What are the prospects for UK financial markets in 2016?

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Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

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

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.

Have technological advances offset the reduction in capital allocated to financial markets trading?

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Macro Letter – No 45 – 06-11-2015

Have technological advances offset the reduction in capital allocated to financial markets trading?

  • Increases in capital requirements have curtailed financial institutions trading
  • Improved execution, clearing and settlement has reduced frictions in transactions
  • Faster real-time risk management systems have enhanced the efficiency of capital
  • On-line services have democratized market access

Liquidity in financial markets means different things to different participants. A sharp increase in trading volume is no guarantee that liquidity will persist. Before buying (or selling) any financial instrument the first thing one should ask is “how easy will it be to liquidate my exposure?” This question was at the heart of a recent paper by the UK Government – The future of computer trading in financial markets – 2012here are some of the highlights:-

…The Project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects. However, it is believed that policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets.

There will be increasing availability of substantially cheaper computing power, particularly through cloud computing: those who embrace this technology will benefit from faster and more intelligent trading systems in particular.

Special purpose silicon chips will gain ground from conventional computers: the increased speed will provide an important competitive edge through better and faster simulation and analysis, and within transaction systems.

Computer-designed and computer-optimised robot traders could become more prevalent: in time, they could replace algorithms designed and refined by people, posing new challenges for understanding their effects on financial markets and for their regulation.

Opportunities will continue to open up for small and medium-sized firms offering ‘middleware’ technology components, driving further changes in market structure: such components can be purchased and plugged together to form trading systems which were previously the preserve of much larger institutions.

The extent to which different markets embrace new technology will critically affect their competitiveness and therefore their position globally: The new technologies mean that major trading systems can exist almost anywhere. Emerging economies may come to challenge the long-established historical dominance of major European and US cities as global hubs for financial markets if the former capitalise faster on the technologies and the opportunities presented.

The new technologies will continue to have profound implications for the workforce required to service markets, both in terms of numbers employed in specific jobs, and the skills required: Machines can increasingly undertake a range of jobs for less cost, with fewer errors and at much greater speed. As a result, for example, the number of traders engaged in on-the-spot execution of orders has fallen sharply in recent years, and is likely to continue to fall further in the future. However, the mix of human and robot traders is likely to continue for some time, although this will be affected by other important factors, such as future regulation.

Markets are already ‘socio-technical’ systems, combining human and robot participants. Understanding and managing these systems to prevent undesirable behaviour in both humans and robots will be key to ensuring effective regulation…

While the effect of CBT (Computer Based Trading) on market quality is controversial, the evidence available to this Project suggests that CBT has several beneficial effects on markets, notably:

liquidity, as measured by bid-ask spreads and other metrics, has improved;

transaction costs have fallen for both retail and institutional traders, mostly due to changes in trading market structure, which are related closely to the development of HFT in particular;

market prices have become more efficient, consistent with the hypothesis that CBT links markets and thereby facilitates price discovery.

While overall liquidity has improved, there appears to be greater potential for periodic illiquidity: The nature of market making has changed, with high frequency traders now providing the bulk of such activity in both futures and equities. However, unlike designated specialists, high frequency traders typically operate with little capital, hold small inventory positions and have no obligations to provide liquidity during periods of market stress. These factors, together with the ultra-fast speed of trading, create the potential for periodic illiquidity. The US Flash Crash and other more recent smaller events illustrate this increased potential for illiquidity.

…Three main mechanisms that may lead to instabilities and which involve CBT are:

nonlinear sensitivities to change, where small changes can have very large effects, not least through feedback loops;

incomplete information in CBT environments where some agents in the market have more, or more accurate, knowledge than others and where few events are common knowledge;

internal ‘endogenous’ risks based on feedback loops within the system.

The crux of the issue is whether market-makers have been replaced by traders. This trend is not new. On the LSE the transition occurred at “Big Bang” in October 1986. The LSE was catching up with the US deregulation which prompted the formation of NASDAQ in 1971.

Electronic trading, once permitted, soon eclipsed the open-outcry of futures pits and traditional practices of stock exchange floors. Transactions became cheaper, audit trails, more accurate and error incidence declined. Commission rates fell, bid/offer spreads narrowed, volumes increased, in an, almost, entirely virtuous circle.

The final development which was needed to insure liquidity, was the evolution of an efficient repurchase market for securities – sadly this market-place remains remarkably opaque. Nonetheless, the perceived need for designated market-makers, with an obligation to make a two-way price, has diminished. It has been replaced by proprietary trading firms, which forgo the privileges of the market-maker – principally lower fees or preferential access to supply – for the flexibility to abstain from providing liquidity at their own discretion.

In the late 1990’s I remember a conversation with a partner at NYSE Specialist – Foster, Marks & Natoli – he had joined the firm in 1953 and sold his business to Spear, Leeds Kellogg in 1994. He told me that during his career he estimated the amount of capital relative to size of the trading portfolio had declined by a factor of five times.

Since the mid-1990’s stock market volumes have increased dramatically as the chart below shows:-

NYSEvolume

Source: NYSE

The recommendations of the UK Government report include:-

European authorities, working together, and with financial practitioners and academics, should assess (using evidence-based analysis) and introduce mechanisms for managing and modifying the potential adverse side-effects of CBT and HFT.

Coordination of regulatory measures between markets is important and needs to take place at two levels: Regulatory constraints involving CBT in particular need to be introduced in a coordinated manner across all markets where there are strong linkages.

Regulatory measures for market control must also be undertaken in a systematic global fashion to achieve in full the objectives they are directed at. A joint initiative from a European Office of Financial Research and the US Office of Financial Research (OFR), with the involvement of other international markets, could be one option for delivering such global coordination.

Legislators and regulators need to encourage good practice and behaviour in the finance and software engineering industries. This clearly involves the need to discourage behaviour in which increasingly risky situations are regarded as acceptable, particularly when failure does not appear as an immediate result.

Standards should play a larger role. Legislators and regulators should consider implementing accurate, high resolution, synchronised timestamps because this could act as a key enabling tool for analysis of financial markets. Clearly it could be useful to determine the extent to which common gateway technology standards could enable regulators and customers to connect to multiple markets more easily, making more effective market surveillance a possibility.

In the longer term, there is a strong case to learn lessons from other safety-critical industries, and to use these to inform the effective management of systemic risk in financial systems. For example, high-integrity engineering practices developed in the aerospace industry could be adopted to help create safer automated financial systems.

Making surveillance of financial markets easier…The development of software for automated forensic analysis of adverse/extreme market events would provide valuable assistance for regulators engaged in surveillance of markets. This would help to address the increasing difficulty that people have in investigating events

At no point do they suggest that all market participants – especially those with principal or spread risk – be required to increase their capital. This will always remain an option. An alternative solution, the reinstatement of designated market-makers with obligations and privileges, is also absent from the report – this may prove to be a mistake.

An example of technological emancipation

In this paper, Review of Development Finance – The impact of technological improvements on developing financial markets: The case of the Johannesburg Stock Exchange – Q3 – 2013 – the authors investigate how the adoption of the SETS trading platform transformed the volume traded on the JSE:-

The adoption of the SETS trading platform was supposed to represent a watershed moment in the history of the Johannesburg Stock Exchange. The JSE is more liquid after SETS. The JSE has nearly doubled its trading activity (volume), trading is cheaper, and there are more trades at JSE after SETS.

Overall, average daily returns are higher. We posit that this is mainly because the returns are increased to the levels demanded for the associated risk. With the new trading platform, it would also be expected that there would be improvements in market efficiency. Higher numbers of investors, more listed companies, faster trading and more trade (evidenced with trading activity and liquidity), all would imply more market efficiency. Contrary to our expectations, however, market-wide and individual-level stock returns are still somewhat predictable; this is a clear violation of market efficiency.

If market participants had been required to increase their capital in line with the increased volume, the transformation would have been far less dramatic. This is not to say that increased trading volume equates to increased risk. Technology has improved access, traders are able to liquidate positions more easily, most of the time, due to improved technology. At any point in the trading day they may hold the same open position size, but by turning over their positions more frequently they may be able to increase their return on capital (and risk) employed.

Federal Reserve concern

The Federal Reserve Bank of New York – Introduction to a series on Liquidity published eleven articles on different aspects of liquidity during the last three months, here are some of the highlights:-

Has U.S. Treasury Market Liquidity Deteriorated? …it might be that liquidity concerns reflect anxiety about future liquidity conditions, with a possible imbalance between liquidity supply and demand. On the demand side, the share of Treasuries owned by mutual funds, which may demand daily liquidity, has increased. On the supply side, the primary dealers have pared their financing activities sharply since the crisis and shown no growth in their gross positions despite the sharp increase in Treasury debt outstanding.

This seems to ignore the effect of QE on the “free-float” of T-Bonds. The chart below shows the growth of the Federal Reserve holdings during the last decade:-

T-Bonds at the Fed - St Louis Fed

Source: St Louis Federal Reserve

Liquidity during Flash Events…all three events exhibited strained liquidity conditions during periods of extreme price volatility but the Treasury market event arguably exhibited a greater degree of price continuity, consistent with descriptions of the flash rally as “slow-moving.”

Unlike the FX and equity market, the US government still appoint primary dealers who have privileged access to the issuer. This probably explains much of the improved price continuity.

High-Frequency Cross-Market Trading in U.S. Treasury Markets. Cross-market trading by now accounts for a significant portion of trading in Treasury instruments in both the cash and futures markets. This reflects improvements in trading technology that allow for high-frequency trading within and across platforms. In particular, nearly simultaneous trading between the cash and futures platforms now accounts for up to 20 percent of cash market activity on many days. Market participants often presume that price discovery happens in Treasury futures. However, our findings show that this is not always the case: Although futures usually lead cash, the reverse is also often true. Therefore, from a price discovery point of view, the two markets can effectively be seen as one.

For many years the T-Bond future was regarded as the most liquid market and was therefore the preferred means of liquidation in times of stress. The most extreme example I have witnessed was in the German bond market during re-unification (1988). The Bund future was the most liquid market in which to lay off risk. As a result, Bund futures traded more than 10 bps cheap to cash and cash Bunds offered a yield premium of 13bps to bank Schuldschein – unsecured promissory notes.

The introduction of electronic trading in T-Bond cash markets has created competing pools of liquidity which should be additive in times of stress. The increasing use of Central Counter Party (CCP) clearing has allowed new market participants to operate with a smaller capital base.

This evolution has also been sweeping through the Interest Rate Swap market, reducing pressure on the T-Bond futures market further still.

The Evolution of Workups in the U.S. Treasury Securities Market. The workup is a unique feature of the interdealer cash Treasury market. Over time, the details of the workup have changed in response to changing market conditions, with the abandonment of the private phase and the shortening of the default duration to 3 seconds. While some market participants may consider it an anachronism, given the increased trading activity in benchmark Treasuries and the tight link to the extremely liquid Treasury futures market, the workup has not only remained an important feature of the interdealer market; it has actually grown in importance, now accounting for almost two-thirds of trading volume in the benchmark ten-year Treasury note.

On the Frankfurt stock exchange each Bund issue is “fixed” at around 13:00 daily. This process creates a liquidity concentration. A similar “clearing” process occurs at the end of LME rings. For spread traders, the ability to “lean” against a relatively un-volatile market – such as during a workup – whilst making an aggressive market in the correspondingly more volatile companion, represents an enhanced trading opportunity. One side of the potential spread price is provided “risk-free”.

What’s Driving Dealer Balance Sheet Stagnation? …The growing role of electronic trading has likely narrowed bid-ask spreads and reduced dealers’ profits from intermediating customer order flow, causing dealers to step back from making markets and reducing their need for large balance sheets. The changing competitive landscape of market making, as manifested by the entry of nondealer firms since the early 2000s, may therefore also play a role in the post-crisis dealer balance sheet dynamics.  …The picture that emerges is that post-crisis dealer asset growth represents the confluence of several issues. Our findings suggest that business-cycle factors (the hangover from the housing boom and bust and subsequent risk aversion) and secular trends (electronification and competitive entry) should be considered alongside tighter regulation in explaining stagnating dealer balance sheets. 

I refer back to my conversation with Mr Foster, the NYSE Specialist; in asset markets – equities and to a lesser extent bonds – as volume increases during a bull-market, the number of market participants increases. In this environment “liquidity providers” trade more frequently with the same capital base. Subsequently, as volatility declines – provided trading volume is maintained – these liquidity providers increase their trading size in order to maintain the same return on capital. When the bear-market arrives, the new participants, who arrived during the bull-market, liquidate. The remaining “liquidity providers” – those that haven’t exited the gene pool – are left passing the parcel among themselves as the return on capital declines precipitously (the chart, some way below, shows this evolution quite clearly).

Has U.S. Corporate Bond Market Liquidity Deteriorated? …price-based liquidity measures—bid-ask spreads and price impact—are very low by historical standards, indicating ample liquidity in corporate bond markets. This is a remarkable finding, given that dealer ownership of corporate bonds has declined markedly as dealers have shifted from a “principal” to an “agency” model of trading. These findings suggest a shift in market structure, in which liquidity provision is not exclusively provided by dealers but also by other market participants, including hedge funds and high-frequency-trading firms.

Given the “quest for yield” and the reduction in T-Bond supply due to QE, this shift in market structure is unsurprising, however the relatively illiquid nature of the Corporate bond repo market means much of the activity is based around “carry” returns. Participants are cognizant of the dangers of swift reversals of sentiment in carry trading.

Has Liquidity Risk in the Corporate Bond Market Increased? …We measure market liquidity risk by counting the frequency of large day-to-day increases in illiquidity and price volatility, where “large” is defined relative to measures of recent liquidity and volatility changes (details are described here). We refer to the illiquidity jumps as “liquidity risk” and to the volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window shows that liquidity risk and vol-of-vol have declined substantially from crisis levels…

…Current metrics indicate ample levels of liquidity in the corporate bond market, and liquidity risk in the corporate bond market seems to have actually declined in recent years. This is in contrast to liquidity risk in equity and Treasury markets…

The Fed methodology is contained in a four page paper A Note on Measuring Illiquidity Jumps. It may be of interest to those with an interest in exotic option pricing. I’m not convinced that I agree with their conclusions about Liquidity Risk – it is difficult to measure that which is unseen.

Has Liquidity Risk in the Treasury and Equity Markets Increased? …While current levels of liquidity appear similar to those observed before the crisis, sudden spikes in illiquidity—like the equity market flash crash of 2010, the recent equity market volatility on August 24, and the flash rally in Treasury yields on October 15, 2014—seem to have become more common. Such spikes in illiquidity tend to coincide with spikes in option-implied volatility, in both equity and Treasury markets…

…we refer to these liquidity jumps as “liquidity risk” and volatility jumps as “vol-of-vol.” Counting the number of such jumps in an eighteen-month trailing window reveals a recent uptick in liquidity risk and vol-of-vol, and confirms the link between them… The evidence that liquidity risk in equities and Treasuries is elevated contrasts with our earlier post, which found no such increase for corporate bonds.

Our findings suggest a trade-off between liquidity levels and liquidity risk: while equity and Treasury markets have been highly liquid in recent years, liquidity risk appears elevated. This change has gone hand in hand with an apparent increase in the vol-of-vol of asset prices, so that illiquidity spikes seem to coincide with volatility spikes. Our findings further suggest that the increase in liquidity risk is more likely attributable to changes in market structure and competition than dealer balance sheet regulations, since the latter would also have caused corporate bond liquidity risk to rise. Moreover, evidence from option markets suggests that this seeming rise in liquidity risk is not reflected in the price of volatility.

Market liquidity in a given market is never constant, the trading volume may remain the same but the market participants, wholly different. In the 1980’s Japanese institutions were a significant influence on the US bond market, today it is the Federal Reserve. Changes, such as minimum price increments and exchange trading hours are significant; the list of factors is long and ever changing. The increase in Liquidity Risk has as much to do with the increase in systematic trading and the relative consistency of approach these traders take to risk management. These traders and their methods have become increasingly prevalent. Whilst cognizant of skewness they see the world through a Gaussian lense. They measure strategy success by Sharpe and Sortino ratio, assessing it by the minute or the hour and being “flat” by market close.

Changes in the Returns to Market Making. We show estimated returns to market making to be at historically low levels—a finding that seems inconsistent with market analysts’ argument that higher capital requirements have reduced market liquidity. The picture that emerges from our analysis is of a change in the risk-sharing arrangement among trading institutions. We uncover a compression in expected returns to market making in the corporate bond market, where dealers remain the predominant market makers, as well as the equity market, where dealers are less important. The compression of market making returns may be tied to competitive pressures, with high-frequency trading competition being important in the equity market.

High-Frequency Equity Market-Making Returns and VIX

Source: Reuters, Haver Analytics

The chart above looks at one minute reversals on the Dow. As long ago as 2003, the HFT customers I dealt with were operating on sub-second reversal time horizons. Nonetheless, the pattern of profitability may be broadly similar.

Redemption Risk of Bond Mutual Funds and Dealer Positioning. Mutual funds’ share of corporate bond ownership has increased sharply in recent years, while dealers’ share has declined substantially. Because mutual funds are subject to redemption risk, this shift in ownership patterns raises the concern that redemption risk might have increased. However, we find no evidence that the net flow volatility of bond funds has increased. Likewise, we uncover no evidence of contrarian behavior by dealers relative to bond fund flows. Therefore, even if we do observe large mutual fund redemptions in the future, our evidence does not suggest that reduced dealer positions will exacerbate the effects on corporate bond pricing and liquidity.

Since the Mutual Fund “Late Trading” scandal of 2003, arbitrage operators have maintained a low-profile. The “flight-to-quality” properties of T-Bonds should also mean mass-redemption is a much lower probability – “mass-subscription” is a higher risk.

The Liquidity Mirage. While low-latency cross-market trading has undoubtedly led to more consistent pricing of Treasury securities and derivatives, there is strong evidence that it has also resulted in a more complex and dynamic nature of market liquidity. Under the new market structure, it has arguably become more challenging for large investors to accurately assess available liquidity based on displayed market depth across venues. The striking cross-market patterns in trading and order book changes suggest that quote modifications/cancellations by high-frequency market makers rather than preemptive aggressive trading are an important contributing factor to the liquidity mirage phenomenon.

In the days of open-outcry trading on futures exchanges “local” traders would frequently cancel and replace bids and offers. These participants were visible, their reliability, or otherwise, was known to the market-place. In an electronic order book there is less transparency. Algorithmic trading solutions have developed, over the last twenty years, to enable efficient execution in this more opaque environment.

“Cost plus” pricing for equity and futures execution is still quite rare outside the HFT world but it has had a dramatic influence on stock market micro-structure and liquidity since the 1990’s.

In a recent speech by Minouche Shafik of the Bank of England – Dealing with change: Liquidity in evolving market structuressuggested that the changes in liquidity are a natural process:-

The reduction in the relative size of dealer balance sheets may also be a natural process of evolution as the market-making industry matures and emphasis is placed on using its warehousing capacity efficiently rather holding lots of inventory. Market making wouldn’t be the first industry to go through such a change: Just In Time management swept through manufacturing in the 70s and 80s with its focus on minimising waste, eliminating inventories, and quickly responding to changing market demand. More recently, supermarkets have reversed their once relentless expansion of retail space, and started moving away from inventory-intensive hypermarkets toward smaller retail units.

Indeed, moving toward smaller in-store inventories is not the only parallel between retailing and market making: both have also been dramatically changed by innovation. Just as the rise of internet shopping has given consumers access to a broader choice of shops and much easier means of price comparison, so has electronic trading facilitated new ways of matching buyers and sellers in financial markets, and added to the data generally available for price discovery.

The Deputy Governor goes on to remind us that the BoE acted as Market-Maker of Last Resort during the last crisis and would do so again.

Conclusion – Financial markets – for the benefit of whom

Financial markets evolve to allow investors to provide capital in exchange for a financial reward. Technology has increased the speed and reliability of market access whilst reducing the cost, however these benefits change the underlying structure of markets, be it co-location of servers in the last decade or block-chain technology in the next.

Politicians seek to encourage long-term investment; high frequency trading is a very short-term investment strategy indeed, but without short-term investors – shall we call them speculators – the ability to transfer of capital is severely impaired. Even the most jaundiced politician will admit, speculators are a necessary evil.

Innovation has democratized financial markets, it has enabled individual investors to create complex portfolios and implement strategies which were once the preserve of hedge funds and investment banks, however the experience has not been an unmitigated success, in the process it purportedly enabled one man from Hounslow to wipe $750bln off the value of the US stock market in May 2010. That this was possible defies credulity for many; I believe it indicates how technology has more than offset the decline in capital allocated to financial market trading, nonetheless, when it comes to financial market liquidity, I concur with Deputy Governor Shakif – “caveat emptor”.

Broken BRICs – Can Brazil and Russia rebound?

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Macro Letter – No 35 – 08-05-2015

Broken BRICs – Can Brazil and Russia rebound?

  • The economies of Brazil and Russia will contract in 2015
  • Their divergence with China and India is structural
  • Economic reform is needed to stimulate long term growth
  • Stocks and bonds will continue to benefit from currency depreciation

When Jim O’Neill, then CIO of GSAM, coined the BRIC collective in 2001, to describe the largest of the emerging market economies, each country was growing strongly, however, O’Neill was the first to acknowledge the significant differences between these disparate countries in terms of their character. Since the Great Recession the economic fortunes of each country has been mixed, but, whilst the relative strength of China and India has continued, Brazil and Russia might be accused of imitating Icarus.

Economic Backdrop

In order to evaluate the prospects for Brazil and Russia it is worth reviewing the unique aspects of, and differences between, each economy.

According to the IMF April 2015 WEO, Brazil is ranked eighth largest by GDP and seventh largest by GDP adjusted for purchasing power parity. Russia was ranked tenth and sixth respectively. Between 2000 and 2012 Brazilian economic growth averaged 5%, yet this year, according to the IMF, the economy is forecast to contract by 1%. The forecast for Latin America combined is +0.6%. For Russia the commodity boom helped GDP rise 7% per annum between 2000 and 2008, but with international sanctions continuing to bite, this year’s GDP is expected to be 3.8% lower.

Brazil’s service sector is the largest component of GDP at 67%, followed by the industry,27% and agriculture, 5.5%. The labour force is around 101mln, of which 10% is engaged in agriculture, 19% in industry and 71% in services. Russia by contrast is more reliant on energy and other natural resources. In 2012[update] oil and gas accounted for 16% of GDP, 52% of federal budget revenues and more than 70% of total exports. As of 2012 agriculture accounted for 4.4% of GDP, industry 37.6% and services 58%. The labour force is somewhat smaller at 76mln (2015).

The Harvard Atlas of Economic Complexity 2012 ranks Brazil 56th and Russia 47th. The table below shows the divergence in IMF forecasts since January. During the period October 2014 and February 2015 the Rouble (RUB) declined by 30% whilst the Brazilian Real (BRL) fell only 9%:-

Country GDP GDP Forecast Forecast Jan-14 Jan-14
2013 2014 2015 2016 2015 2016
Brazil 2.7 0.1 -1 1 -1.3 -0.5
Russia 1.3 0.6 -3.8 -1.1 -0.8 -0.1

Source: IMF WEO April 2015

On March 14th the Bank of Russia published its three year economic forecast: it was decidedly rosy. This was how the Peterson Institute – The Incredibly Rosy Forecast of Russia’s Central Bank described it:-

…the Bank of Russia argues that the huge devaluation of the ruble that took place between October 2014 and February 2015 has a minor effect on economic growth. This claim neglects much empirical evidence that sharp devaluations retard investment activity, for two reasons. First, investment technology from abroad becomes more expensive—nearly 80 percent more expensive in the case of Russia. Second, devaluations increase uncertainty in business planning and hence slow down investment in domestic technology as well. Both effects work to depress economic activity in the short term.

…2017 is presented as the year of a strong rebound, as a result of cyclical macroeconomic forces. In particular, says the Bank of Russia, growth will reach 5.5 to 6.3 percent that year. It is true that the economy was already slowing down in 2012, before last year’s sanctions and devaluation. It is also true that the average business cycle globally has historically lasted about six years. But this is no ordinary cycle—sanctions are likely to play a bigger role than the Bank of Russia cares to admit. The main reason is their effect on the banking sector, where credit activity is already substantially curtailed, and may be curtailed even further once corporate eurobonds start coming due later this year. The devaluation has exacerbated the credit crunch as interest rates spiked in early 2015 to over 20 to 25 percent for business loans. These effects point in one direction: a prolonged recession.

Finally, the Russian government is reducing public investment in infrastructure in this year’s budget to try and cut overall expenditure by about 10 percent. This cutback is going to dampen growth because the multiplier on infrastructure investment is highest among all public expenditures. The Bank of Russia seems to have forgotten to account for this elementary fact of life.

Overall, the economic picture may end up being quite different from what the Bank of Russia forecasts. Instead of economic growth of –3.5 to –4 percent in 2015, –1 to –1.6 percent in 2016, and 5.5 to 6.3 percent in 2017, it may be closer to –6 to –7 percent in 2015, –3 to –4 percent in 2016, and zero growth in 2017. This scenario is worth contemplating, as it would mean that the reserve fund that the government uses to finance its deficit may be fully depleted in this period. What then?

The table below compares a range of other indicators for the two economies:-

Indicator Brazil     Russia    
  Last Reference Previous Last Reference Previous
Interest Rate 13.25% Apr-15 12.75 12.50% Apr-15 14
Government Bond 10Y 12.90% May-15 10.71% May-15
Stock Market YTD* 14.70% May-15 23.20% May-15
GDP per capita $5,823 Dec-13 5730 $6,923 Dec-13 6849
Unemployment Rate 6.20% Mar-15 5.9 5.90% Mar-15 5.8
Inflation Rate – Annual 8.13% Mar-15 7.7 16.90% Mar-15 16.7
PPI – Annual 2.27% Jan-15 2.15 13% Mar-15 9.5
Balance of Trade $491mln Apr-15 458 $13,600mln Mar-15 13597
Current Account -$5,736mln Mar-15 -6879 $23,542mln Feb-15 15389
Current Account/GDP -4.17% Dec-14 -3.66 1.56% Dec-13 3.6
External Debt $348bln Nov-14 338 $559bln Feb-15 597
FDI $4,263mln Mar-15 2769 -$1,144mln Aug-14 12131
Capital Flows $7,570mln Feb-15 10826 -$43,071mln Nov-14 -10260
Gold Reserves 67.2t Nov-14 67.2 1,208t Nov-14 1150
Crude Oil Output ,000’s 2,497bpd Dec-14 2358 10,197bpd Dec-14 10173
Government Debt/GDP 58.91% Dec-14 56.8 13.41% Dec-13 12.74
Industrial Production -9.10% Feb-15 -5.2 -0.60% Mar-15 -1.6
Capacity Utilization 79.70% Feb-15 80.9 59.85% Mar-15 62.04
Consumer Confidence** 99 Apr-15 100 -32 Feb-15 -18
Retail Sales YoY -3.10% Feb-15 0.5 -8.70% Mar-15 -7.7
Gasoline Prices $1.04/litre Mar-15 1.16 $0.68/litre Apr-15 0.61
Corporate Tax Rate 34% Jan-14 34 20% Jan-15 20
Income Tax Rate 27.50% Jan-14 27.5 13% Jan-15 13
Sales Tax Rate 19% Jan-14 19 18% Jan-15 18
*Bovespa = Brazil
*Micex = Russia
** Consumer confidence in Brazil – 100 = neutral, Consumer confidence in Russia – 0 = neutral

Source: Trading Economics and Investing.com

From this table it is worth highlighting a number of factors; firstly interest rates. Rates continue to rise in Brazil despite the relatively benign inflation rate. The rise in the Russian, Micex stock index has been much stronger than that of the Brazilian, Bovespa, partly this is due to the larger fall in the value of the RUB and partly due to the recent recovery in the oil price. PPI inflation in Brazil remains broadly benign, especially in comparison with 2014, whilst in Russia it is stubbornly high – making last week’s rate cut all the more surprising.

Brazilian industrial production continues to decline, a trend it has been struggling to reverse, yet capacity utilisation remains relatively high. Russian industrial production never rebounded as swiftly from the 2008 crisis but has remained in positive territory for the last few years despite the geo-political situation. Remembering that one of Russia’s largest industries is arms manufacture – the country ranks third by military expenditure globally behind China and US – this may not be entirely surprising.

Of more concern for Brazil, is the structural nature of its current account deficit, since the advent of the Great Recession. This combination of deficit and inflation prompted Morgan Stanley, back in 2013, to label Brazil one of the “Fragile Five” alone side India, Indonesia, South Africa and Turkey. Russia, by contrast, has run a surplus for almost the entire period since the Asian crisis of 1998.

The Government debt to GDP ratio in Russia has risen slightly but the experience of the Asian crisis appears to have been taken on board. Added to which, the sanctions regime means Russia is cut off from international capital markets. In Brazil the ratio is not high in comparison with many developed nations but the ratio has been rising since 2011 and looks set to match the 2010 high of 60.9 next year if spending is not curtailed.

A final observation concerns gold reserves. Brazil has relatively little, although they did increase in January 2013 after a prolonged period at very low levels. Russia has taken a different approach, since 2008 its reserves have tripled from less than 400t to more than 1,200t today. There have been suggestions that this is a prelude to Russia adopting a “hard currency” standard in the face of continuous debasement of fiat currencies by developed nation central banks, but that is beyond the remit of this essay.

Are the BRICs broken?

In an article published in July 2014 by Bruegal – Is the BRIC rise over? Jim O’Neill discusses the future with reference to the establishment of a joint development bank:-

Some observers believed that the whole notion of a grouping of Brazil, Russia, India and China never made any sound sense because beyond having a lot of people, they didn’t share anything else in common. In particular, two are democracies, and two are not, obviously, China and Russia.  Similarly, two are major commodity producers, Brazil and Russia, the other two, not. And their levels of wealth are quite different, with Brazil and Russia well above $10,000, China around $ 7-8 k, and India less than $ 2k per head.  And the sceptic would follow all of this by saying, the only reason why Brazil and Russia grew so well in the past decade was simply due to a persistent boom in commodity prices, and once that finished, as appears to be the case now, then their economies would lose their shine, as indeed appears to be the case.  Throw in that China would inevitably be caught by its own significant challenges at some point, which the doubters would say, is now, then all is left is India, and if it weren’t for the election of Modi recently, there has not been a lot to justify structural optimism about that country recently.

…I do believe each of Brazil and Russia have got some challenges to face, that they are not yet confronting, which at the core is to reduce their dependency to the commodity cycle, and while there are many differences between them, they do both need to become more competitive and entrepreneurial outside of commodities and to boost private sector investment.

The development has caused much political jawboning but I suspect its impact will be small in the near-term.

Looking again at the figures for capital flows, Brazil appeared to be in better shape, but Russian FDI has been positive in every quarter since 2008 until the most recent outflow in Q3 2014.

Consumer confidence in Brazil has remained more robust, possibly this is due to innate Latin optimism but it may be partly in expectation of the forthcoming Olympics. The games will take place in Rio, reminding us of the high urbanisation rates in Brazil, 85.4%. This is not dissimilar to Russia at 73.9% but substantially higher than China 54.4% and India 32.4%. Interestingly US urbanisation is 81.4% – but US GDP per capita is significantly higher.

Russia

The Peterson Institute – Russia’s Economic Situation Is Worse than It May Appear from early December 2014 painted a gloomy picture of the prospects:-

The Russian economy suffers from three severe blows: ever worsening structural policies, financial sanctions from the West, and a falling oil price. 

…Russia is experiencing large capital outflows, expected to reach $120 billion. Because of Western financial sanctions, they are set to continue. The large outflows erupted in March as investors anticipated financial sanctions, which hit in July and in effect have closed financial markets to Russia. No significant international financial institution dares to take the legal risk of lending Russia money today. 

Not wishing to be left out of the rhetoric on Russia’s demise, in late December the ECFR – What will be the consequences of the Russian currency crisis?:-

The watershed moment was the imposition of the third round of Western sanctions, which cut Russian companies off from the world’s financial markets. Along with falling oil prices (a key market factor), this caused market players to reassess the risks. Before the introduction of sanctions, the ratio of external debt to foreign exchange reserves (at 1.4) was not particularly worrying. But the fact that companies could no longer refinance their debt on external markets necessitated a rethink. It became clear that, with export revenues falling because of lower oil prices, companies would accumulate excess currency in their accounts. The supply of currency in the market from exporters (many of whom also had large debts) declined sharply, while demand from the debtor companies increased.

In October 2014 the Central Bank was forced to spend another $26 billion to support the rouble. After that, preserving the country’s reserves became the priority, so in November, the bank’s intervention fell to $10 billion. So everything was in place for a currency crisis and this is why the Russian Minister for the Economy called it “the perfect storm”. The storm was only halted by a sharp increase in the Central Bank’s interest rate and by informal pressure on companies that brought about a speedy decline in foreign exchange trading.

…So the double devaluation of the rouble will be felt in rising price and shrinking consumption. According to the Gaidar Institute for Economic Policy, this will add at least 10–12 percentage points to normal inflation, which will reach 15-20 percent. Import substitution options are relatively limited: large-scale import substitution would require significant investment and, at the moment, the resources for this are not there. And a fall in consumption (as a result of the falling purchasing power of households) will cause a decline in production.

According to the Central Bank’s December forecast, GDP in 2015 may fall by 4.5–4.8 percent. This is what the bank calls a “stress scenario”, and it assumes that the oil price will stay at $60 a barrel and Western sanctions will remain in place. In fact, this scenario seems to be the most realistic; any other scenario would involve either the lifting of sanctions or a rise in the oil price to $80 or even $100.

The dismal theme was inevitably taken up by CFR – The Russian Crisis: Early Days in early January:-

The most likely trigger for a future crisis resides in the financial sector. December’s $2 billion bailout of Trust Bank, coupled with news of large and potentially open-ended support for VTB Bank and Gazprombank, highlight the rapidly escalating costs of the crisis for the financial sector as state banks and energy companies face high dollar-denominated debt payments and falling revenues. Rising bad loans, falling equity values, and soaring foreign-currency debt are devastating balance sheets. As foreign banks pull back their support, the combination of sanctions, oil prices, and rising nonperforming loans is creating a toxic mix for Russian banks. So far, a crisis has been deferred by the belief that the central bank can and will fully stand behind the banking system. If any doubt creeps in about the strength of that commitment, a run will quickly materialize.

…Sanctions are a force multiplier. Western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, Western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Russia could have weathered an oil shock or sanctions alone, but not both together.

…Measured by the severity of recent market moves, Russia is in crisis. But from a broader perspective, a comprehensive economic and financial crisis would cause a far greater degree of financial distress for the Russian people. Companies would find working capital unavailable; interest rates of 17 percent (or higher) and exchange rate depreciation would cause a spike in import prices; and capital expenditure would crater. All this would generate sharp increases in unemployment and a far greater fall in gross domestic product (GDP) than we have seen so far.

Chatham House – Troubled Times Stagnation, Sanctions and the Prospects for Economic Reform in Russia – published at the end of February, goes into more depth, concluding:-

Over the past three decades, a precipitous drop in oil prices (and a concomitant sharp reduction in rents) has resulted in economic reforms being undertaken in Russia. Mikhail Gorbachev’s perestroika emerged after the fall in oil prices in 1986. Putin’s earlier, more liberal economic policies were carried out after oil dropped to close to $10 a barrel in 1999. And Dmitri Medvedev’s modernization agenda was strongest in the aftermath of the global recession of 2008–09.

Unfortunately, the prospects for a similar surge in economic reform in Russia today are less good. The unfavourable geopolitical environment threatens to change the trajectory of political and economic development in Russia for the worse. By boosting factions within Russia’s policy elite who favour increased state control and less integration with the global economy, poor relations with the West threaten to reduce the prospects for a market-oriented turn in economic policy. As a result, the prevailing system of political economy that is in such urgent need of transformation may in fact be preserved in a more ossified form. Instead of responding to adversity through openness, Russia may take the historically well-trodden path of using a threatening international environment to justify centralization and international isolation in order to strengthen the existing ruling elite.

Thus, while Western sanctions were not necessarily intended to strengthen statist factions within Russia and force the country away from the global economy, this may prove to be an unintended but important outcome. Consequently, Russia appears to be locked into a path of economic policy inertia, as powerful constituencies that benefit from the existing system are strengthened by the showdown with the West. While Russia may have ‘won’ Crimea, and may even succeed in ensuring that Ukraine is not ‘won’ by the West, the price of victory may be a deterioration in long-term prospects for socioeconomic development.

This is how the USDRUB has performed during the last 12 months, the first interest rate cut (from 17% to 15% took place on 30th January, the RUB fell 3% on the day to around USDRUB 70, since then the RUB has appreciated to around USDRUB 55-55:-

USDRUB 1yr

Source: Yahoo Finance

What caused the RUB to return from the brink was a recovery in the oil price and a slight improvement in the politics of the Ukraine. The Minsk II Agreement, whilst only partially observed, has curtailed an escalation of the Ukrainian civil war. Capital outflows which were $77bln in Q4 2014 slowed to $32bln in Q1 2015. Ironically, the rebound in the currency and appreciation in the Micex index will probably delay the necessary structural reforms which are needed to reinvigorate the economy.

Brazil

At the end of February the Economist – Brazil – In a quagmiredescribed the challenges facing President Rousseff’s weak government:-

Brazil’s economy is in a mess, with far bigger problems than the government will admit or investors seem to register. The torpid stagnation into which it fell in 2013 is becoming a full-blown—and probably prolonged—recession, as high inflation squeezes wages and consumers’ debt payments rise (see article). Investment, already down by 8% from a year ago, could fall much further. A vast corruption scandal at Petrobras, the state-controlled oil giant, has ensnared several of the country’s biggest construction firms and paralysed capital spending in swathes of the economy, at least until the prosecutors and auditors have done their work. The real has fallen by 30% against the dollar since May 2013: a necessary shift, but one that adds to the burden of the $40 billion in foreign debt owed by Brazilian companies that falls due this year.

…Ideally, Brazil would offset this fiscal squeeze with looser monetary policy. But because of the country’s hyperinflationary past, as well as more recent mistakes—the Central Bank bent to the president’s will, ignored its inflation target and foolishly slashed its benchmark rate in 2011-12—the room for manoeuvre today is limited. With inflation still above its target, the Central Bank cannot cut its benchmark rate from today’s level of 12.25% without risking further loss of credibility and sapping investor confidence. A fiscal squeeze and high interest rates spell pain for Brazilian firms and households and a slower return to growth.

Yet the president’s weakness is also an opportunity—and for Mr Levy in particular. He is now indispensable. He should build bridges to Mr Cunha, while making it clear that if Congress tries to extract a budgetary price for its support, that will lead to cuts elsewhere. The recovery of fiscal responsibility must be lasting for business confidence and investment to return. But the sooner the fiscal adjustment sticks, the sooner the Central Bank can start cutting interest rates.

More is needed for Brazil to return to rapid and sustained growth. It may be too much to expect Ms Rousseff to overhaul the archaic labour laws that have helped to throttle productivity, but she should at least try to simplify taxes and cut mindless red tape. There are tentative signs that the government will scale back industrial policy and encourage more international trade in what remains an over-protected economy.

Brazil is not the only member of the BRICS quintet of large emerging economies to be in trouble. Russia’s economy, in particular, has been battered by war, sanctions and dependence on oil. For all its problems, Brazil is not in as big a mess as Russia. It has a large and diversified private sector and robust democratic institutions. But its woes go deeper than many realise. The time to put them right is now.

Earlier this week the Peterson Institute – The Rescue of Brazil summed up the current situation:-

The Brazilian economy has all the characteristics of a country under the tutelage of an International Monetary Fund (IMF) program. The list of its economic imbalances is endless: a rampant current account deficit in excess of 4 percent of GDP, an exchange rate that has long been overvalued but that has collapsed in just a few months, a public debt ratio to GDP in a rapid upward trend, a fiscal deficit of over 6 percent of GDP despite a high tax burden, an annual inflation rate of nearly 8 percent that has unanchored inflation expectations, an accelerated growth of wages well above their very low productivity. The scandal of the oil company Petrobras, the latest in a long series of political corruption scandals, is the straw that could break the back of investors’ patience, the tolerance of Brazilian citizens, and the stamina of the world’s seventh largest economy. The Petrobras scandal has far-reaching ramifications throughout the economy and society, paralyzing activity and collapsing both business and consumer confidence to unprecedented levels. The mass street demonstrations of recent weeks are the most graphic example of this dissatisfaction.

In another Op-ed Peterson – Brazil’s Investment: A Maze in One’s Own Navel the authors point to the relatively closed nature of the Brazilian economy for the lack of international investment:-

Consider the most common explanations for why Brazil’s investment rate shows persistent apathy: Excessive taxes levied on businesses discourage fixed capital formation; poor infrastructure—including ongoing problems in the energy sector—increases production costs; high wages relative to worker productivity weigh on firms, hampering investment; an opaque business environment characterized by obsolete and excessive licensing requirements reduce firms’ incentives to invest; an institutional environment marked by subsidized lending that favors certain firms over others misallocates scarce domestic savings; “state capitalism” and excessive government intervention crowd out the private sector. Evidently, all of these reasons have a role in explaining investment inertia. But, importantly, they are all homegrown.

Perhaps Brazil’s sclerotic investment has something to do with its long-standing lack of openness. It is no mystery that Brazil is one of the most closed economies in the world according to any metric that one chooses to gauge the degree of openness. It is no coincidence that this is also the most striking difference between Brazil and its emerging-market peers: Brazil is more closed than Mexico, Colombia, Peru, and Chile; all members of the Pacific Alliance, their growth rates are higher than Brazil’s. Brazil is also less open than India, China, Turkey, and South Africa.

There is an extensive academic and empirical literature on the relationship between investment and openness (see, for example, the Peterson Institute’s video on trade and investment). Several research papers show that the more open an economy is to international trade, the more foreign direct investment it receives. The more foreign direct investment it receives, the greater the availability of resources for domestic investment. Competition is also crucial: Economies that are more open induce greater competition between local and foreign firms, creating incentives for innovation and investment by domestic companies.

Unfortunately, Brazil is still fairly close-minded when it comes to these issues. Fears of losing market share and the old litany of “selling the country to foreigners” still dominate the national debate.

The weakening of the BRL has continued for rather longer than the decline in the RUB, perhaps as a result of the Petrobras “Car Wash” scandal, but a modicum of stability has been regained since early April, as the chart below shows:-

USDBRL 1yr

Source: Yahoo Finance

Commodity correlation

Both Brazil and Russia are large commodity exporters. The table below is for 2011 but a clear picture emerges:-

Commodity Russia Brazil
Oil & Products $190bln $22bln
Iron Ore & Products $19bln $54bln

Source: CIA Factbook

Platts reported that Iron Ore prices (62% Fe Iron Ore Index) had risen since the end of April to $57.75/dmt CFR North China, up $2.25 on 4th May. It is probably too soon to confirm that Iron Ore prices have bottomed but with oil prices now significantly higher ($60/bbl) since their lows ($45/bbl) seen in March. Copper has also begun to rise – perhaps in response to the performance of the Chinese stock market – rising from lows of less than $2.50/lb in January to $2.94/lb this week.

The chart below shows the relative performance of the CRB Index and the GSCI Index which has a heavier weighting to energy:-

GSCI and CRB 1 yr

Source: FT

The general recovery in commodity prices is still nascent but it is supportive for both Brazil and Russia in the near term. Both countries have benefitted from devaluation relative to their export partners as this table illustrates:-

Russia Exports Brazil Exports
Netherlands 10.70% China 17%
Germany 8.20% United States 11.10%
China 6.80% Argentina 7.40%
Italy 5.50% Netherlands 6.20%
Ukraine 5%
Turkey 4.90%
Belarus 4.10%
Japan 4.00%

Source: CIA Factbook

Asset prices and investment opportunities

Real Estate

Russian real estate prices have been subdued during the last few years, but the underlying market has been active. The lack of price appreciation is due to a massive increase in house building. 912,000 new homes were built in 2013 – the highest number since 1989. Prices are lower in 10 out 46 regions, however, this new supply should be viewed in the context of the housing bubble which drove prices higher by 436% between 2000 and 2007:-

russia-house-prices-2

Source: Global Property Guide

Brazilian property, by contrast, has risen in price. In inflation adjusted terms, prices increased 7.6% in 2013, although these increases are less than those seen during 2011/2012. Rio continues to outperform (+15.2% vs +13.9% nationally) and the forthcoming Olympics should support prices into 2016:-

brazil-house-prices-1

Source: Global Property Guide

Neither of these markets present obvious opportunities. Brazilian prices are likely to moderate in response to higher interest rates whilst increased Russian supply will hang over the market for the foreseeable future. The rental yields in the table are somewhat out of date but clearly offer a less attractive income than government bonds:-

BRAZIL November 16th 2013
SAO PAULO – Apartments
Property Size Yield
80 sq. m. 5.68%
120 sq. m. 4.71%
200 sq. m. 6.15%
350 sq. m. 6.23%
RIO DE JANEIRO -Apartments
60 sq. m. 4.40%
90 sq. m. 3.82%
120 sq. m. 3.91%
200 sq. m. 4.89%
RUSSIA June 24th 2014
MOSCOW – Apartments
Property Size Yield
75 sq. m. 3.84%
120 sq. m. 3.22%
160 sq. m. 3.07%
275 sq. m. 3.42%
ST. PETERSBURG – Apartments
60 sq. m. 6.20%
120 sq. m. 4.36%
175 sq. m. 3.46%

Source: Global Property Guide

Stocks

The chart below compares the performance of Micex and the Bovespa indices over the past year. The devaluation of the RUB has been greater than that of the BRL – this accounts for the majority of the divergence:-

MICEX vs BOVESPA 1yr

Source: FT

Looking more closely at the components of the two indices there is a marked energy and commodity bias, the table below looks at the largest stocks, representing roughly 80% of each index:-

Ticker Stock Weight Sector Free-float
GAZP GAZPROM 15 Energy 46%
SBER Sberbank 14.01 Financial Services 48%
LKOH ОАО “LUKOIL” 13.97 Energy 57%
ROSN Rosneft 5.84 Energy 15%
URKA Uralkali 5.19 Commodity 45%
GMKN “OJSC “MMC “NORILSK NICKEL” 4.79 Commodity 24%
NVTK JSC “NOVATEK” 3.93 Energy 18%
SNGS Surgutneftegas 3.49 Energy 25%
RTKM Rostelecom 3.03 Telecomm 43%
TATN TATNEFT 3.01 Energy 32%
VTBR JSC VTB Bank 2.97 Financial Services 25%
MGNT OJSC “Magnit” 2.22 Commodity 24%
TRNFP Transneft, Pref 2.21 Energy 100%
TOTAL WEIGHTING 79.66
Ticker Stock Weight Sector
ITUB4 ITAUUNIBANCO 10.764 Financial Services
BBDC4 BRADESCO 8.2 Financial Services
ABEV3 AMBEV S/A 7.368 Brewing
PETR4 PETROBRAS 6.045 Energy
PETR3 PETROBRAS 4.416 Energy
VALE5 VALE 3.971 Commodity
BRFS3 BRF SA 3.741 Commodity
VALE3 VALE 3.558 Commodity
ITSA4 ITAUSA 3.433 Financial Services
CIEL3 CIELO 3.37 Financial Services
JBSS3 JBS 2.705 Commodity
UGPA3 ULTRAPAR 2.487 Energy
BBSE3 BBSEGURIDADE 2.47 Financial Services
BVMF3 BMFBOVESPA 2.393 Financial Services
BBAS3 BRASIL 2.344 Financial Services
EMBR3 EMBRAER 1.823 Aerospace
VIVT4 TELEF BRASIL 1.733 Telecomm
PCAR4 P.ACUCAR-CBD 1.663 Retail
KROT3 KROTON 1.49 Support Services
CCRO3 CCR SA 1.48 Transport
BBDC3 BRADESCO 1.445 Financial Services
LREN3 LOJAS RENNER 1.364 Retail
CMIG4 CEMIG 1.207 Energy
CRUZ3 SOUZA CRUZ 1.027 Tobacco
TOTAL WEIGHTING 80.497

Source: Moscow Exchange and BMF Bovespa

The Russian index is clearly more exposed to energy, 48% and commodities, 12%, than the Brazilian index, where the weightings are 14 % each for energy and commodities. It is important to note that the Bovespa index adjusts for the “free-float” for each stock whilst Micex does not, however under Micex rules no stock may account for more than 15% of the index. The free-float adjusted weight of energy and commodities is therefore 18% and 4% respectively.

On the basis of this analysis, currency fluctuation has been the predominant influence on stock market returns, followed by energy and commodity prices. The PE ratios of Micex and Bovespa at roughly 8 times, are undemanding but neither the economic nor the political situation in either country is conducive to long term growth. I expect both markets to continue to recover, although Micex will probably fair best. Longer term, economic reform is required to raise the structural rate of growth.

Although not mentioned in any of the articles quoted above, Russian demographics are unfavourable as this article from Yale University – Russian Demographics: The Perfect Storm – makes clear:-

One measure of an economically secure homeland is women’s willingness to raise children with the expectation of opportunities for good health, education and livelihoods. On that front, Russia confronts a perfect storm – as fertility rates plummeted to 1.2 births per women in the late 1990s and now stand at 1.7 births per women. “Russia’s population will most likely decline in the coming decades, perhaps reaching an eventual size in 2100 that’s similar to its 1950 level of around 100 million,” write demographers Joseph Chamie and Barry Mirkin. The country has high mortality rates due to elevated rates of smoking, alcohol consumption and obesity. Investment on healthcare is low. Over the next decade, Russia’s labor force is expected to shrink by about 15 percent. Other countries with low fertility rates turn to immigration to pick up the slack. While immigrants make up about 8 percent of Russia’s population, the nation has a reputation for nationalism and xenophobia, and fertility rates are even lower in neighboring Belarus, Ukraine and Lithuania, all possible sources of immigration.

Brazil has better demographic prospects in the near term, but its population growth is now not much above the world average and by 2050 it too will be entering a demographic “Götterdämmerung” of declining population. A freer, more open economy is the most efficient method of deflecting the effects of the long term demographic deficits – stock markets reflect this in their risk premiums.

Bonds

Brazilian government bonds offer a real return after adjusting for inflation (10 yr real-yield 4.77%) however, as this March 2015 article from Forbes – With Currency In Gutter And Bad News Galore, Brazil Bonds A Buy makes clear, there are significant risks:-

…the major headwinds against Brazil are domestic. The fact that China is slowing down is no longer a fright factor. What keeps investors up at night is the possibility of Brazil losing its investment grade.  But last month, Standard & Poor’s credit analysts were in Brasilia and left saying that a downgrade to junk was unlikely.

There is the risk of impeachment and the resignation of Finance Minister Joaquim Levy, but that is already priced into the market with local interest rate futures trading over 14.35% compared to the actual benchmark rate of 12.75%.  Moreover, the impeachment of Dilma Rousseff and the resignation of Levy are worse case scenarios with low probabilities. Worries over energy rationing have subsided.

I believe Brazilian bonds offer good value, even at these levels, the central banks has taken a draconian approach to inflation and the BRL has recovered some of the ground it lost during the last year. Exports to the US should improve and signs of a recovery in European growth will benefit the BRL further.

Russian government bonds look less compelling – with headline inflation at 16.9% and 10 yr yields of only 10.71% one might be inclined to avoid them on the grounds on negative real yield – but a case can be made for lower inflation and a resurgence in the value of the RUB as this article from RT – Russia’s ‘junk’ bonds paying off handsomely suggests:-

“It’s very simple advice. Bonds are much more attractive than a year ago. Risks related to the ruble have subsided, inflation is likely to moderate, the BoP (Balance of Payments) and budget situation look reasonably strong and that is why the outlook is quite favorable,” Vladimir Kolychev, Chief Economist for Russia at VTB Capital

“Unless geopolitics interferes, we forecast Russian rates are likely to repeat Hungary’s three-year bull market run in the years ahead,” Bank of America’s head of emerging EMEA economics David Hauner

In a March 11 note, Russia’s Goldman Sachs analysts wrote “Russian bonds are both cyclically and structurally under-priced,” in a big part due devaluation expectations of the ruble stabilizing.

I remain less convinced about the value of Russian bonds but with a low debt to GDP ratio they may perform well.

Here are the recent price charts for 10 year maturities:-

russia-government-bond-yield

Source: Trading Economics

brazil-government-bond-yield

Source: Trading Economics

As inflation declines in both countries their bond markets will continue to rise in expectation of further central bank rate cuts. This will also support stocks but bonds will lead the rally, especially if future growth in Brazil or Russia should disappoint.

Technology Indices and Creative Destruction – When Might the Bubble Burst?

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Macro Letter – No 33 – 10-04-2015

Technology Indices and Creative Destruction – When Might the Bubble Burst?

  • Publically traded technology stocks trade on modest multiples compared to 2000
  • Private sector overinvestment may, however, be cause for concern
  • European technology companies have outperformed US this year – it may not last
  • Technology and growth stocks remain highly correlated to the major indices

I adhere to the belief that technology and other such improvements in manufacturing are the key to delivering productivity growth, which thereby improves the quality of life for the greatest number. Of course, as Joseph Schumpeter so incisively illustrated, the process is often cathartic. For the technology investor this increases both the risk and potential reward.

Technology is affects all industries. In an attempt to be more specific, here is a table taken from a February 2015 report by Brookings – America’s Advanced Industries:-

Americas Advance Industries - Brookings

Source: Brookings

The report goes on to describe the scale and importance of these industries to the US economy:-

As of 2013, the nation’s 50 advanced industries employed 12.3 million U.S. workers. That amounts to about 9 percent of total U.S. employment. And yet, even with this modest employment base, U.S. advanced industries produce $2.7 trillion in value added annually—17 percent of all U.S. gross domestic product (GDP). That is more than any other sector, including healthcare, finance, or real estate.

At the same time, the sector employs 80 percent of the nation’s engineers; performs 90 percent of private-sector R&D; generates approximately 85 percent of all U.S. patents; and accounts for 60 percent of U.S. exports. Advanced industries also support unusually extensive supply chains and other forms of ancillary economic activity. On a per worker basis, advanced industries purchase $236,000 in goods and services from other businesses annually, compared with $67,000 in purchasing by other industries. This spending sustains and creates more jobs. In fact, 2.2 jobs are created domestically for every new advanced industry job—0.8 locally and 1.4 outside of the region. This means that in addition to the 12.3 million workers employed by advanced industries, another 27.1 million U.S. workers owe their jobs to economic activity supported by advanced industries. Directly and indirectly, then, the sector supports almost 39 million jobs—nearly one-fourth of all U.S. employment.

…From 1980 to 2013 advanced industries expanded at a rate of 5.4 percent annually—30 percent faster than the economy as a whole. 

…Workers in advanced industries are extraordinarily productive and generate some $210,000 in annual value added per worker compared with $101,000, on average, outside advanced industries. Because of this, advanced industries compensate their workers handsomely and, in contrast to the rest of the economy, wages are rising sharply. In 2013, the average advanced industries worker earned $90,000 in total compensation, nearly twice as much as the average worker outside of the sector. Over time, absolute earnings in advanced industries grew by 63 percent from 1975 to 2013, after adjusting for inflation. This compares with 17 percent gains outside the sector. Even workers with lower levels of education can earn salaries in advanced industries that far exceed their peers in other industries. In this regard, the sector is in fact accessible: More than half of the sector’s workers possess less than a bachelor’s degree.

The report is not an unalloyed paean of praise, however, they go on to emphasise the need for better education and training in order to maintain momentum.

The last great technology stock collapse was seen in the aftermath of the “Dotcom” bubble which burst in 2001:-

dot-com-bubble

Source: Kampas Research

During the early part of the last decade the growth in valuation of the technology sector returned to its long-term trend. Since 2008, however, central bank policies have changed the valuation paradigm for all stocks by reducing interest rates towards the zero-bound. Their quantitative easing policies (QE) have flattening government bond yield curves to unprecedented levels, especially given the absolute level of rates. Nonetheless, many of the signs of a bubble have begun to emerge as this December 2014 article from the Economist – Frothy.com – explains:-

In December 15 years ago the dotcom crash was a few weeks away. Veterans of that fiasco may notice some familiar warning signs this festive season. Bankers and lawyers are being priced out of office space in downtown San Francisco; all of the space in eight tower blocks being built has been taken by technology firms. In 2013 around a fifth of graduates from America’s leading MBA schools joined tech firms, almost double the share that struck Faustian pacts with investment banks. Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued—and has been largely ignored, just as her predecessor Alan Greenspan was when he urged caution in 1999.

Good corporate governance is, once again, for wimps. Shares in Alibaba, a Chinese internet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.

…Instead, today’s financial excess is hidden partly out of sight in two areas: inside big tech firms such as Amazon and Google, which are spending epic sums on warehouses, offices, people, machinery and buying other firms; and on the booming private markets where venture capital (VC) outfits and others trade stakes in young technology firms.

Take the spending boom by the big, listed tech firms first. It is exemplified by Facebook, which said in October that its operating costs would rise in 2015 by 55-75%, far ahead of its expected sales growth. Forget lean outfits run by skinny entrepreneurs: Silicon Valley’s icons are now among the world’s biggest, flabbiest investors. Together, Apple, Amazon, Facebook, Google and Twitter invested $66 billion in the past 12 months. This figure includes capital spending, research and development, fixed assets acquired with leases and cash used for acquisitions (see chart 1).

Tech spend - Economist

Source: The Economist, Bloomberg

That is eight times what they invested in 2009. It is double the amount invested by the VC industry. If you exclude Apple, investments ate up most of the cashflow the firms generated. Together these five tech firms now invest more than any single company in the world: more than such energy Leviathans as Gazprom, PetroChina and Exxon, which each invest about $40 billion-50 billion a year. The five firms together own $60 billion of property and equipment, almost as much as General Electric. They employ just over 300,000 people. Google says it is determined to keep “investing ahead of the curve”.

…The second area of technology froth is in private markets. Their exuberance was demonstrated on December 4th when Uber closed a $1.2 billion private funding round that valued the five-year old firm at $40 billion. Baidu, China’s biggest search engine, is set to buy a stake, too (see page 101). There are 48 American VC-backed firms worth $1 billion or more, compared with ten at the height of the dotcom bubble, according to VentureSource, a research outfit. In October a software firm called Slack was valued at $1.1 billion, a year after being founded. 2014 looks set to be the biggest year for VC investments since 2000 (see chart 2).

VC in US - Economist

Source: The Economist

Whilst this investment boom has centred around the giants of the technology industry and venture capitalists in the private sector, few large scale scientific research facilities have been developed without government grants or subsidies as this December 2014 FRBSF Economic Letter – Innovation and Incentives: Evidence from Biotech – makes abundantly clear:-

The adoption of biotech subsidies raises the number of star scientists in a state by 15% relative to that state’s pre-adoption number of stars. We find a similar effect from the adoption of R&D credits. These findings are important because of the role star scientists play on the local development and survival of U.S. biotech clusters. In addition, we find that most of the increase in the number of stars is due to their relocation to states that adopt incentives. Meanwhile, subsidies have only a limited effect on the productivity, measured by patenting, of incumbent scientists already in the state. We also find that the increase in star scientists happening after a state adopts a biotech incentive is entirely due to an increase in private/for-profit sector scientists, with no detectable increase in academic scientists.

The authors’ conclusions, however, are qualified:-

We found that, after states adopted incentives, they experienced significant increases in the number of star scientists, the total number of biotech workers, and the number of establishments, but limited effects on salaries and patents. We also uncovered significant spillover effects from biotech incentives to employment in other sectors that provide services in the local economy such as retail and construction.

In terms of policy implications, it is important to keep in mind that our finding that biotech subsidies are successful at attracting star scientists and at raising local biotech employment do not necessarily imply that the subsidies are economically justified. The economic benefits to a state of providing these incentives must be weighed against their fiscal costs—for instance, the loss of tax revenues and resulting loss of public services. Our research suggests that state incentives are successful at increasing the number of jobs inside the state. Nevertheless, our results do not suggest that the social benefit—either for that state or for the nation as a whole—is larger than the cost to taxpayers, nor that incentives for innovation are the most effective way to increase jobs in a state.

Government incentives may appear benign, but, as Michael Dell put it, in a November 2014 Op Ed for the Wall Street Journal – Going Private Is Paying Off for Dell:-

Yet we find ourselves in a world increasingly afflicted with myopia-governments that can’t see beyond the next election, an education system that can’t see beyond the next round of standardized tests, and public financial markets that can’t see beyond the next trade. This was what Dell faced as a public company. Shareholders increasingly demanded short-term results to drive returns; innovation and investment too often suffered as a result. Shareholder and customer interests decoupled.

My personal preference is for a free-market approach, despite the risk of underinvestment in the most capital intensive areas of research.

Valuation?

The valuation of growth stocks has always been fraught with uncertainty, especially when future cashflows are often deferred by several years and earnings forecasts, subject to significant variance. An even greater difficulty, as the chart above makes clear, is to assess, and hopefully anticipate, the herd behaviour of technology investors.

The chart below shows the differential performance of the STOXX Europe 600 Technology Index (FX8.Z) the global IXN Technology ETF and the Nasdaq Composite:-

Stox Tech Euro 600 Nasdaq IXN Global Tech ETF

Source: Yahoo Finance

The European dalliance with technology investment was shorter lived than in the US. So was the violence of the subsequent bust. The market had still not cleared by 2008 and achieved new lows for the decade. The subsequent recovery has been muted. The IXN appears to be roughly halfway between the two extremes. US investor perception of technology seems to be substantially rosier than that of the European investor.

The six month chart reveals a rather different picture. Since the equity market correction last November, European technology has out-performed both the US and other technology stocks globally:-

Tech stocks 6 months

Source: Yahoo Finance

Looks can be deceptive. This move has been broader based than simply the European technology sector. Led by Germany, most Eurozone stock markets have traded higher. This has largely coincided with the QE actions of the ECB and the steady weakening in the value of the Euro that this policy has abetted. The Euro Effective Exchange Rate has fallen from 100 to 90 over the same period.

Research carried out by LinkedIn sheds a unique perspective on global trends in technology industries. Their analysis focussed on migrating workers, identifying which countries and cities were net beneficiaries. This July 2014 article from Bruegal – Fact of the week: Not one European city in the top 10 for tech talenttakes up the story:-

In terms of skills uniquely identified in movers, Math, Science, Technology and Engineering seem to play a particularly important role. In terms of industries, movers are found to work mostly in media and entertainment; professional services; oil and energy; government, education and non-profit but most importantly, technology-software.

…Five out of ten cities attracting people with tech skills (especially IT infrastructure and system managements; Java development and web programming) are located in India, including the first four of the list. San Francisco only comes fifth, followed by two other US cities and two Australian.

No European city at all makes it to the list. For the 52 cities looked at in the study, the median percentage of new residents with tech skills was 16%, or just under 1 in 6; in many of the Indian cities, its more than double that figure. European cities are the real laggards: the percentage of new residents with tech skills was 18% in Berlin, 15% in Paris, 13% in Madrid and 11% in Paris.

The trend obviously mirror the Indian ongoing technology boom, in a still rather “virgin” environment. Kunal Bahl – founder of Snapdeal, a wannabe Indian Amazon – told USA Today in 2011 that India offers huge opportunity “because there are no mature companies, like Google and Microsoft, over there. The feeling is like in the U.S. in 1999.”

But there may be more to that.. Research by Vivek Wadhwa (Stanford) revealed that half of Silicon Valley start-ups were launched by immigrants, many of them educated in US top universities. But he also noticed that “for the first time, immigrants have better opportunities outside the U.S.” because, among other things, of rather strict immigration laws and California’s steep cost of living. Bahl himself, who studied in the US and spent some time working at Microsoft, reportedly wanted to initiate his company in the US but eventually went back to India because of visa problems.

And this is also why the tech industry – at the (by now almost) desperate search for engineers – is supporting the introduction of specific “start-up visa” for high-skilled workers in the US. The insights provided by this data is particularly important in the context of the recent discussions on the US immigration reform, but it is not without implications for Europe, which is at the bottom of the ranking as far as attracting tech talent is concerned.

This research suggests that the recent outperformance of the European technology sector may be short lived, yet, another article from November of last year by Bruegal – Brain drain, gain, or circulation? – indicates a somewhat more optimistic outcome for parts of Europe, specifically the UK and Spain:-

Quality of Scientists - OECD

Source: Bruegal, OECD

This chart benchmarks the median quality of scientists leaving or moving (for the first time) to a country between 1996-2011. The size of the bubble corresponds to total flows (inflows plus outflows). Countries in red are net contributors to the international market for scientists, those in blue net recipients.

Ideally, a country should want to be below or on the 45-degree line, indicating that the quality of the newcomers is just as high (or higher) as that of the leavers. Conditional on this, a country should also prefer a larger rather than smaller bubble, representing a sizeable flow of scientists and indicating a full exploitation of synergies gained from international cooperation. Finally, countries should aim to land in the top-right quadrant, indicating higher quality of both incoming and outgoing researchers. 

Over the long-term (pre-crisis) period analysed, Spain and the UK seemed the best placed at attracting high-quality scientists. France and Germany were broadly breaking even in terms of quality, although we note that they were facing significant net outflows of scientists, as was the UK.

All in all, in the sample here presented, while the US (unsurprisingly) comes out as the top performer in terms of net inflow of quality researchers, Italy ranks quite poorly. Not only the country is a net contributor of scientists, it also trades high quality researchers for lower quality ones. Time for a reform of the university system?

The EU Commission is seeking to address the deficiencies of innovation policy within its borders. At a Bruegal event last January in a speech entitled – The New European Research Agenda – Commissioner Moedas – outlined plans to improve the environment for innovation:-

First, create the framework conditions for a more productive exchange of research results, fundamental science and innovation. Things like:

Screen the regulatory framework in key sectors in order to remove bottlenecks

Accelerate the implementation of standardisation

Promote the public procurement of innovation and innovation in the public sector

Promote a venture capital culture

Reduce bureaucracy in science and innovation systems

Second, is to consolidate fundamental research as the flagship for Europe. As the essential foundation for a knowledge-based society. Working towards a single, open market for knowledge though open science.

Third: implement Horizon 2020 and the new Investment Plan to leverage the Europe economy towards a higher plane as a research and innovation-based area. Working towards a single, open market for knowledge though open science. It is better to focus on our potential than to dwell on illusions. We will always be different from other parts of the world. But that difference has many benefits!

These are stirring words, but in the EU turning words into deeds takes time. In unfettered, free-markets, resources are allocated more efficiently. Nonetheless, hope remains.

In terms of absolute valuation, US technology bulls point to the relatively undemanding PE ratio of the Nasdaq – around 24 times, vs 175 times during the zenith of the Dotcom frenzy. On the other hand, commentators such as Dent Research point to a flat-lining phase of the 45 year innovation cycle – this phase commenced around 2010 and will last until around 2032:-

It shows how clusters of powerful technologies increase productivity and move mainstream for about 22.5 years, like what we saw from 1988 into 2010.

Now we’re in the doldrums of this cycle and won’t move into the next upward swing again until after 2032. In short, the productivity revolution is over for the next two decades or so. That means less earnings and wage gains, regardless of demographic trends.

Interestingly, Dent then go on to wax lyrical about the potential for Bio-tech. In technology even the bears tend to be bullish about something.

We need to read Robert Gordon – Is US economic growth over? Faltering innovation confronts the six headwinds, to find a real bear. His CEPR paper was published in 2012 but these are ideas he has been developing for more than a decade. The premise is that the economic growth of the last 250 years is the exception rather than the rule:-

The ideas developed here are unorthodox yet worth pondering. They are applied only in the context of the US, because the worldwide frontier of productivity and the standard of living have been carved out by the US since the late 19th century. If growth of the US productivity frontier slows down, other nations may move ahead, or the slowing frontier could reduce the opportunities for future growth by all nations as the pace of productivity growth in the US fades out…

… The paper suggests that it is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR3, the follow-up process was much faster. Taking the inventions and their follow up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanisation itself.

The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the US economy, some of which are shared in common with other countries and others are uniquely American. Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99% of the income distribution will be even slower than that.

Gordon goes on to identify six headwinds buffeting the US economy – slowing the pace of GDP growth:-

  1. The disappearance of the demographic dividend
  2. Educational attainment
  3. Rising income inequality
  4. Outsourcing (especially due to technological development)
  5. Environmental constraints on energy pollution
  6. Combined household and government debt

These are important impediments to growth but I believe not all of them are as clear cut as Gordon suggests.

Firstly, the demographic dividend may be in decline but technology has made it easier for people to work until much later in life. Added to which, a more flexible labour market encourages greater participation. I wonder whether the decline in labour force participation is to some extent due to the improvement in welfare provision and not just a deficit of permanent “quality” jobs?

Despite the concerns of Gordon and Bruegal, education is in the process of being revolutionised by new technologies. Mass Open Online Courses (MOOCs) are but one aspect of this sea-change. The cost of providing education – which has risen inexorably over the last 50 years – could be reversed. Of course Gordon has cause for concern about educational achievement. Whilst technology will allow “the horse to be led to water” it is another matter “making it drink”. The Economist – Wealth without workers, workers without wealth – from October 2014, discusses this issue in the broader context of new technologies disruption of labour markets globally:-

The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income.

Income inequality is a popular economic theme and Gordon pays tribute to Emmanuel Saez – though not Thomas Piketty who has become its popular champion. From my interpretation of Piketty’s book, I believe that income inequality is a natural outcome of the long term benefits of peace. Reducing government intervention in the functioning of free markets is a better solution to this structural problem. Smaller government will not remove inequality but it will increase economic mobility, and, in the process, create faster economic prosperity – thereby more rapidly improving the standard of living for the greatest number of people. In freer markets, the technology entrepreneur, and creative risk takers in general, have a greater incentive to embrace opportunities.

Outsourcing is not new, David Riccardo observed its effects long ago. As rich countries adapt to concentrate on their comparative advantages – hopefully undistorted by government subsidy and protective tariff – the short-term headwind of lost domestic labour will be offset by the lower cost to the consumer of outsourced services. A greater proportion of a consumer’s income will then become available for investment. Once the investment has been allocated, the increased pool of available labour can then be retrained for employment in more productive enterprises. Frederic Bastiat – That Which is Seen and That Which is Not Seen makes this point much more eloquently than I could hope to do.

At the global level, man’s capacity to pollute his environment has not diminished but developing countries are less able to afford the luxury of conscience. Our best hope is technology. Yet technological discovery occurs by evolutionary leaps rather than steady increment. The lag between discovery and commercial application can also be long and variable. The collapse in the price of photovoltaic cells, making solar power dramatically more viable as an alternative to fossil fuel, is but one example. The tantalising potential of the development of tidal energy generation is another – especially given man’s predilection to inhabit the margins of the sea. Carbon sequestration technology – at present uneconomic – might be the next technological “leap”. I remain an optimist about man’s ingenuity. Since the Economist first published its Commodity Index in 1864 the price of commodities has been falling by roughly 1% per annum in inflation adjusted terms – punctuated by sharp price increases normally associated with war. Peace leads to investment and, as new technologies are adopted, prices begin to march lower once more.

This leaves Gordon’s concern about debt. Now, debt is a problem. It can be overcome, but the solution to excessive debt is not more debt. Deleveraging can be achieved by steady reduction or sudden default. Sadly, history favours the latter approach – I wonder whether Polonius’s advice to Laertes today would have been:-

Always a borrower never a lender be,

For loan oft loses both itself and bank,

And borrowing sure as hell beats husbandry.

Last September – Deleveraging, What Deleveraging? The 16th Geneva Report on the World Economy – discussed this global issue in detail:-

Contrary to widely held beliefs, the world has not yet begun to delever. Global debt-to-GDP is still growing, breaking new highs. Figure 1 shows the evolution of total debt (excluding the financial sector) for our global sample (advanced economies plus major emerging market economies). While there was a pause during 2008-09, the rise of the global debt-GDP ratio recommenced in 2010-2011.  Data in the report also show that debt-type external financing (leverage) continues to dominate equity-type financing (stock market capitalisation)

Global Debt to GDP

Source: CEPR

Perhaps surprisingly, the authors advise central banks to be cautious about interest rate increases in this environment:-

In such a context, and with still very high leverage, allowing the real rate to rise above its natural level would risk killing the recovery. Beyond pushing the economy into a prolonged period of stagnation, this would also put at risk the deleveraging process which is already very challenging.

Although there is a lot of uncertainty about such predictions, our call is for caution on interest rate rises. The case for caution in pre-emptively raising interest rates is reinforced by the weakness of inflationary pressures.

…The policy requirements for successful exit from a leverage trap are much broader than the appropriate conduct of monetary policy. The report addresses the fiscal challenges, the scope for macro-prudential policies and the restructuring of private-sector (bank, household, corporate) debt and sovereign debt.

The report also argues that – given the risks and costs associated with excessive leverage – more needs to be done to improve the resilience of macro-financial frameworks to debt shocks and to discourage excessive debt accumulation. Finally, we advocate enhanced international policy cooperation in addressing excessive global leverage.

I keep hearing the immortal words of Stan Laurel:-

Well, here’s another nice mess you’ve gotten me into.

Signs of fatigue

With all markets, I begin my analysis with technical patterns. This is a form of self-preservation; to paraphrase Keynes, I may be right in my fundamental analysis but the market is never wrong. On this basis I see no compelling reason to exit the technology sector, although there is a case to be made for rotation out of the Nasdaq and into technology stocks in Europe. I make the caveat, however, that European stocks have inherently less liquidity than US stocks and are therefore likely to exhibit greater volatility, especially on the downside.

The second stage of my analysis is to look at the change in the makeup of tech indexes. The constituents of the Nasdaq are a case in point. The table below shows the top 10 stocks by market capitalisation in 2000 and 2015:-

2000 2015
Microsoft MSFT Apple AAPL
Cisco CSCO Google GOOG
Intel INTC Microsoft MSFT
Oracle ORCL Facebook FB
Sun Microsystems JAVA Amazon.com AMZN
Dell Computer DELL Intel INTC
MCI WorldCom MCWEQ Gilead Sciences GILD
Chartered Semiconductor CHRT Cisco CSCO
Qualcomm QCOM Comcast CMCSA
Yahoo! YHOO Amgen AMGN

Source: Nasdaq

Several of the names have changed, added to which, many of today’s valuations, as measured by P/E ratios, are far less demanding – although Amazon (AMZN) at more than 700 times earnings, remains a notable exception. Looked at from another perspective, the technology promise of 2000 has delivered – today’s top tech companies are delivering real earnings. To understand whether the undemanding multiples are a harbinger of a period of “ex-growth” to come or represent an undervalued opportunity, we need to examine each individual stock in detail. This is beyond the macroeconomic analysis of this report, but one “macro” factor worth considering is the question of debt versus equity finance.

Equity versus Debt

At the risk of making a sweeping generalisation, technology companies are more likely to finance their projects via equity than debt – although established, large cap, technology companies make ample use of the capital markets. Technology projects often require long-lead times to deliver positive cashflows and the value created is invariably intellectual rather than physical. An Oil company with proven reserves may have to wrestle with the volatility in the price of crude oil, but it can mortgage those “reserves” – they have a fairly predictable future demand. Technology companies must endure the vicissitudes of disruptive innovation. Todays “must have” products can rapidly become tomorrow’s museum “curiosities”. To this extent, technology firms are better placed to weather a cycle of increasing interest rates because they carry less debt.

Here lies a dilemma. In the absence of the interest rate on debt to signal the riskiness of an investment, the availability of equity finance becomes critical. As the IPO market has become more active, venture capitalists have been pouring money into earlier and earlier investment opportunities to avoid having to pay too high a price for private equity – I’ve heard the phase “pre,pre-seed” which smacks of a lack of discrimination. Access to equity investment should be a signal about the validity of a project – in the current “overinvestment” environment, the informational value of this “signal” is dramatically diminishing.

Conclusions and Investment Opportunities

The current technology boom is very different from the dotcom bubble of 2000. The top companies in the sector have real earnings and trade at less demanding PE multiples. There are still early stage companies which have no cashflows but these are the much less prevalent today. At the risk of stating the obvious, look for companies with low debt to equity ratios, since these will weather the storm of rising interest rates more comfortably. Look for companies with growing earnings and, where possible, growing dividends. Keep a close watch on the price trend of the stock and have a stop-loss level in mind at which you will exit to preserve capital, regardless of your own opinions. Set a price target if you wish but remember that markets are prone to irrationality – I tend to let the “trend be my friend”.

For the present, technology stocks look set to continue rising, but it is important to remember that the correlation between equity indices tend to be high – The Nasdaq and the S&P500 have a one month correlation of more than 90%. Interest Rates may stay low for a protracted period, but the risk is asymmetric – not far to fall, a long way to rise – and conventional wisdom, which advocates investment in stocks because they are negatively correlated to bonds, may be severely tested as central bank interest rates normalise globally. For more on this topic the November 2013 paper from Pimco – The Stock-Bond Correlation is well worth investigation.

A final caveat concerning technology stocks. Most of the constituents of tech indices are growth stocks and therefore tend to have higher betas than the underlying index. This is a simple measure of their volatility – replete with Gaussian assumptions of “normality”. When constructing your investment strategy, keep the absolute level of volatility in mind, albeit is a measure of variance rather than risk. If this is a technology bubble, make allowance for it and you will weather its tempests, underestimate it and you will be forced to capitulate; the bull market isn’t over yet and the broader market will determine the timing of its demise.

German resurgence – Which asset? Stocks, Bunds or Real Estate

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Macro Letter – No 32 – 20-03-2015

German resurgence – Which asset? Stocks, Bunds or Real Estate

  • German domestic consumption is driving GDP growth as wages rise
  • The effect of a weaker Euro has yet to be seen in exports
  • Lower energy prices are beginning to boost corporate margins
  • Bund yields are now negative out to seven years

Last month Eurostat released German GDP data for Q 2014 at +0.7%, this was well above consensus forecasts of +0.3% and heralded a surge in the DAX stock index. For the year German growth was +1.6% this compares favourably to France which managed an anaemic +0.4% for the same period. German growth forecasts are being, feverishly, revised higher. Here is the latest data as polled by the BDA – revisions are highlighted in bold:-

Institution Survey Date 2015 Previous 2015 2016
ifo ifo Institute (Munich) Dec-14 N/A 1.5  
IfW Kiel Institute Mar-15 1.7 1.8 2
HWWI Hamburg Institute Mar-15 1.3 1.9 1.7
RWI Rheinisch-Westf. Institute (Essen) Dec-14 N/A 1.5  
IWH Institute (Halle) Dec-14 N/A 1.3 1.6
DIW German Institute (Berlin) Dec-14 N/A 1.4 1.7
IMK Macroeconomic Policy Institute (Düsseldorf) Dec-14 N/A 1.6  
Research Institutes Joint Economic Forecast Autumn 2014 Oct-14 N/A 1.2  
Council of experts Annual Report 2014/2015 Nov-14 N/A 1  
Federal Government Annual Economic Report 2015 Jan-15 1.3 1.5  
Bundesbank Forecast (Frankfurt) Dec-14 N/A 1 1.6
IW Köln IW Forecast Sep-14 N/A 1.5  
DIHK German Chambers of Industry and Commerce (Berlin) Feb-15 N/A 0.8 1.3
OECD Nov-14 N/A 1.1 1.8
EU Commission Feb-15 1.1 1.5 2
IMF Oct-14 N/A 1.5 1.8

 

Source: Confederation of German Employers’ Associations (BDA), Survey Date: March 13, 2015

The improvement in German growth has been principally due to increases in construction spending, machinery orders and, more significantly, domestic consumption, which rose 0.8% for the second successive quarter. This, rather than a resurgence in export growth, due to the decline in the Euro, appears to be the essence of the recovery. That the Euro has continued to fall, thanks to ECB QE and political uncertainty surrounding Greece, has yet to show up in the export data:-

germany-exports 2008-2015

Source: Trading Economics

German imports have also remained stable:-

germany-imports 2008-2015

Source: Trading Economics

This may seem surprising given the extent of the fall in the price of crude oil – it made new lows this week. German Natural Gas prices, which had been moderately elevated to around $10.4/btu during the autumn have fallen to $9.29/btu, a level last seen in early 2011. That the improved energy input has not shown up in the terms of trade data may be explained by the fact that crude oil and natural gas imports account for only 10% of total German imports. Nonetheless, I suspect the benevolent impact of lower energy prices is being delayed by the effects of long-term energy contracts running off. Watch for the February PPI data due out this morning (forecast -1.9% y/y).

The ZEW Institute – Indicator of Economic Sentiment – released on Tuesday, showed a fifth consecutive increase, hitting the highest level since February 2014 at 54.8 – the forecast, however, was a somewhat higher 58.2. This is an extract from their press release:-

“Economic sentiment in Germany remains at a high level. In particular, the continuing positive development of the domestic economy confirms the expectations of the experts. At the same time, limited progress is being made with regard to solving the Ukraine conflict and the sovereign debt crisis in Greece. This has a dampening effect on sentiment,” says ZEW President Professor Clemens Fuest. The assessment of the current situation in Germany has improved notably. Increasing by 9.6 points, the index now stands at 55.1 points.

The good news is not entirely unalloyed (pardon the pun) IG Metall – the German metal workers union which sets the benchmark for other union negotiations – achieved a +3.4% wage increase for their 800,000 members in Baden Württemberg, starting next month. Meanwhile, German CPI came in at 0.09% in February after falling -0.4% in January. This real-wage increase is an indication of the tightness of the broader labour market. Nationally wages are rising at a more modest 1.3%, this is, however, the highest in 20 years. German unemployment fell to 4.8% in January, the lowest in 33years, despite the introduction of a minimum wage of Eur8.50/hour, for the first time, on 1st January.

One of my other concerns for Germany is the declining trend of productivity growth. Whilst employment has been growing, the pace of productivity growth has not. This 2013 paper from Allianz – Low Productivity Growth in Germany examines the issue in detail, here is the abstract:-

Since the labor market reforms implemented in the first half of the last decade, Germany’s labor market has been on a marked upward trend. In 2012, there were 2.6 million (+6.8%) more people in work than in 2005 and the volume of labor was up by 2.4 million hours (+4.3%) on 2005. But the focus on this economic success, which has also earned Germany a great deal of recognition on the international stage, makes it easy to overlook the fact that productivity growth in the German economy has continued to slacken. Whereas the increase in labor productivity per person in work was still averaging 1.0% a year between 1995 and 2005, the average annual increase in the period between 2005 and 2012 was only 0.5%. The slowdown in the pace of labor productivity growth, measured per hour worked, is even more pronounced. The average growth rate of 1.6% between 1995 and 2005 had slipped back to 0.9% between 2005 and 2012.

Allianz go on to make an important observation about the importance of capital investment:-

…the capital factor is now making much less of a contribution to economic growth in Germany than in the past, thus also putting a damper on labor productivity growth.

… Since the bulk of the labor market reforms came into force – in 2005 – the German economy has been growing at an average rate of 1.5% a year. Based on the growth accounting process, the capital stock delivered a growth contribution of 0.4 percentage points, with the volume of labor also contributing 0.4 percentage points. This means that total factor productivity contribute 0.7 percentage points to growth. So if the volume of labor and capital stock were to stagnate, Germany could only expect to achieve economic growth to the tune of 0.7% a year.

Although gross domestic product also grew by 1.5% on average during that period, labor productivity growth came in at 2.0%, more than twice as high as the growth rate for the 2005 – 2012 period. Between 1992 and 2001, the contribution to growth made by the capital stock, namely 0.9 percentage points, was much greater than that made in the period from 2005 to 2012; by contrast, the growth contribution delivered by the volume of labor was actually negative in the former period, at -0.4 percentage points, and 0.8 percentage points lower than between 2005 and 2012. This could allow us to draw the conclusion that the labor market reforms boosted economic growth by 0.8 percentage points a year. Although there is no doubt that this conclusion is something of a simplification, the sheer extent of the difference supports the theory that the labor market reforms had a marked positive impact on growth. In the period between 1992 and 2001, total factor productivity contributed 1.0 percentage points to growth, 0.3 percentage points more than between 2005 and 2012. This tends to suggest that the growth contribution delivered by technical progress is slightly on the wane.

The finding that the weaker productivity growth in Germany is due, to a considerable extent, to the insufficient expansion of the capital stock and, consequently, to excessive restraint in terms of investment activity, suggests that there is a widespread cause, and one that is not specific to Germany, that is putting a stranglehold on the German productivity trend.

The hope remains, however, that especially Germany – a country that has managed to get to grips with the crisis fairly well in an international comparison – will be able to return to more dynamic investment activity as soon as possible.  

The issue of under-investment is not unique to Germany and is, I believe, a by-product of quantitative easing. Interest rates are at negative real levels in a number of countries. This encourages equity investment but, simultaneously, discourages companies from investing for fear that demand for their products will decline once interest rates normalise. Instead, corporates increase dividends and buy back their own stock. European dividends grew 12.3% in 2014 although German dividend growth slowed – perhaps another sign of a return to capital investment.

German Bunds

Bunds made new highs again last week. The 10 year yield reached 19 bp. Currently, Bunds up to seven years to maturity are trading at negative yields. These were the prices on Wednesday after then 10 year Bund auction:-

Maturity Yield
1-Year -0.18
2-Year -0.225
3-Year -0.202
4-Year -0.173
5-Year -0.099
6-Year -0.065
7-Year -0.025
8-Year 0.053
9-Year 0.127
10Y 0.212
15-Year 0.38
20-Year 0.519
30-Year 0.626

 

Source: Investing.com

Wednesday’s 10 year auction came in at 0.25% with a cover ratio of 2.4 times, demand is still strong. The five year Bobl auction, held on 25th February, came with a negative 0.08% yield for the first time. Negative yields are becoming common-place but their implications are not clearly understood as this article from Bruegal – The below-zero lower bound explains – the emphasis is mine):-

The negative yields observed on some government and corporate bonds, as well as the recent move into further negative territory of monetary policy rates, are shaking our understanding of the ZLB constraint.

Matthew Yglesias writes… Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative.

Evan Soltas writes… economists had believed that it was effectively impossible for nominal interest rates to fall below zero. Hence the idea of the “zero lower bound.” Well, so much for that theory. Interest rates are going negative all around the world. And not by small amounts, either. $1.9 trillion dollars of European debt now carries negative nominal yields,

Gavyn Davies writes… the Swiss and Danish central banks are testing where the effective lower bound on interest rates really lies. Denmark and Switzerland are clearly both special cases, because they have been subject to enormous upward pressure on their exchange rates. However, if they prove that central banks can force short term interest rates deep into negative territory, this would challenge the almost universal belief among economists that interest rates are subject to a ZLB.

JP Koning writes that there are a number of carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn’t a zero bound, but a -0.5% bound (or thereabouts).

Evan Soltas writes that if people aren’t converting deposits to currency, one explanation is that it’s just expensive to carry or to store any significant amount of it… How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders… The data here suggest a conservative estimate is 2 percent annually.

Barclays writes… Coincidentally, the ECB has calculated that the social welfare value of transactions is 2.3%.

Brad Delong writes…In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it.

Whilst none of these authors definitively tell us how negative is too negative, it is clear that negative rates may have substantially further to go. The only real deterrent is the negative cost of carry, which is likely to make price fluctuations more volatile.

German Stocks

Traditionally Germany was the preserve of the bond investor. Stocks have become increasingly popular with younger investors and those who need yield. Corporate bonds used to be an alternative but even these issues are heading towards a zero yield. I have argued for many years that a well-run company, whilst limited by liability, may be less likely to default or reschedule their debt than a profligate government. Even today, corporates offer a higher yield – the only major concern for an investor is the liquidity of the secondary market.

Nonetheless, with corporate yields fast converging on government bonds, stocks become the “least worst” liquid investment, since they should be supported at the zero-bound – I assume companies will not start charging investors to hold their shares. Putting it in finance terms; whereas we have been inclined to think of stocks as “growth” perpetuities, at the “less-than-zero-bound”, even a “non-growth” perpetuity looks good when compared to the negative yield on dated debt. We certainly live in interesting, or perhaps I should say “uninteresting” times.

A different case for investing in stocks is the potential restructuring risk inherent throughout the Eurozone (EZ). Michael Pettis – When do we decide that Europe must restructure much of its debt? Is illuminating on this issue:-

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

while German institutions and policymakers are as responsible as those in peripheral Europe for the debt crisis, in fact it was German and peripheral European workers who ultimately bear the cost of the distortions, and it will be German households who will pay to clean up German banks as, one after another, the debts of peripheral European countries are explicitly or implicitly written down.

In many countries in Europe there is tremendous uncertainty about how debt is going to be resolved. This uncertainty has an economic cost, and the cost only grows over time. But because most policymakers stubbornly refuse to consider what seems to have become obvious to most Europeans, there is a very good chance that Europe is going to repeat the history of most debt crises.

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

If Pettis is even half-right, the restructuring of non-performing EZ debt will be a dislocating process during which EZ government bond yields will vacillate wildly. If the German government ends up footing the bill for the lion’s share of Greek debt, rather than letting its banking system default, then stocks might become an accidental “safe-haven” but I think it more likely that rising Bund yields will precipitate a decline in German stocks.

Here is how the DAX Index has reacted to the heady cocktail of ECB QE, a falling Euro and a deferral of the Greek dilemma:-

DAX Jan 1998 - March 2015 Monthly

Source: Barchart.com

The DAX has more than doubled since the dark days of 2011 when the ECB saved the day with rhetoric rather than real accommodation. From a technical perspective we might have another 1,500 points to climb even from these ethereal heights – I am taking the double top of 2000 and 2007 together with the 2003 low and extrapolating a similar width of channel to the upside – around 13,500. The speed of the rally is cause for concern, however, since earnings have yet to catch up with expectations, but, as I pointed out earlier, there are non-standard reasons why the market may be inhaling ether. The current PE Ratio is 21.5 times and the recent rally has made the market look expensive relative to forward earning. At 13,500 the PE will be close to 24.5 times. This chart book from Dr Ed Yardeni makes an excellent case for caution. This is a subscriber service if you wish to sign up for a free trial.

The domestic nature of the economic resurgence is exemplified most clearly by the chart below which shows the five year performance of the DAX Index versus the mid-cap MDAX Index, I believe it is time for the large cap stocks to benefit from the external windfalls of a weaker Euro and lower energy prices:-

DAX vs MDAX 2000-2015

Source: Finanzen.net

Real Estate

In Germany, Real Estate investment is different. Government policy has been to keep housing affordable and supply is therefore plentiful. This article from Inside Housing – German Lessons elaborates:-

Do you fancy a one-bed apartment in Berlin for £35,000 or a four- bed detached house in the Rhineland for £51,000?

In many parts of Germany house prices are a fraction of their UK equivalents – in fact, German house prices have decreased in real terms by 10 percent over the past thirty years, whereas UK house prices have increased by a staggering 233 percent in real terms over the same period. Yet German salaries are equal to or higher than ours. As a consequence Germans have more cash to spend on consumer goods and a higher standard of living, and they save twice as much as us, which means more capital for industry and commerce. Is it any surprise that the German economy is consistently out-performing ours?

There are a number of reasons for the disparity between the German and UK housing markets. Firstly, German home ownership is just over 40 percent compared to our 65 percent (there are stark regional variations – in Berlin 90 percent of all homes are privately rented) and the Germans do not worship ownership in the way we do. Not only is it more difficult to get mortgage finance (20 percent deposits are a typical requirement) but the private rented sector offers high quality, secure, affordable and plentiful accommodation so there are fewer incentives to buy. You can rent an 85 square metre property for less than £500 per month in Berlin or for around £360 per month in Leipzig. There is also tight rent control and unlimited contracts are common, so that tenants, if they give notice, can stay put for the long-term. Deposits must be repaid with interest on moving out.

In addition, Germany’s tax regime is not very favourable for property owners. There is a property transfer tax and an annual land tax. But the German housebuilding industry is also more diverse than ours with more prefabraction and more self-builders. The German constitution includes an explicit “right-to-build’’ clause, so that owners can build on their property or land without permission so long as it conforms with local codes.

But the biggest advantage of the German system is that they actively encourage new housing supply and release about twice as much land for housing as we do. German local authorities receive grants based on an accurate assessment of residents, so there is an incentive to develop new homes. The Cologne Institute for Economic Research calculated that in 2010 there were 50 hectares of new housing development land per 100,000 population in Germany but only 15 hectares in the UK. That means the Germans are building three times as many new homes as us pro-rata even though our population growth is greater than theirs. This means that German housing supply is elastic and can respond quickly to rising demand…

 

German rental protection laws – for the renter – are stronger than in other countries – this encourages renting rather than buying. From an investment perspective this makes owning German Real Estate a much more “bond like” proposition. With wages finally rising and economic prospects brightening, Real Estate is a viable alternative to fixed income. The table below was last updated in May 2014, at that time 10 yr Bunds were yielding around 1.5%:-

Apartment Location Cost Monthly Rent Yield
Berlin
45 sq. m. 108,225 500 5.55%
75 sq. m. 230,025 779 4.07%
120 sq. m. 489,360 1,362 3.34%
200 sq. m. 935,200 2,442 3.13%
Frankfurt
45 sq. m. 164,385 788 5.75%
75 sq. m. 308,025 1,182 4.60%
120 sq. m. 538,560 1,750 3.90%
200 sq. m. n.a. 3,066 n.a.
Munich
45 sq. m. 218,160 773 4.25%
75 sq. m. 463,275 1,172 3.00%
120 sq. m. 774,120 2,066 3.20%
200 sq. m. 1,850,000 3,562 2.31%

Source: Global Property Guide Definitions: Data FAQ

For comparison, commercial office space in these three locations also offers a viable yield: –

Office Location   Yield  
  2013 2012 2011
Berlin 4.7 4.8 4.95
Frankfurt 4.65 4.75 4.9
Munich 4.4 4.6 4.75

Source: BNP Paribas

I believe longer term investors are fairly compensated for the relative illiquidity of German Real Estate.

The Euro

For the international investor, buying Euro denominated assets exposes one to the risk of a continued decline in the value of the currency. The Euro Effective Exchange Rate is still near the middle of its long-term range, as the chart below illustrates, though since this chart ends in Q4 2014 the Euro has weakened to around 90:-

Euro_Effective_Excahnge_Rate_-_ECB_1993_-_2015

Source: ECB

Investors must expect further Euro weakness whilst markets obsess about the departure of Greece from the EZ, however, a “Grexit” or a resolution (aka restructuring/forgiveness) of Greek debt will allow the markets to clear.

Conclusion and Investment Opportunities

German Bunds continue to be the safe-haven asset of choice for the EZ, however, for the longer term investor they offer negligible or negative returns. German Real Estate, both residential and commercial, looks attractive from a yield perspective, but take care to factor in the useful life of buildings, since capital gains are unlikely.

This leaves German equities. A secular shift from bond to equity investment has been occurring due to the low level of interest rates, this has, to some extent, countered the demographic forces of an aging German population. Nonetheless, on a P/E ratio of 21.5 times, the DAX Index is becoming expensive – the S&P 500 Index is trading around 20 times.

At the current level I feel it is late to “arrive at the party” but on a correction to test the break-out around 10,000 the DAX looks attractive, I expect upward revisions to earnings forecasts to reflect the weakness of the Euro and the lower price of energy.