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richard_woolnough_100

US Jobless claims as a percentage of the labour force is now at multi-decade lows

I blogged last year about the state of the US labour market and given the recent release of September’s initial jobless claims data, this seems like a good time to revisit these ideas.

US Initial Jobless Claims is an unemployment indicator which tracks the number of people who have filed jobless claims for the first time, representing the flow of people receiving unemployment benefits.  The September headline figure of 288,000 is strikingly low and is the lowest reported month end figure since January 2006. Still, this understates the current strength of the labour market as when adjusting to take into account the working population, jobless claims as a percentage of the US labour force is now at multi-decade historical lows.

Initial jobless claims as % of working age population

Initial Jobless claims data has been taken on a monthly basis whereas the OECD US working age population data is annual. Therefore what is particularly important to note is that the latter figure for 2014 is not yet available and so the 2013 data has been extrapolated and kept stale since year end. As a result, the graph is more conservative than reality since 2014 population growth to date has not been incorporated. If it were, the fall in this indicator would be even more pronounced.

Traditionally monetary policy has worked with the Fed tightening as the economy picks up steam and jobless claims fall. What is remarkable today is that the Fed hasn’t even begun to tighten interest rates. In the past, the Fed would have already ended the tightening cycle by the time jobless claims fell to the levels we see today.

Unemployment and Fed Policy

Time and again the Fed has stressed that rate decisions will be data dependent and on Tuesday and Wednesday next week the FOMC are due to decide on whether or not it ends its QE program. Given the above, it seems that the US economy is continuing its healthy response to the stimulus provided and momentum in the US labour force is gathering pace in a positive direction. With more people working and fewer claiming unemployment benefits, the downward trajectory of this indicator – as well as other labour market indicators – surely helps to paint a positive macro picture. However, the risk-off wobble in markets last week has left many questioning whether the volatility experienced will have any bearing on the QE decision. Considering however that the trigger was the underperformance of US Retails Sales data, it can perhaps be argued that this is a typically volatile number in itself and the data release therefore triggered an overreaction in bond markets (exacerbated by capitulations, technical trading level breaches etc).

If the FOMC is in agreement that the market response was overdone, one should expect their decision to be based on the fundamentals and the picture of an overall improving economy. If true to their rhetoric, markets should expect to see an end to asset purchases, right on schedule.

Wolfgang Bauer

Drifting apart: The decoupling of USD and EUR credit spreads

The decoupling of European and U.S. yields has been one of the key bond market themes in 2014 and therefore a much-discussed topic in our blog and elsewhere. Over the past two and a half months, however, a second type of transatlantic decoupling has emerged, this time with regards to credit spreads.

Let’s first have a look at the relative year-to-date (YTD) performance of USD and EUR investment grade (IG) credit. Both data series in the chart below were rebased, i.e., set to a common starting value of 100. With some minor exceptions, spread levels of both indices have been tending downwards fairly consistently over the year until late July. From this point onwards, a decoupling has been taking place. Whereas EUR IG asset swap (ASW) spreads have further tightened, USD IG ASW spreads have significantly widened.

EUR vs. USD IG Credit Spreads

Considering the divergent economic momentum over the past months, this development seems at first glance somewhat counterintuitive. The economic recovery in the U.S has been notable with 2.6% real GDP growth (Q2 2014, yoy) and a remarkable decline in unemployment rate from 10% (Oct. 2009) to 5.9% (Sep. 2014). In contrast, the Eurozone’s economy has been fairly stagnant with an anaemic real GDP growth of 0.7% (Q2 2014, yoy) and a persistently high unemployment rate of 11.5% (Aug. 2014). Against this backdrop, one might expect that U.S. corporations are in a much better position in terms of growth and profitability prospects than their European competitors, and should therefore be in general less risky bond issuers. Investors should in turn demand higher risk premiums for EUR IG credit. Therefore, USD spreads should have tightened relative to EUR spreads. So why is it exactly the other way round? Why have EUR IG spreads outperformed USD IG spreads over the past two and a half months?

First of all, from a methodological point of view, one could argue that European bond issuers suffering severely from the economic malaise have probably been downgraded into high yield territory by now, and thus cannot adversely affect IG index credit spreads. Apart from this technical side note, three reasons come to mind:

  1. Different central bank policies, adjusted in response to the deepening economic divergence between the U.S and the Eurozone, and their effects on refinancing costs must be taken into consideration. The Federal Reserve is about to exit Quantitative Easing (QE) and is widely expected to hike rates next year, whereas the European Central Bank (ECB) is currently in the process expanding its balance sheet and will most likely keep interest rates close to the zero bound for the foreseeable future. Going forward, U.S. companies might face higher refinancing costs relative to their European peers. To put it the other way round, an increasingly accommodative ECB is likely to keep refinancing for EUR issuers easy and thus keep corporate default rates at ultra-low levels. Therefore, EUR IG credit spreads are permanently suppressed.
  2. Central bank intervention has a strong effect on liquidity in corporate bond markets, too. When a central bank engages into QE, which the ECB is currently doing one way or another, investors are to a certain degree crowded out of (nearly) risk-free assets and forced into riskier assets, such as corporate bonds. More investors rushing into corporate bond markets increase trading activity and thus liquidity there. Therefore, the illiquidity premium embedded in credit spreads should drop. In contrast, if a central bank, like the Fed now, winds down QE, corporate bond liquidity is expected to fall and thus higher illiquidity premiums trigger credit spread widening.
  3. Another argument addresses supply side effects. According to Morgan Stanley Research, global EUR IG bond net issuance has been significantly lower than global USD IG net issuance since August (EUR 21.8 bn vs. USD 135.7 bn, respectively). On a YTD basis, EUR IG credit has in fact been in net redemption territory (maturities exceeding new issuance!) of EUR 2.3 bn, compared to a strong USD IG net issuance of USD 490.3 bn. Hence, EUR IG credit has been in short supply, effectively adding a scarcity premium to EUR bond prices, which in turn has caused spread compression.

Now let’s add some more granularity by decomposing the overall index credit spread levels into individual sector spreads. The chart below shows YTD ranges of ASW spreads for USD IG corporate bond sectors (ML Level 3). All bars are subdivided into four sections, which we refer to in the following as quartiles, each of which containing 25% of the YTD spread readings. Dots and diamonds mark current sector spreads (14 Oct.) and spread levels at the start of the decoupling (24 Jul.), respectively.

Sector Breakdown of USD IG Credit

It is striking that over the past two and a half months all USD IG sector spreads have widened. In the vast majority of cases, spread levels have risen from 1st quartile values near the bottom end of the YTD ranges right into 3rd or even 4th quartile positions. The spread widening has been particularly pronounced for sectors which have recently experienced an elevated level of event risk in the form of actual or rumoured M&A activity (namely healthcare, energy and telecommunications). This leads to another important point: It becomes more and more clear that the U.S. economy has entered a new phase of the business cycle, whereas Europe is still well behind the curve. American companies are increasingly taking on balance sheet risk, for example in the form of M&A, to pursue growth opportunities. Consequently, fixed income investors demand a spread premium for USD IG credit to be adequately compensated for this additional risk exposure.

In terms of EUR IG credit, the picture is more nuanced. Credit spreads of certain sectors have widened (e.g., retail, leisure and insurance) while others have tightened (e.g., healthcare, financial services and telecommunications). This pattern, or rather the absence of a clear pattern, suggests that there are sector-specific factors overlaying the more general reasons listed above. Let’s focus on financials, for example. Banking and financial services credit spreads have substantially tightened and are currently deep in the first quartile of their YTD ranges. This is in very good agreement with a supportive ECB and reduced refinancing costs, which are a particularly important concern for financial bond issuers. In contrast, the already high insurance credit spread has widened into the 4th quartile. One explanation for this contrarian behaviour would be that lingering uncertainties around the approaching implementation of the Solvency II Directive, which selectively affect the European insurance companies, simply eclipse favourable central bank policies and supply side dynamics.

Sector Breakdown of EUR IG Credit

So what are the implications of spread decoupling on the relative attractiveness of USD vs. EUR IG credit? Well, the situation resembles the old Treasuries vs. Bunds debate; it ultimately comes down to the question whether one considers the current decoupling trend sustainable or not. If one genuinely believes that the divergence in terms of economic recovery, central bank policy and credit supply continues to progress, the case in favour of EUR IG credit could easily be made. The prospect of further EUR IG spread tightening, and hence capital appreciation, would outweigh lower spread and yield levels. We have in general preferred USD IG credit for quite a while now, precisely because of the higher average spreads compared to EUR IG credit, even when taking the cross-currency basis into account. Although the decoupling has certainly not worked in our favour in recent times, it has simultaneously strengthened the relative value argument. We are now obtaining an even bigger spread pick-up when investing in USD vs. EUR IG bonds than two and a half months ago. The currently low absolute level of EUR IG spreads makes the upside potential appear rather limited going forward. Finally, the global nature of corporate bond markets is likely to prevent an ever-increasing decoupling. If EUR IG spreads continue to fall relative to USD IG spreads, companies worldwide would try to minimise their borrowing costs by issuing EUR instead of USD denominated bonds. This trend would reverse current supply side imbalances and thus counteract the decoupling.

Claudia_Calich_100

Emerging market debt: notes from my recent trip to the IMF Annual Meetings

Last week I attended the IMF’s Annual Meetings in Washington D.C, where I had a series of very interesting meetings with government officials and other world financial leaders. The underlying theme behind most of the discussions was that emerging market countries continue their adjustment into a new phase characterized by less abundant liquidity and lower commodity prices. This adjustment process has thus far held a reasonably steady course, as the asset class has posted respectable returns year to date, part of that driven by lower US yields and part driven by the tightening of spreads and carry. Currencies, which is one of the main channels of adjustment to this new environment have been depreciating, which is something I had highlighted earlier in the year.

Looking into 2015, concerns are shifting from US rates into more specific EM factors. A slowdown of growth in China and other countries was the main concern voiced through the meetings. This reflects an uneven global recovery, where the US is unable to fully offset the growth drag coming from the Eurozone and Japan. Additionally, geopolitical events and country specific structural issues have also contributed to the slowdown.

In Ukraine, expectations of a restructuring through a voluntary maturity extension seems widely expected, despite the supportive rhetoric coming from IMF officials, suggesting that additional funding may be provided given the higher financing required as a result of the country’s worse than expected conflict. Despite the supportive rhetoric, I remain cautious on the credit at these levels, with the view that there can be contagion arising from defaults of state owned banks in the years ahead as they will have access to Hryvnia liquidity from the Central Bank, but no preferential access to USD given Ukraine’s weak international reserve position.

Slide1

Venezuela’s default expectations seem lower than implied by market prices. I believe the disconnect reflects the uncertain recovery value on the credit compared to prior emerging market restructurings. The amount and seniority of additional claims, such as dollar claims by importers, airlines, compensations for past nationalization of assets by the state and state arrears make the recovery exercise a difficult one.

Argentina will face a difficult year ahead given its stagflation and declining reserves, though it has a slight advantage versus the two other distressed credits in the sense that a new administration is likely to pursue more orthodox economic policies than the current administration. Still, the country’s legal dispute with the holdouts will extend well into next year and there is also the risk that a bond acceleration on the Defaulted Par bonds makes this situation even more complex.

Brazil’s upcoming second round elections on October 26 will be critical. Foreigners are more skeptical that the pro-market Aecio Neves could win. I see the elections a little less binary than the markets. Aecio’s ability to push reforms through Congress can disappoint, given Brazil’s fragmented party structure. At these levels, however, I see more upside in asset prices and particularly local rates should he win, than I see downside should Dilma be re-elected.

As for Russia, its ability to maintain its investment grade rating largely depends on how long with the conflict with Ukraine will last. Relations with the West, particularly with the US have hit bottom and are at the lowest point since the Cold War. US authorities remain quite relaxed in terms of maintaining their sanctions for a very long time if needed. I remain cautious on the credit, but believe that spreads already reflect the deterioration in capital flows, international reserves and the recent decline in oil prices. Credit risk between the sovereign and select state champions such as Gazprom or the larger state owned banks should continue.

In terms of overall asset allocation, there is little consensus on what will outperform next year, whether it is external debt, local debt or corporates. More of a consensus, however, is the fact that return expectations are conservative, with low single digits expected. Reflecting this, inflows into the asset class are expected to remain positive, but materially below levels seen before 2013.

Slide2

In local currency bonds, I believe the recent rally in US rates and fall in commodity prices warrants adding duration in some countries. Various EM Central Banks are willing to allow for additional currency weakening without the need to tighten monetary policy. They believe that any pressures on inflation will be perceived by economic agents to be temporary, particularly in countries such as Chile where an output gap exists, or in countries such as Colombia that have been tightening policy.

I expect returns to be more muted in hard currency next year and the gap between hard and local currency bond returns should not be as wide as this year’s. In addition, country selection remains key and we have already been witnessing this differentiation over the last few years.

matt_russell_100

It’s the taking part that counts: why Europe’s labour market might be stronger than we’d thought

We saw further evidence of the strengthening US labour market on Friday. In September, 248,000 new jobs were added and the unemployment rate fell below 6% for the first time in six years. Headline unemployment rates in Europe, by contrast, have been more dismal, with the latest numbers coming in at 11.5% across the Eurozone for August.

Less encouraging for the US was the participation rate falling to its lowest level since 1978. The participation rate measures the number of people either employed or actively looking for work as a share of the working-age population. One really has to look at both the unemployment and the participation rates together as they give a fuller feel of what’s going on. Take this, admittedly, extreme example: an economy could look like it has full employment (zero unemployment), but if its participation rate is zero, no one is actually working.

The falling US participation rate has been widely discussed as it is one of the measures that Janet Yellen, the Chair of the Federal Reserve, has consistently pointed to when answering questions on the strength of the US economy. It may be happening for a whole host of reasons, including discouraged workers giving up their job search, some opting for early retirement, or others choosing to stay in – or return to – some form of education. Participation rates in Europe however have had less airtime, so I am grateful to Erik Nielsen of Unicredit for highlighting the situation there.

So, in Europe, while unemployment numbers make for pretty sober reading, the participation rate itself has been on a generally upward trajectory. This is true for both core and peripheral Europe (see chart), so it’s not just a case of German data masking lacklustre numbers elsewhere. Again, the reasons for this are diverse, but may include a greater proportion of women joining the labour force in recent years, and an increase in the pension age in some countries.

Slide1

To assess the true situation in various countries and the relative progress each has made, we have held their participation rates constant at their 2000 levels and plotted how the subsequent unemployment data would have looked if the number of people in the workforce had remained at the same levels as at the turn of the century.

As the charts below show, the results are illuminating. Headline unemployment in Italy was running at 12.5% at the end of 2013 (the latest reading available), but once the 2000 participation rate is applied this falls to 8.7%, a fall of some 3.8 percentage points. The same is true for Spain, where the difference is a mighty 13.3%. In the US (where we have more recent data) , in sharp contrast, the current headline level of 5.9% unemployment actually rises to 12.5% when the 2000 participation rate is applied.

Slide2

Slide3

Slide4

I was rather surprised to see the extent of this divergence and that the US is actually in a worse position relative to where it was in 1999 than peripheral Europe. I remain unconvinced as to whether the Eurozone is entering a period of stronger growth or whether its economy will actually come to resemble that of Japan. But these charts definitely move me closer towards the former.

richard_woolnough_100

The lesson the Japanese economy has for the developed world

One of the most commonly reported themes in financial markets today is the fear of disinflation/deflation, and how monetary authorities need to take economic action to avoid becoming the “next Japan”. In February I commented on the fact that the fear of disinflation and deflation is not as logically straight forward as you may think. I think the common assumption that developed economies do not want to end up like Japan is also worth investigating.

Japan is commonly seen as the modern poster child of ineffective monetary and government policy. The policy errors of the Japanese authorities in the 1990s are seen as having resulted in a depressed economy that has stood still over the last 25 years. This view has partly come about as financial markets often simply judge an economy by observing how its equity market performs. Given the crash in the Nikkei from over 40,000 in the early 1990s to around 16,000 today, equity market performance as a measure of Japanese economic health has become engrained in the market’s psyche.

In reality the strength of economies should be measured by their economic output and not equity market performance. In this regard, at first glance the national data bear out that Japan has lagged most countries in terms of nominal and real economic growth.

Slide1

The simple measures of nominal and real GDP are often regurgitated as to why we do not want to end up like Japan. But from an economist’s point of view, what matters most is GDP per head. The fact that one country grows more than another is not to be celebrated economically if it is in fact engendered solely by an increase in population.

Below is a chart of real GDP per capita. It shows that Japan has not been an economic failure from a local point of view. Rather, the Japanese economic experience has actually been quite positive in terms of increasing living standards for the average Japanese citizen over the last 25 years.

Slide2

However the chart above shows Japan still lagging; no wonder economists still fear a Japanese outcome. Nevertheless I believe that a truer measure of GDP should not only be correlated to the number of people in its national boundaries, but should be seen in the context of the shifting function of the long term demographics of the population. A country with a baby boom will experience strong GDP in the boom, and weaker GDP at the end of a population bulge. Workers retire; consumption and investment fall. In order to take into account the true GDP per head, one has to put this into context, by looking at the size of the working population, not just the size of the actual population. Below we chart GDP per head of working population. This adjustment allows a fairer reflection of GDP per head, with the Japanese situation improving on a relative basis again.

Slide3

What lessons can we learn from Japan ? Firstly it is not as bad as it looks given the true potential GDP per head of population. In fact monetary and fiscal policy has worked in Japan. Low inflation and the zero bound of monetary policy is something we and policy makers naturally fear. Maybe we fear it too much based on simple analysis of headline numbers.

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jim_leaviss_100

The Signal and the Noise – why local weather forecasters get it wrong, and what it means for those big market calls

I’ve finally got round to reading Nate Silver’s The Signal and the Noise. It’s a brilliant analysis of why forecasts are often so poor, from the man who called every state correctly in the 2012 US presidential election. In short, predictions are often poor because they are too precise (asserting an absolute outcome rather than assigning probabilities to outcomes); there’s often a bias to overweight qualitative information, gut feel and anecdote over data (these shouldn’t be ignored but must have a high hurdle to overrule the statistics); and there’s also a bias to ignore out of sample data (he suggests that the rating agencies mis-rated CDOs based on MBS because they assumed no correlation between housing defaults, which was indeed the case in the 25 or so years of US data that was used in the models. Japan’s property crisis statistics would have shown that in a downturn the degree of correlation in defaults becomes extremely high). I’d like to propose a deal though – we Brits agree never to use cricket statistics in any academic paper so long as Americans shut up about baseball. What the hell is hitting .300? How many rounders is that?

I liked these charts. The first shows just how good weather forecasting is nowadays. We can’t get the outcome right every time, but we can now call the probability of a weather event occurring right with the same probability of it happening. For example, when the US National Weather Service says that there is a 70% chance of rain, it rains 70% of the time. It snows 20% of the time when they say there is a 20% chance of snow.

Slide1

But when your local TV weatherman gets hold of this same information, he or she distorted that information such that the outcomes were far worse than those of the National Weather Service’s forecasts. The chart below shows that local TV weatherpeople over-predicted weather events consistently. For example, if they say that there is a 100% chance of rain, it rains just 67% of the time, compared with the National Weather Service which if it says there is 100% chance of rain, it always rains.

Slide2

Why? “Presentation takes precedence over accuracy”. In other words local TV news and weather people believe themselves to be entertainers as much as bearers of information. A firm prediction of a biblical rainstorm is more exciting that a range of probable outcomes, and a forecast for a scorching beach day more fun than assigning a 75% chance of sunny intervals. In other studies it was shown that political analysts on panel shows performed extremely badly, systematically predicting outcomes way out of line with statistical polling. The very act of being on TV reduces one’s forecasting ability. I think there is a likelihood that this is also true of economic and market forecasting, which is why market TV channels are full of people either calling for the Dow to soar another 200%, or for the global economy to collapse into a permanent ebola fuelled zombie apocalypse. There’s a danger that when we get phoned by journalists for comment we feel the need to be significantly away from the consensus, on payrolls, on the year end 10 year Treasury yield, on the chances of the Eurozone breaking up – and I’m sure I’ve been guilty of this too in the past. What’s more I’m sure that those who forecast extreme events end up being boxed into a corner where they feel they have to implement those views within portfolios, and end up with portfolios which point only in the direction of tail events and can’t perform in normal economic circumstances. I think this is a must read book for economists and fund managers to help us understand how good forecasts are made, and that the “loudest” forecasts get disproportionate airtime – and are often wrong. Silver has bowled a wicket maiden with this one.

mike_riddell_100

Is China really growing at 7.5%? Not according to Citigroup’s ‘Li Keqiang index’

Say what you like about controversial whistleblowing website WikiLeaks and its embattled founder Julian Assange, but the organisation has lifted the lid on a number of rather glorious indiscretions alongside the more serious leak of military secrets that it has become notorious for.

One such nugget to be revealed was how Li Keqiang – now Chinese premier, but at the time the lesser known head of Liaoning province’s communist party – admitted over dinner with the US ambassador to China in 2007 that the country’s GDP figures were “man-made” and therefore unreliable. Mr Li went on to say that instead, he focused on just three data points – electricity consumption, rail cargo volume and bank lending – when evaluating his province’s economic progress.

Citigroup have taken Mr Li at his word and have constructed an inspired ‘Li Keqiang Index’, using the three economic indicators mentioned above to give an insight into the country’s economic health under his premiership. And indeed, the index (see chart) does point to a significant slump that’s more pronounced than the decline in the official Chinese GDP numbers. This trend ties in with other data that investors have been focussing on, including the slump in commodity prices (although it’s important to remember that the price of an asset can fall not only due to a drop in demand, but also an increase in supply, and some big producers in iron and coal in particular have been ramping up supply).

Some might argue that the reliability of the data underlying the Li Keqiang Index may now also be compromised since his views on what does and doesn’t constitute reliable data first went public back in 2010. Regardless, the various data sources seem to be converging around the point we have been arguing for many years – namely, that China is on course for a fairly spectacular slowdown and that it’s hard to see how it won’t end badly, not least for the many countries that have become increasingly reliant on a strong Chinese economy and are now very vulnerable to Chinese economic weakness.

In further sign of slumping Chinese growth, Citi’s ‘Li Keqiang Index’ has fallen to a new post-crisis low

China’s investment/GDP ratio soars to a totally unsustainably 54.4%.  Be afraid.
The Professor Michael Pettis China forecast: 3-4% real growth on average for the next decade. And that would be a good result
If China’s economy rebalances and growth slows, as it surely must, then who’s screwed?
Chinese housing market, not so magic – will the dragon run out of puff?
Panoramic Outlook – Beware the dangerous emerging market ‘grand narrative’

matt_russell_100

It’s the regulation, stupid: the ECB’s ABS purchase programme

The ECB is finally joining the Quantitative Easing (QE) party. Un-sterilised asset purchases have been a major policy tool in most of the developed world over the past few years but next month (as the Fed ends theirs, incidentally) the ECB will make its first foray into QE proper by embarking on an asset backed security (ABS) purchase programme.

Through this programme, focused on “simple, transparent and real” asset backed securities, the ECB hopes to stimulate lending to the real economy and so help see off the ever looming prospect of deflation. A healthy ABS market should hopefully offer banks a long-term alternative to cheap central bank funding, backed as these instruments are by loans as varied as car loans, mortgages and credit card payments.

It’s pretty clear that the market in Europe is in need of invigoration, having been all but closed for business since the financial crisis. ABS issuance in Europe in 2013 totalled just €183 billion (according to data from the Association for Financial Markets in Europe) compared to €711bn back in 2008. The US market is by contrast in far ruder health, with 2013’s total of 1.5 trillion Euro’s worth of issuance, comfortably surpassing 2008 issuance of the Euro equivalent of 934bn.

2013 issuance as a percentage of 2008 issuance

But – and there is a but – there is a very substantial obstacle currently standing in the ECB’s way. This takes the form of a regulatory barrier – namely, the treatment of securitisation under the latest version of the Solvency II proposal. Under Solvency II, as it stands, insurance companies (a large pre-crisis investor base) have to hold twice as much capital to invest in a five year AAA-rated Dutch RMBS than if they hold a covered bond of the same rating and maturity, backed by similar assets.  For peripheral eurozone issuers the situation is even starker – the capital charge on a five year A+ Spanish RMBS stands at approximately 20%, versus a charge of 7% for a similar covered bond. While this doesn’t apply for asset managers such as ourselves, it presents a very real disincentive for insurers, who must calculate that they can achieve a better return on capital elsewhere.

The idea behind these elevated capital charges is surely to protect balance sheets against the likelihood of default. But a quick look at default data makes for interesting reading. According to a Standard & Poor’s default study, default levels on European RMBS have reached a high of just 1% over the last six years. Yet in the US, where capital charges are more in line with those on corporate bonds, default levels on RMBS have been far higher – up to 28.5% in 2009, and still a little over 10% in 2013. Whilst there is some differentiation between regulatory classifications of ABS securities, in general, US capital charges are significantly lower than in Europe across all instruments.

RMBS default rate

This is a particularly pressing issue on two counts: not only does the ECB hope to kick off its ABS purchase programme in October, but the draft Solvency II legislation is due to be voted on at the end of September. Unless the European Commission moves swiftly to adapt the existing draft regulation, any attempts by the ECB to stimulate the market will likely be in vain. At a minimum, the ECB needs to at least equalise the capital treatment of instruments such as RMBS with that of other asset-backed products such as covered bonds.

After all, without demand from a wider client base than the ECB itself, there will be little incentive for issuers to supply these instruments. In this case, the market will continue to stagnate, and a valuable opportunity to invigorate lending to the real economy will likely be wasted.

anthony_doyle_100

“Global greying” could mean getting used to ultra-low bond yields

The developed world is going through an unprecedented demographic change – “global greying”. This change is having a massive impact on asset prices and resources as populations around the world get older and live longer. It is also having an impact on the effectiveness of monetary policy. We would typically expect older populations to be less sensitive to interest rate changes as they are largely creditors. Younger populations will generally accumulate debt as they set themselves up in life and are therefore more interest rate sensitive. The impact of demographics implies that to generate the same impact on growth and inflation, interest rate changes will need to become larger in older societies relative to younger societies.

Turning to the impact of demographics on inflation, labour force growth may provide some insight into the potential path of future inflation or at least give us some guide as to the long-term structural impact of an aging population on inflation dynamics. The theory is that a large, young generation is less productive than a smaller, older generation. As the large, young generation enters into the economy after leaving school/university the fall in productivity causes costs to rise and therefore inflation increases. Additionally, the younger generation is consumption and debt hungry as they start a family and buy homes. Eventually, the investment in the younger generation comes good and there is a large increase in productivity due to technological change and innovation. As consumers become savers, inflationary pressures in the economy start to subside.

The long-term interplay between US labour force growth and inflation is shown below. Inflation lags labour force growth by around two years as it takes some time for the economy to begin to benefit from productivity gains. As US labour force growth rises and falls over time, inflation generally follows a similar trend.

The long-term relationship between US labour force growth and inflation

The second chart looks at the same economic indicators, this time looking at 10 year growth in the labour force against inflation. Interestingly, this chart seems to show that the baby boomers entered into the workforce around the same time as the global economy experienced a supply-side oil price shock. The influx of new workers into the US economy is likely to have contributed to the great inflation of the 1970s. For the next thirty years or so, inflation fell as the economy enjoyed the technological advantages and productivity gains generated by the baby boomers. Looking forward, it appears that long-term deteriorating labour force growth may contribute to deflationary pressures within the US economy.

10 year US labour force growth and inflation

I am not saying that demographics are the only reason that inflation has fallen in recent years. The massive accumulation of private and public sector debt, globalisation and technological change are also secular trends worth monitoring. Rather I believe “global greying” and the impact of demographics on inflation and the real economy is an additional secular trend worth monitoring. Can central banks do anything in the face of this great generational shift should deflation become a reality? Interest rates are at record lows, quantitative easing has been implemented and we are yet to see the large impact on inflation that many economists expected.

Lower interest rates and the yield-dampening forces that exist in the global economy is a topic I previously covered here. In terms of bond markets, deflationary pressures are a “yield-dampener” and another reason why bond yields could remain low for some time and fall further from current levels over the longer-term.

 

Ana_Gil_100

The M&G YouGov Inflation Expectations Survey – Q3 2014

The results of the August 2014 M&G YouGov Inflation Expectations Survey suggest that inflation expectations have moderated across the UK, most European countries and Asia. Short-term inflation expectations in the UK have fallen from 2.3% to 2.2% after an upwards bounce in the May survey. However, over a five year period, expectations remain unchanged at 3.0% for the 7th consecutive quarter. UK consumers have modestly raised their confidence in the Bank of England, with 49% of respondents now expecting Mark Carney to deliver on price stability.

In Europe, short-term inflation expectations remain unchanged at 2.0% in Spain, Italy and Germany. However, in France, the expected rate of inflation for the next 12 months has dropped a full percentage point over the quarter and is now just 1.0%, the lowest level in the history of the survey. Notably, a larger proportion (48%) of French respondents believe their net income will decrease over the next 12 months, despite the fall in inflation expectations.

M&G YouGov inflation expectations - 1 year ahead

Over the long term, inflation expectations in all Eurozone countries surveyed except France remain above the European Central Bank (ECB) target, although there are signs of moderation in some countries. Compared to last quarter, inflation expectations have fallen across Austria, France and Italy, although not in Germany and Spain, where they have held steady at 3.0%. The downward pressure is most evident in Italy and France where long-term expectations have fallen to 2.5% and 2.0% respectively, amid an increasingly challenging political environment. The number of Italians in disagreement with their government’s current economic policy has increased notably over the quarter from 44% to 53%. Switzerland stands out as being the only country to report a rise in short-term inflation expectations (from 1.1% to 1.3%) and also for the high level of confidence that Swiss consumers continue to place on their central bank (54%).

M&G YouGov inflation expectations - 5 years ahead

In Asia, the gauge for inflation over the short term has fallen to the lowest level since the inception of the survey (Singapore 3.4% and Hong Kong 4.0%). Interestingly, despite reporting a reasonably high level (45%) of confidence in their central bank’s ability to achieve its inflation target, consumers in Singapore nevertheless expect inflation to more than triple to 4.6% over the next five years.

The findings and data from our Q3 survey, which polled almost 8,500 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

M&G YouGov Inflation Expectations Survey 

 

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