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.

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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.

The levee gonna break – Debt, demographics, productivity and financialization

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Macro Letter – No 55 – 20-05-2016

The levee gonna break – Debt, demographics, productivity and financialization

  • Debt and leverage since the financial crisis has continued to rise
  • Demographics trends in developed countries are not supportive of economic growth
  • Productivity growth has been rising much slower since the Great Recession
  • Financialization of the global economy has amplified the business cycle

If it keep on rainin’ the levee gonna break
If it keep on rainin’ the levee gonna break
Some people still sleepin’, some people are wide awake

 Bob Dylan

 In a March paper from the Kansas City Federal Reserve Bank – The Lasting Damage from the Financial Crisis to U.S. Productivity – the authors observe that total factor productivity in the US has not returned to its pre-financial crisis trajectory. They ascribe this to the tightness of credit conditions:-

Our empirical analysis shows the crisis indeed altered this relationship. During normal times, total factor productivity growth fluctuates over the business cycle along with changes in the intensity with which available labor and capital are used; credit conditions are unimportant.

During the crisis, however, distressed credit markets and tighter lending conditions were significant drags on total factor productivity growth. Because productivity’s sensitivity to credit conditions once again diminished after the crisis, the post-crisis easing of credit conditions did not boost productivity growth. As a result, the financial crisis left productivity, and therefore output, on a lower trajectory. Adverse credit conditions appear to have dampened total factor productivity growth by curtailing productivity-boosting innovation during the crisis rather than by hampering the efficient allocation of the economy’s productive resources through reduced creation and destruction of firms and jobs.

The conclusion is a telling indictment on the ability of the mainstream economics profession to unravel the conundrum total factor productivity:-

Our analysis does not explain the slow pace of productivity growth since the crisis, which has been a source of great concern among economists and policymakers. From 2010 to 2014, TFP growth averaged just 0.6 percent per year, well below its average growth rate of 1 percent from 1970 to 2010.

An attempt to counter this deficiency was undertaken by Mauldin Economics – Delta Force and summed up by this simple equation:-

The Greek letter delta (Δ) is the symbol for change. So the change in GDP is written as:-

ΔGDP = ΔPopulation + ΔProductivity

In other words, GDP growth can be achieved by an increase in the working age population or an increase in productivity. They go on to state that the problem of reduced investment is being exacerbated by low interest rates:-

Rather than encouraging businesses to compete by investing in productive assets and trying to take market share, excessive central bank stimulus encourages businesses to buy their competition and consolidate – which typically results in a reduction in the labor force. When the Federal Reserve makes it cheaper to buy your competition than to compete and cheaper to buy back your shares than to invest in new productivity, is it any wonder that productivity drops?

Mauldin go on to discuss demographics and labour force participation, they conclude:-

This demographic cast iron lid on growth helps explain why the Federal Reserve, ECB, and other central banks seem so powerless. Can they create more workers? Not really.

…What Fed policy is clearly not doing is to encourage businesses to invest in growth. Business loan availability is still a problem in many sectors

…Buyouts help shareholders but not workers, as they typically entail a consolidation of company workforces and a reduction in the number of “duplicated” workers. While this culling may be good for the individual businesses, it is not so good for the overall economy. It circumvents Joseph Schumpeter’s law of creative destruction.

…unless something happens to boost worker productivity dramatically, we’re facing lower world GDP growth for a very long time. Could we act to change that? Yes, but as I look at the political scene today, I wonder where the impetus for change is going to come from, absent a serious crisis.

…Given what we did in the last crisis, it is not clear that we still have that capacity.

For investors, this is reality: developed-world economies are going to grow slower. And companies, whose revenue is essentially a function of the growth of the overall economy, are going to grow slower, too…

The absolute level of debt is another factor which is impeding economic potential. Whilst credit creation in the private sector has been choked by continuous regulatory tightening of leverage rules for financial institutions, the capital requirements for investing in “risk-free” assets – ie. Bankrolling the state – has remained unchanged. Meanwhile the reduction of official interest rates to below the level of inflation has enabled governments around the world to dramatically expand deficit financing.

In September 2014 – Buttiglione, Lane, Reichlin and Reinhart produced the 16th Geneva Report on the World Economy – Deleveraging, What Deleveraging? Here is the chart of the growth of world debt to GDP – it caused something of a sensation:-

World Debt growth

Source: voxeu.com, CEPR

Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.

McKinsey Global Institute – Debt and (not much) deleveraging February 2015 picked up the gauntlet:-

Global debt has grown by $57 trillion and no major economy has decreased its debt-to-GDP ratio since 2007. High government debt in advanced economies, mounting household debt, and the rapid rise of China’s debt are areas of potential concern.

They go on to highlight three areas of risk:- rise of government debt – which increased by $25trln between 2007 and 2015 – the continued rise in household debt (especially mortgages in Australia, Canada, Denmark, Sweden, the Netherlands, Malaysia, South Korea, and Thailand ) and the quadrupling of China’s debt to $28trln or 282% of GDP.

China has been attempting its own brand of regulatory tightening of late alongside the great rebalancing towards consumption, but even official measures of GDP suggest that the economy has stalled and stimulus has resumed during the last few months.

Global real-estate continues to benefit from the low interest rate environment, although planning restrictions in many prime locations is the principle driver of price appreciation, notwithstanding Chinese anti-corruption measures which have tempered demand recently.

The rise in government debt continues to crowd out the opportunities for private sector investment, whilst central bank quantitative easing (QE) programmes act as a natural buyer of these securities.

The BIS Working Papers No 559 A comparative analysis of developments in central bank balance sheet composition – provides an insight into the changing structure of the balance sheets of a variety of central banks. For a snapshot of the quantum, Yardeni Research – Global Economic Briefing: Central Bank Balance Sheets published on Monday, is more instructive. At end April Fed, ECB, BoJ and PBoC had a combined record total of $16.7trln, up from around $9trln at the beginning of 2010. The ECB and the BoJ have been the main drivers of growth this year, whilst the Fed and the PBoC balance sheets have marked time.

To summarise: the factors stifling economic growth are demographics, public sector crowding out of private investment, regulatory tightening of credit conditions and artificially low interest rates, however, I believe there is another factor to consider – the Financialization and the World Economy. As far as I can discern, the first academic work on this subject was published by Prof. Gerald Epstein in October 2005. Here is an extract from the introduction:-

Using the case of the US economy, Crotty argues that financialization has had a profound and largely negative impact on the operations of US nonfinancial corporations. This is partly reflected in the increasing incomes extracted by financial markets from these corporations.

…the payments US NFCs paid out to financial markets more than doubled as a share of their cash flow between the 1960s and the 1970s, on one hand, and the 1980s and 1990s on the other. As NFCs came under increasing pressure to make payments, they also came under increasing pressure to increase the value of their stock prices.

…Financial markets’ demands for more income and more rapidly growing stock prices occurred at the same time as stagnant economic growth and increased product market competition made it increasingly difficult to earn profits.

The authors conclude that the solution is redistributive taxation, I would counter that a better solution would be to reduce the tax and regulatory privileges associated with government debt, thus freeing the private sector from the yoke of unfair public sector competition. But this is a polemic for another time and place. What is clear is that the availability of credit and leverage amplifies business cycles in both directions.

Conclusions

Increasing debt and leverage for an economy with a diminishing working age population is not sustainable. Without the demographic windfall of immigration or procreation, increasing productivity is the only way to sustain real economic growth. The short term financial wizardry of the share buy-back is a function of the artificially low price of credit. The longer central bank sponsored largesse continues, the lower the trend rate of GDP growth will become. A combination of fiscal reform and gradual normalisation of monetary policy could redress the situation but I believe it is politically unachievable. Markets climb a wall of fear, even at these exalted levels, it still makes sense to be long bonds, stocks and real-estate but, once the limit of government intervention has been reached, thelevee gonna break”.

 

 

 

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?

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Macro Letter – No 53 – 22-04-2016

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?

  • Oil prices have been below $60/bbl since late 2014
  • The benefit of cheaper oil is being felt across the US
  • Without lower oil prices US growth would be significantly lower
  • Increasing levels of debt are stifling the benefits of lower prices

In this letter I want to revisit a topic I last discussed back in June 2015 – Can the boon of cheap energy eclipse the collapse of energy investment? In this article I wrote:-

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

This week the San Francisco Fed picked up the theme in their FRBSF Economic Letter – The Elusive Boost from Cheap Oil:-

The plunge in oil prices since the middle of 2014 has not translated into a dramatic boost for consumer spending, which has continued to grow moderately. This has been particularly surprising since the sharp drop should free up income for households to use toward other purchases. Lessons from an empirical model of learning suggest that the weak response may reflect that consumers initially viewed cheaper oil as a temporary condition. If oil prices remain low, consumer perceptions could change, which would boost spending.

Given the perceived wisdom of the majority of central banks – that deflation is evil and must be punished – the lack of consumer spending is a perfect example of the validity of the Fed’s inflation targeting policy; except that, as this article suggests, deflations effect on spending is transitory. I could go on to discuss the danger of inflation targeting, arguing that the policy is at odds with millennia of data showing that technology is deflationary, enabling the consumer to pay less and get more. But I’ll save this for another day.

The FRBSF paper looks at the WTI spot and futures price. They suggest that market participants gradually revise their price assumptions in response to new information, concluding:-

The steep decline in oil prices since June 2014 did not translate into a strong boost to consumer spending. While other factors like weak foreign growth and strong dollar appreciation have contributed to this weaker-than-expected response, part of the muted boost from cheaper oil appears to stem from the fact that consumers expected this decline to be temporary. Because of this, households saved rather than spent the gains from lower prices at the pump. However, continued low oil prices could change consumer perceptions, leading them to increase spending as they learn about this greater degree of persistence.

In a related article the Kansas City Fed – Macro Bulletin – The Drag of Energy and Manufacturing on Productivity Growth observes that the changing industry mix away from energy and manufacturing, towards the production of services, has subtracted 0.75% from productivity growth. They attribute this to the strength of the US$ and a decline in manufacturing and mining.

…even if the industry mix stabilizes, the relative rise in services and relative declines in manufacturing and mining are likely to have a persistent negative effect on productivity growth going forward.

The service and finance sector of the economy has a lower economic multiplier than the manufacturing sector, a trend which has been accelerating since 1980. A by-product of the growth in the financial sector has been a massive increase in debt relative to GDP. By some estimates it now requires $3.30 of debt to create $1 of GDP growth. A reduction of $35trln would be needed to get debt to GDP back to 150% – a level considered to be structurally sustainable.

Meanwhile, US corporate profits remain a concern as this chart from PFS group indicates:-

corporate-profits-peak

Source: PFS Group, Bloomberg

The chart below from Peter Tenebrarum – Acting Man looks at whole economy profits – it is perhaps more alarming still:-

saupload_4-whole-economy-profits

Source: Acting Man

With energy input costs falling, the beneficiaries should be non-energy corporates or consumers. Yet wholesale inventories are rising, total business sales seem to have lost momentum and, whilst TMS-2 Money Supply growth remains solid at 8%, it is principally due to commercial and industrial lending.

US oil production has fallen below 9mln bpd versus a peak of 9.6mln. Rig count last week was 351 down three from the previous week but down 383 from the same time last year. Meanwhile the failure of Saudi Arabia to curtail production, limits the potential for the oil market to rally.

From a global perspective, cheap fuel appears to be cushioning the US from economic headwinds in other parts of the world. Employment outside mining and manufacturing is steady, and wages are finally starting to rise. However, the overhang of debt and muted level of house price appreciation has dampened the animal spirits of the US consumer:-

US-house-prices-_Federal_Housing_Finance_Agency

Source: Global Property Guide, Federal Housing Finance Agency

According to the Dallas Fed – Increased Credit Availability, Rising Asset Prices Help Boost Consumer Spendingthe consumer is beginning to emerge:-

A combination of much less household debt, revived access to consumer credit and recovering asset prices have bolstered U.S. consumer spending. This trend will likely continue despite an estimated 50 percent reduction since the mid-2000s of the housing wealth effect— an important amplifier during the boom years.

…Since the Great Recession, the ratio of household debt-to-income has fallen back to about 107 percent, a more sustainable—albeit relatively high—level.

…The wealth-to-income ratio rose from about 530 percent in fourth quarter 2003 to 650 percent in mid-2007 as equity and house prices surged. Not surprisingly, consumer spending also jumped.

The conventional estimate of the wealth effect—the impact of higher household wealth on aggregate consumption—is 3 percent, or $3 in additional spending every year for each $100 increase in wealth.

…Recent research suggests that the spendability, or wealth effect, of liquid financial assets—almost $9 for every $100—is far greater than the effect for illiquid financial assets, which explains why falling equity prices do not generate larger cutbacks in aggregate consumer spending. Other things equal, higher mortgage and consumer debt significantly depress consumer spending.

…The estimated housing wealth effect varies over time and captures the ability of consumers to tap into their housing wealth. It rose steadily from about 1.3 percent in the early 1990s to a peak of about 3.5 percent in the mid- 2000s. It has since halved, to about the same level as that of the mid-1990s. During the subprime and housing booms, rising house prices and housing wealth effects propagated and amplified expansion of consumption and GDP.

During the bust, this mechanism went into reverse. High levels of mortgage debt, falling house prices and a reduced ability to tap housing equity generated greater savings and reduced consumer spending. Fortunately, house prices have recovered, deleveraging has slowed or stopped, and consumer spending is strong, even though the housing wealth effect is only half as large as it was in the mid-2000s.

Countering the positive spin placed on the consumer credit data by the Dallas Fed is a recent interview with  Odysseas Papadimitriou, CEO of CardHub by Financial Sense – Credit Card Debt Levels Reaching Unsustainable Levels:-

In 2015, we accumulated almost $71 billion in new credit card debt. And for the first time since the Great Recession, we broke the $900 billion level in total credit card debt so we are back on track in getting to $1 trillion.

total-consumer-credit-outstanding

Source: Bloomberg, Financial Sense

Another factor which has been holding back the US economy has been the change in the nature of employment. Full-time jobs have been replaced by lower paying part-time roles and the participation rate has been in decline. This may also be changing, but is likely to be limited, as the Kansas City Fed – Flowing into Employment: Implications for the Participation Rate reports:-

After a long stretch of declines, the labor force participation rate has risen in recent months, driven in part by an increase in the share of prime-age people flowing into employment from outside the labor force. So far, this flow has remained largely confined to those with higher educational attainment, suggesting further increases in labor force participation rate could be relatively limited.

…Overall, the scenarios show that while more prime-age people could enter the labor force in the coming years, the cyclical improvement in the overall participation rate may be limited to the extent only those with higher educational attainment flow into employment. In addition, the potential increase in the participation rate could be constrained by other factors such as an increase in the share of prime-age population that reports they are either retired or disabled and a limited pool of people saying they want a job, even if they have not looked recently. Thus, while higher NE flow indicates the prime-age participation rate could increase further, it will likely remain lower than its pre-recession rate.

Conclusion

At the 2015 EIA conference Adrian Cooper of Oxford Economics gave a presentation – The Macroeconomic Impact of Lower Oil Prices – in which he estimated that a $30pb decline in the oil price would add 0.9% to US GDP between 2015 and 2017. If this estimate is correct, lower oil is responsible for more than a quarter of the current US GDP growth. It has softened the decline from 2.9% to 2% seen over the last year.

I would argue that the windfall of lower oil prices has already arrived, it has shown up in the deterioration of the trade balance, the increase in wages versus consumer prices and the nascent rebound in the participation rate. That the impact has not been more dramatic is due to the headwinds on excessive debt and the strength of the US$ TWI – it rose from 103 in September 2014 to a high of 125 in January 2016. After the G20 meeting Shanghai it has retreated to 120.

According to the March 2015 BIS – Oil and debt report, total debt in the Oil and Gas sector increased from $1trln in 2006 to $2.5trln by 2015. The chart below looks at the sectoral breakdown of US Capex up to the end of 2013:-

US CAPEX by sector

Source: Business Insider, Compustat, Goldman Sachs

With 37% allocated to Energy and Materials by 2013 it is likely that the fall in oil prices will act as a drag on a large part of the stock market. Energy and Materials may represent less than 10% of the total but they impact substantially in the financial sector (15.75%).

Notwithstanding the fact that corporate defaults are at the highest level for seven years, financial institutions and their central bank masters will prefer to reschedule. This will act as a drag on new lending and on the profitability of the banking sector.

The table below from McGraw Hill shows the year to date performance of the S&P Spider and the sectoral ETFs. This year Financials are taking the strain whilst Energy has been the top performer – over one year, however, Energy is still the nemesis of the index.

Sector SPDR Fund % Change YTD % Change 1 year
S&P 500 Index 2.86% 0.10%
Consumer Discretionary (XLY) 2.23% 5.05%
Consumer Staples (XLP) 4.16% 6.83%
Energy (XLE) 10.20% -19.16%
Financial Services (XLFS) -2.49% 0.00%
Financials (XLF) -1.22% -2.85%
Health Care (XLV) -1.01% -3.31%
Industrials (XLI) 6.41% -0.07%
Materials (XLB) 8.45% -5.78%
Real Estate (XLRE) 1.98% 0.00%
Technology (XLK) 3.60% 5.19%
Utilities (XLU) 10.74% 7.08%

Source: McGraw Hill

The benefit of lower oil and gas prices will continue, but, until debt levels are reduced, anaemic GDP growth is likely to remain the pattern for the foreseeable future. In Hoisington Investment Management – Economic Review – Q1 2016 – Lacy Hunt makes the following observation:-

The Federal Reserve, the European Central Bank, the Bank of Japan and the People’s Bank of China have been unable to gain traction with their monetary policies…. Excluding off balance sheet liabilities, at year-end the ratio of total public and private debt relative to GDP stood at 350%, 370%, 457% and 615%, for China, the United States, the Eurocurrency zone, and Japan, respectively…

The windfall of cheap oil has arrived, but cheap oil has been eclipsed by the beguiling spectre of cheap debt.

Greece in or out – Investment Opportunities?

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Macro Letter – No 34 – 24-04-2015

Greece in or out – Investment Opportunities?

  • Greece needs to reschedule its debt or default
  • Capital Controls maybe inevitable
  • A piecemeal solution is not the answer, yet it’s more likely than a “Lehman moment”
  • A definitive solution presents investment opportunities

Earlier this week I paid a visit to the Greek Island of Corfu. Whilst most of what we read and observe about the Greek economy revolves around Athens, I thought it would be useful to gain a broader perspective on the state of the economy. I wanted to consider, what things might be like, if Greece stays within the Eurozone (EZ) or, conversely, if they decide to leave.

Firstly a few Greek economic facts:-

Top of FormMarketsBottom of Form Last Date Frequency
GDP Annual Growth Rate 1.2% Nov-14 Quarterly
GDP per capita 18146 USD Dec-13 Yearly
Unemployment Rate 25.7% Jan-15 Monthly
Youth Unemployment Rate 51.2% Dec-14 Monthly
Population 10.99mln Dec-14 Yearly
Minimum Wages 684 Dec-14 Monthly
Inflation Rate -2.1% Mar-15 Monthly
Core Inflation Rate -1.2% Jan-15 Monthly
Producer Prices Change -4.8% Feb-15 Monthly
Balance of Trade -1,425mln Feb-15 Monthly
Exports 2,024mln Feb-15 Monthly
Imports 3,449mln Feb-15 Monthly
Current Account -850mln Jan-15 Monthly
Government Debt to GDP 175% Dec-13 Yearly
Government Spending to GDP 59.2% Dec-13 Yearly
Business Confidence 96.8 Mar-15 Monthly
Manufacturing PMI 48.9 Mar-15 Monthly
Industrial Production 1.9% Feb-15 Monthly
Manufacturing Production 5.8% Feb-15 Monthly
Capacity Utilization 65.7% Feb-15 Monthly
Industrial Production Mom -4.7% Jan-15 Monthly
Consumer Confidence -31 Mar-15 Monthly
Retail Sales YoY -0.1% Jan-15 Monthly
Housing Index -22% Feb-15 Monthly
Corporate Tax Rate 26% Jan-14 Yearly
Personal Income Tax Rate 46% Jan-14 Yearly
Sales Tax Rate 23% Jan-14 Yearly

Source: Trading Economics

Eurostat published their European Winter Economic forecasts 5th February – this is an extract from their, ever so rosy, forecast for Greece:-

Indicator 2013 2014 2015 2016
GDP growth (yoy) -3,9% 1,0% 2,5% 3,6%
Inflation (yoy) -0,9% -1,4% -0,3% 0,7%
Unemployment 27,5% 26,6% 25,0% 22,0%
Public budget balance to GDP -12,2% -2,5% 1,1% 1,6%
Gross public debt to GDP 174,9% 176,3% 170,2% 159,2%
Current account balance to GDP -2,3% -2,0% -1,5% -0,9%

Source: Eurostat

According to information collated from the CIA Factbook , OECD and Eurostat, the Greek public sector still accounts for 40% of GDP. The largest industry is Tourism (18%) followed by Shipping – the Hellenic Merchant Marine is the largest in the world employing 160,000 (4% of the workforce). The Greek shipping fleet is the fourth largest in the world, representing 15.17% of global deadweight tonnage in 2013, although “flag of convenience” issues can make these figures a little misleading. The labour force is estimated at 3.91mln of which immigrants account for 782,000 (20%). This makes Greece the 8th largest immigrant population in Europe – mainly unskilled or agricultural workers. As a result of the economic crisis private saving has increased from 11.2% in 2012 to 14.5% in 2014.

The largest broad industry sector is Services (which includes Tourism) accounting for 80.6% of GDP and 72.4% of employment, followed by Industry – 15.9% of GDP and 14.7% of employment. Agriculture is third in size producing 3.5% of GDP but employing 12.9% of the population.

Greece’s largest export market is Turkey (11.6%) and its largest import partner is Russia (14.1%). Little wonder they wish to maintain good relations with Moscow.

In terms of Tourism, Greece is the 7th most visited country in Europe and the 16th most visited globally. The latest figure I could unearth, from a 2008 OECD report, indicated 840,000 workers employed in the sector, from which I estimate that Tourism accounts for more than 20% of employment.

A more detailed analysis of the island economies of Greece came from a paper published by Sheffield University – A Comparative Analysis of the Economic Performance of Greek and British Small Islands – 2006. They analysed 63 islands with an average population of around 300,000. Employment was at 88.81% whilst Unemployed was a mere 11.19% – this was around the average for the whole country at that time. To my surprise, the level of reported self-employment was a relatively low 20.43%. One of the more puzzling figures was for Home Occupancy 46.05%; the Greek average for Home Ownership is 75.8% (2013). Unsurprisingly the main industry is Tourism followed by agriculture – it’s worth pointing out that Greece is the EU’s largest producer of Cotton, second largest producer of Rice and Olives, third largest producer of Tomatoes and fourth largest producer of Tobacco. It also accounts for 19% of all fish hauled from the Mediterranean, making it the third largest in the EU as of 2007 data.

The table below shows the regional breakdown of GDP by region for 2010:-

Region GDP Euro GDP % GDP Growth
Attica 106,635 48 -3.51
Northern Greece 55,163 24.83 -4.73
Central Greece 38,767 17.45 -3.03
Central Macedonia 30,087 13.54 -5.19
Aegean Islands and Crete 21,586 9.72 -4.84
Crete 10,955 4.93 -3.79
Thessaly 10,742 4.84 -6.55
West Greece 10,326 4.65 -2.9
Sterea Hellas 10,059 4.53 -1.25
Peloponnese 9,436 4.25 -3.97
East Macedonia and Thrace 9,054 4.08 -1.69
South Aegean 7,476 3.37 -5.4
West Macedonia 5,281 2.38 -3.3
Epirus 4,917 2.21 -2.36
Ionian Islands 4,029 1.81 -6.22
North Aegean 3,155 1.42 -7.04

Source: Eurostat

The islands are very much the “poor relation” in terms of economic output but, as the map below, from 2008, shows, the GDP per capita distribution is more dispersed:-

Greece_peripheries_GDP_per_capita_svg 2008 Eurostat

Source: Eurostat

I visited Corfu, the second largest island in the Ionian Sea, with a population of just over 100,000. Its main business is Tourism followed by the production of olives. Back in 2013 NCH Capital – a US investment firm, best known for their investments in agriculture in the Ukraine and Russia, agreed a deal with the Hellenic Republic Development Fund (HRDF) to build a tourist resort on the island. This was the first time the Greek state had sold land to a foreign investor for 15 years. The HRDF has been charged with raising Euro 11bln from asset sales by 2016 – this represents a small fraction of the assets available should the Hellenic Republic decide to cut and run.

The NCH investment is not moving forward as swiftly as they had hoped, as this article from Tax Law explains. It is worth pointing out that Corfu is located at the North West corner of Greece, its North East coast looking across the narrow straits to Albania; little wonder there is some concern about the reduction of a naval presence in the region. However, Albania became a full member of NATO in 2009. Since 2010 Albanians have been able to enter the EU without visas and, as of June 2014, they are officially a candidate to join the EU. As a result of these changes, property development is growing along with tourism. Prices for Albanian property are significantly lower than in neighbouring Montenegro, which in turn offer better value than Greece. Regardless of the fortunes of Albania, the prospects for a significant acceleration of Greek state asset disposals is likely, whether Greece leaves or remains within the EZ.

The residential Real Estate market is still depressed by the economic and political uncertainties of the last few years, but, from a rental perspective, tourists keep returning. The price of dining in restaurants is beginning to look attractive in comparison with other Southern European destinations; perhaps more importantly, the differential with prices in Turkey has narrowed. The cost of more expensive holiday homes in Greece is now comparable with those in Spain or Portugal – it used to command around a 40% premium due to planning restrictions. In 2013 the island of Skorpios sold to a Russian buyer for Eur100mln and the island of Oxia was purchased by a member of the Qatari Royal family for Eur 4.9mln, however, worries about a “Lehman moment” – by which I mean Grexit – have dampened enthusiasm for a number of subsequent deals.

If Greece leaves the EZ and the new currency promptly depreciates, there will still be a number of uncertainties. To begin with, the Greek government is likely to impose capital controls to prevent capital flight – Greek Prime Minister Alexis Tsipras has started the process, instructing local governments to move their funds to the central bank earlier this week. For non-domicile property owners, these controls could mean they are unable to repatriate the proceeds of sales. I was interested to notice how many restaurants no longer accept credit card payment; would you put the proceeds of a property sale into a Greek bank whilst waiting for capital controls to be relaxed?

Another factor which may delay a recovery in Real Estate is the reaction of non-EU nationals who have bought Greek property for more than Eur250,000, in order to gain EU status – a scheme also available in Portugal. This Greek Law Digest article explains.

Selling pressure on property prices will continue to come from Greek domestic investors downsizing of their rental portfolios. During the first few years of EZ membership, many Greeks bought multiple holiday rentals. Since the crisis, maintenance costs have soared as a result of the “haratsi” property tax. Meanwhile, the financial police are aggressively pursuing owners who fail to declare rental income. If Greece exits the EU, I would expect Real Estate supply to hang over the market for some while.

A perusal of the windows of Corfu Real Estate agents, whilst far from scientific, suggests that the price of holiday homes is still relatively high. The properties are normally foreign owned and, for the most part, the owners are not distressed sellers. I was struck, however, by the magnitude of the price reductions (up to 80%) on those properties which had “sold”. It feels like a market with low turnover where price discovery is intermittent at best. For the Greek market nationally residential property appraisals-transactions for 2014 were down 33.20% on 2013, dwelling permits fell by 19.3% between January to November 2014 compared to 2013 and total new floor space declined 13.9% y/y to November 2014. The chart below shows that the pace of decline has moderated in the last year but prices are still falling:-

Greek_House_Prices_1999_-2015

Source: Bank of Greece

The absolute level of the property index suggests that almost all the gains seen in Real Estate prices since joining the EZ have been reversed, but the economy is still not competitive due to the strait-jacket of the Euro:-

Greek_House_Price_index_-_1999-2015

Source: Bank of Greece

This article from The Guardian – Home ownership in Greece ‘a sick joke’ as property market collapses from February 2014, attempts to impart a flavour of the overall market, but, as any home owner knows, all property investment is local.

The year so far

To understand the Greek situation you need to go back to the eve of the introduction of the Euro, in 2000, but for a brief overview of the current crisis this excellent video from the Peterson Institute – Greece: An Economic Tragedy in Six Charts is well worth taking five minutes to peruse. Instead, I want to look at the last few months and consider the implications going forward.

As the Greek government begin further negotiations with EZ Finance Ministers today, in an attempt to reschedule their outstanding debt and interest rate payments, it is becoming clearer, to politicians in Brussels, that the “Greek Problem” will not be resolved by wishful thinking and continued austerity. Since January a new scene in this Greek tragedy has begun to unfold.

At the beginning of January Bruegal – Why Grexit would not help Greece – rebutted many commentators, but specifically the German IFO Institute’s call for Greece to leave the EZ. Bruegal focussed on the unique aspects of the Greek situation, pointing out that, unlike Portugal, Ireland and Spain, Greek imports had collapsed but their exports had only recently started to improve:-

Are high wages the main problem in Greece hampering exports? Is the absence of a real depreciation the main driver of the different adjustment experience of Greece compared to the other euro area countries?

…hourly wages have come down substantially in Greece and are in fact the lowest in the euro area with the exception of Latvia and Lithuania. This contrasts with the experience in the other three countries adjusting, where hourly wages in the private sector have increased.

Average Hourly Earnings - Eurostat

Source: Eurostat

Overall, I conclude that the Greek economy would not benefit as much as hoped for from a rapid depreciation. The reasons for the weak Greek export performance might primarily lie in other factors such as rigid product markets, a political system preventing real change and guaranteeing the benefits of the few, the lack of meritocracy among other factors…

This does not mean that the current debt trajectory and debt level is sustainable. It may be necessary to further alleviate the debt burden on Greece, especially if inflation remains low and growth is weaker than the Troika believes. This has been done a number of times before by the official creditors and already now the average maturity on the European debt is 30 years. This maturity could be increased if necessary, effectively reducing the debt burden further and I could even see a nominal debt cut at some stage.

Later in January Bruegal – How to reduce the Greek debt burden? Looked at the options available to Greece and her creditors:-

Option 1: Reducing the lending rate on the Greek Loan Facility

Option 2: Extending the maturity of the loans in the Greek Loan Facility

Option 3: Extending maturity of EFSF loans

Option 4: Buying-back the Greek government bond holdings of the ECB and National Central Banks

Option 5: Swapping the currently floating interest rate loans to fixed rate loans

Option 6: Swapping the current loans to GDP-indexed loans

Option 7: Pre-privatisation using European funds

The tone of quasi-official commentary changed in February, when the ECB ceased to accept Greek government bonds as collateral for normal refinancing operations. Bruegal – The Greek banking system: a tragedy in the making? finally acknowledged the ECBs obligation to “lend freely” but only “against good collateral”:-

One can criticize the ECB’s decision for aggravating the crisis but one can also argue that the ECB had no choice but to act as it did given the self-proclaimed insolvency of the Greek state.

Greek Finance Minister – Yanis Varoufakis – announced their new plan shortly after Syriza won the election. The FT – Greece finance minister reveals plan to end debt stand-off – 2nd February described it as:-

Attempting to sound an emollient note, Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

…“What I’ll say to our partners is that we are putting together a combination of a primary budget surplus and a reform agenda,”

…“I’ll say, ‘Help us to reform our country and give us some fiscal space to do this, otherwise we shall continue to suffocate and become a deformed rather than a reformed Greece’.”

After talks broke down later in February Bruegal – Europe needs a lasting solution for the Greek problem wrote:-

I expect that fear of Grexit will prompt an agreement between Greece and euro-area partners. But my concern is that the agreement will be only a short-term fix and the various constraints will prevent reaching a lasting solution, thereby just postponing the problems. That would be the next stage in the Greek tragedy, as debt sustainability problems would likely return in a few years.

The following two tables show the payment flashpoints on the Greek road to redemption:-

Greek T-Bill and Bond redemptions 2015

Source: Datastream

IMF Greek loan repayments 2015

Source: IMF

Early March saw the publication of the Greek State Budget Execution Monthly Bulletin the primary balance was only slightly below forecast, but closer inspection revealed that the majority of the improvement in the primary balance has been achieved by reducing expenditures. Revenues were Eur 7.8bln – around Eur 1bln below target. Without the benefit of currency devaluation, the broader Greek economy is still struggling to adjust.

A Closer look at the chances for a Greek recovery

The Greek government debt burden is unsustainable, in 2013 its Debt to GDP ratio was 174.9. According to Nationaldebtclocks.org the current figure is Eur 354bln. Greek 2014 GDP was $246bln (Eur189) and GDP for 2015 is estimated to be +0.7% (Eur 190bln) I assume a EURUSD 1.30 exchange rate so, perhaps, I’m painting an overly bleak picture. Official estimates put Greek government indebtedness at nearer to Eur 228bln.

Assume Greece manages to run a primary surplus of 3% in perpetuity – that equates to around Eur 5bln per annum. Assume they manage to negotiate zero interest on all their outstanding debt. It would take 70 years to repay – and 35 years to bring it back below 100% of current GDP. You may argue that 1. National Debt is the wrong measure, since Government Debt is the issue, but, if Greece leaves the EZ, creditors will need to consider all her obligations. 2. That it is unrealistic to assume no growth in GDP, but Greek GDP growth averaged 0.97% from 1996 to 2014, reaching an all-time high of 7.50% in the fourth quarter of 2003. It crashed to -9.9% in Q1 2011. Meanwhile Greek Inflation averaged 8.94% between 1960 and 2015. Recently deflation has set in, with prices falling to a record low of -2.90% in November of 2013.

These numbers don’t add up; either the creditor nations and institutions embrace substantial rescheduling and debt forgiveness, or Greece defaults, exits the EZ, devalues and potentially precipitates an EZ wide financial crisis. In PWC – Global Economy Watch – What would a Greek exit mean for the Eurozone? The authors estimate the impact of a Grexit on the rest of the EZ, Germany’s banking sector is most exposed (Eur29.5bln) although this still only amounts to 0.8% of GDP:-

Banking sector – Our analysis suggests that the Eurozone banking sector should be able to manage the impact of a Greek exit without severe consequences. The exposure of banks in the four largest Eurozone economies (Germany, France, Italy and Spain) to Greece has fallen from around $104bn in 2010 to $34bn. While the German banking system is the most exposed to Greece, this exposure equates to only around 0.8% of its GDP. For the other economies, France, Italy and Spain, the direct exposure of their banks to Greece is less than 0.1% of GDP.

Greek debt holders – around 60% of Greek government debt is held indirectly by Eurozone governments. If the Greek government defaults on its obligations, then that debt will be written off (at least in part). This could pose a risk to countries which already have a relatively large public debt burden. For example, a Greek exit could have negative implications for Italy, which guarantees around 20% of the Eurozone’s bailout funds, and has a ratio of gross government debt to GDP of around130%. Italy’s exposure to Greek government debt is equivalent to around 2% of its GDP meaning a default could lead to a fiscal squeeze in Italy as the government attempts to fill the hole left in its finances.

Unexpected contagion – A Greek exit could also have effects outside the realm of economic data and financial statistics. It would likely add to political uncertainty as other countries may push for concessions on their commitments or it could set a precedent that sees other countries leave the Eurozone. For example, Spain and Portugal are both experiencing double digit unemployment rates and must hold general elections by the end of 2015. While the domestic consequences of Greece leaving the Eurozone could deter voters in other countries from seeking to leave the single currency area, there remains a possibility of surprising developments occurring in the Eurozone. In addition to this, a Greek exit could also call Greece’s role in the European Union and NATO in to question, spurring even more uncertainty.

Of course, the largest creditors are EZ institutions, led by the ECB which holds Eur 104bln – 65% of Greek GDP, according to Governor Draghi.

By the end of March rumours were starting to circulate of Brussels preparing to impose capital controls in the event of the Greek government running out of money. The Peterson Institute – Can Greece Make a Deal with Europe? suggests a cut-off, but it’s still some way off:-

When Must a Deal Be Struck?

At the very latest, June/July 2015 would seem to be the deadline. At that point, Greece faces about €6.5 billion in euro bond repayments to the ECB, which it will not have the cash to honor without a new arrangement. A default against the ECB would end all liquidity provisions to Greek banks, including emergency liquidity assistance (ELA) from the Greek central bank. A quick economic death spiral would ensue.

According to an article this week the New York Times – European Central Bank Squeezes Greek Banks, Tightening Access to Loans the Greek banks have resorted to issuing bonds to themselves in order to access the ECBs ELA facility: –

For more than three months, Greece’s largest banks have been forced to borrow short-term, higher-interest money from their central bank — a process called emergency liquidity assistance — because the E.C.B. deemed it too risky to extend credit to the banks itself.

The banks, in turn, have to provide adequate collateral to obtain these loans, which now stand at 74 billion euros, $79.7 billion, or more than half the amount of Greek domestic deposits.

…Controversially, Greek banks have even begun to issue bonds to themselves and, after securing a government guarantee, have used the securities to secure short-term financing…

…On April 8, for example, the National Bank of Greece self-issued €4.1 billion of six-month bonds that carried state backing. 

Inevitable “Lehman”?

A number of commentators have been predicting a Greek exit for several years. This was the view expressed in February by David Stockman – History In The Balance: Why Greece Must Repudiate Its ‘Banker Bailout’ Debts And Exit The Euro:–

The true evil started with the bailouts themselves and the resulting usurpation by the EU politicians and apparatchiks of both financial market price discovery and discipline and sovereign democratic prerogatives.  Accordingly, the terms of Greece’s current servitude can’t be tweaked, “restructured” or “swapped” within the Brussels bailout framework.

Instead, Varoufakis must firmly brace his interlocutors on the true history and the condition precedent that stands before them. Namely, that the Greek state was effectively bankrupt even before the 2010 bailout, and that the massive amounts of debt piled upon it thereafter was essentially a fraudulent conveyance by the EU. 

Accordingly, Greece’s legitimate debt is perhaps $175 billion based on the pre-crisis euro debt outstanding at today’s exchange rate and the haircut that would have occurred in bankruptcy. Greece’s new government has every right to repudiate the vast amount beyond that because it arose not from the actions of the Greek people, but from the treachery of EU politicians and the Troika apparatchiks—-along with the unfaithful stooges in the Greek parliament and ministries which executed their fraudulent conveyance.

The Peterson Institute – Greece Should Ponder the Benefits of Devaluationpresents a couple of novel alternatives:-

There are two other mechanisms through which devaluation could occur, but both are more painful and less efficient than the currency (so called external) devaluation. One way is to simply reduce wages, thus achieving lower prices of domestically-produced goods and making them cheaper abroad. This is easier said than done. Wages are notoriously sticky, and even the wage cuts that Greece accepted have already brought protesters to the streets. Greece reduced wages of public-sector workers in 2010 and again in 2012 and endured months-long strikes. The new Syriza government has just started to undo these measures, with pledges to increase wages to precrisis levels.

The other mechanism to achieve internal devaluation is through tax policy—by reducing taxes on labor and increasing consumption taxes. Reducing taxes serves to reduce the overall cost of labor and hence production. It also encourages firms to look for other markets, as higher consumption prices at home reduce demand. Several European countries tried this, including Italy under Prime Minister Mario Monti in 2012—with some success.

I remember discussing a “devaluation and re-joining” concept, with a hedge fund manager friend of mine back in 2010. “How would it work in practice, and what would happen to the bond holders?” were his perfectly valid responses. From the current vantage, five years on, that 20% devaluation would have been a small price for the bond holders to pay. Meanwhile Greek bank accounts are being siphoned of deposits as the crisis deepens, these charts from an article published by CFR -Greece—a Destabilizing Financial Squeezetell an alarming tale:-

EZ Bank deposits GS

Source: Goldman Sachs

It’s amazing that household deposits remain so high, but, with the majority of the Greek people wishing to remain in the Euro, perhaps this is logical.

The chart below shows the breakdown of the balance sheet of the Deutsche Bundesbank:-

Bundesbank_balance_sheet

Source: Soberlook.com

TARGET2 claims represent around 70% of the total – this is the loans of peripheral EZ national central banks. If “Grexit” leads to “Contagion” this half-trillion Euro accounting entry will start to crystallise – the hole in the Bundesbank balance sheet will have to be footed by the German tax payer.

Personally I still favour an EZ solution. Towards the end of February Michael Pettis – When do we decide that Europe must restructure much of its debt? Took up the theme, reminding us of the, less quoted, preamble to Mario Draghi’s “whatever it takes” speech:-

And this is clearly not just about Greece. Everyone understands that Greece has already restructured its debt once before and received partial forgiveness — in fact once coupon reductions are correctly accounted for Greece’s debt ratio is probably much lower than the roughly 180% of GDP the official numbers suggest. Most people also understand that the Greek debate is not just about Greece but also about whether or not several other countries — Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.

What few people realize, however, is these countries have effectively already done so once. This happened two and a half years ago at the Global Investment Conference in London when, on July 26, 2012, Mario Draghi, President of the European Central Bank, made the following statement:

“When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro. And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

“But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Pettis puts the case for a Europe-wide debt resolution. He quotes from McKinsey – Debt and (not to much) deleveraging – but since “a picture paints a thousand words”:-

Debt since 2018 - McKinsey Haver Analytics

Source: Haver Analytics, McKinsey

As Pettis sees it, this is most certainly not about Greece in isolation:-

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

Conclusions and investment opportunities

The yield on Greek 10yr government bonds has begun to rise again (see the monthly chart below) following the dramatic rise in shorter maturities – 2yr yields were at 28% on the open yesterday versus 10yr at 12.7%. This is a clear trend breakout but could be swiftly reversed by an EZ resolution of the current impasse:-

greece-government-bond-yield

Source: Trading Economics

During the last year Greek stocks have trended lower losing more than 45% since the spring of 2014, yet they are still higher than during the teeth of the last storm that battered the EZ in 2012 when the index plumbed the depths of 471:-

Athhens Composite 5 yr

Source: Yahoo Finance

Perhaps of greater relevance, in light of the potential failure of the Greek banking system, is the Greek Bank Index. This, six month chart, highlights the degree to which the economy is being constrained by the spectre of bank defaults:-

FTSEAthex Banks index 6 months

Source: Yahoo Finance

The Greece will either remain mired in the morass of debt, successfully restructure or exit the Euro and default on its obligations. In the first scenario bonds will be rescheduled piecemeal but yields should return to single digits in 10yr maturities, reflecting the continued deflation risk associated with the over-hang of debt, the stock market will under-perform due to continued uncertainty and lack of investment but is unlikely to make fresh lows given the steady improvement in growth prospects for the rest of the EZ. Real Estate will continue to trend lower since the only buyers are likely to be domestic firms or individuals – the substantial inventory of domestic sellers will take a considerable time to clear, whilst net outward migration will increase the supply of Real Estate further. This chart shows the net changes in population since 1980:-

Net migration from Greece

Source: The Economist, Eurostat

In the second scenario, bond yields will trade in a range between high single digits and mid-teens, trading in a broadly similar way to scenario one, though, with less deflation risk, the yields are likely to be structurally higher. The stock market will clear and investment will return. House prices will recover as foreign buyers return and ex-patriot workers come home. Scenario three is the most cathartic. Bond yields will rise dramatically since there will no longer be a strong central bank and few businesses or institutions will be organised to exchange the replacement currency. The new currency will devalue and remain volatile, deterring investors from rushing to invest – once the currency stabilises, bond and equity markets will follow suit. High yield investors will be ready to invest in bonds, equity investors will look for businesses with comparative advantages due to their proximity to, and established trading links with, the EZ. Property will also gradually recover, especially in tourist destinations where “holiday homes” will suddenly become even more affordable for many EZ investors.

As I mentioned already, I think scenario two is most likely (45%) though we may have to wait until the “eleventh hour” to see it come to pass. Sadly scenario one is also quite likely (35%) since the EZ political apparatus seems incapable of addressing tough decisions head-on. This still leaves a 20% chance of a “Lehman moment”.

Prospects for the islands

As the paper from Sheffield University explains, island economies are relatively insulated from the external ebb and flow of the wider economy. Proximity to Athens is clearly a factor, but the performance of Crete is a typical example of the localised nature of these economic units. Corfu is only 30 miles from the heel of Italy and its Venetian architecture is testament to these links. The islands are most reliant on Tourism and, despite the crisis and the rioting in Athens, tourists keep coming back to these beautiful, welcoming islands. Not unlike Greece’s second industry – Shipping – Tourism is an international business; it is not held hostage to the fortunes of the hapless Greek political elite.