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

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

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

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

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

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

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

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

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

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Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

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J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.

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Winners of our @inflationsurvey competition. The M&G YouGov Inflation Expectations Survey for 4Q 2013 will be released next week.

Beginning of November, we published a blog announcing the release of our Q4 YouGov Inflation Expectations Survey for early December. We are now in the final stages of collating and analysing the survey results and will publish the full report in the coming days on Twitter (@inflationsurvey) and our bond vigilantes blog. For those of you who are not aware (where have you been?!), the survey was created by M&G’s retail fixed interest team in partnership with YouGov. We ask over 8,000 consumers from the UK, Europe, Hong Kong and Singapore what their expectations are for inflation over the next 1 and 5 years. This has grown ever more important as central banks have sought to manage interest rate expectations through forward guidance.

The results of the Q3 Survey published last September as well as previous surveys are available here.

So congratulations to the 15 winners listed below, who were chosen at random amongst all our @inflationsurvey followers and who will each receive a copy of Frederick Taylor’s “The Downfall of Money”. We will DM each of you asking for your address so we can send you the book.

Simon Lander @simonlander01
Britmouse  @britmouse
Ian Burrows  @ian_burrows
Richard Lander  @richardlander
Iain Martin ‏  @_IainMartin
Morningstar UK ‏  @mstarholly
Brian Simpson ‏  @simpsob1
Amir Rizwan  @amirriz1
Tim Sharp ‏  @tm_sharp
Leanne Hallworth ‏  @leanneha41
Kevin Fenwick @kevinfenwick
Nico  @nicolocappe
qori nasrul ulum  @reme_dial
Alexander Latter  @AlexanderLatter
Ace AdamsAllStar  @AceAdamsAllStar

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Competition: follow @inflationsurvey on Twitter to have a chance to win one of 15 copies of The Downfall of Money by Frederick Taylor

At the end of October, the Citigroup Inflation Expectations survey showed a record jump in UK inflation expectations. The medium term expectation for UK inflation rose from 3.3% in September to 3.9%, and the number of people expecting inflation over 5% also rose significantly. Inflation expectations have become increasingly important in the UK because, as part of Bank Governor Carney’s new forward guidance regime announced in August, the Bank can raise rates even if unemployment remains high if inflation expectations become “unanchored”. Of course the period when the Citigroup survey was conducted was one where the major UK energy suppliers had announced annual price hikes of around 10%, and this spike in inflation expectations may well not persist. But it will have worried the Bank, and the gilt market fell on the release of the data.

Whilst UK inflation was making the news for its potential to surprise on the upside, Europe faced a very different scenario. October’s euro area CPI reading came in at an annual rate of 0.7%, down from 1.1% in September and below the market’s expectations. A Taylor Rule would suggest that with inflation so far from the ECB’s target of 2%, the central bank should be aggressively easing monetary policy (beyond today’s 25 bps cut, and beyond the zero bound to include QE?).

The next M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies will be released in December. These M&G YouGov surveys are based on the best practice methodology discussed by the New York Fed (for example asking people about inflation rather than “prices of things you buy” as that sort of question tends to make people think solely of milk, bread and beer). We also have a bigger data sample than many of the other inflation surveys. Finally we also ask some interesting supplementary questions on issues like government economic policy credibility. As inflation expectations become increasingly important to central banks we think that we need to pay more attention to them – to date they have been well anchored, despite money printing through QE, but if this changes then so will central bank behaviour.

The Q4 M&G YouGov Inflation Expectations Survey will be released through Twitter. Follow @inflationsurvey to get the release time and date, and also to access the detailed report in December. The feed will also tweet on other inflation surveys and measures of inflation expectations. We hope you find it useful.

To encourage you to follow @inflationsurvey and be first to get the survey results, everybody who does so (and existing followers) will be put into a draw to win one of 15 copies of Frederick Taylor’s The Downfall of Money. This is the story of Germany’s hyperinflation of the 1920s, where the Reichmark fell to 2.5 trillion to the US dollar, and the economy collapsed – arguably sowing the seeds of the Second World War.

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Click here for terms and conditions.

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The European monetary zone getting back on course ?

In my last blog I focused on the transition mechanism of financial policy in the UK, with government actions targeting the housing market, thus having the effect of loosening monetary policy. This encouraged us to look once again at the situation in Europe. Is the ECB any nearer making the monetary transmission system actually work?

Back in May 2011 we wrote about how the monetary system in the eurozone was not working effectively because different nations faced different interest rates in the private and public sector. One central bank rate was not being transmitted across the whole eurozone.

By using official money market rates as depicted by Euribor and adding bank CDS spreads as a proxy for the real cost of borrowing, we illustrated the difficulty the ECB was having in transmitting a single policy through a fractured financial system. We have brought the chart up to date below, and as you can see, the situation is no longer as extreme.

Estimate of marginal funding cost for peripheral banks

Thankfully, some semblance of order is being returned. The drag on growth from the massive fiscal adjustment that most of Europe has been through over the past few years could be petering out. Hopefully, less restrictive policy will point to future economic growth across the region. Although some progress has been made and funding costs have come down, access to credit remains restricted for many in the real world (see for example Ana’s blog from August). But if the ECB and the authorities can continue to heal the banking system then a virtuous circle of confidence could return to the eurozone, once again making loose monetary policy set by the ECB flow into the real world in the periphery.

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Spain’s answer to recession – the times they are a-changin’

Times are changing in Spain, or at least they might – and I am not alluding to tentative signs of economic recovery, such as the recent upgrade of Spain’s 2014 growth forecast from 0.5% to 0.7%. I am, quite literally, referring to a possible change of time in Spain. In late September, a Spanish parliamentary commission issued a report in favour of turning clocks back one hour in Spain. Being located in the wrong time zone, so the argument goes, had negative implications on eating, sleeping and working habits, and hence, a corrective time shift might improve public health as well as economic productivity. Interestingly, Spain had not always been in its current time zone but was moved one hour ahead in 1940 at General Franco’s command to be in line with then fascist allies Germany and Italy. But does the commission have a point; should Spain return to its pre-war time zone?

Let’s have a look at time zones in the European Union. Ignoring overseas territories, EU member countries use three time zones – Western European Time (WET, UTC+00:00), Central European Time (CET, UTC+01:00) and Eastern European Time (EET, UTC+02:00) – as well as the respective daylight saving time derivatives. In the following, only relative time differences between countries will be relevant. Therefore, to simplify matters, we can disregard daylight saving time since all EU member countries move clocks back and forth in sync anyway. Only three EU countries use WET: Portugal, Ireland and the UK. EET is used in the Baltics as well as in Finland, Romania, Bulgaria, Greece and Cyprus. Spain, except for the Canary Islands, is located in the CET zone together with the remaining EU countries.

In order to assess on a geographical basis whether Spain is placed in the wrong time zone or not, I took a look at the location of some of the largest Spanish and other major European cities using WET or CET. For each city I then calculated in degrees of longitude the difference between its actual location and the central axis of its time zone, i.e. the prime meridian for WET and the 15th meridian east for CET.

Is Spain in the wrong time zone?

Amongst these European cities, sorted from west to east, Spanish towns (light green colour) exhibit the highest levels of misplacement. In particular Vigo, located in the north-west autonomous community of Galicia, features an impressive discrepancy of nearly 24°. Apart from Spain, cities in western France, such as Bordeaux, show very high displacement values. Western European cities using WET (marked with an asterisk), e.g. Lisbon, Dublin and London, have distinctly lower discrepancies, though, as their reference axis is the prime meridian rather than the 15th meridian east. Strictly speaking, only cities east of the Benelux countries, i.e. Rome onwards in the chart, are fitting geographically into the CET zone. Spain, in contrast, is clearly much more suitable for the WET zone. Sticking with CET causes a permanent mismatch between official time and actually perceived solar time. But why has Spain not switched to WET long time ago?

One reason is that some of the effects of the time mismatch are actually considered desirable. For instance, an extra hour of sunshine in the evening might be beneficial for tourism in Spain. Another consideration to be taken into account is the effect a change from CET to WET would have on Spain’s cross-border business. It is likely that in case of a switch to WET, business with CET countries would become more difficult. Due to a misalignment of daily schedules, business and trading hours, transaction costs could rise. Similarly business with EET countries might suffer as an additional hour of time difference would be added. In contrast, business with WET countries would most likely be facilitated. In order to evaluate these contrary effects, I grouped Spain’s intra-EU exports and imports over the past five years into time zones. For the sake of simplicity, I did not include Spain’s foreign trade outside of the EU. Major trading partners, such as China and the US, are separated from Spain by several time zones, and hence a shift of one hour would most likely have only negligible consequences.

Which time zone dominates Spain’s EU exports and imports?

Over the past five years the composition of Spain’s EU exports and imports by time zone has remained remarkably stable. EET countries are only niche markets for Spain’s exports and imports. Both sides of the balance of trade are clearly dominated by business with CET countries (72-74% of exports and 80-81% of imports). Exports to and imports from WET countries account for only 22-24% and 16-18%, respectively. This suggests that moving from CET to WET bears the risk of making the vast majority of Spain’s EU trade more difficult.

But is there a way to reduce this risk and still enable Spain to switch to WET?  Well, here is a thought: Spain could launch a lobbying campaign and convince France as well as the Benelux countries to switch together from CET to WET. As shown in Chart 1, cities in these countries, particularly in western France, would geographically fit much better into the WET zone. In addition, there is also a political argument to be put forward as CET was introduced at gunpoint in these countries during the German occupation in the Second World War. Therefore, a move to WET could be presented to the affected electorate as a long overdue measure to remove the legacy of fascist aggression in western Europe – and who could seriously question such an honourable pursuit? A large-scale move of several major EU countries from CET to WET would have significant implications for the composition of Spain’s EU exports and imports as well as for the economic power balance of the EU in general. The below chart compares the actual 2012 percentage division of Spain’s EU exports and imports as well as the EU’s GDP into time zones with a hypothetical 2012 scenario in which Spain, France and the Benelux countries are located within the WET zone.

What if France and the Benelux countries adopted WET, too?

As pointed out above, in terms of Spain’s EU exports and imports CET countries currently dominate over WET countries. However, if other major western European countries moved together with Spain to WET this relationship would reverse, as indicated in the theoretical scenario. In this case, WET countries would account for 58% of Spain’s EU exports and 53% of its EU imports. Furthermore, the economic weights of CET and WET within the EU would change drastically. The WET’s share of the total EU GDP would rise from 17% to 49%, whereas the CET’s share would drop accordingly from 78% to 46%.

In conclusion, it would make perfect sense for Spain to switch from CET to WET for geographical reasons. However, in order to guard against potential negative side effects on its cross-border business, Spain should lobby hard to convince France and the Benelux countries to copy its move. If this move is successful, then Portugal, Ireland and the UK will likely benefit as well.

Finally, if you think Spain has time-keeping issues, spare a thought for India and China. Indian Standard Time applies throughout India and Sri Lanka, and is confusingly GMT+ 5 hours 30 minutes.  The time zone covers over 28 degrees of longitude, meaning the sun rises two hours earlier in the east of India than the west.  Meanwhile, China has one official time zone spanning more than 60 degrees of longitude (the 48 contiguous US states cover 25 degrees of longitude), and while this problem is tempered by most of the Chinese population living on the east coast, sunrise in the western city of Kashgar can be as late as 10.17am!

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How do house prices feed into inflation rates around the world? It’s important for central banks, and for bond investors.

After the collapse in real estate prices in many of the major developed nations during and after the Great Financial Crisis, housing is back in demand again. Strong house price appreciation is being seen in most areas of the US, in the UK (especially in London), and German property prices have started to move up. We’re even seeing prices rise in parts of Ireland, the poster child for the property boom and bust cycle. I wanted to take a quick look at what rising house prices do for inflation rates. Not the second round effects of higher house prices feeding into wage demands, or the increased cost of plumbers and carpets, but the direct way that either house prices, mortgage costs and rents end up in our published inflation stats. Also, the question about whether central banks should target asset prices is another debate too (there’s some good discussion on that here).

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There is no simple answer to the question “how do house prices feed into the inflation statistics”. It varies not just from country to country, but also within the different measures of inflation within one geographical area. But given central banks’ rate setting/QE behaviour is determined by the published inflation measures it’s important to understand how house prices might, or might not, drive changes in those measures.

The US

“Shelter” is around 31% of the CPI which is used to determine the pricing of US inflation linked bonds (TIPS), but just 16% of the Core PCE Deflator, the measure that the Federal Reserve targets. The PCE is a broader measure, with much bigger weights to financial services and healthcare, so shelter measures therefore have to have a smaller weight in that measure. The CPI shelter weight looks high by international standards. For the Bureau of Labor Statistics, the purchase price of a house is not important except in how it influences the ongoing cost of providing shelter to its inhabitants. The method that the BLS uses to determine what those costs might be is “rental equivalence”. It surveys actual market rents, and augments this data by asking a sample of homeowners to estimate what it would cost them to rent the property that they live in (excluding utility bills and furniture). You can read a detailed explanation of this process here. In both the CPI and PCE, pure market rents are given around a quarter of the weight given to OER, Owners’ Equivalent Rent. There are problems with this – and not just with the accuracy of the homeowners’ rental guesses. Having rents and rental equivalence in the inflation data rather than a house price measure means that you can have – simultaneously – a house price bubble, and a falling impact from house prices in the inflation data. We’ve seen times when a speculative frenzy means house prices rise, but the impact of that speculation is overbuilding of property (just before the 2008 crash there was 12 months of excess inventory of houses in the US compared to a pre-bubble level of around 5 months) leading to falling rents. The reverse happened as the US recovered. House prices continued to tank, but because of a lack of mortgage finance more people were forced to rent, pushing up rents within the inflation data.

The UK

How house prices feed into the UK inflation data depends on whether you care about CPI inflation (which the Bank of England targets) or RPI inflation (which we bond investors care about as it’s the statistic referenced by the UK index linked bond markets). House prices directly feed into the RPI, but because house prices have little direct input into the CPI, the recent trend higher in UK property will lead to a growing wedge between the two measures – good news for index linked bond investors! The RPI captures house price rises in two ways – through Mortgage Interest Payments (MIPs) and House Depreciation. Mortgage payments will increase as the price of property rises, but they will most quickly reflect changes in interest rates. For example Alan Clarke of Scotia estimates that a hike in Bank Rate of 150 bps would feed almost immediately into the RPI, adding 1% to the annual rate. This is despite the trend in the UK for people to fix their mortgage payments. Housing Depreciation linked to UK house prices with a lag, and is an attempt to measure the cost of ownership (a bit like the BLS’s aim with rental equivalence) but has been criticized as overstating the cost of ownership in rising markets as house price inflation is almost always about land values accelerating rather than the bricks and mortar themselves. Land does not depreciate like other fixed assets (no wear and tear). Housing is very significant in the UK RPI, making up 17.3% of the basket (8.6% actual rents, 2.9% MIPs, 5.8% depreciation).

The UK’s CPI is a European harmonised measure of inflation. It only takes account of housing costs through a 6% weight on actual rents. There has never been agreement within the EU about how wider housing costs should be measured! Countries with high levels of home ownership have different views from countries with a high proportion of renters. Housing is around 18% of the expenditure of a typical person in the UK, so the Office of National Statistics regards the current CPI weight as a “weakness”. They therefore are now publishing CPIH, which includes housing on a rental equivalence basis (the same idea that the ONS measures “the price owner occupiers would need to rent their own home” as a dwelling is a “capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period”). CPIH has a 17.7% weight to housing, but remains an experimental series, and plays no part in the official monetary targets.

The Eurozone

The European Central Bank targets CPI inflation, at or a little below 2%. As mentioned above the harmonised measure that Eurostat produces does not include any measure of housing other than actual rents, with a weight of 6%. If you think house price inflation (or deflation) is important for policymakers this low weighting has probably never mattered since the Eurozone came into existence. Although there have been pockets of very high house price inflation (Spain, Ireland, Netherlands) because the Big 3, Germany, France and Italy have had very little house price movement I doubt that a CPIH measure would be terribly different. We are, however, now seeing some upwards movements in the German residential property market in “prime” regions – albeit it as Spanish and Dutch house prices continue to freefall. It’s also important to note the range of importance of rents within the individual countries’ CPI numbers. For Slovenians it makes up 0.7% of their inflation basket, but for the Germans it is 10.2%.

Japan

Housing makes up 21% of the headline CPI. Like the US CPI the Japanese statistical authorities use a measure of an “imputed rent of an owner-occupied house” as well as actual rental costs. Again the imputed rents from owner occupiers (15.6%) dwarf the actual numbers from renters (5.4%) – aren’t these large weightings to imputed rents here and elsewhere a bit worrying? How would you homeowners reading this go about guessing a rent for your property? I’d only get close by looking at websites for similar places to mine up for rent nearby. Is that cheating?

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So why does this matter? Well if there is no correlation between house price inflation and consumer price inflation then it probably doesn’t. But intuitively both the direct impact on wage demands of workers who see house prices going up, and the wealth effect on the consumption of those who see their biggest asset surging in value should be significant. Therefore central banks will be missing this if they use statistics where the relationship between house prices and their impact in those statistics is weak.

 

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A roadmap for Europe after the German elections

August is usually a dull month in German politics. It’s holiday season, and national parliamentary politics takes a break at the same time. However, this year German politicians don’t have time to put their feet up. The period of parliamentary recess marks the peak of the electoral campaign in Germany before the general elections take place on 22 September. Many people seem to expect that not only will the holiday period end in September, but also the recent lull in European politics. The hope is that the European Union, and the Eurozone in particular, will finally move on to sorting out its structural issues once the German elections are over. I’m not really convinced that this is going to be the case, and here is why.

Not much upside from a shift in policy

Angela Merkel has indicated she would like to renew the current coalition with the liberal FDP after the general elections in September, while the Social Democrats (SPD) and Greens strive for a remake of their 1998/2002 electoral victory. Merkel’s Christian Democrats are currently far ahead in the polls, but a renewal of the coalition with the stumbling FDP is highly uncertain. On the other hand, a coalition of SPD and Greens looks as probable as an English victory against Germany in a football tournament through a penalty shootout. This could leave the two major parties, CDU/CSU and SPD, with the choice of immediate snap elections or a grand coalition. I tend to believe that they would not ignore the electoral will of the German people who remain very open towards the idea of a grand coalition. The recent figures from one of the major German polls, the ARD-DeutschlandTrend, suggest that 23 per cent would prefer a coalition of CDU/CSU and SPD, while the parties’ preferred coalitions qualified for 17 per cent of the poll votes each. In addition, around half of the Germans have consistently described a coalition of CDU/CSU and SPD as a very good or good option over the past few months. If CDU/CSU supporters are left with a coalition choice between Greens and SPD under the assumption of a shortage of combined votes with the FDP, then polls suggest a strong preference for the SPD. That is, the most likely coalition options after the general elections seem to be: CDU/CSU and FDP (existing coaliton) or CDU/CSU and SPD (grand coalition).

It stands out in the current electoral campaign that Europe has not been a major topic. European politics does not feel like a policy area where the major opposition party SPD can win votes or would be able to distinguish itself sufficiently from the government’s policy stance. This has also been reflected by the previous legislature period when the opposition parties widely tolerated Merkel’s course on Europe. Bearing the previous policy stance as well as the current polls in mind, I struggle to find strong arguments why a new German government would fundamentally change European day-to-day politics. I expect a continuation of the pragmatic approach of austerity-focused, but sufficiently accommodative steps to keep the Eurozone together, including another bailout package for Greece that treasurer Schäuble hinted upon. Thus far, this political approach has proven to be fairly successful domestically. It feels that it’d require a major game changer to trigger an immediate change in policy. It seems more likely that any political developments with regard to Europe may rather be undertaken with a long-term time horizon.

Deeper European integration could require a referendum in Germany

While a newly elected German government might find it politically too costly to redefine European day-to-day politics, it could also struggle to conclude long-term structural reforms – ranging from Euro bonds, more centralised European governance of national budgets to full political and fiscal union. The president of the German Constitutional Court, Andreas Voßkuhle, pointed out in 2011 that the German Constitution does not allow for further significant European integration. He concluded that the additional transfer of national sovereignty to the European Union, eg the national budget, would require a referendum. This is very noteworthy as Germany has not had a referendum in its post-war history despite the adoption of a new constitution, membership in the European Union as well as the re-unification of East and West Germany. The preparation of a referendum takes a significant amount of time, and the selection of a date is a sensitive issue. In this instance, it might also take time to explain to the public why the proposed structural changes, eg a political and fiscal union, would be in their long-term interest and how it would affect their life as national citizens. The referendum would most likely be based on the adoption of a new European Union treaty which would provide for the future design of European politics and governance. The ratification process and enactment of the last EU treaty, the Lisbon treaty, took more than five years from June 2004 to December 2009. Factoring for some potential political goodwill this time, wouldn’t the next German general elections in 2017 be a reasonable point in time to ask the political parties to communicate their positions on the subject and to let voters subsequently decide upon their future within Europe (or outside)?

Policymakers are unlikely to bear political and fiscal costs amid uncertainty

This may sound familiar to our British readers whose Conservative party has already announced its intentions to call for a referendum on Britain’s future in the European Union by 2017. In the UK, the Conservative party’s commitment to 2017, as well as the prospect of an indispensable referendum in Germany (and elsewhere in Europe), might have set a reasonable deadline for European leaders to develop a concept for the future institutionalisation and integration process of the Union, including the Eurozone. This could then be ratified across Europe, including Germany. Not 2013, but 2017 could mark a historically important year for European politics as national voters could be asked to re-commit to a deeply integrated (and burden-sharing) Europe. If such a scenario for Europe turns into a national government’s base case, it will be difficult to picture these policymakers agreeing on politically and fiscally costly policy measures that go beyond the current pragmatic attitude towards Europe. This argument could not only hold with regard to the aforementioned countries – Germany (anything beyond emergency bail-outs for Eurozone peers) and the UK (financial regulation and EU banking reform) – but also for governments that currently face a strong headwind in the polls. A very recent example is the political situation in the Netherlands where the current government would be dwarfed to a vote share of 23 per cent from a share of 53 per cent in last year’s elections, while the right wing and euro-sceptical party PVV has gained around 10 per cent in electoral support.

If I had to draw a roadmap for Europe until 2017, then the first part of this political journey would carry significant risk of a slow moving city traffic experience, but which could ultimately end on the high-speed Autobahn.

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The arguments in favour of the euro surviving

Poor economic growth prospects, high unemployment, large debt burdens, poor public finances – it is all too easy for analysts and economists to say that the euro won’t be around indefinitely. Yet here we are, coming up to the five year anniversary of the Lehman Brothers collapse and having lived through a number of sovereign debt crises, and the euro remains the single currency for the Economic and Monetary Union (EMU) after being established in 1999. Many will argue, as we have in the past, that a monetary union is unsustainable without a full and proper fiscal union and that to devalue internally through lower unit labour costs is too painful for countries like Ireland and Greece. This would likely result in a divergence of growth within the Eurozone. However, we have to acknowledge that the European Union members and European Central Bank have done a remarkable job of managing the short-term symptoms of the crisis and have met every challenge that having the monetary union in place has produced so far.

That said, the long-term challenge remains: convergence amongst the Eurozone members so that a single monetary policy based on some level of price stability is as relevant for Germany as it is for Greece. The difficulty in achieving this convergence is the main challenge facing the EMU today due to the difficulties in operating under a single monetary policy and a single exchange rate.

With this in mind, now is a good time to think about whether the most ambitious currency union in history has the legs to go the distance after all. What are the main reasons why the euro will survive and prosper in the future?

The Eurozone is on the cusp of recovery and there are signs of convergence amongst members

Leading indicators like the PMIs and industrial production are pointing toward positive growth in Q2. Consumer confidence is improving, while unemployment numbers are starting to slowly improve in some countries as well. Of course, Europe is not yet out of the woods and continues to face significant growth headwinds which we have written about before. Nonetheless, it may be that we are witnessing the some early signs that the substantial structural reforms in the periphery are starting to bear some fruit.

Importantly, the Eurozone is showing signs of rebalancing. Unit labour costs (ULC) rose too quickly during the boom years in peripheral Europe and in Germany they did not increase enough. This eventually resulted in a large difference in competitiveness within the Eurozone which has started to dissipate (though countries like Italy and France still have further work to do – see our blog here). Turning to current account balances, Italy and Ireland are running a surplus, Greece has reduced its large deficit and Spain and Portugal are running small deficits.

These are small, but necessary, steps toward ensuring the survival of the euro.

Germany is the China of Europe

In contrast to the southern European countries and Ireland, Germany has experienced an economic boom. Unemployment is low, exports are strong, inflation is low, the consumer sector is vibrant and we are starting to see some signs of house price appreciation in parts of Germany. A large reason Germany has done so well during the period of turmoil is because its external competitiveness has not been offset by a rising currency. For example, Germany’s real exchange rate under the euro is around 40 per cent below where the deutschemark used to trade against the US dollar.

Germany is operating as the China of Europe (at least from a trade surplus perspective) – a massively undervalued exchange rate is generating the world’s largest trade surplus of around €193bn a year (China’s is running at around 150bn USD a year). This surplus is overwhelmingly being generated through trade with other Eurozone members (like Italy, Greece, Spain, Portugal and Ireland).

The surplus capital that Germany’s improved international competitiveness generated has found its way into southern Europe and Ireland. German banks and investors were part of the international community that lent to the respective governments and businesses of the peripheral countries in search of higher yields than their own German bunds were offering. Of course, if this capital had not been provided, the southern European countries and Ireland would not have had the ability to build up so much debt (in 2008, around 80% of Greek, Irish and Portuguese government bonds were owned by foreign investors). Additionally, ULC growth could have been more constrained in these countries (particularly in the public sector) and the gulf in competitiveness between Germany and the peripheral countries would be less pronounced than it is today.

Germany has been the greatest beneficiary of the common currency. Any default would devastate its banking system and export industry. Germany is on the hook, so it is very difficult to see why it would abandon the euro.

The alternative for southern Europe and Ireland is way too painful

Germany currently benefits to a much larger degree from the euro than the heavily indebted countries. This is because the single currency has robbed these nations of the ability to become more competitive through currency devaluation (compare the experience of these countries against the UK for example). Additionally, interest rates are way too restrictive and deflationary forces have taken hold due to excess capacity and ultra high unemployment rates. Countries like Greece and Ireland have not had a recession, they have had a depression.

Because policy makers in southern Europe and Ireland have no access to the monetary policy or the currency lever, there remains only one possibility to gain competitiveness – painful austerity and internal devaluation through reduced wages. This is the only way that these countries can hope to compete with the likes of Germany in the globalised environment.

So why doesn’t a country leave? Greece, Ireland and Cyprus have severely tested the euro in recent years yet remain in the union. The strongest argument that has been put forward is that the costs of leaving the EMU will be too painful relative to the gains. Capital outflows, skyrocketing inflation, bankruptcy on a national scale, mass unemployment and social unrest do not make the option particularly enticing. And just imagine what will happen if Italy or Spain decide to get out. To retain the euro is the least worst option for the debtor countries.

The European Central Bank will do “whatever it takes”

It has now been a year since ECB President Mario Draghi delivered one of the most important speeches in the history of Europe and stated: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” In stating these remarks, Draghi convinced the markets that the ECB had unlimited firepower to support its members and more specifically, Spain and Italy. Immediately, yields on peripheral European sovereign bonds fell from dangerously high levels that made borrowing unsustainable over the long term and are currently much lower than their levels a year ago. It is fair to say the market still believes Draghi and is now pricing risks more appropriately. With the ECB taking tentative steps towards forward guidance, it may not be long before we see further unconventional monetary policy measures like a new LTRO announcement.

Do not underestimate the political desire to keep the euro area intact

Despite the problems – 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 and Estonia in 2011) and may add more (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.

It is true that Europe remains a huge concern for us. A successful monetary union requires not only political but also economic integration. European politicians must accept greater limits on their policy autonomy and this will be difficult to gain. Economic convergence is necessary. Perhaps most worryingly, a cocktail of lower domestic demand, austerity, reduced wages and high unemployment is normally politically costly and breeds social unrest. However, given the track record that the EU and ECB has shown and for the reasons listed above, perhaps the euro may be around much longer than some economic commentators currently expect.

 

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You don’t expect any inflation in Europe? The Germans do. Look at their housing market!

Being a German abroad, I am very aware that one never runs out of German stereotypes to discuss. One of the stereotypes is the German obsession with price stability and fear of price instability. The latest results of the M&G YouGov Inflation Expectations Survey indeed confirm the current worry about inflation amongst the German public. The chart below suggests that Germans have an exceptionally low confidence in the ECB’s policymaking and expect inflation to be above the two per cent target both one year and five years ahead. Although we have seen a declining trend from February to May 2013, inflation expectations over the medium term in particular remain significantly elevated.

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It seems to be clear that Bundesbank president Jens Weidmann’s metaphorical use of Goethe’s figure of the devil, Mephisto, as well as other critical remarks by the Bundesbank, may not have helped the German public’s confidence in the ECB’s ability to deliver price stability. However, it looks to me that there are more factors at play that currently shape the German expectation of rising inflation. Earlier this year, I shared my observations on wage dynamics in Germany and concluded that we could see some notable real wage growth in 2013.

But Germans are also experiencing another form of inflation that is different to most parts of Europe: rising house prices. While an increasing house price level is a form of asset price inflation rather than consumer price inflation, it also has wider implications for the general consumer price level. Firstly, property owners tend to pass on the higher mortgage refinancing costs through increases in rents. For instance, rental costs form a significant part of the German CPI basket (21 per cent) and therefore feed through into the general inflation number. Furthermore, in an environment of rising house prices, homeowners have a greater ability to increase consumption spending by borrowing against the higher asset valuation (although this does not appear to be happening given the lack of German credit growth). The chart below shows that German house prices have increased on average by 10 to 20 per cent from 2007 to 2011, with significant variation dependent on the residential area and property type. The DIW Institute finds evidence that this trend has continued and seems to be accelerating in German cities. Prices for flats in Berlin, Munich and Hamburg are estimated to have risen by around ten, seven and six per cent annually since 2007.

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The German housing market history stands in stark contrast to many European countries. ECB interest rates were too high for Germany up until 2008, but too low for the high growth economies of Ireland and Spain. Germany therefore did not experience the credit-induced property boom in the 2000s that subsequently sent the Irish and Spanish homeowners into financial difficulties. Irish and Spanish house prices have fallen considerably since their housing bubbles popped, but they still look high compared to pre-Eurozone levels. The Netherlands is the most recent example of a European economy that is struggling with a bursting housing bubble, with house prices 9.6 per cent lower year on year. The downward trajectory of the Dutch economy seems to be accelerating and is certainly one to keep a very close eye on. Remarkably, house prices in the UK are back to pre-crisis level – and the government’s ill thought through “Help to Buy” scheme might fuel prices even more.

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Although German house prices have recently begun to climb, if you expand your time horizon to the point of German reunification in 1990, it becomes evident that the general German house price level has barely increased over the past 23 years in nominal terms, let alone in real terms. The recent increases in house prices at the national level and in cities like Berlin have started from a very low base, and there is significant potential for further increases if you consider that housing affordability, as measured by the home price-to-rent ratio and home price-to-income ratio, is still significantly below the historical average. At the same time, housing in the UK, Spain and the Netherlands remains expensive compared to historical levels. So if refinancing rates are cheap in the current low interest rate environment (the ECB’s monetary policy is arguably too loose for Germany) and house prices are on an upward trend, wouldn’t you expect the Germans to invest in new homes?

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Well, so far they haven’t really done so, at least not by European standards. Homeownership has increased in recent years, but still remains significantly below the levels of the rest of Europe. Only about half of the population lives in their own houses (the German census from 2010 suggests that homeownership stands at 45.7 per cent, while the Eurostat figures above are around 8.7 per cent higher). This compares with an average ownership level of around 70 per cent in Europe. Let’s have a look at some of the reasons why Germany has not seen a property investment boom yet.

Homeownership is less widespread for a number of historical, cultural and economic reasons. For instance, domestic credit lending has been fairly strict and, as a result, Germany has not seen a mortgage boom which inflated the US, Irish and Spanish housing bubbles (sadly tight lending standards did not apply to overseas lending, as illuminated by the 2008 crisis and more recently by German banks’ exposure to Detroit’s default). The average initial repayment rate stands at around two per cent currently and the average loan-to-value ratio remains below 80 per cent. To put this into context, loans without an initial repayment rate and a loan-to-value ratio of more than 90 per cent were very common in the US prior to the financial crisis. Also the recent mortgage loan growth rates of 1.2 (2011) and 0.3 per cent (2012) show no evidence for a hot property market.

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Historically, the German housing culture has been to rent a property, and it takes a long time for culture to change. The predisposition to rent can be traced to the policy measures by the German government after WWII. The government responded to the acute lack of residential property by highly subsidising social housing instead of providing cheap funding for new private home builds. The chart above shows that German housing investment saw an enormous boom from 1949 to 1979 and that most of the current rental property stock dates back to this period. Many of the German baby boomers were brought up in rented flats and houses – it has been the norm, not the exception. However, the chart also presents strong evidence that it has become significantly more expensive to rent in the last 3 years, particularly in more prosperous urban areas. Property developers have managed to push up rents for new residential property by more than 20 per cent. The German government released a report in October last year suggesting that the demand for urban housing in the strong economic regions remains high due to continuous migration flows from the economically weaker regions of the country. It is estimated that Germany faces an annual construction demand of 183,000 residential apartments until 2025.

Given the considerable demand for new urban housing and the current favourable investment environment, German house prices may be set to rise for some time. In particular, price inflation for new property developments in prosperous urban areas, such as in Hamburg, Stuttgart and Munich, seems to be baked in the cake for the next years. However, a housing bubble is not in sight yet as we are not experiencing any excessive credit growth given that banks remain capital constrained, and valuations are not in bubble territory as housing affordability still looks reasonable relative to historical levels. Germany is currently heading for a natural adjustment of its house prices, and this may be a positive development for the Eurozone. That is, an increase in property investment would subsequently lead to a decrease of the excess German savings rate, bring down the enormous current account surplus and therefore help the Eurozone rebalancing.

However, German government interference might distort the natural adjustment process of German house prices. Decreases in rent affordability are a real concern in the German public at present. Consequently, not only the left-leaning German parties, but also Angela Merkel’s Christian Democrats (CDU) have agreed upon a “Mietpreisbremse” in their electoral manifesto, a policy to cap the maximum rental growth rate that can be imposed if a flat or house is re-let. The FDP, the CDU’s coalition partner, seems to be the only major German party that doesn’t support such a policy initiative. Therefore, it is very possible that we could see some sort of “Mietpreisbremse” after the general election in September. This policy would potentially have a disinflationary impact. Subsequently, this might be reflected in the public’s medium term inflation expectations which could then trend downward from the current elevated levels. Ultimately, the rental cap might also affect house prices. The prospect of being restricted in the ability to pass on higher prices and financing costs to the tenant in form of higher rents could make property investment less attractive. This argument may be countered by suggesting that a shortage of supply could cause a squeeze in the German property market and actually keep pushing prices up if residential investment doesn’t pick up. That is, Germany could see further asset price inflation, but a slowdown of the rental growth rate and, consequently, of CPI inflation. Against this background, it’s definitely worth to keep an eye on both the German housing market and inflation expectations!

 

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