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anthony_doyle_100

“Global greying” could mean getting used to ultra-low bond yields

The developed world is going through an unprecedented demographic change – “global greying”. This change is having a massive impact on asset prices and resources as populations around the world get older and live longer. It is also having an impact on the effectiveness of monetary policy. We would typically expect older populations to be less sensitive to interest rate changes as they are largely creditors. Younger populations will generally accumulate debt as they set themselves up in life and are therefore more interest rate sensitive. The impact of demographics implies that to generate the same impact on growth and inflation, interest rate changes will need to become larger in older societies relative to younger societies.

Turning to the impact of demographics on inflation, labour force growth may provide some insight into the potential path of future inflation or at least give us some guide as to the long-term structural impact of an aging population on inflation dynamics. The theory is that a large, young generation is less productive than a smaller, older generation. As the large, young generation enters into the economy after leaving school/university the fall in productivity causes costs to rise and therefore inflation increases. Additionally, the younger generation is consumption and debt hungry as they start a family and buy homes. Eventually, the investment in the younger generation comes good and there is a large increase in productivity due to technological change and innovation. As consumers become savers, inflationary pressures in the economy start to subside.

The long-term interplay between US labour force growth and inflation is shown below. Inflation lags labour force growth by around two years as it takes some time for the economy to begin to benefit from productivity gains. As US labour force growth rises and falls over time, inflation generally follows a similar trend.

The long-term relationship between US labour force growth and inflation

The second chart looks at the same economic indicators, this time looking at 10 year growth in the labour force against inflation. Interestingly, this chart seems to show that the baby boomers entered into the workforce around the same time as the global economy experienced a supply-side oil price shock. The influx of new workers into the US economy is likely to have contributed to the great inflation of the 1970s. For the next thirty years or so, inflation fell as the economy enjoyed the technological advantages and productivity gains generated by the baby boomers. Looking forward, it appears that long-term deteriorating labour force growth may contribute to deflationary pressures within the US economy.

10 year US labour force growth and inflation

I am not saying that demographics are the only reason that inflation has fallen in recent years. The massive accumulation of private and public sector debt, globalisation and technological change are also secular trends worth monitoring. Rather I believe “global greying” and the impact of demographics on inflation and the real economy is an additional secular trend worth monitoring. Can central banks do anything in the face of this great generational shift should deflation become a reality? Interest rates are at record lows, quantitative easing has been implemented and we are yet to see the large impact on inflation that many economists expected.

Lower interest rates and the yield-dampening forces that exist in the global economy is a topic I previously covered here. In terms of bond markets, deflationary pressures are a “yield-dampener” and another reason why bond yields could remain low for some time and fall further from current levels over the longer-term.

 

Ana_Gil_100

Are wages at the tipping point in the US labour market?

Five years into the US recovery, the labour market is quickly returning to full health. Hiring activity is picking up, employers have added a robust 1.3 million jobs over the past 6 months and the unemployment rate is rapidly approaching a level that could prompt the Fed to start thinking about raising interest rates.  All labour market indicators seem to have improved except for the one that workers should care most about: wages.

Indeed wage inflation has been the key missing piece of the recovery puzzle, and the lack of it appears somehow contradictory in the context of a rapidly improving economy. A valid reason could be that wages are widely known to be a pro-cyclical lagging indicator. An alternative, as Federal Reserve chairwoman Janet Yellen recently pointed out, is that wages didn’t quite adjust enough during the deep recession and will only rise once employers catch up for the “overpayments”.

As the US economic recovery marches on and corporates continue strengthening, the labour market could soon see wage growth begin to accelerate. Economic history has always been a great place to search for clues to future economic performance with the added benefit of hindsight. A look into 30 years’ worth of US labour market data reveals an interesting relationship between headline unemployment and wages, measured by hourly earnings of all employees on private nonfarm payrolls. As is shown in the chart below, wages seem to have historically accelerated whenever the US unemployment rate has touched, or come close to, a 6% level. History may not repeat itself, but it could well rhyme.

Wages seem to have historically accelerated as the unemployment rate has approached a 6% level

With unemployment sinking to 6.1% and nominal wages heading upwards, the US economy could be approaching full employment faster than the Fed may think. What unemployment rate is consistent with full employment is a subject very much open to debate. The Federal Open Market Committee (FOMC) estimates the current non-accelerating inflation rate of unemployment(NAIRU i.e. the level unemployment can fall to without causing capacity problems and demand pull inflation) to be at around 5.4% with concerns around labour underutilisation, but rising wages would suggest it is higher.

A further sign of emerging wage pressure can be found in the forward-looking National Federation of Independent Business(NFIB) compensation plans index, which is best known for anticipating wage increases to small businesses over the next 12 months. This index seems particularly relevant given SMEs (i.e. those with fewer than 500 employees) are the true backbone of the American economy– responsible for creating two out of three net new jobs. The chart below shows the NFIB index has been gaining momentum over the past year and is now at levels last seen prior to the recession.

Uptrend in companies planning to raise compensation

The most recent Job Openings and Labour Turnover Survey (JOLTS) report conducted by the Labour Department shows job vacancies have risen back to pre-crisis levels as a high percentage of employers are having trouble finding skilled workers. To attract the needed candidates, employers are having to raise compensation. Interestingly, comparing the NFIB index with lagged earnings data reveals a strong correlation over time. With the number of firms expecting to raise compensation on a strong upward trend, wages are likely to follow through.

As the labour market continues to tighten, it will not be surprising to see further wage growth build up. Most wage measures (including the widely followed Employment Cost Index and Unit labour costs) are on a clear uptrend today which is likely to continue unless economic growth slows or we were to see a sudden leap in productivity. Back in 1994, when the Fed had just started a series of aggressive rate hikes, US wage growth was only 2.4% YoY. Today, wage growth is 2.5%. Yet, Fed speakers have argued some slack remains in the labour market, hence the need to maintain a very patient policy stance – but could the prospect of rising wages in an economy rapidly approaching full employment be the tipping point that prompts the Fed to change rhetoric?

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mike_riddell_100

The Great British Austerity Myth

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

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

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

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

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

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

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

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French government should push for further tax and labour market reforms

France has a unique social model. It originates from the end of the Second World War, when the National Council of the Resistance (NCR) hastily put together a plan to rebuild the country after five years of Nazi occupation. Despite not having any official political affiliations, the NCR was in fact influenced by left wing individuals and the “National Front”, a communist party. The NCR’s “action plan” helped shape France in the aftermath of the war and is one of the reasons today that trade unions have such a prominent position in society and why the French are so fond of their “established social rights”.

Since then, reforming France has always been a difficult task. Given that it was announced last week that the country has experienced a second consecutive quarter of no growth, it seems obvious that some sort of change is urgently required. France has grown by only 0.1% in the past year. Despite extremely low interest rates and fiscal tightening, the government’s budget remains in structural deficit and the debt to GDP ratio has increased from 77% to 93%. More worryingly, despite French President Hollande’s very vocal claim that he would “invert the unemployment curve” by the end of 2013, the number of job seekers continues to rise at an alarming rate, hampering consumer confidence and business spending.

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So what can the Hollande government do in a country that is difficult to reform and where scope for public spending is limited?

First of all he should aim to simplify France’s highly complex tax regime, which over the years has become almost illegible. This toing-and-froing over taxes continues to hurt the French economy by creating uncertainty and hampering business investment. In the last 2 years alone, French legislators have created 84 new taxes, for a total of €60 billion Euros.

Second, the government must reduce the burden of social security contributions on the business sector. Today, France spends 17% of its GDP in social contribution taxes, the highest amount out of all of the 28 EU countries. While many people in the country believe that this is the price to pay to finance France’s generous welfare system, its financing relies too heavily on businesses.  In the rest of Europe the burden of social security payments is shared on average equally between employers and employees. In France, almost 70% of these payments are paid by employers. This has a direct effect on the cost of labour and diminishes companies’ abilities to compete in an increasingly globalised world. The French government has started to address this issue by granting a €20 billion tax credit (CICE) to all French businesses, but much more needs to be accomplished. Indeed, in order to put France on equal footing with its neighbour Germany, employer social security contributions would need to be reduced by a further €80 billion per year.

Slide2

Finally, the government should also tackle the excessive bureaucracy in the labour market. For example, many small firms today refuse to grow beyond the threshold of 50 employees because exceeding this number triggers a raft of regulatory and legal obligations. It would make sense to push this threshold to 250 employees, and bring France in line with the European norm. The French Labour Code is 3500 pages long and weighs 1.5 kilo, while the Swiss Code, where unemployment is 3% rate, is 130 pages and weighs 150 grams (anecdotally comparing unemployment rates with the number of pages of labour codes for different countries could be the subject of a future blog).  This excessive bureaucracy is partially the reason why France’s competitiveness has been declining in recent years. In its latest Global Competitiveness report, the World Economic Forum ranked France 23rd overall, but 21st in 2013 and 18th in 2012. More alarmingly, the country is ranked 116th for “labour market efficiency” (out of a total of 148 countries), 135th for “cooperation in Labour-employer relations” and 144th in “hiring and firing practices”. When asked what the most problematic factor for doing business in the country, the number 1 answer provided by respondents was “restrictive labour regulations”.

As France teeters on the brink of recession, Hollande is today in a very difficult position. A complete overhaul of the French social model would create much civil unrest and probably push the country into recession. On the other hand, doing nothing is likely to have the same effect as France would continue to lose competitiveness on a global scale. In a recent study published by “Le Monde”, 60% of respondents said they were “satisfied” with the French social model, but 64% also declared that the model should be at least partially reformed. The French government should use this as a sign that it can make some adjustments to the French tax system and labour markets, without jeopardising its chance of being re-elected in two years. With its popularity at an all-time low and unemployment at an all-time high, there is no more time to waste.

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

anthony_doyle_100

What could possibly derail the global economy?

Things are looking pretty good for the global economy right now. The U.S. Federal Reserve is slowly reducing quantitative easing, China is continuing to grow at a relatively rapid pace, the Bank of England is talking about rate hikes, and the central banks of Japan and Europe continue to stimulate their respective economies with unconventional and super-easy monetary policy. The International Monetary Fund expects growth in the developed economies to pick-up from a 0.5% low in 2012 to almost 2.5% by 2015, while emerging market economies are expected to grow by 5.5%.

Of course, it is notoriously difficult to forecast economic growth given the complexity of the underlying economy. There are simply too many moving parts to predict accurately. This is why central banking is sometimes described as similar to “driving a car by looking in the rear-view mirror

With this in mind, it is prudent to prepare for a range of possible outcomes when it comes to economic growth. Given the consensus seems pretty optimistic at the moment, we thought it might be interesting to focus on some of the possible downside risks to global economic growth and highlight three catalysts that could cause a recession in the next couple of years. To be clear, there are an infinite range of unforeseen events that could possibly occur, but the below three seem plausibly the most likely to occur in the foreseeable future.

Risk 1: Asset price correction

Every investor is a winner

There is no question that ultra-easy monetary policy has stimulated asset prices to some degree. A combination of low interest rates and quantitative easing programmes has resulted in fantastic returns for investors in various markets ranging from bonds, to equities, to housing. Investors have been encouraged by central banks to put their cash and savings to work in order to generate a positive real return and have invested in a range of assets, resulting in higher prices. The question is whether prices have risen by too much.

This process is likely to continue until there is some event that means returns on assets will be lower in the future. Another possibility is that a central bank may be forced to restrict the supply of credit because of fears that the economy, or even a market, is overheating. An example of this is the news that the Bank of England is considering macro-prudential measures in response to the large price increases in the UK property market.

In addition, there is a surprising lack of volatility in investment markets at the moment, indicating that the markets aren’t particularly concerned about the current economic outlook. Using the Chicago Board Options Exchange OEX Volatility Index, also known as the old VIX (a barometer of U.S. equity market volatility) as an example shows that markets may have become too complacent. Two days ago, the index fell to 8.86 which is the lowest value for this index since calculations started in 1986. Previous low values occurred in late 1993 (a few months before the famous bond market sell-off of 1994) and mid-2007 (we all remember what happened in 2008). The lack of volatility has been something that several central banks have pointed out, including the U.S. Federal Reserve and the Bank of England. The problem is, it is the central banks that have contributed most to the current benign environment with their forward guidance experiment, which has made investors relaxed about future monetary policy action.

If these events were to occur, we could see a re-pricing of assets. Banks suffer as loans have been given based on collateral that has been valued at overinflated prices. A large impact in currency markets is likely, as investors become risk averse and start to redeem assets. These events could spill over to the real economy and could therefore result in a recession.

Risk 2: Resource price shock

Energy prices could hamper economic growth

It appears that the global economy may be entering a renewed phase of increased volatility in real food and fuel prices. This reflects a number of factors, including climate change, increasing biofuel production, geopolitical events, and changing food demand patterns in countries like China and India. There may also be some impact from leveraged trading in commodities. There are plenty of reasons to believe that global food price shocks are likely to become more rather than less common in the future.

As we saw in 2008, these shocks can be destabilising, both economically and politically. In fact, you could argue that the Great Financial Crisis was caused by the spike in commodity prices in 2007-08, and the impact on the global economy was so severe because high levels of leverage made the global economy exceptionally vulnerable to external shocks. Indeed, each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices (as the FT has previously pointed out here). Commodity price spikes impact both developed and developing countries alike, with low-income earners suffering more as they spend a greater proportion of their income on food and fuel. There is also a large impact on inflation as prices rise.

A resource price shock raises a number of questions. How should monetary and fiscal policy respond? Will central banks focus on core inflation measures and ignore higher fuel and food prices? Will consumers tighten their belts, thereby causing economic growth to fall? Will workers demand higher wages to compensate for rising inflation?

Risk 3: Protectionism

After decades of increased trade liberalisation, since the financial crisis the majority of trade measures have been restrictive. The World Trade Organisation recently reported that G-20 members put in place 122 new trade restrictions from mid-November 2013 to mid-May 2014. 1,185 trade restrictions have been implemented since October 2008 which covers around 4.1% of world merchandise imports.  Some macro prudential measures could even be considered a form of protectionism (for example, Brazil’s financial transactions tax (IOF) which was designed to limit capital inflows and weaken the Brazilian currency).

If this trend is not reversed, trade protectionism – and currency wars – could begin to hamper economic growth. Small, open economies like Hong Kong and Singapore would be greatly impacted. Developing nations would also be affected due to their reliance on exports as a driver of economic growth.

Many economists blame trade protectionism for deepening, spreading and lengthening the great Depression of the 1930s. Should the global economy stagnate, political leaders may face growing pressure to implement protectionist measures in order to protect industries and jobs. Policymakers will need to be careful to not repeat the mistakes of the past.

Economic forecasting is a tricky business. It is important that investors are aware of these risks that may or may not eventuate, and plan accordingly. The outlook may not be as rosy as the consensus thinks it is.

Claudia_Calich_100

Playing Russian roulette

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

Slide1

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

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

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

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

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

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

Slide4

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

richard_woolnough_100

The UK electoral cycle is alive and kicking

Yesterday’s UK Budget had one major surprise, the relaxation of rules regarding drawing down your pension. This means that from April 2015 you can draw down your pension pot in one go, to do with it as you wish. This policy move chimes with the coalition’s beliefs that one should take responsibility over one’s own finances. However, like all political decisions there may well be an ulterior motive behind the timing of this decision.

We talked previously about why a dovish central banker appointment at the Bank of England was politically expedient two years ahead of the May 2015 election. The current government had its last opportunity yesterday to add a last feel-good give away Budget to enhance the economy and its own electoral prospects. At first glance, what has it achieved with its surprise change in pension policy?

It has potentially released a huge wave of spending commencing April 2015. This will obviously make people feel wealthy as the cash literally becomes theirs as opposed to being locked away for a rainy day. The economic effect looks as though it would be too late to boost the economy ahead of the 2015 general election. However it is highly likely that the forthcoming pension pot release will be taken into account. Holidays would be booked ahead of the windfall, cars could be purchased, redecorating done, and Christmas presents bought as the promise of money tomorrow means you can run down saving and consume today. This pension release scheme will spur growth in the UK ahead of the election.

The particular neat trick of this policy change is that it is a giveaway Budget measure at no cost. This is because it is not the government giving away money, but it is simply giving people access to their own money. Fiscal stimulus at no cost, combined with low rates and a strong government sponsored housing market means the UK will continue to have a relatively strong economy.

anthony_doyle_100

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

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

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

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

2014-02 blog

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

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

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

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

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

mike_riddell_100

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

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

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

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

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

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

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

Fast forward to 21st century China.

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

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

Slide1

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

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

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

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

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

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

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

Slide2

jim_leaviss_100

The Professor Michael Pettis China forecast: 3-4% real growth on average for the next decade. And that would be a good result.

Having seen one of my favourite economists, Professor Michael Pettis, present twice in the past couple of months, I thought I’d try to distil his important messages about the future of the Chinese economy. For those with more time, he also writes a blog which you can find here. The recent presentations aside, I first saw Professor Pettis at a breakout session during the World Bank-IMF meeting in Tokyo in 2012. I was in the crowd in a packed room when Pettis said that Chinese GDP growth would likely fall to an average of 4% for the next decade. Across the audience there were audible titters and even people making the “he’s crazy” thing by swirling their fingers next to their heads. Little more than a year on, and the China slowdown view is nearer to the consensus – although you’d still find it difficult to find an official sub-5% China GDP forecast over any timeframe. Pettis maintains that 3-4% average growth is China’s likely future; the IMF’s World Economic Outlook has revised down its estimate of Chinese potential growth, but only from 8.9% to 8.0%. This morning the 2013 Chinese GDP number was released, at 7.7%, the 4th year in a row now of lower annual growth rates (and even then sceptics suggest that electricity consumption data and freight analysis show that the GDP numbers are overstated in the official statistics).

Professor Pettis’s starting point is that any investment led growth model eventually comes to an end as the quick wins from early infrastructure spending and urbanisation/industrialisation fade away and profitable investment opportunities become harder to find. And this investment has to be financed somehow – and it is the household that pays. For Brazil, the first example of an “economic miracle”, the investment was financed through high income taxes. In the “East Asian” model however (and this was true in Japan’s growth phase post WW2 as well as in China today) the burden on households is less explicit than taxation. The three hidden methods of boosting investment growth at the expense of consumption growth are:

  1. An undervalued exchange rate, boosting exporting manufacturers at the expense of higher imported goods prices for consumers.
  2. Low wage growth vs productivity growth, a subsidy for employers.
  3. And most importantly, financial repression. This confiscates savings from consumers and is another subsidy for, in particular the State Owned Enterprises (SOEs). Pettis estimates that Chinese interest rates have at times been 8-10% below where they “should” have been.

When the supply of profitable investment starts to run out, debt starts to rise more quickly than the ability to service that debt. This leads to a Japan style debt crisis or stagnation. Some estimate that 30% of new loans issued are simply to rollover debt that would otherwise be in default, and that non-performing loans are seriously underestimated in the official data (under 1% according to the China Banking Regulatory Commision). But what about reform, as promised by the Third Plenum? President Xi Jinping appears to recognise the problems that the economy faces, and accepts the need for rebalancing towards consumption. But he has also publically recognised the vested interests in China. The interests of the political elite are aligned with infrastructure projects and the State Owned Enterprises, and this will make reform exceptionally difficult. Studies of “successful” economic development have suggested that nations that democratise quickly and fully or nations that centralise aggressively do well economically over the long term. Examples of those that do neither are Argentina and Russia. It remains unclear whether China will follow a “successful” path, because of its vested interests. As a result growth of 7-8% per year might continue to be the debt-fuelled norm – but the hangover will be much bigger (disorderly negative growth rather than 3-4% in an orderly rotation away from investment towards consumption).

What would real reform look like, in Professor Pettis’s view?

  1. Reduced investment into the SOEs, local government and real estate sectors. Increased investment in SMEs.
  2. Liberalisation of interest rates to reflect the real risks of lending.
  3. Reduction in overall Chinese debt to GDP ratio.

You can read FT Alphaville’s Third Plenum cheat sheet here. You would have to say that progress towards what Michael Pettis thinks is necessary looks pretty slow – although it does appear that there has been some upwards movement in Chinese money market rates more recently, with the average 3 month money market rate (SHIBOR) moving up from below 5% in Q3 2013 to over 5.5% now.

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