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France and Ireland – a look at the economic scorecard before the big game this weekend

The 6 Nations Rugby Championship comes to a conclusion this weekend, with three teams still in the running to win. The key game to watch will be France versus Ireland, as a French win would open the door for France or England to win. Of course, England will still have to beat the Azzuri in Rome. An Irish win would see the “boys in green” send record-breaking captain Brian O’Driscoll home to Dublin with the Championship trophy in his final game of rugby.

In the spirit of competition, here is a look at the economic scorecard for France and Ireland. Will it provide an indication of who will win Saturday’s match?

Round 1 – Real gross domestic product per capita

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Despite a large deceleration in output from the Irish between the years of 2007-2010, the Irish are still producing around €6,000 more per capita more than the French. IMF forecasts suggest that by 2018, Irish GDP per capita will be around €38,000 while the French equivalent is estimated to be around €30,000. The IMF forecasts suggest that the Irish workforce is expected to remain more efficient and productive than the French in coming years. For the entire Eurozone, the Irish currently rank second behind Luxembourg on this measure. The French are ranked seventh.

On this measure, it is a clear win for Ireland.

Round 2 – The unemployment rate

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Based on recent trends, the unemployment rates in France and Ireland appear to be converging. The Irish unemployment rate has fallen from a peak of 15.1% in January 2012 to sit at 11.9% only two years later. Over the same time period, the French unemployment rate has risen from 9.9 to 10.9%. The deterioration in the labour market in France reflects the general stagnation of economic growth. In recent months, the French government has been attempting to tackle the problem of the deteriorating labour market through its active employment policies such as sponsored contracts and training positions for the unemployed.

Despite the improving unemployment rate in Ireland, and worsening unemployment rate in France, round two goes to France on account of the unemployment rate being 1% lower than Ireland. Unless France can generate better growth, it may be the case that in twelve months’ time the Irish unemployment rate is actually lower than the French equivalent. For now, it’s a French win.

Round 3 – Household saving rate

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French households have consistently saved between 15-16% of their gross disposable income over the past ten years, suggesting that there is some scope for French consumers to stimulate their economy should confidence pick-up. The Irish household saving rate has been more volatile, falling and rising as one would expect given the concerns around the economic outlook for the country. More recently, Irish households have been spending more and supporting the economic recovery. This is a tough one to call, as the fall in household savings suggests stronger economic growth in Ireland in the short-term. However, because of the potential for French consumer to spend some of their savings in the future, France wins this round.

Round 4 – Percentage of the population with tertiary education

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Since 2004 there has been a substantial increase in the percentage of the population that has attained a tertiary level of education in Ireland, with an increase from 24.9 to 35.9%. France, whilst improving, has not been able to generate the same increase and in 2013 the percentage of the population that had obtained a tertiary level of education was 28.7%. Ireland ranks number one while France is at number twelve in the EU on this key measure. There is widespread recognition that tertiary education is a major driver of economic competitiveness in an increasingly knowledge-driven global economy. Ireland’s well educated workforce has certainly assisted the economy in recovering from the financial crisis. It has become increasingly difficult for industries in the west to compete with the emerging nations in terms of manufacturing products; a flexible, highly-educated and competitive labour force is vital in our globalised world.

Ireland’s workforce looks like a winger, whereas the French workforce could be compared to a prop forward. Ireland wins this round.

Looking at measures like real GDP per capita, the unemployment rate, household savings and the level of education in the workforce for Ireland and France is interesting. It shows that Ireland appears very well positioned to generate positive economic growth over the medium term. The old way of categorising European economies as “core” or “peripheral (or worse – PIIGS)” appears no longer relevant, as “peripheral” nations have taken a lot of vital steps to become more competitive through internal devaluation and lower wages. Improved export performance has been reflected in an improvement in current account balances in recent years. Today, the French economy appears cumbersome; it is hampered with a relatively inflexible and rigid labour market and is struggling to become more competitive in a globalised economy as we previously mentioned here.

Final round – the rugby statistics

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After a 2-2 economic scorecard, the final round had to focus on the rugby itself. Unfortunately for the French, the Irish rugby team appear superior in 16 out of 20 key rugby statistics including total points, metres gained and lineouts won. The French have home advantage which is a big positive; though this will be mitigated by the emotion felt by the Irish players given it is Brian O’Driscoll’s last match.

This leaves a 3-2 economic and rugby scorecard win to Ireland over France. That said, it would take a brave pundit to discount Les Bleus, who have a habit of rising for the big occasions. If you don’t believe me, just ask any New Zealander.

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Europe’s debt/GDP levels are worse today than during the Euro crisis. So why are bond yields falling?

Two and a half years ago, there was a real fear in the marketplace that the euro would not survive. It appeared unlikely that Greece would be able to remain in the Eurozone and that some of the larger distressed economies like Italy and Spain may follow them out. High levels of government debt, unemployment and a banking system creaking under all this pressure did not bode well for the future. The mere possibility of a Eurozone nation leaving triggered massive volatility in asset markets from government bonds to equities, as investors grappled with the consequences of such an event occurring.

Of course, the bearish forecast for Europe did not eventuate. Perceptions had shifted significantly from the darkest days of the euro crisis. Politicians and central bankers have shown significant determination in keeping the euro intact, despite often only acting at the darkest hour. In markets, confidence returned after ECB President Mario Draghi’s now famous “whatever it takes” comment and it had a real effect on government bond yields with spreads over German bunds collapsing across the Eurozone.

Unfortunately for European government bond investors, the Eurozone could re-emerge as a source of risk. The reason is, since 2011 European government and economic fundamentals have generally gotten worse and not better.

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When we look at the above table – which measure fundamental indicators like total investment, the unemployment rate and gross levels of government debt to GDP from 2011 and compares it to now – we can see a lot more red (which indicates a deterioration) than green (which indicates an improvement). Yet what is striking is that apart from Germany and the Netherlands who have seen their 10 year government bond yields increase slightly, all other European nations have seen their yields fall. This is not what we would expect to see given that various metrics like GDP, the unemployment rate, output gap and government debt to GDP are actually worse now than they were at the height of the Eurozone crisis.

I can see three main reasons why yields have fallen across the Eurozone despite a worsening in the economic statistics. The first is that confidence has returned and the credit risk premium demanded by bond investors has fallen. Investors in European bonds now believe that default risk has fallen from the dark days of 2011, despite a general worsening in conditions which would imply higher – and not lower – default risk. When Draghi said the ECB would do “whatever it takes”, the market believed him.

Secondly, the inflation risk premium that investors demand has collapsed as Eurozone inflation has collapsed. Low inflation in the Eurozone is largely the result of painful internal devaluation, high unemployment and government austerity. Countries like Ireland, Portugal and Greece are feeling this the most, having experienced deflation over the last couple of years. As we can see in the table, austerity has meant that budget deficits have improved across the Eurozone, but this has also resulted in deflationary forces becoming more pronounced. Lower European inflation means higher real yields, and this has contributed to nominal yields falling or remaining low in Eurozone government bonds. However, the danger for the periphery is that lower inflation implies lower nominal growth rates, and this means even greater pressure on the Eurozone periphery’s huge debt burdens. Markets should react to lower nominal growth rates by questioning these counties’ solvency, pushing bond yields higher.

Thirdly, the other main reason that peripheral yields have converged is that there are genuine signs of rebalancing, as indicated by improving current account balances and falling unit labour costs. The majority of Eurozone nations are now running a current account surplus, including Spain, Portugal, and Ireland. Despite being locked into the single exchange rate which is arguably way too high for these countries, global competitiveness has improved and exports have increased.

There are good reasons the euro will survive. However, it is important to question whether the market is charging a high enough credit risk premium given the challenges that continue to face the Eurozone. Increasingly, bond investors need to assess the risks of deflation in Europe as well. Arguably a lot of good news is priced in to government bond markets at the moment, and we remain hesitant to lend to those European countries displaying weaker financial metrics at this point in the cycle. With the IMF recently finding “no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised”, it suggests that there are many more important things to bond investors than the public debt/GDP ratio (like credit growth, labour markets and inflation). Public debt/GDP ratios are what investors have been fixated on since the financial crisis, but they are a lazy and incomplete way of assessing the risks in government bond markets.

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Should the Bank of England hike rates?

Many of us have become accustomed to a world of ultra-low interest rates and quantitative easing (QE). Taking into account inflation, real short-term interest rates are negative in most of the developed world. Of course, these historically low interest rates were a central bank response –co-ordinated on some occasions – to the Great Financial Crisis of 2008. Whilst we are still waiting for the official data, it appears increasingly likely that 2013 marked the start of a synchronised recovery in the advanced economies. So is it now time for the Bank of England to consider hiking the base rate? Perhaps good – and not awesome – economic growth is more appropriate to avoid a bust down the line.

Economic theory and real world experience tells us that interest rates that are kept too low for too long will distort investment decisions and lead to excessive risk-taking. They may also result in the formation of asset price bubbles that ultimately collapse. With parts of the UK housing market (including London and the south-east) posting double-digit returns in 2013, the FTSE 100 within arm’s reach of an all-time high last seen during the tech bubble (and up over 60% since 2009), and UK non-financial corporate bond spreads 45 basis points away from 2007 lows; it is clear that ultra-low interest rates have had a great effect on both financial markets and the real economy.

At the risk of being called a party pooper, here are 5 reasons why I think we could see an interest rate hike before year end (the market is pricing in around February/March 2015), and certainly before the third quarter of 2016 (the time when the BoE think the unemployment rate will fall to 7%).

  1. Asset price bubbles are forming
  2. Unemployment is falling quickly towards 7%
  3. Inflation risks should not be forgotten
  4. The Taylor rule suggests interest rates are way below neutral
  5. The risk of Euro area break-up appears to have fallen

Asset prices bubbles are forming

There has been a significant run-up in UK financial assets over the course of the past five years, particularly since QE became a feature of the financial landscape. Investors in equity and bond markets alike have been enjoying the fruits of QE. Those that own financial assets have seen their net wealth increase substantially from the post-crisis lows. Consensus forecasts for 2014 suggests that most market forecasters expect another robust year for risk assets, fuelled by easy money and the search for positive real returns.

Of course, the greatest financial asset that the average UK household own is their own house. In 2011, it was estimated that around 15 million households are owner-occupied (a rate of around 65% of total households). Thus it is unsurprising that newspaper readers are usually hit with a headline about rising house prices on a daily basis. House prices, on a number of measures, have begun to accelerate again with low interest rates and tight housing supply a key contributor to the price increase. Low interest rates have given UK consumers the incentive to accumulate high levels of household debt compared to their incomes.  The average house price is now 5.4 times earnings, the highest level since July 2010 and well above the long-run average of 4.1.

UK house prices are re-accelerating and pushing higher

The Help-To-Buy scheme is contributing to the run-up in this highly leveraged and interest-rate sensitive sector (a topic I covered back in July here). By hiking the base rate this year, the BoE would hopefully achieve a reduction in speculation and debt accumulation in the housing sector. This would not be a popular action to take – it never is – but we should all be wary about the damage a rampant housing market can have on an economy.  BoE Governor Mark Carney – as head of the Financial Policy Committee – has already moved to stop the Funding for Lending Scheme and mentioned that placing restrictions on the terms of mortgage credit may be a tool that can be used to reign in house prices.

Whether macro-prudential policy tools will work or not remains open to debate. Ultimately, central banks are trying to focus in on one element of the economy by raising interest rates or restricting credit. We do have a real-life macroeconomic example currently taking place though. On October 1, the Reserve Bank of New Zealand imposed a limit on how much banks could devote to low-deposit loans and required major banks to hold more capital to back loans. It’s very early days but for the month of November, the Real Estate Institute of New Zealand reported a 1.2% increase in New Zealand house prices and 9.6% over the year. The RBNZ and BoE might find that trying to slow the housing market using macro-prudential measures is a bit like trying to stop a car by opening the doors and hoping that wind-resistance does the rest. You really need to put your foot on the brake.

The longer the boom lasts, the greater the pain when it inevitably ends.

Unemployment is falling quickly towards 7%

The unemployment rate has fallen from 7.9 to 7.4% over the past nine months and is a key tenet of the BoE’s forward guidance. The fast decline has seen some speculation amongst economists that the BoE may lower the unemployment threshold from 7.0 to 6.5%. Of course, the 7.0% threshold that it has set it is not a trigger to hike interest rates, rather it is a point at which the BoE would consider hiking rates. However, the labour market has improved much quicker than the BoE has been expecting with the unemployment rate now sitting at the lowest rate since March 2009. We are still well above the average unemployment rate seen during the period between 2000 and 2008, but I would argue that this was an abnormal period for the UK economy. It was a NICE period – non-inflationary, constantly expanding – and is unlikely to be repeated. Arguably the UK’s natural rate of unemployment is now a percentage point or two higher than that of the noughties, suggesting less spare capacity in the UK economy than many expect. It may not be long before we start to see wage demands start to pick up, leading to rising inflationary pressures. Higher wage growth in 2014 would bode well for consumption and household net wealth given the increase in house prices and investment portfolios.

The UK unemployment rate is below the long-run average

As it is generally accepted that monetary policy operates with a lag, (the BoE estimate a lag time of around two years), and the unemployment rate itself is a lagging indicator of economic activity. If the BoE waits until the unemployment rate hits 7%, or for confirmation that economic growth is strong, then it may be too late. A slight tap on the breaks by hiking the base rate may be appropriate.

Inflation risks should not be forgotten

Ben wrote an excellent piece on the UK’s inflation outlook last month. To quote:

Current inflation levels may seem benign. However, potential demand-side shocks coupled with a build-up in growth momentum and the difficulty of removing the huge wall of money created by QE will pose material risks to inflation in the medium term. Markets have become short-sightedly focused on the near term picture as commodity prices have weakened and inflation expectations have been tamed by the lack of growth.

In addition, central banks have a nasty habit of keeping monetary policy too loose for too long. It even has a name – “The [insert FOMC Chairperson Name] Put”. The easy-money policies of the FOMC in the 1970s are seen as a key contributor to the runaway inflation seen during the period.  Eventually, the FOMC reversed its own policies, hiking rates to 19% in 1981.

Of course, what central bankers really fear is that ultra-easy monetary policy and the great experiment of QE will lead to an increase in inflation. A return of inflation will only be tamed by hiking rates. Whilst the inflation rate has been moderating in the UK and is close to the Bank of England’s target at 2.1%, it follows almost 5 years of above target inflation. Whist it is not a clear and present danger, the experience of the 1970s suggests that we cannot ignore the threat that inflation poses to the UK economy, especially as rising inflationary expectations are often difficult to contain.

The Taylor rule suggests interest rates are way below neutral

The Taylor rule provides a rough benchmark of the normal reaction to economic conditions as it relates interest rates to deviations of inflation from target and the output gap. According to the Taylor rule for the UK, a base rate of 0.5% is around 2.0% below where it should be given current rates of growth and inflation.

The BoE base rate remains highly stimulatory

Negative real interest rates have done the job by stabilising the economy, but is it now time to tap the brakes? With the UK economy growing at an annualised rate of more than 3% in the second and third quarters of 2013 (above the long-term average of 2%), the UK may be operating much closer to full employment than many currently estimate. Forward looking survey indicators and economic data suggest the UK economy is growing strongly, with business confidence at a 20 year high and the UK Services PMI for December suggesting a strong broad-based upturn. Of course, the BoE would like the other components of GDP like exports and investment to contribute more to economic growth. A rising currency wouldn’t help this. But sometimes it is difficult to have your cake and eat it too, especially if you are a central banker.

The risk of Euro area breakup appears to have fallen

Now it’s time for the “Draghi Put”. Draghi’s famous “whatever it takes” speech is probably the most important speech ever given by a central banker. The speech has had a fantastic effect on assets from government bonds to European equity markets and everything in between. More importantly, as I wrote here back in July 2013, despite the problems that Europe faces – the concerning outlook, the record levels of unemployment and debt, the proposed tax on savers in Cyprus – no country has left the EMU. The EMU has in fact added new members (Slovakia in 2009, Estonia in 2011, Latvia in 2014). European countries remain open for trade, have continued to enforce EU policies and have not resorted to protectionist policies. EU banking regulation has become stronger, the financial system has stabilised, and new bank capital requirements are in place.

This bodes well for the UK, as stabilisation in the Eurozone suggests stronger export demand, increased confidence, and higher investment in the UK from European firms. Perversely, an interest rate hike might actually improve confidence in the UK economy, signalling that the central bank is confident that economic growth is self-sustaining.

The BoE must walk the tightrope between raising rates slightly now to avoid higher inflation and financial instability or risk having to do a lot more monetary policy “heavy-lifting” down the line. A base rate at 0.5% is way below a neutral level and the BoE has a long way to go before getting anywhere near this level. It could act this year and gradually start raising interest rates to lessen the continued build-up of financial imbalances. The difficult action in the short-run to raise the base rate will help to support “healthy” economic growth in the long-run.

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A Fed taper is on the table

The FOMC took markets and economists by surprise in September this year when the committee members decided to hold off from tapering and maintain its bond-buying programme at $85bn per month. Three months down the road and the consensus for the December meeting outcome is that the Fed will not reduce the pace of MBS or treasury purchases. Consensus has been wrong before; will it be wrong again tomorrow? We think it will be a closer call than many expect.

In our opinion, there are several good reasons for the Fed to taper very slowly. Firstly, inflation is a non-issue, below target and close to lows not seen for decades. Secondly, the 30 year mortgage rate has risen from 3.5% in May to around 4.5% today, impacting US housing affordability and already tightening policy for the Fed. Thirdly, there is continued concern that 2014 may bring a return of the political brinkmanship that characterised late September, with the US Treasury signalling that the debt limit will have to be raised by February or early March to avoid default. Ultimately, the Fed is nowhere near hiking the FOMC funds rate.

There is no doubt after the September decision that tapering is truly data dependent and in this sense, macro matters. Fortunately, Ben Bernanke has told us what economic variables he and the FOMC will be looking at a press conference in June. The Fed wants to see a broad based improvement in three economic variables – employment, growth and inflation – before reducing the scale of bond buying.

The table below shows that the data has improved across the board. Annualised GDP is stronger, the unemployment rate is lower and the CPI is only 1.2%. Other key leading economic indicators like the ISM and consumer confidence are higher while markets are in a remarkably similar place to where they were three months ago with the 10 year yield at 2.86%.

US macroeconomic indicators chart

After the surprise of September’s announcement, we believe that every FOMC meeting from here on out is “live” – that is, there is a good chance that the Fed may act to reduce its bond-buying programme in some way until it reaches balance sheet neutrality. A reduction in bond purchases is not a tightening of policy, we view it as a positive sign that policymakers believe that the US economy is finally healing after the destruction of the financial crisis. As I wrote in September, interest rate policy is set to remain very accommodative for a long time, even after balance sheet neutrality has been achieved.

Given the positive developments in the US economy over the past three months, the December FOMC announcement could announce a) a small reduction in bond buying and b) an adjustment of the unemployment rate threshold or a lower bound on inflation. Whatever the case, quantitative easing is getting closer to making its swansong.

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The M&G YouGov Inflation Expectations Survey – Q4 2013

The M&G YouGov Inflation Expectations Survey for November shows that consumers in all countries surveyed expect inflation to rise from current levels in both one and five years’ time. In the UK, short-term inflation expectations fell over the quarter to 2.8%, following recent downward pressure on UK CPI. It may also suggest that the shock from recent increases in utility bills may be fading. Over five years, however, inflation is once again expected to rise to 3.0%, suggesting expectations for future inflation remain well anchored above the Bank of England’s (BoE) CPI target of 2.0%. We did not see the same spike in inflation expectations as in other recent inflation expectations surveys such as the Bank of England’s own survey, possibly as ours is more recent and was conducted between November 22-25.

In Europe, all countries surveyed with the exception of Switzerland, expect inflation to be equal to or higher than the European Central Bank’s (ECB) CPI target of 2.0% on both a one- and five-year ahead basis. All European Monetary Union (EMU) countries expect inflation to be higher in both one and five years than it is currently, while only two countries – Spain and Switzerland – anticipate it being less than 3.0% in 5 years’ time.

Comparing the results with those from earlier surveys reveals a number of noteworthy observations. Inflation expectations for one year ahead have fallen in all surveyed EMU countries since the start of 2013. This is unsurprising given the weak macroeconomic environment and the fact that commodity prices have declined by roughly 5.6% in the past three months. Consumers have also benefitted from a stronger euro, which has gained around 6.6% over the past year on a real effective exchange rate (REER) basis. Notably, short-term inflation expectations in France, Spain and Italy are now running well above their current inflation rates.

Survey respondents in Hong Kong show no signs of moderating their inflation expectations, which remain at a high level of 5.0% and 5.5% over one and five years, respectively. In Singapore, inflation expectations over one year are double current inflation (2%) whilst the five-year reading remains stable at 5.0%, as it has done throughout the course of 2013.

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

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Jim Leaviss’ outlook for 2014. The taper debate (watch the data), inflation (where is it?), and it’s a knockout. Merry Christmas!

With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago. It might not always have felt like it at the time – indeed, over the summer when markets were sent into a spin by the prospect of the US Federal Reserve (the Fed) cutting its supply of liquidity earlier than expected, it almost certainly did not. But riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.

Meanwhile, the macroeconomic backdrop has generally improved over the past year, with the economic recovery gaining significant momentum in the US and, more recently, the UK. However, the picture in Europe remains mixed, while our concerns over the emerging markets are mounting. However, despite their disparate prospects, all countries – and all bond markets – are united by at least one common dependency: the Fed.

So what does 2014 have in store for global bond markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And for those of you who have been wondering, the annual M&G Bond Vigilantes Christmas quiz will be posted later this week.

Enjoy!

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Research trip video: Australia – the land of houses and holes

A couple of weeks ago I headed back to my hometown of Sydney, Australia. In between the barbies, the beach and a few beers, I managed to get around and film this short research video.

Australia is the 13th largest economy in the world and those that live there enjoy a very high standard of living. Growth is dominated by its service sector which makes up around 70% of GDP, whilst the total mining sector represents around 20% of GDP. With one of the most expensive housing markets in the world, a strong currency and the possibility of a China slowdown clearly on the horizon, will Australia’s economic performance over the next twenty years be as strong as the last?


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It’s Halloween so time for some spooky, if not downright scary charts

Some people will watch a scary movie on October 31st. Others like to go to costume parties and dress up. For us, there is no better way to scare ourselves silly than by reading a few IMF reports. So in the spirit of the holiday, here are five scary charts. Boo!

1. An oldie but a goodie – high public debt-to-GDP ratios

G7 Debt-to-GDP ratios remain at a scary level

Economic theory has told us for a long time that debt held by the public is what we should be looking at when trying to work out the potential impacts that high debt levels could have on an economy. This is because the borrowing associated with government debt competes for capital with investment needs in the private sector (for factories, equipment, housing, etc) and can affect interest rates. A good ol’ classic case of “crowding out” in the IS-LM model.

More recently, the market has taken its focus off looking at debt-to-GDP ratios. A 2010 research paper by Carmen Reinhart and Kenneth Rogoff was found to have computational errors, resulting in some serious question marks being raised about their finding that a debt-to-GDP ratio of 90 per cent or more is associated with significantly lower growth rates. Following this debacle, we now know that there is probably no magic threshold for the debt ratio above which countries pay a marked penalty in terms of slower economic growth.  For all it’s importance, the 60% debt-to-GDP ratio target written into the Maastricht Treaty adopted by the European Union was pretty much based on zero economic evidence.

This doesn’t mean we shouldn’t keep an eye on the measure though. High government debt means a high debt servicing cost. In general, a lower debt-to-GDP ratio is preferred because of the additional flexibility it provides policymakers facing economic or financial crises.  What has now changed is that it has been acknowledged by policy makers that lowering the debt ratio comes at a cost to economic growth, requiring larger spending cuts, higher revenues, or both. Should the financial system face another wobble, for whatever reason, we would have to question the capacity of governments to step in and support their banks like they did back in 2008.

2. Deteriorating health and ageing in the developed economies

Projected increase in public health spending, 2013–30

The world’s population is growing older, leading us into uncharted demographic waters. There will be higher absolute numbers of elderly people, a larger share of the elderly, longer healthy life expectancies, and relatively fewer numbers of working-age people. We are aging due to three underlying factors: increased longevity, declining fertility and the baby boomers getting older.

This signals a profound economic and social change, with big implications for businesses and investors. Will we see an asset meltdown as the elderly sell off their assets? How will publicly funded pension systems deal with rising beneficiaries and falling contributors? How will policy makers react to a chart like the one above, which shows ever-increasing expenditure on public health as a percentage of GDP? The need for policy adaptations to an aging population will become more important in the face of retirement of the baby boomers, slowing labour force growth, and the rising costs of pension and health care systems, especially in Europe, North America, and Japan.

As a result of this key demographic change we can now reasonably expect to retire later in life, work harder as the size and quality of the workforce deteriorates, and pay higher taxes to fund those expensive medical technologies. Scary, huh?

3. Economic inequality and its impact on society

Shares of net wealth held by bottom 50% and top 10%

Income inequality is of great interest to economists due to the impact that it could potentially have on economic growth. Robert Shiller, who recently won the Nobel Prize in Economic Science, said that income inequality is the most important problem that we are facing now. Billionaire investor Warren Buffett thinks that rising income inequality is a drag on US economic growth. He said in an interview with CNN Money that “the rich have come back strong from the 2008 panic, and the middle class hasn’t. That affects demand, that affects the economy. The people at the bottom end should be doing better.” Stan Druckenmiller, who spent more than a decade as chief strategist for George Soros, has described QE as causing “the biggest redistribution of wealth from the middle class and the poor to the rich ever. Who owns assets?  The rich.”

What is really scary about this chart is the social and political ramifications that some economists have hypothesised. One theory suggests that high inequality could lead to a lower level of democracy, high rent-seeking policies, and a higher probability of revolution. An economy could fall into a vicious cycle because the breakdown of social cohesion brought about by income inequality could threaten democratic institutions.

4. A new economic world order

A new economic world order

The last decade has witnessed the emergence of China as an economic superpower, the next decade may well be characterised by the emergence of India. China and India will both expect their global influence to expand in the coming years and decades, but strong growth will not be without some headaches. Political leaders must deal with the environmental consequences, an aspirational middle class and rising social inequality. We have all felt the impact of the ascension of the developing economies through their thirst for commodities; the next phase may well see these two nations become the most influential in the world.

Markets don’t particularly like uncertainty. How they react to this new world order is anyone’s guess. This chart isn’t particularly frightening. What it does is challenge the economic status quo that many of us have become accustomed to.

5. Feeding the world

Feeding the world – per capita consumption set to increase

The global population is set to grow considerably in coming years, though there will likely be considerable differences across countries. It has been estimated that the world’s population could increase by 2 billion people to exceed 9 billion people by 2050. Of course, global agricultural production will have to increase in order to meet this demand.  If our farmers don’t manage to produce more, then we could easily find ourselves in an inflationary environment as our grocery shopping bills increase. Not only that, we have to become much smarter about using the planet’s limited resources.

Increasing farmers output won’t be easy, or without cost. Recent experience suggests that an increase in production efforts can lead to significant negative environmental effects, like pollution and soil erosion.

Increased productivity and innovation alone will not tackle the demand that will come from our growing, global population. Investment and infrastructure is vital. Farmers are likely to adopt technologies only if there are sound incentives to do so. This calls for well-functioning and efficient capital markets, a stable financial environment and sound risk management tools.

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Australian sport as a lead indicator for the housing market

Being an Australian sporting fan hasn’t been easy during my time at M&G over the past five years. The Olympics, rugby, cycling, cricket, tennis… Britain’s golden-age of sport has coincided perfectly with the decline in Australia’s sporting prowess. On top of this, I had the misfortune of seeing my premier league team get relegated last season (though there are definite green shoots of recovery emerging for QPR) and I am about as excited about the upcoming Ashes series as someone who has just been told that they need root canal surgery.

It has now got to the stage that my British colleagues – with memories of their national sporting teams’ performances during the 90s in the back of their minds – have taken pity on me, stating that it’s all cyclical. It’s enough to make you cry into a snakebite down at the Walkie (there’s only one left in London!).

One thing that hasn’t been cyclical is the Australian housing market. House prices seem to go only one way, and that’s to the moon. Australians haven’t had much to talk about on the sporting front in recent years, so most of the chat at BBQs has turned to properties (“How many do you own?”) and prices (“Get your feet on the housing ladder”). The increase in Australian house prices far exceeds the land of sub-prime loans (the US) and goes some way to explain why Sydney, Melbourne and Wollongong are more expensive on a median multiple basis than New York, Miami and Washington.

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Twenty-one years of sustained economic growth, low unemployment and the boost to incomes that has come from a record increase in Australia’s trade, have lulled most of the population into a false sense of security that house prices will never go down. There is a well-known rule in Australia for property investing – prices double every 7-10 years. Absolute madness. Throw into this economic bonfire the most favourable tax treatment of property investments in the world and record low interest rates and it’s easy to see why there is a clamour to own bricks and mortar. Not only as a source of shelter but also as a retirement policy. The blinkers have been well and truly fixed to the Aussie home buyer.

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We have written before that the Australian housing market worries us (see here, here and here). And with confirmation last week from the regulator that Australian financial companies have lent $1.13 trillion AUD in residential loans to facilitate the increase in house prices we are even more worried. In the background, national papers have been reporting that auction clearance rates have been higher than 80% for almost two and half months and that Chinese buyers are increasingly entering the market due to government restrictions on purchases at home.

The regulator must keep an eye on debt levels and the quality of banks loans to individuals. In Q2 2013, financial institutions lent $79bn to home buyers. $31bn of this was interest-only and low-documentation lending. As we all know this is the area where mortgage delinquencies will first occur in an economic downturn. In Australia, there is a close relationship between debt/GDP levels and house prices. Should the banks be forced to rein in lending, we could see some big ramifications for the housing market pretty quickly.

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Australian housing is showing all the signs of a bubble. When lenders start resorting to the cute little kid to shift 95% loan-to-value mortgages you have to wonder how much longer this can go on.

How has the Reserve Bank of Australia (RBA) reacted to this asset price bubble and the risks that it poses to financial stability? By stating that there is no bubble. Dr Malcolm Edey, who is responsible for financial stability at the RBA, stated last week that: “We’re in one of the higher-than-average periods at the moment, but we shouldn’t be rushing to reach for the bubble terminology every time the rate of increase in house prices is higher than average, because by definition that’s 50 per cent of the time. You’re just going to be unrealistically alarmist by making that call every time that happens.” So it appears the RBA, much like the Federal Reserve in the US under Alan Greenspan, would be very hesitant to raise rates to reduce any “froth” that may develop in areas of the Australian housing market.

It is easy to see why the RBA would avoid such an action. Higher rates, in a world where interest rates are near zero in the developed markets, would drive the AUD higher and reduce whatever little competitiveness the manufacturing and export sector had after years of an overvalued AUD in a globalised economy.

The catalyst for any house price correction in Australia will be the labour market. And leading indicators aren’t great. The Australian Institute of Mining and Metallurgy released a report yesterday showing that unemployment amongst its members had increased from 1.7% in July 2012 to 10.9% in July 2013.

Unlike the RBA, we think that it is time to be alarmist, particularly given our concerns around China. More than a decade of digging stuff up and shipping it to China has left Australia with all the telltale symptoms of Dutch disease. The mining industry is not only one of the largest employers in the country, it is famously one of the best paying as well (who hasn’t heard the anecdotes of cleaners being paid $100k a year to clean the miners living quarters?). Should the resources boom fizzle out, as it most likely will in conjunction with a China slowdown, hundreds of thousands will face losing their jobs across the economy. Not only that, we will see a massive impact on consumption within the economy as consumers tighten their belts to try and pay their ultra-high mortgage payments (Aussies will have to quickly deploy the savings they have been building up – the household saving ratio has increased from -2.4% in 2002 to 10.8% today). With unemployment and mortgage defaults rising, the RBA will hit the zero interest rate bound and embark on quantitative easing quicker than you can say “why didn’t we see this coming?”

Most economists see an orderly rotation away from the mining sector as the driving force of the economy to the services sector. The main reason they point to is that a sharply lower AUD should allow sectors like manufacturing and tourism to thrive again. In terms of the housing market, many point to significant under supply and full recourse loans as protection against a meaningful correction in Australian house prices to saner levels. The consensus expects modest gains in house prices for the foreseeable future.

Personally, I am not so sure. Can we really expect a hollowed out manufacturing sector to soak up the excess workers that the mining sector is shedding at a record rate? Remember when central bankers told us the sub-prime crisis was contained? Or the tech boom of the late 90s when everyone was an I.T. expert? Or perhaps it was that developments in Thailand were unlikely to spread and affect developed markets in 1997?

I’ll put my hands up; I’ve thought that a meaningful correction has been coming for at least the five years I’ve been in London. But I haven’t been as convinced as I am today that we are close to the end. There is enough evidence to suggest that Australian central bankers and policymakers should be greatly concerned and the absence of any meaningful debate in the recent election suggests there is limited political will to address any housing affordability problems that Australia is experiencing. I am amazed that young people all over Australia have not made more of an impact on the national debate on house prices. But then again, those born in the 80s and 90s think that rising house prices and economic prosperity is a way of life, so why not borrow eight times your income and leverage yourself up to buy your first house? You can always sell it in five years’ time and buy a better one.

Australia’s national sporting teams may recover from their current downturn. Hopefully the cricketers will in time for the Ashes which begin in November. Whether the Australian economy can survive the double-whammy of a China slowdown and housing correction is another story.

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The Fed didn’t taper – what’s next for US monetary policy and bond markets?

Last night the Federal Open Market Committee (FOMC) delivered a massive surprise by deciding to not taper QE. For us, this isn’t a huge deal. Since May, the market has placed way too much emphasis and concern over tapering and lost focus on the fundamental economic situation that the US has now found itself in – an economy where unemployment has fallen to 7.3% (helped by a falling participation rate) and a central bank that remains dovish due to a declining trend in core inflation. Now we are through the Fed meeting, arguably the market will now re-focus on the economic data. With interest rate policy set to remain very accommodative for a long period of time – even after balance sheet neutrality has been achieved – the sell-off in government bonds may be close to coming to an end (as witnessed by the 19bps fall in the US 10 year yield from 2.89% yesterday afternoon to 2.70% this morning).

US 10yr bond yields during quantitative easing

Fed concern number 1: US core PCE inflation is flirting with historic low levels

It is well known that FOMC Chairman Ben Bernanke, a student of the US economic depression of the 1930s, has great concerns about deflation and in 2002 gave a speech outlining how the US could avoid a deflationary trap which gave him the moniker “Helicopter Ben”. In the speech, Bernanke makes the important statement that “…Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation.”

The Fed’s preferred inflation measure, the core PCE, is exhibiting a worrying downward trend. This greatly concerns at least one member of the FOMC – St. Louis Federal Reserve Bank President James Bullard – who believes the FOMC should have more strongly signalled its willingness to defend its inflation target of 2 per cent in light of recent low inflation readings. The Fed minutes from the June meeting (at which Bullard dissented) showed that Bullard believed that the Fed was not doing enough to protect against the threat of deflation and that the FOMC must defend its inflation target when inflation is below target as well as when it is above target.

A key component of the Fed’s dual mandate – price stability – is clearly below where the FOMC wants it to be. There are big risks to reducing stimulatory monetary policy when core inflation is running at recessionary levels and on this measure suggests any interest rate hikes a long way away.

 

Inflation trending lower on both total and core PCE

Fed concern number 2: the labour market

The latest payroll report was weaker than market economists had become used to, with payroll growth averaging around 148,000 over the past three months. This is some way off the 200,000+ numbers that the consensus was expecting earlier in the year and confirms a deceleration in the trend in nonfarm payroll growth. Yes, the unemployment rate fell to 7.3%, but this was largely the result of the labour force shrinking and a decline in the participation rate in August. The labour market is not as strong as the headline number suggests.

Arguably, the fall in the unemployment rate has surprised most Fed members. Nonetheless, unemployment is not expected to fall to the 6.5% “think about raising interest rates” level until late 2014. It would have been a confusing message to start to implement tapering given the lower trend in job creation. The Fed reiterated that the economy and labour market have to be strong enough before in contemplates reducing asset purchases going forward. This helps to explain why the FOMC sat on its hands in September.

 

Unemployment rate quickly falling towards Fed thresholds

Fed concern number 3: the increase in mortgage rates

Following the moves in markets over the summer, the average rate for a 30-year fixed mortgage has now increased to around 4.5% from 3.4% in May. Essentially, the market has already tightened for the Fed. The housing market is a vital component of US economic growth, and this increase will cut into housing affordability. It could also force potential homebuyers out of the market. A slowing housing market means fewer jobs, less consumption, and lower growth. The increase in yields in the government bond market has been brutal, and does pose some risks to interest-sensitive sectors.

 

The rise in 30 year mortgage rates will concern the Fed

Given the above, it appears that the Fed refused to be bullied into tapering today by the bond markets, though tapering speculation may have reduced the “froth” that had developed in risk assets over the first half of 2013. It is likely that low inflation, a recovering labour market, and a slowing housing market will ensure that interest rate policy remains accommodative for the foreseeable future. The “Fed fake” suggests that tapering is truly data dependent and not predetermined. Macro matters.

As the market begins to refocus on the economic data, it is likely that government bonds may find some support. Additionally, the FOMC may reduce bond purchases slower than anyone currently expects. We expect that market concerns over the impact of tapering decisions will likely diminish over time as the Fed slowly and gradually moves towards a neutral balance sheet policy next year.

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