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anthony_doyle_100

Crazy weather and the butterfly effect on inflation

It seems that the wettest “summer” on record in England is not only playing havoc with the M&G cricket team’s schedule, it is also having a massive impact on the nation’s butterflies. Sir David Attenborough is asking people to participate in the world’s biggest butterfly survey – The Big Butterfly Count – to see how the butterfly population has fared after all the wet weather we have been having. So get out in your garden and see how many butterflies and moths you can count in 15 minutes – counting butterflies has been described as “taking the pulse of nature”.

It should be noted though that England is not the only country that has been experiencing adverse weather conditions. In the US there have been wildfires in Colorado, a heatwave across the eastern seaboard, and a “super derecho” which caused mass destruction from west of Chicago to east of Washington, D.C. Russia has experienced flash flooding in the Krasnodar region and the drought experienced in southern Russia has expanded into western Ukraine and southeastern Europe.

For investment markets, extreme weather events tend to result in a lower supply of soft commodities like maize, wheat, soybeans and corn. Because supply is now expected to fall due to these extreme weather events, the price of soft commodities has sky rocketed over the course of 2012.

Soft commodities rising fastOf course, higher food prices means higher inflation numbers. In the UK, food makes up 11.4% of the RPI index and 9.8% of the CPI index. In Europe, food makes up 13.9% in the HICP. In the US, food is 14.2% of the CPI. The recent price increases for soft commodities are currently not expected to result in higher overall inflation.

That said, if we do get some pass-through, central bankers would tend to describe the increase in inflation as temporary. Central bankers prefer to look at “core” measures of inflation that exclude potentially volatile categories like food and energy. Mike recently wrote that the state of the global economy is quite poor, so it is more than likely that the central bank authorities will describe any increase in inflation as temporary and that real economies remain weak. We have been describing central bank regime change for a while now, and it appears clear to us that central banks aren’t really all too fussed about inflation anymore. It’s all about unemployment and debt.

However, inflation affects everyone. We can debate whether this is fair or not, as the average consumer doesn’t exclude food and energy from their basket of goods, but rising food prices are arguably an even bigger issue in EM countries. The following chart highlights the weight of food in the inflation basket across the continent of Europe. For EM countries like Romania (29.7%), Turkey (24.3%) and Lithuania (23.6%), the food bill is a substantial amount of money to the average citizen of these nations.  In China, the weight of food is close to a third and in India it is almost half. Many of these countries are currently embarking on monetary policy easing and if food inflation continues for a sustained period of time, then this could put these policy easing plans at risk.

% weight of food in HICP index in EuropeAs I mentioned last year, the  Food and Agriculture Organisation (FAO) of the United Nations is a great source of information on agricultural production and the outlook for food commodity prices. And as I said last year, their agricultural outlook does not make for comforting reading. The chart below shows their nominal price forecasts for crops, livestock and fats out to 2021. There is a continued increase in commodity prices particularly for oilseeds, beef, and fish. The FAO highlight that the key issue facing global agriculture is how to increase productivity in a more sustainable way to meet the rising demand for the “four F’s” – food, feed, fuel and fibre. It is forecast that agricultural production will need to increase by 40% over the next 40 years but total arable land will increase by only 5%. Increasing productivity and developing new technologies will be crucial.

Price trends of agricultural commodities (nominal)So keep an eye on those butterflies. They could very well be a leading indicator to food prices and inflation outcomes.

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Peripheral corporate bonds and mass downgrade risk

Staying with the Bon Jovi theme, ‘Ugly’ was a track released by Jon Bon Jovi on his second solo album in 1998. It isn’t well known, or any good for that matter, but it does aptly describe the price action of Spanish and Italian corporate paper of late.

Plenty of attention has been paid to the yield on Spanish and Italian govies – currently around 7% and 6% for 10-year bonds – but their bellwether non-financial corporate issuers have also seen their yields come under significant pressure. 5-year CDS levels for the likes of Iberdrola, Gas Natural, Repsol and Enel are trading near their all-time wides at 500, 525, 475 and 455 bps respectively. And it isn’t just the utilities that have come under pressure: Telefonica and Telecom Italia have also seen their risk premia balloon to over 500bps. (see chart 1)

Whilst the aforementioned companies are still rated investment grade – some by many notches – they are actually trading wide of the Merrill Lynch BB Euro High Yield Non Financial Index (current asset swap of +440). Put another way, the market does not believe that these businesses represent investment grade risks.

Such a view isn’t without logic. The current ratings for the largest Spanish and Italian non-financial issuers (see chart 2) suggest that the market is right to be nervous. On average, the four largest Spanish issuers are only two notches above high yield status; for Italy’s five largest issuers it’s about three notches. That may seem like a fair bit of runway until you think about the pace of downgrades suffered by their sovereigns of late. Keep in mind that as late as July 2011 Moody’s rated Spain at Aa2, seven notches higher than its current Baa3 rating. Italy has also seen its rating cut a full four notches between June 2011 and Feb 2012 by the agency. And S&P hasn’t been much kinder, slashing Spain’s rating from AA- to BBB+ in under a year and reducing Italy from A+ to BBB+.

Both Spanish and Italian corporates saw negative rating actions as a consequence of those sovereign downgrades. Moody’s allows non-financial corporates a maximum two-notch rating uplift versus the sovereign, whereas S&P permits a maximum of six in extremis, with a couple of notches uplift far more common. The impact on Greek and Portuguese corporate bonds – such as EDP, OTE and Portugal Telecom – after their sovereigns lost their investment grade status serves to reinforce the potentially significant relationship between sovereign and corporate credit ratings.

So, in a hypothetical mass downgrade scenario what quantum of debt could be downgraded to high yield? If all Italian and Spanish non-financial paper were eventually to lose its investment grade status, we calculate that €47bn nominal of Spanish paper and €59bn nominal of Italian paper could fall into high yield territory. That would be a massive €106bn worth of paper – or 80% of the existing non-financial Euro High Yield index – heading into the high yield market. That’s a lot of paper for it to swallow.

Of course, the actual amount of debt that would end up for sale is difficult to quantify. This would depend, among other things, on index rules and investors’ willingness and ability to hold high yield bonds. However, it seems reasonable to assume that over the coming months and even years a significant amount of paper will need to find a new home. Yields may well have to climb further, potentially a lot further, before traditional high yield investors see value in these names.

 

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UK gilts – “Whoah we’re half way there, Whoah livin’ on a prayer…”

Last week the Bank of England announced a further round of quantitative easing of £50bn, bringing the total to £375bn. It is obvious that the MPC thinks that monetary policy is still not sufficiently loose to create the desired economic effect and hence further stimulus is needed.

We have written numerous times on QE. When we started scribing on this novel experiment we focused on why it needed to be done, and how it was meant to work (like walking on custard) and the bizarre effect this may have on the bond market.

One thing we did not focus on was the length of time monetary policy would have to be kept super accommodative, though we did expect it to be for an extended period of time (certainly until we begin to see a meaningful recovery in employment outcomes as outlined here).

Mervyn King appears surprised by the extent of the crisis. The MPC were slow in aggressively cutting rates after the onset of the credit crunch in 2007, but to his credit Mervyn and the UK authorities have been at the forefront of corrective action and have correctly realised the severity of the credit crisis. The MPC was correct to not interpret the inflation scare of 2008 or the economic rebound of 2009 as economic recovery. They have been spot on.

But how accurate is his current thinking?

The Governor is not one to pre-commit. However he did say something recently that shows how he feels about the potential long term outlook for rates. At the latest Treasury Select Committee he repeated that at this point in time – and he has said it at every committee meeting – that he believes we are not yet half way through the crisis.

“When this crisis began in 2007-2008, most people including ourselves did not believe that we would still be right in the thick of it, in the middle of it, quite this late. All the way through, I’ve said to this committee that I don’t think we are yet half-way through – I’ve always said that and I’m still saying it.” Mervyn King, June 26, 2012.

From the chart below we can see that BoE base rate has been set at 0.5% since March 2009, and over £325bn has been pumped into the financial system through QE. If we are not yet half-way through this crisis, then this implies that rates will stay at these levels for at least another 3 years to 2015, and a further round of £375bn of QE is potentially on the agenda.

If this interpretation of the outlook turns out to be correct then these very low levels of short and long term gilt yields begin to look more logical to gilt investors. And we can assume that the UK won’t recover fully until the US and Europe does as well, which means that ultra low yields on Treasuries and Bunds may also make sense.

Monetary policy is living on the edge, and if Mervyn King were to do a turn at a city karaoke machine, then the bar could well be ringing out to this Bon Jovi classic…

“Whoah we’re half way there, Whoah livin’ on a prayer…”

Naturally, his audience of gilt investors – despite the ultra low yield they are currently receiving – will sing back “We got to hold on to what we’ve got”.

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Two charts for anyone who still believes in ‘decoupling’

Q2 was a grim quarter, not just for the Eurozone economy but for the global economy. The downturn in Citigroup’s economic surprise indices that began in March picked up speed through to June, while PMIs in almost all corners of the world weakened in Q2 as can be seen by the PMI heatmap.

The good news is that the authorities have begun to respond to the downturn with more stimulus (as seen by yesterday’s actions from the BoE, ECB and PBoC). Some would argue that economic data are all different degrees of lagging indicators, so people may take more comfort from the forward looking financial markets having bounced since the end of June (although I think is misplaced optimism – political and fiscal union remains miles away, and the EFSF/ESM bailout mechanism is deeply flawed).

The bad news is that areas of the bond market are showing severe distress once more. Long dated Spanish government bond yields have jumped again, and yields are right on the intraday record high set on June 18th at the time of writing. Long dated Slovenian government bonds are yielding 7% amid mounting speculation that a bailout is imminent. And two year German government bond yields have again turned negative.

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Competition: win David Graeber’s “Debt: the First 5000 Years”

I’ve not read David Graeber’s “Debt: the First 5000 Years” yet – an anthropological investigation into the origins of money and debt – but have had it highly recommended to me and the reviews on Amazon suggest it’s a staggering original work. So I’ve bought a job lot for the team, and 10 extras for you to win in today’s competition.

Question: Denmark yesterday cut official interest rates on its certificates of deposit. To what level?

Please see here for terms and conditions, and submit your answer here by 5pm on Thursday 12th July 2012. The first 10 correct answers out of the hat will win a copy of the book.

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Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.

jamestomlins_100

US – a video from Chicago. Research trip on the US High Yield market

I recently returned from Chicago after a research trip. We put together a short video to share a few of our findings with the wider world. The mood of most economists, investors and indeed the man on the street was noticeably more upbeat than in Europe. With positive GDP growth, a housing market showing the first signs of stabilisation, if not growth, and – in our opinion – a banking system that is in better shape than its European equivalent, the US continues to provide a more benign context for High Yield investors. Indeed, whenever we encountered concerns and pessimism it was firmly focused on this part of the world. Consequently, we continue to find some interesting themes and opportunities in the US, both from a top down perspective and also for individual issuers and bonds.

jim_leaviss_100

Why does UK government guaranteed Network Rail keep issuing debt in its own name – and at a higher cost?

Network Rail, the organisation that owns and manages the UK’s rail infrastructure, has just issued more of three tranches of its index-linked corporate bonds.  These bonds are, like all of Network Rail’s debt, rated AAA and fully guaranteed by the UK government (the business was effectively nationalised in 2002 having bought Railtrack out of administration) .  These bonds were issued with spreads around 30 bps over similar maturity UK index-linked gilts.  That level of spread is typical of where Network Rail’s corporate bonds trade at the moment – and there is over £28 billion of this public debt outstanding.  This means that if that corporate debt were issued today it would bear a total interest cost that is £84 million per year higher than the cost of issuing gilts (plus the costs of issuing debt as a corporate, e.g. separate listings, investment bank fees).  Present value a perpetual income stream of £84 million at, say, 3% (the yield of ultra long dated gilts) and that is an additional cost of £2.8 billion.

So why isn’t the government borrowing in its own name at rates 0.3% per year lower than Network Rail and then directly on-lending the money to it?  After all it has already assumed all of the credit risk through the guarantee.  I know that £2.8 billion is relatively small in the scale of the UK’s debt problems nowadays (it was roughly the overshoot in May’s government borrowing requirement), and that assuming Network Rail’s debt obligations directly would increase the total UK national debt, but we’re talking about a simple accounting change to save billions of pounds.

Just don’t let’s get started talking about PFI…

jim_leaviss_100

The UK’s AAA rating looks increasingly vulnerable. Growth negative, borrowing up. It might not matter though.

On 14th February this year, Moody’s put the UK’s AAA credit rating on negative outlook.  This means that the agency says there is a 30% chance of the UK being downgraded within the next 18 months (i.e. by mid 2013).  A month later, Fitch moved the UK’s AAA rating to negative too – for them this means a slightly greater than 50% chance that there is a downgrade within the next two years.  At the time Moody’s said that “any further abrupt economic or fiscal deterioration would put into question the government’s ability to place the debt burden on a downward trajectory for fiscal year 2015-16″.

Since that Moody’s action, we have seen deterioration, both in economic growth and on the fiscal side.  Q4 2011 GDP was revised down from -0.2% to -0.3%, and now today to -0.4%, and an official recession is now occurring with 2012 Q1 GDP growth coming in at -0.3%.  Whilst the latest survey of economic forecasts has a median Q2 GDP growth of +0.1%, the impact of the extra bank holiday on economic activity has 35% of forecasters expecting a third consecutive negative quarter.  At the same time, and as a direct result of that weak growth performance, government borrowing is overshooting.  In May the UK borrowed £18 billion, compared with an expectation of £14.5 billion.  This is £3 billion more than in May 2011 and was driven both by weakness in tax receipts (-7% year on year) and higher government spending (+8% year on year).

The government then came out and announced a freeze in petrol duty, postponing a planned 3p rise in the rate due to take place in August.  The cost of this, whilst “only” £550 million, appears to be unfunded – there was talk of departmental underspends, although the monthly borrowing numbers don’t seem to reflect such savings yet.  As Treasury minister Chloe Smith said in “that” Newsnight interview, “it is not possible to give you a full breakdown (of the underspends)…because the figure is evolving somewhat”.  Whilst as a good Keynesian I’m all in favour of fiscal stimulus helping to support the existing monetary stimulus in the UK, this is not the implicit deal that Chancellor George Osborne made with the rating agencies – that being that he would deliver both growth and austerity together and thus get the UK’s debt/GBP ratios down in coming years.  Failing to both get government spending down, and to grow the economy means that that debt/GDP ratio will continue to grow, and it becomes increasingly likely that the UK will lose its prized AAA ratings.  Whether this matters is a different question – our sovereign CDS spreads are lower than AAA Germany’s (70 bps vs 103 bps), our bond yields are as low as they’ve ever been, and whilst the Eurozone crisis continues the UK remains a safe haven for capital.  And as we know, when S&P downgraded the US last year its bond yields subsequently fell.  It’s also unlikely that gilts will sell off, as UK rates are pinned at 0.5% (or lower) for the foreseeable future, and more Quantitative Easing is on its way.  A downgrade might therefore just be an embarrassment for the Chancellor, rather than the starting gun for a race out of UK bond markets.

anthony_doyle_100

Lonesome George (Osborne) should get rid of one and two penny coins

Some sad news has reached us on the bond desk. Lonesome George, a giant tortoise that lived in the Galapagos Islands, has died. Lonesome George was known as the rarest creature in the world because he was the last known individual from his subspecies. Which is kind of relevant, as today’s blog will be covering another endangered species – one penny and two pence coins.

It was announced earlier this year that in an effort to cut costs, the Canadian government would be eliminating the penny from Canada’s coinage system. Canada isn’t the first country to pinch its pennies. Australia removed its one and two cent coins from circulation in 1992 due to the high cost of production, the United Kingdom lost the half-penny in 1984 when it became more expensive to make than its face value, and after getting rid of its one and two cent coins in 1990, New Zealand followed suit in 2006 with the five cent coin.

The Canadian government has asked businesses and consumers to simply round up (or down) to the nearest five cents at the cash register. Businesses will be asked to return pennies to financial institutions. The coins will be melted and the metal content recycled. Could the UK and Eurozone announce similar measures in the future?

Last year, the UK issued 304,304,000 one penny and two pence coins. The value of these coins is around £4 million pounds. They are copper-plated steel and are around 93% steel and 7% copper. Our rough estimate suggests that this equates to around 1,314 tonnes of steel and 100 tonnes of copper. For some context, a London double decker bus weighs about 15 tonnes.

At current market prices, the value of all this metal is about $1.2 million (metal prices are quoted in USD/tonne). But what if all the one penny and two pence coins in circulation were melted down? We could use this metal for other purposes (for example, the Aussies made Bronze Olympic medals out of their one and two cent coins). Using figures from The Royal Mint, we have found that there were 16.7 million coins produced between 1992-2011 (93% steel, 7% copper) and 14.2 million coins produced between 1971-1991 (97% copper), equating to 39,000 tonnes of steel and 73,000 tonnes of copper. If all the coins that were produced over this period were melted down, the value of all that metal on the open market would be $554 million (assuming that not a single penny was lost or destroyed).

The same analysis for the Eurozone shows that last year’s one and two cent issuance has a scrap value of $17.8 million. Do the peripheral Eurozone nations really have the spare change to mint these coins?  The scrap value of all the one and two cent euro coins in existence is almost $200 million.

So is it time the UK and Europe did away with these fiddly coins to save on minting and metal costs for the taxpayer? Some monetary union countries already have. The Netherlands and Finland produce only a small number of one and two cent coins for collecting purposes only. In these countries, businesses round prices up or down to the nearest five cents (Swedish rounding) if paying with cash. Eliminating lower denomination coins in Australia and New Zealand had negligible impact on inflation. Speaking of inflation, one penny in 1970 would buy 13p worth of goods and services today. There are also efficiency gains to be had at shopping tills around the country as businesses move customers through their tills at a quicker rate. And hopefully I would be able to get on my bus faster.

At a time when we are all penny pinching, it’s about time that those in government – including the UK Chancellor George Osborne – started thinking about it too.

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Should Europe let the single currency go to save the Union?

Today is the day on which football is going to meet the Eurozone crisis when Germany and Greece compete in the Euro Cup’s quarterfinal. Spectators will be watching closely any gestures by Angela Merkel sitting in the stadium next to other political and executive representatives, any behaviour (and banners) of both team’s supporters inside and outside of the stadium, and any appearance and words of the squads on the pitch and during the post-match interviews. The fact that much of the recent news coverage has been centred on the political dimension of this match shows once more the polarised times in which we’re currently living. A match that, frankly speaking, has never been a big deal for either nation before, suddenly has turned into a highly emotional act about success, respect and even dignity, according to some commentators and officials. Nowadays European integration looks more and more like a very complex theory whose (successful or unsuccessful?) proof might turn out to be one of the biggest challenges of the 21st century. Interestingly, I will have insider status tonight. Being a German watching this match in the European capital of Brussels, the main hub for European bureaucrats, politicians, enthusiasts and sceptics, this experience will be insightful. Let’s see in which way, given that my past experiences in Brussels made it feel rather like a bubble than a true reflection of common sentiment.

Knowing that I’m going to be in Brussels this weekend and having spoken with many of my peers who work for institutions and companies closely related to the European Union, I couldn’t really stop thinking about the political dimension of the Eurozone crisis. I asked myself the question “if the European Union is particularly a political project or even a political and economic project which was meant to develop both political stability and economic prosperity, can’t one possibly argue that it does currently not only fail on the economic dimension (as argued before), but also on the political dimension?”

Why is this? My first thought is this. If the euro is interpreted as a continuation of the European integration process which by nature was about

  • preventing a dominant state in Europe after the second world war which is able to dictate the fate of the continent
  • enhancing social and economic mobility and establishing a European identity
  • supporting democracy and, consequently, making democratic institutions an inevitable pre-condition to any membership,

then don’t we find ourselves currently in a situation in which the single currency union has led to a failure of delivery, given that

  • Germany appears to dictate the agenda and appears to be the elephant in the room
  • we’re seeing increasing nationalist tendencies in parts of Europe, and negatively polarised sentiment towards fellow member states
  • Italy, founding member of the Union, empowered a non-democratically elected prime minister (incl. a technocrat government) to run the country for around 1.5 years, assuming that the next general elections will take place in April 2013?

My second thought is about the legitimacy of any further European integration (fiscal union, Eurobonds, political union) which is currently being discussed as part of the solution of the crisis. If the European project is also defined around the lines of democracy, a value which is primarily promoted, isn’t there still a long way to go for politicians in order to convince the electorate that further integration is actually what they want, given that

  • the electorate in parts of Europe is not prepared for the idea to bail out other countries, i.e. share the burden
  • a common European identity is apparently not reality
  • social and economic mobility is far away from being fully fluid, and current political discussions at the national level across Europe rather suggest a decreasing tendency in the light of talks about the part suspension of the Schengen agreement.

The third thought to conclude the argument is about the nature of integration and, consequently, the European Union. Isn’t European integration rather something ex post than ex ante? That is, it is not the idea that you force upon someone, but rather a process facilitated by institutions and paced by the electorate at whose end integration is concluded. Institutions and electorate interact closely during the process, and one cannot really deviate too far from the state of development, from the ‘mind set’ of the other because then it turns into an unhealthy relationship in which legitimacy and accountability become problematic. That is, the formalisation of political union may require a common sentiment, a common identity in this direction first before a new treaty should enact it.

But what could be the pre-requisite of further integration? Away from all the economics, I think that Wilhelm von Humboldt, the German philosopher, has a point by saying that a language draws a circle around a nation, deciding upon inclusion and exclusion. Going back in history, isn’t one of the main differentiating factors between the United States of America and the idea of a United States of Europe that the separate states of North America emerged as satellite states of a single country – Britain – whose language, culture and legal system built the shared founding ground, as Tony Judt argues in ‘Postwar’?

If the European integration process was to resume in political union at one point in the future, shouldn’t we start to acknowledge that the electorate isn’t ready for this step yet and, equally importantly, that we’re currently jeopardising this prospect? There may be some valid economic arguments for steps to more integration, but the political arguments don’t seem to be matching this. European integration has been on the fast track over the past decades, and much of it has shaped the interaction of states, companies and individuals across countries very positively. But the Eurozone crisis also seems to show that the electorate might not have kept up with the institutionalisation process. A full political union looks to me like something bigger than an emergency solution to a financial crisis. There is another dimension to it defined by identity and democratic legitimacy. If the Eurozone crisis jeopardises, rather than facilitates, further integration on both dimensions, politically and economically, wouldn’t it be sensible to take a step back (euro break-up?) in order to overcome the structural imbalances, allow for slower, but more persistent structural alignment, and a less heated atmosphere in which a more shared identity can flourish? It is likely that a break-up will have adverse effects in the shorter term, but isn’t there the possibility that it could lay the ground for a stronger subsequent economic, political and social recovery and, consequently, mark two steps forwards towards political stability and economic prosperity in the long term? That is, let one project go (optimists might argue here “put on hold”) in order to ensure the survival of the bigger one.

Fingers crossed that Germany wins tonight – and Europe succeeds as a project in the long term.

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