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Bondfire of the Maturities: how to improve credit market liquidity

Liquidity in credit markets has been a hot topic in recent months. The Bank of England has warned about low volatility in financial markets leading to excessive reaching for yield, the FT suggested that the US authorities are considering exit fees for bond funds in case of a run on the asset class, and you’ve all seen the charts showing how assets in corporate bond funds have risen sharply just as Wall Street’s appetite for assigning capital to trade bonds has fallen. But why the worry about corporate bond market liquidity rather than that of equity markets? There are a couple of reasons. Firstly the corporate bond markets are incredibly fragmented, with companies issuing in multiple maturities, currencies and structures, unlike the stock markets where there are generally just one or two lines of shares per company. Secondly, stocks are traded on exchanges, and market makers have a commitment to buy and sell shares in all market conditions. No such commitment exists in the credit markets – after the new issue process you might see further offers or bids, but you might not – future liquidity can never be taken for granted.

So how can we make liquidity in corporate bond and credit markets as good as that in equity markets? First of all let’s consider fragmentation. If I type RBS corp <Go> into Bloomberg there are 1011 results. That’s 1011 different RBS bonds still outstanding. It’s 19 pages of individual bonds, in currencies ranging from the Australian dollar to the South African rand. There are floating rate notes, fixed rate bonds with coupons ranging from below 1% to above 10%, maturities from now to infinity (perpetuals), inflation-linked bonds, bonds with callability (embedded options), and there are various seniorities in the capital structure (senior, lower tier 2, upper tier 2, tier 1, prefs). Some of these issues have virtually no bonds left outstanding and others are over a billion dollars in size. Each has a prospectus of hundreds of pages detailing the exact features, protections and risks of the instrument. Pity the poor RBS capital markets interns on 3am photocopying duty. The first way we can improve liquidity in bond markets is to have a bonfire of the bond issues. One corporate issuer, one equity, one bond.

Jim blog

How would this work? Well the only way that you could have a fully fungible, endlessly repeatable bond issue is to make it perpetual. The benchmark liquid bond for each corporate would have no redemption date. If a company wanted to increase its debt burden it would issue more of the same bond, and if it wanted to retire debt it would do exactly the same as it might do with its equity capital base – make an announcement to the market that it is doing a buyback and acquire and cancel those bonds that it purchases in the open market.

What about the coupon? Well you could decide that all bonds would have, say, a 5% coupon, although that would lead to long periods where bonds are priced significantly away from par (100) if the prevailing yields were in a high or low interest rate environment. But you see the problems that this causes in the bond futures market where there is a sporadic need to change the notional coupon on the future to reflect the changing rate environment. So, for this reason – and for a purpose I’ll come on to in a while – all of these new perpetual bonds will pay a floating rate of interest. They’ll be perpetual Floating Rate Notes (FRNs). And unlike the current FRN market where each bond pays, say Libor or Euribor plus a margin (occasionally minus a margin for extremely strong issuers), all bonds would pay Libor or Euribor flat. With all corporate bonds having exactly the same (non) maturity and paying exactly the same coupon, ranking perceived creditworthiness becomes a piece of cake – the price tells you everything. Weak high yield issues would trade well below par, AAA supranationals like the World Bank, above it.

So your immediate objection is likely to be this – what if I, the end investor, don’t want perpetual floating rate cashflows? Well you can add duration (interest rate risk) in the deeply liquid government bond markets or similarly liquid bond futures market, and with corporate bonds now themselves highly liquid, a sale of the instrument would create “redemption proceeds” for an investor to fund a liability. And the real beauty of the new instruments all paying floating rates is that they can be combined with the most liquid financial derivative markets in the world, the swaps market. An investor would be able to swap floating rate cashflows for fixed rate cashflows. This happens already on a significant scale at most asset managers. Creating bigger and deeper corporate bond markets would make this even more commonplace – the swaps markets would become even more important and liquid as the one perpetual FRN for each company is transformed into the currency and duration of the end investor’s requirement (or indeed the company itself can transform its funding requirements in the same way as many do already). Investors could even create inflation linked cashflows as that CPI swaps market deepened too.

So what are the problems and objections to all of this? Well loads I’m guessing, not least from paper mills, prospectus and tombstone manufacturers (the Perspex vanity bricks handed out to everyone who helped issue a new bond). But the huge increase in swapping activity will increase the need for collateral (cash, government bonds) in the system, as well as potentially increasing systemic risks as market complexity increases. Collateralisation and the move to exchanges should reduce those systemic risks. Another issue regards taxation – junky issuers will be selling their bonds at potentially big discounts to par. Tax authorities don’t like this very much (they see it as a way of avoiding income tax) and it means that investors would have to be able to account for that pull to par to be treated as income rather than capital gain. Finally I reluctantly concede there might have to be 2 separate bond issues for banks and financials. One reflecting senior risk, and one reflecting subordinated contingent capital risk (CoCos). But if we must do this, the authorities should create a standard structure here too, with a common capital trigger and conversion. Presently there are various levels for the capital triggers, and some bonds convert into equity whilst others wipe you out entirely. There is so much complexity that it is no wonder that a recent RBS survey of bond investors showed that 90% of them rate themselves as having a higher understanding of CoCos than the market.

Addressing the second difference between bonds and equities, the other requirement would be for the investment banks to move fully to exchange trading of credit, and to assume a market making requirement for those brokers who lead manage bond transactions. This doesn’t of course mean that bonds won’t fall in price if investors decide to sell en masse – but it does mean that there will always be a price. This greater liquidity should mean lower borrowing costs for companies, and less concern about a systemic credit crisis in the future.

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.

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Global banking – does it hurt ‘national champions’?

There has been a lot of comment recently on the slimming down at Barclays investment bank. This has generally been couched as a change in business plan, with less of a focus on fixed income, commodities and derivatives, to a less capital intensive more traditional model. One of the interesting things for us is that this is not an idiosyncratic event, but part of a trend.

Barclays, like RBS, UBS, and Credit Suisse, has decided to reverse its pre crisis ambition of being a dominant player in the global fixed income market. From a pure opportunity set this seems strange as the huge increase in volume of outstanding corporate and government debt is potentially an enormous business opportunity. So why the retreat?

Like any company that exits a business line, presumably it’s because Barclays believes it is or will be less profitable. Despite the expansion of fixed income markets, banks are less able to make money due to a change in their cost of capital. Regulators have effectively reduced the banks’ ability to make money, via constraints on leverage ratios, which are a good thing from a bondholder’s perspective but increases their effective costs and reduces profitability.

However, this banking trend also has a European flavour. The firms scaling back their ambitions are all non US banks. Why the difference across the Atlantic given both economic blocks have faced harsher regulation and more capital requirements? We think North American banks have a natural advantage versus their “alien” investment bank counterparts in three ways.

Firstly they operate in the largest capital market in the world. This gives them strong economies of scale compared to those whose ‘national champion’ home market advantage is in  smaller markets.

Secondly, even when comparing the big US capital markets with the second largest Euro capital markets, the European players have a disadvantage. The euro is a single market, but  banks  are constrained nationally.  They are all large relative to their domestic economy, which makes the home regulator understandably nervous, imposing higher capital, leverage and loss-absorbing debt requirements on the banks in their jurisdiction. This is less of an issue in the US, where the geographic regulated area and the currency coincide for a significantly greater percentage of their business. Therefore the US regulator can be more relaxed about having large banks.

Thirdly, globalisation is also resulting in more dominance from US non-bank corporations, whether that be through their innovation, or their own natural economies of scale in the US. This can be seen over the last year with Vodafone selling its wireless business to Verizon, Liberty Global buying Virgin Media, and the potential attempts by Pfizer to take control of Astra Zeneca. It is natural for US businesses to work with US banks, and the development of large corporations with large funding needs means there needs to be a large capital market. All these things point to a reinforcing increase in the relative size of the US capital markets. This is one of the factors that has been driving the increase in the relative sizes of the European and US investment grade bond markets, as illustrated in the chart below.

US IG bond market growing faster than European market

Barclays’ reduced ambition is part of a banking trend. We have seen these kind of moves before in the banking sector where bank management move together in the same direction. The lesson from these recent moves is that globalisation will not only change the face of the world economy, but will benefit those nations not only who are efficient and innovative, but have the largest efficient domestic markets, thus allowing economies of scale. Good news for the US listed companies, and a potential issue for the rest of the world.

 

anthony_doyle_100

Sell in May and go away – does it work for European fixed income?

As is usually the case on 1 May, there was a plethora of articles and commentary on the “sell in May and go away” effect. If you are unfamiliar with this highly sophisticated trading strategy, it involves closing out any equity exposure you may have on 30 April and re-investing on 1 November. Historically, U.S. equities have underperformed in the six-month period commencing May and ending in October, compared to the six-month period from November to April. No one knows why this seasonal pattern exists, but some theories include lower trading volumes in the summer holiday months and increased investment flows when investors come back from holidays.

With this in mind, we thought it might be interesting to see if the same effect exists in European fixed income markets. In order to identify the sell in May effect, we generated total returns on a monthly basis for a portfolio of European government, investment grade and high yield bonds. We then generated a total return for a portfolio that was invested between the months of November and April and compared this with a portfolio that was invested between the months of May and October. In order to generate the maximum number of observations possible, we went back to the inception of the respective Merrill Lynch Bank of America indices. The results are below.

Slide1

There appears to be a seasonal effect in European high yield markets. This is the fixed income asset class that is most correlated to equity markets, and the analysis shows that a superior return was generated by only being invested between the months of November and April (199% total return). In fact, this strategy substantially outperformed a strategy of being invested over the whole period (1997 – April 2014). If an investor chose to only invest between the months of May and October, they would have suffered a 21% loss over the past 16 years.

Slide2

The natural extension of this analysis is to gauge how a trading strategy that was fully invested in European government bonds between the months of May and October and fully invested in European investment grade between November and April would have performed over the past 18 years. We can then assess how this strategy would have performed relative to portfolios that were fully invested in European government bonds, European investment grade corporate bonds and European equities only. The results show that a strategy of selling investment grade assets in May and buying government bonds has produced superior returns equal to 5.9% per annum, outperforming European equities by 56% in total or 2.5% p.a.

Slide3

The above chart shows the same analysis, this time looking at how the strategy would have performed in total return terms but we have replaced European investment grade exposure with European high yield. Following this strategy would have generated an annualised return of around 10.5% or 391% over 16 and a bit years. This is far superior to the returns on offer in the European high yield and European equity markets over the same time period, which were 155% and 43% respectively.

Our analysis shows that there is a strong seasonal effect evident in European high yield markets, where returns are more volatile and there can be large upside and downside contributions due to fluctuations in the capital value of high yield bonds. However, it should be acknowledged that the results have been biased by the fact that major risk-off events (like Lehman Brothers, the Asian financial crisis and the Russian financial crisis for example) have generally occurred between the months of May and October. Nonetheless, historical total returns suggest that there is a seasonal effect in European high yield markets that investors should probably be aware of. Ignoring transaction costs or tax implications which would eat into any total returns, a strategy of selling investment grade or high yield corporate bonds in May and buying government bonds until November would have produced superior returns relative to European government bonds, investment grade corporate bonds, high yield corporate bonds and European equities.

Whilst it is always dangerous to base a trading strategy around a nursery rhyme, based on historical total returns there does appear to be a bit of sense in selling risk assets in May, retreating into government bonds which would likely benefit most in a risk-off event, and adding risk back into fixed income portfolios in November. But of course, another old saying still rings true – past performance is not a guide to future performance.

anthony_doyle_100

Jim Leaviss’ outlook for 2014. The taper debate (watch the data), inflation (where is it?), and it’s a knockout. Merry Christmas!

With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago. It might not always have felt like it at the time – indeed, over the summer when markets were sent into a spin by the prospect of the US Federal Reserve (the Fed) cutting its supply of liquidity earlier than expected, it almost certainly did not. But riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.

Meanwhile, the macroeconomic backdrop has generally improved over the past year, with the economic recovery gaining significant momentum in the US and, more recently, the UK. However, the picture in Europe remains mixed, while our concerns over the emerging markets are mounting. However, despite their disparate prospects, all countries – and all bond markets – are united by at least one common dependency: the Fed.

So what does 2014 have in store for global bond markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And for those of you who have been wondering, the annual M&G Bond Vigilantes Christmas quiz will be posted later this week.

Enjoy!

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A new source of supply in the ABS market

One of the features of the ABS market this year has been the lower levels of primary issuance. That, coupled with increased comfort in the asset class and higher risk/yield appetite has caused spreads to tighten.

Slide1

We have had a few new deals, but 10 months in and new issuance volume is only about half the amount seen in 2012, and just a third of 2011 issuance.

Slide2

What we’ve seen of late, despite the subdued new issuance, is an increase in the number of these securities available in the market. In the not-so-distant past, banks would structure a securitised deal, place some with the market and keep some to pledge to their central bank as collateral for cheap cash.

Now spreads have tightened, and the market feels healthier, some of these issuers are taking the opportunity to wean themselves off the emergency central bank liquidity and are offering the previously retained securities to the public market.

Another dynamic in ABS at the moment is that ratings agency Standard and Poor’s is considering changing its rating methodology for structured securities in the periphery. S&P is considering tightening the six notch universal ratings cap – countries rated AA or above will not be affected, but bonds issued from countries with a rating below AA could be downgraded as they won’t be allowed to be rated as many notches above their sovereign as they were before.

The implication is that securities that get downgraded will become less attractive for banks to pledge as collateral because of the haircuts central banks apply to more risky (lower rated) securities. Our thinking is that southern European issuers will be hit hardest by this change. So unless the ECB loosens its collateral criteria (which it can and has done previously), one would expect to see more of those previously retained deals coming to the market as well.

So whilst we haven’t seen too much in the way of new issuance, it looks like we could be about to see an increasing number of opportunities in the secondary market.

 

anthony_doyle_100

It’s Halloween so time for some spooky, if not downright scary charts

Some people will watch a scary movie on October 31st. Others like to go to costume parties and dress up. For us, there is no better way to scare ourselves silly than by reading a few IMF reports. So in the spirit of the holiday, here are five scary charts. Boo!

1. An oldie but a goodie – high public debt-to-GDP ratios

G7 Debt-to-GDP ratios remain at a scary level

Economic theory has told us for a long time that debt held by the public is what we should be looking at when trying to work out the potential impacts that high debt levels could have on an economy. This is because the borrowing associated with government debt competes for capital with investment needs in the private sector (for factories, equipment, housing, etc) and can affect interest rates. A good ol’ classic case of “crowding out” in the IS-LM model.

More recently, the market has taken its focus off looking at debt-to-GDP ratios. A 2010 research paper by Carmen Reinhart and Kenneth Rogoff was found to have computational errors, resulting in some serious question marks being raised about their finding that a debt-to-GDP ratio of 90 per cent or more is associated with significantly lower growth rates. Following this debacle, we now know that there is probably no magic threshold for the debt ratio above which countries pay a marked penalty in terms of slower economic growth.  For all it’s importance, the 60% debt-to-GDP ratio target written into the Maastricht Treaty adopted by the European Union was pretty much based on zero economic evidence.

This doesn’t mean we shouldn’t keep an eye on the measure though. High government debt means a high debt servicing cost. In general, a lower debt-to-GDP ratio is preferred because of the additional flexibility it provides policymakers facing economic or financial crises.  What has now changed is that it has been acknowledged by policy makers that lowering the debt ratio comes at a cost to economic growth, requiring larger spending cuts, higher revenues, or both. Should the financial system face another wobble, for whatever reason, we would have to question the capacity of governments to step in and support their banks like they did back in 2008.

2. Deteriorating health and ageing in the developed economies

Projected increase in public health spending, 2013–30

The world’s population is growing older, leading us into uncharted demographic waters. There will be higher absolute numbers of elderly people, a larger share of the elderly, longer healthy life expectancies, and relatively fewer numbers of working-age people. We are aging due to three underlying factors: increased longevity, declining fertility and the baby boomers getting older.

This signals a profound economic and social change, with big implications for businesses and investors. Will we see an asset meltdown as the elderly sell off their assets? How will publicly funded pension systems deal with rising beneficiaries and falling contributors? How will policy makers react to a chart like the one above, which shows ever-increasing expenditure on public health as a percentage of GDP? The need for policy adaptations to an aging population will become more important in the face of retirement of the baby boomers, slowing labour force growth, and the rising costs of pension and health care systems, especially in Europe, North America, and Japan.

As a result of this key demographic change we can now reasonably expect to retire later in life, work harder as the size and quality of the workforce deteriorates, and pay higher taxes to fund those expensive medical technologies. Scary, huh?

3. Economic inequality and its impact on society

Shares of net wealth held by bottom 50% and top 10%

Income inequality is of great interest to economists due to the impact that it could potentially have on economic growth. Robert Shiller, who recently won the Nobel Prize in Economic Science, said that income inequality is the most important problem that we are facing now. Billionaire investor Warren Buffett thinks that rising income inequality is a drag on US economic growth. He said in an interview with CNN Money that “the rich have come back strong from the 2008 panic, and the middle class hasn’t. That affects demand, that affects the economy. The people at the bottom end should be doing better.” Stan Druckenmiller, who spent more than a decade as chief strategist for George Soros, has described QE as causing “the biggest redistribution of wealth from the middle class and the poor to the rich ever. Who owns assets?  The rich.”

What is really scary about this chart is the social and political ramifications that some economists have hypothesised. One theory suggests that high inequality could lead to a lower level of democracy, high rent-seeking policies, and a higher probability of revolution. An economy could fall into a vicious cycle because the breakdown of social cohesion brought about by income inequality could threaten democratic institutions.

4. A new economic world order

A new economic world order

The last decade has witnessed the emergence of China as an economic superpower, the next decade may well be characterised by the emergence of India. China and India will both expect their global influence to expand in the coming years and decades, but strong growth will not be without some headaches. Political leaders must deal with the environmental consequences, an aspirational middle class and rising social inequality. We have all felt the impact of the ascension of the developing economies through their thirst for commodities; the next phase may well see these two nations become the most influential in the world.

Markets don’t particularly like uncertainty. How they react to this new world order is anyone’s guess. This chart isn’t particularly frightening. What it does is challenge the economic status quo that many of us have become accustomed to.

5. Feeding the world

Feeding the world – per capita consumption set to increase

The global population is set to grow considerably in coming years, though there will likely be considerable differences across countries. It has been estimated that the world’s population could increase by 2 billion people to exceed 9 billion people by 2050. Of course, global agricultural production will have to increase in order to meet this demand.  If our farmers don’t manage to produce more, then we could easily find ourselves in an inflationary environment as our grocery shopping bills increase. Not only that, we have to become much smarter about using the planet’s limited resources.

Increasing farmers output won’t be easy, or without cost. Recent experience suggests that an increase in production efforts can lead to significant negative environmental effects, like pollution and soil erosion.

Increased productivity and innovation alone will not tackle the demand that will come from our growing, global population. Investment and infrastructure is vital. Farmers are likely to adopt technologies only if there are sound incentives to do so. This calls for well-functioning and efficient capital markets, a stable financial environment and sound risk management tools.

mike_riddell_100

Will the Fed push EM over the edge?

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

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

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

Slide1

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

Slide2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Lower for longer – the path to Fed tightening

The disclosure of the latest Federal Open Market Committee (FOMC) meeting minutes last night has pushed the US bond market to new lows for the year, further extending the current bear market in world government bonds. Looking at what the Fed is doing is nothing new. Back in the day when I first started, we had dedicated teams of Fed watchers, trying to work out its next move, as rate changes were frequent and unpredictable. The current policy is to make less frequent changes and be more transparent. So what does the FOMC’s forward guidance by providing its internal thoughts tell us today?

The committee knows that what is discussed will affect the markets, so a stylised version of its discussion needs to be produced. The release of the minutes is a manufactured and glossy disclosure of its work presented to make the FOMC look good and influence its followers. So what was the message from last night?

Well, it is more of the same about the need to tighten as we previously blogged here. The Fed continues to follow the script. The basic scenario is that they need to get the party goers out of the bar with the minimum trouble. This is why the Fed is keen for us to see that they discussed reducing the unemployment threshold at the last meeting. This is akin to saying ‘drink up’ to a late night reveller, with the hint that once they’ve done so there is a chance the bar staff will pour them another drink.

The Fed wants a steady bear market in bonds in this tightening cycle as it is still fearful over economic strength and fortunately inflationary pressures remain benign. This is very different from major tightening cycles in the past such as 1994, when the Fed was more keen to create uncertainty and fear in the bond market as they wanted to tighten rapidly and were still fearful of inflation given the experience of the 70s and 80s.

So when will official interest rates go up? Strangely you could argue that the successful creation of a steady bear market in bonds extends the period they can keep rates on hold. Monetary tightening via the long end reduces the need for monetary tightening in the conventional way. For example, as you can see from the following chart, the 100bps or so sell-off in 30 year treasuries since May has translated into a similar move higher in mortgage costs for the average American.

22.08.14 30y mortgage costs

If the Fed has its way in guiding a steady bear market in bonds, then bizarrely short rates could indeed stay lower for longer.

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Tier 1 capital: too much faith in a Q&A, or why didn’t you call me?

It turns out that market participants may have put too much faith in the European Banking Authority (EBA). The EBA’s answer to a submitted question indicated that non-called bank Tier 1 instruments – or at least those similar to one described by the questioner – cannot simply be reclassified as Tier 2 capital after the first call date. The EBA’s answer to this specific question – which some wrongly characterised as an “EBA ruling” – fuelled speculation that all callable Tier 1 would henceforth be called at the first call date because of a loss of capital credit. Deutsche Bank’s 5.33% Tier 1, callable on September 19, 2013, leapt in price.

Jeff_Too much faith in the EBA

The market began to speculate that Deutsche Bank – which has declined to call capital instruments before – would have a change of heart and redeem this bond at the first call date. We don’t want to comment specifically on Deutsche Bank’s decisions here, but this non-call demonstrates why we don’t believe that investors can or should base valuations on their own predictions about whether or when banks will redeem their callable capital instruments. And the point to bear in mind here is that capital credit is just one factor for banks to consider when asking their regulator for permission to redeem an instrument. The importance of capital credit – and of elements within the tiers of bank capital – will vary widely from bank to bank. Finally, regulators need to approve the redemption in any event.

So is this the beginning of a trend of banks not calling their hybrids? We wouldn’t make such a sweeping declaration. First, even with the EU Banking Union project underway, many decisions are still made at the national level with respect to capital. CRD IV, the new Capital Requirements Directive that implements Basel III within the EU, is still being passed by legislatures of the member states. It’s possible that some home country regulators are allowing banks to continue to count their hybrid Tier 1 securities as Tier 1 capital through the end of 2013 irrespective of a call being missed. That may mean redemptions in 2014. Or it may not: these bonds might still be useful for banks as a buffer to protect their senior funding under new rules that banks will have to have a minimum amount of liabilities available for write-down or conversion to equity in case of a resolution.

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