Are we nearly there yet? Employment, interest rates and inflation

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Macro Letter – No 92 – 09-03-2018

Are we nearly there yet? Employment, interest rates and inflation

  • Rising interest rates and inflation are spooking financial markets
  • Unemployment data suggests that labour markets are tight
  • Central Banks will have to respond to a collapse in the three asset bubbles

There are two factors, above all others, which are spooking asset markets at present, inflation and interest rates. The former is impossible to measure with any degree of certainty – for inflation is in the eye of the beholder – and the latter is divergent depending on whether you look at the US or Japan – with Europe caught somewhere between the two extremes. In this Macro Letter I want to investigate the long term, demand-pull, inflation risk and consider what might happen if stocks, bonds and real estate all collapse in tandem.

It is reasonable to assume that US rates will rise this year, that UK rates might follow and that the ECB (probably) and BoJ (almost certainly) will remain on the side-lines. An additional worry for export oriented countries, such as Japan and Germany, is the protectionist agenda of the current US administration. If their exports collapse, GDP growth is likely to slow in its wake. The rhetoric of retaliation will be in the air.

For international asset markets, the prospect of higher US interest rates and protectionism, spells lower growth, weakness in employment and a lowering of demand-pull inflationary pressure. Although protectionism will cause prices of certain goods to rise – use that aluminium foil sparingly, baste instead – the overall effect on employment is likely to be swift.

Near-term impact

Whilst US bond yields rise, European bond yields may fail to follow, or even decline, if export growth collapses. Stocks in the US, by contrast, may be buoyed by tax cuts and the short-term windfall effect of tariff barriers. The high correlation between equity markets and the international nature of multinational corporations, means global stocks may remain levitated a while longer. The momentum of recent economic growth may lead to increased employment and higher wages in the near-term – and this might even spur demand for a while – but the spectre of inflation at the feast, will loom like a hawk.

Longer-term effects

But is inflation really going to be a structural problem? In an attempt to answer this we must delve into the murky waters of the employment data. As a starting point, at what juncture can we be confident that the US and other countries at or near to full-employment? Let us start by looking at the labour force participation rate. It is a difficult measure to interpret. As the table below shows, in the US and Japan the trend has been downward whilst the UK and the EU are hitting record highs:-

Labor_Force_Participation_Rates

Source: Trading Economics

One possible reason for this divergence between the EU and the US/Japan is that the upward trend in European labour participation has been, at least partially, the result of an inexorable reduction in the scope and scale of the social safety net throughout the region.

More generally, since the Great Recession of 2008/2009 a number of employment trends have been evident across most developed countries. Firstly, many people have moved from full-time to part-time employment. Others have switched from employment to self-employment. In both cases these trends have exerted downward pressure on earnings. What little growth in earnings there has been, has mainly emanated from the public sector, but rising government deficits make this source of wage growth unsustainable in the long run.

The Record of Meeting of the CAC and Federal Reserve Board of Governors – published last November, stated the following in relation to US employment:-

The data indicate that despite the drop in unemployment, there has not been an increase in the number of quality jobs—those that pay enough to cover expenses and enable workers to save for the future. The 2017 Scorecard reports that one in four jobs in the U.S. is in a low-wage occupation, which means that at the median salary, these jobs pay below the poverty threshold for a family of four. For the first time, the 2017 Scorecard includes a measure of income volatility that shows that one in five households has significant income fluctuations from month to month. The percentage varies by state, from a low of 14.7 percent of households in Virginia to a stunning 29.8 percent of households in Wyoming. In addition, 40 percent of those experiencing volatility reported struggling to pay their bills at least once in the last year because of these income fluctuations. These two factors contribute significantly to the fact that almost 37 percent of U.S. households, and 51 percent of households of color, live in the financial red zone of “liquid asset poverty.” This means that they do not have enough liquid savings to replace income at the poverty level for three months if their main source of income is disrupted, such as from job loss or illness. This level of financial insecurity has profound implications for the security of households, and for the overall economic growth of the nation.

Another trend that has been evident is the increase in the number of people no longer seeking employment. Setting aside those who, for health related reasons, have exited the employment pool, early retirement has been one of the main factors swelling the ranks of the previously employable. For this growing cohort, inflation never went away. In particular, inflation in healthcare has been one of the main sources of increases in the price level over the past decade.

At the opposite end of the working age spectrum, education is another factor which has reduced the participation rate. It has also exerted downward pressure on wages; as more students enrol in higher education in order to gain, hopefully, better paid employment, the increased supply of graduates insures that the economic value of a degree diminishes. Whilst a number of corporations have begun to offer apprenticeships or in-work degree qualifications, in order to address the skill gap between what is being taught and what these firms require from their employees, the overall impact of increased demand for higher education has been to reduce the participation rate.

For a detailed assessment of the situation in the US, this paper from the Kansas City Federal Reserve – Why Are Prime-Age Men Vanishing from the Labor Force? provides some additional and fascinating insights. Here is the author’s conclusion:-

Over the past two decades, the nonparticipation rate among primeage men rose from 8.2 percent to 11.4 percent. This article shows that the nonparticipation rate increased the most for men in the 25–34 age group and for men with a high school degree, some college, or an associate’s degree. In 1996, the most common situation prime-age men reported during their nonparticipation was a disability or illness, while the least common situation was retirement. While the share of primeage men reporting a disability or illness as their situation during nonparticipation declined by 2016, this share still accounted for nearly half of all nonparticipating prime-age men. This result is in line with Krueger’s (2016) finding, as many of these men with a disability or illness are likely suffering from daily pain and using prescription painkillers.

I argue that a decline in the demand for middle-skill workers accounts for most of the decline in participation among prime-age men. In addition, I find that the decline in participation is unlikely to reverse if current conditions hold. In 2016, the share of nonparticipating prime-age men who stayed out of the labor force in the subsequent month was 83.8 percent. Moreover, less than 15 percent of nonparticipating prime-age men reported that they wanted a job. Together, this evidence suggests nonparticipating prime-age men are less likely to return to the labor force at the moment.

The stark increase in prime-age men’s nonparticipation may be the result of a vicious cycle. Skills demanded in the labor market are rapidly changing, and automation has rendered the skills of many less-educated workers obsolete. This lack of job opportunities, in turn, may lead to depression and illness among displaced workers, and these health conditions may become further barriers to their employment. Ending this vicious cycle—and avoiding further increases in the nonparticipation rate among prime-age men—may require equipping workers with the new skills employers are demanding in the face of rapid technological advancements.

For an even more nuanced interpretation of the disconnect between corporate profits and worker compensation this essay by Jonathan Tepper of Varient Perception – Why American Workers Aren’t Getting A Raise: An Economic Detective Story – is even more compelling:-

Rising industrial concentration is a powerful reason why profits don’t mean revert and a powerful explanation for the imbalance between corporations and workers. Workers in many industries have fewer choices of employer, and when industries are monopolists or oligopolists, they have significant market power versus their employees.

The role of high industrial concentration on inequality is now becoming clear from dozens recent academic studies. Work by The Economist found that over the fifteen-year period from 1997 to 2012 two-thirds of American industries were more concentrated in the hands of a few firms. In 2015, Jonathan Baker and Steven Salop found that “market power contributes to the development and perpetuation of inequality.”

One of the most comprehensive overviews available of increasing industrial concentration shows that we have seen a collapse in the number of publicly listed companies and a shift in power towards big companies. Gustavo Grullon, Yelena Larkin, and Roni Michaely have documented how despite a much larger economy, we have seen the number of listed firms fall by half, and many industries now have only a few big players. There is a strong and direct correlation between how few players there are in an industry and how high corporate profits are.

Tepper goes on to discuss monopolies and monopsonies. At the heart of the issue is the zombie company phenomenon. With interest rates at artificially low levels, companies which should have been liquidated have survived. Others have used their access to finance, gained from many years of negotiation with their bankers, to buy out their competitors. If interest rates were correctly priced this would not have been possible – these zombie corporations would have gone to the wall. I wrote a rather long two part essay on this subject in 2016 for the Cobden Centre – A history of Fractional Reserve Banking – or why interest rates are the most important influence on stock market valuations? This is about the long-run even by my standards but I commend it to those of you with an interest in economic history. Here is a brief quote from part 2:-

…This might seem incendiary but, let us assume that the rate of interest at which the UK government has been able to borrow is a mere 300bp below the rate it should have been for the last 322 years – around 4% rather than 7%. What does this mean for corporate financing?

There are two forces at work: a lower than “natural” risk free rate, which should make it possible for corporates to borrow more cheaply than under unfettered conditions. They can take on new projects which would be unprofitable under normal conditions, artificially prolonging economic booms. The other effect is to allow the government to crowd out private sector borrowing, especially during economic downturns, where government borrowing increases at the same time that corporate profitability suffers. The impact on corporate interest rates of these two effects is, to some extent, self-negating. In the long run, excessive government borrowing permanently reduces the economic capacity of the country, by the degree to which government investment is less economically productive than private investment.

To recap, more people are remaining in education, more people are working freelance or part-time and more people are choosing to retire early. The appreciation of the stock, bond and property markets has certainly helped those who are asset rich, choose to exit the ranks of the employable, but, I suspect, in many cases this is only because asset prices have been rising for the past decade. Pension annuity rates appear to have hit all-time lows, a reckoning for asset markets is overdue.

What happens come the next bust and beyond?

If inflation rises and Central Banks respond by raising interest rates, bond prices will fall and stocks will have difficulty avoiding the force of gravity. Once bond and stock markets fall, property prices are likely to follow, as the cost of financing mortgages increases. With all the major asset classes in decline, economic growth will slow and unemployment will rise. Meanwhile, the need to work, in order to supplement the reduction in income derived from a, no longer appreciating, pool of assets, will increase, putting downward pressure on average earnings. Here is the most recent wage, inflation and real wage data. For France, Germany and the UK, wages continue to lag behind prices. A 2% inflation target is all very well, just so long as wages can keep up:-

Wages_and_Inflation

Source: Trading Economics

The first place where this trend in lower earnings will become evident is likely to be among freelance and part-time workers – at least they will still have employment. The next casualty will be the fully employed. Corporations will lay-off staff as corporate profit warnings force their hands. Governments will be beseeched to create jobs and, regardless of whether the inflation rate is still rising or not, Central Banks will be implored, cajoled (whatever it takes) to cut interest rates and renew their quest to purchase every asset under the sun.

Wage deflation will, of course, continue, harming those who have no alternative but to work; those who lack sufficient unearned income to survive. Government debt will accelerate, Central Bank balance sheets will balloon and asset prices will eventually recover. Bond yields may even reach new record lows, prompting assets to flow into stocks – the ones Central Banks have not yet purchased as part of their QQE programmes – despite their inflated valuations. Corporate executives will no doubt take the view that interest rates are artificially low and conclude that they can best serve their shareholders by buying back their own stock – accompanied by the occasional special dividend to avoid accusations for impropriety.

As economic growth takes a nose drive, inflation will moderate, providing justification for the pre-emptive rate cutting and balance sheet expanding actions of the Central Banks. Articles will begin to appear, in esteemed journals, talking of a new era of low economic trend growth. Finally, after several years of QE, QQE and whatever the stage beyond that may be – helicopter money anyone? – the world economy will start to grow more rapidly and the labour force participation rate, increase once more. Inflation will start to rise, interest rates will be tightened, bond yields, increase. At this point, stocks will fall and the next downward leg of the economic cycle will have to be averted by renewed QQE and fiscal stimulus. If this is reminiscent of a scene from Groundhog Day, I regret to inform you, it is.

There will be a point at which the financialisation of the global economy and the nationalisation of the stock market can no longer deliver the markets from the deleterious curse of debt, but, sadly, I do not believe that moment has yet arrived. Are we nearly there yet? Not even close.

 

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Global Real Estate and the end of QE – Is it time to be afraid?

Global Real Estate and the end of QE – Is it time to be afraid?

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Macro Letter – No 86 – 03-11-2017

Global Real Estate and the end of QE – Is it time to be afraid?

  • Rising interest rates and higher bond yields are here to stay
  • Real estate prices seem not to be affected by higher finance costs
  • Household debt continues to rise especially in advanced economies
  • Real estate supply remains constrained and demand continues to grow

During the past two months two of the world’s leading central banks have begun the process of unwinding or, at least, tapering the quantitative easing which was first initiated after the great financial recession of 2008/2009. The Federal Reserve FOMC statement for September and their Addendum to the Policy Normalization Principles and Plans from June contain the details of the US bank’s policy change. The ECB Monetary policy decision from last week explains the European position.

Whilst the Federal Reserve is reducing its balance sheet by allowing US treasury holdings to mature, the US government has already breached its debt ceiling and will need to issue new bonds. The pace of US money supply growth is unlikely to be reversed. Nonetheless, 10yr US bond yields have risen from a low of 1.35% in July 2016 to more than 2.6% earlier this year. They currently yield around 2.4%. Over the same period 2yr US bond yields have risen from 0.49% to a new high, this week, of 1.60% – their highest since October 2008.

Back in April I wrote about the anomaly in the US interest rate swaps market – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter? What is interesting to note, in relation to global real estate, is that the 10yr Swap spread over US Treasuries (which is currently negative) has remained stable at -8bp during the recent rise in yields. Normally as interest rates on government bonds declines credit spreads tighten – as rates rise these spreads widen. So far, this has not come to pass.

In the US, mortgages are, predominantly, long-term and fixed rate. US 30yr mortgage rates has also risen since July 2016 – from 2.09% to 3.18% at the end of December. Since then rates have moderated, they now stand at 2.89%, approximately 1% above US 30yr bonds. The chart below shows the spread since July 2016:-

30yr_Mortgage_-_Bond_Spread_July_2016_to_October_2

Source: Federal Reserve Bank of St Louis

Apart from the aberration during the US presidential elections the spread between 30yr US Treasuries and 30yr Mortgages has been steadily narrowing despite the tightening of short term interest rates and the increase in yields across the maturity spectrum.

Mortgage finance costs have increased since July 2016 but by less than 50bp. What impact has this had on real estate prices? The chart below shows the S&P Case-Shiller House Price Index since 2006, the increase in mortgage rates has failed to slow the rise in prices. The year on year increase is currently running at 5.6% and forecasters predict this rate to increase to 5.8% when September data is released:-

SandP_Shiller_Case_House_Price_Index_-_2006-2017_Q

Source: Federal Reserve Bank of St Louis, S&P Case-Shiller

At the global level house prices have not taken out their pre-crisis highs, as this chart from the IMF reveals:-

globalhousepriceindex_lg

Source: IMF, BIS, ECB, Federal Reserve, Savills

The latest IMF – Global Housing Watch – report for Q2 2017 is sanguine. They take comfort from the broad range of macroprudential measures which have been introduced during the past decade.

The IMF go on to examine house price increases on a country by country basis:-

housepricesaroundtheworld_lg

Source: IMF, BIS, ECB, Federal Reserve, Savills, Sinyl Real Estate

The OECD – Focus on house priceslooks at a variety of different metrics including changes in real house prices: the OECD average is more of less where it was in 2010 having dipped during 2011/2012 – here is breakdown across a selection of regions. Please note the charts are rather historic they stop at January 2014:-

OECD Real Estate charts 2010 -2014

Source: OECD

The continued fall in Japanese prices is not entirely surprising but the steady decline of the Euro area is significant.

Similarly historic data is contained in the chart below which ranks countries by Price to Income and Price to Rent. Portugal, Germany, South Korea and Japan remain inexpensive by these measures, whilst Belgium, New Zealand, Canada, Norway and Australia remain expensive. The UK market also appears inflated but the decline in Sterling may be a supportive factor: international capital is flowing into the UK after the devaluation:-

Real Estate P-E and P-R chart OECD

Source: OECD

Bringing the data up to date is the Knight Frank’s global house price index, for Q2 2017. The table below is sorted by real return:-

Real_Estate_Real_Return_Q2_2017_Knight_Frank

Source: Knight Frank, Trading Economics

There is a saying in the real estate market, ‘all property is local’. Prices vary from region to region, from street to street, however, the data above paints a picture of a global real estate market which has performed strongly in response to the lowering of interest rates. As the table below illustrates, the percentage of countries recording positive annual price changes is now at 89%, well above the levels of 2007, when interest rates were higher:-

Real_Estate_Price_Change_-_Knight_Frank

Source: Knight Frank

The low interest rate environment has stimulated a rise in household debt, especially in advanced economies. The IMF – Global Financial Stability Report October 2017 makes sombre reading:-

Although finance is generally believed to contribute to long-term economic growth, recent studies have shown that the growth benefits start declining when aggregate leverage is high. At business cycle frequencies, new empirical studies—as well as the recent experience from the global financial crisis—have shown that increases in private sector credit, including household debt, may raise the likelihood of a financial crisis and could lead to lower growth.

These two charts show the rising trend globally but the relatively undemanding levels of indebtedness typical of the Emerging Market countries:-

IMF_Household_Debt_to_GDP_ratios_-_Advanced_Econom

Source: IMF

IMF_Household_Debt_to_GDP_ratios_-_Emerging_Econom

Source: IMF

As long ago at February 2015 – McKinsey – Debt and (not too much) deleveraging – sounded the warning knell:-

Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points.

According to the Institute of International Finance Q2 2017 global debt report – debt hit a new all-time high of $217 trln (327% of global GDP) with China leading the way:-

iif china debt to GDP

Source: IIF

Household debt is growing in China but from a relatively low base, it is as the IMF observe, the advanced economies where households are becoming addicted to low interest rates and cheap finance.

Conclusions and investment opportunities

Economist Global House prices

Source: The Economist

The chart above shows a few of the winners since 1980. The real estate market remains sanguine, trusting that the end of QE will be a gradual process. Although as a recent article by Frank Shostak – Can gradual interest rate tightening prevent shocks? reminds us, ‘…there is no such thing as “shock-free” monetary policy’:-

Can a gradual tightening prevent an economic bust?

Since monetary growth, whether expected or unexpected, gives rise to the redirection of real savings it means that any monetary tightening slows down this redirection. Various economic activities, which sprang-up on the back of strong monetary pumping, because of a tighter monetary stance get now less real funding. This in turn means that these activities are given less support and run the risk of being liquidated.  It is the liquidation of these activities what an economic bust is all about.

Obviously, then, the tighter monetary stance by the Fed must put pressure on various false activities, or various artificial forms of life. Hence, the tighter the Fed gets the slower the pace of redirection of real savings will be, which in turn means that more liquidation of various false activities will take place. In the words of Ludwig von Mises,

‘The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.’

Consequently, the view that the Fed can lift interest rates without any disruption doesn’t hold water. Obviously if the pool of real savings is still expanding then this may mitigate the severity of the bust. However, given the reckless monetary policies of the US central bank it is quite likely that the US economy may already has a stagnant or perhaps a declining pool of real savings. This in turn runs the risk of the US economy falling into a severe economic slump.

We can thus conclude that the popular view that gradual transparent monetary policies will allow the Fed to tighten its stance without any disruptions is based on erroneous ideas. There is no such thing as a “shock-free” monetary policy any more than a monetary expansion can ever be truly neutral to the market.

Regardless of policy transparency once a tighter monetary stance is introduced, it sets in motion an economic bust. The severity of the bust is conditioned by the length and magnitude of the previous loose monetary stance and the state of the pool of real savings.

If world stock markets catch a cold central banks will provide assistance – though not perhaps to the same degree as they did last time around. If, however, the real estate market begins to unravel the impact on consumption – and therefore on the real economy – will be much more dramatic. Central bankers will act in concert and with determination. If the problem is malinvestment due to artificially low interest rates, then further QE and a return to the zero bound will not cure the malady: but this discussion is for another time.

What does quantitative tightening – QT – mean for real estate? In many urban areas, the increasing price of real estate is a function of geography and the limitations of infrastructure. Shortages of supply are difficult (and in some cases impossible) to alleviate; it is unlikely, for example, that planning consent would be granted to develop Central Park in Manhattan or Hyde Park in London.

Higher interest rates and weakness in household earnings growth will temper the rise in property prices. If the markets run scared it may even lead to a brief correction. More likely, transactional activity will diminish. A price collapse to the degree we witnessed in 2008/2009 is unlikely to recur. Those markets which have risen most may exhibit a greater propensity to decline, but the combination of steady long term demand and supply constraints, will, if you’ll pardon the pun, underpin global real estate.

European Bonds – warning knell or cause for celebration?

European Bonds – warning knell or cause for celebration?

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Macro Letter – No 85 – 13-10-2017

European Bonds – warning knell or cause for celebration?

  • Greek bonds have been the best performer in the Eurozone year to date
  • IMF austerity is still in place but there are hopes they will relent
  • Portuguese bonds have also rallied since March whilst Spanish Bonos declined
  • German Bund yields are up 28bps since January heralding an end to ECB QE

Writing, as government bond yields for peripheral European markets peaked in Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? I felt that another Eurozone crisis could not be ruled out:-

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

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Greece vs Germany 10yr yield 2017

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Bond_yields_Jan_vs_October_2017 (1)

Source: Investing.com

This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

Where now for European bonds?

A good place to start when attempted to divine where the European bond markets may be heading is by considering the outcome of the German election. Wolfgang Bauer of M&G Bond Vigilantes – Angela Merkel’s Pyrrhic victory – writing at the end of last month, prior to the Catalan vote, takes up the story:-

Populism is back with a vengeance

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

European Unemployment - BNP Paribas

Source: BNP Paribas Asset Management, Datastream

The rate of economic expansion in European is increasing and measures of the popularity of the Eurozone look robust. Nathalie Benatia of BNP Paribas – Yes, Europe is indeed back puts it like this:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

EZ survey July 2017

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-

Euro_Bond_spreads_2009_versus_2017

Source: Investing.com

Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.

Central Bank balance sheet adjustment – a path to enlightenment?

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Macro Letter – No 79 – 16-6-2017

Central Bank balance sheet adjustment – a path to enlightenment?

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

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

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

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

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

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

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

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

Central_Bank_Balance_Sheets_-_Yardeni_May_2017

 Source: Yardeni Research, Haver Analytics

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

China FX reserves and stocks 2014 - 2017

Source: Trading Economics

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

An historical perspective

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

Federal_Reserve_Balance_Sheet_-_History_-_St_Louis

Source: Federal Reserve, Haver Analytics

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

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

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

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

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

BoE_Balance_Sheet_to_GDP_since_1701_-_BoE_and_FRED

Source: Federal Reserve, Bank of England

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

UK-equities-1700-2012 Stockmarket Almanac

Source: The Stock Almanac

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

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

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

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

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

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

Adjustment without tightening

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Commercial_Bank_Loan_Creation_US

Source: Federal Reserve, Zero Hedge

The global perspective

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

Fulcrum_Projections_for_tapering

Source: FT, Fulcrum Asset Management

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

Fulcrum CB Liquidity Injections - March 2017 forecast

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

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

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

Fulcrum Estimates of CB Balance sheets - March 2017 

Source: Haver Analytics, Fulcrum Asset Management

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

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

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

Conclusions and Investment Opportunities

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

centralbankbalancesheetgdpratios

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

Source: National Inflation Association

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

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

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

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

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

Is the “flight to quality” effect breaking down?

400dpiLogo

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.

Quantitative to qualitative – is unelected nationalisation next?

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Macro Letter – No 52 – 08-04-2016

Quantitative to qualitative – is unelected nationalisation next?

  • Negative interest rates are reducing the velocity of circulation
  • Qualitative easing is on the rise
  • Liquidity in government bond markets continues to decline
  • A lack of liquidity in equity markets will be next

Last year, in a paper entitled The Stock Market Crash Really Did Cause the Great Recession – Roger Farmer of UCLA argued that the collapse in the stock market was the cause of the Great Recession:-

In November of 2008 the Federal Reserve more than doubled the monetary base from eight hundred billion dollars in October to more than two trillion dollars in December: And over the course of 2009 the Fed purchased eight hundred billion dollars worth of mortgage backed securities. According to the animal spirits explanation of the recession (Farmer, 2010a, 2012a,b, 2013a), these Federal Reserve interventions in the asset markets were a significant factor in engineering the stock market recovery.

The animal spirits theory provides a causal chain that connects movements in the stock market with subsequent changes in the unemployment rate. If this theory is correct, the path of unemployment depicted in Figure 8 is an accurate forecast of what would have occurred in the absence of Federal Reserve intervention. These results support the claim, in the title of this paper, that the stock market crash of 2008 really did cause the Great Recession.

Central banks (CBs) around the globe appear to concur with his view. Their response to the Great Recession has been the provision of abundant liquidity – via quantitative easing – at ever lower rates of interest. They appear to believe that the recovery has been muted due to the inadequate quantity of accommodation and, as rates drift below zero, its targeting.

The Federal Reserve (Fed) was the first to recognise this problem, buying mortgages as well as Treasuries, perhaps guided by the US Treasury’s implementation of TARP in October 2008. The Fed was fortunate in being unencumbered by the political grid-lock which faced the European Central Bank (ECB). They acted, aggressively and rapidly, hoping to avoid the policy mistakes of the Bank of Japan (BoJ). The US has managed to put the great recession behind it. But at what cost? Only time will tell.

Other major CBs were not so decisive or lucky. In the immediate aftermath of the sub-prime crisis the Swiss Franc (CHF) rose – a typical “safe-haven” reaction. The SNB hung on grimly as the CHF appreciated, especially against the EUR, but eventually succumbed to “the peg” in September 2011 after the Eurozone (EZ) suffered its first summer of discontent. It was almost a year later before ECB President Draghi uttered his famous “Whatever it takes” speech on 26th July 2012.

Since 2012 government bond yields in the EZ, Switzerland, Japan and the UK have fallen further. In the US yields recovered until the end of 2013 but have fallen once more as international institutions seek yield wherever they can.

By 2013 CBs had begun to buy assets other than government bonds as a monetary exercise, in the hope of simulating economic growth. Even common stock became a target, since they were faced with the same dilemma as other investors – the need for yield.

In late April 2013 Bloomberg – Central Banks Load Up on Equities observed:-

Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk-averse investors toward equities.

In a survey of 60 central bankers…23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves.

…The SNB allocated 82 percent of its 438 billion Swiss francs ($463 billion) in reserves to government bonds in the fourth quarter, according to data on its website. Of those securities, 78 percent had the top, AAA credit grade and 17 percent were rated AA.

…The survey of 60 central bankers, overseeing a combined $6.7 trillion, found that low bond returns had prompted almost half to take on more risk. Fourteen said they had already invested in equities or would do so within five years.

…Even so, 70 percent of the central bankers in the survey indicated that equities are “beyond the pale.”

the SNB has allocated about 12 percent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 percent of its $77 billion reserves on U.S. stocks.

…the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 percent of the total, up from 5.4 percent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.

Reserves have increased at a slower pace since 2012, but the top 50 countries still accounted for $11.4trln, according to the latest CIA Factbook estimates. The real growth has been in emerging and developing countries – according to IMF data, since 2000, in the wake of the Asian crisis, their reserves grew from $700bln to above $8trln.

By June 2014 the Financial Times – Beware central banks’ share-buying sprees was sounding the alarm:-

An eye-catching report this week said that “a cluster of central banking investors has become major players on world equity markets”. An important driver was revenues foregone on bond portfolios.

Put together by the Official Monetary and Financial Institutions Forum, which brings together secretive and normally conservative central bankers, the report’s conclusions have authority. Some equity buying was in central banks’ capacity as, in effect, sovereign wealth fund managers. China’s State Administration of Foreign Exchange, which has $3.9tn under management, has become the world’s largest public sector holder of equities.

The boundary, however, with monetary policy making is not always clear. According to the Omfif report, China’s central bank itself “has been buying minority equity stakes in important European companies”.

…Central bank purchases of shares are not new. The Dutch central bank has invested in equities for decades. The benchmark for its €1.4bn portfolio is the MSCI global developed markets index.

The Italian, Swiss and Danish central banks also own equities. Across Europe, central banks face pressures from cash-strapped governments to boost income. As presumably cautious and wise investors, they have also been put in charge of managing sovereign wealth funds – Norway’s, for instance.

…the Hong Kong Monetary Authority launched a large-scale stock market intervention in 1998, splashing out about $15bn – and ended up making a profit. Since the Asian financial crisis of that year, official reserves have expanded massively – far beyond what might be needed in future financial crises or justified by trade flows.

The article goes on to state that CB transparency is needed and that it should be made clear whether the actions are monetary policy or investment activity. Equities are generally more volatile than bonds – losses could lead to political backlash, or worse still, undermine the prudent reputation of the CB itself.

Here is an example of just such an event, from July last year, as described by Zero Hedge – The Swiss National Bank Is Long $94 Billion In Stocks, Reports Record Loss Equal To 7% Of Swiss GDP:-

…17%, or CHF91 ($94 billion) of the foreign currency investments and CHF bond investments assets held on the SNB’s balance sheet are foreign stocks…

In other words, the SNB holds 15% of Switzerland’s GDP in equities!

Zero Hedge goes on to remonstrate against the lack of transparency of other CBs equity investment balances – in particular the Fed.

The ECB, perhaps due to its multitude of masters, appears reluctant to follow the lead of the SNB. In March 2015 it achieved some success by announcing that it would buy Belgian, French, Italian and Spanish bonds, under its QE plan, in addition to those of, higher rated, Finland, Germany, Luxembourg and the Netherlands. EZ Yield compression followed with Italy and Spain benefitting most.

The leading exponent of this “new monetary alchemy” is the BoJ. In an October 2015 report from Bloomberg – Owning Half of Japan’s ETF Market Might Not Be Enough for Kuroda the author states:-

With 3 trillion yen ($25 billion) a year in existing firepower, the BOJ has accumulated an ETF stash that accounted for 52 percent of the entire market at the end of September, figures from Tokyo’s stock exchange show.

…Japan’s central bank began buying ETFs in 2010 to spur more trading and promote “more risk-taking activity in the overall economy.” Governor Haruhiko Kuroda expanded the program in April 2013 and again last October.

BoJ ETF holdings - October 2015 - Bloomberg

Source: Bloomberg, TSE

More ETFs can be created to redress the balance, or the BoJ may embark on the purchase of individual stocks. They announced a small increase in ETF purchases in December, focused on physical and human capital firms – also advising that shares they bought from distressed financial institutions in 2002 will be sold (very gradually) at the rate of JPY 300bln per annum over the next decade. At the end of January the BoJ decided to adopt negative interest rate policy (NIRP) rather than expand ETF and bond purchases – this saw the Nikkei hit its lowest level since October 2014 whilst the JYP shed more than 8% against the US$. I anticipate that they will soon increase their purchases of ETFs or stocks once more. The NIRP decision was half-hearted and BoJ concerns, about corporates and individuals resorting to cash stashed in safes, may prove well founded – So it begins…Negative Interest rates Trickle Down in Japan – Mises.org discusses this matter in greater detail.

In early March the ECB acted with intent, CNBC – ECB pulls out all the stops, cuts rates and expands QE takes up the story:-

…the ECB announced on Thursday that it had cut its main refinancing rate to 0.0 percent and its deposit rate to minus-0.4 percent.

“While very low or even negative inflation rates are unavoidable over the next few months as a result of movement in oil prices, it is crucial to avoid second-round effects,” Draghi said in his regular media conference after the ECB statement.

The bank also extended its monthly asset purchases to 80 billion euros ($87 billion), to take effect in April.

…the ECB will add corporate bonds to the assets it can buy — specifically, investment grade euro-denominated bonds issued by non-bank corporations. These purchases will start towards end of the first half of 2016.

…the bank will launch a new series of four targeted longer-term refinancing operations (TLTROs) with maturities of four years, starting in June.

The Communique from the G20 meeting in Shanghai alluded to the need for increased international cooperation, but it appears that a sub-rosa agreement may have been reached to insure the Chinese did not devalue the RMB – in return for a cessation of monetary tightening by the Fed.

In an unusually transparent move, a report appeared on March 31st on Reuters – China forex regulator buys $4.2 bln in stocks via new platform:-

Buttonwood Investment Platform Ltd, 100 percent owned by the State Administration of Foreign Exchange (SAFE), and Buttonwood’s two fully-owned subsidiaries, have bought shares in a total of 13 listed companies, the newspaper reported, citing top 10 shareholder lists in the companies latest earnings reports.

Shanghai Securities News said the investments are part of SAFE’s strategy to diversify investment channels for the country’s massive foreign exchange reserves.

Recent earnings filings show Buttonwood is among the top 10 shareholders of Bank of China, Bank of Communications , Shanghai Pudong Development Bank , Everbright Securities and Industrial and Commercial Bank of China.

Conclusions and investment opportunities

The major CBs are beginning to embrace the idea of providing capital to corporates via bond or stock purchases. With next to no yield available from government bonds, corporate securities appear attractive, especially when one has the ability to expand ones balance sheet, seemingly, without limit.

The CBs are unlikely to buy when the market is strong but will provide liquidity in distressed markets. Once they have purchased securities the “free-float” will be almost permanently reduced. The lack of, what might be termed, “trading liquidity”, which has been evident in government bond markets, is likely to spill over into those corporate bonds and ETFs where the CBs hold a significant percentage. In the UK, under our takeover code, a 30% holding in a stock would obligate the holder to make an offer for the company – the 52% of outstanding ETFs held by the BoJ already seems excessive.

The ECB has plenty of government, agency and corporate bonds to purchase, before it moves on to provide permanent equity capital. The BoE and the Fed are subject to less deflationary forces; they will be the last guests to arrive at the “closet nationalisation” party. The party, nonetheless, is getting underway. Larger companies will benefit to a much greater extent than smaller listed or unlisted corporations because the CBs want to appear to be “indiscriminate” buyers of stock.

As the pool of available bonds and stocks starts to dry up, trading liquidity will decline – markets will become more erratic and volatile. Of greater concern in economic terms, malinvestment will increase; interest rates no longer provide signals about the value of projects.

For stocks, higher earning multiples are achievable due to the rising demand for equities from desperate investors with no viable “yield” alternative. CBs are unelected stewards on whom elected governments rely with increasing ease. For notionally independent CBs to purchase common stock is de facto nationalisation. The economic cost of an artificially inflated stock market is difficult to measure in conventional terms, but its promotion of wealth inequality through the sustaining of asset bubbles will do further damage to the fabric of society.