Is the “flight to quality” effect breaking down?

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Macro letter – No 61 – 16-09-2016

Is the “flight to quality” effect breaking down?

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

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

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

zerohedge_-_100bp_move_in_yields

Source: ZeroHedge

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

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

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

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

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

Source: Fixed Income Investor, Investing.com

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

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

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

Source: Fixed Income Investor, Investing.com

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

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

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

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

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

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

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

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

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

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

Source: Market Axess, Investing.com

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

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

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

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

which-corporate-bonds-ecb3

Source: M&G Investments, ECB, Bloomberg

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

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

Source: BIS

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

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

 Conclusions and investment opportunities

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

Source: Wall Street Journal, Callan Associates

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

Dividends

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

dididend-yld-sandp

Source: Multpl.com

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

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

Source: TopYield.nl

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

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

Bond bear-market?

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

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How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

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Macro Letter – No 26 – 19-12-2014

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

  • Oil prices have fallen by more than 40% in H2 2014
  • Inflation expectations will be lowered further
  • US Growth should be higher longer-term
  • Near-term, contagion from the “energy bust” is under estimated by the market

 

With the recent collapse in the price of crude oil it seems appropriate to review the forecasts for inflation and growth in the US. Earlier this week, during an interview with CNBC, Bill Gross – ex-CIO of PIMCO – suggested that US growth would be around 2% going forward rather than the 3% to 4% seen in the recent past. The Atlanta Fed – Now GDP forecast for Q4 2014 was revised up to +2.2% from +2.1% on 11th December. This is higher than the Conference Board – Q4 GDP forecast of 2.0% from 10th December, here is their commentary:-

The U.S. growth momentum may pause in the fourth quarter, due to some special circumstances. The outlook for early 2015 shows some upside beyond the 2.5 percent pace. And this is despite continued slow economic growth around the world and a rise in the value of the dollar. The biggest disappointment right now is business spending on equipment which is slowing from an average pace of 11 percent over the past two quarters. But if final demand picks up as expected, business investment might also gain some momentum. One key driver of demand is continued improvement in the labor market. Job growth has been solid for the past year and the signal from the latest reading on The Conference Board Employment Trends Index™ (ETI) is that it will continue at least over the very near term. In fact, continued employment gains are likely to lead to better gains in wages in the first half of 2015. Job and income growth may provide some moderately positive momentum for the housing market. Low gasoline prices will also further support household spending. Finally, very low interest rates, at both the short and long end of the yield spectrum help consumers and businesses. The strengthening of domestic growth is intensifying pressures to increase the base interest rate, but speed and trajectory remain important questions.

There is a brief mention of the fall in gasoline prices and hopes for increased domestic demand driven by a better quality of jobs. Thus far official expectations have failed to shift significantly in response to the fall in oil. If the price remains depressed I expect these forecasts to change. The geographic make-up of US growth is quite skewed. The map below shows the breakdown of GDP growth by state in 2013:-

US GDP by State 2013

Source: Bureau of Economic Analysis

The predominant feature of many high growth states is strength of their energy sector. One state which has been a major engine of US employment growth in absolute terms, since the Great Recession, is Texas. In 2013 Texas jobs growth slowed from 3.3% to 2.5%. In percentage terms, it slipped into third place behind the stellar growth seen in North Dakota and Florida. Florida is an interesting indication of the process by which the drivers of growth are gradually switching away from the energy related impetus seen over the past few years. This article from the Dallas Fed – Texas to Remain a Top State for Job Growth in 2014 looks more closely at some nascent growth trends:-

Oil- and gas-producing states—leaders in the early years of the U.S. recovery—no longer predominated. This reflects the energy sector’s slowing expansion, although two states with the strongest shale activity, Texas and North Dakota, remained near the top. Meanwhile, several Sunbelt states hit hard by the housing crisis—Florida, Georgia and Arizona, for instance—are beginning to bounce back. In these states, employment remains significantly below the prerecession peak; in Texas, it is significantly above.

Texas is vulnerable, as are other energy rich US states, due to the weakness in the price of oil, however, Texas is also reliant on trade with Mexico for more than half of its exports. The down-turn in Mexican growth due to the weaker oil price, is an additional headwind for the “lone star” state.

You might expect this to be cause for some relief on the part of Richard Fisher – President of the Dallas Fed, yet, writing in mid-October in the Dallas Fed – Economic Letter – he remained, consistently hawkish on the prospects for inflation:-

The point is not that wage growth has been worrisomely high (it hasn’t been) or that we’re in imminent danger of a wage-price spiral (we likely aren’t). Rather, there’s nothing in the behavior of wage inflation over the course of the recovery to suggest that the unemploy­ment rate has been sending misleading signals about our progress toward full employment. A secondary point—a cau­tion, really—is that when trying to draw inferences about labor-market slack from the behavior of wages, it’s important to recognize that wage inflation’s response to slack is both nonlinear and delayed.

…Do we keep the accelerator pedal to the floor right up to the point where we reach our destination? Or do we ease up as we near our goal? The answer depends on an assessment of the costs of possibly delaying achievement of our objectives versus the costs of overshoot­ing those objectives. Proponents of a patient approach to removing accom­modation emphasize the risk of having to backtrack on policy, should either real growth or inflation expectations falter. On the other hand, Fed policymakers successfully “tapped the brakes” in the middle of three of our longest economic expansions (in the 1960s, 1980s and 1990s), slowing—but not ending—the unemployment rate’s decline. By com­parison, there are no instances where the Fed has successfully eased the unem­ployment rate upward after having first overshot full employment: When the economy goes into reverse, it has a pro­nounced tendency to lurch backward all the way into recession.

The Federal Reserve Bank of San Francisco – The Risks to the Inflation Outlook – November 17th – has a rather different view of the risks of inflation:-

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

The chart below shows the wide range of PCE forecasts, interestingly the IMF WEO forecast is 1.8% for 2015:-

PCE Inflation projection - FRBSF

Source: FRBSF

The author goes on to conclude:-

Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future.

The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model.

It would appear that even before the recent decline in the price of oil the Fed was not expecting a significant increase in inflationary pressure. What should they do in the current environment where the US$ continues to appreciate against its major trading partners and if the price of oil remains at or below $60/barrel? These are one-off external price shocks which are a boon to the consumer, however they make exports uncompetitive and undermine the longer term attractiveness of investment in the domestic energy sector. IHS Global Insight produced the following forecast for the Wall Street Journal earlier this month:-

US_Pricing_Power_and_Oil_-_IHS_Global_Insight_WSJ

Source: IHS Global Insight and WSJ

My concerns are two-fold; firstly, what if the oil price rebounds? The latest IEA report noted that global demand for oil increased 0.75% between 2013 and 2014 and is running 3.6% above the average level of the last five years (2009 – 2013) this leaves additional supply as the main culprit of the oil price decline. With oil at $60/barrel it is becoming uneconomic to extract oil from many of the new concessions – over-supply may swiftly be reversed. Secondly, the unbridled boon to the wider economy of a lower oil price is likely to be deferred by the process of rebalancing the economy away from an excessive reliance on the energy sector. In an excellent paper in their Power and Growth Initiative series, the Manhattan Institute – Where The Jobs Are: Small Businesses Unleash Energy Employment Boom– February 2014 conclude:-

According to a recent poll from the Washington Post Miller Center, American workers’ anxiety over jobs is at a four-decade record high. Meanwhile, the hydrocarbon sector’s contributions to America’s job picture and the role of its small businesses in keeping the nation out of a long recession are not widely recognized. Another recent survey found that only 16 percent of people know that an oil & gas boom has increased U.S. energy production—collaterally creating jobs both directly and indirectly.

America’s future, of course, is not exclusively associated with hydrocarbons or energy in general. Over the long term, innovation and new technologies across all sectors of the economy will revitalize the nation and create a new cycle of job growth, almost certainly in unexpected ways. But the depth and magnitude of job destruction from the Great Recession means that creating jobs in the near-term is vital. As former chair of the Council of Economic Advisers and Harvard professor Martin Feldstein recently wrote: “The United States certainly needs a new strategy to increase economic growth and employment. The U.S. growth rate has fallen to less than 2%, and total employment is a smaller share of the population now than it was five years ago.”

In a new report evaluating five “game changers” for growth, the McKinsey Global Institute concluded that the hydrocarbon sector has the greatest potential for increasing the U.S. GDP and adding jobs—with an impact twice as great as big data by 2020. McKinsey forecasts that the expanding shale production can add nearly $700 billion to the GDP and almost 2 million jobs over the next six years.

Other analysts looking out over 15 years see 3–4 million more jobs that could come from accelerating domestic hydrocarbon energy production. Even these forecasts underestimate what would be possible in a political environment that embraced growth-centric policies.

In November 2013, President Obama delivered a speech in Ohio on jobs and the benefits from greater domestic energy production. The president highlighted the role of improved energy efficiency and alternative fuels. But as the facts show, no part of the U.S. economy has had as dramatic an impact on short-term job creation as the small businesses at the core of the American oil & gas boom. And much more can be done.

A recent report by Deutsche Bank – Sinking Oil May Push Energy Sector to the Brink – estimated that of $2.8trln annual US private investment, $1.6trln is spent on equipment and software and $700bln on non-residential construction. Of the equipment and software sector, 25-30% is investment in industrial equipment for energy, utilities and agriculture. Non-residential construction is 30% energy related. With oil below $60/barrel much of that private investment will be postponed or cancelled. That could amount to a reduction in private investment of $500bln in 2015. This process is already underway; according to Reuters, new oil permits plummeted 40% in November.

Since 2007 shale producing states have added 1.36mln jobs whilst the non-shale states have shed 424,000 jobs. The table below shows the scale of employment within the energy sector for key states:-

State Hydro-carbon jobs 000’s
Texas 1800
California 780
Oklahoma 350
Louisiana 340
Pennsylvania 330
New York 300
Illinois 290
Florida 280
Ohio 260
Colorado 210
Virginia 190
Michigan 180
Kentucky 170
West Virginia 170
Georgia 160
New Jersey 150

Source: Manhattan Institute

This chart from Zero Hedge shows the evolution of the US jobs market in shale vs non-shale terms since 2008:-

Jobs in shale ve non-shale - Zero Hedge BLS

Source: Zero Hedge and BLS

2015 will see a correction in this trend, not just because investment stalls, but also as a result of defaults in the high-yield bond market.

Junk Bonds and Bank Loans

It is estimated that around 17% of the High-yield bond market in the US is energy related.  The chart below is from Zero Hedge, it shows the evolution of high yield bonds over the last four years. The OAS is the option adjusted spread between High Yield Energy bonds and US Treasury bonds:-

Energy_High_Yield_-_zero_hedge

Source: Zero Hedge and Bloomberg

Deutsche Bank strategists Oleg Melentyev and Daniel Sorid estimate that, with oil at $60/barrel, the default rate on B and CCC rated bonds could be as high as 30%. Whilst this is bad news for investors it is also bad news for banks which have thrived on the securitisation of these bonds. The yield expansion seen in the chart above suggests there is a liquidity short-fall at work here – perhaps the Fed will intervene.

As a result of the growth in the US energy sector, banks have become more actively involved in the energy markets. Here the scale of their derivative exposure may become a systemic risk to the financial sector. When oil was trading at its recent highs back in July the total open speculative futures contracts stood at 4mln: that is four times the number seen back in 2010. The banks will also be exposed to the derivatives market as a result of the loans they have made to commodity trading companies – some of whom may struggle to meet margin calls. Bad loan provisions will reduce the credit available to the rest of the economy. This will dampen growth prospects even as lower energy prices help the consumer.

The US Treasury Bond yield curve has also “twisted” over the past month, with maturities of five years and beyond falling but shorter maturities moving slightly higher:-

Maturity 17-Nov 17-Dec Change
2yr 0.504 0.565 0.061
3yr 0.952 1.005 0.053
5yr 1.607 1.534 -0.073
7yr 2.019 1.863 -0.156
10yr 2.317 2.078 -0.239

Source: Investing.com

On the 15th October, at the depths of the stock market correction, 2yr Notes yielded 0.308% whilst 10yr Notes yielded 2.07%. Since then the 2yr/10yr curve has flattened by 25bp. I believe this price move, in the short end of the market, is being driven by expectations that the Fed will move to “normalise” policy rates in the next 12 months. Governor Yellen’s change of emphasis in this weeks FOMC statement – from “considerable time” to “patient” – has been perceived by market pundits as evidence of more imminent rate increases. An additional factor driving short term interest rates higher is the tightening of credit conditions connected to the falling oil price.

Longer maturity Treasuries, meanwhile, are witnessing a slight “flight to quality” as fixed income portfolio managers switch out of High Yield into US government securities even at slightly negative real yields. According to an article in the Financial Times – Fall in oil price threatens high-yield bonds – 7th December $40bln was withdrawn from US High Yield mutual fund market between May and October. I expect this process to gather pace and breed contagion with other markets where the “carry trade” has been bolstered by leveraged investment flows.

Where next for stocks?

The New York Fed – Business Leaders Survey showed that, despite easing energy costs and benign inflation, business leaders expectations are not particularly robust:-

The Federal Reserve Bank of New York’s December 2014 Business Leaders Survey indicates that activity in the region’s service sector expanded modestly. The survey’s headline business activity index fell ten points to 7.8, indicating a slower pace of growth than in November. The business climate index inched down two points to -7.8, suggesting that on balance, respondents continued to view the business climate as worse than normal. The employment index climbed three points to 16.3, pointing to solid gains in employment, while the wages index drifted down five points to 25.6. After declining sharply last month, the prices paid index climbed four points to 42.2, indicating a slight pickup in the pace of input price increases, while the prices received index fell eight points to its lowest level in two years, at 5.4, pointing to a slowing of selling price increases. The current capital spending index declined ten points to 10.1, while the index for future capital spending rose six points to 25.0. Indexes for the six-month outlook for business activity and employment fell noticeably from last month, suggesting that firms were less optimistic about future conditions.

Set against this rather negative report from the Fed, is this upbeat assessment of the longer-term prospects for US manufacturing from the Peterson Institute – The US Manufacturing Base:

Four Signs of Strength it makes a compelling case for an industrial renaissance in the US. The four signs are:-

  1. US manufacturing output growth
  2. US manufacturing competitive performance relative to other sectors of the US economy
  3. US manufacturing productivity growth relative to other countries
  4. New evidence on outward expansion by US multinational corporations and economic activity by those same firms at home

Another factor supporting the stock market over the last few years has been the steady increase in dividends and share buybacks. According to Birinyi Associates, US corporations bought back $338.3bln of stock in H1 2014 – the most in any six month period since 2007. Here are some of the bigger names; although they account for less than half the H1 total:-

Name Ticker Buyback $blns
Apple APPL 32.9
IBM IBM 19.5
Exxon Mobil XOM 13.2
Pfizer PFE 10.9
Cisco CSCO 9.9
Oracle ORCL 9.8
Home Depot HD 7.6
Wells Fargo WFC 7.5
Microsoft MSFT 7.3
Qualcomm QCOM 6.7
Walt Disney DIS 6.5
Goldman Sachs GS 6.4

Source: Barclays and Wall Street Journal

Share buybacks are running at around twice their long run average and dividends have increased by 12% in the past year. On average, companies spend around 85% of their profits on dividends and share repurchases. This October 6th article from Bloomberg – S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts goes into greater detail, but this particular section caught my eye:-

CEOs have increased the proportion of cash flow allocated to stock buybacks to more than 30 percent, almost double where it was in 2002, data from Barclays show. During the same period, the portion used for capital spending has fallen to about 40 percent from more than 50 percent.

The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

I am cynical about share buybacks. If they are running at twice the average pace this suggests, firstly, that the “C suite” are more interested in their share options than their shareholders and, secondly, that they are still uncomfortable making capital expenditure decisions due to an utter lack of imagination and/or uncertainty about the political and economic outlook. Either way, this behaviour is not a positive long-term phenomenon. I hope it is mainly a response to the unorthodox policies of the Fed: and that there will be a resurgence in investment spending once interest rates normalise. This might also arrive sooner than expected due to a collapse in inflation rather than a rise in official rates.

The US economy will benefit from lower energy prices in the long term but the rebalancing away from the energy sector is likely to take time, during which the stock market will have difficulty moving higher. For the first time since 2008, the risks are on the downside as we head into 2015. Sector rotation is certainly going to feature prominently next year.

Last weeks National Association of Manufacturers – Monday Economic Report – 8th December 2014 shows the optimism of the manufacturing sector:-

Business leaders continue to reflect optimism about the coming months, with 91.2 percent of survey respondents saying they are either somewhat or very positive about their own company’s outlook. Moreover, manufacturers predict growth of 4.5 percent in sales and 2.1 percent in employment over the next 12 months, with both experiencing the strongest pace in at least two years. 

These findings were largely consistent with other indicators released last week. Most notably, the U.S. economy added 321,000 nonfarm payroll employees on net in November. This was well above the consensus estimate, and it was the fastest monthly pace since April 2011. Hiring in the manufacturing sector was also strong, with 28,000 new workers during the month. Since January, manufacturers have hired almost 15,000 workers on average each month, or 740,000 total since the end of 2009. In other news, manufacturing construction spending was also up sharply, increasing 3.4 percent in October and a whopping 23.0 percent year-over-year. 

These reports suggest that accelerating growth in demand and output is beginning to translate into healthier employment and construction figures, with businesses stepping up investments, perhaps as a sign of confidence. This should bode well for manufacturing employment as we move into 2015. In particular, the Institute for Supply Management’s (ISM) manufacturing Purchasing Managers’ Index (PMI) remains strong, despite edging marginally lower in November. For instance, the production index has now been 60 or higher, which indicates robust expansionary levels, for seven straight months. Similarly, the new orders index has been 60 or higher for five consecutive months, and the export measure also noted some improvements for the month. 

Speaking of exports, the U.S. trade deficit changed little in October, edging marginally lower from the month before. Still, growth in goods exports was somewhat better than the headline figure suggested, with the value of petroleum exports declining on lower crude oil costs. The good news is that year-to-date manufactured goods exports have increased to each of our top-five trading partners so far this year.

They go on to temper this rosy scenario, which is why I anticipate the interruption to the smooth course of stock market returns during the next year :-

…growth in manufactured goods exports remains sluggish through the first 11 months of 2014, up just 1.1 percent relative to the same time frame in 2013. Not surprisingly, challenges abroad continue to dampen our ability to grow international sales.  New factory orders have declined for the third straight month, a disappointing figure particularly given the strength seen in other measures. In addition, the NAM/IndustryWeek survey noted that the expected pace of exports decelerated once again, mirroring the slow growth in manufactured goods exports noted above.

This week saw the release of revised Industrial Production and Capacity Utilisation data – this was the commentary from the Federal Reserve:-

Industrial production increased 1.3 percent in November after edging up in October; output is now reported to have risen at a faster pace over the period from June through October than previously published. In November, manufacturing output increased 1.1 percent, with widespread gains among industries. The rise in factory output was well above its average monthly pace of 0.3 percent over the previous five months and was its largest gain since February. In November, the output of utilities jumped 5.1 percent, as weather that was colder than usual for the month boosted demand for heating. The index for mining decreased 0.1 percent. At 106.7 percent of its 2007 average, total industrial production in November was 5.2 percent above its year-earlier level. Capacity utilization for the industrial sector increased 0.8 percentage point in November to 80.1 percent, a rate equal to its long-run (1972–2013) average.

This paints a positive picture but, with Capacity Utilisation only returning to its long-run trend rate, I remain concerned that the weakness of the energy sector will undermine the, still nascent, recovery in the broader economy in the near-term.

Conclusion and investment opportunities

The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.

Where the US stock market leads it is difficult for the rest of the world not to follow. The table below from March 2008 shows the high degree of monthly correlation of a range of stock indices to the Nasdaq Composite. In a QE determined world, I would expect these correlations to have risen over the last six years: –

Ticker Index Country 10 years 5 years 1 year
^IXIC Nasdaq Composite USA 1 1 1
^GSPC S&P 500 USA 0.8 0.86 0.83
^DWC Wilshire 5000 USA N/A 0.9 0.85
^AORD All Ords Australia 0.64 0.6 0.93
^BVSP Bovespa Brazil 0.62 0.53 0.83
^GSPTSE TSX Canada N/A 0.66 0.83
399300.SZ Shanghai Composite China N/A N/A 0.68
^GDAXI DAX Germany N/A 0.73 0.83
^HSI Hang Seng Hong Kong 0.6 0.54 0.79
^BSESN BSE Sensex India 0.44 0.5 0.75
^N225 Nikkei 225 Japan 0.51 0.49 0.87
^MXX IPC Mexico 0.67 0.56 0.33
RTS.RS RTS Russia N/A N/A 0.53
^KS11 Kospi South Korea 0.57 0.59 0.8
^FTSE FTSE100 UK N/A 0.57 0.87

Source: Timingcube.com

A decline in the S&P 500 will impact other developed markets, especially those reliant on the US for exports. 2015 will be a transitional year if oil prices remain depressed at current levels, yet the longer term benefit of lower energy prices will feed through to a recovery in 2016/2017. A crisis could ensue next year, but, with China, Japan and the EU continuing to provide quantitative and qualitative support, I do not believe the world’s “saviour” central banks are “pushing on a string” just yet. Inflation is likely to fall, global growth will be higher, but US stocks will, at best, mark time in 2015.

In bond markets, credit will generally be re-priced to reflect the increased risk of corporate defaults due to mal-investment in the energy sector. Carry trades will be unwound, favouring government bonds to some degree.

Recently heightened expectations of higher short term interest rates will recede. This should be supportive for the Real-Estate market. With a presidential election due in 2016 both the Democrats and the Republicans will be concocting policies to support house prices, jobs, average wages and the value of 401k’s. After three years of deliberation, the introduction of watered down QRM – Qualified Residential Mortgage – rules in October suggests this process is already in train.

Many investors have been waiting to enter the stock market, fearing that the end of QE would herald a substantial correction. 2015 might provide the opportunity but by 2016 I believe this window will have closed.

Oil and Growth

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Macro Letter – No 24 – 21-11-2014

Oil and Growth

  • The oil price has fallen by 30% since the summer
  • Global inflation expectations are starting to be revised downwards accordingly
  • Global growth, led by energy importers will be revised higher

 

The Oil Price

Since the summer crude oil prices have fallen sharply from above US$105 to below US$75/barrel. This price move has led to discussion of lower demand stemming from a slow-down in global economic activity. Whilst I expect a benign influence on inflation I am not convinced that the price decline is due to a reduction in global demand. Here is a daily chart for Spot West Texas Intermediate crude oil (WTI) since November 2007:-

TWI Spot - November 2007 - November 2014

Source: Barchart.com

The precipitous decline in 2008 was driven by the global recession following the US sub-prime crisis. The liquidity fuelled recovery in the oil price and the world economy was engineered by the largest central banks. During the same period the US$ Index rose and then declined in a broadly inverse manner to Oil though the motivation for the vacillations in the value of the US currency is broader:-

US Dollar Index - November 2007 - November 2014

Source: Barchart.com

Aside from the steady strengthening of the US$ there are a number of factors which have conspired to drive oil prices lower. Firstly there has, and will continue to be, additional supply emanating from the US where improved energy technology has produced significant increase in production over the last five years –from 1.8bln barrels in 2008 to 2.3bln barrels in 2013. In May 2014 it hit a 25 year high of 8.4mln barrels and the Energy Information Administration (EIA) forecast 2015 production will hit the highest level since 1972. The economic impact of cheaper US energy underpins a manufacturing renaissance which is slowly gathering momentum across America.

The next factor is Saudi Arabian production which has not yet been reduced in response to lower prices. Perhaps this, in turn, is a reaction to the secular decline in oil demand from developed countries; though the announcement, last week, of an emissions reduction agreement by China and the USA may add to the downward pressure. Brookings – The U.S. and China’s Great Leap Forward opined thus: –

The world’s two largest emitters of carbon dioxide together pledged deep reductions – well in advance of the pressure they will face in the upcoming UN Climate Change negotiations that begin in Lima later this month, and which are scheduled to conclude a year from now in Paris.  They also did so at a level deeper than many had expected.  While both countries have already begun efforts to cut emissions, the timing of the announcement and the depth of the reductions went beyond what many diplomats, businesses and environmental groups anticipated.

… Internationally, both countries have a range of other issues to address – including working with the poorest nations which lack the resources to make similarly dramatic cuts, but who are deeply affected by a warmer, wetter world. Still, even with all those obstacles ahead, today’s agreement is the beginning of a great leap forward for climate protection.

Additional supply could swiftly come on stream from Libya. Further talks are scheduled between the rival Libyan factions in Khartoum, Sudan, on December 1st.  The chart below shows how swiftly Libyan production has declined:-

Libyan crude_oil_production EIA

Source: EIA

Also hanging over the market is the prospect of Iranian production increases as international sanctions are reduced. Between 2011 and 2013 Iranian oil exports declined from 3mln bpd to less than 1mln bpd. This year they have rebounded strongly, averaging more than 1mbpd. Iranian production has been running at around 3 mbpd but the National Iranian Oil Company expects an increase to 4.3 mbpd next year – though several commentators are doubtful of Iran’s ability to achieve this increase in output. For more detail on the Iranian situation this article – Al Monitor – Iran takes steps to reduce economic risk of falling oil prices may be of interest.

There are some demand factors which may also undermine prices. Chinese growth has been slowing but, more importantly, the Chinese administration has adopted a policy of re-balancing away from production towards domestic consumption. In theory this process should reduce China’s energy demand; off-set, to some degree, by increased export demand from other emerging market countries as they seek to supply China’s consumption needs. I believe lower energy prices will help Chinese exporters to increase margins or export volumes – or both.

The latest IEA Oil Market Report made these observations: –

Oil’s rout gained momentum in October and extended into November, with Brent at a four-year low below $80/bbl. A strong US dollar and rising US light tight oil output outweighed the impact of a Libyan supply disruption. ICE Brent was last trading at $78.50/bbl – down 30% from a June peak. NYMEX WTI was at $75.40/bbl.

Global oil supply inched up by 35 kb/d in October to 94.2 mb/d. Compared with one year ago, total supply was 2.7 mb/d higher as higher OPEC production added to non-OPEC supply growth of 1.8 mb/d. Non-OPEC production growth is forecast to ease to 1.3 mb/d for 2015 from this year’s 1.8 mb/d high.

OPEC output eased by 150 kb/d in October to 30.60 mb/d, remaining well above the group’s official 30 mb/d supply target for a sixth month running. The group’s oil ministers meet on 27 November against the backdrop of a 30% price decline since they last gathered in June.

Global oil demand estimates for 2014 and 2015 are unchanged since last month’sReport, at 92.4 mb/d and 93.6 mb/d, respectively. Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.

OECD industry oil stocks built counter-seasonally by 12.6 mb in September. Their deficit versus average levels, after ballooning earlier this year, fell to its narrowest since April 2013. Preliminary data show that despite a 4.2 mb draw, stocks swung into a surplus to average levels in October for the first time since March 2013.

Global refinery crude demand hit a seasonal low in October amid peak plant maintenance and seasonally weak product demand. The 4Q14 throughput estimate is largely unchanged since last month’s Report, at 77.5 mb/d, as robust Russian and Chinese throughputs offset a steeper-than-expected drop in US runs in October.

Set against these forces, driving the price of oil lower, is the geo-political tension between Russia and NATO, the ISIS insurgency in Iraq and the continued instability of the Middle East emanating from the civil war in Syria. It is difficult to estimate how far the oil price would decline if the civil unrest in Ukraine and Syria ended tomorrow, I suspect, another 20% to 25%% -during the Kuwait War in the month of October 1990 the price of WTI declined from $40 to $27/barrel even before the war was over:-

WTI Spot - July 1990 - March 1991

Source: Barchart.com

From a technical perspective the breakout from the 2011 range to the downside suggests support around $66, $62, $58, with a final capitulation target of $46. There are, however, reasons to be more optimistic about the prospects for oil, even near-term.

A factor, mentioned by the IEA, which may lead to a reduction in supply, is the outcome of the forthcoming OPEC meeting due to take place on 27th November. Qatar has already begun, reducing production from 800,000 bpd to 650,000bpd last month. At the end of November they will reduce production further to 500,000 bpd – in total a 40% cut. They are not the only countries to be reducing production. The tables below are taken from the OPEC Monthly Report November 2014 which included Secondary Sources: –

OPEC-Secondary-Sources  September 2014

Source: OPEC

Whilst oil prices may trend somewhat lower the term structure of the TWI futures market has recently returned from several years of backwardation to contango – Brent Crude has been in contango for some while. This suggests that lower prices are beginning to reduce US domestic over-supply as smaller US operators cease to be able to produce oil profitably. Below $65 the EIA forecast for 2015 will probably need to be revised lower. Prices are likely to be better underpinned at their current levels.

Another encouraging factor is US domestic demand from refiners. US Crack spreads – the price spread between crude oil and its products – has started to widen in recent weeks. Oil demand should increase in response to higher product margins. The cracking margins have risen most dramatically for Gasoline but Heating Oil margins have also improved and may catch up if predictions of an exceptionally cold winter in the Northern hemisphere prove to be correct. NOAA – Winter Outlook from last month is reasonably sanguine – warm in the West and Alaska, cold in South and Rockies – but substantial snowfall in Siberia (the largest in October since 1967) is cause for caution.

Global Growth

This brings me on to the impact of lower oil prices on global growth. Obviously the large crude oil exporting countries will suffer from reduced revenue but the importers of oil – and gas, since many gas contracts are referenced to the price of oil – should be beneficiaries.  This recent article from Brookings – Oil – A Question of Economics – reminds readers of some of the ubiquitous benefits to the global economy of lower energy prices: –

Virtually all businesses will benefit from lower transportation costs by expanding their profit margins or passing the benefit to consumers at lower prices. The lower income groups, who spend a higher proportion of their incomes on transport, will see their disposable incomes rise, benefiting retailers who serve their needs and thereby increasing demand in the economy. Food prices are also likely to fall, as food production, processing and sales distribution are energy intensive activities, thereby benefiting lower income groups further. Increased consumption will stimulate aggregate demand, creating investment opportunities and economic growth. Governments in the west may also have the opportunity to increase fuel taxes to cover the real cost of the negative externalities of carbon emissions, or raise revenue to improve public transportation systems. Furthermore, governments in the Middle East and Asia will reduce spending on their fuel subsidies and may take the opportunity to improve the workings of market forces, which the IMF and Western powers have been seeking for them to do.

The effect of lower oil prices is felt quite rapidly by consumers globally. Oil consumers, at the household level, receive an immediate boost to their real income. This “wind-fall” is then either spent or saved. An explanation of these effects can be found in this Gavyn Davies article in the Financial Times – Large global benefits from the 2014 oil shock (Some of you may need to subscribe to this “limited free service”). He uses IMF data to produce two very interesting charts: –

Oil and GDP - IMF Fulcrum

Source: IMF and Fulcrum

The fall in inflation will be of greater concern to the ECB than the other major central banks. The BoJ has already acted aggressively in response to the economic slowdown in Japan, the Abe government has deferred a scheduled tax increase and announced an early election. The Federal Reserve, having completed its tapering of QE, will be focussed on wage growth. As central bank to the world’s second largest and rising oil producer, the Fed will be concerned about the drag on growth from a slowdown in the energy and utility sectors; market expectations of interest rate increases will be deferred once again. If the ECB act aggressively to head off the chimera of deflation this may be enough to improve global confidence – I believe this makes the blue line prediction more likely. If WTI should plummet towards $60, the improvement in economic growth should be even greater.

As recently as last month the IMF – World Economic Outlook – forecast for Oil prices was $102.76 for 2014 and $99.36 for 2015. They continue to cling to their forecasts based on expectation of increased geo-political tensions. Given that their 2015 forecast is around 30% above current levels if they are mistaken and the oil price remains subdued their global growth forecast could be around 0.6% too low.

Last month The Economist – Cheaper Oil: Winners and Losers – took up the theme of lower oil prices:-

A 10% change in the oil price is associated with around a 0.2% change in global GDP, says Tom Helbling of the IMF. A price fall normally boosts GDP by shifting resources from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. If increased supply is the driving force, the effect is likely to be bigger—as in America, where shale gas drove prices down relative to Europe and, says the IMF, boosted manufactured exports by 6% compared with the rest of the world. But if it reflects weak demand, consumers may save the windfall.

The authors go on to discuss farmers as the main direct beneficiaries of cheaper oil. India especially but other economies with a large agricultural sector as well: –

Energy is the main input into fertilisers, and in many countries farmers use huge amounts of electricity to pump water from aquifers far below, or depleted rivers far away. A dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods, says John Baffes of the World Bank. Farmers benefit from cheaper oil. And since most of the world’s farmers are poor, cheaper oil is, on balance, good for poor countries.

Take India, home to about a third of the world’s population living on under $1.25 a day. Cheaper oil is a threefold boon. First, as in China, imports become cheaper relative to exports. Oil accounts for about a third of India’s imports, but its exports are diverse (everything from food to computing services), so they are not seeing across-the-board price declines. Second, cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment.

Third, cheaper oil cuts India’s budget deficit, now 4.5% of GDP, by reducing fuel and fertiliser subsidies. These are huge: along with food subsidies, the total is 2.5 trillion rupees ($41 billion) in the year ending March 2015—14% of public spending and 2.5% of GDP. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. As in China, cheaper oil should reduce the pain of cutting subsidies—and on October 19th Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

The price move has also prompted a response from the researchers at the Dallas Fed – Oil Prices Fall Despite Global Uncertaintywhilst their concern is broadly domestic they note that it is Non-OECD demand which is driving the increase in oil demand. The largest beneficiaries of lower oil prices will be oil importing emerging market countries: China, India and, to the extent that they are still considered an emerging economy, South Korea. Other candidates include Singapore, Taiwan, Poland, Greece, Indonesia, South Africa, Brazil and Turkey.

Conclusion and Investment Opportunities

Foreign Exchange

The fall in oil prices has been mirrored, inversely, by the rise of the US$. This trend is already well established but I expect it to continue. This is not so much a reflection of the strength of the US economy as the moribund nature of growth expectations in the EU and Japan.

Government Bonds

Lower inflation expectations, combined with central bank inflation targets, should ensure a delay to interest rate tightening even in response to a resurgence of wage growth. Bond prices will continue to be underpinned. At any sign of a slowing of economic growth, yield curves will flatten further. Convergence of EZ bond yields will continue.

Equities

The chart below shows the relative performance of the S&P500 Index vs MSCI Emerging Market ETF (EEM) over the last five years, after an initial rebound from the Great Recession the US stock market began to outperform other stock markets, driven by the economic boon of oil and gas technology, the implementation of TARP  and the highly accommodative policies of the Fed. With the current round of QE at an end, US investors may need to look further afield in search of value :-

EEM vs SandP 5yr

Source: Yahoo Finance

Expectation of “Lower for Longer” interest rates and cheaper oil is supportive for stock markets in general although there will be sector specific winners and losers. Geographically, lower oil prices will favour those economies most reliant on oil imports, especially if their exchange rate is pegged to the US$. Given the under-performance of many emerging market equities over the last few years I believe this offers the best investment opportunity going forward into 2015. Those countries with floating exchange rates such as India have already benefitted from currency devaluation of 2013; however, there is still potential upside for equities, even after the strong performance of 2014. The SENSEX Index (BSE) started the year around 21,000 and is currently making new highs at 28,000, but during the last three months it has tended to track the performance of the S&P 500 Index – despite the fall in oil prices. I anticipate a general re-rating of emerging market equities next year.

European Markets and Unification

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Macro Letter – No 3 – 17 -01-2014

European Markets and Unification

During 2013 developed market equities were the top performing major asset class. The US and UK had justification for rising since the effects of quantitative easing appear to have stimulated some economic activity. Europe, however, has less reason for strength since ECB policies have been less accommodative. The performance of the German mid-cap index aside, European equity market performance in 2013 was largely due to receding fears of the break-up of European currency union. This has been a major contributor to the decline in peripheral bond yields as the chart below shows.

European Bond Yields - 2005 - 2014 - Bloomberg.

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Source: Bloomberg

Banking Union and the ECB

In 2014 the focus will be on deepening unification, commencing with a European Banking Union. Der Spiegel reports: –

Not Fit for the Next Crisis: Europe’s Brittle Banking Union – 19th December 2013

http://www.spiegel.de/international/business/weak-eu-banking-union-could-have-dangerous-side-effects-a-940065.html

When German Finance Minister Wolfgang Schäuble, a trained lawyer, announced an agreement on Wednesday night in Brussels on the long negotiated EU banking union, observers might have been left thinking that he is precisely this type of lawyer.

On paper, Schäuble and his negotiators are right about very many points. They succeeded in ensuring that in 2016, the Single Resolution Mechanism will go into effect alongside the European Union banking supervisory authority. The provision will mean that failing banks inside the euro zone can be liquidated in the future without requiring German taxpayers to cover the costs of mountains of debt built up by Italian or Spanish institutes.

They also backed the European Commission, which wanted to become the top decision-maker when it comes to liquidating banks. The Commission will now be allowed to make formal decisions, but only in close coordination with national ministers from the member states.

But it goes even farther. Negotiators from Berlin have also created an intergovernmental treaty, to be negotiated by the start of 2014, that they believe will protect Germany from any challenges at its Constitutional Court that might arise out of the banking union.

They also established a very strict “liability cascade” that will require bank shareholders, bond holders and depositors with assets of over €100,000 ($137,000) to cover the costs of a bank’s liquidation before any other aid kicks in. The banks are also required to pay around €55 billion into an emergency fund over the next 10 years. Until that fund has been filled, in addition to national safeguards, the permanent euro bailout fund, the European Stability Mechanism, will also be available for aid. However, any funds would have to be borrowed by a national government on behalf of banks, and that country would also be liable for the loan. This provision is expected to be in place at least until 2026.

The government in Berlin put a strong emphasis on preventing the ESM, with its billions in funding, from being used to recapitalize debt-ridden European banks. Schäuble was alone with this position during negotiations, completely isolating himself from the other 16 finance ministers from euro-zone countries. Brussels insiders report that it was “extremely unusual because normally at least a few countries share Germany’s position.”

The article goes on to highlight some of the weaknesses with this agreement: –

  1. 1.       It’s too complex – The Financial Times stated, “In total, the process could involve nine committees and up to 143 votes cast.”
  2. It’s underfunded – The Single Resolution Mechanism, at Euro 55bln by 2026, is a drop in the ocean.
  3. It’s primarily a domestic affair, the union will be subject to national borders
  4. It will probably take at least five years to establish joint European liability.

Bruegel – Ending uncertainty: recapitalisation under European Central Bank Supervision – takes up the subject:-

http://www.bruegel.org/publications/publication-detail/publication/806-ending-uncertainty-recapitalisation-under-european-central-bank-supervision/

• Estimates of the recapitalisation needs of the euro-area banking system vary between €50 and €600 billion. The range shows the considerable uncertainty about the quality of banks’ balance sheets and about the parameters of the forthcoming European Central Bank stress tests, including the treatment of sovereign debt and systemic risk. Uncertainty also prevails about the rules and discretion that will apply to bank recapitalisation, bank restructuring and bank resolution in 2014 and beyond.

• The ECB should communicate the relevant parameters of its exercise early and in detail to give time to the private sector to find solutions. The ECB should establish itself as a tough supervisor and force non-viable banks into restructuring. This could lead to short-term financial volatility, but it should be weighed against the cost of a durably weak banking system and the credibility risk to the ECB. The ECB may need to provide large amounts of liquidity to the financial system.

• Governments should support the ECB, accept cross-border bank mergers and substantial creditor involvement under clear bail-in rules and should be prepared to recapitalise banks. Governments should agree on the eventual creation of a single resolution mechanism with efficient and fast decision-making procedures, and which can exercise discretion where necessary. A resolution fund, even when fully built-up, needs to have a common fiscal backstop to be credible.

The initial Asset Quality Review (AQR) of European Banks carried out in 2011 by the European Banking Authority proved to be a political embarrassment since almost every bank was found to be in relatively rude financial health: shortly before bailouts were required.

Breaking Views – Still time to undo EU bank stress test fiasco – November 2011 – sums up the problems with the previous stress tests eloquently: –

http://www.breakingviews.com/still-time-to-undo-eu-bank-test-fiasco/1616988.article

The test, which was blessed by last month’s ill-fated European summit, had two problems. First, it wasn’t stringent enough: the European Banking Authority concluded that Europe’s lenders needed an additional 106 billion euros, when the International Monetary Fund thought about twice as much was needed. The test has done little to restore confidence in the blighted sector. Banks are still unable to issue long-term unsecured debt, and have been increasingly thrown back on short-term support from the European Central Bank.

Second, the test encouraged deleveraging by expressing the capital requirement as a ratio and giving lenders eight months to get there. Given depressed share prices, many banks are anxious to avoid issuing equity. Instead they are trying to boost capital ratios by shrinking their balance sheets. This will almost certainly have the unfortunate side-effect of further suffocating the European economy, which is already on the edge of recession.

The current iteration of the AQR will, undoubtedly, have more “teeth” but these are shark infested waters where an ECB “health warning” might precipitate an ugly banking crisis.

The Peterson Institute – The European Central Banks Big Moment – December 2013 –  elaborates:-

http://www.piie.com/publications/opeds/oped.cfm?ResearchID=2527

Europe’s banking union project has had many doubters since it started to be widely discussed in the spring of 2012. What is not in doubt, however, is its transformative nature. In June 2012, EU leaders chose—in a galloping hurry, as usual—to move towards the centralization of bank supervision across euro area countries, with this authority entrusted to the European Central Bank (ECB). The consequences have only gradually become apparent to most and represent both an opportunity and a risk.

The opportunity is to reestablish trust in European banks, reboot the pan-European interbank market, end dysfunctional credit allocation, and start reversing the vicious circle between bank and sovereign credit. In an optimistic scenario, the ECB’s 12-month process of “comprehensive assessment,” including an asset quality review (AQR) and stress tests of about 130 credit institutions covering 85 percent of the euro area’s banking assets, will trigger the triage, recapitalization, and restructuring that history suggests is a prerequisite for systemic crisis resolution.

The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy—and the perception of Europe’s ability to get anything done—could be affected. After all, this exercise is unprecedented in scale and scope, which means the ECB has little prior experience. At the same time, the political fallout is potentially poisonous to most of the states concerned.

Thus, much is at stake in the balance sheet review, and the scene is set for an escalating confrontation between the ECB and member states in the months ahead. The ECB has pointedly made clear that it will form an independent judgment on the capital strength of the banks examined, without necessarily following the views of national supervisors.

A successful AQR and establishment of the Single Supervisory Mechanism (SSM)—EU jargon for the handover of supervisory authority to the ECB—would have structural consequences. Europe’s national and local governments often use their leverage over the publicly-regulated banking industry for industrial policy purposes or to facilitate their own financing, a dynamic known to economists as financial repression.

Bruegel – Supervisory transparency in the European banking union – January 2014  – looks, in more detail, at the issues surrounding European bank regulation by the  ECB, they acknowledge the need for greater transparency and highlight the dangers of a half-baked approach to a banking union: –

http://www.bruegel.org/publications/publication-detail/publication/807-supervisory-transparency-in-the-european-banking-union/

• Bank supervisors should provide publicly accessible, timely and consistent data on the banks under their jurisdiction. Such transparency increases democratic accountability and leads to greater market efficiency.

• There is greater supervisory transparency in the United States compared to the member states of the European Union. The US supervisors publish data quarterly and update fairly detailed information on bank balance sheets within a week. By contrast, based on an attempt to locate similar data in every EU country, in only 11 member states is this data at least partially available from supervisors, and in no member state is the level of transparency as high as in the US.

• Current and planned European Union requirements on bank transparency are either insufficient or could be easily sidestepped by supervisors. A banking union in Europe needs to include requirements for greater supervisory transparency.

I always find Bruegel comments useful , not only in terms of what should be done to move the “European Project” forward, but also as a guide to what the institutional response is likely to be should an EU proposal fail to be adopted. They conclude: –

Finding agreement on an EU legal change that requires the ECB and member-state supervisors to open their books to greater scrutiny will surely be a difficult task given the current diversity of practices and interests – eg banks, national supervisors – that benefit from this diversity.

But greater supervisory transparency will facilitate more efficient distribution of capital and increase market discipline. It will increase the legitimacy of actions that the regulator takes against banks. The European Union receives justified flak that there is a great distance between European citizens and the institutions that make decisions on their behalf. There is real suspicion of the financial sector and distrust that public money goes only to help out political friends. Transparency in terms of the data the supervisors themselves use to make decisions would allow the public, and more realistically the various interest groups one finds in civil society, to judge whether regulators did choose actions consistent with protecting the public interest. Such ‘fire alarms’ therefore represent one small step towards addressing the democratic deficit that most citizens think exists in Europe.

If such transparency is not possible, for purposes of increasing ‘output legitimacy’ more work should be done to strengthen the role of parliaments. For the European Parliament, the autumn 2013 interinstitutional agreement with the European Central Bank represents a good start. Under all current proposals, national regulators will continue to play an important role especially for any bank resolution. As discussed earlier, the German Bundestag gains the ability in 2014 to investigate specific banks as part of the national implementation of Basel III. Such parliamentary powers should become standard in all European Union member states. Moreover, such a procedure should be not only a theoretical power, but also one that is used.

Nationalist Backlash

In a more recent post this month – Peterson Institute – Calm Seas in Europe in 2014? – Jacob Funk Kirkegaard predicts that whilst 2013 was a year of relative calm for the Eurozone, 2014 may be a very different matter. As usual the driving force behind any change in sentiment will be political: –

http://www.piie.com/blogs/realtime/?p=4195

No major EU elections are scheduled in 2014. In Italy, a new electoral law is unlikely to be agreed upon before it takes over the rotating EU presidency in the second half of 2014. By tradition, countries in that position refrain from holding national elections. Rather, European Parliament elections in May will be the political highlight of 2014. As discussed earlier, there is a risk that angry voters will turn out and elect some colorful non-mainstream members to that body. Still, there seems little risk that the European Parliament will become a “Weimar Parliament” with a majority of anti-EU members. Instead the established European parties seem likely to prevail with a smaller majority, ensuring that Europe remains governable.

With their increased representation, the question of what the anti-EU parties want (aside from their daily parliamentary allowances) will arise. Much has been written about the alliance between Marine Le Pen, leader of the French National Front, and the leader of the Dutch Freedom Party Geert Wilders. But theirs is little more than a photo-op coalition, posing limited political risks. There are inherent limitations on the ability of nationalist parties to collaborate across borders.

The European Parliament elections, though, may also indirectly influence the choice of the next president of the European Commission. In an attempt to broaden the democratic appeal of the European Union, the European political parties have suggested that they each propose a pan-European spitzen-kandidat for the post and then let the European voters decide. Of course, this is a naked—if well-intended—power grab by the European Parliament, as the right to select the Commission president resides with the EU member states according to the EU Treaty. And they are unlikely to surrender this right. At the same time, it will be very difficult for the EU member states to ignore the winning side in the European Parliament election. The heads of states will hence likely be compelled to at least choose a new European President from the side of the political aisle that won the most votes in the election. Their selection power will thus be constrained…

Economically, the biggest event in 2014 will be the rollout of the ECB’s asset quality review (AQR) and stress tests of the euro area banking system, representing the opportunity to finally restore the soundness of Europe’s bank balance sheet. Failure to carry out a convincing review will threaten the region with Japanese-style prolonged stagnation and undermine the credibility of the ECB. The AQR/stress test is more important than the hotly debated single resolution mechanism (SRM) designed to close down or consolidate failing banks, finally agreed by the EU finance ministers in late December [pdf]. Only a successful AQR/stress test can avert the continuing fragmentation of credit markets and reduce the high interest spreads between the core and periphery. Assuming that the SRM can fix financial fragmentation is erroneous, and much of the related criticism of the complex SRM compromise is misplaced. Even an optimally designed SRM would not make euro area banks suddenly lend to each other again.

A more pertinent question is whether the SRM compromise makes it more or less likely that the AQR succeeds in 2014. For sure the envisioned SRM is far from perfect. It has an excessively complex structure, including a 10-year phase-in, and a multistage resolution process involving a resolution board, the European Commission, and the EU finance ministers in the ECOFIN (finance ministers’) Council. Parts of it are grounded in EU law and parts are to be embodied by a new intergovernmental treaty. Hopefully some of these kinks will be corrected in the ongoing final reconciliation negotiations on the SRM between the member states and the European Parliament. But writing off the SRM as unworkable just because it is complex is a mistake. The European Union of 28 member states works every day, despite breathtaking complexity. Moreover, in emergencies the European bureaucracy can be circumvented and a decision forced through in 24 hours.

The European political landscape may become more polarised in 2014 with right wing parties gaining ground in the European parliament.

The Economist – Europe’s Tea Parties – 4th January 2014 – looks at the rise of nationalist parties in Europe, making comparison with the US Tea Party Republican group, there are some similarities but the differences are more pronounced: –

There are big differences between the Tea Party and the European insurgents. Whereas the Tea Party’s factions operate within one of America’s mainstream parties, and have roots in a venerable tradition of small-government conservatism, their counterparts in Europe are small, rebellious outfits, some from the far right. The Europeans are even more diverse than the Americans. Norway’s Progress Party is a world away from Hungary’s thuggish Jobbik. Nigel Farage and the saloon-bar bores of the United Kingdom Independence Party (UKIP) look askance at Marine Le Pen and her Front National (FN) across the Channel. But there are common threads linking the European insurgents and the Tea Party. They are angry people, harking back to simpler times. They worry about immigration. They spring from the squeezed middle—people who feel that the elite at the top and the scroungers at the bottom are prospering at the expense of ordinary working people. And they believe the centre of power—Washington or Brussels—is bulging with bureaucrats hatching schemes to run people’s lives.

The minority parties might seem largely irrelevant but voter apathy towards voting at European Elections gives European “Tea Parties” an opportunity to punch above their weight: –

Ultimately, though, the choice falls to voters themselves. The Tea Party thrived in America partly because a small minority of voters dominate primary races especially for gerrymandered seats. In elections to the European Parliament many voters simply do not bother to take part. That is a gift to the insurgents. If Europeans do not want them to triumph, they need to get out to the polls.

For an historical perspective on how the Eurozone might move towards closer unification the New York Fed – The Mississippi Bubble of 1720 and the European Debt Crisis – 10th January 2014 – offers some interesting observations. This is part of a series of articles called the “Crisis Chronicles” from Liberty Street Economics: –

http://libertystreeteconomics.newyorkfed.org/2014/01/crisis-chronicles-the-mississippi-bubble-of-1720-and-the-european-debt-crisis.html

Austerity and Debt Restructuring

From summer 2012 through 2013 European equities performed well, with peripheral markets such as Greece and Ireland benefitting from the reduced risk of a Greek exit and single currency area breakup. Bond markets exhibited a similar response with higher yielding peripheral markets outperforming the core – see first chart above.  2014 may see these convergence patterns reverse as this article from the Council for Foreign Relations – Beware of Greeks Bearing Primary Budget Surpluses – points out: –

http://blogs.cfr.org/geographics/2013/12/04/greeksurpluses

Sovereign Debt Default and Primary Balances - Source IMF.

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Source: IMF

Things are looking up in Greece – that’s what Greek ministers have been telling the world of late, pointing to the substantial and rapidly improving primary budget surplus the country is generating.  Yet the country’s creditors should beware of Greeks bearing surpluses.

A primary budget surplus is a surplus of revenue over expenditure which ignores interest payments due on outstanding debt.  Its relevance is that the government can fund the country’s ongoing expenditure without needing to borrow more money; the need for borrowing arises only from the need to pay interest to holders of existing debt.  But the Greek government (as we have pointed out in previous posts) has far less incentive to pay, and far more negotiating leverage with, its creditors once it no longer needs to borrow from them to keep the country running.

This makes it more likely, rather than less, that Greece will default sometime next year.  As today’s Geo-Graphic shows, countries that have been in similar positions have done precisely this – defaulted just as their primary balance turned positive.

The upshot is that 2014 is shaping up to be a contentious one for Greece and its official-sector lenders, who are now Greece’s primary creditors.  If so, yields on other stressed Eurozone country bonds (Portugal, Cyprus, Spain, and Italy) will bear the brunt of the collateral damage.

European debt restructuring meanwhile still has far to go but many EZ countries seem to think that being “developed” precludes the need to restructure and reform. Carmen Reinhart and Kenneth Rogoff produced a working paper for the IMF –  Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten – December 2013 – which takes a global look at this subject in detail: –

http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf

Here’s the abstract: –

Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging market counterparts. The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression. As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.

The paper follows on from research they have undertaken over the last couple of years including their seminal work – Growth in a time debt – NBER – January 2010 – which achieved considerable notoriety when an economics student discovered statistical errors in the paper – a short version is available here: –

http://www.nber.org/digest/apr10/w15639.html

Their new paper concludes: –

Of course, if policymakers are fortunate, economic growth will provide a soft exit, reducing or eliminating the need for painful restructuring, repression, or inflation. But the evidence on debt overhangs is not heartening. Looking just at the public debt overhang, and not taking into account old-age support programs, the picture is not encouraging. Reinhart, Reinhart, and Rogoff (2012) consider 26 episodes in which advanced country debt exceeded 90 percent of GDP, encompassing most or all of the episodes since World War II. (They tabulate the small number of cases in which the debt overhang lasted less than five years, but do not include these in their overhang calculations.) They find that debt overhang episodes averaged 1.2 percent lower growth than individual country averages for non-overhang periods. Moreover, the average duration of the overhang episodes is 23 years. Of course, there are many other factors that determine longer-term GDP growth, including especially the rate of productivity growth. But given that official public debt is only one piece of the larger debt overhang issue, it is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today’s advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago.

Germany’s slowing growth and potential banking crisis

Meanwhile, Germany, which has benefitted economically from the painful Hartz reforms of the early 2000’s may be losing momentum.

Peterson Institute –  Making Labor Market Reforms Work for Everyone: Lessons from Germany – sets the scene, highlighting how labour reform in Germany has given the country a significant competitive edge: –

http://www.piie.com/publications/pb/pb14-1.pdf

…First, Germany has the best functioning labor market among large economies in Europe and the United States. Second, German wage restraint is of a relatively limited magnitude compared with most euro area countries and hence fails to explain the uniformly large intra–euro area unit labor cost divergences between Germany and other members after 1999. Third, total German labor costs per worker continue to exceed costs in other major EU countries and the United States. Fourth, Germany’s recent labor market revival has not come about through the expansion of predominantly low wage jobs. Fifth, the expansion of mini-jobs in Germany since 2003 has overwhelmingly taken place as second jobs. And sixth, the successful reliance on kurzarbeit programs in 2009 was not an innovation but rather another instance of labor input adjustment in favor of “insider workers” in Germany.

I’m indebted to Quartz.com for the table below which shows German exports and imports by region. Within the Eurozone the two components are fairly balanced but this disguises country specific imbalances, for example, for the first 10 months of 2013, Germany ran a surplus with France of Euro 30bln but a deficit with the Netherlands of Euro 15bln.

German exports and imports by region - source Quartz.

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Source: Quartz.com

The Economist – Die grosse stagnation – 30th November 2013 – paints a rather different picture of the risks ahead for Germany – once again these risks are political in nature, but their principal concern is that the recent coalition deal looks set to reverse a number of these successful reforms: –

http://www.economist.com/news/leaders/21590903-germanys-proposed-new-government-set-turn-motor-europe-slowcoach-die-grosse

…That is because Germany’s economy has been living off past glory—especially “Agenda 2010”, a series of reforms launched in 2003 by Gerhard Schröder, Mrs Merkel’s predecessor. But it is running out of puff. Labour productivity has grown less than half as fast as Spain’s over the past ten years; and its overall rate of public and private investment, at 17% of GDP, has fallen by more than a fifth since the euro was introduced. No European country has carried out fewer reforms than Germany since the euro crisis began.

… The coalition’s 185-page “treaty” was a chance to launch a new reform agenda. Instead, its proposals are a mixture of the irrelevant—charging foreigners to use German motorways—and the harmful.

…The coalition’s pension policy seems even more retrogressive. These days, most advanced economies are expecting longer-living people to be longer-working, too. But the coalition wants the pension age, raised to 67 in the previous grand coalition, to be moved back down again for specific groups, in some cases to 63. France’s president, François Hollande, was rightly mocked, not least by Mrs Merkel, for a similar ploy. Now the woman who has lectured the rest of Europe about the unsustainability of its welfare spending will follow down the same spendthrift road.

…The impact on this coalition on the rest of Europe would not be all bad. One bonus is that, for all its primitive economic policies, the SPD seems keener to support some basic reforms such as the creation of a banking union. But that will count for little if Germany, the motor of Europe’s economy, stalls. And, in the light of the coalition agreement, that is a real danger.

After a strong performance by European Equities and peripheral government bonds in 2013, the prospects for 2014 may be less sanguine, though I’m not bearish at this stage. The principal market risk is likely to emanate from the European banking sector. One example of this, concerns shipping. The chart below shows the Baltic Dry Freight Index month end values from 1985 to end December 2013 – it’s worth noting that the BDI has plummeted this month leading many commentators to predict a global economic downturn.

Baltic Dry index 29 yrs.

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Source: Bloomberg

Over the past ten years the price of “Dry” cargoes has soared and plummeted. During this cycle European banks, German ones in particular – abetted by favourable German government tax treatment – moved aggressively into the shipping finance sector; it is estimated that German banks are currently the financiers behind more than 40% of the world container shipping fleet. These shipping loans were often repackaged and sold on to high net worth investors but, rumour has it, the majority of these investments carried a “principal guarantee”. The ships, meanwhile, are no longer competitive due to improvements in fuel efficiency since the mid 2000’s. The banks are effectively left long “scrap metal”.

Moody’s gave an estimate last month for German banks impairment due to shipping loans of US$22bln for 2014, they went on to state: –

Germany’s eight major ship financiers have lent a total of 105 billion euros to the sector, a fifth of which are categorized as non-performing…

We expect the extended downward shipping cycle to cause rising problem loans in the shipping sector during 2013-14, requiring German banks to increase their loan-loss provisions. This will challenge their earnings power.

Here is the Reuters article for further detail: –

http://www.reuters.com/article/2013/12/10/moodys-shippingbanks-idUSL6N0JP2CV20131210

I wonder whether the ECB’s AQR will uncover the extent of this problem. Last Autumn S&P estimated European banks had a funding gap of Euro 1.3trln as at the end of 2012. My guess is that this is understated: shipping is just one sector, the “quest for yield” is industry wide.

EZ Money supply growth and rising peripheral debt

Another headwind facing Europe is the weakness in money supply growth. In 2012 EZ M3 was growing at above 3%, it dipped below 3% in H1 2013 and below 2% in H2 2013.

Eurozone M3 - ECB.

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Source: ECB

The ECB CPI target of 2% is roughly consistent with M3 growth of 4-6%.

The Telegraph – Eurozone M3 plunge flashes deflation alert – Novemebr 28th 2013

takes up the theme of potential deflation:-

http://www.telegraph.co.uk/finance/economics/10481773/Eurozone-M3-money-plunge-flashes-deflation-alert-for-2014.html

The European Central Bank said M3 money growth fell to 1.4pc from a year earlier, lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel.

A rather more extreme view is expressed by Andrew Cullen – Europeans Looking To Inflate Their Debts Away – Mises Institute – 12th November 2013

http://mises.org/daily/6581/Europeans-Looking-To-Inflate-Their-Debts-Away

How does a reduction in consumer price inflation become “deflation”? How does a minor improvement in the purchasing power of consumers become a problem for liquidity in the financial markets? Austrian-economic thinking, which understands that new money is never neutral in its effects, offers insight:

[T]he crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money …[4]

European politicians and central bank policy-makers are concerned not about consumer price reductions but about real reductions in the money supply as such reductions would force governments to abandon permanent budget deficit monetization. That is why they maintain a monopoly over the power to create money and they like to control where money enters the economy. Politicians use these advantages in two ways.

First, they are all, with the sole exception of the Bundesbank, “inflationists” when it comes to monetary policy. Inflation (that is, an increase in the money supply) steadily reduces the purchasing power of a fiat money and, in parallel, eases the burden of debt repayments over time as nominal sums become progressively of less relative value.

Such price inflation benefits debtors at the expense of creditors. Hence, for highly indebted Eurozone governments, price inflation is the perceived “get out of jail” card, permitting them to meet their debt obligations with a falling share of government expenditures.

Second, at least amongst the political elites in the “PIIGS” (Portugal, Italy, Ireland, Greece, Spain) and in France, they espouse “reflation” plans using the ECB’s money-creation powers which would ratchet up to another degree inflation of the money supply, monetization of government debt, and increases in total government debts; and thereby protect and enhance the economic power and privileges of governments and the state.[5]

Yet growth of PIIGS governments’ debts as a proportion of GDP (Table 1) have now crossed above the critical 90 percent ratio advised by Rogoff and Reinhart as being the threshold above which growth rates irrevocably decline.[6]

Table 1. Gross Government Debt as Per cent of GDP 2008-14 for the Eurozone and selected member countries (Adapted from: IMF Fiscal Monitor: Taxing Times, p16. October 2013)

                                2008       2010       2012       2014 (forecast)

Eurozone                70.3        85.7        93.0        96.1

Spain                      40.2        61.7        85.9        99.1

Italy                        106.1      119.1      127.0      133.1

Portugal                 71.7        94.0        123.8      125.3

Ireland                    44.2        91.2        117.4      121.0

There is another potential problem: European commercial banks may be too fragile to fulfil their allotted role. ECB President Mario Draghi himself has initiated another round of stress testing of European banks’ balance sheets against external shocks, a sign that the ECB itself has doubts about systemic stability in the banking sector. But this testing has hardly begun. Here are four risk factors in play:

First, there has been large-scale flight of deposits from banks operating within the PIIGS’ toward banks of other Eurozone countries,[7] as well as outside the Eurozone entirely. This phenomenon is caused by elevated risk of seizures, consequent upon the forced losses on bondholders at Greek banks and the recent “bail-in” of depositors at the Bank of Cyprus.

Second, many PIIGS’ domestic banks still hold on their books bad loans arising from the boom years (2000-2007). Failure to deleverage and liquidate losses is prolonging the banks’ adjustment process.

Third, they already hold huge quantities of sovereign debt (treasury bonds) from Eurozone governments from previous rounds of buying. Banks have had to increase their risk weightings on such debt holdings as Ratings Agencies have downgraded these investments to comply with Basel II. This constrains their forward capacity for lending to these governments.

Fourth, there is concern for rising interest rates. Since the famous “Draghi put” in July 2012, real rates remain low and yields on PIIGS’ sovereign bonds fell back closer to German bunds. But this summer yields on US Treasury bonds with long maturities started to rise on Fed taper talk.[8] Negative surprises knock confidence in the international bond markets. The risk of massive losses should bond prices drop is one that the European-based banks cannot afford given their still low capital reserves and boom phase legacy of over-leveraging.

Implementation impediments aside, a new phase of aggressive easy money policy from the ECB is both probable and imminent.

[4] J.G. Hülsmann, Deflation & Liberty (2008), p. 27.

You might also enjoy Andrew’s blogsite where he also speculates about large scale asset purchases from the ECB: –

http://www.thecantillonobserver.com

European equity and bond market prospects for 2014

This brings me neatly to what you may consider a rather contrarian view of European equities and bonds. So far this article has focussed on the negative headwinds which many commentators expect to undermine confidence in financial markets, however, I’m reminded of some sage words from the “Sage of Omaha” – the quote below comes from an interview/speech which Warren Buffet gave in July 2000 at the Allen & Co, Sun Valley corporate gathering, reported here by Fortune/CNN: –

http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/

In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.

So here’s the record on interest rates at key dates in our 34-year span. They moved dramatically up–that was bad for investors–in the first half of that period and dramatically down–a boon for investors–in the second half.

Since short term rates are close to zero and central bank buying of government bonds has flattened yield curves in most major markets, surely the risk has to be that government bond yields have an asymmetric upside risk? Well, yes, but only if investors lose all confidence in those “risk-free” government obligations. Added to which – what is the correct size for a central bank balance sheet – $4trln or $400trln? When measured in balance sheet expansion terms the ECB is far behind the curve; they have availed themselves of the aggressive quantitative easing of other central banks to exert internal pressure on profligate EZ countries, cajoling them to structurally reform. I believe this austerity has largely run its course, but, as the AQR, is likely to show, it has left the EZ financial system in a weak position.

European bond convergence between the core and periphery continues as the table below (15/1/2014) from Bloomberg shows : –

Europe Yield

1 Day

1 Month

1 Year

Germany 1.82% +1 -1 +24
Britain 2.86% +3 -4 +84
France 2.47% +1 +4 +34
Italy 3.88% +1 -21 -33
Spain 3.82% +1 -28 -120
Netherlands 2.13% +1 -1 +43
Portugal 5.25% 0 -77 -104
Greece 7.67% 0 -95 -388
Switzerland 1.18% +1 +22 +56

European stock markets are making new highs – although EuroStoxx 50 is still some way below its 2008 peak, unlike the S&P. EUR/USD continues to regain composure after the fears of an EZ break-up in the summer of 2012. In this environment I see no reason to liquidate long positions in European equities and higher yielding peripheral bond markets. If US Equities turn bearish and US bond yields rise abruptly, as they did in 2013, then I would expect the ECB to provide their long overdue support. However, a precipitous decline in EUR/USD is cause for concern as this may herald the beginning of another Eurozone crisis – whilst I anticipate some of the above issues will surface during 2014, the “Draghi put” still offers significant protection, whilst the Peterson Institute – Why the European Central Bank Will Likely Shrink from Quantitive Easing – January 15th 2014 – makes a strong case for the ECBs hands being tied: –

http://blogs.piie.com/realtime/?p=4208

I still believe European markets represent a “hedged” exposure to the continued bullish trends in major market equities and higher yielding bonds – the market always prefers to travel than to arrive.