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

Posted on 23 May 2013 by Mike Riddell

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.

A look at housing affordability in the US and UK

Posted on 10 May 2013 by Guest contributor - Mark Wheatley-Smith, M&G Investments Graduate

In recent months we have blogged about the recovery in the US housing market that is currently underway. This is in contrast to the UK experience, where the housing market appears to be stuck in the mud. We thought a quick look under the bonnet could reveal the dynamics at play in both countries.

In order to do this, we have constructed a housing affordability index that captures the three main barometers of the health of the housing market; wages, house prices and mortgage rates. By combining average house prices and mortgage rates, we can estimate the typical payments facing a mortgage holder in either country. We have then divided the average wage in both countries by this number. We think that this enables us to get a pretty good read on how affordable housing is in the respective countries.

As the chart shows, owning a house has become considerably more affordable in the US relative to the UK since 2007. There are a number of reasons why this has occurred.

Firstly, US house buyers are feeling rate cuts to a greater extent than their UK counterparts. For example, at the end of 2012 30-year US fixed rate mortgages were 3.35% compared to an average UK fixed rate mortgage of 4.10%. As outlined earlier this month, UK building societies are finding it difficult to pass on any rate cuts because of the impact that such a move would have on their profits. Secondly, wage increases have also favoured potential American homeowners. In the US, wages have risen by nearly 16% compared to an increase of 12% in the UK.

The US has improved on two metrics relative to the UK, but the difference isn’t enough to explain the divergence in affordability between the two markets. The dominant affordability factor has been house prices.

US house prices saw a greater correction, falling by 30% from the peak to trough, while UK prices only fell by 18%. We have now seen US house prices generate solid returns for buyers, with prices now growing at over 10% year-on-year. This is likely to have a significant impact through the multiplier effect on consumption and GDP growth. In contrast, the UK housing market recovered relatively quickly, but since late 2010 house prices have been anaemic.

With the standard variable mortgage rate rising over the last 11 months, limited upward pressure on wages, and stable house prices it appears unlikely that the UK housing market is going to become more affordable for home buyers anytime soon. It is thus understandable that in order to assist potential homeowners, the government has launched its “Help-to-Buy” scheme (following the muted impact of its Funding for Lending scheme) which will come into effect in January next year.

Whether the scheme will work or not will continue to be debated amongst economists. The Help-to-Buy scheme should theoretically impact house prices in a positive way. But this could actually have a negative impact on those looking to buy and potential homeowners may end up borrowing more to purchase a house than they would if the scheme didn’t exist at all.

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

Posted on 2 May 2013 by Mike Riddell

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).

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:

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.
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.
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.

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.

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.

¿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.

Five reasons why Mark Carney might be short of options when he becomes BoE Governor in July

Posted on 2 May 2013 by Jim Leaviss

Mark Carney, currently Canadian central bank governor, will become the Governor of the Bank of England at the start of July. Handpicked from outside of the official application process by Chancellor George Osborne, he comes with high expectations about what he can do to get the UK economy out of a downturn arguably more severe in GDP terms than was seen during the Great Depression (or The Slump as it was known here). This now famous chart from the NIESR shows the extent of the underperformance of the economy relative to past recessions.

Carney’s stock is high – whilst the UK and the Eurozone remain in, or around, recessions, Canadian GDP is growing at 1.7% year on year, and its growth has outperformed the US economy both during and post the financial crisis. Inflation in Canada has averaged 1.8% over the past 6 years, compared with 3.1% CPI in the UK – perhaps the real blemish on inflation puritan Mervyn King’s legacy.

With Osborne having ruled out fiscal policy as a tool to get the UK out of its current Slump, our hopes now rest on either a significant and speedy recovery of our biggest trading partner, the Eurozone economy (and that looks to be going in the wrong direction), or monetary policy. In other words do the government’s hopes all rest on Carney doing something new and different, or massively increasing the scale of what the Bank of England has done before? If so we might all be disappointed. Here are five reasons why Mark Carney’s degrees of freedom might be fewer than he, and we, had hoped…

1 You can’t cut bank rate in the UK because you hit the building societies.
Easy right, you fly over, cut rates and give a small but welcome boost to the economy. But bank rate has been stuck at 0.5% since early 2009, through double dip recessions and increases in Quantitative Easing. There is clearly scope to cut towards zero (like the Fed) and this would clearly have some benefit to consumers and companies who have mortgages and loans linked to base rate, or Libor. But the Bank has repeatedly rejected calls to cut from here – not because those benefits might be modest (although that was a line at one point) but because the building societies might well become loss making if further cuts were made. And we need our building societies – as banks’ appetite to lend has fallen, the societies now provide 22% of gross mortgage lending compared with 13% in 2009. Why do the societies get hit disproportionately by lower bank rate? The first problem is the amount of tracker mortgages that they sold historically, where homeowners pay interest explicitly based on a bank rate plus (and in some cases MINUS) basis, so revenues fall as rates fall. And at the same time the societies have very little share of the current account market, so to fund mortgage lending they rely on having market leading savings rates to raise deposits. In recent years much of this has been done on a fixed rate basis. The chart below shows that net interest income as a percentage of assets has been falling steadily as bank rate fell from 5.5% to 0.5% over that period. Once costs are taken out (the “net of costs” margin is shown in blue) there is little room for revenues to fall before the sector becomes loss making. As for negative bank rate (mentioned by Paul Tucker as being “unlikely…but we should think about all sorts of things”), that would be even more harmful.

2 You can’t target a weaker £ because the impact on consumption is higher than the boost to manufacturing.
A competitive devaluation of the pound would lead to a windfall for our manufacturing economy as exports become cheaper. Contrary to urban myth and legend, we do make stuff (manufacturing is 12% of the economy and the UK is good at making cars, jet engines, chemicals and military hardware). Carney could use Open Mouth Policy to talk down our Winston Churchill branded currency (slogan “I have nothing to offer but blood, toil, tears and sweat”), or failing that intervene by printing pounds and selling them to buy foreign currencies. We could even end up with our own Sovereign Wealth Fund! Again there is a “but”. It feels like the Bank of England already tried this, and realised that it wasn’t going to work – trade weighted Sterling fell by 7% in January and February this year before Mervyn King stated that “we’re certainly not looking to push sterling down…we’re moving to a properly valued exchange rate. I think we’re probably there”. The problem is that whilst manufacturing is important, consumption is much more so. Morgan Stanley research shows that contrary to popular opinion, UK manufacturing barely benefits from declines in the pound. And rising import prices as a result of a weaker pound mean that inflation rises, which means that real incomes fall, which means that consumption falls. And as the consumption impact is greater than the manufacturing boost impact (negligible), the impact of a weaker pound on the UK economy is negative.

3 You may be the boss, but the only power is in voting last and thus having a deciding vote.
And right now 6 out of the 9 MPC members don’t want to do more monetary stimulus. You could be in the minority forever, although a prudent Governor probably realises that this kind of split might be damaging for perceptions of stability – not what you want when foreigners are net buyers of on average £6 billion gilts every month. The Canadian monetary policy framework is based on “consensus” rather than voting – my gut feel is that this delivers more power to senior Council members in comparison to a straight vote.

4 If there was a chance to review the Bank of England’s remit from the government to make it significantly more pro-growth, it may have gone.
In the March Budget, George Osborne set out a new remit: “the new remit explicitly tasks the MPC with setting out clearly the trade-offs it has made in deciding how long it will be before inflation returns to target”. He is also changing the timing of the exchange of letters between Chancellor and Governor when the inflation target is breached. And he asked the Bank to review its communications policy (it “may wish” to provide forward guidance). But Osborne didn’t wait for Carney to arrive before changing the remit and given the market’s expectations of a much more pro-growth Governor arriving (helped by Carney’s Nominal GDP speech to the CFA Society of Canada in December), these remit changes feel modest. Perhaps the only hope for a more radical Bank comes with that potential change in communications strategy – does that open the way for statements linking future rate hikes to sustained GDP growth rather than just inflation changes?

5 And finally, the UK is not Canada.
Our banks are broken (Canada didn’t even have an official bailout during the credit crisis, although some speculate there was significant support through the state mortgage agency the CMHA). Our biggest trading partner is broken (Canada’s biggest export market is the US, which is far stronger than the Eurozone). Our natural resources are in decline (North Sea oil is producing 1.5 million barrels per day compared with 4.5 million in 1999; Canada is the world’s largest uranium and hydro-electricity producer, and the world’s fifth largest energy producer in total). And most importantly Canada had its fiscal crisis in the 1990s. S&P cut it from AAA to AA+ in 1992 triggering a consensus amongst politicians to reduce the national debt burden. Debt/GDP peaked in 1996 at around 70%, and by 2002 Canada was AAA/Aaa again. The UK is in a very different economic position, and one with substantially greater fiscal headwinds than those experienced by Mark Carney during his time in charge of Canada’s central bank.

But it’s not all bad news. Although there are clear limits to what Mark Carney will be able to do, he might have luck on his side when it comes to timing. To quote Deputy Governor Paul Tucker, who spoke last night, “looking over the past year (the UK economy is) perhaps not as bad as the headline figures suggest…I think there’s a long way to go but there’s certainly reason for hope”.

Peripheral Europe is still facing a debt crisis, despite appearances

Posted on 26 April 2013 by Mike Riddell

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).

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:

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
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
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.

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.

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.

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.

Lessons from Zimbabwe

Posted on 19 April 2013 by Nicolo Carpaneda

Stefan took some time off over Easter for a quick holiday in Zimbabwe and, as always, he remained on the lookout for economic insights.

As the only country to experience hyperinflation this millennium, Zimbabwe can certainly provide valuable lessons. From late 2008 its inflation was estimated to be running at a staggering 489,000,000,000% on an annual basis. The economy collapsed, and the population suffered food and fuel shortages, amid a mad dash for foreign currency.

Zimbabwe’s experience is particularly pertinent at a time when central banks are experimenting with unprecedented levels of monetary easing. At times, politicians may view inflation as a convenient way to reduce exorbitant debt burdens but inflation is a dynamic force and Zimbabwe’s cautionary tale teaches us to be careful what you wish for…

20/20 hindsight – looking at three year government bond market returns

Posted on 18 April 2013 by Anthony Doyle

Investors in government bonds – historically seen as a low volatile and safe asset class – have had to get to grips with assessing credit risk as well as duration risk in their portfolios. It is simply no longer the case that investors can safely lend to a government without first assessing the government’s willingness and ability to pay back the borrowed sum. This has had a large impact on government bond market returns over the past three years, the results of which are shown below.

Given the fall in yields in developed bond markets, it is unsurprising to see long duration assets like UK index-linked gilts and government bonds performing very well. For example, a broad based measure of the UK index-linked market has generated a 40% total return for investors since the end of March 2010. This is despite the UK losing its prized AAA credit rating this year. Even more surprising is the fact that the big buyer in the gilt market – the Bank of England – has not spent a single penny on a UK index-linked gilt. To date, all £332bn of government bond purchases have been in the gilt market. One investor that did buy index-linked gilts was the Bank’s £3bn pension fund, which had a 95% allocation to index-linked gilts and corporates as at February 2012.

Looking elsewhere, those that were willing to take some credit risk were handsomely rewarded in European government bond markets. For example, investors in Irish debt generated a return of 25% over the past three years. This compares favourably to Europe’s true “risk-free” asset, German government bunds, which generated a total return of 19%. That said, it was not all smooth sailing for peripheral bond investors. Just ask investors in Greek debt, who suffered a 40% loss. Investors in Cypriot government debt fared somewhat better, losing 6% over the three years. Unfortunately for investors seeking protection from Italian inflation, Italian index-linked government bonds generated a return of only 6%. This was below the increase in Italian inflation of 9% over the three year period and is the result of investors becoming more pessimistic about the Italian growth outlook.

Overall, the gold medal for government bond 3 year returns goes to the Philippines with equity-like performance of 64%. The bond market has benefited from purchases by foreign investors, largely due to its relatively strong fundamentals. The combination of a relatively high yield, strong growth and low inflation has been a magnet for government bond investors.

This analysis isn’t much of a guide for what is going to happen over the next three years. Going back to March 2010, I can’t remember many forecasting that Ireland would outperform Germany in government bond markets or that UK linkers would outperform their Italian equivalents by over 30% . So should we be worried about what the consensus is saying now? Isn’t 20/20 hindsight a wonderful thing.

Old Lady sells her bonds

Posted on 15 April 2013 by Richard Woolnough

Back in 2009 the Bank of England (the Old Lady of Threadneedle Street) began buying a portfolio of investment grade bonds to provide funding to UK corporates, to aid liquidity in the corporate bond market and to supplement their QE purchases of gilts. Last Friday this investor sold its last corporate bonds.

This has been a great success from a profit point of view. The attached chart shows the total return of an index of non-financial corporate bonds over the period of the bank’s purchases and sales as well as an indication of their total holdings.

I believe its actions helped stabilise the corporate bond market in the UK by providing a backstop bid, therefore helping to reduce the cost of funding at the margin for issuers, and would have added to the effects of QE. However, empirically measuring these effects is hard to do – corporate bond markets that experienced no domestic support from their central banks appear to have performed similarly, and the debate on the true effectiveness of QE remains.

What is the primary lesson we have learned? I think it is that state intervention can work where markets are priced inefficiently. This is illustrated by the large profits the bank has made by buying an out of favour asset class from the private sector. It is probably a good base to have the state intervene where markets are inefficient, for example in areas such as healthcare, defence, law and order, and infrastructure. The danger comes when the state interferes to the detriment of an efficient market. From an economic point of view, aggressive trade barriers are the first thing that comes to mind where there would be a great deal of consensus from the left and right side of politics. Other actions may depend on your economic or political view. The best current example of this is the single European currency experiment. Does it aid a free market via price transparency and low transaction costs, or does it hinder efficiency by having one single interest rate and exchange rate for such diverse economies ?

The Old Lady’s portfolio of corporates has served her and the UK well because she bought them at cheap levels from distressed sellers. Unfortunately, this investor has a significantly bigger portfolio of gilts. The carry and mark to market on these looks great. However, turning this unrealised gain into a realised profit still remains a challenge. If she comes to sell, her position is likely to drive the market against her.

Should we worry about recent rises in capacity utilisation?

Posted on 28 March 2013 by Wolfgang Bauer

In recent years the use of capacity utilisation (CU) as a leading indicator for inflation, and hence for interest rates, has fallen somewhat out of favour. The large amount of spare capacity in the developed world in 2009-10 failed to translate into the substantial deflation that many had anticipated. Most economists and investors are eagerly focussing on U.S. labour market data instead, given that the Federal Reserve has tied its interest rate policy to an unemployment rate threshold of 6.5%. So, is it time to throw CU into the dustbin of economic history once and for all? This might be premature; ignore CU at your own peril.

Every month the Federal Reserve Board produces a CU percentage figure for industries in manufacturing, mining and utilities by essentially dividing actual output by capacity, i.e. a maximum sustainable output level. In general, capacity figures are derived from physical product data from government and trade sources or, if actual product data is unavailable, from responses to the Bureau of the Census’s Quarterly Survey of Plant Capacity. The basic rationale behind using CU figures as a leading inflation indicator reads as follows: in economic boom times factories tend to bring their output closer to full capacity, which places growing strains on their goods-producing capital. Excess demand and lack of supply, in combination with failure of stressed equipment, can lead to product shortages, sparking price increases and inflationary pressures. A more detailed explanation can be found in chapter 4 of Richard Yamarone’s book “The Trader’s Guide to Key Economic Indicators” from 2012.

Prior to the financial crisis in the late 2000s, the Fed apparently followed this line of argumentation. As the first chart shows, major hikes in the Federal Funds Rate, e.g. the January 1994 and July 2005 rate hiking cycles, marked by white dotted lines, followed periods of rising CU numbers. However, from 2008 onwards this relationship has clearly broken down. Although CU has risen by more than 11 percentage points from 66.9% in June 2009 to 78.3% in February 2013, the Fed Funds Rate has been kept close to zero. One could argue that despite this remarkable CU growth, i.e. reduction in spare capacity, in recent years the absolute CU level is still below the psychologically significant 80% threshold. For instance, the 1994 rate hike, and the subsequent “death of the bond market”, began at a considerably higher CU level of 82.4% (January 1994). However, I do not find this argument particularly convincing, considering that the Fed’s most recent major rate hiking cycle started at a CU level of only 77.9% (July 2004), 0.4% below the current figure.

Another aspect worth exploring is the relationship between CU and business investment spending. Maybe U.S. companies have simply slashed their investment plans and decided to run down their plants and equipment after the financial crisis, scared to invest their cash safety blankets. In this case, rising CU numbers would merely be an artefact and no indicator for economic recovery and inflationary pressure. The second chart shows both CU and quarter-on-quarter (qoq) changes in non-residential fixed investment for 2009 onwards. With increasing CU figures, investment changes get less negative in 2009 before they enter positive territory in Q1 2010. Throughout the following three years, business investment has grown in 10 out of 12 quarters. Slightly negative qoq changes of -1.3% and -1.8% were recorded in Q1 2011 and Q3 2012, respectively. It should also be noted that the decline in qoq investment changes from Q3 2011 to Q3 2012, which was addressed in a Wall Street Journal article from November 2012, has come to an end by jumping to +8.4% in Q4 2012. Considering this pattern of investment spending, recent CU increases cannot be explained by cut backs in business investment. Therefore, I believe that the rise of CU is indeed a strong sign for an ongoing recovery of the U.S. economy.

In conclusion, although at the moment the Fed seems to be preoccupied with the unemployment rate, I believe it is worthwhile keeping an eye on CU. If CU continues to rise, while being backed up by growing business investments, this would indicate inflationary pressures too strong to be forever ignored by the Fed.

Beware the demise of the Hungarian forint

Posted on 27 March 2013 by Tolani Benson

Guest contributor – Tolani Benson (Financials/Sovereign analyst, M&G Credit Analysis team)

Hungary has a substantial amount of debt outstanding – the IMF estimates levels were around €75bn at the end of last year, corresponding to 74% of GDP. Its local currency debt makes up a decent proportion of emerging market indices, constituting a not insignificant 4.6% of the widely used JPMorgan GBI-EM Global Diversified Index. A drop in Hungarian government bond values and/or the Hungarian forint means a drop in the index.

Not an EM investor? A substantial proportion of Hungarian sovereign debt is also owned by its banks, which are themselves owned by the Western European banks you may be more familiar with. Hungarian government bond holdings at three of Hungary’s biggest foreign owned banks were equal to between 10% and 25% of their parent banks’ tangible common equity at YE 2011 (2012 data isn’t out yet for the Hungarian banks). These three large parent banks have all had to receive bail-out capital from their respective governments since 2008 – a writedown of their Hungarian government bonds would not be a minor event for any of them. Appetite for recapitalising banks in the Eurozone is moving increasingly away from government capital injections towards bailing in unsecured senior and subordinated creditors and uninsured depositors, as we have seen with this week’s debacle in Cyprus.

So what is going on in Hungary? Hungary’s currency, the forint, has always been a high beta version of the euro (see chart), but it has significantly underperformed since mid-October, plummeting 10% against the euro. And on Friday we saw the forint reaching a 52-week low after S&P changed their outlook on Hungary to negative (currently rated BB by the agency).

Some may argue that for a highly indebted nation suffering from a stagnant economy, a devaluing currency should be a good thing – Hungary becomes more competitive, economic activity picks up, government revenues increase, the deficit decreases, and government debt levels fall – great.

If only things were that simple. Forint weakness is a serious problem for Hungary. It has huge amounts of foreign currency debt across the whole economy; the government, its citizens, and corporations. The weaker the forint becomes the more expensive it is for both the public and private sectors to service their debts. Plus, almost half of the government’s local currency debt is held externally (see chart), making it extremely vulnerable to sell-offs in the forint. If foreign investors pull out, Hungary’s funding costs will soar and the country will struggle to refinance. The ECB puts the Hungarian economy’s gross external debt (i.e. any liabilities held by foreign creditors, including foreign owned domestic debt) at almost 130% GDP. Economists Reinhart and Rogoff in their paper ‘Growth in a time of debt’ have estimated that growth is significantly impaired when external debt is beyond 60% of GDP, and growth rates are halved above 90% of GDP. In their 2003 study with Miguel Stevanso, ‘Debt intolerance’, they also found that when external debt to GNP ratios are above 30-35% in emerging market economies, there is a substantial increase in the likelihood of a credit event. Hungary is well beyond these threshold levels, which should set alarm bells ringing.

Though the weak forint has helped Hungary’s trade balance, it is not enough. Despite posting a trade surplus of €6.8bn in 2012, GDP contracted by 1.5%. Unemployment is high and rising, reaching 11.2% in January this year. Hungarian businesses have been stifled by the credit crunch that has come about as a result of the government’s measures to reduce its citizens’ foreign currency debt burdens by writing off huge amounts of individuals’ debts, forcing losses onto the banks and restricting their ability to lend. And herein lies the root of most of Hungary’s problems; government policy.

Since taking power in 2010, the current government has been chugging out reams of controversial and counter-productive policies whilst making countless changes to the constitution. Such behaviour has been making investors uncomfortable, causing the forint to devalue. The business environment in Hungary is far too volatile to attract external investment – the key to growth – due to constantly changing regulation, heavy industry levies, and the possibility that the government may nationalise private corporations. Economic policy has been questionable, relying more upon one-offs such as the highly contentious appropriation of citizens’ private pension fund assets onto the government balance sheet, and much less upon vital structural change. Attitude towards the IMF since requesting a bailout loan in 2011 has been confrontational, with various government departments dismissing any need for assistance. The government started publishing anti-IMF propaganda in local media portraying the IMF as a threat to the country’s sovereignty. Unsurprisingly, any IMF deal now seems to be off the table.

Even more troubling than the government’s handling of the economy are the changes it has implemented at key institutions. It has thrown out the independence of the central bank by taking control of appointments, dismissing independent members, and placing the government’s former Economy Minister in the top seat as Governor, and in the process replacing the hawkish former governor, András Simor, who consistently resisted government attempts to influence monetary policy. The most concerning change is doing away with the Constitutional Court’s ability to perform its intrinsic function. Its power to overrule legislation that is deemed unconstitutional has been removed, so that it may only object on procedural grounds. This also allows any previous rulings by the Constitutional Court to be thrown out, effectively allowing the government to undo work done by the court to protect Hungary’s citizens in the past.

Being a member of the EU, Hungary’s actions have not gone unnoticed, but as yet appear to be unpunished. Hungary is like the naughty student that gets called up to the headmaster’s office every day – only the headmaster is the EC, and rather than silly classroom pranks, this bad behaviour is much more concerning. Should the forint continue its gradual demise it is the Hungarian citizens that suffer with a stagnating economy, a credit crunch, and the gradual withdrawal of their human rights. They will also have to deal with the long period of painful austerity that is inevitable when the IMF eventually has to pick up the pieces after years of terrible policy decisions have run the country into the ground. If that IMF assistance involves restructuring of sovereign debt, it is also the holders of EM debt and creditors of some large Western European banks that may be feeling the pain.

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