 4th that they intend to purchase £10bln of Investment Grade corporate bonds as part of their Asset Purchase Programme. Spreads between Corporates and Gilts narrowed since early August, although shorter maturities benefitted most.

Issuer Maturity Yield Gilt yield Spread over Gilts Corporate Change 7th to 12th Gilts change 7th to 12th
Barclays Bank Plc 2026 3.52 0.865 2.655 0.19 0.18
A2Dominion 2026 2.938 0.865 2.073 0.03 0.18
Sncf 2027 1.652 0.865 0.787 0.18 0.18
EDF 2027 1.9 0.865 1.035 0.19 0.18
National Grid Co Plc 2028 1.523 0.865 0.658 0.19 0.18
Italy (Republic of) 2028 2.891 0.865 2.026 0.17 0.18
Kreditanstalt fuer Wiederaufbau 2028 1.187 0.865 0.322 0.18 0.18
EIB 2028 1.347 0.865 0.482 0.18 0.18
BT 2028 1.976 0.865 1.111 0.2 0.18
General Elec Cap Corp 2028 1.674 0.865 0.809 0.2 0.18
Severn Trent 2029 1.869 1.248 0.621 0.19 0.18
Tesco Plc 2029 4.476 1.248 3.228 0.2 0.18
Procter & Gamble Co 2030 1.683 1.248 0.435 0.2 0.18
RWE Finance Bv 2030 3.046 1.248 1.798 0.17 0.22
Citigroup Inc 2030 2.367 1.248 1.119 0.2 0.22
Wal-mart Stores 2030 1.825 1.248 0.577 0.2 0.22
EDF 2031 2.459 1.248 1.211 0.22 0.22
GE 2031 1.778 1.248 0.53 0.21 0.22
Enterprise Inns plc 2031 6.382 1.248 5.134 0.03 0.22
Prudential Finance Bv 2031 3.574 1.248 2.326 0.19 0.22
EIB 2032 1.407 1.248 0.159 0.2 0.22
Kreditanstalt fuer Wiederaufbau 2032 1.311 1.248 0.063 0.19 0.22
Vodafone Group PLC 2032 2.887 1.248 1.639 0.24 0.22
Tesco Plc 2033 4.824 1.248 3.576 0.21 0.22
GE 2033 1.88 1.248 0.632 0.21 0.22
Proctor & Gamble 2033 1.786 1.248 0.538 0.2 0.22
HSBC Bank Plc 2033 3.485 1.248 2.237 0.21 0.22
Wessex Water 2033 2.114 1.248 0.866 0.19 0.22
Nestle 2033 0.899 1.248 -0.349 0.16 0.22
Glaxo 2033 1.927 1.248 0.679 0.2 0.22
Segro PLC 2035 2.512 1.401 1.111 0.19 0.22
Walmart 2035 2.028 1.401 0.627 0.2 0.22
Aviva Plc 2036 3.979 1.401 2.578 0.18 0.22
General Electric 2037 2.325 1.401 0.924 0.23 0.22
Lcr Financial Plc 2038 1.762 1.401 0.361 0.2 0.22
EIB 2039 1.64 1.401 0.239 0.2 0.22
Lloyds TSB 2040 2.693 1.495 1.198 0.2 0.22
GE 2040 2.114 1.495 0.619 0.2 0.22
Direct Line 2042 6.738 1.495 5.243 0.06 0.22
Barclays Bank Plc 2049 3.706 1.4 2.306 0.1 0.22

Source: Fixed Income Investor, Investing.com

The spread between international issuers such as Nestle – which, being Swiss, trades at a discount to Gilts – narrowed, however, higher yielding names, such as Direct Line, did likewise.

For comparison the table below – using the issues in bold from the table above – shows the change between the 22nd and 23rd June – pre and post-Brexit:-

Maturity Gilts 22-6 Corporate 22-6 Gilts 23-6 Corporate 23-6 Issuer Spread 22-6 Spread 23-6 Spread change
10y 1.314 4.18 1.396 4.68 Barclays 2.866 3.284 0.418
15y 1.879 3.86 1.96 3.88 Vodafone 1.981 1.92 -0.061
20y 2.065 4.76 2.124 4.78 Aviva 2.695 2.656 -0.039
25y 2.137 3.42 2.195 3.43 Lloyds 1.283 1.235 -0.048
30y 2.149 4.21 2.229 4.23 Barclays 2.061 2.001 -0.06

Source: Fixed Income Investor, Investing.com

Apart from a sharp increase in the yield on the 10yr Barclays issue (the 30yr did not react in the same manner) the spread between Gilts and corporates narrowed over the Brexit debacle too. This might be because bid/offer spreads in the corporate market became excessively wide – Gilts would have become the only realistic means of hedging – but the closing prices of the corporate names should have reflected mid-market yields.

If the “safe-haven” of Gilts has lost its lustre where should one invest? With patience and in higher yielding bonds – is one answer. Here is another from Ben Lord of M&G’s Bond Vigilantes – The BoE and ECB render the US bond market the only game in town:-

…The ultra-long conventional gilt has returned a staggering 52% this year. Since the result of the referendum became clear, the bond’s price has increased by 20%, and in the couple of weeks since Mark Carney announced the Bank of England’s stimulus package, the bond’s price has risen by a further 13%.

…the 2068 index-linked gilt, which has seen its price rise by 57% year-to-date, by 35% since the vote to exit Europe, and by 18% since further quantitative easing was announced by the central bank. Interestingly, too, the superior price action of the index-linked bond has occurred not as a result of rising inflation or expectations of inflation; instead it has been in spite of significantly falling inflation expectations so far this year. The driver of the outperformance is solely due to the much longer duration of the linker. Its duration is 19 years longer than the nominal 2068 gilt, by virtue of its much lower coupon!

When you buy a corporate bond you don’t just buy exposure to government bond yields, you also buy exposure to credit risk, reflected in the credit spread. The sterling investment grade sector has a duration of almost 10 years, so you are taking exposure to the 10 year gilt, which has a yield today of circa 0.5%. If we divide the yield by the bond’s duration, we get a breakeven yield number, or the yield rise that an investor can tolerate before they would be better off in cash. At the moment, as set out above, the yield rise that an investor in a 10 year gilt (with 9 year’s duration) can tolerate is around 6 basis points (0.5% / 9 years duration). Given that gilt yields are at all-time lows, so is the yield rise an investor can take before they would be better off in cash.

We can perform the same analysis on credit spreads: if the average credit spread for sterling investment grade credit is 200 basis points and the average duration of the market is 10 years, then an investor can tolerate spread widening of 20 basis points before they would be better off in cash. When we combine both of these breakeven figures, we have the yield rise, in basis points, that an investor in the average corporate bond or index can take before they should have been in cash.

With very low gilt yields and credit spreads that are being supported by coming central bank buying, accommodative policy and low defaults, and a benign consumption environment, it is no surprise that corporate bond yield breakevens are at the lowest level we have gathered data for. It is for these same reasons that the typical in-built hedge characteristic of a corporate bond or fund is at such low levels. Traditionally, if the economy is strong then credit spreads tighten whilst government bond yields sell off, such as in 2006 and 2007. And if the economy enters recession, then credit spreads widen and risk free government bond yields rally, such as seen in 2008 and 2009.

With the Bank of England buying gilts and soon to start buying corporate bonds, with the aim of loosening financial conditions and providing a stimulus to the economy as we work through the uncertain Brexit process and outcome, low corporate bond breakevens are to be expected. But with Treasury yields at extreme high levels out of gilts, and with the Fed not buying government bonds or corporate bonds at the moment, my focus is firmly on the attractive relative valuation of the US corporate bond market.

The table below shows a small subset of liquid US corporate bonds, showing the yield change between the 7th and 12th September:-

Issuer Issue Yield Maturity Change 7th to 12th Spread Rating
Home Depot HD 2.125 9/15/26 c26 2.388 10y 0.17 0.72 A2
Toronto Dominion TD 3.625 9/15/31 c 3.605 15y 0.04 1.93 A3
Oracle ORCL 4.000 7/15/46 c46 3.927 20y 0.14 1.54 A1
Microsoft MSFT 3.700 8/8/46 c46 3.712 20y 0.13 1.32 Aaa
Southern Company SO 3.950 10/1/46 c46 3.973 20y 0.18 1.58 Baa2
Home Depot HD 3.500 9/15/56 c56 3.705 20y 0.19 1.31 A2
US Treasury US10yr 1.67 10y 0.13 N/A AAA
US Treasury US30y 2.39 30y 0.16 N/A AAA

Source: Market Axess, Investing.com

Except for Canadian issuer Toronto Dominion, yields moved broadly in tandem with the T-Bond market. The spread between US corporates and T-Bonds may well narrow once the Fed gains a mandate to buy corporate securities, but, should Fed negotiations with Congress prove protracted, the cost of FX hedging may negate much of the benefit for UK or European investors.

What is apparent, is that the “flight to quality” effect is diminished even in the more liquid and higher yielding US market.

The total market capitalisation of the UK corporate bond market is relatively small at £285bln, the US market is around $4.5trln and Europe is between the two at Eur1.5trln. The European Central Bank (ECB) began its Corporate Sector Purchase Programme (CSPP) earlier this summer but delegated the responsibility to the individual National Banks.

Between 8th June and 15th July Europe’s central banks purchased Eur10.43bln across 458 issues. The average position was Eur22.8mln but details of actual holdings are undisclosed. They bought 12 issues of Deutsche Bahn (DBHN) 11 of Telefonica (TEF) and 10 issues of BMW (BMW) but total exposures are unknown. However, as the Bond Vigilantes -Which corporate bonds has the ECB been buying? point out, around 36% of all bonds eligible for the CSPP were trading with negative yields. This was in mid-July, since then 10y Bunds have fallen from -012% to, a stellar, +0.3%, whilst Europe’s central banks have acquired a further Eur6.71bln of corporates in August, taking the mark-to-market total to Eur19.92bln. The chart below shows the breakdown of purchases by country and industry sector at the 18th July:-

which-corporate-bonds-ecb3

Source: M&G Investments, ECB, Bloomberg

Here is the BIS data for total outstanding financial and non-financial debt as at the end of 2015:-

Country US$ Blns
France 2053
Spain 1822
Netherlands 1635
Germany 1541
Italy 1023
Luxembourg 858
Denmark 586

Source: BIS

In terms of CSPP holdings, Germany appears over-represented, Spain and the Netherlands under-represented. The “devil”, as they say, is in the “detail” – and a detailed breakdown by issuer, issue and size of holding, has not been published. The limited information is certainly insufficient for traders to draw any clear conclusions about which issues to buy or sell. As Wolfgang Bauer, the author of the M&G article, concludes:-

But as tempting as it may be to draw conclusions regarding over- and underweights and thus to anticipate the ECB’s future buying activity, we have to acknowledge that we are simply lacking data. Trying to “front run” the ECB is therefore a highly difficult, if not impossible task.

 Conclusions and investment opportunities

Back in May the Wall Street Journal published the table below, showing the change in the portfolio mix required to maintain a 7.5% return between 1995 and 2015:-

Source: Wall Street Journal, Callan Associates

The risk metric they employ is volatility, which in turn is derived from the daily mark-to-market price. Private Equity and Real-Estate come out well on this measure but are demonstrably less liquid. However, this table also misses the point made at the beginning of this letter – that “risk-free” assets are encumbered with much higher “capital” risk in a ZIRP to NIRP world. The lower level of volatility associated with bond markets disguises an asymmetric downside risk in the event of yield “normalisation”.

Dividends

Corporates with strong cash flows and rising earnings are incentivised to issue debt either for investment or to buy back their own stock; thankfully, not all corporates and leveraging their balance sheets. Dividend yields are around the highest they have been this century:-

dididend-yld-sandp

Source: Multpl.com

Meanwhile US Treasury Bond yields hit their lowest ever in July. Below is a sample of just a few higher yielding S&P500 stocks:-

Stock Ticker Price P/E Beta EPS DPS Payout Ratio Yield
At&t T 39.97 17.3 0.56 2.3 1.92 83 4.72
Target TGT 68.94 12.8 0.35 5.4 2.4 44 3.46
Coca-cola KO 42.28 24.3 0.73 1.7 1.4 80 3.24
Mcdonalds MCD 114.73 22.1 0.61 5.2 3.56 69 3.07
Procter & Gamble PG 87.05 23.6 0.66 3.7 2.68 73 3.03
Kimberly-clark KMB 122.39 22.8 0.61 5.4 3.68 68 2.98
Pepsico PEP 104.59 29.5 0.61 3.6 3.01 85 2.84
Wal-mart Stores WMT 71.46 15.4 0.4 4.6 2 43 2.78
Johnson & Johnson JNJ 117.61 22.1 0.43 5.3 3.2 60 2.69

Source: TopYield.nl

The average beta of the names above is 0.55 – given that the S&P500 has an historic volatility of around 15%, this portfolio would have a volatility of 8.25% and an average dividend yield of 3.2%. This is not a recommendation to buy an equally weighted portfolio of these stocks, merely an observation about the attractiveness of returns from dividends.

Government bonds offer little or no return if held to maturity – it is a traders market. For as long as central banks keep buying, bond prices will be supported, but, since the velocity of the circulation of money keeps falling, central banks are likely to adopt more unconventional policies in an attempt to transmit stimulus to the real economy. If the BoJ, BoE and ECB are any guide, this will lead them (Fed included) to increase purchases of corporate bonds and even common stock.

Bond bear-market?

Predicting the end of the bond bull-market is not my intention, but if central banks should fail in their unconventional attempts at stimulus, or if their mandates are withdrawn, what has gone up the most (government bonds) is likely to fall farthest. At some point, the value of owning “risk-free” assets will reassert itself, but I do not think a 1% rise in yields will be sufficient. High yielding stocks from companies with good dividend cover, low betas and solid cash flows, will weather the coming storm. These stocks may suffer substantial corrections, but their businesses will remain intact. When the bond bubble finally bursts “risky” assets may be safer than conventional wisdom suggests. The breakdown in the “flight to quality” effect is just one more indicator that the rules of engagement are changing.

Here comes summer – Did you sell in May?

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Macro Letter – No 56 – 10-06-2016

Here comes summer – Did you sell in May?

  • Are Central Bankers approaching the limit of their power?
  • Individual stock volatility is reaching extremes relative to the indices
  • When dispersion of stock returns is high the risk relative to reward also rises
  • Some hedge fund strategies offer long-term benefits in this environment

This week’s letter is a departure from my normal format. Enclosed is a commentary on the prospects for the financial markets from my friend Allan Rogers whom I have been fortunate enough to know since the early 1990’s. Latterly the CIO of Loews Corporation’s Continental Assurance, Allan was a proprietary trader at Bankers Trust when the bank was in its heyday. Here is the note he kindly sent me on 14th May:-

Summer 2016 features a rising wave of frustration and voter antipathy toward most governing bodies and central banks, with good reason.  Ballot box dynamics threaten numerous incumbent government officials.  Demographic aging phenomena, technological innovation and minimum wage adjustments combine to thwart cyclical labor market improvement.  As post-war economic models fail to anticipate these rapid market adjustments, Central Banks cling desperately to their Milton Friedman monetary theory and Keynesian fiscal assumptions, relying on their imaginations, luck, and prayer to launch wave after wave of novel liquidity infusions.  So far, no good.  In their haste to revive growth after the financial crisis, they have handcuffed the dealer liquidity providers with ill-conceived regulations that endanger the liquidity network plumbing whenever expectations shift abruptly.  We have devolved into a nightmare of ZIRP, NIRP, QE, and God knows what’s next.  But, rather than wring our hands over this dilemma, let’s contemplate sensible portfolio management strategy for a few minutes.

As discussed last year, foreign exchange currency reserves still exceed $14 trillion.  Their potential deployment for economic stimulus remains intact.  Sovereign wealth funds, mostly invested in equity proxies, provide additional support for equity markets.  Central Banks are squeezing private investors as they desperately acquire dominant portions of the most liquid segments of risk-free(?) sovereign debt, corporate debt in Europe, and ETF’s and equities in Asia.  As a result, P/E ratios are elevated and yields bear little relationship to economic fundamentals.  As the political outlook befuddles the experts and aggravates voters, portfolio managers, facing new accountability regulations and third-quarter restrictions on Money Market Funds, need to become even more tactical in their asset allocation until clarity on Trump/Clinton, Brexit, etc. emerges later this year.  Until then, counter-trading the price action makes the most sense.  Even the hedge funds and private equity managers are struggling to perform in this turbulence as previous experience appears to provide useful insights.  The erratic price action reminds me of the late 1970’s when thirty years of fixed rates were followed by the oil price shocks that ushered in the Volcker era. Desperate pension funds and insurance companies might applaud such a development now as their yield assumptions fall 100’s of basis points short of any hope of meeting their forward liabilities.  In a market where the Yen and Euro rally despite explicit efforts to devalue them, one might surmise that their appreciation is only driven by the final unwinding of the massive Yen-carry trade by hedge funds facing redemptions after disappointing performance.

Amid all the chaos, do not expect central banks to abandon their printing presses. Syrian immigration issues in Europe and Trumpian nationalism will retard global trade and risk a replay of more intense competitive devaluation.  When we do reach the point of exhaustion for monetary stimulus, central banks have NO exit strategy. Bond markets will break down abruptly, but until then, US Treasuries should out-perform all other sovereigns. 10 year notes may well flirt with 1% as NIRP experimentation continues. Debates about the number of Fed “tightening” moves are irrelevant. The outlook, going forward, is all about liquidity management.  Although gold has rallied sharply so far this year, I suggest owning some gold, although one should heed the cautious brilliance of Stan Druckenmiller in conceivably buying a more significant percentage.

In this climate, equity markets offer the most promising net returns, IF one is willing to trade them actively.  “Buy and Hold” is a death wish. For over ten years, opportunistic equity traders have encountered volatile, but profitable equity markets. As we sit close to record high prices and valuations, why now? Amid illiquid markets, individual equities experience incredible price volatility despite the tame VIX market. The table below details the price ranges of the Dow Jones Industrials over the previous 52 weeks. If a money manager budgets an annual return of 7-8%, as many pension funds do, then opportunistic trading of these large-cap, blue chips makes achievement of those returns possible. Incremental usage of options and dividends sweeten the results.  But, you must trade these ranges, or, only buy weakness. I know this runs counter to indexing and most notions of prudent investment, but look at the table and draw your own conclusions. Incidentally, these ranges are not atypical, even in years where the averages experience only modest annual changes.

Stock  52 wk low 52 wk high 52 wk range % change
AAPL 89.47 132.97 43 48
AXP 50.27 81.92 31 63
BA 102.1 150.58 48 47
CAT 56.36 89.62 33 59
CSCO 22.46 29.9 7 33
CVX 69.58 109.3 40 57
DD 47.11 75.72 28 61
DIS 86.25 122.08 37 42
GE 19.37 32.05 12 65
GS 139.05 218.77 80 57
HD 97.17 137.82 40 42
IBM 116.9 174.44 57 49
INTC 24.87 35.59 11 43
JNJ 81.79 115 33 41
JPM 50.07 70.61 20 41
KO 36.56 47.13 10 29
MCD 87.5 131.96 44 51
MMM 134 171.27 37 28
MRK 45.69 61.7 16 35
MSFT 39.72 56.85 17 43
NKE 47.25 68.19 21 44
PFE 28.25 36.46 8 29
PG 65.02 83.87 19 29
TRV 95.21 118.28 23 24
UNH 95 135.11 40 42
UTX 83.39 119.66 36 43
V 60 81.73 22 36
VZ 38.06 54.49 16 43
WMT 56.3 79.94 24 42
XOM 66.55 90 23 35
         
Average       43
         
DIA 150.57 183.35 32 22
SPY 181.02 213.78 33 18

 

Source: Yahoo Finance

These data observations, while hardly profound, illustrate the range of possibility for trading profit, even in the largest stocks. Notice that the average price range of individual equities is more than twice the range of the large-cap averages, as reflected in their ETF’s. If you need to earn 8% per annum and the average Dow Industrial offers a 43% annual trading range, you don’t need to channel Jesse Livermore to achieve your objective. These results do not include dividends or option writing benefits.

This series of macro letters is entitled “In the Long Run” so you may, quite reasonably assume that I have “sold out”. I have not, but Allan, highlights the essence of the dilemma facing long-term investors looking ahead. During the past eight years interest rates have fallen in several countries to the lowest levels since records began. Being long government bonds below ones own rate of inflation (and there are few people whose living costs genuinely rise as slowly at RPI, HICP etc.) is irrational, since your real return will be negative – switching to “risker” assets makes sense.

With the Fed expected to tighten, if not this month then very soon, and other central banks contemplating how they may unwind the QE experiment, it seems likely that government yields may rise, credit spreads widen and equities decline.  As Mark Twain once proclaimed, “History doesn’t repeat but it rhymes” the aforementioned scenario occurred in January and February – this spooked central bankers who promptly enacted the secret “Shanghai Accord”. The next round of “risk off” will be different.

Strategies not Asset Classes

It is well documented that the average “long only” portfolio manager underperforms the benchmark over time. Unconstrained investing, either of a “long only” absolute return type or “long/short” makes sense, but make sure your expectations are realistic. Assets such as commodities have a structurally negative real-return, even if they can perform strongly on a cyclical basis. Even “risk free” government bonds can suffer restructuring or be subject to default.

Alternative investments may provide a solution but many liquid alternative strategies (by which I mean Hedge Funds) are highly correlated to equity or fixed income indices, although they offer similar returns with substantially lower volatility. Others, are either negatively or non-correlated. For example, the discipline of the short biased manager is undervalued, given that they actively bet against the long term trend of the stock market. As an addition to a portfolio they can offer a form of active risk management. At the end of April the Barclay Hedge – Equity Short Bias Index was +3.37% YTD whilst the Equity Long Biased Index was still languishing at -1.85%; that is 1.52% of Alpha if the general market is your index.

Two other strategies worth maintaining an exposure to are Global Macro and Managed Futures. Global Macro incorporates the widest array of approaches and exposures – at the index level it is unsurprising that it rarely does well, choose carefully and keep the faith. Managed futures is also diverse but there is still a concentration on systematic momentum and trend following strategies which provide negative correlation during equity bear markets and non-correlation during other periods. It also has the advantage that you can, usually, discover the investment process prior to investment. If style drift should subsequently occur this is your signal to redeem; otherwise you should not need to intervene. It can be a remarkably light touch investment.

I could describe a number of other strategies which have merit in the current market conditions but in the interests of brevity I will close with a recent assessment of the three main risks to financial markets according to Gavekal’s Anatoly Kelestsky:-

  • The June 23 “Brexit” vote in the UK
  • US elections on November 7th
  • German elections in mid-2017

Allan Rogers sees this as a traders market whilst ex-Dallas Fed President – Richard Fisher, speaking at the Mauldin SIC event last month, described his portfolio positioning as “Fetal”. Perhaps this year, more than most, the old adage “Sell in May and go away, return again St Leger’s day” (2nd October) may be apposite.

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

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Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

Flash-Gordon-flash-gordon-23432257-1014-1600

Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.

China

The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-

Demand_Growth_in_Asia

Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.

India_moving_to_centre

Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.

A_new_chapter_in_Chinas_growth_story

Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”

A_new_balancing_item_in_the_oil_market

Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.

Power_is_leading_the_transformation

Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.

Technology

“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

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

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.

US_Index_-_5_yr_Marketwatch

Source: Marketwatch

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

400dpiLogo

Macro Letter – No 29 – 06-02-2015

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

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

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

EURCHF_10_yr

Source: Bigcharts.com

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

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

 

Source: Investing.com

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

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

Discontinuation of the minimum exchange rate

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

Interest rate lowered

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

Outlook for inflation and the economy

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

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

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

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

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

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

Breaking the Bank

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

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

Source: SNB and snbchf.com

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

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

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

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

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

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

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

Is it the money supply?

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

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

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

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

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

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

 

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

Swiss-M3-and-Lending-2014-Ireland

Source: SNB and snbchf.com

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

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

Growth in money supply driven by lending

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

Stable mortgage lending growth in the third quarter

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

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

…Growing ratio of bank lending to GDP

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

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

Swiss Francs in the long run

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

Real_Effective_CHF_Exchange_rate_EURCHF18_01_2013-

Source: Pictet

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

switzerland-balance-of-trade

Source: Trading Economics and Swiss Customs

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

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

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

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

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

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

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

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

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

Swiss_ExportsByCountry

Source: snbchf.com

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

Swiss_TradeBalanceByCountry

Source: snbchf.com

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

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

Swiss-Imports-Exports-by-Type

Source: snbchf.com

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

Conclusion and investment opportunities

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

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

Swiss Markets

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

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

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

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

Eurozone Markets

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

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