February 16, 2018 by In the long run

A safe place to hide – inflation and the bond markets

Macro Letter – No 91 – 16-02-2018

A safe place to hide – inflation and the bond markets

US bond yields have risen from historic lows, they should rise further, they may not
The Federal Reserve is beginning to reduce its balance sheet other CBs continue QE
US bonds may still be a safe haven but a hawkish Fed makes short duration vulnerable
Short dated UK Gilts make be a safe place to hide, come the correction in stocks

US Bonds

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993

Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.

More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19^th October 1955:-

If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.

Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-

US Inflation and 10yr bond yield 1950 to 1973

Source: Trading Economics

I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.

Central Bank balance sheets

Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-

CB_Balance_Sheets_-_Yardeni

Source: Haver Analytics, Yardeni Research

Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-

US_debt_ownership_Dec_2016

Source: US Treasury

As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.

Bond Markets in Europe and Japan

The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.

Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-

Germany vs Greece 10yr yields

Source: Trading Economics

By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.

Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.

The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.

Conclusions and Investment Opportunities

From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.

As a defensive investment one should look for short duration bonds, but in the US this brings the investor into conflict with the hawkish policy stance of the Fed; that is, what my friend Ben Hunt of Epsilon Theory dubs, the Inflation Narrative. For a contrary view this Kansas City Fed paper may be of interest – Has the Anchoring of Inflation Expectations Changed in the United States during the Past Decade?

In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-

united-kingdom-2-year-note-yield - 5yr

Source: Trading Economics

UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.

With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.

October 13, 2017 by In the long run

European Bonds – warning knell or cause for celebration?

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:-

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:-

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 4^th 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:-

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.

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:-

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.

September 16, 2016 by In the long run

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 10^th 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 4^th 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 22^nd and 23^rd 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 7^th and 12^th 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.

July 15, 2016 by In the long run

Uncharted British waters – the risk to growth, the opportunity to reform

400dpiLogo

Macro Letter – No 59 – 15-07-2016

Uncharted British waters – the risk to growth, the opportunity to reform

Uncertainty will delay investment and damage growth near term
A swift resolution of Britain’s trade relations with the EU is needed
Without an aggressive liberal reform agenda growth will be structurally lower
Sterling will remain subdued, Gilts, trade higher and large cap stocks well supported

Look, stranger, on this island now
The leaping light for your delight discovers,
Stand stable here
And silent be,
That through the channels of the ear
May wander like a river
The swaying sound of the sea.

W.H. Auden

thames-chart-collins-3057

Source: Captain Greenvile Collins – Great Britain’s Coasting Pilot – 1693

Captain Greenvile Collins was the Hydrographer in Ordinary – to William and Mary. His coastal pilot was the first, more or less, accurate guide to the coastline of England, Scotland and Wales, prior to this period mariners had relied mainly on Dutch charts. Collins’s charts do not comply with the convention of north being at the top and south at the bottom – the print above, of the Thames estuary, has north to the right. This, and the extract from W. H. Auden with which I began this letter, seem appropriate metaphors for the new way we need to navigate the financial markets of the UK post referendum.

Sterling has borne the brunt of the financial maelstrom, weakening against the currencies of all our major trading partners. Gilts have rallied on expectations of further largesse from the Bank of England (BoE) and a more generalised international flight to quality in “risk-free” government bonds. This saw Swiss Confederation bonds trade at negative yields to maturity out to 48 years.

With interest rates now at historic lows around the developed world and investors desperate for yield, almost regardless of risk, equity markets have remained well supported. Many individual UK companies with international earnings have made new all-time highs. Banks and construction companies have not fared so well.

Now the dust begins to settle, we have the more challenging task of anticipating the longer term implications of the British schism, both for the UK and its European neighbours. In this letter I will focus principally on the UK.

A Return to the Astrolabe?

Astrolabe

Source: University of Cambridge

The Greeks invented the astrolabe sometime around 200BCE. The one above of Islamic origin and dates from 1309. Before the invention of the sextant this was the only reliable means of navigation.

Our aids to navigation have been compromised by the maelstrom of Brexit – it’s not quite a return to the Astrolabe but we may have lost the use of GPS and AIS.

This week the OECD was forced to suspend the publication of its monthly Composite Leading Indicators (CLI). Commenting on the decision they said:-

The CLIs cannot…account for significant unforeseen or unexpected events, for example natural disasters, such as the earthquake, and subsequent events that affected Japan in March 2011, and that resulted in a suspension of CLI estimates for Japan in April and May 2011. The outcome of the recent Referendum in the United Kingdom is another such significant unexpected event, which is affecting the underlying expectation and outturn indicators used to construct the CLIs regularly published by the OECD, both for the UK and other OECD countries and emerging economies.

It will be difficult to draw any clear conclusions from the economic data produced by the OECD or other national and international agencies for some while.

Speaking to the BBC prior to the referendum, OECD Secretary General, Angel Gurria had already suggested that UK growth would be damaged:-

It is the equivalent to roughly missing out on about one month’s income within four years but then it carries on to 2030. That tax is going to be continued to be paid by Britons over time.

Back in March Open Europe – What if…? The consequences, challenges and opportunities facing Britain outside the EU put it thus:-

UK GDP could be 2.2% lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU or reverts into protectionism. In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world, whilst pursuing large-scale deregulation at home, Britain could be better off by 1.6% of GDP in 2030. However, a far more realistic range is between a 0.8% permanent loss to GDP in 2030 and a 0.6% permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.

…Based on economic modelling of the trade impacts of Brexit and analysis of the most significant pieces of EU regulation, if Britain left the EU on 1 January 2018, we estimate that in 2030:

In a worst case scenario, where the UK fails to strike a trade deal with the rest of the EU and does not pursue a free trade agenda, Gross Domestic Product (GDP) would be 2.2% lower than if the UK had remained inside the EU.

In a best case scenario, where the UK strikes a Free Trade Agreement (FTA) with the EU, pursues very ambitious deregulation of its economy and opens up almost fully to trade with the rest of the world, UK GDP would be 1.6% higher than if it had stayed within the EU.

Open_Europe_Brexit_Impact_Table

Source: Open Europe, Ciuriak Consulting

Given that UK annual GDP growth averaged 2.46% between 1956 and 2016, the range of outcomes is profoundly important. GDP forecasts are always prone to error but the range of outcomes indicated above is exceedingly broad – divination might prove as useful.

Also published prior to the referendum Global Counsel – BREXIT: the impact on the UK and the EU assessed the prospects both for the UK and EU in the event of a UK exit. The table below is an excellent summary, although I don’t entirely agree with all the points nor their impact assessment:-

Global_Counsel_-_Brexit

Source: Global Counsel

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

Curiouser and Curiouser – the myth of devaluation continues. The 1992 experience….

“The UK’s trade performance since the onset of the economic downturn in 2008 has been one of the more curious developments in the UK economy” according to a recent report from the Office for National Statistics. “Explanation beyond exchange rates: trends in UK trade since 2007.

We would argue, it is only curious for those who choose to ignore history.

Much reference is made to the period 1990 – 1995 when the last “great depreciation led to an improvement in the balance of payments” – allegedly. Analysing the trade in goods data [BOKI] from the ONS own report demonstrates the failure of depreciation to improve the net trade in goods performance in the period 1990 – 1995.

Despite the fall in sterling, the inexorable structural decline in net trade in goods continued throughout. As we have long argued would be the case, in the most recent episode. Demand co-efficients are powerful, the price co-efficients much weaker and almost inelastic with regard to imports. Check out the slide show below for more information.

The conclusions from the ONS report do not add up. Curiouser and Curiouser, policy makers just like Alice, sometimes choose to believe in as many as six impossible things before breakfast.

A brief history of devaluation from 1925 onwards….

The great devaluation of 1931 – 24%

In 1925, the dollar sterling exchange rate was $4.87. Britain had readopted the gold standard. Unfortunately, the relative high value of the pound placed considerable pressure on the trade and capital account, the balance of payments problem developed into a “run on the pound”. The UK left the gold standard in 1931, the floating pound quickly dropped to $3.69, providing an effective devaluation of 24%. The gain, if such it was, could not be sustained. Over the next two years, confidence in the currency returned, the dollar weakened, sterling rallied in value to a level of $5.00 but…Fears of conflict in Europe placed pressure on the sterling. In 1939, with the outbreak of World War II the rate dropped to $3.99 from $4.61. In March, 1940, the British government pegged the value of the pound to the dollar, at $4.03.

The great devaluation of 1949 – 30%

Post war, Britain was heavily indebted to the USA. Despite a soft loan agreement with repayments over fifty years, the pound remained once again under intense pressure In 1949 Stafford Cripps devalued the pound by over 30%, giving a rate of $2.80.

The great devaluation of 1967 – 14%

In 1967 another “balance of payments” crisis developed in the British economy with a subsequent “run on the pound. Harold Wilson announced, in November 1967, the pound had been devalued by just over 14%, the dollar sterling exchange rate fell to $2.40. This the famous “pound in your pocket” devaluation. Wilson tried to reassure the country by pointing out that the devaluation would not affect the value of money within Britain.

In 1971, currencies began to float, depreciation not devaluation became the guideline

In 1977, sterling fell against the dollar with pound plummeting to a low of $1.63 in the autumn 1976. Another sterling crisis and a run on the pound. The British government was forced to borrow from the IMF to bridge the capital gap. The princely sum of £2.3 billion was required to restore confidence in the pound.

By 1981, the pound was trading back at the $2.40 level but not for long. Parity was the pursuit by 1985 as the pound fell in value to a month low of $1.09 in February 1985.

In the late 1980s, Chancellor Lawson was pegging the pound to the Deutsche Mark to establish some form of stability for the currency. In October of 1990, Chancellor Major persuaded Cabinet to enter the ERM, the European Exchange Rate Mechanism. The DM rate was 2.95 to the pound and $1.9454 against the dollar.

Less than two years later, Britain left the European experiment.

The strains of holding the currency within the trading band had pushed interest rates to 12% in September, with some suggestions that rates would have to rise to 20% to maintain the peg.

In September 1992, Chancellor Lamont announced the withdrawal from the ERM. The Pound fell in value against the dollar from $1.94 to $1.43, an effective depreciation of 26%. According to the wider Bank of England Exchange rate the weighted depreciation was 15%.

The chart below shows GBPUSD since 1953, it doesn’t capture everything mentioned above but it highlights the volatility and terminal decline of the world’s ex-reserve currency:-

Cable since 1953

Source: FX Top

Reform, reform, reform

The UK needs to renegotiate terms with the EU as quickly as possible in order to minimise the damage to UK and global economic growth. I believe there are four options: –

EEA – the Norwegian Option

Pros

Maintain access to the Single Market in goods and services and movement of capital.
Ability to negotiate own trade deals.
Least disruptive alternative to EU membership.

Cons

Commitment to free movement of people and the provision of welfare benefits to EU citizens.
Accept EU regulation but have no influence over them.
Must comply with “rules of origin” – which impose controls on the use of products from outside the EU in goods which are subsequently exported within the EU. The cost of determining the origin of products is estimated to be at least 3.0% – the average tariff on goods from the US and Australia is 2.3% under World Trade Organisation (WTO) rules.
Comply with EU rules on employment, consumer protection, environmental protection and competition policy.
Pay an annual fee to access the Single Market, although less than for full EU membership.

EFTA – the Swiss Option

Pros

Maintain access to the Single Market in goods.
Ability to negotiate own trade deals.
Greater independence over the direction of social and employment law.

Cons

Commitment to free movement of people.
Must comply with “rules of origin”.
Restricted access to the EU market in services – particularly financial services.

WTO – the Default Option

Pros

Subject to Most Favoured Nation tariffs under WTO guidelines. In 2013, the EU’s trade-weighted average MFN tariff was 2.3% for non-agricultural products.
Ability to negotiate own trade deals.
Independence over legislation.

Cons

Tariffs on agricultural products range from 20% to 30%.
Tariffs for automobiles are 10%.
Services sector would face higher levels of non-tariff barriers such as domestic laws, regulations and supervision. Services made up 37% of total UK exports to the EU in 2014 – the WTO option will be costly.

Bilateral Free-Trade Agreement – the Canadian Option

Pros

Negotiate a bilateral trade agreement with the EU – sometimes called the Canada option after the, still unratified, Comprehensive Economic and Trade Agreement (CETA).

Cons

Must comply with “rules of origin” – if it mirrors the CETA deal.
Services are only partially covered.
Negotiations may take years.

The quickest solution would be the WTO default option, the least cathartic would be to join the EEA. I suspect we will end up somewhere between these two extremes; The Peterson Institute – Theresa May—More Merkel than Thatcher? Is of a different opinion:-

To survive politically at home, May must deliver Brexit at almost any cost, suggesting that she might well in the end be compelled to accept a “hard Brexit” that puts the UK entirely outside the internal market. Lacking a public mandate in a fractious party that retains only a slim parliamentary majority, May not surprisingly opposes new general elections, which would focus on Brexit and thus easily cost the Conservatives their majority, along with their new prime minister’s job. Unless the UK suffers substantially additional economic hardship in the coming years, the next UK elections may well occur as late as 2020.

For the financial markets there is a certain elegance in the “hard Brexit” WTO option. Uncertainty is removed, unilateral trade negotiations can be undertaken immediately and the other options remain available in the longer term.

Beyond renegotiation with the EU there is a broader reform agenda. Dust off your copy of Hayek’s The Road to Serfdom, this could see a return to the liberal policies, of smaller government and freer trade, which we last witnessed in the 1980’s. The IEA’s Ryan Bourne wrote an article this week for City AM – Forget populist executive pay curbs: Prime Minister May should embrace these six policies to revitalise growth in which he advocated:-

1) Overhaul property taxation: the government should abolish both council tax and stamp duty entirely and replace them with a single tax on the “consumption” of property – i.e. a tax on imputed rent. It is well known among economists that taxes on transactions like stamp duty are highly damaging, and we have already seen the high top rates significantly slow transactions since April.

2) Abolish corporation tax entirely: profit taxes discourage capital investment by lowering returns, which makes workers less productive and results in lower wage growth. In a globalised world, profits taxation also encourages capital to move elsewhere, both because it makes the UK less attractive as a location for “real” economic activity and because it creates incentives for avoidance through complex business structures. Rather than continuing this goose chase, let’s abolish it entirely and tax dividends at an individual level, as Estonia does.

Read more: Ignore Google’s corporation tax bill and scrap the tax altogether

3) Planning liberalisation: if you ask anyone to name the UK’s main economic problems, you’ll probably hear “poor productivity performance”, “a high cost of living” and “entrenched economic difficulties in some areas”. Constraining development through artificial boundaries and regulations is acknowledged to be a key driver of high house price inflation. Less acknowledged is that, for sectors like childcare, social care, restaurants and even many office-based industries, high rents and property prices raise other prices for consumers, with a dynamic strain on our growth prospects brought about by a reduction in competition and innovation. That’s not to mention the impact on labour mobility. Liberalisation of planning, including greenbelt reform – which May has sadly already seemingly ruled out – is probably the closest thing to a silver bullet as far as productivity improvements are concerned.

4) Sensible energy policy: the UK government has gone further than many EU countries on the “green agenda”. But the EU’s framework, with binding targets for renewables, has certainly helped shape policy in the direction of subsidies and subsidy-like obligations and interventions. Even if one accepts the need to reduce carbon emissions, an economist would suggest the implementation of either a straight carbon tax or, less optimally, a cap-and-trade scheme, rather than the current raft of interventions which make energy more expensive than it need be.

5) Agricultural liberalisation: exiting the EU Common Agricultural Policy gives us the opportunity to reassess agricultural policy. The UK should gradually phase out all subsidies, as New Zealand did, opening up the sector to global competition. This improved agricultural productivity in that country significantly. Combined with a policy of unilateral free trade, it would deliver substantially lower food prices for consumers too.

6) Deregulation: in the long term, Britain should extricate itself from the Single Market and May should set up a new Office for Deregulation, tasked with examining all existing EU laws and directives, with the clear aim of removing unnecessary burdens and lowering costs. In particular, this should focus on labour market regulation, financial services, banking and transport

In a departure from my normal focus on the nexus of macroeconomics and financial markets I wrote a reformist article last week for the Cobden Centre – A Plan to Engender Prosperity in Perfidious Albion – from Pariah to Paragon; in it, I made some additional reform proposals:-

Banking Reform: The financialisation of the UK economy has reached a point where productive, long term capital investment is in structural decline. Increasing bank capital requirements by 1% per annum and abolishing a zero weighting for government securities would go a long way to reversing this pernicious trend.

Monetary Reform: The key to long term prosperity is productivity growth. The key to productivity growth is investment in the processes of production. Interest rates (the price of money) in a free market, act as the investment signal. Free banking (a banking system without a lender of last resort) is a concept which all developed countries have rejected. Whilst the adoptions of Free banking is, perhaps, too extreme for credible consideration in the aftermath of Brexit, a move towards the free-market setting of interest rates is desirable to attempt to avert any further malinvestment of capital.

Labour Market Reform: A repeal of the Working Time Directive and the Agency Workers Directive would be a good start but we must resist the temptation to close our borders to immigration. Immigrants, both regional and international, have been essential to the economic prosperity of Britain for centuries. There will always be individual winners and losers from this process, therefore, the strain on public services should be addressed by introducing a contribution-based welfare system that ensures welfare for all – migrants and non-migrants – contingent upon a record of work.

Educational Reform: investment in technology to deliver education more efficiently would yield the greatest productivity gains but a reform of the incentives based on individual choice would also help to improve the quality of provision.

Free Trade Reform: David Ricardo defined the economic law of comparative advantage. In the aftermath of the UK exit from the EU it would be easy for the UK to slide towards introspection, especially if our European trading partners close ranks. We should resist this temptation if at all possible; it will undermine the long term productivity of the economy. We should promote global free trade, unilaterally, through our membership of the World Trade Organisation. In the last 43 years we have lost the art of negotiating trade deals for ourselves. It will take time to reacquire these skills but gradual withdrawal from the EU by way of the EEA/EFTA option would give the UK time to adjust. The EEA might even prove an acceptable longer term solution. I suspect the countries of EFTA will be keen to collaborate with us.

We should apply to rejoin the International Organization for Standardization , the International Electrotechnical Commission , and the International Telecommunication Union (all of which are based in Geneva) and, under the auspices of EFTA, we can rejoin the European Committee for Standardization (CEN), the European Committee for Electrotechnical Standardization (CENELEC), the European Telecommunications Standards Institute (ETSI), and the Institute for Reference Materials and Measurements (IRMM).

Conclusion

Financial markets will remain unsettled for an extended period; domestic capital investment will be delayed, whilst international investment may be cancelled altogether. If growth slows, and I believe it will, further easing of official interest rates and renewed quantitative easing are likely from the BoE. Gilts will trade higher, pension funds and insurance companies will continue to purchase these fixed income assets but the BoE will acquire an ever larger percentage of outstanding issuance. In 2007 Pensions and Insurers held nearly 50%, with Banks and Building Societies accounting for 17% of issuance. By Q3 2014 Pensions and Insurers share had fallen to 29%, Banks and Building Societies to 9%. Over seven years, the BoE had acquired 25% of the entire Gilt issuance.

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

July 3, 2015 by In the long run

Which way now – FTSE, Gilts, Sterling and the EU referendum?

Macro Letter – No 39 – 03-07-2015

Which way now – FTSE, Gilts, Sterling and the EU referendum?

Uncertainty is bad for business and the UK will struggle ahead of the referendum
Gilt yields have been around 150bps higher than Bunds over the last 25yrs
The DAX has substantially outperformed FTSE over the same period
Higher productivity is key to UK growth but, in the long run, demographics will help

Last week the UK Prime Minister began to debate EU treaty reform with his European counterparts. He has a long way to go. The deadline for a UK referendum on EU membership is the end of 2017 but an up-hill battle is likely because all EU countries must ratify treaty changes – the referendum will come before EU treaty changes have been agreed. In this letter I will review the history of UKs, uncomfortable, membership of the EU and previous renegotiations, compared with today’s proposals. I will then go on to consider the implications for Sterling, Gilts and UK Stocks should the UK decide to stay or go.

A brief history of the UK and the EU

The last time the UK voted on EU, or as it was then called, European Economic Community (EEC) membership, was in 1975. At that time the “yes” vote won by 67.5%. This took place only two years after first joining, previous attempts to join in 1961 and 1967 having been vetoed by French President de Gaulle.

British scepticism about the political ambitions of the Schuman declaration of May 1950 meant the UK failed to join the European Coal and Steel Community – established at the Treaty of Paris in 1951 – but spent much of the decade debating EEC membership. When the EEC was finally established in 1958, the UK opted out for two principal reasons: concern about its relationship with the Commonwealth and other international alliances, and its preference for free-trade over economic organisation and sectoral policies. At that time the UK was torn between two foreign policy strategies, one focused on the European Free Trade Area, the other on the General Agreement on Tariffs and Trades – the predecessor to the World Trade Organisation (WTO).

The 1974 treaty renegotiation, just a year after joining the EEC, was driven by three factors: free-trade versus political integration, the effects of the collapse of Bretton Woods and subsequent inflation on the UK economy – Sterling had been considered a quasi-reserve currency up to this point – and the size of UK contributions to the EEC budget which the UK government considered to be excessive.

The table below lists the 1974 UK government demands for renegotiation and the outcomes:-

DEMAND	OUTCOME
Changes to CAP so as not to undermine free-trade	None
Fairer financing of EEC budget	Correcting mechanism
Withdrawal of UK from EMU	Accepted
Retention of UK powers over regional, industrial and fiscal policy	Creation of Regional Development fund supported by Ireland and Italy
Agreement on capital movement to protect UK jobs and balance of payments	None
No harmonisation of VAT	Never planned anyway
Access to Commonwealth goods	Minor concessions

The next major test of the UK relationship with the EU came during Margaret Thatcher’s first Conservative government (1979-1983) although an agreement with the EEC was not reached until her second term in 1984. On this occasion the issue was simply a question of how much the UK was paying in to the EU budget given that 80% of that budget was then spent on maintaining the Common Agricultural policy (CAP). The UK “rebate” was sanctioned because at that time the UK was the second poorest of the ten member EEC.

UK demands for treaty change 2015

The current UK renegotiation of EU membership is concerned with the following issues:-

Restrictions to freedom of movement within the EU

Sovereignty of Sterling

Structural reform of the EU bureaucracy

Reclaiming of powers from Brussels to protect UK interests

On the latter point, this takes two principal forms: the ability to block EU legislation where it may be detrimental to UK interests and the ending of a commitment to “ever closer union” in respect of UK membership.

The Sovereignty of Sterling is a relatively uncontentious issue, whilst structural reform of the EU bureaucracy is an ideal to which all European governments will accede, at least in principal; the problems arise over restrictions on free-movement of people – enshrined in Article 48 of the Treaty of Rome:-

1.Freedom of movement for workers shall be secured within the Community by the end of the transitional period at the latest. 2. Such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the Member States as regards employment, remuneration and other conditions of work and employment. 3. It shall entail the right, subject to limitations justified on grounds of public policy, public security or public health: (a) to accept offers of employment actually made; (b) to move freely within the territory of Member States for this purpose; (c) to stay in a Member State for the purpose of employment in accordance with the provisions governing the employment of nationals of that State laid down by law, regulation or administrative action; (d) to remain in the territory of a Member State after having been employed in that State, subject to conditions which shall be embodied in implementing regulations to be drawn up by the Commission. 4. The provisions of this Article shall not apply to employment in the public service.

This leaves, the reclaiming of powers from Brussels. “Ever closer union” is probably negotiable since EU member states have always moved at different rates, both economically and culturally. Allowing the UK to pick and choose which aspects of EU legislation it accepts, however, is like joining an exclusive club and then ignoring the rules. Under normal circumstances you’d be asked to leave.

One of the associated problems for the EU – that of, when to stop expanding – is discussed in this essay by Tim Price – Let’s Stick Together. He reviews the work of Leopold Kohr, in particular his seminal work “The Breakdown of Nations”:-

It all comes down to scale. As Kirkpatrick Sale puts it in his foreword to ‘The Breakdown of Nations’,

“What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.”

Kohr showed that there are unavoidable limits to the growth of societies:

“..social problems have the unfortunate tendency to grow at a geometric ratio with the growth of an organism of which they are a part, while the ability of man to cope with them, if it can be extended at all, grows only at an arithmetic ratio.”

In the real world, there are finite limits beyond which it does not make sense to grow. Kohr argued that only small states can have true democracies, because only in small states can the citizen have some direct influence over the governing authorities.

What’s in it for the UK

In the interests of levity I’ve included a link to this summation of UK foreign policy with regard to Europe from the satirical TV programme Yes, Minister – this episode was first aired in 1980.

In the intervening 35 years, trying to decipher what is best for the UK has not become any easier. I’ve chosen just two organisations to represent the views for and against EU membership: Business for New Europe and Better off Out. Here’s how Business for New Europe make the case for staying in:-

As a member of the European Union, our companies can sell, without barriers, to a market of 500 million people. The Single Market means that exporters only need to abide by one set of European regulations, instead of 28 national ones. Europe is our biggest trading partner- it buys 45% of our exports. If we left the EU, companies would face tariffs and regulatory barriers to trade.

The free movement of capital means that EU companies can invest here in Britain freely. This investment, by companies like Siemens, creates jobs and grows our economy. 46% of all the foreign investment in Britain came from EU countries.

The EU provides funding for businesses to all regions of Britain, particularly those with the greatest need. From 2014 until 2020, £8 billion of EU money will go from Brussels to the UK. The biggest winners from this process are Cornwall, Wales, the Scottish Highlands, Northern Ireland and the North of England.

EU research funding helps universities and firms innovate to create the technologies of the future. Britain will receive £7 billion from the EU’s Horizon 2020 fund, and our small businesses receive more funding for hi-tech research than those of any other EU country. EU membership is vital to rebalancing the British economy.

Better off Out – sponsored by the Freedom Association – counter thus:-

10 Reasons to Leave

1.Freedom to make stronger trade deals with other nations. 2. Freedom to spend UK resources presently through EU membership in the UK to the advantage of our citizens. 3. Freedom to control our national borders. 4. Freedom to restore Britain’s special legal system. 5. Freedom to deregulate the EU’s costly mass of laws. 6. Freedom to make major savings for British consumers. 7. Freedom to improve the British economy and generate more jobs. 8. Freedom to regenerate Britain’s fisheries. 9. Freedom to save the NHS from EU threats to undermine it by harmonising healthcare across the EU, and to reduce welfare payments to non-UK EU citizens. 10. Freedom to restore British customs and traditions.

They go on to highlight 10 Myths about the risk of leaving – not all are economic so I’ve paraphrased their opinions below;-

Britain would lose 3mln jobs if we left the EU – Under the terms of the Lisbon Treaty the UK would enter into an FTA with the EU. The WTO obliges them to do so too. Of more importance the UK trade balance will the EU is in increasing deficit – the other member states have more to lose.

Britain will be excluded from trade with the EU by Tariff Barriers – EU has FTAs with 53 countries with a further 74 countries pending. In 2009 UK charged customs duty of just 1.76% on non-EU imports. The EU Common Market is basically redundant already.

Britain cannot survive economically outside the EU in a world of trading blocs – Japan does and it’s not a member. The EU’s share of world GDP is forecast to be 15% in 2020, down from 26% in 1980. Norway and Switzerland export more, per capita, to the EU than the UK does. Britain’s best trading relationships are with the USA and Switzerland. The largest investor in the UK is US.

The EU is moving towards the UK’s position on cutting regulation and bureaucracy – EU directives are subject to a ‘rachet’ effect – once in place they are unlikely to be reformed or repealed. 80% of the UK’s GDP is generated within the UK so should not be subject to EU laws. In 2010, Open Europe estimated EU regulation had cost Britain £124 billion since 1998.

If we leave, Britain will have to pay billions to the EU and implement all its regulations without having a say – The UK has 8.4% of votes. The Lisbon Treaty ensured the loss of Britain’s veto in many more policy areas.

Swiss Case Study: The Swiss pay the EU less than CHF600mln a year for access to the EU market. They estimate the cost of full membership would be CHF3.4bln.

Norway Case Study: In 2009 Norway’s total financial contributions to the EEA (European Economic Area) agreement was Eur340mln Britain pays £18.4bln per annum.

The EU has a positive impact on the British Economy – Fishing (115,000 jobs lost) farming, postal services and manufacturing have been devastated by EU membership. Unnecessary red tape, aid contributions, inflated consumer prices (due to CAP etc.) are indirect costs.

Britain will lose vital foreign investment as a consequence of leaving the EU – The 2010 Ernst and Young survey on UK’s attractiveness to foreign investors, found Britain still the number one Foreign Direct Investment (FDI) destination in Europe owing largely to the City of London and the UK’s close corporate relationship with the US. Key factors, in order of importance:-

Culture and values, English language, Telecommunications infrastructure, Quality of life, Stable social environment, Transport and logistics infrastructure.

Britain will lose all influence in the world by being outside the EU – Britain has a substantial ‘portfolio of power’ including membership of the G20 and G8, a permanent seat on the UN Security Council and seats on the IMF and WTO. The British Commonwealth has 54 nations which is being discriminated against by EU policy. London is the financial capital of the world and Britain has the sixth largest economy. The UK is also in the top ten manufacturing nations in the world.

Legally, Britain cannot leave the EU – A single clause Bill passed at Westminster can repeal the European Communities Act 1972 and its attendant Amendment Acts.

Having dealt with the main arguments for remaining in the EU, Better off Out do point out that creating an FTA with the EU may take time.

Greenland established a precedent when it left the EEC in 1985, this followed a referendum in 1982 and the signing of the Greenland Treaty in 1984. It had joined, as part of Denmark in 1973 but after it had achieved home rule in 1979 the importance of its fishing industry became a major economic incentive for it to leave the forerunner to the EU.

Greece may leave as early as next week and, as this March 2015 article from ECFR – The British problem and what it means for Europe makes clear, a Brexit will not be good for the EU either:-

An EU without Britain would be smaller, poorer, and less influential on the world stage. The UK makes up nearly 12.5 percent of the EU’s population, 14.8 percent of its economy, and 19.4 percent of its exports (excluding intra-EU trade). Furthermore, it runs a trade deficit of £28 billion, is home to around two million other EU citizens, and remains one of the largest net contributors to the EU budget (responsible for 12 percent of the budget in total).

Meanwhile the Confederation of British Industry claim that being a member of the EU is worth £3,000 per household whilst Business for Britain estimate that the UK would save £933 per person from cheaper food if they left. In a report last week S&P chimed in, saying 30% of foreign direct investment (FDI) into the UK – representing 17% of GDP – was directed to financial services and insurance. 50% of this FDI emanated from other EU countries – this could be at risk if the UK should leave. So the debate rumbles on.

How is the UK economy evolving?

UK manufacturing has been in decline since the start of the millennium, whilst this decline was initially a reaction to the strength of Sterling it has yet to benefit from the subsequent weakness of the currency:-

Source: ERC, IMF, UN

Total factor productivity is near the heart of this conundrum:-

Source: ERC, ONS

The UK is lying 6th out of the G7 in terms of output per hours worked, and since 2007, has underperformed the G7 average. The dotted line shows where productivity would have been had the recession not hit. The UK had been lagging its peers during the 1990’s so the predicted outperformance would merely have brought it back into the fold.

In a speech given last week the BoE’s Sir John Cunliffe – Pay and productivity: the next phase made a number of observations about the future:-

Between 2000 and 2007, the average worker in the UK automotive manufacturing industry produced 7.7 vehicles a year. Over the past seven years he/she averaged 9.8 vehicles a year. Productivity – output per worker – in car manufacturing has increased by 30% since the onset of the great financial crisis. Britain has become the fourth-biggest vehicle maker in the EU and is more efficient than bigger producers such as Germany and France.

… Unfortunately productivity in the UK has not followed the lead of the car industry. Indeed, the opposite is true. In 2014 labour productivity in the UK was actually slightly lower than its 2007 level. In the seven years between 2000 and 2007 labour productivity grew at an average annual rate of about 2% a year. In the seven years that followed, our annual productivity growth averaged just below zero.

Or to look at it another way, the level of labour productivity – output per hour worked – in the UK economy is now 15% below where it would have been if pre-crisis trends had continued.

…It is true that the average output per hour of the rest of the G7 advanced economies is only around 5% above its pre-crisis level. But as I have noted, in the UK it has not even recovered to that level. And in 2013 output per hour in the UK was 17 percentage points below the average for the rest of the G7 – the widest gap since 1992.

…In the 10 years prior to the crisis, growth in the hours worked in the UK economy, accounted for 23% of the UK’s overall economic growth. The mainstay of our economic growth, the other 77%, came from growth in productivity. Since 2013 only 9% of our annual economic growth has come from productivity improvement. The remaining 91% has come from the increase in the total hours worked.

As a result, employment in the UK is now around its highest rate since comparable records began in 1971. Over 73% of people aged 16-64 are working. There are now over 31 million people in work in the UK. Unemployment has fallen at among its fastest rate for 40 years and is now very close to its pre-crisis level – over the past two years over 1 million jobs have been created.

… Productivity growth can be divided into two sorts of change: the change in productivity inside individual firms and the changes between firms. The first, the changes within firms, happens as firms increase their efficiency. The second happens as labour and capital are reallocated between firms, from the less productive ones to the more productive.

… After collapsing in the crisis, productivity began to increase again within firms two years ago. We expect that to continue. As the economy grows, spare capacity is used up. The real cost of labour increases relative to the cost of investment. Firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.

In contrast, productivity growth due to the reallocation of resources in the economy remains weak. We can see this in the divergence of rates of returns across firms which remain remarkably and unusually high and the change in capital across sectors which has been particularly low. When the reallocation mechanism is working, the transfer of capital and labour from the less productive to the more productive pulls up the level of productivity in the economy and reduces the divergence between firms. The high degree of divergence between firms at present implies that this reallocation mechanism is working significantly less powerfully now than before the crisis. This can also be seen in the proportion of loss-making firms which stands at around 20% higher than its long-run average. Company liquidations also remain low. So there is still more than a hint of ‘zombiness’ in the corporate sector.

For more on productivity issue this working paper BoE – The UK productivity puzzle 2008–13: evidence from British businesses is full of interesting insights.

The UK service sector continues to grow, although its share of exports to the EU remains smaller than that of goods – 37% vs 49%. Services exports to the rest of the world are the driver of UK export growth.

Conclusion and Investment Opportunities

Sterling

In search of a surrogate for the uncertainty surrounding the UK referendum, the chart below shows the impact on Sterling of the sudden realization that the Scottish might vote to leave the Union in 2014:-

Source: Oanda and ERC

Should the population of the UK vote to forsake the EU, the relative stability of the GBPEUR exchange rate is likely to become structurally more volatile, the move against the USD from 1.72 to 1.61 is but a foretaste of what we should anticipate. However, the 40% appreciation in the UK effective exchange rate between 1995 and 2000 – see the earlier chart above – and reversal between 2000 and 2009, suggests that membership of the EU has not led to the stability in exchange rates one might have expected.

Between the breakdown of Bretton Woods in March 1973 and the establishment of the European Exchange Rate Mechanism (ERM) In March 1979 (which the UK chose not to join until October 1990) was a period of intense currency volatility – exacerbated by significant interest rate differentials. During this period the GBP effective exchange rate actually moved less than it has since 2000. Nonetheless, higher daily volatility will impose a modicum of additional cost on UK businesses. This 2004 paper from the FRBSF – Measuring the Costs of Exchange Rate Volatility looks at the subject in more detail:-

The main quantitative finding is that the welfare effects of exchange rate volatility are likely to be very small for many countries. When numbers are chosen to permit the model to reproduce basic characteristics of the U.S. economy, the model indicates that the loss of utility is equal in size to only about 0.1% of annual consumption; that is, people would be willing to exchange only about 0.1% of their annual consumption level to eliminate the exchange rate volatility in the economy.

Gilts

The UK has exhibited structurally higher inflation than much of the Eurozone (EZ) since the collapse of Bretton Woods. That, combined with the relative asynchronicity of the UK and German economic cycles, made it difficult for the UK to operate inside the ERM – it lasted less than two years, from October 1990 to September 1992. The chart below shows German and UK 10yr Government bond yields during this period, Bunds, with lower yields, on the right hand scale:-

Source: Trading Economics

Germany was struggling during this period and the Hartz labour market reforms occurred shortly thereafter.

Source: Trading Economics

As the chart above shows UK Gilts have traded at a higher yield than German Bunds for most of last 25 years. I think it would be reasonable to assume Gilt yields, had the UK remained in the ERM and joined the Euro, would have been between those of Germany and France during this period. In other words, the cost of UK government financing has been around 150bp higher than it might have achieved had it joined the EZ.

UK inflation over the same period has been significantly higher than Germany’s, in real-terms Bunds have offered vastly superior returns. This differential may also be due to the UK government running a substantially larger budget deficit during the period. I regret the data in the chart below only goes back to 1996. The UK balance is shown on the right hand scale:-

Source: Trading Economics

Stocks

The chart below shows the relative performance of the FTSE100 vs Germany’s DAX40 since 1990. The German market (right hand scale) has increased from 2,000 to 12,000 whilst the UK market has risen from 2,000 to 7,000. Germany has been the clear winner of this race:-

Source: Trading Economics

Would the UK stock market have fared better inside the EZ and would the UK departure from the EU be detrimental or positive to stock performance going forward? Here is the 1990-2015 comparison between FTSE100 and the French CAC40 index:-

Source: Trading Economics

Germany appears to be something of an exception, France, Italy and the Netherlands have underperformed the UK during the same period: although Spain has delivered German-like returns. It is worth mentioning that Germany has run a balance of trade surplus for the entire period 1990 – 2015 whilst, excepting a brief period between 1991 and 1997, the UK has run a continuous trade deficit.

I don’t believe UK membership of the EU has much influence over the value of UK stocks in aggregate. Certain companies benefit from access to Europe, others are disadvantaged.

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign. The chart below shows UK GDP by sector since 2008. Services stand out both in terms of their resilience to the effects of the recession and continued growth in its aftermath, it is now 8.5% higher than before the recession, all the remaining sectors languish below their 2008 levels. Improving total factor productivity is key:-

Source: ERC and ONS

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

Longer term the demographic divergence between the UK and other countries of Europe will become evident. By 2060 the working age population of the UK is projected to increase from 37.8mln (2013) to 41.8mln whilst in Germany the same population will decline from 49.7mln to 35.4mln. The EC – Ageing Report 2015 – has more details. The UK can benefit from staying in the EU and continuously negotiating. However, it must become much more involved in the future of the EU project, including “ever closer union”. It can also benefit from “Brexit”, directly flattering the government’s bottom line. The worst of both worlds is to remain, as the UK has since 1950, sitting on the fence –decisiveness is good for financial markets and the wider economy.

January 31, 2014 by In the long run

Whither the UK – From Tantalus to Sisyphus?

Macro Letter – No 4 – 31-01-2014

Whither the UK – From Tantalus to Sisyphus?

It has been a long time since I have reviewed the UK economy and the prospects for our financial markets but the recent spate of positive economic news deserves investigation.

Sterling

To begin I have enclosed a chart of GBP/USD. You will notice that despite a significant strengthening of GBP, in line with the improving economic data, we still have a distance to travel before returning to the pre-Northern Rock range. The near-term trend looks clear but a comprehensive break above 1.70 is required for confirmation.

GBP/USD FX 10yr – source fxtop.com

To understand why GP/USD may return to its pre-crisis range one needs to consider why it has been languishing in purgatory since 2008/2009. Partly this is due to the size of the UK financial services sector, where regulatory headwinds remain fierce, and partly the direction of long-term interest rates globally. Here is a chart of 10 year Gilt yields:-

10yr Gilt yield – 10yr Monthly – source investorsintelligence.com Stockcube Research Ltd

Of course short and long term interest rates have declined in most countries since the Great Recession but traditionally GBP was a “carry-currency” due to our structurally higher inflation rates. The “sea-change” in interest rate differentials has seen the “carry-trader” depart this sceptre isle. There are a number of other factors including the arrival of a coalition government in 2010, a significant decline in the UK housing market and a collapse in the UK export sector, despite the precipitous decline of sterling against its trading partners. Financial services went out of fashion and North Sea oil and gas production took an unfortunate nose-dived simultaneously.

The chart below showing the GBP Trade-Weighted Index is from Ashraf Laidi . It is a couple of years old but it’s still valid, the annotation is his:-

Source – AshrafLaidi.com

Gilts

Looking at the chart of 10 year Gilt yields above, you will notice that yields bottomed in mid-2012 whilst GBP/USD took until 2013 to begin its recovery. The external factor driving Gilt yields to their nadir was the Eurozone crisis, however, since Draghi’s “whatever it takes” speech (July 26^th 2012) Gilt yields have begun to normalise in a similar manner to the US. Meanwhile Eurozone rates have converged lower and German 10 year Bund rates have remained relatively low.

Looking ahead it is not unreasonable to expect Gilt yields to go higher, but, with GBP rising and inflation falling this is likely to be a gradual process; added to which the Bank of England (BoE) have been softening their tone on prospective interest rate increases.

Here’s a quote from MPC member Ben Broadbent speaking at the LSE on 17^th January: –

The final and more general point is to caution against inferring too much about future growth from its current composition. Of course there’s a risk the recovery could falter. But, if it does, it will probably be because of more fundamental problems – a failure of productivity to respond to stronger demand, for example, or continuing stagnation in the euro area – not any imbalance in expenditure or income per se. These are outcomes, not determinants, of the economic cycle. As we shall see, they are poor predictors of future growth.

http://www.bankofengland.co.uk/publications/Pages/news/2014/024.aspx

On 23^rd January Ian McCafferty reiterated the MPC’s position on rates: –

…the MPC sees no immediate need to increase interest rates, even if unemployment reaches 7% in the near future.

McCafferty goes on to discuss capital expenditure which, along with productivity growth, has been weak during the early stages of the recovery.

http://www.bankofengland.co.uk/publications/Pages/news/2014/027.aspx

Also on 23^rd January MPC memberPaul Fisher, after explaining why the BoE allowed inflation to remain above target for so long, went on to opine: –

We are very conscious that the headwinds have not gone away: much of Europe and some other parts of the world continue to struggle for sustained growth; fiscal consolidation in the UK (and elsewhere) is likely to continue for a while to come; and the financial sector still needs some rebuilding. Indeed, the official production and construction data released earlier this month were rather disappointing, reminding us that strong growth from here on is by no means guaranteed.

http://www.bankofengland.co.uk/publications/Pages/news/2014/028.aspx

Fisher goes on to explain that unemployment, and the composition of employment, are key metrics in their thought process. The whole speech is also a fascinating insight into the MPCs approach and their ideas on forward guidance.

BoE Governor – Mark Carney addressed the CBI at Davos on 24^th January: he discussed the UK economy and the need to reach “escape velocity”: –

After the Great Moderation and the Great Recession, there are several reasons why it will be years before any superlatives are attached to this recovery.

First, for all the talk of austerity and deleveraging, the aggregate debt burdens of advanced economies have actually increased; with their total non-financial sector debt rising by 25% relative to GDP since 2007. Balance sheet repair in the public and private sectors will exert a persistent drag on major economies for some time.

Second, the need to rebalance demand from deficit to surplus countries endures. Given the adjustment pressures on the former, without progress on rebalancing, robust and sustainable global growth will remain an aspiration.

Third, confidence, while improved, remains subdued. Recognising that the end isn’t nigh is far from marking the normalisation of business and consumer sentiment. Given past shocks and modest prospects, business investment in particular remains hesitant across the advanced world. On balance, corporations remain more focused on reducing operating expenditures than increasing capital expenditures.

… Nevertheless, it appears that the recovery will need to be sustained for a period before productivity gains can resume in earnest. The latest data show that more than a quarter of a million jobs were created in a three-month period – the biggest increase since records began in 1971. As a result, unemployment seems to be falling at a pace that will reach our 7% threshold materially earlier than we had expected.

Crucially, unemployment remains above the level that is likely to be consistent with maintaining inflation at the target in the medium term. It is not just that nearly three quarters of a million more people are out of work than before the crisis; another three quarters of a million more people are involuntarily working part time.

The effect of this slack in the labour market is evident in wage inflation, which is at around 1% so that, even with weak productivity, unit labour cost growth remains below 2%.

http://www.bankofengland.co.uk/publications/Pages/speeches/2014/705.aspx

All of these comments concerning lack of productivity growth, elevated levels of unemployment, growth of part-time employment, lack of capital expenditure and international headwinds from the Eurozone, suggest that interest rates will stay low and the BoE will risk above target inflation to insure the economic recovery broadens and deepens. In this environment I see Gilts remaining in a relatively narrow range, even if inflation ticks higher once more.

Politics

On 29^th January, Mark Carney spoke in Edinburgh on The economics of currency unions. The full speech is here: –

http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech706.pdf

He attempted to be deliberately non-political – to judge by the press comment afterwards he failed – but it is a timely reminder that Scotland will vote on whether they remain in the Union on 18^th September. The uncertainty surrounding the possible break-up of the Union and one what economic terms is another factor which will temper a broader based recovery.

Other political clouds on the horizon include the European Parliament elections (22^nd to 25^th May) where nationalist parties are expected to gain significant ground.

Equities

The FTSE100 has performed strongly since the beginning of 2013, in line with other developed country stock markets. The large dose of QE delivered by the BoE has underpinned this trend, but, now that the economy has regained some upward momentum, many commentators are becoming doubtful about the prospects for UK stocks – after all, lower interest rates are one of the most powerful drivers of equity market performance.

Firstly, I believe UK-centric stock momentum is increasing, but a number of external factors will be supportive of the UK equity market: –

China has announced a rebalancing of their economy towards domestic consumption, even if this is at the expense of headline GDP growth. This makes inward foreign investment into China less attractive – I expect capital to flow back to UK and USA.
Japan is attempting to deliver economic growth through what PM Abe has dubbed the “Three Arrows” policy, this has already seen a significant decline in the JPY and a new “quasi-carry trade” is being driven but expectation of relative government spending. The US has begun to taper (another $10bln just this week) and the UK might follow suit at some point this year, but Japan will continue with QE.
Emerging markets have already started to react to the changed policy of the Federal Reserve: India, beginning last year, Argentina, South Africa and Turkey, have seen their currencies depreciate and respond with higher interest rates since the start of the year. Emerging market bonds have, needless the say, fallen sharply, prompting international investors to liquidate some of their investments. The reversal of more than a decade of Capital flows to emerging markets will support developed country currencies, especially those, like the UK, with Capital account surpluses.

Secondly, UK Exports have remained resilient despite the strengthening of sterling.

Source – tradingeconomics.com

I have some caveats concerning UK equities however; banking and financial services firms are still under pressure due to regulatory change – a new report from United Nations Conference on Trade and Development (UNCAD) shows the UK falling to second place behind the USA; down more than 20% from its peak only seven years ago. The European Commission has just announced plans to stop all proprietary trading by Banks by 2017 – whilst this is likely to be challenged by UK, France and Germany it will lead to the postponement of any expansion plans in this area. Another sector which is under pressure is mining or commodity firms which are still suffering from the downturn in prices in 2013 – this tallies with my short-term concerns about emerging markets.

UK House Prices

A number of commentators have suggested that the recent strength of the UK economy has been largely driven by increased debt, especially mortgages. Government schemes such as “funding for lending” actively encouraged UK banks to lend more aggressively despite their balance sheet constraints.

MPC member David Mills, in a speech to the Dallas Federal Reserve, discussed housing last November:-

That problem with using monetary policy to stabilise the housing market would be acute if housing markets were overheating when the wider economy was not and consumer price inflation was low even though house price inflation was high.

…High leverage is at the heart of problems in housing market. Monetary policy and macro prudential policy can influence leverage. But more fundamentally, use of outside equity might be a way of permanently bringing down reliance upon debt financing.

http://www.bankofengland.co.uk/publications/Pages/news/2013/132.aspx

In other words the BoE is unlikely to be concerned about house price inflation and will use macroprudential measures rather than interest rates to stem its rise should it occur in isolation. This is clearly good for property but, in anticipation of the “Macroprudential Stick” other asset classes, such as equities, may benefit by association.

The housing market is finally recovering from the bottom up as the following chart makes clear: –

Source – Council for Mortgage Lenders

First time buyers have returned, perhaps because banks are more amenable about loan to value ratios but also because real house prices are well off their highs: –

Real House Prices since 1975 – source Nationwide Building Society

House price momentum appears to have turned higher once more – this chart, from MarketOracle.co.uk, uses data to November 2013:-

Source – MarketOracle.co.uk and Halifax

The December 2013 report from the Land Registry, published on 29^th January, shows continued improvement: –

http://www.landregistry.gov.uk/__data/assets/pdf_file/0020/71192/HPIReport20140122.pdf

Independent forecasts for UK property are strongly positive, here is a recent sampling:-

CBRE – 17% Rise by 2018 – Commercial property consultants

OBR – 20% Rise by end of 2018

Knight Frank – 24% rise by end of 2018 – Retail property specialists

Savills – 25% rise by end of 2018 – Retail property specialists

Why so strong? Because interest rates are low and therefore housing is relatively affordable. Here is one of my favourite measures of housing affordability from Moneystepper.com:-

UK Mortgage payment to income ratio – source Moneystepper.com

The author uses the Nationwide House Price Index, the BoE base rate plus 2% and the ONS after-tax income data.

For a more detailed investigation of the UK property market here is their post from November 2013, it’s the second of three articles:-

http://moneystepper.com/financial-planning/housing-bubble-uk-2/

Why Tantalus to Sisyphus?

Almost everything I’ve written so far has been positive for the UK economy and neutral or positive for UK markets. After unprecedented actions by the BoE, the “Tantalus Phase” appears to be over; growth that was just out of reach is now within our grasp, however, ahead of us lies the “Sisyphus Phase” where we have to pay the piper.

To begin with I want to look at money supply growth. Here is the Ratio of M4 to M0 from BoE data: –

Ratio of M4 to M0 – source Bank of England – John Phelan

An excellent article by John Phelan written for the Cobden Centre analyses this development in more detail: –

http://www.cobdencentre.org/2014/01/britains-inflationary-outlook

Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009.

This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.

This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.

A paper published in December 2013 by European Commission – The flow of credit in the UK economy and the availability of financing to the corporate sector – looks in more detail at the problem of the transmission of credit:-

http://ec.europa.eu/economy_finance/publications/economic_paper/2013/pdf/ecp509_en.pdf

They conclude on an optimistic note: –

The flow of credit in the UK economy may be close to turning a corner in connection with recent improvements in the macroeconomic outturns and outlook, and as banks finish adapting to a new regulatory environment. Improving access to finance for firms and SMEs is set to remain a crucial element for driving the desirable rebalancing of the UK economy, fomenting investment and fostering the reallocation of resources to the most productive sectors of the economy throughout the on-going recovery.

The BoE – Corporate Credit Conditions Survey – Q4 2013 – released earlier this month, also suggests this process is starting to happen:-

Overall credit availability to the corporate sector was reported to have increased significantly in 2013 Q4; lenders have now reported an increase in availability for five consecutive quarters. Lenders cited market share objectives, competition from capital markets and an improvement in the economic outlook as factors that had contributed significantly to the increase in availability. All these factors were expected to contribute significantly to availability in 2014 Q1.

http://www.bankofengland.co.uk/publications/Documents/other/monetary/ccs/creditconditionssurvey140108.pdf

Against this back-drop of improving conditions, however, it is important to realise that the combination of UK public and private sector debt is the second largest of any developed country on the planet relative to GDP – only Japan carries a greater burden. Academic research has shown that when the ratio of debt to GDP exceeds 260% to 275% this tends to act as a drag on economic growth.

The chart below is from 2012 but the situation has not improved.

Total Debt to GDP – source DailyMail – January 2012

UK Household debt is now at a record £1.43trln, although, it has fallen from 167% of income to 140% since 2008.

At some point in the future we will have a “reckoning” – probably when broad-based inflation begins to rise once more. Interest rates will rise dramatically to control credit growth. What the catalyst will be is difficult to say – a breakup of the Eurozone could lead to a collapse of GBP, the next major leg of a commodity super-cycle turbo-charged by the collapse of the Saudi regime – it’s best not to speculate, but, perhaps the longer term factor most likely to re-ignite the inflationary potential of the “great debasement” is demographic.

As the “Baby-boomers” finish retiring and downsizing the next leg of the demographic cycle will begin, with increased spending and consumption. When these “new-boomers” eclipse the “old-boomers” inflation will regain its power to decimate the value of money whilst at the same time asset prices will collapse under a deluge of foreclosures and debt default. The Sisyphian task will be to reduce the debt against the rising tide of servicing costs. But when will the next “Baby Boom” arrive?

Here is a fascinating chart from the ONS:-

UK Baby boom – source Office of National Statistics

According to ONS data, UK population growth to mid-2011 was the highest in 40 years. They predict that, should this trend continue, the UK will have the largest population of any country in Europe by 2050. Recent CML data shows the average age of first time house buyers to be 29/30 years. I therefore anticipate a “mini-baby boom” effect kicking in between 2015 and 2020, followed by a 10 year decline. From 2030 this pattern will reverse; by 2040 the next significant inflation wave will be in full swing.

This weekCharles Goodhart, speaking at the LSE predicted that “The Next Crisis” – which was the title of his speech – will occur around 2025/2026. Here’s the podcast, he starts his argument around 10 minutes in and make the case for 17 year cycles. Hence 2025/26 will see the next UK crisis which, he believes, will be more severe than the recent downturn due to a greater concentration on lending to the property sector, exacerbated by the regulatory curtailment of investment banking activity in favour of more traditional bank lending: –

http://www.lse.ac.uk/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=2219

My expectation is that during the remainder of this decade demographic forces will be somewhat supportive of inflation but attempts to deleverage UK debt after 2020 will have more deflationary consequences.

Conclusion

Sterling looks well placed to move back into its pre-crisis range. Gilts are caught between inflationary and deflationary forces and should remain range-bound. UK Equities are likely to benefit from inward capital flows and UK property looks better than ever – barring a significant change in UK planning laws, this is my preferred UK asset class for 2014, and probably beyond.

In the Long Run

Macroeconomics and the Markets

Gilts

A safe place to hide – inflation and the bond markets

European Bonds – warning knell or cause for celebration?

Is the “flight to quality” effect breaking down?

Uncharted British waters – the risk to growth, the opportunity to reform

Which way now – FTSE, Gilts, Sterling and the EU referendum?

Whither the UK – From Tantalus to Sisyphus?