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.

Ana_Gil_100

The M&G YouGov Inflation Expectations Survey – Q2 2014

Today we are launching the next wave of the M&G YouGov Inflation Expectations Survey which aims to assess consumer expectations of inflation over the short and medium term.

With interest rates at multi century lows, central banks continue to inject large amounts of monetary stimulus into the global economy. Recent inflation rates in the US, UK and Germany have proved central to the current market focus, as actions from policymakers have become increasingly sensitive to inflation trends.  This is true for the Fed and the BoE, as markets assess their possible exit strategies/timing, but especially for the ECB, whose last round of action is perceived to have been largely motivated by disinflationary pressures in the Euro area. In that context, market focus on inflation expectations has increased.

The results of the May 2014 M&G YouGov Inflation Expectations Survey suggest that both short and medium-term inflation expectations remain well anchored across most European countries.

Short-term expectations have risen from 2% to 2.3% in the UK as the country showed further signs of economic growth and reaccelerating wage pressure. On the other hand, inflation expectations for German consumers moderated in the last quarter as the downward trend in German HICP (1.1% YoY in April) may have added to the expectation that German inflation will remain subdued over the next year.

The general downward trend in short-term inflation expectations seems to have largely receded in all EMU countries and the UK. This may be somewhat surprising with much of Europe still experiencing low and falling inflation.

Inflation expectations – 12 months ahead

Over the medium term, inflation expectations remain above central bank targets in all countries surveyed, suggesting that consumers may lack confidence in policymakers’ effectiveness in achieving price stability. Over 5 years, UK inflation is expected to remain well anchored at a remarkably stable 3%. Despite recent low inflation rates across Europe, the majority of consumers in France, Italy and Spain continue to view inflation as a concern, and long-term expectations in those countries has risen back to 3%.

Inflation expectations – 5 years ahead

The findings and data from our May survey, which polled over 8,700 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

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Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

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Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

Wolfgang Bauer

The Great Compression of peripheral to core European risk premiums

Are investors still compensated adequately for investing in peripheral rather than core European debt, or has the on-going convergence eroded debt valuation differentials altogether? In his latest blog entry, James highlighted five signs indicating that the bond markets consider the Eurozone crisis resolved. Inter alia, James pointed out that risk premiums for peripheral vs. core European high yield credit had essentially disappeared over the past two years. Here I would like to extend the periphery/core comparison by taking a look at investment grade (IG) credit and sovereign debt.

First, let’s have a look at the spread evolution of peripheral and core European non-financial (i.e., industrials and utilities) IG indices over the past 10 years. In addition to the absolute asset swap (ASW) spread levels, we plotted the relative spread differentials between peripheral and core credit. The past ten years can be divided into three distinct phases. In the first phase, peripheral and core credit were trading closely in line with each other; differentials did not exceed 50 bps. The Lehman collapse in September 2008 and subsequent market shocks lead to a steep increase in ASW spreads, but the strong correlation between peripheral and core credit remained intact. Only in the second phase, during the Eurozone crisis from late 2009 onwards, spreads decoupled with core spreads staying relatively flat while peripheral spreads increased drastically. Towards the end of this divergence period, spread differentials peaked at more than 280 bps. ECB President Draghi’s much-cited “whatever it takes” speech in July 2012 rang in the third and still on-going phase, i.e., spread convergence.

As at the end of March 2014, peripheral vs. core spread differentials for non-financial IG credit had come back down to only 18 bps, a value last seen four years ago. The potential for further spread convergence, and hence relative outperformance of peripheral vs. core IG credit going forward, appears rather limited. Within the data set covering the past 10 years, the current yield differential is in very good agreement with the median value of 17 bps. Over a 5-year time horizon, the current differential looks already very tight, falling into the first quartile (18th percentile).

Peripheral vs. core European non-financial IG credit

Moving on from IG credit to sovereign debt, we took a look at the development of peripheral and core European government bond yields over the past 10 years. As a proxy we used monthly generic 10 year yields for the largest economies in the periphery and the core (Italy and Germany, respectively). Again three phases are visible in the chart, but the transition from strong correlation to divergence occurred earlier, i.e., already in the wake of the Lehman collapse. At this point in time, due to their “safe haven” status German government bond yields declined faster than Italian yields. Both yields then trended downwards until the Eurozone crisis gained momentum, causing German yields to further decrease, whereas Italian yields peaked. Once again, Draghi’s publicly announced commitment to the Euro marked the turning point towards on-going core/periphery convergence.

Italian vs. German government bonds

Currently investors can earn an additional c. 170 bps when investing in 10 year Italian instead of 10 year German government bonds. This seems to be a decent yield pick-up, particularly when you compare it with the more than humble 18 bps of core/periphery IG spread differential mentioned above. As yield differentials have declined substantially from values beyond 450 bps over the past two years, the obvious question for bond investors at this point in time is: How low can you go? Well, the answer mainly depends on what the bond markets consider to be the appropriate reference period. If markets actually believe that the Eurozone crisis has been resolved once and for all, not much imagination is needed to expect yield differentials to disappear entirely, just like in the first phase in the chart above. When looking at the past 10 years as a reference period, there seems to be indeed some headroom left for further convergence as the current yield differential ranks high within the third quartile (69th percentile). However, if bond markets consider future flare-ups of Eurozone turbulences a realistic scenario, the past 5 years would probably provide a more suitable reference period. In this case, the current spread differential appears less generous, falling into the second quartile (39th percentile). The latter reading does not seem to reflect the prevailing market sentiment, though, as indicated by unabated yield convergence over the past months.

In summary, a large portion of peripheral to core European risk premiums have already been reaped, making current valuations of peripheral debt distinctly less attractive than two years ago. Compared to IG credit spreads, there seems to be more value in government bond yields, both in terms of current core/periphery differentials and regarding the potential for future relative outperformance of peripheral vs. core debt due to progressive convergence. But, of course, on-going convergence would require bond markets to keep believing that the Eurozone crisis is indeed ancient history.

jamestomlins_100

5 Signs That the Bond Markets (rightly or wrongly) think the Eurozone Crisis is Over

Regardless of your opinion on the merit of the ECB’s policy, there is little doubt that the efficacy of Mario Draghi’s various statements and comments over the past 2 years has been radical.  Indeed there are several signs in the bond markets that investors believe  the crisis is over. Here are some examples:

1)      Spanish 10 yr yields have fallen to 3.2%, this is lower than at any time since 2006, well before the crisis hit, having peaked at around 6.9% in 2012. This is an impressive recovery, almost as impressive as …

Spanish 10 Year Government Bond Yields

2)      The fall in Italian 10 year bond yields, which have hit new 10 year lows of 3.15%, lower than any time since 2000. The peak was 7.1% in December 2011. To put this in context, US 10 year yields were at 3% as recently as January this year.

Italian 10 Year Government Bond Yields

3)      Last month, Bank of Ireland issued €750m of covered bonds (bonds backed by a collateral pool of mortgages), maturing in 2019 with a coupon of 1.75%. These bonds now trade above par, with a yield to maturity of 1.5%. The market is not pricing in any material risk premium relating to the Irish housing market.

4)      There is no longer any risk premium within the high yield market for peripheral European risk. The chart below (published by Bank of America Merrill Lynch) shows that investors in non-investment grade corporates no longer discriminates between “core” and “peripheral” credits when it comes to credit spreads.

Core vs. peripheral high yield bond spreads

5)      Probably the biggest sign of all, is that today Greece is re-entering the international bonds markets. The country is expected to issue €3bn 5 year notes with a yield to maturity of 4.95%.

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The power of duration: a contemporary example

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

US UK and German 10 year yields

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

The importance of duration

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come.  As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

anthony_doyle_100

Should the Bank of England hike rates?

Many of us have become accustomed to a world of ultra-low interest rates and quantitative easing (QE). Taking into account inflation, real short-term interest rates are negative in most of the developed world. Of course, these historically low interest rates were a central bank response –co-ordinated on some occasions – to the Great Financial Crisis of 2008. Whilst we are still waiting for the official data, it appears increasingly likely that 2013 marked the start of a synchronised recovery in the advanced economies. So is it now time for the Bank of England to consider hiking the base rate? Perhaps good – and not awesome – economic growth is more appropriate to avoid a bust down the line.

Economic theory and real world experience tells us that interest rates that are kept too low for too long will distort investment decisions and lead to excessive risk-taking. They may also result in the formation of asset price bubbles that ultimately collapse. With parts of the UK housing market (including London and the south-east) posting double-digit returns in 2013, the FTSE 100 within arm’s reach of an all-time high last seen during the tech bubble (and up over 60% since 2009), and UK non-financial corporate bond spreads 45 basis points away from 2007 lows; it is clear that ultra-low interest rates have had a great effect on both financial markets and the real economy.

At the risk of being called a party pooper, here are 5 reasons why I think we could see an interest rate hike before year end (the market is pricing in around February/March 2015), and certainly before the third quarter of 2016 (the time when the BoE think the unemployment rate will fall to 7%).

  1. Asset price bubbles are forming
  2. Unemployment is falling quickly towards 7%
  3. Inflation risks should not be forgotten
  4. The Taylor rule suggests interest rates are way below neutral
  5. The risk of Euro area break-up appears to have fallen

Asset prices bubbles are forming

There has been a significant run-up in UK financial assets over the course of the past five years, particularly since QE became a feature of the financial landscape. Investors in equity and bond markets alike have been enjoying the fruits of QE. Those that own financial assets have seen their net wealth increase substantially from the post-crisis lows. Consensus forecasts for 2014 suggests that most market forecasters expect another robust year for risk assets, fuelled by easy money and the search for positive real returns.

Of course, the greatest financial asset that the average UK household own is their own house. In 2011, it was estimated that around 15 million households are owner-occupied (a rate of around 65% of total households). Thus it is unsurprising that newspaper readers are usually hit with a headline about rising house prices on a daily basis. House prices, on a number of measures, have begun to accelerate again with low interest rates and tight housing supply a key contributor to the price increase. Low interest rates have given UK consumers the incentive to accumulate high levels of household debt compared to their incomes.  The average house price is now 5.4 times earnings, the highest level since July 2010 and well above the long-run average of 4.1.

UK house prices are re-accelerating and pushing higher

The Help-To-Buy scheme is contributing to the run-up in this highly leveraged and interest-rate sensitive sector (a topic I covered back in July here). By hiking the base rate this year, the BoE would hopefully achieve a reduction in speculation and debt accumulation in the housing sector. This would not be a popular action to take – it never is – but we should all be wary about the damage a rampant housing market can have on an economy.  BoE Governor Mark Carney – as head of the Financial Policy Committee – has already moved to stop the Funding for Lending Scheme and mentioned that placing restrictions on the terms of mortgage credit may be a tool that can be used to reign in house prices.

Whether macro-prudential policy tools will work or not remains open to debate. Ultimately, central banks are trying to focus in on one element of the economy by raising interest rates or restricting credit. We do have a real-life macroeconomic example currently taking place though. On October 1, the Reserve Bank of New Zealand imposed a limit on how much banks could devote to low-deposit loans and required major banks to hold more capital to back loans. It’s very early days but for the month of November, the Real Estate Institute of New Zealand reported a 1.2% increase in New Zealand house prices and 9.6% over the year. The RBNZ and BoE might find that trying to slow the housing market using macro-prudential measures is a bit like trying to stop a car by opening the doors and hoping that wind-resistance does the rest. You really need to put your foot on the brake.

The longer the boom lasts, the greater the pain when it inevitably ends.

Unemployment is falling quickly towards 7%

The unemployment rate has fallen from 7.9 to 7.4% over the past nine months and is a key tenet of the BoE’s forward guidance. The fast decline has seen some speculation amongst economists that the BoE may lower the unemployment threshold from 7.0 to 6.5%. Of course, the 7.0% threshold that it has set it is not a trigger to hike interest rates, rather it is a point at which the BoE would consider hiking rates. However, the labour market has improved much quicker than the BoE has been expecting with the unemployment rate now sitting at the lowest rate since March 2009. We are still well above the average unemployment rate seen during the period between 2000 and 2008, but I would argue that this was an abnormal period for the UK economy. It was a NICE period – non-inflationary, constantly expanding – and is unlikely to be repeated. Arguably the UK’s natural rate of unemployment is now a percentage point or two higher than that of the noughties, suggesting less spare capacity in the UK economy than many expect. It may not be long before we start to see wage demands start to pick up, leading to rising inflationary pressures. Higher wage growth in 2014 would bode well for consumption and household net wealth given the increase in house prices and investment portfolios.

The UK unemployment rate is below the long-run average

As it is generally accepted that monetary policy operates with a lag, (the BoE estimate a lag time of around two years), and the unemployment rate itself is a lagging indicator of economic activity. If the BoE waits until the unemployment rate hits 7%, or for confirmation that economic growth is strong, then it may be too late. A slight tap on the breaks by hiking the base rate may be appropriate.

Inflation risks should not be forgotten

Ben wrote an excellent piece on the UK’s inflation outlook last month. To quote:

Current inflation levels may seem benign. However, potential demand-side shocks coupled with a build-up in growth momentum and the difficulty of removing the huge wall of money created by QE will pose material risks to inflation in the medium term. Markets have become short-sightedly focused on the near term picture as commodity prices have weakened and inflation expectations have been tamed by the lack of growth.

In addition, central banks have a nasty habit of keeping monetary policy too loose for too long. It even has a name – “The [insert FOMC Chairperson Name] Put”. The easy-money policies of the FOMC in the 1970s are seen as a key contributor to the runaway inflation seen during the period.  Eventually, the FOMC reversed its own policies, hiking rates to 19% in 1981.

Of course, what central bankers really fear is that ultra-easy monetary policy and the great experiment of QE will lead to an increase in inflation. A return of inflation will only be tamed by hiking rates. Whilst the inflation rate has been moderating in the UK and is close to the Bank of England’s target at 2.1%, it follows almost 5 years of above target inflation. Whist it is not a clear and present danger, the experience of the 1970s suggests that we cannot ignore the threat that inflation poses to the UK economy, especially as rising inflationary expectations are often difficult to contain.

The Taylor rule suggests interest rates are way below neutral

The Taylor rule provides a rough benchmark of the normal reaction to economic conditions as it relates interest rates to deviations of inflation from target and the output gap. According to the Taylor rule for the UK, a base rate of 0.5% is around 2.0% below where it should be given current rates of growth and inflation.

The BoE base rate remains highly stimulatory

Negative real interest rates have done the job by stabilising the economy, but is it now time to tap the brakes? With the UK economy growing at an annualised rate of more than 3% in the second and third quarters of 2013 (above the long-term average of 2%), the UK may be operating much closer to full employment than many currently estimate. Forward looking survey indicators and economic data suggest the UK economy is growing strongly, with business confidence at a 20 year high and the UK Services PMI for December suggesting a strong broad-based upturn. Of course, the BoE would like the other components of GDP like exports and investment to contribute more to economic growth. A rising currency wouldn’t help this. But sometimes it is difficult to have your cake and eat it too, especially if you are a central banker.

The risk of Euro area breakup appears to have fallen

Now it’s time for the “Draghi Put”. Draghi’s famous “whatever it takes” speech is probably the most important speech ever given by a central banker. The speech has had a fantastic effect on assets from government bonds to European equity markets and everything in between. More importantly, as I wrote here back in July 2013, despite the problems that Europe faces – the concerning outlook, the record levels of unemployment and debt, the proposed tax on savers in Cyprus – no country has left the EMU. The EMU has in fact added new members (Slovakia in 2009, Estonia in 2011, Latvia in 2014). European countries remain open for trade, have continued to enforce EU policies and have not resorted to protectionist policies. EU banking regulation has become stronger, the financial system has stabilised, and new bank capital requirements are in place.

This bodes well for the UK, as stabilisation in the Eurozone suggests stronger export demand, increased confidence, and higher investment in the UK from European firms. Perversely, an interest rate hike might actually improve confidence in the UK economy, signalling that the central bank is confident that economic growth is self-sustaining.

The BoE must walk the tightrope between raising rates slightly now to avoid higher inflation and financial instability or risk having to do a lot more monetary policy “heavy-lifting” down the line. A base rate at 0.5% is way below a neutral level and the BoE has a long way to go before getting anywhere near this level. It could act this year and gradually start raising interest rates to lessen the continued build-up of financial imbalances. The difficult action in the short-run to raise the base rate will help to support “healthy” economic growth in the long-run.

anthony_doyle_100

The M&G YouGov Inflation Expectations Survey – Q4 2013

The M&G YouGov Inflation Expectations Survey for November shows that consumers in all countries surveyed expect inflation to rise from current levels in both one and five years’ time. In the UK, short-term inflation expectations fell over the quarter to 2.8%, following recent downward pressure on UK CPI. It may also suggest that the shock from recent increases in utility bills may be fading. Over five years, however, inflation is once again expected to rise to 3.0%, suggesting expectations for future inflation remain well anchored above the Bank of England’s (BoE) CPI target of 2.0%. We did not see the same spike in inflation expectations as in other recent inflation expectations surveys such as the Bank of England’s own survey, possibly as ours is more recent and was conducted between November 22-25.

In Europe, all countries surveyed with the exception of Switzerland, expect inflation to be equal to or higher than the European Central Bank’s (ECB) CPI target of 2.0% on both a one- and five-year ahead basis. All European Monetary Union (EMU) countries expect inflation to be higher in both one and five years than it is currently, while only two countries – Spain and Switzerland – anticipate it being less than 3.0% in 5 years’ time.

Comparing the results with those from earlier surveys reveals a number of noteworthy observations. Inflation expectations for one year ahead have fallen in all surveyed EMU countries since the start of 2013. This is unsurprising given the weak macroeconomic environment and the fact that commodity prices have declined by roughly 5.6% in the past three months. Consumers have also benefitted from a stronger euro, which has gained around 6.6% over the past year on a real effective exchange rate (REER) basis. Notably, short-term inflation expectations in France, Spain and Italy are now running well above their current inflation rates.

Survey respondents in Hong Kong show no signs of moderating their inflation expectations, which remain at a high level of 5.0% and 5.5% over one and five years, respectively. In Singapore, inflation expectations over one year are double current inflation (2%) whilst the five-year reading remains stable at 5.0%, as it has done throughout the course of 2013.

The findings and data from our November survey, which polled over 8,500 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

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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.

Enjoy!

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