Recent posts


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

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

Jeff_Too much faith in the EBA

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

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


Interest rate duration or defaults – which is the lesser of two evils?

So far this year returns for the high yield market seem solid if unspectacular; 2.9% for the global index, 4.5% for Europe and 3.4% for the US. However, these overall numbers mask some interesting gyrations within the markets. It’s been a mixed year for government bonds but a solid year for credit spreads. Indeed, recent moves in the sovereign bond markets continue to focus investors’ minds on the haunting spectre of interest rate risk. The high yield market is not entirely immune to such fears but we need to remember that interest rates are only one driver of performance. High yield returns are also subject to factors such as changes in credit spreads, default rates and carry.

To illustrate this, we have two sets of bonds below: two long dated BB rated bonds (issued by German healthcare business Fresenius and US listed packaging group Owens Illinois) and two short dated CCC bonds (issued by the global chemicals company Ineos and another packaging group, Reynolds). The BB bonds carry relatively more interest rate risk than the latter due to their longer maturity, but less credit risk given the higher credit rating.

Price S&P Rating Moodys Rating Spread (bps) Modified Duration (yrs)
Fresenius 2.875% 2020 100.25 BB+ Ba1 162 6.1
Owens Illinois 4.875% 2022 102.6 BB+ Ba2 313 6.1
Ineos 7.875% 2016 101.25 B- Caa1 503 2.1
Reynolds 8.0% 2016 100.125 CCC+ Caa2 565 2.8

Source: Bloomberg,  M&G, August 2013

So how have these bonds fared over the past few weeks ? The chart below shows the relative price performance.

tomlins blog

The chart shows that none of the bonds were immune to the volatility we saw over the summer. Indeed this was a relatively rare period where interest rate duration and credit risk premia moved in tandem. However, what is clear is that the longer dated bonds suffered more during the correction. When we consider total returns, this becomes more stark. The table below shows the impact of the different coupons over the three months in question. Again, the shorter dated CCC bonds fare better.

Period 01/05/13 – 19/08/13 Price Return Income Return Total Return
Fresenius 2.875% 2020 -1.05% 0.85% -0.20%
Owens Illinois 4.875% 2022 -3.03% 1.37% -1.66%
Ineos 7.875% 2016 -0.18% 2.31% 2.13%
Reynolds 8.0% 2016 -0.10% 2.37% 2.28%

Source: Bloomberg, M&G, August 2013

The point here is that judiciously taking on more default risk in the form of a higher coupon and or spread whilst at the same time minimising your interest rate risk by focusing on short dated bonds, is one way that fixed income investors can ride out greater volatility within the government bond markets and still look to generate positive total returns. In this environment, default risk (as opposed to duration) really is the lesser of two evils.

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Mr 7 percent – exploring unemployment in the UK

The governor at the Bank of England stepped forward last week with guidance about its future plans and conditions regarding the tightening of monetary policy. Ben gave his views on the announcement here last week, but what I am going to focus on is the 7 percent unemployment rate ‘knockout’.

Firstly, why has the Bank of England decided to use the unemployment rate as an indicator of inflationary pressures? Well, in the press conference they expressed that this is a good indicator of excess capacity. This has some obvious logic to it, so let’s explore this knockout level in an historical context.

Below is a chart of UK unemployment going back 20 years. As you can see, the rate was below 7 percent from 1997 to 2009 – a period of good economic growth where the bank acted regularly to tighten policy to keep inflation under control. In fact this new knockout does not appear to be new news, as the bank rate has rarely increased when unemployment exceeded 7 percent over this period.

Rates have rarely been hiked with unemployment above 7%

Looking at the next chart you can see the regions that currently have unemployment at 7 percent or below and the ones that do not. This regional disparity is not as strong as in Europe, but is something one should take into account.

UK unemployment by region

Mobility of labour is needed for the rate to fall below 7 percent, with work relocated to labour and labour relocated to work. This is beyond the Bank of England’s remit, and is more of a central government economic project. The better regional labour mobility is, the quicker the UK can get unemployment below 7 percent. So, the easier it is to move house, or the quicker transport links are, the quicker unemployment can get below 7 percent. If regional labour mobility in the UK is very rigid then getting below 7 percent may not occur for years.

One new factor that we should take into account is the developing context of the wider European labour market. The UK workforce is not only competing as a whole internationally, but within the domestic economy it now also competes with international labour. The free movement of labour in the European Union combined with high rates of unemployment on the continent means that UK unemployment (spare labour capacity) can no longer be set with reference to our domestic borders. The huge pool of available labour could well dampen reductions in UK measured unemployment, aided by the UK’s tradition of welcoming foreign labour, its diversity of population (especially in areas seeking workers), and the fact that English is a well taught second language abroad. This could well act to reduce the ability of unemployment to fall in the UK despite low policy rates.

Even if the UK economy does respond to monetary policy and we reach escape velocity, labour immobility in the UK and or the supply of continental labour will have a baring on when the 7 percent unemployment rate is knocked out. Using this as a signal to raise rates could well mean that rates stay low for a long time even as the economy recovers.


Monster Munch update – a victory for

One of our most popular posts of all time was written back in 2011. The subject was not the US losing its AAA rating, the impact of the default of Lehman Brothers or any other weighty matter of great economic import, but rather a quick look at how packets of Monster Munch were getting smaller over time and the associated inflationary impact.

Hence my surprise when I went into a shop last weekend and saw that Monster Munch packets have now been restored to their old 40g size, replacing the measly and frankly unsatisfying 22g version of recent times.


Further research on the manufacturer’s website revealed that

“ … The re-launch comes in response to growing consumer demand and will take Monster Munch back to the original retro pack design and old texture, flavour and crunchiness that consumers remember and love … Consumers have made it clear through both our own research and within online communities that they miss Monster Munch the way it used to be ..”

I like to think that our blog was the spark that lit the fuse of this virtual nostalgia-laden fast food insurgency. A resounding victory for fighting in the name of consumer activism!

But wait, it gets better. Back in October 2011, the M&G coffee shop charged 45p for 22g, or 2.05 pence per gram. Today, the same shop charges 65p (RRP 50p) for a 40g packet, or 1.63 pence per gram. This is a fall of 20.5% in nominal terms. Put simply, you are also getting more for your money.

However, before we applaud the manufacturer for their largesse, let’s look at the main raw material. Back in October 2011, we pointed out that the headline cost of Monster Munch closely followed the corn price.


Since October 2011 the corn future has fallen by around 28.5% in price to $4.64 per bushel, a rare case of deflation in recent times. In sterling terms, the fall is around 25.5%. Accordingly, the dramatic fall off in corn prices has allowed the manufacturer to pass on part of this benefit to consumers, reducing the headline per gram price, but at the same time retaining some of the benefit in the form of an enhanced profit margin.

So whilst we cannot claim all the credit for this victory, this is a rare piece of welcome news for the consumer of corn based snacks.


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In search of satisfaction – our analysis of the BoE press conference

Listening to the Bank of England Quarterly Inflation Report press conference – the first with Mark Carney steering the ship – a song immediately sprung to mind. The song was written by a former student of the London School of Economics, Sir Michael “Mick” Jagger with his colleague Keith Richards in 1965. There is no better way to analyse the current thinking of the Bank of England than through one of The Rolling Stones best songs, (I Can’t Get No) Satisfaction.

I can’t get no satisfaction

The new BoE Governor began with the positive news that “a recovery appears to be taking hold”. This wasn’t news to the markets, as more recently we have seen a remarkably strong string of economic data. However, the very next word in Mr Carney’s introduction was “But…”. What followed was, in my opinion, the most dovish sounding central bank policy announcement since the darkest days of the financial crisis.

Carney firmly announced his arrival as the global independent (excluding BoJ) central banking community’s uber-dove through the acknowledgement of a broadening economic recovery in the UK, and then making explicit that the BoE remains poised to conduct more, not less, monetary stimulus. Until now, these two conditions were considered by bond markets to be pretty much incompatible.

’Cause I try and I try and I try and I try

Carney told us that the BoE will maintain extreme monetary slack (in terms of both the 0.5% base rate and the £375 billion of gilts held) until the unemployment rate has fallen to at least 7%. He went even further than this, stating the MPC is ready to increase asset purchases (QE) until this condition is met. However, there are two conditions under which the BoE would break the new, explicit link between monetary stimulus and unemployment: namely, high inflation and threats to financial stability. Did the new governor have to put these caveats in place because other members of his committee would only agree to the announcement if they were mentioned?

Supposed to fire my imagination

The new framework announcements were broadly in-line with what we were expecting. In that respect, the Governor’s major announcement was not too much of a surprise. The market agreed and there was a relatively muted response. Carney was supposed to fire our imaginations, so the question is – did we learn anything new? The “yes” and “no” arguments are outlined in the below table.

2013-08 ben blog

When I’m watchin’ my T.V. and that man comes on to tell me how [the economy should] be…

The market suspected Mr Carney would bring in some forward guidance, but I think the most interesting implication of this announcement today is that he felt the need to do something, but did not feel the need to increase asset purchases through QE. Mervyn took on the first part of Friedman’s equation, the supply of money. This was not inflationary as the transmission mechanism was broken, and the cash was hoarded and not released into the real economy. Could Carney be the governor to focus on the second part of the equation, money velocity? Forward guidance is designed to give individuals and companies the confidence to borrow in order to spend or invest. If they do, velocity will return as the transmission mechanism repairs. I believe we are considerably less likely to see an increase in QE under the new governor.

If forward guidance does not have the consequences Carney intends, and my belief that he is more focused on the transmission mechanism than his predecessor, what might Carney do next? At that point, he might increase schemes akin to Funding for Lending, and hand banks cheap funds at the point at which the banks release the loans to borrowers. This way, banks are heavily incentivised to lend at levels that are attractive to individuals and companies.

He’s tellin’ me more and more, about some useless information

Carney told us that if and when unemployment reaches 7%, policy will start to tighten. But then he stated that if inflation exceeds 2.5% on the BoE’s shocking 2 year forecast (is this a rise in the inflation target?), or if inflation expectations move beyond some unannounced bound, or if financial stability is under threat, then he might have to break the newly explicit link between unemployment and monetary policy. And then he stated that even if unemployment hits 7%, this will not trigger a policy change, but a discussion around one.

I don’t think we actually got pure forward guidance, but a pretty muddled variant thereof. Bond markets are rightly unsure as to how to react, and have struggled for a satisfying interpretation. All we can really take from the BoE is that they will need to be sufficiently satisfied that the UK economy has reached escape velocity before hiking rates or reversing policy.


Panoramic: The Power of Duration

The early summer surge in bond yields will have focused the minds of many investors on the allocation of assets in their portfolios, particularly their fixed income holdings.

The largest risk to a domestic currency fixed income portfolio is duration. When investors discuss duration they are more often than not referring to a bond or portfolio’s sensitivity to changes in interest rates. Corporate bonds however also carry credit spread duration – the sensitivity of prices to moves in credit spreads (the market price of default risk).

Exposure to interest rate risk and credit risk should be considered independently within a portfolio. Clearly the desirable proportion of each depends heavily on the economic environment and future expectations of moves in interest rates.

I believe that the US economy and, to a lesser extent, the UK economy are improving and at some point interest rates will begin to move closer to their (significantly higher) long-term averages. We may still be a way off from central banks tightening monetary policy, but they will when they believe their economies are healthy enough to withstand it. Since a healthier economy increases the probability of tightening sooner, and is positive for the corporate sector, one should endeavour to gain exposure to credit risk premiums while limiting exposure to higher future interest rates.

In the latest version of our Panoramic series I examine the US bond market sell-off of 1994 to see what we can learn from the historical experience. Additionally, I analyse the power of duration and its importance to fixed income investors during a bond market sell-off.


Small business, big deal – a look into peripheral SMEs

It should come as no surprise to any investor that European banks are still too large. Despite having reduced their balance sheets by around €2.4tn since 2011, they continue to have the world’s largest asset base, with an aggregate balance sheet size circa 3.3x the Eurozone’s GDP. Further balance sheet contraction can be expected in the coming years as the European banks strive to recapitalise their balance sheets to conform to stricter Basel-III norms.

Whilst the ECB’s LTRO (long-term refinancing operation) liquidity injections and OMT (Outright Monetary Transactions) programme have arguably suppressed interest rates and helped debt capital markets, they have also anaesthetised bank lending to corporates, particularly in peripheral economies where the transmission mechanism of current accommodative policy continues to be broken.

Small and medium businesses are crucial to the European economy. However, SMEs are facing severe financing problems of late, particularly those in peripheral Europe. Not only has credit availability dried up for these companies in the last five years, but those lucky enough to get access to credit are doing so at a significantly higher cost. As shown in the chart below, southern European companies are paying a 2-3% interest premium over their continental peers.

SME blog_31Jul

Looking at countries like Spain or Italy, the situation becomes particularly acute. To understand the scale of the problem we should look at the importance of small and medium sized firms in these countries. Italian or Spanish SMEs are responsible for 75-80% of job creation, compared to 50% in the US and 59% in the UK. Furthermore, SMEs and micro companies in these countries represent 99% of total national businesses and generate around 60% of GDP. However, their lack of access to capital markets makes them reliant on banks for borrowing.

ECB interest rates are currently as low as they have ever been. Yet, Spain is one of the European countries with the most punitive corporate financing costs. This is a problem that has often been described as the “diabolical loop” between the Sovereign and corporate sector.

We have previously discussed how the Spanish government is dangerously indebted and accumulates a high fiscal deficit. Such a situation naturally has important consequences for Spanish banks – investors know that if loan delinquencies start to rise, banks have a slim chance of being bailed out by their sovereign. A risk premium is therefore warranted, which is also passed on to the corporate sector in the form of higher financing costs.

The Spanish economy is undergoing a painful recession and the state of its corporate sector is a clear reflection of this. SMEs are deteriorating rapidly, as credit taps are running dry, companies have stopped hiring and have been forced into restructuring their businesses in order to remain competitive vs their continental European peers. As delinquency rates rise, banks’ risk premiums continue to soar and the economic situation deteriorates further. Reduced corporate activity diminishes fiscal revenues for the sovereign, worsening the country’s fiscal deficit and we are then back to square one. The diabolical loop starts again.

Whilst the UK launched the FLS scheme last year aimed at stimulating lending to the real economy, Spain could be running short on time to deal with a problem of potentially larger consequences. Spanish SMEs are the true back-bone of the economy; they are primarily responsible for the country’s wealth and economic growth. Therefore, reinstating credit access while allowing banks to re-size and heal is critical for economic stabilisation. Until this happens, it will be difficult for Spain and other peripheral countries to exit recession.


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.



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

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

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

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

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

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



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.


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.


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.


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?


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.


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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