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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.


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**.


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.


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.


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.


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
  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.


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.


1For a more complex example of score betting on World Cups, see
2For an empirical discussion of emerging market carry trades, see
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.


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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Asian currency wars; is China really the ‘currency manipulator’?

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

CNYJPY spot exchange rate


Why we love the US dollar, and worry about EM currencies

The US dollar has been one of the worst performing currencies in the world in the last decade, but we think it is ripe for a rally. We expect the US dollar’s correlation with risky assets to steadily change (in fact this is already happening). We believe that the US monetary policy transmission mechanism is actually working fine. We are bullish on US growth, particularly in relation to other regions. The Federal Reserve appears behind the curve, but a number of policy makers are increasingly realising this. And following a prolonged period of big underperformance, the US dollar is looking fundamentally cheap, especially in relation to some emerging market currencies.

The main push back we hear regarding our bullish US dollar view is that by being long US dollar you’re basically being short of risky assets. Lately this has been true; the US dollar has tended to rally sharply when large banks are blowing up or the Eurozone is threatening to fall apart, and has tended to perform poorly when everything looks alright again.

However the US dollar has not always had this risk on/risk off (“RoRo”) characteristic. The first chart below plots the US Dollar Index (a general international value of the US Dollar) against the MSCI World equity index, and the chart immediately following shows the rolling two year correlation of the two indices with some rough annotations (usual causation/correlation disclaimer applies).

It’s noticeable that the RoRo qualities of the US Dollar have weakened in the last two years, presumably on the back of a broader risk rally at a time when investors and central banks have been dumping/diversifying away from euro denominated assets. Going further back, it’s also apparent that the US dollar has not always been a ‘risk off currency’, where a major factor appears to be Fed Funds rate cycles.

The US dollar has definitely not always been a 'risk off' currency

On the point of Fed Funds rate cycles, we think that the Federal Reserve continues to be behind the curve, or following the Federal Reserve’s change in communication, it’s perhaps more accurate to say that the market is behind the curve. We spent much of last year discussing how the US housing market was starting to take off (eg see here), which is evidence that the monetary policy transmission mechanism is no longer broken. But it’s interesting to consider the chart below – wherever the Fed Funds rate has gone in the last four decades, unemployment eventually follows. The shock to the US economy in 2008 was obviously huge, but this cycle doesn’t actually look that different to previous ones.

The current trajectory suggests that the US unemployment rate could hit 6.5% sometime in the middle of next year, an eventuality that would surely see US Treasuries sell off violently. There are eerie echoes of 1994, when the Fed hiked rates from 3% in January 1994 to 6% in February 1995 with very little prior warning; investors were caught with their pants down and markets were given a jolly good spanking (the 10 year US Treasury yield had fallen to 5.2% in late 1993 but a year later peaked at 8%).

It’s likely that the US dollar would appreciate as US yields jumped if you assume that hikes in the Fed Funds rate won’t be replicated around the world. This seems a relatively safe assumption given the Japanese devaluation rhetoric and continuing mess in Europe (Eurozone unemployment recently hit a record high of 11.5%, while the UK is likely to have experienced negative growth in Q4). That said, the US dollar surprisingly depreciated versus the Japanese yen and a number of European currencies in 1994, prompting then Fed chairman Alan Greenspan to state that the US dollar was weaker than it should be – Greenspan’s wish was granted from 1995-2000 though, as the US dollar was supported by factors such as high relative real interest rates, a US productivity surge, EM crises and Japanese stagnation.

Wherever US Fed Funds rate goes, unemployment follows (eventually)

Another plus point for the US dollar is that the horrendous performance of the currency over the last decade has left the US economy looking competitive. Last February I wrote about how some manufacturers were moving operations from China to Mexico to take advantage of the dramatic increase in Mexico’s relative competitiveness (see here). I’ve since heard a number of anecdotes – admittedly the weakest form of evidence – about manufacturers also relocating back to the US.

The conclusion from the chart below is that such behaviour makes a lot of sense. It shows the relative performance of real effective exchange rates, which is a measure of a country’s trade weighted exchange rate adjusted for inflation. Real effective exchange rate measurement is imprecise since inflation data can be unreliable (eg Argentina) and calculations can vary depending upon the particular measure of inflation used (eg CPI, PPI, export price indices, core inflation, unit labour costs). The starting point can also make a lot of difference when using a time series – I’ve chosen 1994, which is immediately after China’s 50% devaluation*, but before the Latin American and Asian financial crises.

But while the absolute level of some of the exchange rates in the chart below need to be treated with a pinch of salt, the direction of travel should give a relatively unbiased view. The US dollar (thick red line) is looking very competitive versus the majority of emerging market currencies.

US dollar is looking very competitive against many EM currencies

Meanwhile a surprising – and worrying – aspect of the last year has been that emerging market FX reserve growth appears to have stalled. Part of this can be explained by weaker global demand resulting in weaker EM exports. Part of this can be explained by EM countries gradually rebalancing their growth models away from exports and towards domestic consumption, the result of which means a narrowing of the global current account imbalances.

However, lower FX reserve growth is not at all consistent with EM countries continuing to receive large Foreign Domestic Investment (FDI) and record portfolio inflows – you’d expect to see reserves jump. And neither is lower FX reserve growth consistent with the US dollar’s performance over the past year – a slowdown in FX reserve accumulation is typically synonymous with US dollar strength because FX reserves are typically measured in US dollars, and non-US dollar denominated assets would fall in value when measured in US dollar terms. Yet the US dollar has been broadly flat and if anything weaker over this period.

It is a very dangerous combination to have flat or falling export growth (see previous blog) combined with flat or falling FX reserve growth combined with a significant appreciation in real effective exchange rates. In a study of prior academic literature, Frankel and Saravelos (2009) find that measures of FX reserves and real effective exchange rates stand out as easily the most important lead indicators of financial crises. Note that other lead indicators with strong predictive powers were found to be credit growth, GDP and current account measures, and a number of EM countries are looking shaky on these measures too.

Concerns around stalling FX reserve growth are tempered by the fact that reserves in many countries are at or close to record highs. But while high levels of FX reserves do act as a cushion for the individual country during a crisis, FX reserve accumulation can also have significant downside risks for the individual country (eg real estate bubbles, credit bubbles, misallocation of domestic banks’ lending – sound familiar?). Much has also been written about the risks to the global financial system** as a whole and I’d recommend this 2006 ECB paper for a good overview. I’d add that while countries with high levels of FX reserves allow countries to weather crises better, they don’t make countries immune to crises; despite high levels of FX reserves, Taiwan still saw its currency slump 20% against the US dollar in 1997.

When is the US dollar likely to appreciate, or EM currencies depreciate? EM debt crises since the 1980s have tended to follow periods of rising Fed Funds rate and/or US dollar strength, so this would suggest it’s not imminent. However I was presenting at a conference last month and found a kindred spirit in CLSA’s Russell Napier, who has near identical concerns about EM debt, and his view is that there have been many examples where bubbles have burst before the risk free rate rises – domestic overinvestment, lending to poor credits, commodity price declines and capital exodus can cause debt crises independent of external factors.

Either way, the reason that EM FX reserves are not increasing (see charts below) at a time when EM currencies aren’t strengthening seems most likely to be because EM currencies are at best no longer cheap, and at worst have become overvalued. Which is another reason to like the US dollar right now.

Asian FX reserve accumulation has ground to a halt


Latin America FX reserve growth has weakened

* China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade now than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way? A counterargument could be that a big yen sell off would encourage Japanese savings to flood into its trade partners’ capital markets – capital controls meant this wasn’t possible following China’s devaluation.

** Ben Bernanke’s global savings glut hypothesis argues that excess global savings have been responsible for lower government bond yields. The fact that EM FX reserves have stalled suggests that these countries have not been net buyers of US Treasuries in the last year. The baton had been taken on by countries such as Switzerland and Denmark, whose FX interventions to maintain their respective currency pegs resulted in rapid FX reserve increases and strong support for core government bonds, but upwards pressure on these countries’ exchange rates has recently greatly reduced and their reserves are no longer growing either. That really just leaves the GCC countries, whose FX reserves are largely a function of the oil price. Yields on core government bonds would presumably therefore be significantly higher were it not for large scale domestic central bank purchases.

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Asian economic slowdown and the EMD bubble

Last month I commented on the long term headwinds facing Asia and tried to cut through the sales cheese (see here). The last few weeks have seen more evidence of a slowdown in Asia, and seemingly more people buying into the EMD story as valuations in a number of countries have hit extremely expensive levels. Taking one example, in the middle of last week the $2.25bn issue of Peru 7.35% 2025s reached a yield spread of 109 basis points over US Treasuries. Liquidity on the bond is not fantastic, with a bid-offer spread of 1% on screens, implying that over a one year time horizon the yield spread is an illiquidity premium, with almost zero credit risk priced in. Spreads are reaching levels of the super liquid days prior to 2008. Bubbletastic.

Some charts below.

Australia’s economy appears to be struggling, with the Australian Dollar pushed higher by speculative inflows.

Many of the countries reliant on exporting to China are seeing flat or negative export growth year on year.

As discussed last month, Chinese growth has been highly dependent upon excessive investment growth. This has been driven by construction, which has been reliant on steel. So it’s interesting that steel prices have fallen 25% in the last year in China.

And finally the current bubbletastic spread levels on emerging market debt.


Emerging market debt is ‘cool’ – but you may be surprised what you find if you strip away the marketing myths

EM debt is a bit like Converse shoes; it seems almost everyone I speak to owns some.

Readers will no doubt be familiar with the EM ‘grand narrative’ (eg EM will surely outperform because of low debt levels, high growth, strong demographics etc etc). We’ve written an in-depth note, which is part of our Panoramic series for professional investors, in an attempt to bash away this EM ‘grand narrative’. You can access the Panoramic using this link.

It explores what really have been the primary performance drivers of the three main investable subsets of EM debt (EM local currency sovereign, EM external sovereign, EM external corporates). It touches on themes I’ve previously written about on the risks to EM debt posed by Eurozone instability and the associated risks posed by a reversal of the huge decade-long portfolio flows that have supported the asset class. But the main focus of the note is on the sizeable additional long term risk posed to EM debt by the inevitable economic rebalancing of the world’s second largest economy – China.

EM debt is still ‘cool’ within the investment universe. However, it’s curious that people now say EM debt is a good investment ‘in the long term’, a subtle change brought about by the miserable performance of some EM countries over the past year. This miserable performance has been most notable within the BRIC economies* , where in recent months, the Brazilian Real and Russian Ruble hit three year lows against the US Dollar, the Indian Rupee hit a record low against the US dollar, and this year the Chinese Yuan has had the biggest drop against the US dollar since its big devaluation in 1994.

I’m not saying that EM debt will never offer good value; it’s important to stress that there is no such thing as a good or bad asset class, only a good or bad valuation. I’m simply saying that it’s important to understand the performance characteristics of EM debt, the risks facing EM debt appear to be rising, and while some exchange rates have begun to move, the asset class does not appear to be pricing in these risks. Fashions rarely last – EM debt has been very trendy before, but favourable demographics and previously strong growth rates didn’t save emerging markets in 1981-3, 1997-98 and 2001-02. And Converse shoes haven’t always been ‘cool’ either – Converse had to file for bankruptcy protection in 2001 and ended up being bought out by Nike.

* Societe Generale’s Albert Edwards has amusingly and rightly described BRIC as a ‘Bloody Ridiculous Investment Concept’

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Should Europe let the single currency go to save the Union?

Today is the day on which football is going to meet the Eurozone crisis when Germany and Greece compete in the Euro Cup’s quarterfinal. Spectators will be watching closely any gestures by Angela Merkel sitting in the stadium next to other political and executive representatives, any behaviour (and banners) of both team’s supporters inside and outside of the stadium, and any appearance and words of the squads on the pitch and during the post-match interviews. The fact that much of the recent news coverage has been centred on the political dimension of this match shows once more the polarised times in which we’re currently living. A match that, frankly speaking, has never been a big deal for either nation before, suddenly has turned into a highly emotional act about success, respect and even dignity, according to some commentators and officials. Nowadays European integration looks more and more like a very complex theory whose (successful or unsuccessful?) proof might turn out to be one of the biggest challenges of the 21st century. Interestingly, I will have insider status tonight. Being a German watching this match in the European capital of Brussels, the main hub for European bureaucrats, politicians, enthusiasts and sceptics, this experience will be insightful. Let’s see in which way, given that my past experiences in Brussels made it feel rather like a bubble than a true reflection of common sentiment.

Knowing that I’m going to be in Brussels this weekend and having spoken with many of my peers who work for institutions and companies closely related to the European Union, I couldn’t really stop thinking about the political dimension of the Eurozone crisis. I asked myself the question “if the European Union is particularly a political project or even a political and economic project which was meant to develop both political stability and economic prosperity, can’t one possibly argue that it does currently not only fail on the economic dimension (as argued before), but also on the political dimension?”

Why is this? My first thought is this. If the euro is interpreted as a continuation of the European integration process which by nature was about

  • preventing a dominant state in Europe after the second world war which is able to dictate the fate of the continent
  • enhancing social and economic mobility and establishing a European identity
  • supporting democracy and, consequently, making democratic institutions an inevitable pre-condition to any membership,

then don’t we find ourselves currently in a situation in which the single currency union has led to a failure of delivery, given that

  • Germany appears to dictate the agenda and appears to be the elephant in the room
  • we’re seeing increasing nationalist tendencies in parts of Europe, and negatively polarised sentiment towards fellow member states
  • Italy, founding member of the Union, empowered a non-democratically elected prime minister (incl. a technocrat government) to run the country for around 1.5 years, assuming that the next general elections will take place in April 2013?

My second thought is about the legitimacy of any further European integration (fiscal union, Eurobonds, political union) which is currently being discussed as part of the solution of the crisis. If the European project is also defined around the lines of democracy, a value which is primarily promoted, isn’t there still a long way to go for politicians in order to convince the electorate that further integration is actually what they want, given that

  • the electorate in parts of Europe is not prepared for the idea to bail out other countries, i.e. share the burden
  • a common European identity is apparently not reality
  • social and economic mobility is far away from being fully fluid, and current political discussions at the national level across Europe rather suggest a decreasing tendency in the light of talks about the part suspension of the Schengen agreement.

The third thought to conclude the argument is about the nature of integration and, consequently, the European Union. Isn’t European integration rather something ex post than ex ante? That is, it is not the idea that you force upon someone, but rather a process facilitated by institutions and paced by the electorate at whose end integration is concluded. Institutions and electorate interact closely during the process, and one cannot really deviate too far from the state of development, from the ‘mind set’ of the other because then it turns into an unhealthy relationship in which legitimacy and accountability become problematic. That is, the formalisation of political union may require a common sentiment, a common identity in this direction first before a new treaty should enact it.

But what could be the pre-requisite of further integration? Away from all the economics, I think that Wilhelm von Humboldt, the German philosopher, has a point by saying that a language draws a circle around a nation, deciding upon inclusion and exclusion. Going back in history, isn’t one of the main differentiating factors between the United States of America and the idea of a United States of Europe that the separate states of North America emerged as satellite states of a single country – Britain – whose language, culture and legal system built the shared founding ground, as Tony Judt argues in ‘Postwar’?

If the European integration process was to resume in political union at one point in the future, shouldn’t we start to acknowledge that the electorate isn’t ready for this step yet and, equally importantly, that we’re currently jeopardising this prospect? There may be some valid economic arguments for steps to more integration, but the political arguments don’t seem to be matching this. European integration has been on the fast track over the past decades, and much of it has shaped the interaction of states, companies and individuals across countries very positively. But the Eurozone crisis also seems to show that the electorate might not have kept up with the institutionalisation process. A full political union looks to me like something bigger than an emergency solution to a financial crisis. There is another dimension to it defined by identity and democratic legitimacy. If the Eurozone crisis jeopardises, rather than facilitates, further integration on both dimensions, politically and economically, wouldn’t it be sensible to take a step back (euro break-up?) in order to overcome the structural imbalances, allow for slower, but more persistent structural alignment, and a less heated atmosphere in which a more shared identity can flourish? It is likely that a break-up will have adverse effects in the shorter term, but isn’t there the possibility that it could lay the ground for a stronger subsequent economic, political and social recovery and, consequently, mark two steps forwards towards political stability and economic prosperity in the long term? That is, let one project go (optimists might argue here “put on hold”) in order to ensure the survival of the bigger one.

Fingers crossed that Germany wins tonight – and Europe succeeds as a project in the long term.


German government bond yields may need to get very negative for the euro to weaken much further. And it could easily happen (update)

In January I argued that negative German government bond yields would be a rational response to the rising probability that the euro breaks up and Germany reintroduces the Deutsche Mark (see here).  This was because German government bonds have significant optionality.  Assume that the Eurozone is forced to reintroduce national currencies – if you are living in Spain, then a German government bond yielding -0.5% won’t necessarily provide the investor a -0.5% return if held to maturity, it could result in a capital gain of perhaps 40% since the Deutsche Mark would significantly appreciate versus the new Spanish Peseta.

German 2 year government bond yields did indeed turn negative on May 31st, while 2 year US Treasury yields have remained little changed since January.  The euro has weakened so far this year, and the correlation that I discussed in January has continued to hold reasonably well.  The chart below is an update from January’s blog comment.

German government bond yields have sold off in the last two weeks, prompting speculation that Germany is becoming the next Eurozone country to be hit by the bond vigilantes.  I disagree, and believe this is much more to do with profit taking of some very long positioning ahead of Greek elections.  The investor base seems to have moved from extremely overweight Germany to very overweight Germany.  As is always the risk with such crowded positions, the sell off that began at the beginning of June resulted in a number of banks and leveraged investors falling over eachother stopping eachother out, leading to a further sell off. It is reminiscent of the last notable wobble in Germany that occurred in November following a weak German auction, but it didn’t take long for the bund rally to resume back then.  The long term trend of deposit and capital flight from Southern Europe to Northern Europe remains in place as investors become increasingly concerned of the risks of Eurozone breakup, and this should continue to support German government bonds.

How negative can German government bond yields get?  It’s interesting to look at Switzerland, where five year government bond yields are now negative, i.e. if you want to buy 5 year Swiss government debt, you have to pay them for the privilege.  The reason for negative bond yields in Switzerland is all to do with growing speculation that the Swiss franc peg against the euro is unsustainable (or the euro will cease to exist), and in the event that it breaks, investors would realise a potentially large capital gain in owning Swiss government bonds. In a similar way, Denmark 10 year government bonds yield 10 basis points less than German government bonds of the same maturity since presumably if the Eurozone begins to splinter then one of the first things to break would be the Danish krone peg against the euro.   As Eurozone stress increases, German bund yields could easily become very negative, and across the whole yield curve.


♥Mexico♥ – a rare ‘EM’ country that we love

I’ve always had a problem with the standard narrative that you hear about emerging markets (EM). Investors are constantly hearing, or telling, stories about how you must have exposure to EM because these countries have much stronger growth rates and prospects than the developed world, how EM countries have far superior demographics, or how EM countries have much lower public/debt to GDP ratios. An example I like to provide that exposes these myths is to consider a country that has grown 6.2% per annum for 10 years, has decent demographics, has a public/debt GDP ratio of less than 40%, and just to cap it all off has a world class education system and strong political institutions. That country is Ireland in 2007. As the Irish example shows, there are many more important things to look at, not least real credit/GDP growth rates and rapidly rising real estate prices (the two are obviously connected).

The reality is that emerging markets always have been, still are, and will most likely continue to be all about global capital flows. Global capital flows are themselves very cyclical, so when the global growth outlook is improving you find that capital flows from developed markets (DM) to the juicier yields in EM, and EM therefore typically outperforms. When the global growth outlook is deteriorating, capital tends to flow back from emerging markets to developed markets. Hence the comment on this blog in July last year that the market was priced as if EM was a safe haven from developed market woes, and the market was therefore smoking crack.

The EM countries that are particularly exposed to these global capital flows are the ones running large current account deficits, since by definition countries running current account deficits are reliant on capital inflows from abroad to fund themselves.  A ‘sudden stop’ or reversal in these capital flows leaves these countries very vulnerable. We saw this dynamic play out in a big way in 2008, and saw it again last year when DM equities outperformed EM equities despite all the problems being in the Eurozone.  Unsurprisingly,  the countries that saw their currencies get hit the hardest in 2011 were generally those EM countries running large current account deficits – the South African Rand fell 10.5% against the euro, while the Turkish Lira fell 8.6%, the Polish Zloty 6.7% and the Indian Rupee 4.7%.

Another currency that fell quite sharply last year was the Mexican Peso, which tumbled more than 5% against the euro and by more than 8% against the US dollar.  This wasn’t due to Mexico running a large current account deficit (it’s running a small 0.5% deficit).  In fact the Mexican Peso was hammered in 2007-08 too, falling 12% against the Euro and 7% against the US dollar.  Ongoing peso weakness in 2009 was partly Swine Flu related, and the peso’s high beta characteristics probably owe something to it being one of the most liquid EM markets, but whatever the reason the Mexican peso is looking very cheap to us. And it’s not just the currency that looks attractive – in a world of negative real yields, Mexican real yields stand out as being huge (Mexican core inflation is 3.3%yoy, 10 year nominal Mexican local currency bonds, or Mbonos, yield over 6%). These high real yields aren’t because of any concerns regarding credit risk, since Mexico is one of the best quality EM debt issuers – Mexico is actually also considered a developed market, having been admitted to the widely followed Citigroup World Government Bond Index in October 2010. We like Mexico, and were buyers of Mexican local currency bonds earlier this year.

These positive views about Mexico were reinforced recently following a highly informative week in Mexico City, kindly set up by HSBC, where I met key members of the government and central bank to gain a better understanding on economic issues, and where I spoke to pollsters and political analysts to get a handle on Mexican politics ahead of the elections in July this year. Below are the main takeaways.

Firstly politics. Financial markets have a tendency to become very excitable around elections, and this occurs not just in EM countries but in developed markets too.  Almost always this volatility (which is normally volatility of the bad kind) turns out to be unjustified. To cite a couple of examples, consider how Peruvian asset prices sold off sharply last year when left wing candidate Ollanta Humala was voted in, but asset prices then recovered rapidly when markets realised he wasn’t Chavez. And consider the UK in 2010, when asset prices wobbled on political instability fears as it became increasingly likely the UK would have a rare coalition government, but how the UK is now seen (rightly or wrongly) as one of the world’s few ‘safe havens’.

The last general election in Mexico in 2006 was another example of this unjustified volatility. The election saw a near dead heat with the centre right PAN candidate Felipe Calderon defeating the left wing PRD candidate Andrés Manuel López Obrador by fewer than 250 thousand votes, or 0.56% of the vote. As uncertainty escalated in the run-up to the election from February to June 2006, the Mexican peso was the sixth weakest currency in the world and Mexican government bonds performed poorly.  After the election result was announced,  López Obrador, the PRD candidate, reacted by claiming electoral fraud and instigated massive marches in Mexico City, a city in which he was very popular following a successful stint holding a position akin to mayor. After losing in his attempt to get the result overturned, he and his supporters embarked on an ultimately unsuccessful two month blockade of one of the main roads in the heart of Mexico City.

The situation today is very different. The PRD’s López Obrador is running for President again, but despite having a fiercely loyal group of supporters, his behaviour following the 2006 election has cost him significant political capital and he is languishing in third place in the polls. In second place in the polls is Josefina Vázquez Mota, the ruling party PAN’s recently nominated candidate, who is the first female candidate from one of the main parties. But Vázquez Mota too has significant ground to make up on the clear front runner, the chisel jawed Enrique Peña Nieto, who has about 50% of the vote in the polls and is candidate for PRI, the party that held power for over 70 years prior to PAN’s victory in the 2000 election.

Given recent events, though, Peña  Nieto is more than capable of blowing his lead. The strength of his vote among women (who at rallies chant what can loosely be translated as “my chocolate, I want you for my mattress”) was recently called into question after Peña Nieto disclosed that he has had two children during extramarital affairs when married to his now deceased first wife (he has remarried a Mexican soap star, which cynics see as a bit of a publicity stunt). He has recently been accused of being sexist – when asked about the price of tortillas in December he got the answer completely wrong and replied ‘I am not a housewife’. And to add to his gaff prone image, at a recent international book fair where he was promoting his own (ghost written) book, in response to a question on which three books had influenced him, he floundered for a number of minutes before saying the Bible and then mixed up the authors and titles of other books. But even in the unlikely event of Peña Nieto losing his lead before polling day, it’s difficult to see that markets will be ruffled by Vázquez Mota keeping PAN in power – in fact it may even be seen as a good thing.

The strength of the Mexican economy is more obvious than that of its politics. The weakness of the Mexican peso has been a boon to Mexican industry, and auto manufacturers such as Nissan, Mazda, Toyota, GM and Chrysler have been investing heavily in the country. Interestingly ( and this tells you as much about Chinese headwinds as Mexican tailwinds), Mexico is seeing a reversal of what happened in 2001, when companies up and left to go to China. In 2001, Mexican wages were 250% higher than Chinese wages so it made a lot of sense to shift production to Asia, but by 2007 the gap had fallen to 40% and now the difference is only around 10-15%. Today it is much more economical to manufacture in Mexico and export to the US, where 78% of all Mexican exports end up, than to export to the US from China (as an aside, this trend of moving production away from China will have interesting dynamics on shipping rates, or given the recent collapse in rates perhaps it already is having an effect).

The Bank of Mexico (or ‘Banxico’), headed by the highly respected Agustín Carstens, forecasts that the Mexican economy will grow a robust 3-4% this year, and although the recent drought is causing a temporary uptick in headline inflation, core inflation stands close to a record low.  Credit growth is not too hot, and is coming from low levels of penetration.  The economy is in strong fiscal shape thanks to reforms in recent years such as the 2006 Budget and Fiscal Responsibility Law and 2007 Integral Fiscal Reform, and last year’s budget deficit of 2.5% is likely to slightly improve in 2012.  Central government debt remains very manageable.

Mexico has also succeeded in greatly reducing its reliance on foreign currency denominated debt (ie external debt) by maintaining its policy of issuing 80% of its debt in local currency and the remainder in foreign currency.  A side effect of this policy has been foreign ownership of the local currency bond market dramatically increasing to about 44%, although Mexico’s recent inclusion in the Citigroup World Government Bond Index means that unlike in a number of other EM countries, ownership is spread across a diverse number of investors rather than dangerously concentrated in a small handful of large global bond investors.  All of these supportive factors made the central bank’s tirade against the rating agencies that I heard understandable – they had a point when they argued that the agencies’ methodologies are flawed, unfairly penalising not just Mexico but a number of EM countries versus a number of better rated but far less solvent developed countries.  Indeed, judging by the default risk implied by the credit derivatives market, the market has long agreed.

Despite the Mexican economy’s obvious strengths though, many investors remain deeply frustrated that the economy hasn’t performed considerably better given the country’s oil windfall.  In 1971, a Mexican fisherman named Rudesindo Cantarell complained to Mexico’s state owned oil company Pemex over what he thought was an oil spill that was ruining his fishing nets.  Pemex asked Cantarell to show them where this had occurred and it was confirmed in 1976 that the fisherman had found an oil seep from what is one of the biggest oil fields ever discovered (the field’s structure is actually a result of the asteroid impact in the Gulf of Mexico that is believed to have wiped out the dinosaurs 65 million years ago).   At its peak production in 2004, the Cantarell oil field produced 2.1 million barrels per day, which at the time made it the second most productive field in the world after Saudi Arabia’s ginormous Ghawar field.  In 2010 Mexico was still the seventh biggest producer of crude oil, ahead of Norway, the UK, Venezuela (which has the world’s largest proven oil reserves), Iraq and Brazil.  About 35% of Mexican government revenues are from the oil industry.

The worry is that Mexico won’t be able to rely on the oil windfall to anything like the same extent in future.  Production in Cantarell has declined exceptionally rapidly, falling to just 400 thousand barrels per day in November last year.  Mexico could become a net oil importer by the end of the decade, which is ridiculous given the large reserves that Mexico still has.  Mexico isn’t just blessed with oil reserves either – it is estimated to have the fourth biggest reserves of shale gas in the world that has barely been tapped at all, and the sad reality is that Mexico’s inefficient state monopolies are unable to take advantage of this (despite its gas reserves Mexico is importing gas from the US).

This is where Mexican politics meets economics.  Reform has long been slow and it’s becoming urgent.  Reform is most obviously needed in the energy sector (the General Director of the Mexican auto industry specifically cited power as a region where Mexico is not at all competitive) but there is little prospect of anything changing soon because Mexico’s constitution states that all oil and gas belongs to the Mexican state, which is a belief that has been hard wired into the Mexican psyche (Pemex was created in 1938 following the expropriation of foreign owned oil assets).  Inefficiencies are not limited to energy either – whole swathes of Mexican industry, ranging from telecoms to media, are dominated by rent seeking behaviour where the powerful have no incentive to introduce competition and change the status quo.  Reforms require a two thirds majority in congress, which has been historically difficult to achieve and worryingly the front running PRI party have been keen to veto proposed reforms in recent years.

Finally, drugs.  As widely publicised, parts of Mexico have become dangerous with the areas bordering the US essentially lawless.  The Mexican State of Chihuahua and its largest city Juarez were described by government security staff as being ‘worse than Iraq’.  Violence has fallen slightly since the peak in mid 2010, but it’s difficult to argue that the crackdown has been a huge success (although 80% of the population approves of the government’s policies).  Longer term, Mexico probably faces two choices – legalise drugs, or go the route of Colombia and seek involvement from the US military (the second option is far more likely to happen).  In terms of the bigger picture, it’s very difficult to see how the drug problem in Central America can be eliminated.  It’s like squeezing a balloon – Mexico’s drug clampdown has simply resulted in a big escalation of violence in countries where there are fewer resources to throw at the problem such as in Guatemala, Honduras, El Salvador and the Dominican Republic.  Drug cartels are merely trying to meet the big demand that continues unabated from the US, and where there’s demand, there’s supply.

It’s worth putting the drug war in Mexico into perspective though.  Mexico still has a lower homicide rate than Brazil at around 20 homicides per 100 thousand, and murders are much lower than in a country such as Jamaica that has a homicide rate above 50 per 100 thousand.  Furthermore, while the government estimates that areas with major drug issues see economic growth about 2% below safe regions, it’s not apparent that there has been much effect on the Mexican economy as a whole (although given the government is spending 1.5% of GDP trying to combat the problem there is surely some impact).  So while security is clearly an important issue for the population, it shouldn’t be a major influence on the decision whether or not to invest in Mexico.

Overall, the high yields on offer in Mexico more than justify the risks in my opinion, with the caveat as mentioned at the beginning that Mexican assets are subject to global capital flows like any other EM asset.  On this point, though, it’s interesting to note that Brazil’s changing IOF tax policies on bond holdings is encouraging all those yield chasing ‘Mrs Watanabes’ in Japan to look at Mexico as a carry trade alternative to Brazil in the region.  If Japanese investor interest results in even half the Japanese capital flows that have gone into Brazil in recent years then this would be a major boost to not just future Mexican borrowing costs but to the Mexican Peso too.

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