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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.



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.


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.


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.



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.


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.


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.


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).


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).


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.**


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).


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).


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.


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.


Five reasons why the European high yield market is better value than its US cousin

Since the start of 2011 we have seen the onset of the Eurozone crisis, endemic political uncertainty, a return to recession and a de facto Greek sovereign default. Contrast this to the path the US has taken with aggressive QE, positive growth and a recovery in the housing market. The somewhat surprising fact is that in spite of all this, the European high yield market has outperformed its US counterpart, returning 29.0% and 24.8% respectively*.

There is little doubt that the US presents a more benign fundamental and macroeconomic environment for leveraged companies. Nevertheless, there are still compelling reasons to believe the European market offers the better investment opportunity. Here are 5 reasons why:

  1. Lower sensitivity to interest rates – since the genie of “Tapering” has been let out of the bottle this summer, investors have become acutely aware of the interest rate risk inherent in their holdings. The European high yield market has an effective interest rate duration of 3.2 years compared to 4.4 years for the US. Accordingly, the European market will be less sensitive to a further sell off in government bonds all other things being equal.
  2. Lower average cash price – European high yield bonds trade with an average cash price of 101.98 with the US at 102.92. This may seem like a small difference, but given the presence of call options in many high yield bonds, a cash price above 100 indicates limited scope for capital appreciation. The European market suffers from the same constraint, but with an extra 1% of headroom.
  3. Higher quality market – viewed through the prism of credit ratings, the European market is lower risk. BB rated bonds make up 67% of the market compared 42% for the US. Higher risk B rated bonds make up 23% and 41% respectively with the remainder within CCC’s. This means two thirds of the European market is rated just below investment grade, whereas over half the US market is well into “Junk” territory with a B or CCC rating.
  4. Higher credit spread – the European market as a whole trades with a credit spread over government bonds of 508bps compared to 471bps in the US. When controlled for credit rating, the difference is even more stark. European BB rated bonds trade at 410bps over sovereigns with US BB’s at 342. The numbers are 607bps and 454bps respectively for B rated instruments. We know the European economy is struggling but this is already factored into valuations.
  5. Lower default rate – According to Bank of America Merrill Lynch statistics for the public bond markets, the trailing last 12 month issuer weighted default rate for the European market is 1.2% compared to 2.1% for the US. There is little to suggest that this trend will dramatically change in the near future given low interest rates and supportive refinancing trends.

Of course there are always mitigating elements to this argument – the all-in yield of the European market , for example, is lower at 5.1% (US is 6.1%) – reflecting both the lower duration of the market, but also the divergence of European and US government bond market yields over recent months. Nevertheless, with lower interest rate risk, lower average cash price, higher credit quality, higher credit spreads and lower default rates, the investment case for the European market continues to look more compelling compared to its American cousin.

*BofA Merrill Lynch US and Euro High Yield Indices 31/12/2010 – 26/07/2013



EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?

On Friday last week, EM debt funds saw a daily outflow of $1.27bn, which equalled the record set during the dark days of September 2011, a time when the Eurozone periphery and the ECB were particularly active bungee jumping down a precipice.   Outflows were even bigger on Monday this week, as EM debt funds were hit by $1.44bn in outflows.  The fact that Monday saw a daily record wasn’t much of a surprise; markets were violent, even by recent standards, with some Turkish bank bonds down 10% intraday at one point.   Outflows were a slightly less bad $1.07bn on Tuesday this week (the most recent data available), but that’s still $3.78bn of EM debt fund outflows in just three days.

The chart below plots the year to date daily flows in US high yield and EM debt, courtesy of EPFR.  Note that this data is for mutual funds only and doesn’t include flows from insurance companies, central banks etc, so while it gives you an idea of how grim the picture looks, it’s perhaps only 10% of the whole picture.  Note also that the EM debt asset class is significantly bigger than it was just two years ago thanks to a huge amount of debt issuance, meaning that although Monday saw a record outflow in absolute terms, it actually ranked number four relative to the size of the market.

EM debt funds hit by record daily outflow on Monday this week

Do the outflows matter?  EM debt bulls might argue no -  fund flows tend to lag market performance and flows have historically had little if any predictive power in forecasting future returns. The collective human instinct is always to buy at the top and sell at the bottom, and the losses in EM assets in the last seven weeks told you the outflows were coming.  Bulls might also argue it is comforting that EM debt outflows haven’t actually been bigger.  EM debt has seen the biggest drawdown since Q4 2008 – in the last 7 weeks the JP Morgan GBI-EM Index, a commonly used EM local currency sovereign debt index, has plummeted  13%, and the JP Morgan EMBI Global diversified index, a widely used EM sovereign external debt benchmark, has fallen over 10%.  Real money investors aren’t yet capitulating, which suggests that the huge inflows of the last few years are relatively sticky.

EM debt bears might look at it another way – in the context of the enormous inflows into EM debt in the last four years in particular, outflows haven’t actually been that huge, and yet returns have been abysmal.  One of the unintended consequences of much tighter bank regulation and balance sheet deleveraging is that market markers have reduced ability to warehouse risk, so relatively small changes in EM debt fund flow dynamics are causing far greater swings in market prices.   If outflows continue at this pace or worsen, then the effect on EM debt will likely be cataclysmic.

Are these outflows just a tremor, or are we witnessing ‘The Big One’?  To begin to attempt to answer that, it’s necessary to figure out what has caused such a violent sell off.  About a year ago I tried to explain that the reasons most people seem to buy EM debt – strong growth, good demographics, low government debt levels, an ‘under-owned asset class’ – are broadly irrelevant.   Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis.  Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either. EM debt returns are instead largely a function of US Treasury yields, the US dollar, and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt (see Emerging market debt is cool but you may be surprised what you find if you strip away the marketing myths for more).

The recent EM debt sell off appears to justify this view of the primary drivers of EM debt returns.  Market commentators’ explanation for the recent leg down in EM debt is Bernanke’s tapering talk, and this is clearly a factor.  Treasury yields have jumped, the US dollar has soared, and EM currencies have mostly slumped.  This is something that we had anticipated and were positioned for as explained in January, see Why we love the US Dollar and worry about EM currencies.

If you assume this EM debt sell off has all been about Fed speak, then I’d actually be much more comfortable about EM debt valuations now. EM bond yields have risen significantly faster than US Treasury yields, while EM currencies have generally fallen sharply, so EM debt valuations are obviously relatively more attractive now versus two months ago.   At the time of writing back in January, 10 year US Treasury yields were 1.8% and we believed they looked ripe for a correction.  Now, however, yields are above 2.5%, and yet the solid but unspectacular trajectory of the US economy hasn’t really changed that much.  Meanwhile US inflation expectations have in fact fallen considerably – for example the US 5 year 5 year forward breakeven inflation rate has slumped from 3% to 2.4%.  Jim discussed the US economy following a research trip in a blog earlier this month, see While the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation.

However, the recent EM debt move is unlikely to be all about Fed speak.  EM debt has been a stand out underperformer in the great carry sell off of the last two months, and dynamics in Japan and China are surely also important.  I believe that the behaviour of domestic Japanese investors is playing a greatly under-appreciated role.  In the early days and months of the much hyped but so far little-achieving ‘Abenomics’, every man, his dog, and his dog’s unborn puppies seemed to have gone long USD, short JPY, long risky assets and particularly long EM debt.  Some did it in a very leveraged way, and these trades have been a disaster since the beginning of May.  As mentioned in a blog a month ago, Japanese investors have in fact done the precise opposite of what every market participant seemed to think they would do. Below is an updated chart from a blog last month (see Japanese investors are not buying foreign bonds, they’re selling).  Japanese selling of foreign bonds has accelerated further recently, with the announcement overnight that there were ¥1.2 trillion of sales alone during the week to June 21st. Taking a rolling three month average, Japanese investors are selling foreign bonds at a near record pace.

Japanese investors have been selling foreign bonds not buying

It is the China dynamic that I find particularly worrying.  Commentators have focused on the drying up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown.  There is much speculation as to why SHIBOR has soared, the only additional observation I have is that spikes in SHIBOR are nothing new – I wrote a brief comment about a previous episode in January 2011, see funny goings on in Chinese banking sector.  There was a near replica of the current SHIBOR spike exactly two years ago, and while the SHIBOR moves this time around are particularly big, it’s hard to see why this time it’s different and the PBOC won’t supply liquidity.

A much bigger longer term China worry is that market participants still believe that China can grow at 7%+ ad infinitum, but I can’t see any scenario under which this is actually possible.  China’s wages have doubled since 2007 and its currency has appreciated 25% against the euro and 35% against the US dollar (based on spot return) since China dropped its peg in 2005.  Competitiveness has therefore significantly weakened.  Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen.   If you add that an enormous demographic time bomb is starting to go off in China (eg see article from The Economist here), China’s long term sustainable growth must be considerably lower than consensus expectations.  Some believe the Renminbi’s destiny is to become a currency to rival the US dollar.  I think it’s more likely that opening up the capital account will encourage big capital outflows as domestic investors seek superior investment returns abroad (as an aside,  Diaz-Alejandro’s paper Goodbye Financial Repression, Hello Financial Crash offers some background on Latin America’s experience with financial liberalisation in the 1970s and 1980s).

My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and EM debt in particular.  If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich. Rather than regurgitate the arguments, see blog from March (If china’s economy rebalances and growth slows, as it surely must, then who’s screwed?).  I continue to believe that EM and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes (eg Australia, South Africa, Indonesia, Chile, Brazil) are acutely vulnerable.

In sum, EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble.  That doesn’t mean I’m bullish.   The arguments put forward in September 2011 (see The new big short -  EM debt, not so safe) are more valid now than ever.  Foreign ownership of many EM countries’ bond markets has climbed higher (see chart below), and the EM debt outflows of the past few weeks are a pimple on an elephant’s derriere in relation to the decade-long inflows.  These inflows were initially driven by US investors fleeing the steadily depreciating US dollar, and more recently driven by European investors looking to park money outside the Eurozone.   Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.

Foreign ownership has increased enormously

The recent EM debt sell off probably isn’t yet ‘The Big One’, it is more a tremor.  ‘The Big One’ will probably need either US growth and inflation surprising considerably to the upside or China surprising to the downside.  If that happens then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in. It will take a much bigger sell off in EM debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.  Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978-1985, 1995-2002) have been coupled with EM crises.


Chinese housing market, not so magic – will the dragon run out of puff?

‘The ruin of a nation begins in the homes of its people.” – Ashanti proverb

In the last ten years, around the world, we’ve seen a series of housing led credit booms inflict heavy recessions on economies. We seem to be seeing the same thing happening today in parts of China.

Deutsche Bank’s excellent economist Torsten Slok has produced the following graph; which clearly shows how unaffordable house prices are becoming, relative to incomes, in some major Chinese cities.

While property prices in the rest of the world continue to adjust towards more fundamental valuations, China’s credit boom is allowing the opposite to happen.

Current property prices in major Chinese cities are unsustainable. Either they adjust (a bursting of the bubble) or real wages have to catch up (massive inflationary pressure).

The currently inflated dragon is unlikely to survive in its current form.


Government bond returns and “back door” QE policy

Journalists and financial commentators have been kept very busy this year. Market participants and investors have clamoured for information on debt ceilings, credit ratings, and restructurings. 2011 looks like a year that will go down in history as one of the most volatile on record.

With that in mind, I thought it might be useful to focus on the actual returns within government bond markets over the course of the year. The below chart represents the total return of a 7-10 year bond index compiled by Bloomberg/EFFAS in local currency terms.

Government bond 7-10yr returns - YTD

We found this analysis very interesting. Looking at the member nations of the EU, the German government bond market has been the top performer with a 10.0% return, followed by Ireland and Austria with 9.1% and 7.4% respectively. Investors in Italian government bonds have made 1.0% , despite a widening in Italian 5 year CDS from 240 to 450 basis points (currently equating to a 30% probability of a default event occurring in the next 5 years).

There are a couple of factors at play here.

Firstly, all returns are local currency. Government bond yields are major drivers of currency, so the above chart could be capturing currency strength or weakness. In order to account for the currency impact, I have re-based the returns to the world’s reserve currency – the US dollar.

USD weakness has been a major theme this year

We now get a clear picture of a) the US dollar weakness versus most major currencies this year and b) the impact that an increase in risk aversion will have on the returns for government bonds. Clearly, Switzerland and Norway have benefitted from solid appetite for government debt and strengthening currencies versus the USD. Time will tell whether the Swiss National Bank’s intervention in currency markets will be able to be maintained without inflation becoming a concern for the SNB. Though there might be an easier way for the Swiss to benefit from a weak currency – join the euro.

Secondly, European bonds have performed very strongly this year, despite concerns over the ability of governments to fund themselves in capital markets. These returns show that Germany remains a safe haven of choice, despite concerns that it will have to backstop weaker peripheral European nations. This has resulted in Bund yields collapsing, and peripheral European sovereign bonds have benefitted from this (as they are priced off “risk-free” bunds, in a similar way that corporates are). Spreads on peripheral sovereign debt are wide, but absolute yields have fallen.

Finally, there is a big elephant in the room, and Jean-Claude Trichet is riding it. The ECB, through its Securities Markets Programme, spent €13.3bn on sovereign bond purchases last week which brought its total holding of Eurozone government bonds to €188.6bn. Having such a large buyer in the market is obviously keeping yields on European government debt lower than equilibrium levels. The big question that we are trying to digest is just how governments and policymakers can stimulate their economies without further extraordinary monetary policy measures. It looks to us like this has been a jobless recovery, consumers are hiding, and stimulatory fiscal policy can be ruled out due to heavily indebted governments.

Mike referred to QE3 in an earlier blog, and we are starting to think that the odds we might see QE10 in the US are rising. Top of the agenda at the Bank of England’s MPC meeting will be whether it should deploy more QE. As for the ECB, it may well be forced to provide “enhanced credit support” (also known as “backdoor QE” here on the M&G bond desk) for the remainder of 2011.

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