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The Great British Austerity Myth

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

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

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

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

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

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

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

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Stamping down on foreign flows into UK property could be sterling suicide

So now we know what the Bank of England intends to do about the UK’s housing market, a market that Governor Carney has previously referred to as the biggest risk to financial stability and therefore to the economic expansion (the IMF and the EC had similar warnings).The answer, in short, is not much at the moment – while Carney is not “happy” with the buoyant UK housing market, he is willing to “tolerate” it.

Before wondering what to do – and what not to do – about the housing market, it’s worth asking whether the UK housing market is in a bubble. It’s not as crazy a question as you might think – in real terms (i.e. adjusting for inflation), UK house prices rose by just +1.2% per annum from 1974 to the end of 2013, and by 2.2% per annum from 1974 to the end of 2007. It was the early noughties when things got crazy, as UK real house prices saw double digit returns in four consecutive years from 2001-2004 – strip out these years, and UK real house price growth has actually been negative in the last four decades*. But even including 2001-04, if you consider that the UK’s productivity growth since the mid 1970s has averaged about 1% per annum, and that UK population growth has averaged 0.3% per annum over this period, then small positive real house price growth doesn’t appear hugely alarming.

That said, 40 year average price changes don’t tell the whole story. The performance of the housing market in the past year is remarkable – UK house prices were up 11.1% in nominal terms in the year to May according to Nationwide, which is still a long way short of the 2001-04 bubble years, but is the fastest pace since then. Meanwhile data from the ONS shows that nominal London house prices rocketed 18.7% in the year to April. These rates of growth are well in excess of inflation, and well in excess of wage growth.

What is causing the recent jump higher in house prices? By definition the answer is an excess demand versus a lack of supply, although almost all commentary on the UK housing market seems to focus primarily on the latter rather than the former. Public debate about UK housing has been strongly influenced by then MPC member Kate Barker’s government commissioned 2004 review of housing supply, where she argued that ‘the long-term upward trend in house prices and recent problems of affordability are the clearest manifestations of a housing shortage in the UK’, and that the UK needed to build up to 260,000 new homes per year to meet demand. In the decade since the report was published, less than half this figure has been built, suggesting a shortfall of 1 million houses has accumulated.

But is the spike in house prices really all down to supply? As Fathom Consulting have pointed out, if there was a housing shortage then why haven’t real rent costs jumped higher? The chart below plots nominal wage growth versus UK rent costs back to 2001 – rent costs were actually increasing at a slower pace than wages pre-2008, and have only been running fractionally above wage growth more recently. If there was a supply shortage, then we would expect to see real rent costs increasing quite sharply as people become forced to spend more on housing as a percentage of their income, but this isn’t the case.

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The next chart suggests that the pick-up in house prices that began last year is much more likely (as always) to have had more to do with demand, namely lower mortgage rates and easy mortgage availability. The left hand chart is from the Bank of England’s recent Financial Stability Report, and shows the loan to income ratio on new mortgages advanced for house purchase. Around 10% of new mortgagees are now borrowing at a loan to income ratio at or in excess of 4.5 times income. Over half of home buyers are now having to borrow at 3+ times income, which is a ratio about 5 times higher than immediately before the UK housing market crash of the early 1990s. It’s striking how closely correlated loan to income ratios (left chart) are with house prices (right chart). It suggests that limiting loan to income ratios will also serve to limit house price appreciation, although the correlation doesn’t necessarily imply causation. It could be that a jump higher in house prices forces buyers to take on more debt, since only additional debt will make it possible to get onto the bottom rung of the housing ladder**.

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The other growing source of demand for UK property is likely to be overseas investors. When sterling collapsed post the 2008 crisis, the assumption was that the UK would see an export-led recovery thanks to a huge improvement in its competitive position. Unfortunately, this didn’t really happen, because the UK’s big export – financial services – was in little demand post crisis. UK exports did initially pick up, but today are only 10% higher than at their peak in 2008, and have moved sideways since 2011. Spain’s exports, in contrast, are almost 30% above 2008 levels in euro terms, despite the euro strengthening against sterling over the period.

Sterling depreciation may not have resulted in a surge in exports of UK goods and services, but it does appear to have led to a pick-up in a new kind of export – London’s housing stock. Savills, an estate agent, estimates that overseas equity into just prime London residential property was above £7bn in 2012, and presumably it was higher still in 2013. Overseas buyers have always been involved in London property thanks to market transparency, liquidity, political stability, a clear rule of law, decent education, and low taxes versus countries such as France or Spain, but the 2012 inflows were twice the amount seen in 2008 or 2009, and about a third higher than in 2006.

It’s easy to see why overseas buyers have taken a shine to UK property from the chart below. British houses feel far from cheap in local currency terms, but they look considerably cheaper from the perspective of all the traditional foreign buyers, with the exception of Russians. From the perspective of Chinese investors, London house prices are still 17.5% below their 2007 highs when measured in Chinese Yuan.

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The Bank of England’s strategy for reducing domestic demand for UK housing via macro-prudential measures such as limiting loan-to-income ratios should be the primary way to tackle the destabilising effects of housing related indebtedness, and the Bank of England arguably could have done more. Stemming foreign flows into the UK housing market is much more attractive politically, but could be very unwise.

Data from last week showed that the UK’s current account deficit improved slightly in Q1 2014, but Q4 2013 was downwardly revised to 5.7% of GDP and Q3 2013 to 5.9%, a worrying new record. Of the so-called ‘Fragile 5’ emerging market countries, only Turkey had a bigger deficit in Q4.

A current account deficit is a broader measure of a country’s trade balance. The UK’s large deficit can be attributed to various factors (e.g. a sustained trade deficit, a deteriorating income balance which may partly reflect an increase in foreign companies taking over British companies, and sustained budget deficits), but generally speaking a chronic current account deficit is indicative of competitiveness problems. The chart below shows that a large and deteriorating UK current account balance has historically preceded a sterling crisis, where a sharp depreciation in sterling subsequently restored the UK’s competitiveness, and hence its current account balance. If you consider that foreigners buying new build houses in London is little different to foreigners mass buying Scotch Whiskey in terms of its effects on the national accounts, then proposals to tax foreign buyers of London property is the equivalent to taxing your own exports! Not a very clever thing to do with such a precarious current account balance. Note that taxing exports is considerably worse than protectionism, which typically involves taxing imports.

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Macro prudential controls are a positive step and should help curb some of the local mortgage excess that has built up over the last couple of years. However, those pointing to supply-side factors as the primary reason for higher prices aren’t viewing the whole picture. UK property is cheap from an overseas perspective and will likely remain in demand to foreign buyers looking for solid returns in a low-yielding world. And beware the clamour of calls to stem foreign inflows into the UK housing market, which is turning into one of the UKs most in-demand exports. Of course, if macro prudential measures fail to take some of the heat out of the market, the Bank of England could always raise interest rates (if only they could remember how to….)

*This is calculated using UK RPI and the UK Nationwide House Price Index. Given there are methodological issues with both RPI and Nationwide data, it’s worth treating the calculation slightly cautiously – for example, UK RPI has averaged 0.9% higher than UK CPI since 1989, so real house prices appreciation is an additional 0.9% p.a. on a CPI basis.

**The recent nudge higher in both house prices and the move higher in first time buyer loan to income ratios is likely to have been assisted by the help to buy scheme (or the ‘help to sell scheme’, as we called it at the time), although given that as at the end of May, only 7313 houses were sold under the scheme with the total value of mortgages supported by the scheme at £1bn, there are other forces at play.

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China’s investment/GDP ratio soars to a totally unsustainable 54.4%. Be afraid.

Once upon a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets of unlimited civil liberties. They asserted with increasing self-confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economies, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again” – a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The passage is the opening to the highly readable and hugely influential 1994 paper The Myth of Asia’s Miracle. The period referenced is the early 1960s, the dynamic president was John F. Kennedy (read Bill Clinton), and the rapidly growing Eastern economies were the Soviet Union and its satellite nations (read East Asia). Author Paul Krugman took on the prevalent East Asian euphoria by drawing disturbing parallels between the unsustainable way that the Asian Tigers were managing to generate supersonic growth, and how the recently obsolete Soviet Union had also once achieved seemingly miraculous growth rates. Krugman’s paper gained widespread attention at the time (even more so post the 1997 Asian crisis), and succeeded in refocusing attention on the concept of productivity. It mattered not what the growth rate was, but how it was achieved.

To explain this and briefly summarise, consider what actually drives economic growth. Growth accounting shows that GDP per capita growth comes from two main sources; inputs and efficiency. The ‘inputs’ can be split into labour (e.g. growth in employment) and capital (e.g. the accumulation of physical capital stock such as machines and buildings). But long term, sustained per capita economic growth tends to come not from increases in the ‘inputs’, but from increases in efficiency, of which the main driver is technological progress. Nobel Laureate Robert Solow showed in his seminal 1956 paper that technological progress had accounted for 80% of US per capita growth between 1909 and 1949, although more recent studies have suggested a still substantial figure of more like 45-55% thereafter.

Krugman pointed to previous research showing that the Soviet Union’s rapid growth had not been due to efficiency gains. Indeed, the USSR was considerably less efficient than the US, and showed no signs of closing the gap. Soviet growth had been solely due to the ‘inputs’, and input-driven growth has diminishing returns (e.g. there is a finite number of workers you can educate). The USSR’s growth was largely ‘built on perspiration rather than inspiration’.

In a similar way, the Asian Tigers’ rapid growth was due to an ability to mobilise resources. There was no great improvement in efficiency, and no ‘miracle’ – it could be fully explained by the employed share of the population rocketing, education improving dramatically, and an enormous investment in physical capital (in Singapore, investment as a share of output jumped from 11% to more than 40% at its peak). But these were one time changes; they weren’t repeatable.

Fast forward to 21st century China.

There is a perception that China’s rocketing growth rate has always been reliant on heavy investment, but that’s not the case. Investment, or capital formation, has of course been an important driver, but the ‘pre 2008’ China did achieve rapid productivity gains thanks to the rise of the private sector and technological catch-up as the economy slowly began to open its borders.

In the chart below, I’ve looked at how much the world’s biggest economies have invested as a percentage of their GDP, and compared this to the countries’ GDP per capita growth rates. Countries with higher investment rates tend to have higher GDP growth rates and vice versa, which is intuitive and supports the discussion above. Since the 1990s, most (but not all) emerging/developing countries have been positioned towards the top right hand side with higher investment and higher growth rates, and the more advanced economies have typically been towards the bottom left with lower investment and lower growth rates. In one extreme you have China, where investment has averaged over 40% of GDP, and the GDP per capita growth has averaged a phenomenal 9.5%. The fact that China’s growth rate is well above the trend line in the chart is indicative of the productivity gains that China has achieved over the period as a whole on average. The country with the weakest investment rate is the UK.

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‘Post 2008’ China looks a different animal. Productivity and efficiency seem to be plummeting, where GDP growth is becoming dangerously reliant on the ‘inputs’, namely soaring investment. We’ve all heard about how China’s leaders desire a more sustainable growth model, featuring a rebalancing of China’s economy away from investment and export dependence and towards one that is more reliant on domestic demand and consumer spending (e.g. see the 12th 5 year plan covering 2011-2015 or the Third Plennum). In practice, what we’ve instead consistently seen is an inability or unwillingness to meaningfully reform, where any dip in economic growth has been met with yet another wave of state-sponsored overinvestment. (Jim recently blogged about economist Michael Pettis’ expectation that China long term growth could fall to 3-4%, a view with which I have a lot of sympathy. Please see also If China’s economy rebalances and growth slows, as it really must, then who’s screwed? for an additional analysis of the implications of China’s economic slowdown).

It was widely reported earlier this week that China’s 2013 GDP growth rate fell to a 13 year low of 7.7%, a slowdown that seems to have continued into 2014 with the release of weak PMI manufacturing reading yesterday. But much more alarming is how the makeup of China’s growth has changed: last year investment leapt from 48% of China’s GDP to over 54%, the biggest surge in the ratio since 1993.

The chart below puts China’s problems into perspective. As already demonstrated, there is a strong correlation between different countries’ investment rates and GDP growth rate. There also tends to be a reasonable correlation over time between an individual country’s investment rate and its GDP growth rate (Japan’s experience from 1971-2011 is a good example, as shown previously on this blog). Over time, therefore, a country should be broadly travelling between the bottom left and top right of the chart, with the precise location determined by the country’s economic model, its stage of development and location in the business cycle.

It should be a concern if a country experiences a surge in its investment rate over a number of years, but has little or no accompanying improvement in its GDP growth rate, i.e. the historical time series would appear as a horizontal line in the chart below. This suggests that the investment surge is not productive, and if accompanied by a credit bubble (as is often the case), then the banking sector is at risk (e.g. Ireland and Croatia followed this pattern pre 2008, Indonesia pre 1997).

But it’s more concerning still if there is an investment surge accompanied by a GDP growth rate that is falling. This is where China finds itself, as shown by the red arrow.

Part of China’s growth rate decline is likely to be explained by declining labour productivity – the Conference Board, a think tank, has estimated that labour productivity growth slowed from 8.8% in 2011 to 7.4% in 2012 and 7.1% in 2013. Maybe this is due to rural-urban migration slowing to a trickle, meaning fewer workers are shifting from low productivity agriculture to higher productivity manufacturing, i.e. China is approaching or has arrived at the Lewis Turning Point (see more on this under China – much weaker long term growth prospects from page 4 of our July 2012 Panoramic).

However the most likely explanation for China’s surging investment being coupled with a weaker growth rate is that China is experiencing a major decline in capital efficiency. Countries that have made the rare move from the top left of the chart towards the bottom right include the Soviet Union (1973-1989), Spain (1997-2007), South Korea (1986-1996), Thailand (1988-1996) and Iceland (2004-2006). Needless to say, these investment bubbles didn’t end well. In the face of a labour productivity slowdown, China is trying to hit unsustainably high GDP growth rates by generating bigger and bigger credit and investment bubbles. And as the IMF succinctly put it in its Global Financial Stability Report from October 2013, ‘containing the risks to China’s financial system is as important as it is challenging’. China’s economy is becoming progressively unhinged, and it’s hard to see how it won’t end badly.

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Will the Fed push EM over the edge?

We’ve been very worried about emerging markets for a couple of years, initially because of surging portfolio flows, better prospects for the US dollar and historically tight valuations (see The new Big Short – EM debt, not so safe, Sep 2011). But increasingly recently our concern has been driven by deteriorating EM fundamentals (see Why we love the US dollar, and worry about EM currencies, Jan 2013). A combination of miscommunicated and misconstrued Fed speak in May brought things to a head, and EM debt crashed in May to July (see EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’? Jun 2013), although the asset class has since recovered roughly half of the losses. So where are we at now?

First up, fund flow data. Outflows from EM debt funds abated in July and August, briefly turned into inflows in mid September immediately following the non-tapering decision, but have since broadly returned to outflows (see chart below). Outflows from EM debt funds since May 23rd have been a very chunky $28bn, over $3bn of which have come since September 23rd.

However, as explained in the blog comment from June, EPFR’s now much-quoted fund flow data only apply to mutual funds, and while you get an idea of what the picture looks like, it’s only a small part of the picture. Just to emphasise this point, it has now become apparent that a significant part of the EMFX sell was probably due to central banks. The IMF’s quarterly Cofer database, which provides (limited) data on reserves’ currency composition, stated that advanced economy central banks’ holdings of “other currencies” fell by a whopping $27bn in Q2, where much of this ‘other’ bucket is likely to have been liquid EM currencies. Maybe half of this fall was driven by valuation effects, but half was probably dumping of EM FX reserves. Limitations of the EPFR data are also apparent given that there has been a slow bleed from EMD mutual funds this month, but that doesn’t really tally with market pricing given that EM debt and EM FX have been edging higher in October. An increase in risk appetite among EMD fund managers could account for this differential, although it’s more likely that institutional investors and other investors have been net buyers.

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A relative stabilisation in fund flows doesn’t mean that planet EM is fine again. The recent IMF/World Bank meetings had a heavy EM focus, which followed on from the negative tone towards EM in the latest editions of the IMF’s flagship World Economic Outlook and Global Financial Stability Report (GFSR). The IMF again voiced concerns about the magnitude of the EM portfolio flows, and the chart below suggests that flows have deviated substantially from what the IMF believes is a gentle trend upwards in investors’ allocation to EM. A reversal of recent years’ inflows back towards the long term trend level would cause considerable pain, and while $28bn of outflows since May 23rd may sound like a lot, this is only equivalent to the inflows in the year up to May 23rd, let alone the inflows from the preceding years. As explained in Chapter 1 of the GFSR, which is highly recommended reading, foreign investors have crowded into local emerging markets but market liquidity has deteriorated, making an exit more difficult.

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What now for EM debt? Your outlook will likely depend on how you weight and assess the different performance drivers for the asset class. There has been a heated debate in recent years on whether emerging market portfolio flows are driven primarily by so called ‘push factors’ (eg QE and associated negative developed country real interest rates pushing capital into countries where rates are higher), or whether flows are driven by ‘pull factors’ (eg domestic factors such as reforms or financial liberalisation). EM countries have tended to argue that push factors dominate, with Brazilian Finance Minister Mantega going as far as to accuse G3 policymakers of currency manipulation, while Fed Chairman Bernanke and future Chairman (Chairperson?) Yellen have argued that EM countries should let their currencies appreciate, although a recent Federal Reserve paper highlights both push and pull factors.

Number crunching from the IMF suggests that it is the EM policy makers who have the stronger arguments. In April’s GFSR, the IMF’s bond pricing model indicated that stimulative US monetary policy and lower global risk (itself partly attributable to the actions of advanced economy central banks) together accounted for virtually all of the 400 basis point reduction in hard currency sovereign debt from Dec 2008-Dec 2012, as measured by JP Morgan EMBI Global Index. Meanwhile, external factors were found to have accounted for about two thirds of the EM local currency yield tightening over this period. ‘Push factors’ therefore appear to dominate ‘pull factors’, something I agree with and have previously alluded to.

The relevance of external factors shouldn’t be a major surprise for EM investors given that the arguments are not remotely new. Roubini and Frankel have previously argued that macroeconomic policies in industrialised countries have always had an enormous effect on emerging markets. Easy monetary policy and a low global cost of capital in developed countries (as measured by low real interest rates) in the 1970s meant that developing countries found it easy to finance their large current account deficits, but the US monetary contraction of 1980-2 pushed up nominal and real interest rates, helping to precipitate the international debt crisis of the 1980s. In the early 1990s, interest rates in the US and other industrialised countries were once again low; investors looked around for places to earn higher returns, and rediscovered emerging markets. Mexico received large portfolio inflows, enabling it to finance its large current account deficit, but the Fed’s 1994 rate hikes and subsequent higher real interest rates caused a reversal of the flows and gave rise to the Tequila Crisis.

High real interest rates were maintained through the mid 1990s, the US dollar strengthened. Countries pegged to the US dollar lost competitiveness, saw external vulnerabilities grow and in 1997 we had the Asian financial crisis. In 1998, Russia succumbed to an artificially high fixed exchange rate, chronic fiscal deficits and low commodity prices (which were perhaps due in part to the high developed country real interest rates). A loosening of US monetary policy in the second half of 1998 alleviated the pressure on EM countries, but a sharp tightening in US monetary policy in 1999-2000 was arguably the final nail in the coffin for Argentina, and only IMF intervention prevented the burial of the rest of Latin America. The low US real interest rates/yields that have been in place ever since 2001-02 and particularly since 2009, together with the weak US dollar, have sparked not only large, but also uniquely sustained, portfolio flows into EM. [This is of course a gross simplification of the crises of the last 30 years, and there were also numerous domestic factors that explained why some countries were hit much harder than others, but it's difficult to dispute that US monetary policy has played a major role in the direction of capital flows on aggregate].

It’s starting to feel like Groundhog Day. Soaring US real and nominal yields from May through to August were accompanied by an EM rout. The tentative rally in EM over the last month has been accompanied by lower US real and nominal yields. Correlation does not imply causation, but investors should probably be concerned by the potential for US nominal and real yields to move higher as easy monetary policy is unwound. The date for the great monetary policy unwind is being pushed back, with consensus now for US QE tapering in March 2014, and if anything I’d expect it to be pushed back further given that it is hard to see how we’re going to avoid a rerun of the recent US political farce early next year. But this should only be a postponement of US monetary tightening, not a cancellation.

This year has been painful for EM, but it has been more a ‘spasmodic stall’ in capital flows rather than a fully fledged ‘sudden stop’. If, or perhaps when, the day of reckoning finally comes and US monetary policy is tightened, EM investors should be very concerned with EM countries’ growing vulnerability to portfolio outflows and ‘sudden stops’. [Guillermo Calvo coined the phrase 'sudden stop', and he and Carmen Reinhart have written extensively on the phenomenon, eg see 'When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options (2000)']

History suggests that a good old fashioned ‘sudden stop’ would be accompanied by banking and particularly currency crises in a number of countries. There are numerous variables you can use to assess external vulnerabilities, and many people have been busy doing precisely that since May (eg see the Economist or a writeup on a piece from Nomura). In January I highlighted some of the lead indicators of EM crises regularly cited in the academic literature, namely measures of FX reserves, real effective exchange rates, credit growth, GDP and current account balances.

To be fair, a few of these crisis indicators are pointing to a slight improvement. Most notably, FX reserves are on the rise again – JP Morgan has highlighted that FX reserves of a basket of EM countries excluding China fell by $40bn between April and July, but that decline was fully reversed through August and September, even accounting for the fall in the US dollar (which pushes up the USD value of non-USD holdings).

Currencies of a number of EM countries have seen a sizeable and much needed nominal adjustment, although it’s important to highlight that while nominal exchange rates have fallen, the fact that inflation rates tend to be a lot higher in EM than in DM means that real exchange rates have dropped only perhaps 5% on average, which still leaves the majority of EM currencies looking overvalued and in need of significant further adjustment. In particular, Brazil has much further to go to unwind some of the huge appreciation of 2003-2011. Venezuela looks in serious trouble, which is what you expect given it is trying to maintain a peg to the US dollar at the same time as its official inflation rate has soared to 49.4% (Venezuela’s FX reserves have halved in five years, and are at the lowest levels since 2004).

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However some of these lead indicators are just as worrying as they were in January. While the rapid credit growth rates of 2009-2012 have eased a little in most countries, perhaps partly on the back of weaker portfolio flows, there’s no evidence of deleveraging. Indeed, China is as addicted to its credit bubble as ever, while Turkish credit growth is inexplicably re-accelerating. The charts below put China’s credit bubble into perspective, where the increase in China’s private debt/GDP ratio since 2008 is bigger than the US’ and the UK’s credit bubbles in the years running up to 2008, and China’s total debt/GDP ratio is approaching Japan’s ratio in 1988. A banking crisis in China at some point looks inevitable. Although a banking crisis will put a dent in China’s GDP growth, it shouldn’t be catastrophic for the economy in light of existing capital controls and high domestic savings (these savings will just be used to plug the holes in banks’ balance sheets). The pain will likely be felt more in China’s key trade partners, particularly in those most reliant on China’s surging and unsustainable investment levels, and of those, particularly the countries with growing external vulnerabilities (see If China’s economy rebalances and growth slows, as it surely must, then who’s screwed? Mar 2013).

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And probably the biggest concern is the rapidly deteriorating current account balances for almost all EM countries, where a country’s current account is essentially a broad measure of its trade balance. If you look through historical financial crises, large and/or sustained current account deficits are a feature that appears time and time again. Current account deficits were a feature of the LatAm debt crisis of the early 1980s, the Exchange Rate Mechanism (ERM) crisis in 1992-3, Mexico in 1994, Asia in 1997, (arguably) Russia in 1998, Argentina and LatAm generally in 1999-02, Eastern Europe and many developed countries in the run up to 2008, and the Eurozone periphery (2010-?). Current account deficits are not by themselves necessarily ‘bad’ since by definition a current account deficit in one country must be balanced by a current account surplus elsewhere, and a country ought to be running a current account deficit and therefore attracting foreign capital if it has a young population and superior investment prospects. Foreign investors will willingly fund a current account deficit if they expect their investment will result in future surpluses, but no country is able to run a current account deficit (which is the same as accumulating foreign debt) indefinitely – if foreigners see a deficit as unsustainable then a currency crisis is likely. Maybe Mongolia’s or Mozambique’s current account deficits of almost 40% last year can be justified by the high expected returns from the huge mining/energy investment in the countries. Or maybe not.

But consistently large deficits, or rapidly deteriorating current account balances, can be indicative that things aren’t quite right, and that’s how many EM countries look to me today. Morgan Stanley coined the catchy term the ‘fragile five‘ to describe the large EM countries with the most obvious external imbalances (Indonesia, South Africa, Brazil, Turkey and India), and this is a term I gather those countries understandably aren’t overly impressed with (BRICS sounded so much nicer…). Unfortunately the list of fragile EM countries runs considerably longer than just these five countries.

The chart below highlights a select bunch of EM countries that are running current account surpluses and deficits. Some countries look OK – the Philippines and Korea appear to be in healthy positions on this measure with stable surpluses. Hungary has moved from running a large deficit to a small surplus, although Hungary needs to run sustained surpluses to make up for the period of very large deficits pre 2009*.

Almost all the other surplus countries have seen fairly spectacular declines in their current account surpluses. Malaysia’s surplus has plummeted from 18% of GDP in Q1 2009 to 4.6% in Q2 2013, while Russia, which is regularly cited as being among the least externally vulnerable EM countries, has seen its current account surplus steadily decline from over 10% in 2006 down to 2.3% in Q2 this year, a number last seen in Q2 1997, a year before it defaulted. Russia’s deteriorating current account is all the more alarming given that the historically high oil price should be resulting in large surpluses. Financing even a small current account deficit (which by definition would need financing from abroad) could cause Russia serious problems, and a lower oil price could also result in grave fiscal stresses given that the breakeven oil price needed to balance Russia’s budget has soared from $50-55/ barrel to about $118/ barrel in the last five years.

Many (but not all) current account deficit countries are looking grimmer still. A number of countries are seeing current account deficits as large or larger than they have historically experienced immediately preceding their previous financial crises. Turkey has long had a very large current account deficit, and while it has improved from almost 10% of GDP in 2011 to 6.6% in Q2 this year, the central bank’s reluctance to hike rates in response to a renewed credit bubble suggests this will again deteriorate. Despite the sharp drop in the rand, South Africa’s economic data has not improved – its current account deficit was 6.5% of GDP, and Q3 is likely to be very weak given the awful trade data in July and August. I continue to think South Africa should be rated junk, as argued in a blog from last year (the modelled 10% drop in the rand actually turned out to be overly optimistic!). India’s chronic twin deficits have been well documented – its current account deteriorated sharply in recent years, hitting a record 5.4% in Q4 2012 and with only a marginal improvement seen since then. As previously highlighted, Indonesia’s current account is now back to where it was in Q2 1997, immediately before the outbreak of the Asian financial crisis. Thailand’s previously large current account surplus has moved into deficit. Latin American countries tend to run reasonable sized deficits (as they generally should, given their stage of development), although Brazil and Chile have moved right into the danger zone.**

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Another concern is contagion risk. If the Fed does tighten monetary policy next year, investors withdraw from EM en masse and capital flows back to the US, and/or China blows up and takes EM down with it, then an EM crisis this time around could look very different to previous ones. EM crises have historically been regional in nature – the international debt crisis of the early 1980s is a possible exception, but even then it was Latin America that bore the brunt. The big difference this time around is that a material portion of the portfolio flows are from dedicated global EM funds and large ‘Total Return’ style global bond strategies, as opposed to flows from banks. If these funds withdraw from EM countries, or to be more precise, if the end investors in these funds liquidate their holdings in the funds, then the funds will be forced sellers of not only the countries that may be in trouble at that point in time, but will also be forced sellers of those countries that aren’t necessarily in trouble. In fact, in a time of crisis, they may only be able to sell down the better quality more liquid positions such as Mexico in order to meet redemptions. So if a crisis does develop then you’ll probably see a correlation of close to one across EM countries. And not just between EM countries – the fate of, say, Ireland, may now be tied to that of Ukraine, Ghana, Mexico, and Malaysia.

That’s the rather lengthy ‘story’ for emerging markets, but what about the most important thing – valuations? In June I concluded that following the sharp sell-off, EM debt offered better value than a few months before, and it therefore made sense to be less bearish on an asset class that we have long argued has been in a bubble (but that didn’t mean I was bullish). As mentioned above, EMD has now recovered roughly half the sharp losses of May and June, but given very little has fundamentally changed over the period, it makes sense to be more concerned about valuations again.

The charts below illustrate the yield spread pick up over US Treasuries on hard currency (as shown by the JPM EMBI Global spread) and EM local currency (as shown by 10 year yields on Brazil, Indonesia and Mexico). Even though a number of EM macroeconomic indicators are at or approaching historical crisis levels, spreads on hard currency EM debt are not far off the tights (although at least you are exposed to the US dollar, whose valuation I like). EM local currency yields are also offering an unspectacular yield pick up over US treasuries, but here you have to contend with a lot of EM currencies with arguably shaky valuations, and you additionally face the risk of some countries being forced to run pro-cyclical monetary policy (i.e. EM central banks hiking rates in the face of weakening domestic demand in order to prevent a disorderly FX sell-off , the result of which sees local currency bond yields rising, as seen recently in Brazil, India, Indonesia).

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So rising EM external vulnerabilities, combined with what are now fairly unattractive valuations, means that EM debt could potentially be teetering over the edge. Would the Fed give EM the final shove though?

On the one hand, while US domestic demand was considerably stronger in the 1990s than today, it’s interesting that during the really bad EM crises in 1997 & 1998, US GDP didn’t wobble at all, not remotely. US GDP was 5% in 1998, the strongest year since 1984, and 1997 saw the US economy grow at a not too shabby 4.4%. The Fed Funds rate didn’t budge at all in 1997 through the Asian crisis, and it wasn’t until after the Russian crisis in September 1998 that the Fed cut interest rates from 5.5% to 5.25% (and then again in October and November down to 4.75%), although this was a combination of domestic and foreign factors. Rates were actually back at 5.5% by November 1999 and continued higher to 6.5% by May 2000.

On the other hand, EM countries now account for about half of global GDP, so a direct hit to EM could loop quickly back to the US. This is something that the Federal Reserve has become acutely aware of in recent months (in case they weren’t already) given the extreme moves in EM asset prices. And in both the June and September press conferences, Bernanke was keen to stress that the Fed has lots of economists whose sole job is to assess the global impact of US monetary policy, and what’s good for the US economy is good for EM. That said, if US growth hits 3% next year, which is possible, it’s tricky to see how the Fed won’t start tightening monetary policy regardless of what EM is up to.

But the deteriorating EM current accounts may mean that at least a few EM countries won’t have to wait for a push from the Fed; they may topple over by themselves. A deteriorating current account deficit means that a country needs to attract ever increasing capital from abroad to fund this deficit. If developed countries’ appeal as investment destinations improves at the same time that a country such as South Africa’s appeal is deteriorating due to deteriorating economic fundamentals or other domestic factors, then investors will begin to question the sustainability of the deficits, resulting in a balance of payments crisis. EM investors need to be compensated for these risks in the form of higher yields, but in the majority of cases, yields do not appear sufficiently high, which therefore makes me more bearish on EM debt valuations.

*A current account deficit is an annual ‘flow’ number; Hungary’s ‘stock’ still looks ugly thanks to years of deficits, as shown by its Net International Investment Position. Hungary’s current account surplus is one of the few things Hungary has going for it. For more see previous blog.

** I’m still slightly baffled as to why Mexico HASN’T had a credit bubble given the huge portfolio inflows, the relative strength of its banking sector and a very steep yield curve, and it remains a favoured EM play (see Mexico – a rare EM country that we love from Feb 2012, although I’d downgrade ‘love’ to ‘like’ now given the massive inflows of the last 18 months and less attractive valuations versus its EM peers).

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Why the US Dollar now looks cheap against, well, basically everything

Back in January I wrote about why we loved the US dollar and worry about EM currencies, and did an update on EM in June (see EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?).  Another EM piece will follow soon (the short version is that while it was ‘just’ a tremor,  I’m increasingly worried that ‘The Big One’ is coming).

The US Dollar was strong through Q1 and Q2, but an interesting development in Q3 was that while the US Dollar held up OK against most EM currencies, it performed abysmally against other developed currencies.  Below is a chart of the US Dollar Index, a gauge of US Dollar performance against a basket of major world currencies, where the basket contains EUR (57.6%) JPY( 13.6%) GBP (11.9%) CAD (9.1%) SEK (4.2%) CHF (3.6%). The Dollar Index is back to where it was at the beginning of the year, and despite the relative strength of the US economy versus other developed countries, the Dollar Index has now returned to the average level of the last five years.

US Dollar Index has cheapened all the way back to 5yr average

The reasons that led us (and an increasing number of others) to be so excited about the US dollar over the past 18 months were namely compelling USD valuations following a decade long slump, an improving current account balance, the rapid move towards energy independence, and a strengthening US economic recovery where a surging housing market and a steadily falling unemployment rate made it likely that the US would lead most of the world in the monetary policy tightening cycle.

The long term positives for the US dollar are still there, but have recently been overshadowed by negative ones.  So what has changed?  Recent US Dollar weakness is probably to do with the Fed’s non-tapering in September, the ongoing budget nonsense, and a very big unwind in a whole heap of long USD positions.

It makes sense to be more bullish on the US dollar because these negative forces appear to be dissipating.

Firstly the non-tapering event.  Treasury yields and the US dollar had already started to drop ahead of the non-tapering decision thanks to a slight weakening in US data, with US 10 year yields dropping from 3% on September 5th to 2.9% on September 18th and the Dollar Index falling 2%.  Nevertheless markets were still taken by surprise, and Treasury yields and the US Dollar had another leg lower with US 10 year yields briefly dropping below 2.6% at the end of September, and the Dollar Index falling almost another 2%.

But then on Wednesday we had September’s FOMC minutes, which were surprisingly hawkish.  The decision not to taper was a close call, where most members still viewed it as appropriate for tapering to start this year and for asset purchases to be finished by the middle of next year.  Yes, the US government shutdown that has occurred since the meeting took place appears to be already starting to hit US economic data (estimates vary enormously for the total hit to Q4 US GDP), and the weaker data is therefore likely to push the start date for tapering back a little.  But if you assume that the US government shutdown is a one off event (admittedly not a particularly safe assumption), then the shutdown should merely slightly delay the tapering decision and the normalisation of US monetary policy, it should not result in a permanent postponement.

That said, something that was a little disconcerting from the minutes of the September FOMC meeting was that the jump in mortgage rates played a key role in the decision not to start tapering, with some members worrying that a reduction in asset purchases “might trigger an additional unwarranted tightening of financial conditions”.  HSBC’s Kevin Logan makes the good point that higher mortgage rates present Fed policy makers with a dilemma; if rates rise because the markets expect a tapering of QE, and that in turn stops the Fed from tapering, then it makes any QE exit pretty tricky and it appears that the Fed now has an additional criterion for reducing QE – not only must the economy and labour market be doing better, but long-term interest rates cannot rise too much in advance, or even during, the tapering process.  If the Fed’s decision not to taper was heavily influenced  by higher mortgage rates, though, then their fears should now be allayed given the chart below.  This chart, together with the effect that mortgage rates have on the US housing market, has clearly taken on added importance.

Mortgage rates now appear key to whether & when to taper

What about the ongoing budget nonsense?  This one takes a bit of a leap of faith, but markets are clearly starting to price in the risk of something going very badly wrong as demonstrated by the jump in T-bill yields and the surge in 1yr US CDS (i.e. the cost of insuring against a US default, see chart below).  But market stresses should make the prospect of a deal more likely, and this appears to be starting to happen.  It’s dangerous reading too much into the headline tennis, but the latest news is that Republican and Democratic leaders are open to a short term increase in the debt limit.  And don’t forget, the debt ceiling has been raised 74 times since March 1962 – past performance is no guide to the future as everyone knows, but while this episode is particularly chaotic, is this time really different?

Government shutdown is starting to cause market distress

Finally, the technicals for the US Dollar are now much more appealing.  US Dollar positioning has seen a sharp reversal from earlier this year, and Deutsche Bank estimates the US dollar is the only substantial short in the market (see charts below).  Does this matter?  To finish with a quote from John Maynard Keynes* regarding investing, “It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.  When you find any one agreeing with you, change your mind.  When I can persuade the Board of my Insurance Company to buy a share, that, I am learning  from experience, is the right moment for selling it”‘.

In a complete reversal from earlier this year, investors are very short USD

*Keynes is famous for amassing a fortune through investing, but in 1920 he had to be bailed out by his father together with an emergency loan from Sir Ernest Cassel, and he came very close to being wiped out in the 1929 and 1937 stock market crashes.  So clearly the consensus can occasionally be right.

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EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?

On Friday last week, EM debt funds saw a daily outflow of $1.27bn, which equalled the record set during the dark days of September 2011, a time when the Eurozone periphery and the ECB were particularly active bungee jumping down a precipice.   Outflows were even bigger on Monday this week, as EM debt funds were hit by $1.44bn in outflows.  The fact that Monday saw a daily record wasn’t much of a surprise; markets were violent, even by recent standards, with some Turkish bank bonds down 10% intraday at one point.   Outflows were a slightly less bad $1.07bn on Tuesday this week (the most recent data available), but that’s still $3.78bn of EM debt fund outflows in just three days.

The chart below plots the year to date daily flows in US high yield and EM debt, courtesy of EPFR.  Note that this data is for mutual funds only and doesn’t include flows from insurance companies, central banks etc, so while it gives you an idea of how grim the picture looks, it’s perhaps only 10% of the whole picture.  Note also that the EM debt asset class is significantly bigger than it was just two years ago thanks to a huge amount of debt issuance, meaning that although Monday saw a record outflow in absolute terms, it actually ranked number four relative to the size of the market.

EM debt funds hit by record daily outflow on Monday this week

Do the outflows matter?  EM debt bulls might argue no -  fund flows tend to lag market performance and flows have historically had little if any predictive power in forecasting future returns. The collective human instinct is always to buy at the top and sell at the bottom, and the losses in EM assets in the last seven weeks told you the outflows were coming.  Bulls might also argue it is comforting that EM debt outflows haven’t actually been bigger.  EM debt has seen the biggest drawdown since Q4 2008 – in the last 7 weeks the JP Morgan GBI-EM Index, a commonly used EM local currency sovereign debt index, has plummeted  13%, and the JP Morgan EMBI Global diversified index, a widely used EM sovereign external debt benchmark, has fallen over 10%.  Real money investors aren’t yet capitulating, which suggests that the huge inflows of the last few years are relatively sticky.

EM debt bears might look at it another way – in the context of the enormous inflows into EM debt in the last four years in particular, outflows haven’t actually been that huge, and yet returns have been abysmal.  One of the unintended consequences of much tighter bank regulation and balance sheet deleveraging is that market markers have reduced ability to warehouse risk, so relatively small changes in EM debt fund flow dynamics are causing far greater swings in market prices.   If outflows continue at this pace or worsen, then the effect on EM debt will likely be cataclysmic.

Are these outflows just a tremor, or are we witnessing ‘The Big One’?  To begin to attempt to answer that, it’s necessary to figure out what has caused such a violent sell off.  About a year ago I tried to explain that the reasons most people seem to buy EM debt – strong growth, good demographics, low government debt levels, an ‘under-owned asset class’ – are broadly irrelevant.   Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis.  Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either. EM debt returns are instead largely a function of US Treasury yields, the US dollar, and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt (see Emerging market debt is cool but you may be surprised what you find if you strip away the marketing myths for more).

The recent EM debt sell off appears to justify this view of the primary drivers of EM debt returns.  Market commentators’ explanation for the recent leg down in EM debt is Bernanke’s tapering talk, and this is clearly a factor.  Treasury yields have jumped, the US dollar has soared, and EM currencies have mostly slumped.  This is something that we had anticipated and were positioned for as explained in January, see Why we love the US Dollar and worry about EM currencies.

If you assume this EM debt sell off has all been about Fed speak, then I’d actually be much more comfortable about EM debt valuations now. EM bond yields have risen significantly faster than US Treasury yields, while EM currencies have generally fallen sharply, so EM debt valuations are obviously relatively more attractive now versus two months ago.   At the time of writing back in January, 10 year US Treasury yields were 1.8% and we believed they looked ripe for a correction.  Now, however, yields are above 2.5%, and yet the solid but unspectacular trajectory of the US economy hasn’t really changed that much.  Meanwhile US inflation expectations have in fact fallen considerably – for example the US 5 year 5 year forward breakeven inflation rate has slumped from 3% to 2.4%.  Jim discussed the US economy following a research trip in a blog earlier this month, see While the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation.

However, the recent EM debt move is unlikely to be all about Fed speak.  EM debt has been a stand out underperformer in the great carry sell off of the last two months, and dynamics in Japan and China are surely also important.  I believe that the behaviour of domestic Japanese investors is playing a greatly under-appreciated role.  In the early days and months of the much hyped but so far little-achieving ‘Abenomics’, every man, his dog, and his dog’s unborn puppies seemed to have gone long USD, short JPY, long risky assets and particularly long EM debt.  Some did it in a very leveraged way, and these trades have been a disaster since the beginning of May.  As mentioned in a blog a month ago, Japanese investors have in fact done the precise opposite of what every market participant seemed to think they would do. Below is an updated chart from a blog last month (see Japanese investors are not buying foreign bonds, they’re selling).  Japanese selling of foreign bonds has accelerated further recently, with the announcement overnight that there were ¥1.2 trillion of sales alone during the week to June 21st. Taking a rolling three month average, Japanese investors are selling foreign bonds at a near record pace.

Japanese investors have been selling foreign bonds not buying

It is the China dynamic that I find particularly worrying.  Commentators have focused on the drying up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown.  There is much speculation as to why SHIBOR has soared, the only additional observation I have is that spikes in SHIBOR are nothing new – I wrote a brief comment about a previous episode in January 2011, see funny goings on in Chinese banking sector.  There was a near replica of the current SHIBOR spike exactly two years ago, and while the SHIBOR moves this time around are particularly big, it’s hard to see why this time it’s different and the PBOC won’t supply liquidity.

A much bigger longer term China worry is that market participants still believe that China can grow at 7%+ ad infinitum, but I can’t see any scenario under which this is actually possible.  China’s wages have doubled since 2007 and its currency has appreciated 25% against the euro and 35% against the US dollar (based on spot return) since China dropped its peg in 2005.  Competitiveness has therefore significantly weakened.  Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen.   If you add that an enormous demographic time bomb is starting to go off in China (eg see article from The Economist here), China’s long term sustainable growth must be considerably lower than consensus expectations.  Some believe the Renminbi’s destiny is to become a currency to rival the US dollar.  I think it’s more likely that opening up the capital account will encourage big capital outflows as domestic investors seek superior investment returns abroad (as an aside,  Diaz-Alejandro’s paper Goodbye Financial Repression, Hello Financial Crash offers some background on Latin America’s experience with financial liberalisation in the 1970s and 1980s).

My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and EM debt in particular.  If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich. Rather than regurgitate the arguments, see blog from March (If china’s economy rebalances and growth slows, as it surely must, then who’s screwed?).  I continue to believe that EM and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes (eg Australia, South Africa, Indonesia, Chile, Brazil) are acutely vulnerable.

In sum, EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble.  That doesn’t mean I’m bullish.   The arguments put forward in September 2011 (see The new big short -  EM debt, not so safe) are more valid now than ever.  Foreign ownership of many EM countries’ bond markets has climbed higher (see chart below), and the EM debt outflows of the past few weeks are a pimple on an elephant’s derriere in relation to the decade-long inflows.  These inflows were initially driven by US investors fleeing the steadily depreciating US dollar, and more recently driven by European investors looking to park money outside the Eurozone.   Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.

Foreign ownership has increased enormously

The recent EM debt sell off probably isn’t yet ‘The Big One’, it is more a tremor.  ‘The Big One’ will probably need either US growth and inflation surprising considerably to the upside or China surprising to the downside.  If that happens then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in. It will take a much bigger sell off in EM debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.  Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978-1985, 1995-2002) have been coupled with EM crises.

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Japanese investors are not buying foreign bonds, they’re selling

One of the stories that has driven global financial markets higher for the past few months has been about how Japanese investors are piling, or will pile, into foreign assets. Surely a rational Japanese investor would dump Japanese assets in an attempt to escape the exploding yen and the ravages of domestic inflation, or at the very least seek out a bigger yield than the puny returns available on the artificially suppressed domestic government bonds?

Well, they haven’t been buying foreign bonds; actually they’ve done the opposite. There were lots of headlines earlier this month after Japanese investors were (just about) net purchasers of foreign bonds in the three weeks to May 10th. But data out overnight showed that there were ¥804.4bn worth of net sales of foreign bonds in the week to May 17th, which more than reversed the previous three weeks’ purchases.

The chart below shows the weekly net purchases of foreign bonds, where the data is based on reports from designated major investors including banks, insurance companies, asset management companies etc. The blue line in the chart below is the 3 month moving average, and it shows that Japanese redemptions of foreign bonds are running at close to the highest rate since data began in 2001.

It’s difficult to deduce too much from all the data, but it appears likely that the rally in the Nikkei, the drop in the yen and the rally in semi-core Eurozone government bonds has been down to foreign investors front running something that so far has not actually happened. Japanese investors may still flee their domestic market, but it will require (mostly foreign) investors’ already high inflation expectations to be realised (the bond market is pricing in Japanese inflation averaging +1.8%pa for the next 5 years, despite there being little evidence that QE in Japan or other countries has succeeded in either generating inflation or in weakening currencies). It probably also requires changes to the higher capital charges that major Japanese investors face when investing in overseas assets, although even with this, funding costs and hedging requirements will ensure that home bias continues.

Bondvigilantes Japanese purchases of foreign bonds MR May 13

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Pese a las apariencias, los países periféricos de Europa continúan padeciendo una crisis de deuda

This article appeared in English on 26 April.

A comienzos de esta semana, las rentabilidades de la deuda española a 5 y 10 años cayeron hasta los niveles más bajos desde el cuarto trimestre de 2010. No cabe duda de que esta recuperación fue estimulada por los comentarios de Mario Draghi relativos a que el BCE haría « todo lo necesario para salvar el euro» y posteriormente alentada por la mejora de los datos económicos de la zona euro registrada durante el segundo semestre de 2012 la cual, probablemente, se debió en parte a las palabras de Draghi. No obstante, la recuperación de los países periféricos ha continuado durante este año a pesar del importante deterioro que han sufrido los datos económicos en los últimos meses. Actualmente, los fundamentales económicos y las valoraciones avanzan rápidamente en direcciones opuestas.

Lo anterior queda reflejado en el siguiente gráfico: el eje izquierdo representa el diferencial de rentabilidad entre la deuda italiana y alemana a 10 años, y el derecho representa el índice Citi Eurozone Economic Surprise (de forma que si la línea verde asciende implica que los datos económicos son más débiles de lo previsto).

Recuperacion de la deuda soberana de los paises perifericos pese al empeoramiento de los datos

Sigo manteniendo mis dudas respecto a la solvencia de España donde, por insolvencia, me refiero a la situación en la que la ratio de deuda pública sobre el PIB aumenta de forma indefinida. Sí, el BCE puede inyectar liquidez en España para posponer el pago de la deuda y sí, podría decirse que hay muchos otros países desarrollados que se encuentran enla misma situación—la ratio de deuda pública sobre el PIB de Japón se acerca rápidamente al 300%, lo que hace que la deuda pública española parezca relativamente raquítica. Pero como ya hemos visto en el caso de Grecia, la deuda soberana de la zona euro puede ser y será reestructurada si se considera que un país es insolvente y, como ya comentamos anteriormente en una entrada de 2010, parece que  España se dirige hacia tal situación.

Centrándonos en la dinámica de la deuda española a largo plazo, es preciso recordar que la ratio de la deuda pública sobre el PIB de un país cambia en funciónde las siguientes tres variables:

  1. La diferencia entre los costes de financiación de la deuda y el crecimiento nominal como porcentaje del PIB. Si el coste de financiación es mayor que el PIB nominal, aumentará la ratio de deuda pública sobre el PIB.
  2. El cambio en el balance primario de un país como porcentaje del PIB (donde balance primario es el balance presupuestario antes del pago de intereses). Un mayor déficit presupuestario equivale a un aumento de la ratio de deuda pública sobre el PIB.
  3. Variaciones en el ajuste deuda-déficit. Normalmente este ajuste es relativamente pequeño, pero si un gobierno recapitaliza un banco, la ratio de deuda pública sobre el PIB aumenta (más información).

La ratio de la deuda pública sobre el PIB de España se ha disparado como consecuencia de estas tres variables. Analizando a su vez cada una de estas variables, en el siguiente gráfico representa el crecimiento del PIB nominal de España comparado con su coste de financiación nominal a 6 años (en sentido estricto, el dato incluido en la fórmula debería ser el promedio de los costes en concepto de interesesque, en el caso de España, en la actualidad es próximo al 4% —en este caso he utilizado la rentabilidad de la deuda española con vencimiento a 6 años en su lugar). Un coste de financiación del 4% estaba bien entre 2001 y 2007, cuando España aun podía generar un crecimiento del PIB nominal de entre el 7 y el 9%, pero dada la situación actual no es una cifra tan positiva.

Incluso con un menor coste de financiacion, sin crecimiento Espana sigue mostrandose insolvente

Dado que los costes de financiación de España son superiores a su tasa de crecimiento nominal, necesita acumular un superávit primario para poder estabilizar su ratio de deuda pública sobre el PIB (tal como se ha indicado en el punto 2). Pero en la actualidad España presenta un enorme déficit presupuestario (del 10,2% de media desde 2009) y por tanto tiene un enorme déficit primario. En el siguiente gráfico mostramos cómo el FMI ha aumentado de forma constante sus previsiones para el déficit presupuestario español desde 2011.

Los deficits presupuestarios han superado sustancialmente las expectativas

En parte el FMI ha previsto déficits cada vez mayores debido a que sus previsiones de crecimiento han sido excesivamente optimistas. En el siguiente gráfico se muestra como en el 2011 el FMI pensaba que España estaría actualmente creciendo a un ritmo estable del 2%, mientras que la realidad es que se encuentra todavía inmersa en una crisis (recientemente se ha confirmado una tasa de desempleo del 27.2% para el primer trimestre del ano, una cifra récord). La mayoría de las estimaciones de crecimiento a largo plazo elaboradas son simples promedios históricos a la larga, pero dados los elevados niveles de endeudamiento tanto público como privado de España, así como el deterioro de su demografía, la tasa de crecimiento potencial a largo plazo puede ser de tan solo el +1% anual.

El crecimiento de Espana se ha quedado sustancialmente por debajo de las expectativas

¿Y qué sucede con el tercer punto relativo a la ratio deuda/PIB: los ajustes deuda-déficit? Nuestro analista de banca española, Ed Felstead, considera que no es impensable que incluso algunos de los bancos que ya han sido recapitalizados por el estado necesiten serlo nuevamente, a pesar de haber transferido sus activos y préstamos inmobiliarios más tóxicos ala Sareb, el «banco malo» español. Las ratios de préstamos morosos de los bancos ya «saneados» siguen siendo elevadas y la generación de ingresos se mantiene baja debido a la reducción de los márgenes de beneficio. Si se produjera un mayor deterioro de préstamos no-inmobiliarios, los bancos tendrán que hacer mayores provisiones, lo cual generará pérdidas, sin que haya forma de sustituir el capital perdido. Es probable que dicho deterioro se produzca dada la frágil situación de la economía española, junto con el hecho de que las ventas de activos por parte de la Sareb ejercerán presión sobre los precios de los mismos, y la posibilidad de que se introduzca una nueva legislación en materia de ejecuciones hipotecarias y las deudas en mora más favorable para los prestatarios.

Por ello, si no se consigue reanudar el crecimiento en España, los gastos de financiación seguirán superando la tasa de crecimiento, continuarán existiendo grandes déficits presupuestarios y posiblemente veamos la necesidad de realizar nuevas recapitalizaciones bancarias. El FMI ya no prevé una estabilización de los niveles de endeudamiento españoles, al contrario,cree que continuarán aumentando en un futuro próximo, y esto es con unas expectativas de crecimiento del PIB que pueden considerarse todavía algo optimistas. La deuda de los países de la Europa periferica, sobre todo la española, parece todavía vulnerable a sufrir a una venta masiva.

Menor crecimiento y mayor deficit rapido deterioro de la ratio de deuda

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Peripheral Europe is still facing a debt crisis, despite appearances

Earlier this week, 5 and 10 year Spanish yields fell to the lowest levels since Q4 2010. The rally was no doubt kick started by Mario Draghi’s “do whatever it takes to preserve the euro” comment, and was given further fuel by the improvement in Eurozone economic data over the latter half of 2012, which was probably due in part to Draghi. However, the peripheral rally has continued this year in the face of a significant deterioration in economic data in recent months. Economic fundamentals and valuations are currently moving rapidly in opposite directions.

The chart below illustrates this – on the left axis is the Italian 10 year yield spread over Germany, and on the right axis is Citi’s Eurozone Economic Surprise Index (so if the green line moves up, data is coming in weaker than expectation).

Slide1

I continue to doubt whether Spain in particular is solvent, where I’d define insolvency as being where a country’s public debt/GDP ratio increases indefinitely. Yes, the ECB can throw liquidity at Spain to keep the debts rolling over, and yes, many other developed countries are arguably in the same boat – Japan’s public debt/GDP ratio is quickly rising towards 300%, which makes Spain’s public debt burden look relatively puny. But as we’ve seen with Greece, sovereign Eurozone debt can and will be restructured when a country is deemed insolvent, and as previously argued in a comment in 2010, this is where Spain appears to be heading.

Focusing on Spanish long term debt dynamics, it’s worth recapping that the change in a country’s government debt/GDP ratio is a function of three variables, namely:

  1. The difference between debt interest costs and nominal growth as a % of GDP. If interest costs are greater than nominal GDP, then this leads to a higher public debt/GDP ratio
  2. The change in a country’s primary balance as a % of GDP (where a primary balance is the budget balance before interest payments). A larger budget deficit equals a higher public debt/GDP ratio
  3. Changes in the stock-flow adjustment. This adjustment usually relatively small, but if a government recapitalises a bank, the public debt/GDP ratio increases (see here for more information)

Spain’s public debt/GDP ratio has been soaring because of all three of the above variables. Taking each of these variables in turn, the chart below plots Spain’s nominal GDP growth against its 6 year nominal borrowing cost (strictly speaking it should be the average interest cost that goes into the formula, which for Spain is currently about 4% – I’ve taken the yield on Spain’s 6 year maturity as a proxy). A borrowing cost of 4% was fine from 2001 to 2007, as Spain was able to generate nominal GDP growth of between 7 and 9%. It’s not so fine now.

Slide2

Given that Spain’s borrowing costs are higher than its nominal growth rate, it needs to run a primary surplus if it is to stabilise its public debt/GDP ratio (as per point 2). But Spain is actually running a huge budget deficit (averaging 10.2% since 2009), and is therefore running a large primary deficit. The chart below shows how the IMF has steadily increased its forecast for Spain’s budget deficits since 2011.

Slide3

Part of the reason why the IMF has forecast larger and larger deficits is down to its growth forecasts being hopelessly optimistic. The chart below shows how in 2011, the IMF thought Spain would be growing at a tidy 2% by now, when instead Spain remains mired in a slump (yesterday it was announced that the unemployment rate hit a record 27.2% in Q1). Most forecasters’ long term growth estimates are simply countries’ long run historical averages, but given Spain’s high private and public debt levels, as well as deteriorating demographics, Spain’s long run potential growth rate may be as little as +1% per annum.

Slide4

What about the third point about the debt/GDP ratio, namely stock flow adjustments? Our Spanish banks analyst Ed Felstead believes it isn’t inconceivable that even some of the banks that have been recapitalised by the state will need additional recapitalisations, despite the transfer of their most toxic real estate developer loans and assets to Sareb, Spain’s ‘bad bank’. Non Performing Loan (NPL) ratios at the now ‘clean’ banks remain high and revenue generation remains low on falling margins. Any further deterioration in asset quality on non-real estate developer loans will result in the banks having to take more provisions, which will lead to losses, with no way to replace the lost capital. This deterioration is likely given the state of the Spanish economy mentioned above, along with Sareb asset sales putting pressure on asset prices, and potential new borrower-friendly legislation on foreclosures and arrears.

So in the absence of a miraculous return to growth, Spain’s borrowing costs will continue to exceed its growth rate, large budget deficits will remain a feature, and it’s easy to see how further bank recapitalisations will be necessary. The IMF is no longer forecasting that Spanish debt levels will level off but will continue rising for the foreseeable future, and that’s even with what appears to be over-optimistic mean reverting GDP growth assumptions. Peripheral Eurozone bonds, and Spain’s in particular, look vulnerable to a sell off.

Slide5

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The bond vigilantes are being zombified, but the currency vigilantes are rampant

We have written extensively on this blog in the last year about what we’ve termed ‘central bank regime change’ (eg see Jim’s article here from a year ago), where we have argued that in the years ahead, central banks would care less about inflation and more about growth and unemployment. We have since seen a number of examples of this playing out – the Federal Reserve has started targeting the unemployment rate, the Bank of Japan is trying to generate inflation, and the ECB has said it will do “whatever it takes to preserve the euro”.

More recently we’ve seen the Bank of England join the party, where 3 of the 9 members of the MPC voted for additional asset purchases despite forecasting that inflation is likely to remain above the 2% target for the next two years. And then last week we had the bombshell in the Financial Times that conversations are being had about changing the BoE’s remit, which looks suspiciously like a leak (again today it was reported that Carney has met with the Treasury to discuss remit change).

Richard wrote about the ‘currency vigilantes’ in 2010 (see here), where he discussed how QE was taming the bond vigilantes, how in the new topsy turvy world the highest inflation economies could have the lowest bond yields, and how the currency vigilantes will take the bond vigilantes’ place to enforce discipline. If you look at FX performance year to date then the currency vigilantes are clearly on the hunt – the world’s worst performing major currency at the time of writing is the Japanese Yen (-9.7% vs USD) and the second worst is the British Pound (-8.5% vs USD).

Meanwhile, QE has successfully turned the bond vigilantes into bond zombies. Market participants no longer appear to be forcing up profligate countries’ nominal government bond yields; they are instead buying up these countries’ inflation linked bonds. So in another topsy turvy development, it is becoming cheaper rather than more expensive for these governments to borrow. Cynics would argue that was the whole idea.

The result is that as real yields fall versus nominal bond yields, market implied inflation expectations are by definition increasing. One measure of market implied inflation expectations is the 10 year breakeven inflation rate, which is the gap between the 10 year real yields and 10 year nominal yields. The chart below shows that US 10 year inflation expectations are at the highs of the range of the last 15 years. Today the UK 10 year breakeven inflation rate hit 3.36%, the highest since September 2008. If you consider that the UK breakeven inflation rate is priced off RPI, and RPI is likely to be around 1% higher than CPI over the long term, then the UK bond market is still only pricing in a 10 year CPI average of just over the current 2% target. We think this still has a lot further to go – and we still hate sterling.

The ‘bondvigilantes’ are busy buying linkers

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