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jim_leaviss_100

The Signal and the Noise – why local weather forecasters get it wrong, and what it means for those big market calls

I’ve finally got round to reading Nate Silver’s The Signal and the Noise. It’s a brilliant analysis of why forecasts are often so poor, from the man who called every state correctly in the 2012 US presidential election. In short, predictions are often poor because they are too precise (asserting an absolute outcome rather than assigning probabilities to outcomes); there’s often a bias to overweight qualitative information, gut feel and anecdote over data (these shouldn’t be ignored but must have a high hurdle to overrule the statistics); and there’s also a bias to ignore out of sample data (he suggests that the rating agencies mis-rated CDOs based on MBS because they assumed no correlation between housing defaults, which was indeed the case in the 25 or so years of US data that was used in the models. Japan’s property crisis statistics would have shown that in a downturn the degree of correlation in defaults becomes extremely high). I’d like to propose a deal though – we Brits agree never to use cricket statistics in any academic paper so long as Americans shut up about baseball. What the hell is hitting .300? How many rounders is that?

I liked these charts. The first shows just how good weather forecasting is nowadays. We can’t get the outcome right every time, but we can now call the probability of a weather event occurring right with the same probability of it happening. For example, when the US National Weather Service says that there is a 70% chance of rain, it rains 70% of the time. It snows 20% of the time when they say there is a 20% chance of snow.

Slide1

But when your local TV weatherman gets hold of this same information, he or she distorted that information such that the outcomes were far worse than those of the National Weather Service’s forecasts. The chart below shows that local TV weatherpeople over-predicted weather events consistently. For example, if they say that there is a 100% chance of rain, it rains just 67% of the time, compared with the National Weather Service which if it says there is 100% chance of rain, it always rains.

Slide2

Why? “Presentation takes precedence over accuracy”. In other words local TV news and weather people believe themselves to be entertainers as much as bearers of information. A firm prediction of a biblical rainstorm is more exciting that a range of probable outcomes, and a forecast for a scorching beach day more fun than assigning a 75% chance of sunny intervals. In other studies it was shown that political analysts on panel shows performed extremely badly, systematically predicting outcomes way out of line with statistical polling. The very act of being on TV reduces one’s forecasting ability. I think there is a likelihood that this is also true of economic and market forecasting, which is why market TV channels are full of people either calling for the Dow to soar another 200%, or for the global economy to collapse into a permanent ebola fuelled zombie apocalypse. There’s a danger that when we get phoned by journalists for comment we feel the need to be significantly away from the consensus, on payrolls, on the year end 10 year Treasury yield, on the chances of the Eurozone breaking up – and I’m sure I’ve been guilty of this too in the past. What’s more I’m sure that those who forecast extreme events end up being boxed into a corner where they feel they have to implement those views within portfolios, and end up with portfolios which point only in the direction of tail events and can’t perform in normal economic circumstances. I think this is a must read book for economists and fund managers to help us understand how good forecasts are made, and that the “loudest” forecasts get disproportionate airtime – and are often wrong. Silver has bowled a wicket maiden with this one.

ben_lord_100

Not all change is bad: coming reforms to credit default swaps

There is a lot of analysis and conjecture about how much impact the financial crisis has had on the global economy and financial markets. There has been considerably less analysis around the impact of the crisis on bond fund managers. In a small attempt to quantify these impacts, we have dug out a few old photos of members of the M&G bond team pre and post-crisis. The photos show clearly where change has been bad.

2008-08 ben

There is, though, good change. In September there are changes taking place to bank CDS contracts that represent clearly positive progression.

The CDS rules and definitions of 2003 state that there are 3 different credit events that will trigger corporate and financial CDS contracts: 1. failure to pay 2. bankruptcy, and 3. restructuring (this means that a company can’t modify the conditions of debt obligations detrimentally as far as investors are concerned). If any of these are determined to have occurred, then buyers of protection receive par from sellers of protection (and sellers of protection pay out par minus the recovery value of the defaulted bonds, so are in the same situation as if they owned the defaulted bond). In the event of one of these events being triggered, buyers of protection are ‘insured’ against the losses incurred on the bonds.
However, whilst the above works well in most cases of corporate defaults, we have seen several examples in the last few years in terms of banks in which the outcomes have left buyers of protection in effectively defaulted bonds none the better off. For purposes of succinctness and relevance, I would like to mention two of the more recent such cases so as to bring out the flaws of the existing financial CDS contracts, and to highlight the improvements we will soon see.

In early 2013, the Dutch government expropriated the subordinated debt of SNS Bank, which had got into serious difficulties. Bondholders would therefore no longer receive coupons or principal, and so the determinations committee ruled, quite simply, that a restructuring event had occurred. However, the buyers of protection had to deliver defaulted bonds to the sellers, and there being no subordinated bonds left, had to deliver senior bonds, whose value was around 85p in the pound. This meant that they ‘owned’ bonds worth zero, and were being paid out 15p as a result of the protection they had bought!

The most recent example of subordinated CDS not working is still on-going, being the case of Banco Espirito Santo. This bank has seen all the good assets, deposits and senior debt transferred to a new, good, bank, and all the bad assets, subordinated debt and equity stay with the old, bad, bank. So subordinated debt will very likely get a very low recovery (the sub bonds are today trading at around 15 cents). Subordinated bank debt is now, in practical terms, able to take losses and be written down in European banks. Senior bank debt will also become write-down-able at the start of 2016, but as yet legislators and regulators are showing the continued desire to make senior good. In BES’ case, though, with all the deposits and senior debt moving to the good bank (and with a very thin layer of subordinated debt), more than 75% of the liabilities will go to the new entity. In CDS terms, this means that the contracts move to the new entity. So, again, buyers of subordinated protection in BES are left with significant losses on their bonds, but will have to deliver senior bonds which are trading close to and in some cases above par. Not the outcome that the owners of protection wanted or expected. And, frankly, not the right outcome.

So the existing rules around financial CDS are unfit for purpose. Starting in September, new rules will come into place that will vastly improve the economics of these contracts, and in simple terms will make them behave far more like senior and subordinated bonds, which after all is what they are meant to do. The major differences can be summarised into two: a new, fourth, credit event trigger called Government Intervention will be added; and the removal of the cross default provision. The Government Intervention trigger will mean that in instances such as SNS, when governmental authorities impair debt, CDS contracts will be triggered, and in the same case, owners of subordinated protection would have delivered a claim on the Dutch government that was worth zero, through the expropriation, and would have received par from sellers of protection. In terms of the second major reform to financial CDS contracts, current contracts mean that a credit event on subordinated CDS also results in a credit event on senior. This clause will be removed, meaning that in the Banco Espirito Santo on-going case, subordinated CDS contracts would travel with the subordinated bonds, and senior with senior. Unlike the changing faces of the Bond Vigilantes, the changes soon coming in CDS are ones we think are positive.

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jim_leaviss_100

What is the collapse in the Baltic Dry shipping index telling us about global growth?

The Baltic Dry Index (BDI) is a daily priced indicator of the cost of shipping freight on various trade routes for dry bulk carriers, based on data submitted by shipbrokers to the Baltic Exchange in London. Since March this year the index has fallen by over 50%, and this has made economists worry that the fall reflects a generalized slowdown in global trade – dry bulk goods include cement, coal, ore as well as food stuffs like grain. A lot of it is the stuff that China imports to support its investment led growth model, so a collapse in demand for the ships that carry bulk dry goods to China might be telling us that China is slowing rapidly. And that obviously has significant impacts on those economies which are reliant on exporting to China for their own growth – for instance Australia, Chile, South Africa and South Korea all have between 21% and 36% of their exports going to China.

Obviously though demand for space on ships is only half of the equation. As expectations grew that the Great Financial Crisis was behind us, and as China kept publishing high single digit growth rates, there was a significant expansion in shipbuilding. Since 2010 annual growth in Dry Bulk supply has been anywhere from 5% to over 15% year on year – in most periods outstripping demand growth, and certainly depressing prices. It’s not just dry bulk, there’s also big excess supply in container ships. Shipping companies are trying to manage these supply problems – the average age of ships when scrapped has fallen from 28 years in 2011 to 21 years in Q1 2014, 4% of the fleet is “idle”, ships are “slow steaming” (going slowly to save fuel and costs of being idle at port) and shipping companies are cancelling future orders for new ships (in 2013 32% of orders were not delivered as planned and were either postponed or cancelled). But for 2014 and 2015 at least the excess supply problem gets worse, not better.

So is the Baltic Dry Index telling us anything about global trade and growth? We started off from a position of scepticism – there used to be a good relationship (we wrote about it here in 2011), but since the massive shipping supply boom maybe it had lost its power as in indicator? But it turns out that the correlation between world trade and the BDI is EXTREMELY good. The CPB Netherlands Bureau for Economic Policy Analysis produces the monthly CPB World Trade Monitor. It’s clear from these global trade data that the volume of trade has been weakening since the end months of 2013. Trade actually fell in May, by 0.6% month on month, although due to volatility and seasonals, a rolling 3 month versus previous 3 month measure is preferred. The chart below shows that after some strong momentum in global trade in 2010 it’s fallen to a much more stagnant growth level in the past couple of years, and a brief recovery in mid 2013 has tailed away. In Q1 this year, world trade momentum turned negative. We have shown the Baltic Dry Index against this measure of world trade – it doesn’t just look like a strong relationship optically, but it has a correlation coefficient of 0.74 (strong) with a t value of 7.83 (statistically significant at an extremely high level).

Baltic Dry vs World Trade - Chart - v01 - CHART 1

When we last wrote about the Baltic Dry Index we pointed out that it appeared to be a good lead indicator for 10 year US Treasury yields, the theory being that a fall in the BDI presaged falling GDP and therefore justified lower rates. And indeed the fall in the BDI in early 2011 did nicely predict the big Treasury rally 3 months later. There is still a relationship today, but sadly for us bond fund managers the better relationship is with UST yields predicting movements in the BDI (so ship-owners please feel free to make money on the back of this). Nevertheless, over the same time period as the earlier chart there is still a decent correlation if you use the BDI as a leading indicator and push it forward by 3 months, so it does appear to have some predictive powers.

Baltic Dry as Leading Indicator for 10Y Treasury Yield - Chart - v01 - CHART 2

So we’ll keep looking at the Baltic Dry Index for the same reason that we like the Billion Prices Project for inflation. When you can find a daily priced, publically available measure or statistic that comes out a month or more ahead of official data and is a strong proxy for that data it’s very valuable.

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jim_leaviss_100

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.

richard_woolnough_100

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!

matt_russell_100

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.

 

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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.

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