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Stamping down on foreign flows into UK property could be sterling suicide

So now we know what the Bank of England intends to do about the UK’s housing market, a market that Governor Carney has previously referred to as the biggest risk to financial stability and therefore to the economic expansion (the IMF and the EC had similar warnings).The answer, in short, is not much at the moment – while Carney is not “happy” with the buoyant UK housing market, he is willing to “tolerate” it.

Before wondering what to do – and what not to do – about the housing market, it’s worth asking whether the UK housing market is in a bubble. It’s not as crazy a question as you might think – in real terms (i.e. adjusting for inflation), UK house prices rose by just +1.2% per annum from 1974 to the end of 2013, and by 2.2% per annum from 1974 to the end of 2007. It was the early noughties when things got crazy, as UK real house prices saw double digit returns in four consecutive years from 2001-2004 – strip out these years, and UK real house price growth has actually been negative in the last four decades*. But even including 2001-04, if you consider that the UK’s productivity growth since the mid 1970s has averaged about 1% per annum, and that UK population growth has averaged 0.3% per annum over this period, then small positive real house price growth doesn’t appear hugely alarming.

That said, 40 year average price changes don’t tell the whole story. The performance of the housing market in the past year is remarkable – UK house prices were up 11.1% in nominal terms in the year to May according to Nationwide, which is still a long way short of the 2001-04 bubble years, but is the fastest pace since then. Meanwhile data from the ONS shows that nominal London house prices rocketed 18.7% in the year to April. These rates of growth are well in excess of inflation, and well in excess of wage growth.

What is causing the recent jump higher in house prices? By definition the answer is an excess demand versus a lack of supply, although almost all commentary on the UK housing market seems to focus primarily on the latter rather than the former. Public debate about UK housing has been strongly influenced by then MPC member Kate Barker’s government commissioned 2004 review of housing supply, where she argued that ‘the long-term upward trend in house prices and recent problems of affordability are the clearest manifestations of a housing shortage in the UK’, and that the UK needed to build up to 260,000 new homes per year to meet demand. In the decade since the report was published, less than half this figure has been built, suggesting a shortfall of 1 million houses has accumulated.

But is the spike in house prices really all down to supply? As Fathom Consulting have pointed out, if there was a housing shortage then why haven’t real rent costs jumped higher? The chart below plots nominal wage growth versus UK rent costs back to 2001 – rent costs were actually increasing at a slower pace than wages pre-2008, and have only been running fractionally above wage growth more recently. If there was a supply shortage, then we would expect to see real rent costs increasing quite sharply as people become forced to spend more on housing as a percentage of their income, but this isn’t the case.

Slide1

The next chart suggests that the pick-up in house prices that began last year is much more likely (as always) to have had more to do with demand, namely lower mortgage rates and easy mortgage availability. The left hand chart is from the Bank of England’s recent Financial Stability Report, and shows the loan to income ratio on new mortgages advanced for house purchase. Around 10% of new mortgagees are now borrowing at a loan to income ratio at or in excess of 4.5 times income. Over half of home buyers are now having to borrow at 3+ times income, which is a ratio about 5 times higher than immediately before the UK housing market crash of the early 1990s. It’s striking how closely correlated loan to income ratios (left chart) are with house prices (right chart). It suggests that limiting loan to income ratios will also serve to limit house price appreciation, although the correlation doesn’t necessarily imply causation. It could be that a jump higher in house prices forces buyers to take on more debt, since only additional debt will make it possible to get onto the bottom rung of the housing ladder**.

Slide2

The other growing source of demand for UK property is likely to be overseas investors. When sterling collapsed post the 2008 crisis, the assumption was that the UK would see an export-led recovery thanks to a huge improvement in its competitive position. Unfortunately, this didn’t really happen, because the UK’s big export – financial services – was in little demand post crisis. UK exports did initially pick up, but today are only 10% higher than at their peak in 2008, and have moved sideways since 2011. Spain’s exports, in contrast, are almost 30% above 2008 levels in euro terms, despite the euro strengthening against sterling over the period.

Sterling depreciation may not have resulted in a surge in exports of UK goods and services, but it does appear to have led to a pick-up in a new kind of export – London’s housing stock. Savills, an estate agent, estimates that overseas equity into just prime London residential property was above £7bn in 2012, and presumably it was higher still in 2013. Overseas buyers have always been involved in London property thanks to market transparency, liquidity, political stability, a clear rule of law, decent education, and low taxes versus countries such as France or Spain, but the 2012 inflows were twice the amount seen in 2008 or 2009, and about a third higher than in 2006.

It’s easy to see why overseas buyers have taken a shine to UK property from the chart below. British houses feel far from cheap in local currency terms, but they look considerably cheaper from the perspective of all the traditional foreign buyers, with the exception of Russians. From the perspective of Chinese investors, London house prices are still 17.5% below their 2007 highs when measured in Chinese Yuan.

Slide3

The Bank of England’s strategy for reducing domestic demand for UK housing via macro-prudential measures such as limiting loan-to-income ratios should be the primary way to tackle the destabilising effects of housing related indebtedness, and the Bank of England arguably could have done more. Stemming foreign flows into the UK housing market is much more attractive politically, but could be very unwise.

Data from last week showed that the UK’s current account deficit improved slightly in Q1 2014, but Q4 2013 was downwardly revised to 5.7% of GDP and Q3 2013 to 5.9%, a worrying new record. Of the so-called ‘Fragile 5’ emerging market countries, only Turkey had a bigger deficit in Q4.

A current account deficit is a broader measure of a country’s trade balance. The UK’s large deficit can be attributed to various factors (e.g. a sustained trade deficit, a deteriorating income balance which may partly reflect an increase in foreign companies taking over British companies, and sustained budget deficits), but generally speaking a chronic current account deficit is indicative of competitiveness problems. The chart below shows that a large and deteriorating UK current account balance has historically preceded a sterling crisis, where a sharp depreciation in sterling subsequently restored the UK’s competitiveness, and hence its current account balance. If you consider that foreigners buying new build houses in London is little different to foreigners mass buying Scotch Whiskey in terms of its effects on the national accounts, then proposals to tax foreign buyers of London property is the equivalent to taxing your own exports! Not a very clever thing to do with such a precarious current account balance. Note that taxing exports is considerably worse than protectionism, which typically involves taxing imports.

Slide4

Macro prudential controls are a positive step and should help curb some of the local mortgage excess that has built up over the last couple of years. However, those pointing to supply-side factors as the primary reason for higher prices aren’t viewing the whole picture. UK property is cheap from an overseas perspective and will likely remain in demand to foreign buyers looking for solid returns in a low-yielding world. And beware the clamour of calls to stem foreign inflows into the UK housing market, which is turning into one of the UKs most in-demand exports. Of course, if macro prudential measures fail to take some of the heat out of the market, the Bank of England could always raise interest rates (if only they could remember how to….)

*This is calculated using UK RPI and the UK Nationwide House Price Index. Given there are methodological issues with both RPI and Nationwide data, it’s worth treating the calculation slightly cautiously – for example, UK RPI has averaged 0.9% higher than UK CPI since 1989, so real house prices appreciation is an additional 0.9% p.a. on a CPI basis.

**The recent nudge higher in both house prices and the move higher in first time buyer loan to income ratios is likely to have been assisted by the help to buy scheme (or the ‘help to sell scheme’, as we called it at the time), although given that as at the end of May, only 7313 houses were sold under the scheme with the total value of mortgages supported by the scheme at £1bn, there are other forces at play.

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The reliability of market and consumer inflation expectations

After yesterday’s poor U.S. GDP number and despite Mark Carney’s seemingly dovish testimony before the Treasury Select Committee, the Bank of England is increasingly looking like it will be the first of the major central banks to hike rates. At this stage, the BoE can retain its dovish stance because inflation is not an issue. However, in an environment of falling unemployment, early signs of a pick-up in wage inflation, rising house prices and stronger economic growth, consumers and markets may increasingly begin to focus on inflation. In anticipation, we think now is a good time to compare the inflation forecasting performance of markets and consumers.

In the graphs below we have compared UK RPI bond breakevens (a measure of market inflation expectations) with the Bank of England’s Gfk NOP Inflation Attitudes Survey (i.e. a UK household survey with over 1900 respondents consisting of nine questions on expectations for interest rates and inflation). An important point to note is that the analysis compares realised inflation (% yoy) with what survey expectations and breakeven rates indicated 2 years before.

How reliable are inflation expectations?

The comparison presents a number of interesting results:

Unexpected deflation: Both the survey and breakevens underestimated actual RPI inflation outcomes between 2006-2008 (in other words, nobody anticipated the inflationary shock coming from higher commodity/energy prices).  In 2008, UK RPI was rising at an annual rate of 5.2% as high oil prices were feeding through into higher energy bills. Market and consumer inflation expectations largely ignored the higher inflation numbers, a sign the central bank inflation targeting credibility remained strong.

UK RPI turned negative in 2009 as the world plunged into recession and the BOE cut interest rates. The market eventually began to price in deflation but only after RPI turned negative. For example, in November 2008 the 2 year breakeven was -1.4%, the actual RPI print in November 2010 was 4.7%. Owing 2 year gilt linkers relative to conventional 2 year gilts directly after the financial crisis was a great trade.

Deflation (and recessions) appear particularly hard to forecast, for consumers and markets alike. This is because consumers and markets tend to anchor their future expectations off current inflation (and growth) readings.

Post-crisis unanchoring:  Consumer inflation expectations generally underestimated realised inflation up until the global financial crisis, and has overestimated it since then, a possible sign that the crisis-recession years may have affected consumer views on the BoE’s commitment to fight inflation. Between 2000 and 2009, 2 year-ahead expected inflation averaged 2.5%. Since 2009, it has averaged 3.4%, almost one percentage point higher; suggesting a lower level of confidence that price stability will be achieved and also reflecting the higher RPI prints post 2009.

Surprisingly similar forecasts: Breakeven and survey rates differed only slightly over the sample period, with the largest gap (400bps) opening up in October 2008 after the Lehman crash. This was probably caused by the forced unwind of leveraged long inflation trades combined with a huge flight to quality bid for nominal government bonds, which distorted the market implied inflation rate. The average differential through the period (excluding years 08-09) is just 8bps. Nevertheless, breakevens seem to track RPI better since consumer surveys are usually carried out on a quarterly basis whilst the former are traded and re-valued with higher frequency. This makes them better at capturing quick moves and turning points in inflation.

Future expectations: Over the next 2 years, both consumers and markets expect RPI to rise above the current level of 2.6%. With a 2.7% implied breakeven, 2-year gilt linkers look relatively inexpensive today.

Of course, breakevens are far from being a perfect measure of inflation, as they embed inflation and liquidity risks premia, but they do appear to be better predictors of future inflation relative to consumer surveys. That does not mean survey-based data does not provide us with useful information, and for this purpose we launched the M&G YouGov Inflation Expectations Survey last year (available here). Consumer inflation expectations affect a number of economic variables, including consumer confidence, retail spending, and unit labour costs. However, during inflection points, such as the one we may be going through at present and in a world of approaching shifts in monetary policy, the timeliness of breakevens could represent an advantage that makes it worthwhile to follow them carefully.

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What could possibly derail the global economy?

Things are looking pretty good for the global economy right now. The U.S. Federal Reserve is slowly reducing quantitative easing, China is continuing to grow at a relatively rapid pace, the Bank of England is talking about rate hikes, and the central banks of Japan and Europe continue to stimulate their respective economies with unconventional and super-easy monetary policy. The International Monetary Fund expects growth in the developed economies to pick-up from a 0.5% low in 2012 to almost 2.5% by 2015, while emerging market economies are expected to grow by 5.5%.

Of course, it is notoriously difficult to forecast economic growth given the complexity of the underlying economy. There are simply too many moving parts to predict accurately. This is why central banking is sometimes described as similar to “driving a car by looking in the rear-view mirror

With this in mind, it is prudent to prepare for a range of possible outcomes when it comes to economic growth. Given the consensus seems pretty optimistic at the moment, we thought it might be interesting to focus on some of the possible downside risks to global economic growth and highlight three catalysts that could cause a recession in the next couple of years. To be clear, there are an infinite range of unforeseen events that could possibly occur, but the below three seem plausibly the most likely to occur in the foreseeable future.

Risk 1: Asset price correction

Every investor is a winner

There is no question that ultra-easy monetary policy has stimulated asset prices to some degree. A combination of low interest rates and quantitative easing programmes has resulted in fantastic returns for investors in various markets ranging from bonds, to equities, to housing. Investors have been encouraged by central banks to put their cash and savings to work in order to generate a positive real return and have invested in a range of assets, resulting in higher prices. The question is whether prices have risen by too much.

This process is likely to continue until there is some event that means returns on assets will be lower in the future. Another possibility is that a central bank may be forced to restrict the supply of credit because of fears that the economy, or even a market, is overheating. An example of this is the news that the Bank of England is considering macro-prudential measures in response to the large price increases in the UK property market.

In addition, there is a surprising lack of volatility in investment markets at the moment, indicating that the markets aren’t particularly concerned about the current economic outlook. Using the Chicago Board Options Exchange OEX Volatility Index, also known as the old VIX (a barometer of U.S. equity market volatility) as an example shows that markets may have become too complacent. Two days ago, the index fell to 8.86 which is the lowest value for this index since calculations started in 1986. Previous low values occurred in late 1993 (a few months before the famous bond market sell-off of 1994) and mid-2007 (we all remember what happened in 2008). The lack of volatility has been something that several central banks have pointed out, including the U.S. Federal Reserve and the Bank of England. The problem is, it is the central banks that have contributed most to the current benign environment with their forward guidance experiment, which has made investors relaxed about future monetary policy action.

If these events were to occur, we could see a re-pricing of assets. Banks suffer as loans have been given based on collateral that has been valued at overinflated prices. A large impact in currency markets is likely, as investors become risk averse and start to redeem assets. These events could spill over to the real economy and could therefore result in a recession.

Risk 2: Resource price shock

Energy prices could hamper economic growth

It appears that the global economy may be entering a renewed phase of increased volatility in real food and fuel prices. This reflects a number of factors, including climate change, increasing biofuel production, geopolitical events, and changing food demand patterns in countries like China and India. There may also be some impact from leveraged trading in commodities. There are plenty of reasons to believe that global food price shocks are likely to become more rather than less common in the future.

As we saw in 2008, these shocks can be destabilising, both economically and politically. In fact, you could argue that the Great Financial Crisis was caused by the spike in commodity prices in 2007-08, and the impact on the global economy was so severe because high levels of leverage made the global economy exceptionally vulnerable to external shocks. Indeed, each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices (as the FT has previously pointed out here). Commodity price spikes impact both developed and developing countries alike, with low-income earners suffering more as they spend a greater proportion of their income on food and fuel. There is also a large impact on inflation as prices rise.

A resource price shock raises a number of questions. How should monetary and fiscal policy respond? Will central banks focus on core inflation measures and ignore higher fuel and food prices? Will consumers tighten their belts, thereby causing economic growth to fall? Will workers demand higher wages to compensate for rising inflation?

Risk 3: Protectionism

After decades of increased trade liberalisation, since the financial crisis the majority of trade measures have been restrictive. The World Trade Organisation recently reported that G-20 members put in place 122 new trade restrictions from mid-November 2013 to mid-May 2014. 1,185 trade restrictions have been implemented since October 2008 which covers around 4.1% of world merchandise imports.  Some macro prudential measures could even be considered a form of protectionism (for example, Brazil’s financial transactions tax (IOF) which was designed to limit capital inflows and weaken the Brazilian currency).

If this trend is not reversed, trade protectionism – and currency wars – could begin to hamper economic growth. Small, open economies like Hong Kong and Singapore would be greatly impacted. Developing nations would also be affected due to their reliance on exports as a driver of economic growth.

Many economists blame trade protectionism for deepening, spreading and lengthening the great Depression of the 1930s. Should the global economy stagnate, political leaders may face growing pressure to implement protectionist measures in order to protect industries and jobs. Policymakers will need to be careful to not repeat the mistakes of the past.

Economic forecasting is a tricky business. It is important that investors are aware of these risks that may or may not eventuate, and plan accordingly. The outlook may not be as rosy as the consensus thinks it is.

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Burrito Bonds – an example of the retail bond market

One of our local burrito vendors has been advertising a new 8% bond to its customer base. The company, Chilango, wants to raise up to £3m to fund expansion of its chain in central London. This will be done via a crowd sourced retail offering that’s already drawn some interesting coverage in the financial press. Having performed some extensive due diligence on the company’s products as a team, we can safely say they make a pretty good burrito. However, when we compare the bond to the traditional institutional high yield market, we have some concerns that investors should be aware of.

  1. Disclosure – a typical high yield bond offering memorandum (the document that sets out the rules of the issue, its risk and all the necessary historical financial disclosure) can be several hundred pages long. Producing this is a very time intensive and expensive process, but a valuable one for producing a host of useful information for potential investors. Additionally, a law firm and an accounting firm typically sign off on this document, effectively staking their reputation and incurring litigation risk based on the veracity of the information disclosed.

    In contrast, the Chilango’s document is 33 pages long, with some fairly superficial financial disclosure. The photo below illustrates this comparative informational disadvantage and the relative lack of depth in financial information compared to a recent institutional high yield bond offering from Altice.

    Slide1

  2. Financial Risk – there are two big potential concerns here. Firstly, the starting leverage for the bonds is potentially quite high. Using some admittedly finger in the air assumptions regarding the potential cash flow of each new outlet opened (a necessary approach given poor disclosure), leverage could be around 6.0x Net Debt/EBITDA in 2015. This is certainly at the riskier end of the high yield spectrum. The second major concern is that we don’t know for certain how much debt the company will raise. Chilango state that they target at least £1m in this issue, but are willing to raise up to £3m, leverage is likely to be north of 10x (again this is a best guess). All this means the bonds would in our opinion get at best a CCC rating, right at the riskiest end of the credit rating spectrum for sub-investment grade bonds.Slide2
  3. Security – Chilango state very clearly that these bonds will be unsecured instruments. This means that in the event of a default, the creditors will rank behind any secured creditors. There appears to be limited existing secured creditors, but we see nothing in the documentation to prevent a layer of new secured debt being raised ahead of these notes (something that is a common covenant in institutional bonds deals). Consequently, it’s prudent to assume that in a default situation the recovery value of the bonds is likely to be significantly below face value. This equity-like downside means investors should demand an equity-like return in our view.
  4. Call Protection – these bonds are redeemable at the option of the issuer at any time. Consequently, investor returns could be materially curtailed due to the lack of call protection. Call protection is the premium over face value the investors get when the issuing company redeems the debt early (their call option). Thus some of the benefit also accrues to the bondholder. Take the following return profile:
    8% Bond, Callable at Par
    Years Outstanding Total Return
    1 8%
    2 17%
    3 26%
    4 36%

    If the plan to open new branches goes well, the bond investor should be happy right? Wrong. If this happens, the company may well look like a less risky prospect and will be able to raise debt finance more cheaply. Let’s say a bank offers them a loan at 5%, they could then redeem the 8% bond early, diminishing the total return to bondholders (as per above), and save £90,000 a year on interest costs per year (assuming they issued £3m bonds). Again, call protection is a common feature of the institutional high yield market which protects investors in these situations.

  5. Liquidity – these are non-transferrable bonds. This means that a) the company does not have to file a full offering memorandum hence the lack of disclosure and b) it will not be possible to buy or sell the bonds in a secondary market. This is more akin to a bilateral loan between an individual investor and the company, with the investor in it for the long haul. Consequently, an investor will neither be able to easily manage their risk exposure nor will they be able to take profits should they so wish before the bond is redeemed.
  6. Value – we can see that there are many risks – but to be fair that is the nature of high yield investing. So the real question is, “is 8% sufficient compensation for this risk”. The good news is that this bond has a unique bonus coupon in the form of a free burrito a week for anyone prepared to invest £10,000. At current prices, this equates to 3.63% additional coupon (a steak, prawn or pork burrito with extra guacamole is £6.99), so an all-in coupon of 11.63% (8% cash + 3.63% burrito).We’d argue that a “burrito fatigue factor” should be applied, simply because you may not want a burrito every week and you will probably not be physically near a Chilango every week to cash in this extra coupon. A 75% factor feels about right, which reduces the burrito coupon to 2.72% and the all-in return to 10.72%. So is 10.72% a fair price? To get a sense of this we can look at some GBP dominated CCC rated institutional bonds in other asset light industries
    Bond Price Yield
    Phones 4 U 10% 2019 90.5 12.7%
    Towergate 10.5% 2019 98.5 10.9%
    Matalan 8.875% 2020 101.5 8.5%
    Average: 10.7%

    By coincidence, the all in coupon of 10.7% is bang in line with the average of this (very limited) group of comparable bonds. However, I’d argue that the Chilango bonds should be significantly cheaper than the bonds above due to higher leverage, no liquidity, no call protection and the lack of disclosure. What should this differential be? Again, there is no scientific answer, but our starting point would probably be in the 15-20% range, and only then with some more certainty around the potential maturity of the bond and the ability to share in the future success of the company.

So, much as though we would all enjoy the tasty weekly coupons, our view is that like many of the so-called “retail” or “mini” bond offerings, the Chilango burrito bonds stack up poorly against some of the current opportunities in the institutional high yield market.

M&G has no financial interest in seeing this issue succeed or fail, either directly or indirectly.

Ana_Gil_100

The M&G YouGov Inflation Expectations Survey – Q2 2014

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

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

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

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

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

Inflation expectations – 12 months ahead

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

Inflation expectations – 5 years ahead

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

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Why aren’t bund yields negative again?

Whether or not you believe that the ECB moves to full government bond purchase quantitative easing this week (and the market overwhelmingly says that it’s only a remote possibility) the fact that German bund yields at the 2 year maturity remain positive is a bit surprising. The 2 year bund currently yields 0.05%, lower than the 0.2% it started the year at, but higher than you might have expected given that a) they have traded at negative yields in 2012 and 2013 and b) that the market’s most likely expected outcome for Thursday’s meeting is for a cut in the ECB’s deposit rate to a negative level.

The chart below shows that in the second half of 2012, and again in the middle of 2013, the 2 year bund yield was negative (i.e. you would expect a negative nominal total return if you bought the bond at the prevailing market price and held it to maturity), hitting a low of -0.1% in July 2012.

2y bund yields chart

Obviously in 2012 in particular, the threat of a Eurozone breakup was at its height. Peripheral bond spreads had hit their widest levels (5 year Spanish CDS traded at over 600 bps in July 2012), and Target2 balances showed that in August 2012 German banks had taken Euro 750 billion of “safe haven” deposits from the rest of the euro area countries (mostly from Spain and Italy). So although the ECB refinancing rate was at 0.75% in July 2012 compared with 0.25% today, the demand for German government assets rather than peripheral government assets drove the prices of short dated bunds to levels which produced negative yields.

This time though, whilst the threat of a euro area breakup is much lower – Spanish CDS now trades at 80 bps versus the 600 bps in 2012 – the prospect of negative deposit rates from the ECB might produce different dynamics which might have implications for short dated government bonds. The market expects that the ECB will set a negative deposit rate, charging banks 0.1% to deposit money with it. Denmark successfully tried this in 2012 in an attempt to discourage speculators as money flowed into Denmark out of the euro area. Whilst the ECB refinancing rate is likely to remain positive, the cut in deposit rates might have significant implications for money market funds. David Owen of Jefferies says that there is Euro 843 billion sitting in money market funds in the euro area, equivalent to 8.5% of GDP. But what happens to this money if rates turn negative? In 2012, when the ECB cut its deposit rate to zero, several money market fund managers closed or restricted access to their money market funds (including JPM, BlackRock, Goldman Sachs – see FT article here). Many money market funds around the world guarantee, or at least imply, a constant or positive net asset value (NAV) – this is obviously not possible in a negative rate environment, so funds close, at least to new money. And if you are an investor why would you put cash into a money market fund, taking credit risk from the assets held by the vehicle, when you could own a “risk free” bund with a positive yield?

So whilst full blown QE may well be months off, if it ever happens, and whilst Draghi’s “whatever it takes” statement means that euro area breakup risk is normalising credit risk and banking system imbalances, the huge amount of money held in money market funds that either wants to find positive yields, or is forced to find positive yields by fund closures, makes it a puzzle as to why the 2 year bund yield is still above zero.

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

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

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

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

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

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

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

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

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

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

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

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

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

BoJ basic discount and ECB main refinancing rates

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

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Global banking – does it hurt ‘national champions’?

There has been a lot of comment recently on the slimming down at Barclays investment bank. This has generally been couched as a change in business plan, with less of a focus on fixed income, commodities and derivatives, to a less capital intensive more traditional model. One of the interesting things for us is that this is not an idiosyncratic event, but part of a trend.

Barclays, like RBS, UBS, and Credit Suisse, has decided to reverse its pre crisis ambition of being a dominant player in the global fixed income market. From a pure opportunity set this seems strange as the huge increase in volume of outstanding corporate and government debt is potentially an enormous business opportunity. So why the retreat?

Like any company that exits a business line, presumably it’s because Barclays believes it is or will be less profitable. Despite the expansion of fixed income markets, banks are less able to make money due to a change in their cost of capital. Regulators have effectively reduced the banks’ ability to make money, via constraints on leverage ratios, which are a good thing from a bondholder’s perspective but increases their effective costs and reduces profitability.

However, this banking trend also has a European flavour. The firms scaling back their ambitions are all non US banks. Why the difference across the Atlantic given both economic blocks have faced harsher regulation and more capital requirements? We think North American banks have a natural advantage versus their “alien” investment bank counterparts in three ways.

Firstly they operate in the largest capital market in the world. This gives them strong economies of scale compared to those whose ‘national champion’ home market advantage is in  smaller markets.

Secondly, even when comparing the big US capital markets with the second largest Euro capital markets, the European players have a disadvantage. The euro is a single market, but  banks  are constrained nationally.  They are all large relative to their domestic economy, which makes the home regulator understandably nervous, imposing higher capital, leverage and loss-absorbing debt requirements on the banks in their jurisdiction. This is less of an issue in the US, where the geographic regulated area and the currency coincide for a significantly greater percentage of their business. Therefore the US regulator can be more relaxed about having large banks.

Thirdly, globalisation is also resulting in more dominance from US non-bank corporations, whether that be through their innovation, or their own natural economies of scale in the US. This can be seen over the last year with Vodafone selling its wireless business to Verizon, Liberty Global buying Virgin Media, and the potential attempts by Pfizer to take control of Astra Zeneca. It is natural for US businesses to work with US banks, and the development of large corporations with large funding needs means there needs to be a large capital market. All these things point to a reinforcing increase in the relative size of the US capital markets. This is one of the factors that has been driving the increase in the relative sizes of the European and US investment grade bond markets, as illustrated in the chart below.

US IG bond market growing faster than European market

Barclays’ reduced ambition is part of a banking trend. We have seen these kind of moves before in the banking sector where bank management move together in the same direction. The lesson from these recent moves is that globalisation will not only change the face of the world economy, but will benefit those nations not only who are efficient and innovative, but have the largest efficient domestic markets, thus allowing economies of scale. Good news for the US listed companies, and a potential issue for the rest of the world.

 

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Respect Your Seniors – TXU Default Case Study

On 29th April, Energy Future Holdings Corp (the energy business formerly known as TXU) filed for Chapt 11 bankruptcy, listing $49.7bn in debt liabilities. This came after several months of back and forth negotiations between various creditors and the owners of the business. As such the filing was widely expected and the market had been pricing this in.

One thing that was quite an eye-opener, however, was the huge range of recovery values on the various tranches of debt issued by the business. Part of this was due to the inherent complexity of the company’s capital structure. The company had 14 separate major bond issues, issued out of a range of different entities with differing claims on the company’s various assets as shown below:

Slide1

This great diversity of debt and different legal entities in the capital structure has meant similar differentiation in recovery values for the bonds. Below are some of the trading levels we currently see in the market for the more liquid bonds. At one end of the extreme, the TXU 11.75% 2022’s are currently trading at 119.5% of face value whilst the TXU 10.5% 2016’s languish at 8.8 cents in the dollar. The difference in price reflects the bonds’ relative position in the queue of claims for the company’s assets.

Slide2

The difference of experience in terms of total returns from these bonds is also stark. Holders of the 11.75% 2022 bonds enjoyed a capital return of c 20% over the past two years (on top of the 11.75% coupon each year), whereas holders of the 10.25% 2015 bonds have been hit with a capital loss of c.70%.

Slide3

What we think this illustrates very well is that seniority and position in a capital structure has a major impact when determining potential downside for high yield investors. Indeed this factor can often be more important in the event of a default than the quality and credit worthiness of the underlying borrower. Additionally, and somewhat counter-intuitively, it also shows that bondholders can still experience positive returns even if the business they have lent to goes bankrupt.

Whilst the TXU bankruptcy is one of the echoes of the last LBO frenzy of 2006 and 2007, we believe that where you invest in the capital structure will also be important going forward. When default rates do eventually rise from their currently low levels, investing in bonds that rank senior in a capital structure will be one way to limit the potential downside of a high yield portfolio.

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Video – Some thoughts on U.S. credit from our American research trip

A few of the M&G bond team recently visited New York and Chicago on a research trip. We put together a short video to share some of our thoughts regarding US credit markets. A particular focus is the U.S. high yield market where we highlight some sector themes. We also consider the potential impact on U.S. credit spreads when the Fed starts to raise interest rates.


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