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Anjulie-Rusius_100

Falling soft commodity prices are a piece of cake

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

Slide1

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

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

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

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

Ana_Gil_100

The M&G YouGov Inflation Expectations Survey – Q2 2014

Today we are launching the next wave of the M&G YouGov Inflation Expectations Survey which aims to assess consumer expectations of inflation over the short and medium term.

With interest rates at multi century lows, central banks continue to inject large amounts of monetary stimulus into the global economy. Recent inflation rates in the US, UK and Germany have proved central to the current market focus, as actions from policymakers have become increasingly sensitive to inflation trends.  This is true for the Fed and the BoE, as markets assess their possible exit strategies/timing, but especially for the ECB, whose last round of action is perceived to have been largely motivated by disinflationary pressures in the Euro area. In that context, market focus on inflation expectations has increased.

The results of the May 2014 M&G YouGov Inflation Expectations Survey suggest that both short and medium-term inflation expectations remain well anchored across most European countries.

Short-term expectations have risen from 2% to 2.3% in the UK as the country showed further signs of economic growth and reaccelerating wage pressure. On the other hand, inflation expectations for German consumers moderated in the last quarter as the downward trend in German HICP (1.1% YoY in April) may have added to the expectation that German inflation will remain subdued over the next year.

The general downward trend in short-term inflation expectations seems to have largely receded in all EMU countries and the UK. This may be somewhat surprising with much of Europe still experiencing low and falling inflation.

Inflation expectations – 12 months ahead

Over the medium term, inflation expectations remain above central bank targets in all countries surveyed, suggesting that consumers may lack confidence in policymakers’ effectiveness in achieving price stability. Over 5 years, UK inflation is expected to remain well anchored at a remarkably stable 3%. Despite recent low inflation rates across Europe, the majority of consumers in France, Italy and Spain continue to view inflation as a concern, and long-term expectations in those countries has risen back to 3%.

Inflation expectations – 5 years ahead

The findings and data from our May survey, which polled over 8,700 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

jim_leaviss_100

Why aren’t bund yields negative again?

Whether or not you believe that the ECB moves to full government bond purchase quantitative easing this week (and the market overwhelmingly says that it’s only a remote possibility) the fact that German bund yields at the 2 year maturity remain positive is a bit surprising. The 2 year bund currently yields 0.05%, lower than the 0.2% it started the year at, but higher than you might have expected given that a) they have traded at negative yields in 2012 and 2013 and b) that the market’s most likely expected outcome for Thursday’s meeting is for a cut in the ECB’s deposit rate to a negative level.

The chart below shows that in the second half of 2012, and again in the middle of 2013, the 2 year bund yield was negative (i.e. you would expect a negative nominal total return if you bought the bond at the prevailing market price and held it to maturity), hitting a low of -0.1% in July 2012.

2y bund yields chart

Obviously in 2012 in particular, the threat of a Eurozone breakup was at its height. Peripheral bond spreads had hit their widest levels (5 year Spanish CDS traded at over 600 bps in July 2012), and Target2 balances showed that in August 2012 German banks had taken Euro 750 billion of “safe haven” deposits from the rest of the euro area countries (mostly from Spain and Italy). So although the ECB refinancing rate was at 0.75% in July 2012 compared with 0.25% today, the demand for German government assets rather than peripheral government assets drove the prices of short dated bunds to levels which produced negative yields.

This time though, whilst the threat of a euro area breakup is much lower – Spanish CDS now trades at 80 bps versus the 600 bps in 2012 – the prospect of negative deposit rates from the ECB might produce different dynamics which might have implications for short dated government bonds. The market expects that the ECB will set a negative deposit rate, charging banks 0.1% to deposit money with it. Denmark successfully tried this in 2012 in an attempt to discourage speculators as money flowed into Denmark out of the euro area. Whilst the ECB refinancing rate is likely to remain positive, the cut in deposit rates might have significant implications for money market funds. David Owen of Jefferies says that there is Euro 843 billion sitting in money market funds in the euro area, equivalent to 8.5% of GDP. But what happens to this money if rates turn negative? In 2012, when the ECB cut its deposit rate to zero, several money market fund managers closed or restricted access to their money market funds (including JPM, BlackRock, Goldman Sachs – see FT article here). Many money market funds around the world guarantee, or at least imply, a constant or positive net asset value (NAV) – this is obviously not possible in a negative rate environment, so funds close, at least to new money. And if you are an investor why would you put cash into a money market fund, taking credit risk from the assets held by the vehicle, when you could own a “risk free” bund with a positive yield?

So whilst full blown QE may well be months off, if it ever happens, and whilst Draghi’s “whatever it takes” statement means that euro area breakup risk is normalising credit risk and banking system imbalances, the huge amount of money held in money market funds that either wants to find positive yields, or is forced to find positive yields by fund closures, makes it a puzzle as to why the 2 year bund yield is still above zero.

stefan_isaacs_100

Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

jamestomlins_100

Video – Some thoughts on U.S. credit from our American research trip

A few of the M&G bond team recently visited New York and Chicago on a research trip. We put together a short video to share some of our thoughts regarding US credit markets. A particular focus is the U.S. high yield market where we highlight some sector themes. We also consider the potential impact on U.S. credit spreads when the Fed starts to raise interest rates.


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Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.

Claudia_Calich_100

Playing Russian roulette

The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability but high impact game.

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I just returned from a trip to Moscow. You would not know there is the possibility of a war going on next door by walking around the city, if you didn’t turn to the news. Its picture perfect spring blue skies were in stark contrast to the dark clouds looming over the economy.

The transmission mechanism of the political impact into the economy is fairly predictable:

  1. Political-related risk premia and volatility remaining elevated, translating into weakening pressure on the ruble;
  2. Pressure for higher rates as the ruble weakens (the CBR has already hiked rates by 200 bps, including the unexpected 50bps hike last week, but more will be needed if demand for hard currency remains at the Q1 2014 level and pressure on the currency increases further);
  3. Downside pressure on growth as investment declines and through the impact of sanctions or expectation of additional sanctions (through higher cost of capital);
  4. Downward pressures on international reserves as the capital account deteriorates and CBR smoothens the currency move;
  5. Decline of the oil reserve fund should it be used for counter-cyclical fiscal purposes or refinancing of maturing debt (the $90 billion fund could theoretically cover one year of amortizations, but in that case, capital flight and dollarization would escalate further as the risk perception deteriorates).

All these elements are credit negative and it is not a surprise that S&P downgraded Russia’s rating to BBB-, while keeping it on a negative outlook. What is less predictable, however, is the magnitude of the deterioration of each of these elements, which will be determined by political events and the extent of economic sanctions.

My impression was that the locals’ perception of the geopolitical risks was not materially different from the foreigners’ perception shown above – i.e. that a major escalation in the confrontation remains a tail risk. The truth is, there is a high degree of subjectivity in these numbers and an over-reaction from either side (Russia, Ukraine, the West) can escalate this fluid situation fairly quickly. The locals are taking precautionary measures, including channelling savings into hard currency (either onshore or offshore), some pre-emptive stocking of non-perishable consumer goods, considering alternative solutions should financial sanctions escalate – including creating an alternative payment system and evaluating redirecting trade into other currencies, to the extent it can. Locals believe that capital flight peaked in Q1, assuming that the geopolitical situation stabilizes. Additional escalations could occur around 1st and 9th of May (Victory Day), as well as around the Ukrainian elections on 25th of May.

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The table below assigns various CDS spread levels for each of the scenarios, with the probabilities given per the earlier survey. The weighted probability average is still wider than current levels, though we have corrected by a fair amount last week. I used CDS only as it is the best proxy hedge for the quasi-sovereign and corporate risk. Also, the ruble would be heavily controlled by the CBR should risk premia increase further, and may not work as an optimal hedge for a while, while liquidity on local bonds and swaps would suffer should the sanctions directly target key Russian banks.

Slide4

The risk-reward trade-off appears skewed to the downside in the near term.

Nicolo_Carpaneda-100

Video – some thoughts on emerging markets from Hong Kong and Singapore

I recently visited Hong Kong and Singapore to attend some conferences and meet clients in the region. While travelling, I put together a short video to share some of our views on Asian emerging economies and emerging markets in general.

As recently reported in Claudia’s Panoramic outlook here, following both the 2013 sell-off and the recent EMFX volatility experienced earlier this year, investors’ attitudes towards emerging markets have changed. Volatile capital flows, unsustainable growth models, a deterioration in current accounts, excessive credit growth and currency depreciation are key concerns for local and global investors. Some trends have become unsustainable and a rebalancing process has started. Emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

While adjustments take place, new opportunities present themselves. But not all emerging markets are equal. As emerging economies are on diverging paths, especially in Asia – some are deteriorating (eg China) while others are improving (eg Philippines or Sri Lanka) – asset allocation and stock selection will be key. Watch the video to find out our preferences.


Claudia_Calich_100

World Cup currency trading strategies: emerging vs. developed markets

With just under two months to go to the opening match and tensions already mounting within our team (we have 8 different participating countries covered – Australia, Brazil, England, France, Germany, Italy, Spain and USA), we thought it was time for a World Cup themed blog. Our prior predictor of the 2010 World Cup winner proved to be perfectly off the mark. Based on expected growth rates in 2010, we predicted that Ghana would win and Spain would come last – and we know what happened subsequently. However, in defence of the IMF, Ghana were the surprise package of 2010, only failing to reach the semis thanks to a Luis Suarez handball.

However, despite the tradition of ‘lies, damned lies, and statistics’, I still believe in analysing data and making predictions. Was it coincidence that the team that was not part of our predictions (North Korea), given the lack of available economic data, ranked last? Would Argentina have made it to the quarter-finals had it not been altering its inflation statistics?

Historically, the World Cup has been won 9 times by an emerging country and 10 times by a developed country. Will an emerging country win and tie the score this year?
We present two currency trading strategies associated with the World Cup:

  1. Arbitrage: in currencies with full convertibility or minimal transaction costs, arbitrage opportunities are very limited. However, currencies that are subject to restrictions on capital flows, taxation or regulatory requirements often offer arbitrage opportunities in excess of the costs associated with these factors. For example, for the World Cup in Brazil, ticket prices for non-residents are determined in USD and in BRL for Brazilian residents. Ticket prices were set by FIFA in May 2013 (1980 Brazilian Reals or 990 US Dollars for category 1 tickets), based on the prevailing US Dollar / Brazilian Real exchange rate of 2.00. As ticket prices remain unchanged in USD and BRL and given the depreciation of the Real since then, ticket prices in BRL are now 14% cheaper than tickets purchased in USD.1
    Slide1
  2. Currency carry trades: a popular strategy which is relatively easy to implement and which has proven profitable2. We test the strategy by going long a basket of emerging market currencies of the qualifying countries (which are normally higher yielding due to higher inflation, economic risks, etc.) funded by a basket of developed market currencies of the qualifying countries (which are normally lower yielding, which has been exacerbated by quantitative easing). Out of the countries that qualified for the recent World Cups, we arbitrarily classify them as 18 emerging and 14 developed. However, if we measure them by currency, the numbers change slightly. A few emerging countries have a developed market currency as legal tender (for example, Ecuador adopted the US Dollar as its legal tender in 2000), so it makes sense to count them as developed countries. We keep Ivory Coast under the emerging basket, as the West CFA Franc, while pegged to the Euro, is not the same as having Euro as its legal tender.

We test our World Cup carry trade performance during the last 2 World Cups between January 1 (a clean start date once the 32 qualifying teams became known) and the start dates for each tournament.

Slide2
Slide3

The EM vs DM FX carry trade posted a small profit in 2006 (+0.4%) and was a clear winner in 2010 (+2.4%)3 . On the football field, however, emerging market lost to developed market in both instances (Italy and Spain won). Ahead of the upcoming cup, the carry total return points to a loss on the EM carry trade so far (-2.8% to the 11th of April). On this basis, I predict that an EM team will win the cup in Brazil.

Slide4

1For a more complex example of score betting on World Cups, see http://elsa.berkeley.edu/~botond/szjrt.pdf.
2For an empirical discussion of emerging market carry trades, see http://www.nber.org/papers/w12916.pdf?new_window=1.
3For simplicity reasons, we have omitted bid-offer transaction costs from the calculations. Given that some of the smaller EM currencies are less liquid and have higher costs (in this case, one buy and subsequent sell), the results slightly overstate the returns of the EM long side. On the short side, we only included the Euro once, to maintain a “diversified” basket of developed currencies.

Claudia_Calich_100

The emerging markets rebalancing act

Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits. Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption.

In our latest issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.

  

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anthony_doyle_100

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

Slide1

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

Slide2

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

Slide3

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

Slide4

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

Slide5

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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