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Exceptional times

Interest rates – both short and long term – are at record lows in Europe. The driving force behind this is the belief that both employment and inflation will be lower for longer. This is something that concerns the ECB and Drahgi’s Jackson Hole speech implies further easing ahead. These appear to be exceptional times.

The story of how we got here is pretty simple: a global banking collapse in 2008, followed by a further severe bout of local damage to the banking system in Europe caused by the sovereign debt crisis in 2011 and 2012.

The chart below is an attempt to illustrate where true borrowing rates have been. Taking a proxy for the cost of finance and adding that to three month Euribor gives a better picture of real monetary conditions than by simply looking at the headline ECB rate. Monetary policy in the Euro crisis was tightened in the core, but more so in the periphery.

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In the following charts we break out the inflation and employment data of the core and the periphery. What we see is that where tighter monetary policy is applied unemployment is subsequently higher and inflation is lower. It is not surprising that the Euro area and particularly the periphery have been weak given the severe monetary shock they took in the Euro crisis. This suggests that monetary policy still works.

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Going forward, real monetary policy has effectively been eased aggressively from the summer of 2012 through to now. This should provide a boost to the Euro area, and in particular the periphery. Monetary policy is generally assumed to work with an 18 month lag and interestingly unemployment is already heading down. I expect this trend will continue.

We are in exceptional times from an interest rate perspective, but from an economic perspective unemployment has been this high before from 1994 to 1997, and inflation was below 1.0% in 1999 and 2009.

When economics deviates from markets you have to decide which is correct. I think that monetary policy works, and the huge easing from 2012 will bring about falling unemployment and prevent significant deflation. Exceptionally low interest rates in Europe seem out of line with the current and potential future economic data.

Wolfgang Bauer

Race to the Bottom: Eurozone Inflation Rates

In principle, the European Central Bank (ECB) is well in line with its price stability objective, which it defines as a “year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. Nonetheless, July inflation numbers released last week bring the currency union as a whole dangerously close to deflationary territory. The aggregate HICP annual rate of change for the Eurozone fell to 0.4%, its lowest inflation print since October 2009.

But what has been driving this development? To answer this question we broke down HICP headline inflation numbers into three components: (i) food, alcohol and tobacco (FAT); (ii) energy; and (iii) core inflation, i.e., the remainder when stripping out (i) and (ii) from the headline figure. In the chart below we plotted the contributions of each of these three components to the headline number, calculated by multiplying the annualised monthly changes of the component indices by their respective weights within the overall HICP.

Decomposition of Eurozone Inflation Numbers

Only a relatively small part of the substantial drop in HICP headline inflation from 3.0% in the end of 2011 to currently 0.4% can be attributed to core inflation. Admittedly, core inflation contribution has fallen from 1.1% to 0.6% in this time period but compared to the other two components it has been much more stable. This result intuitively makes sense as core inflation comprises very different items, such as clothing, healthcare and communications. The inherent diversification subdues core rate volatility as fluctuations in individual item levels are likely to balance out each other to a certain degree. The fall in Eurozone inflation has mainly been caused by FAT and energy. Whereas FAT and energy boosted headline inflation by 0.7% and 1.3%, respectively, in November 2011, by now both components have essentially become a drag, chipping off 0.1% each from the July 2014 aggregate figure. Declining inflation rates in the Eurozone can at least partially be explained by a strengthening of the Euro vs. USD (c. USD 1.27 per EUR in the beginning of 2012 to a peak level of c. USD 1.39 in early May 2014), having a deflationary effect on import prices. In recent months, when the exchange rate trend started to reverse, the oil price dropped sharply (c. USD 114 per barrel Brent in mid June 2014 to currently c. USD 102), which helped to put downward pressure on energy prices. It will be interesting to see how geopolitical developments in the Ukraine and the Middle East are going to affect energy inflation contributions in the months to come.

Now let’s turn towards inflation rates of individual countries. The two biggest Eurozone economies, Germany and France, showed July inflation rates clearly below 1% (0.8% and 0.6%, respectively). The periphery experienced either no inflation at all (Italy with 0%) or even deflation (Spain with -0.4%, Portugal with -0.7%, Greece with -0.8%). Undoubtedly, these numbers are low. But how do they compare with historical inflation rates? We took a look at the past ten years of inflation rate data (HICP annual rates of change, published monthly) for the Eurozone in total, its four main economies and, for comparison, the United States. For each entity, we ranked the numbers from smallest to largest and divided the range of inflation rates into three bands, containing the bottom 25%, middle 50% and top 25% of data points, respectively (see chart below). The white lines mark the border below which the bottom 10% of inflation rate prints are located for each data series. In addition, we highlighted the most recent inflation numbers as well as the figures from one and two years ago.

Current Inflation Numbers in Historic Context

We can draw a number of conclusions from this chart. For instance, inflation rate spans for Germany with 4.2% (-0.7% to 3.5%) and Italy with 4.3% (-0.1% to 4.2%) are significantly smaller than for Spain with 6.6% (-1.3% to 5.3%) and the U.S. with 7.7% (-2.1% to 5.6%). Most importantly, the chart puts the drop in European inflation rates over the past years into some statistical context. July 2012 inflation prints still rank within the middle 50%, or even in the top 25% in the case of Italy. Except for Germany, inflation rates exceeded the ECB’s upper limit of 2% back then. However, the most recent data points from July 2014 can all be found in the bottom 10% of the 10-year inflation rate ranges. German inflation is exactly at and the French figure slightly below their respective bottom 10% thresholds. Italy’s and Spain’s inflation rates have fallen deep into their bottom 10% ranges. Italy’s current 0% inflation figure marks in fact the country’s second lowest monthly reading within the past 10 years. In contrast, U.S. consumer price inflation is not on a downward trajectory but numbers have been bouncing back and forth between 1% and slightly above 2.0% over the past two years. The July 2012 print of 1.4%, for example, ranks in the bottom 25%, whereas inflation rates both for July 2013 and July 2014 sit with 2% within the middle 50%.

What does this mean for fixed income investors? For a start, the divergence of European and U.S. inflation rates, in combination with substantial differences in real GDP growth (Eurozone with -0.4% in 2013 and 0% in Q2 2014 vs. U.S. with 2.2% and 4.0%, respectively) and labour market strength (Eurozone with 11.9% unemployment rate in 2013 and 11.6% in Q2 2014 vs. U.S. with 7.4% and 6.2%, respectively), reinforces the argument of an on-going decoupling between the two economic areas. The progressive fall of Eurozone inflation rates well below the 2% level gives the ECB some room for manoeuvre. European interest rates are likely to stay at essentially zero for the time being, and we should not be surprised if more accommodative monetary policies, such as asset purchases, were implemented by the ECB going forward in an attempt to stimulate economic recovery.

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The Great British Austerity Myth

On the right is UK Chancellor George Osborne, the austerity axeman.  On the left was opposition leader Ed Miliband, the fiscal freedom fighter.  But it now appears that Miliband and co are so alarmed that Cameron and Osborne are better trusted by the electorate to run the now booming UK economy that they are quietly embracing Tory austerity. The Liberal Democrats have accused the Tories of pursuing austerity for austerity’s sake, but are still targeting eliminating the budget deficit in the next three to four years.  That essentially leaves the Scottish National Party, which is urging Scots to vote for independence so that Scotland can ”escape Westminster’s austerity agenda”.

The problem with all this austerity posturing is that it’s built on a completely phoney premise. As confirmed by data released today, there hasn’t been any UK austerity, at least not for a couple of years.  Indeed, that probably goes a long way to explaining why the IMF predicts that the UK will have the fastest growing economy in the developed world this year.

The chart below puts the UK’s budget balance into international context.  The US has seen immense fiscal consolidation, which was a major drag on growth in 2011-2013 but which will substantially fall hereafter, and is one of a number of reasons why we’re US economy bulls.  Eurozone fiscal consolidation was enforced by markets to an extent, although the Eurozone as a whole -  as per the US – is currently running a budget deficit akin to levels seen in 2004-05.  And Germany, a country under zero pressure from markets, expects to balance its budget this year. The UK economy grew almost three times faster than Germany’s in the year to Q2, and yet its deficit remains huge by historical standards.

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The primary reason for the UK’s unfrugal fiscal policy is an inability to cut back on government spending.  It’s not just overspending, however. Tax revenues in the first four months of this tax year are 1.9% below where they were in July 2013, and that’s in nominal terms, let alone real terms.  The Office for Budget Responsibility (OBR) will be able to provide more detail on this when they release their summary later today. It’s likely that part of this is due to the front loading of receipts last year, thus making like for like comparisons tricky, and the OBR will probably forecast a pick up in receipts towards the end of this year.

The chart below illustrates how government spending in the UK has increased every single year.

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An addiction to spending combined with weak tax revenue growth means that the Public Sector Net Borrowing figures are going nowhere fast. In the four months to July, Public Sector Net Borrowing (ex financial interventions) was actually higher than in 2011/12, 2012/13 and 2013/14.  Again, the OBR will have more to say about this later, but there’s no denying that the UK’s government finances make grim reading.

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Now all that said, I’m not suggesting that the UK government should necessarily adopt tighter fiscal policy.  While current fiscal policies aren’t sustainable in the long term, loose fiscal policy has recently been successful in generating strong economic growth, and more importantly it appears to have helped encourage the private sector to finally start investing.  Furthermore, you would traditionally expect countries that run sustained loose fiscal policy to have relatively steep yield curves, but the opposite is true in the UK at the moment, with some longer forward yields close to record lows.  In other words, the markets don’t care – yet – and a good argument can be made for the government to fund some much-needed and ultimately productive UK infrastructure investment. All I’m saying is that the UK electorate deserves a lot more honesty in the debate.

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French government should push for further tax and labour market reforms

France has a unique social model. It originates from the end of the Second World War, when the National Council of the Resistance (NCR) hastily put together a plan to rebuild the country after five years of Nazi occupation. Despite not having any official political affiliations, the NCR was in fact influenced by left wing individuals and the “National Front”, a communist party. The NCR’s “action plan” helped shape France in the aftermath of the war and is one of the reasons today that trade unions have such a prominent position in society and why the French are so fond of their “established social rights”.

Since then, reforming France has always been a difficult task. Given that it was announced last week that the country has experienced a second consecutive quarter of no growth, it seems obvious that some sort of change is urgently required. France has grown by only 0.1% in the past year. Despite extremely low interest rates and fiscal tightening, the government’s budget remains in structural deficit and the debt to GDP ratio has increased from 77% to 93%. More worryingly, despite French President Hollande’s very vocal claim that he would “invert the unemployment curve” by the end of 2013, the number of job seekers continues to rise at an alarming rate, hampering consumer confidence and business spending.

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So what can the Hollande government do in a country that is difficult to reform and where scope for public spending is limited?

First of all he should aim to simplify France’s highly complex tax regime, which over the years has become almost illegible. This toing-and-froing over taxes continues to hurt the French economy by creating uncertainty and hampering business investment. In the last 2 years alone, French legislators have created 84 new taxes, for a total of €60 billion Euros.

Second, the government must reduce the burden of social security contributions on the business sector. Today, France spends 17% of its GDP in social contribution taxes, the highest amount out of all of the 28 EU countries. While many people in the country believe that this is the price to pay to finance France’s generous welfare system, its financing relies too heavily on businesses.  In the rest of Europe the burden of social security payments is shared on average equally between employers and employees. In France, almost 70% of these payments are paid by employers. This has a direct effect on the cost of labour and diminishes companies’ abilities to compete in an increasingly globalised world. The French government has started to address this issue by granting a €20 billion tax credit (CICE) to all French businesses, but much more needs to be accomplished. Indeed, in order to put France on equal footing with its neighbour Germany, employer social security contributions would need to be reduced by a further €80 billion per year.

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Finally, the government should also tackle the excessive bureaucracy in the labour market. For example, many small firms today refuse to grow beyond the threshold of 50 employees because exceeding this number triggers a raft of regulatory and legal obligations. It would make sense to push this threshold to 250 employees, and bring France in line with the European norm. The French Labour Code is 3500 pages long and weighs 1.5 kilo, while the Swiss Code, where unemployment is 3% rate, is 130 pages and weighs 150 grams (anecdotally comparing unemployment rates with the number of pages of labour codes for different countries could be the subject of a future blog).  This excessive bureaucracy is partially the reason why France’s competitiveness has been declining in recent years. In its latest Global Competitiveness report, the World Economic Forum ranked France 23rd overall, but 21st in 2013 and 18th in 2012. More alarmingly, the country is ranked 116th for “labour market efficiency” (out of a total of 148 countries), 135th for “cooperation in Labour-employer relations” and 144th in “hiring and firing practices”. When asked what the most problematic factor for doing business in the country, the number 1 answer provided by respondents was “restrictive labour regulations”.

As France teeters on the brink of recession, Hollande is today in a very difficult position. A complete overhaul of the French social model would create much civil unrest and probably push the country into recession. On the other hand, doing nothing is likely to have the same effect as France would continue to lose competitiveness on a global scale. In a recent study published by “Le Monde”, 60% of respondents said they were “satisfied” with the French social model, but 64% also declared that the model should be at least partially reformed. The French government should use this as a sign that it can make some adjustments to the French tax system and labour markets, without jeopardising its chance of being re-elected in two years. With its popularity at an all-time low and unemployment at an all-time high, there is no more time to waste.

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Sprouting out: green bonds come of age

Green bonds are instruments in which proceeds are exclusively applied towards new and existing green projects – defined as activities that promote climate or other environmental sustainability purposes. They enable capital raising and investment in projects with environmental benefits. The International Capital Market Association (ICMA) set out some guidelines for issuing of green bonds in January 2014.

Originally dominated by supranational issuers (for example, European Investment Bank, World Bank and the European Bank for Construction and Redevelopment), financials and corporate issuers are increasingly tapping into this new source of funding.

Green corporate bonds, being a nascent asset class, are a place for many firsts. In October 2012, industrial gases company Air Liquide claimed they were the ‘first private company to issue bonds meeting the SRI investors’ criteria’. This bond predated the Green Bond Principles, and technically may not be a green bond, but is noteworthy in having been ‘mostly placed with Socially Responsible Investor (SRI) mandated issuers’. Since then, we’ve had French utility EDF in November 2013 announce ‘the issuance of the first corporate Green Bond’, although that title may just (by a couple of days) go to the Swedish property company Vasakronan. More recently we’ve had consumer goods company Unilever announce in March 2014 ‘Unilever’s green sustainability bond is the first green bond in the sterling market, and the first by a company in the FMCG sector’.

It is apparent that corporate issuers are keen to spur the development of the green bond market as an alternative funding source and, in doing so, raise awareness of the environmental issues they face. Looking at the chart below shows that corporates are now the single largest source of green bond issuance. Whilst it’s clear that issuers and investors both earn brownie (greenie?) points in terms of enhanced reputation for their involvement and support of sustainable projects, green bonds lack a binding internationally recognised definition, they merely adhere to a voluntary set of guidelines.

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One of the structural features of green bonds is that they are often issued off existing Euro Medium Term Note (EMTN) programs and guaranteed by the parent company. Cash flows that service bonds come from the issuer, therefore benefiting from the overall cash flows of the corporate, not just the project that is being funded. It is not surprising, therefore, that the credit rating of these bonds is in line with other bonds issued by the same issuer. This dislocation does, however, mean that investors are not able to identify the cash flows from the underlying project.

Corporate bonds issuers often bracket their use of proceeds into ‘general corporate purposes’, which rarely tells investors much about how or where the proceeds are to be used. Is it, for example, for refinancing, M&A, capital expenditure or share buybacks? In contrast, one of the cornerstones of a green bond is that the use of proceeds is defined in the legal documentation of the security, which should bring a degree of transparency. I say degree because, in practice, once the proceeds are deployed the investor may have limited information on the progress of the project and the extent to which it is meeting environmental targets. For instance, are bond proceeds for the specified project leading to an identifiable reduction in greenhouse gases, water and waste?

There is a certain asymmetry in green credentials required between issuers and investors. For an entity to issue a green bond they have to abide by the principles as outlined by the ICMA. Alongside use of proceeds, these also include project evaluation and selection, reporting, as well as management of proceeds. The latter includes a suggestion to enhance the environmental integrity of the instrument through the use of an external auditor, an independent verifier or as some have called it, a Socially Responsible Investment (SRI) rating agency. Yet with so much stringency on the issuer side, there seems to be no limitation on which bonds funds are able to participate in owning such an issue. Whilst issuers are often citing a desire to diversify their funding sources and attract SRI and Environmental Social and Governance (ESG) conscious investors seeking sustainable (both from a cash flow and environmental perspective) fixed-income instruments, the investors themselves do not necessarily need to have such a green bill of health.

Indeed, even a bond issued in a ‘green wrapper’ may not satisfy certain SRI funds which may argue, rightly or wrongly, for example, that EDF is using cash flows generated through nuclear power activities to pay coupons on its green bond. Another angle on this would be to say that environmental projects are receiving credit enhancement through use of corporate cash flows to prop-up investment in green initiatives. Regardless, the burden remains with the investor to determine how green the bond is. The rating agencies have so far not waded into the argument by assigning a relative ranking of ‘greenness’.

Finally, looking at a few examples of corporate green bond issuers in the table below, it appears that the pricing of green bonds on the secondary market is in line with other (‘non-green’) issues, which to us makes sense given the structural and cash flow arguments mentioned.

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Not all change is bad: coming reforms to credit default swaps

There is a lot of analysis and conjecture about how much impact the financial crisis has had on the global economy and financial markets. There has been considerably less analysis around the impact of the crisis on bond fund managers. In a small attempt to quantify these impacts, we have dug out a few old photos of members of the M&G bond team pre and post-crisis. The photos show clearly where change has been bad.

2008-08 ben

There is, though, good change. In September there are changes taking place to bank CDS contracts that represent clearly positive progression.

The CDS rules and definitions of 2003 state that there are 3 different credit events that will trigger corporate and financial CDS contracts: 1. failure to pay 2. bankruptcy, and 3. restructuring (this means that a company can’t modify the conditions of debt obligations detrimentally as far as investors are concerned). If any of these are determined to have occurred, then buyers of protection receive par from sellers of protection (and sellers of protection pay out par minus the recovery value of the defaulted bonds, so are in the same situation as if they owned the defaulted bond). In the event of one of these events being triggered, buyers of protection are ‘insured’ against the losses incurred on the bonds.
However, whilst the above works well in most cases of corporate defaults, we have seen several examples in the last few years in terms of banks in which the outcomes have left buyers of protection in effectively defaulted bonds none the better off. For purposes of succinctness and relevance, I would like to mention two of the more recent such cases so as to bring out the flaws of the existing financial CDS contracts, and to highlight the improvements we will soon see.

In early 2013, the Dutch government expropriated the subordinated debt of SNS Bank, which had got into serious difficulties. Bondholders would therefore no longer receive coupons or principal, and so the determinations committee ruled, quite simply, that a restructuring event had occurred. However, the buyers of protection had to deliver defaulted bonds to the sellers, and there being no subordinated bonds left, had to deliver senior bonds, whose value was around 85p in the pound. This meant that they ‘owned’ bonds worth zero, and were being paid out 15p as a result of the protection they had bought!

The most recent example of subordinated CDS not working is still on-going, being the case of Banco Espirito Santo. This bank has seen all the good assets, deposits and senior debt transferred to a new, good, bank, and all the bad assets, subordinated debt and equity stay with the old, bad, bank. So subordinated debt will very likely get a very low recovery (the sub bonds are today trading at around 15 cents). Subordinated bank debt is now, in practical terms, able to take losses and be written down in European banks. Senior bank debt will also become write-down-able at the start of 2016, but as yet legislators and regulators are showing the continued desire to make senior good. In BES’ case, though, with all the deposits and senior debt moving to the good bank (and with a very thin layer of subordinated debt), more than 75% of the liabilities will go to the new entity. In CDS terms, this means that the contracts move to the new entity. So, again, buyers of subordinated protection in BES are left with significant losses on their bonds, but will have to deliver senior bonds which are trading close to and in some cases above par. Not the outcome that the owners of protection wanted or expected. And, frankly, not the right outcome.

So the existing rules around financial CDS are unfit for purpose. Starting in September, new rules will come into place that will vastly improve the economics of these contracts, and in simple terms will make them behave far more like senior and subordinated bonds, which after all is what they are meant to do. The major differences can be summarised into two: a new, fourth, credit event trigger called Government Intervention will be added; and the removal of the cross default provision. The Government Intervention trigger will mean that in instances such as SNS, when governmental authorities impair debt, CDS contracts will be triggered, and in the same case, owners of subordinated protection would have delivered a claim on the Dutch government that was worth zero, through the expropriation, and would have received par from sellers of protection. In terms of the second major reform to financial CDS contracts, current contracts mean that a credit event on subordinated CDS also results in a credit event on senior. This clause will be removed, meaning that in the Banco Espirito Santo on-going case, subordinated CDS contracts would travel with the subordinated bonds, and senior with senior. Unlike the changing faces of the Bond Vigilantes, the changes soon coming in CDS are ones we think are positive.

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The yield-dampeners: will interest rates inevitably rise when QE ends?

After the ‘taper tantrum’ of 2013, many commentators predict that the catalyst for a sell-off in fixed income assets could be the ending of quantitative easing by the US Federal Reserve later this year. In the latest issue of our Panoramic Outlook series, I present an alternative view to this consensus thinking, analysing a number of dynamics in bond markets that have surprised investors during this period of extraordinary monetary policy. My emphasis is on what I view as three key ‘yield-dampeners’ at work that investors should be aware of:

  • The fragility of the global economic recovery and high debt levels in the US economy make it unlikely that interest rates will return to pre-crisis levels, limiting the potential downside to bonds.
  • There are some powerful structural deflationary forces which are helping to keep inflation low.
  • A strong technical factor – the global savings glut – is likely to remain supportive to fixed income assets as is firm demand from large institutional pension funds and central banks.

Given these influences, it’s very much possible that those looking for yields to rise back to pre-crisis levels when QE ends may be disappointed. Not only are these yield-dampening forces at play in the US Treasury market, but they could also easily be applied to the UK or European government bond markets, potentially providing a useful lesson for the future path of yields. This will impact the attractiveness of other fixed income assets such as investment grade and high yield corporate bonds. Arguably, ultra-low cash rates and a stable interest rate environment for government bonds would provide a solid base for corporate bond markets as investors continue to seek positive real returns on their investments. The full analysis is located here.

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What is the collapse in the Baltic Dry shipping index telling us about global growth?

The Baltic Dry Index (BDI) is a daily priced indicator of the cost of shipping freight on various trade routes for dry bulk carriers, based on data submitted by shipbrokers to the Baltic Exchange in London. Since March this year the index has fallen by over 50%, and this has made economists worry that the fall reflects a generalized slowdown in global trade – dry bulk goods include cement, coal, ore as well as food stuffs like grain. A lot of it is the stuff that China imports to support its investment led growth model, so a collapse in demand for the ships that carry bulk dry goods to China might be telling us that China is slowing rapidly. And that obviously has significant impacts on those economies which are reliant on exporting to China for their own growth – for instance Australia, Chile, South Africa and South Korea all have between 21% and 36% of their exports going to China.

Obviously though demand for space on ships is only half of the equation. As expectations grew that the Great Financial Crisis was behind us, and as China kept publishing high single digit growth rates, there was a significant expansion in shipbuilding. Since 2010 annual growth in Dry Bulk supply has been anywhere from 5% to over 15% year on year – in most periods outstripping demand growth, and certainly depressing prices. It’s not just dry bulk, there’s also big excess supply in container ships. Shipping companies are trying to manage these supply problems – the average age of ships when scrapped has fallen from 28 years in 2011 to 21 years in Q1 2014, 4% of the fleet is “idle”, ships are “slow steaming” (going slowly to save fuel and costs of being idle at port) and shipping companies are cancelling future orders for new ships (in 2013 32% of orders were not delivered as planned and were either postponed or cancelled). But for 2014 and 2015 at least the excess supply problem gets worse, not better.

So is the Baltic Dry Index telling us anything about global trade and growth? We started off from a position of scepticism – there used to be a good relationship (we wrote about it here in 2011), but since the massive shipping supply boom maybe it had lost its power as in indicator? But it turns out that the correlation between world trade and the BDI is EXTREMELY good. The CPB Netherlands Bureau for Economic Policy Analysis produces the monthly CPB World Trade Monitor. It’s clear from these global trade data that the volume of trade has been weakening since the end months of 2013. Trade actually fell in May, by 0.6% month on month, although due to volatility and seasonals, a rolling 3 month versus previous 3 month measure is preferred. The chart below shows that after some strong momentum in global trade in 2010 it’s fallen to a much more stagnant growth level in the past couple of years, and a brief recovery in mid 2013 has tailed away. In Q1 this year, world trade momentum turned negative. We have shown the Baltic Dry Index against this measure of world trade – it doesn’t just look like a strong relationship optically, but it has a correlation coefficient of 0.74 (strong) with a t value of 7.83 (statistically significant at an extremely high level).

Baltic Dry vs World Trade - Chart - v01 - CHART 1

When we last wrote about the Baltic Dry Index we pointed out that it appeared to be a good lead indicator for 10 year US Treasury yields, the theory being that a fall in the BDI presaged falling GDP and therefore justified lower rates. And indeed the fall in the BDI in early 2011 did nicely predict the big Treasury rally 3 months later. There is still a relationship today, but sadly for us bond fund managers the better relationship is with UST yields predicting movements in the BDI (so ship-owners please feel free to make money on the back of this). Nevertheless, over the same time period as the earlier chart there is still a decent correlation if you use the BDI as a leading indicator and push it forward by 3 months, so it does appear to have some predictive powers.

Baltic Dry as Leading Indicator for 10Y Treasury Yield - Chart - v01 - CHART 2

So we’ll keep looking at the Baltic Dry Index for the same reason that we like the Billion Prices Project for inflation. When you can find a daily priced, publically available measure or statistic that comes out a month or more ahead of official data and is a strong proxy for that data it’s very valuable.

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Falling soft commodity prices are a piece of cake

Higher agricultural commodity prices at the start of the year raised concerns about the impact these could have on retail food prices, should the trend prove persistent. Fortunately, the price of soft commodities (coffee, sugar, wheat etc) appears to have decoupled from that of hard commodities (gold, silver, platinum etc) in recent months. Indeed, data from the last seven quarters indicate that the price of many agricultural commodities have actually fallen, as the chart below shows.

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Coffee prices are now at a five month low, after fears of a shortage of coffee beans from Brazil have receded. The supply of sugar has increased year-on-year, while wheat prices have also fallen due to increased harvests and easing crop concerns.

In order to gauge the collective effect of these changing agricultural commodity prices and how they could potentially feed through into UK inflation, I have constructed a simple cake index, teaming up Global Commodity Price data with some basic recipes from the BBC Good Food website. Given that sponge and individual cakes are two of the representative items included in the CPI 2014 basket of goods – and that food and drink items make up 11.2% of the overall CPI index – combining the commodities in this way gives an indication of how future changes might affect the average consumer.

The graph below shows the results of the cake index, demonstrating the change in various cake costs (since October 2012) versus the UK CPI (yoy %). What’s interesting is the generally downward trend of all cake indices in the last seven quarters. Sponge cake and plain scones look particularly good value in recent months, owing to the high proportion of wheat in their recipes. Apple cake unsurprisingly provides a price signal for its key ingredient (the price of apples has fallen 4% YTD), while coffee cake gives a less pronounced but similar effect. The good news – particularly for lovers of chocolate cake – is that despite the persistent increase in the cost of cocoa, the price of other cake constituents such as sugar, wheat and palm oil (used as a proxy for butter) have all fallen sufficiently to offset this, bringing the price of chocolate cake lower in recent months.

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Despite the recent June increase in CPI to 1.9% yoy, due to the lag between raw commodity prices and their general price level, we should perhaps expect to see deflation feeding into cake prices and the overall food constituent of CPI in the coming months. Therefore although it is unclear who exactly was the first to declare “let them eat cake!”, this person may have been on to something. Personally, I’d recommend the (relatively cheap) scones.

Wolfgang Bauer

How to find relative value in EUR and USD investment grade credit using CDS

There is more than one way to skin a cat for credit investors. Those looking for credit exposure can do so through either owning the debt issued by an issuer or by selling credit default swap (CDS) protection for the same issuer. The differential in price between the corporate bond and CDS contract can mean the difference between outperforming and underperforming in a world of tight credit spreads and low yields. Additionally, it is possible to do this for the whole investment grade or high yield market, allowing bond investors to gain credit exposure in their preferred geographical region (for example, the U.S., Europe, or Asia). U.S. and European credit spreads have compressed substantially and are now at levels last seen before the Lehman Brothers collapse. Given this convergence, the question for global IG bond investors today is which market is relatively more attractive from a valuation perspective?

Let’s first take a look at EUR versus USD credit. The easiest way to do this is by using two credit default swap indices. These indices (also known as CDI) represent 125 of the most liquid five-year credit default swaps on investment grade (IG) entities in Europe (iTRAXX EUR 5Y) and North America (CDX IG 5Y). Looking at the historical performance of both indices, the differential between both index levels remained basically flat until the onset of the financial crisis in the second half of 2007. During this period, iTRAXX EUR traded around 10-15 basis points (bps) tighter than the CDX IG. During the crisis, the absolute levels of both indices increased substantially but iTRAXX EUR outperformed CDX IG, with the North American index moving up to a peak level of around 230bps in late 2008. In the following three years, with the easing of the U.S. recession and the emergence of the Eurozone crisis, CDX IG outperformed iTRAXX EUR by around 120 bps.

Starting from its minimum of -64 bps in November 2008, the index differential turned positive in May 2010 and reached its peak value of 57 bps in November 2011. With the Eurozone crisis calming down, iTRAXX EUR has once again outperformed CDX IG. Today the index differential has virtually disappeared (4 bps), and both indices have tightened to around 65bps by the end of May, a level not seen since the end of 2007. iTRAXX EUR continued to tighten in June and temporarily traded through CDX IG for the first time since March 2010.

CDS indices: EUR vs. USD IG credit

Selling CDS protection for a company creates a credit risk exposure that is essentially equivalent to buying a comparable bond of the same issuer. Hence, from a fixed income investor’s point of view, it is worth comparing the CDS spread and the credit spread of the cash bond. The difference between these two is often referred to as the CDS basis. Positive values (i.e., CDS spread > bond Z-spread) indicate a higher compensation for taking the same credit risk through the CDS of a company rather than owning the bond of a company, and vice versa for a negative basis.

Drawing a direct like-for-like comparison between CDS and corporate bond indices can be tricky. For example, it is impossible to find appropriate outstanding cash bonds for all the companies that are in the CDS indices. Furthermore, CDS indices comprise contracts with a certain maturity (e.g., five years) and roll every six months, whereas cash bonds approach a predefined maturity and are eventually redeemed, assuming they don’t default or are perpetual instruments.

We approached the problem by constructing our own equally-weighted non-financial CDS and cash bond indices, both for U.S. and Eurozone issuers. In terms of EUR issuers, we started from the current iTRAXX EUR roll, ranked the constituent entities by total debt outstanding and selected the top 20 Eurozone non-financial issuers with comparable outstanding bonds (c. five years until maturity, senior unsecured, vanilla, reasonable level of liquidity, etc.) for our CDS and bond indices. We then compared the year-to-date evolution of weekly CDS and cash bond spreads as well as the CDS basis, averaged over the 20 index members. For our USD indices we applied the same strategy, selecting a subset of 20 US non-financial issuers from the current CDX IG roll.

The chart below shows CDS spreads, bond Z-spreads and CDS bases both for our EUR and USD indices. Throughout the year, all four non-financial IG index spreads have been grinding tighter. The CDS basis for USD non-financial IG credit has been consistently negative (-19 bps on average). In absolute terms the negative USD basis has receded, moving from between -30 and -20 bps in January to -11 bps in the first week of July. In contrast, except for the first week of January which might be distorted by low trading volumes, the EUR non-financial IG CDS basis has been positive (+12 bps on average) and amounts to +11 bps for the first week of July.

CDS basis: EUR vs. USD non-financial IG credit

Several reasons have been put forward to explain the contrast between EUR and USD CDS basis values, including supply/demand imbalances within European cash bond markets adding a scarcity premium to bond prices and thus suppressing bond spreads. It has also been argued that in Europe CDS contracts were predominantly used for hedging purposes (i.e., to reduce credit exposure by buying the CDS contract) driving up CDS spreads, whereas the use of USD CDS contracts was more balanced between increasing and decreasing credit risk exposure.

In the current market environment characterised by low yields and tight credit spreads, CDS basis values do matter. The choice between a cash bond or a credit derivative is another lever fixed income investors can use to exploit relative value opportunities. By carefully selecting the financial instrument, cash bond vs. CDS contract, a spread pickup of tens of basis points can be realised for taking equivalent credit risk. A positive basis indicates that the CDS looks cheap relative to the cash bond, and vice versa for a negative basis. For instance, at the moment it often makes a lot of sense for us to get exposure to EUR IG credit risk through CDS contracts rather than through cash bonds, when we see attractive positive CDS basis values.

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