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jim_leaviss_100

The UK’s current account deficit keeps getting worse. Terrible numbers today – time to reduce sterling exposure?

There were some reasons to be cheerful in today’s UK economic data – second quarter GDP growth wasn’t quite as bad as previously thought (the economy shrank by 0.4% rather than 0.5%), and stripping out the weak construction sector, the economy is growing at a reasonable (if below trend) rate.

But we also had news that the UK’s current account deficit showed a significant deterioration. The gap between imports and exports grew during the quarter, to a deficit of £20.8 billion – equivalent to 5.4% of GDP. Additionally the first quarter deficit data was revised higher by £4 billion to over £15 billion. The relative strength of the pound is hindering the effort of the UK to rebalance its economy away from consumption and towards manufacturing and exports. On a trade weighted basis, sterling is around a 4 year high – helping to feed our addiction to consumer goods (and as a positive side effect helping keep inflation below the BoE’s letter writing territory for the first time in ages).

The chart below perhaps acts as a warning for those of us who by domicile or asset allocation are exposed to the pound. It shows the UK’s current account position going back to 1955, and you can see that periods when the deficit exceeded around 3% of GDP, a severe weakening of the pound often followed. In the mid 1970s the pound fell by nearly 30% against the Deutsche Mark and US dollar, and big falls also followed in the early 1990s, and in the first wave of the credit crisis. Of course there are other things you can point to in all of these occasions (bad UK banks in 2008, leaving the ERM 20 years ago this month) but if the UK’s safe haven status comes under question (for example if we lose our AAA rating post the Chancellor’s Autumn Statement) that might give the currency markets an excuse to revalue the pound downwards.

UK current account balance

Incidentally, on a purchasing power parity measure (PPP, which looks at the level of exchange rates needed to equalise the price of buying things in different economies) sterling is fair value against the Euro, cheap against the Australian dollar (which looks 23% overvalued – if you’ve been there on holiday and paid a million pounds for a schooner of lager you’ll know that’s true), but 15% dear against the US dollar.

jamestomlins_100

European High Yield – stay in the game, but don’t bet the ranch.

We mentioned late last year that the high yield market had crossed into cheap territory as credit spreads went over 1,000bps. Historically this has proven to be a relatively robust signal to take a constructive view on the market, and it proved so once again. To use a poker analogy, it was like being dealt a full house – the odds were sufficiently in your favour that, even if you didn’t know exactly what would happen, it was worth making a reasonably big bet.

In what’s been a fairly rocky ride, the European high yield market has seen a total return of 20.1%* so far this year, which compares to a 15.8% rise in the S&P 500, a 10.4% for the Euro Stoxx 50 and 4.8% for the FTSE 100. In all honesty, this has been a stronger result than we anticipated, fuelled mainly by the actions of the ECB (most of this year’s returns coming in Q1 on the back of the LTRO programme) Mr Draghi’s commitment to “do what it takes” and other central bank injections of liquidity in what has been an otherwise lacklustre year for economic growth.

So far so good, but the real question is where to now for high yield? Can we see another few months of double digit returns?

To try and answer this, first let’s consider a few of the key valuation signals. In terms of all-in yields, the high yield market is not too far away from multi year lows. The European market is currently yielding around 7.3% to maturity** compared to a 10 year low of 5.3% in February 2005. There is some scope for yields to fall further on this basis, but the scale of the move will not be enough to generate the sort of capital gains we have seen in the last few months.

Merrill Lynch European High Yield Index Yield to Worst (%)

This means that anyone who buys high yield assets at this point in the cycle looking for large capital gains will probably be disappointed. To generate a further capital return of around 16%, for example, yields would have to fall to around 2% on average. Does this then mean high yield is a screaming sell ? No, not really. To think that high yield is a sell you have to be fearful of either a big rise in underlying government bonds yields, a major re-pricing of credit spreads or both.

In the case of government bond yields, we could well see a rise from current levels, however, the extent of the rise, in my view, will be limited. I don’t think we will see 10 year yields north of 5% for Treasuries, Bunds and Gilts anytime soon as governments and policy makers have made it very clear that they will continue to intervene in the markets to keep long term interest rates lower for longer. Nominal growth and the labour markets are the primary concern, not the risk of higher inflation. This means the potential move up in sovereign yields is likely to be limited and hence capital losses for high yield bonds due to this move will be relatively benign. To put this in context, the modified duration of the European high yield market is currently 3.1 years**, hence if government bond yields rose by 1% across the board, the capital loss would be around 3% all other things being equal. When you add back a credit spread of 6.7%, assuming that you are not hit by a wave of defaults (always a big ‘if’ admittedly), then the total return from high yield would still be positive.

The more important driver of returns for the asset class will be any move in credit spreads and what default rates are likely to be. In contrast to all-in yields in the previous chart, we can see from the chart below, that credit spreads are still a long way off their lows. The incremental yield over government bonds was at 7.4% at the end of August, compared to 1.9% in May 2007. As such, there seems to be plenty of scope for spreads to go tighter, with the potential for some capital gains as they do so.

Merrill Lynch European High Yield Index Option Adjusted Spread (bps)

Does this mean high yield is a screaming buy? Again, no. We have to look at credit spreads in the context of the economic reality for companies in Europe. Much of Europe remains in the grip of low or no growth and credit remains scarce. As such the price of credit (the spread) should reflect that reality. At the end of the day, investors should demand a credit spread that adequately compensates them for the illiquidity inherent in the asset class and a modest rise in default rates. With this in mind, spreads are extremely unlikely to go anywhere near the 2007 level of 1.9% any time soon. There is also the ever present threat of a macro-economic or political curve ball that prompts a general shift in risk appetite and push spreads wider. Nevertheless, when we look at fundamentals and consider the medium term valuation case I think high yield spreads are closer to “fair value” right now.

This leads us to the rather unsatisfying conclusion that whilst the high yield market may not generate big capital returns, there is a case for remaining invested. What I would say though, is that a more defensive approach within high yield portfolios is probably merited in the current environment. The risk/reward trade off between a more aggressive position and a less aggressive position has shifted in favour of the latter. In essence, this means dialling down the “beta” for want of a better phrase.

To revert to the poker analogy, betting on the high yield market right now is like playing a hand with two pairs – you might make money so it’s worth staying in, but it doesn’t feel like the time to go all in and bet the ranch.

*Merrill Lynch Euro High Yield Index total return from 31st Dec 2011 to 21st Sep 2012. Equity market returns year to date as of 21st Sep 2012. Source: Bloomberg, Bank of America Merrill Lynch

** Merrill Lynch Euro High Yield Index as of 21st Sep 2012, Source: Bloomberg, Bank of America Merrill Lynch

richard_woolnough_100

ECB to ECP (European Centre for Politics)

The ECB is modelled on the idea of an independent central bank, where decisions are made to enforce economic rather than political discipline. Recently however, its role and mandate seem to be changing.

This move by the ECB to become more an arm of the state is typified by Mr Weidmann’s comments recently. He draws comparisons of the recent potential bond buying announcement, with that of aggressive state financing via the printing of money by non independent central banks.

Not only has the ECB agreed to become more like an arm of the state, it is potentially attempting to become the state. Its bond purchase programme is dependent on a sovereign state meeting certain conditions, which means it is now aiming to have the powers of a state, in terms of controlling net taxation and spending. It would therefore control the printing press and control expenditure. It would then automatically face the tricky political task of switching the printing press off if conditions are not met by its subjected member state. No wonder Mr Weidmann does not approve.

This is not the only way the central bank has become more political recently. By having the explicit aim of saving the euro at all costs it has basically made a political decision. Currency unions are by definition a political construct. Therefore, its recent move to a dual mandate of inflation targeting and saving the euro is a move towards a more politically focused ECB.

One of the problems the ECB faces as a political animal is its construction. It has not exactly been constructed in an efficient, democratic manner. Firstly, one country one vote means proportional representation is out the window, potentially annoying the larger members who do not agree with the policy and have to pick up the bill (Germany). Secondly, the appointment of its council members is undemocratic. Thirdly, council members, as national central bank governors, tend to be economists!

There is always a connection between a central bank and the state that it is theoretically acting in the independent interest of. The ECB is becoming more like the ECP (the European Centre for Politics). Will European governments give it this increasing power? Will it be able to exercise this power correctly?

mike_riddell_100

Is the Federal Reserve running out of ammo, and if so, what does this mean for financial markets?

Almost every financial asset seems to have gone up – in the last year, you’d have made money if you’d bought US Treasuries, corporate bonds, gold or even Italian equities.  It’s only really emerging market currencies or EM equities that have disappointed.  The concept of portfolio diversification and uncorrelated asset classes seems to have gone out of the window, but who cares when everything’s going up, right?

The first chart illustrates this point, showing the S&P 500 (pink line, left axis) against the 30 year US Treasury yield (green line, right axis).  US Treasury yields and US equities used to be strongly correlated, but in the last year Treasury yields have collapsed while equities have soared to 2007 levels.  The time value of money concept suggests it makes sense for equities to rally if US treasury yields have collapsed, because all else being equal, the present value of a company’s dividends or free cash flow or whatever you’re looking at has increased dramatically owing to the much lower discount rate.

Still, this correlation breakdown bothers me.  If it’s correct that everything has rallied on the back of the promise of central bank liquidity, then presumably every asset class can also fall if this liquidity is no longer available.

The central bank that seems to me to be closest to running out of policy options appears to be the Fed.  Sure, unemployment is falling at a painfully slow rate, but unemployment is a lagging indicator.  Probably the most important thing for the US economy is the US housing market.  The US consumer may be close to having delevered, and if the housing market rallies, consumers are fine, banks are fine, banks can start lending again and economic growth can return.  US house prices are (just) increasing again, and some of the lead indicators are unquestionably bullish.  In 2007/08 we focused a lot on measures such as the months supply of houses, which says how long the supply of houses on the market will last at current levels of demand.   In 2007/08 we showed that this measure was predicting a US recession (see here), whereas this lead indicator is now suggesting the total opposite – the months supply of new homes (for which there is a much longer history) has only looked more favourable a handful of times in the last 50 years, and is closing in on the go go years of 1997-2005.

This chart also bothers me.  The Federal Reserve’s favourite measure of market implied inflation expectations is the 5 year 5 year forward breakeven inflation rate, and inflation expectations have recently risen above 2.8%, the highest in over a year.  Admittedly part of the increase in inflation expectations has been due to Bernanke’s comments, but it’s noticeable how much higher inflation expectations are today versus where they were in summer 2010, when the Fed indicated it was getting ready for QE2.

It’s possible that we’ll see additional stimulus from the Fed over the coming months and years, and we are still very far away from a 1970s-style stagflationary environment that would likely see all asset classes really suffer.  But the ‘Bernanke put’ is becoming a lot harder to justify, and this could pose problems to both ‘safe haven’ assets as well as risky assets.

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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.

anthony_doyle_100

Who owns government bonds these days?

The IMF recently released a working paper entitled “Government Bonds and Their Investors: What are the Facts and Do They Matter?” which helps shine a light on whether a change in the investor base in recent years has had an impact on yields. One of the key trends since the onset of the crisis has been a shift in the ownership of government bonds from foreign holders back to domestic holders. This can partly be explained by the various forms of quantitative easing that central banks have embarked on and a move by banks to hold more government bonds.

The IMF find that an increasing share of non-resident investors is associated with lower yields. The econometric results show that an increase (decrease) in non-resident investors by 10 percentage points is associated with a reduction (increase) in 10-year government bond yields of between 32 to 43 basis points, whereby the effect is closer to 66 basis points for euro area countries. With that finding in mind, let’s look at the proportion of non-resident holdings of government bonds across the countries.

The first chart looks at who owns the government debt of Australia and Japan. We have written before about our concerns about the amount of Australian debt that non-resident investors own. For us, this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad). Non-resident holdings of AGBs has risen from around 30% in 2000 to over 80% today. In contrast, Japan has a very low share of non-resident holdings. This domestic investor base is mostly the result of pension savings and a strong home bias. The large domestic investor base has been associated with the low and stable yields despite very high debt.

In many countries, non-resident holders make up the largest share of the investor base though this has fallen somewhat in recent years. This is particularly the case for euro area countries. Aggregating the data for individual countries across the euro area, about one quarter of the outstanding debt is held by euro-area residents other than the issuing country, while another quarter is held by residents outside the euro area. Despite the apparently very high share of non-resident holdings in the euro area, on aggregate the euro area depends less on foreign buyers than the United Kingdom or the United States.

Whilst the UK and US show similar ownership proportions for non-residents, there is a large difference in the proportion that domestic banks, insurance companies and pension funds own. In the United Kingdom, long term yields declined following the increase in pension funds’ holdings of gilts. This portfolio shift, in particular into ultra-long gilts, has been attributed to changes of U.K. pension fund regulations with the aim of reducing the maturity mismatch between assets and pension liabilities. In the US, the large proportion of intragovernmental holdings can in-part be attributed to the Social Security Trust Fund which holds about 20 percent of outstanding U.S. Treasuries.

The other interesting data in the IMF paper was on non-resident holdings of US Treasuries. The total amount of US government debt owned by China, the Oil exporters and other EM has been falling since 2010. That said, as at August 2011, non-residents owned almost $5.0 trillion of US Treasuries.

mike_riddell_100

Asian economic slowdown and the EMD bubble

Last month I commented on the long term headwinds facing Asia and tried to cut through the sales cheese (see here). The last few weeks have seen more evidence of a slowdown in Asia, and seemingly more people buying into the EMD story as valuations in a number of countries have hit extremely expensive levels. Taking one example, in the middle of last week the $2.25bn issue of Peru 7.35% 2025s reached a yield spread of 109 basis points over US Treasuries. Liquidity on the bond is not fantastic, with a bid-offer spread of 1% on screens, implying that over a one year time horizon the yield spread is an illiquidity premium, with almost zero credit risk priced in. Spreads are reaching levels of the super liquid days prior to 2008. Bubbletastic.

Some charts below.

Australia’s economy appears to be struggling, with the Australian Dollar pushed higher by speculative inflows.

Many of the countries reliant on exporting to China are seeing flat or negative export growth year on year.

As discussed last month, Chinese growth has been highly dependent upon excessive investment growth. This has been driven by construction, which has been reliant on steel. So it’s interesting that steel prices have fallen 25% in the last year in China.

And finally the current bubbletastic spread levels on emerging market debt.

matt_russell_100

Olympigs

Rough cost of the Olympics – £9bn, US national debt – $15.8tn, Quantitative easing – £375bn. These numbers blow my mind. I know they’re big but I don’t really have a concept of how big. So I thought I’d try and put them into some context. I took a look at the national debt of the Euro’s peripheral countries and calculated how many gold medals each country would need to win to pay off their debts.

Of the 412 grams that a London 2012 gold medal weighs roughly 6 grams are gold, 381 are silver and the remaining 25 copper. Giving a market price today of about $700.

Below is a table of how many gold medals each country would have to win to get themselves out of the red:

Gold medals needed
Portugal 273,728,118
Ireland 220,449,211
Italy 3,445,899,490
Greece 627,153,707
Spain 1,295,304,783

That works out to each member of the population needing to win the following:

Gold medals needed per person
Portugal 26
Ireland 48
Italy 57
Greece 56
Spain 28

That there are only 302 possible medal events in the entire competition makes this pretty depressing reading for our European friends, especially given where they are sitting the medals table (as I type). If it makes you feel any better every US citizen would have to win 73 gold medals to get them out of their hole.

richard_woolnough_100

Climate change – bzirc monetary policy

As investors we get used to living within certain recognised bounds. For example, it has been commonly assumed that interest rates cannot be sub-zero. There has been the odd historical quirk when we’ve seen negative rates (Switzerland in the 1970s), but that’s more for amusement than general investment consumption. However, there now appears to be the potential for a major investment climate change.

There are already plenty of bond markets now living in the sub zero ice age, such as Switzerland, Denmark, Germany, Finland and the Netherlands. In these cases, the existence of negative rates could be down to the desire to express a currency or re-denomination view (as Mike previously wrote), so may be seen as a by-product of external factors and not of domestic monetary policy. However, there is now the potential for G7 monetary policy to enter the previously unbelievable reality of official sub-zero rates.

Many G7 economies have implemented very low rates and quantitative easing for a number of years, yet still appear to be in the economic doldrums with high unemployment, low growth and limited fiscal room. It could now be time for a significant change in the investment text book as central banks experiment with rates below zero.

Theoretically, a negative interest rate sounds simple – you put £100 in the bank and you get £99 back a year later if the rate is -1%. A  rational investor would of course have the alternative of simply keeping their cash under the mattress and not suffering the negative rate, although the incentive to behave rationally would be limited by the administrative burden and security risk of holding cash.  The central bank could simply limit this activity by basically not printing enough cash. Therefore the vast majority of money would have to be held electronically and could therefore suffer a penal negative rate. Implementation of sub zero rates is possible.

From a central bank’s point of view this should be stimulative, as it would discourage saving and encourage consumption like any traditional interest rate cut. At the extreme you could create exceptionally low, zero, or even negative borrowing rates.

The challenges faced by central banks and governments are still there despite traditional and unconventional policy action. Maybe it will soon be time to use the conventional tool of cutting interest rates in an unconventional way by making them negative. The next step to be taken by the authorities might mean economies working in a below zero interest rate climate (bzirc monetary policy).

mike_riddell_100

Emerging market debt is ‘cool’ – but you may be surprised what you find if you strip away the marketing myths

EM debt is a bit like Converse shoes; it seems almost everyone I speak to owns some.

Readers will no doubt be familiar with the EM ‘grand narrative’ (eg EM will surely outperform because of low debt levels, high growth, strong demographics etc etc). We’ve written an in-depth note, which is part of our Panoramic series for professional investors, in an attempt to bash away this EM ‘grand narrative’. You can access the Panoramic using this link.

It explores what really have been the primary performance drivers of the three main investable subsets of EM debt (EM local currency sovereign, EM external sovereign, EM external corporates). It touches on themes I’ve previously written about on the risks to EM debt posed by Eurozone instability and the associated risks posed by a reversal of the huge decade-long portfolio flows that have supported the asset class. But the main focus of the note is on the sizeable additional long term risk posed to EM debt by the inevitable economic rebalancing of the world’s second largest economy – China.

EM debt is still ‘cool’ within the investment universe. However, it’s curious that people now say EM debt is a good investment ‘in the long term’, a subtle change brought about by the miserable performance of some EM countries over the past year. This miserable performance has been most notable within the BRIC economies* , where in recent months, the Brazilian Real and Russian Ruble hit three year lows against the US Dollar, the Indian Rupee hit a record low against the US dollar, and this year the Chinese Yuan has had the biggest drop against the US dollar since its big devaluation in 1994.

I’m not saying that EM debt will never offer good value; it’s important to stress that there is no such thing as a good or bad asset class, only a good or bad valuation. I’m simply saying that it’s important to understand the performance characteristics of EM debt, the risks facing EM debt appear to be rising, and while some exchange rates have begun to move, the asset class does not appear to be pricing in these risks. Fashions rarely last – EM debt has been very trendy before, but favourable demographics and previously strong growth rates didn’t save emerging markets in 1981-3, 1997-98 and 2001-02. And Converse shoes haven’t always been ‘cool’ either – Converse had to file for bankruptcy protection in 2001 and ended up being bought out by Nike.

* Societe Generale’s Albert Edwards has amusingly and rightly described BRIC as a ‘Bloody Ridiculous Investment Concept’

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jamestomlins_100

The quiet de-coupling of high yield from equity markets continues

High yield and equities have historically been seen as highly correlated in terms of their returns, and before 2008, this was true. However, what we have witnessed in the post-Lehman environment is a structural shift that requires a more nuanced appreciation of the relationship between fixed income and equities. This is something we looked at in a more in depth piece we published earlier this year.

This point has been reinforced by the surprisingly divergent performance of the European high yield market and the European equity markets so far this year.

The chart below shows that European high yield performance has been strong, returning a little over 12% year to date. This contrasts sharply with lacklustre equity returns. The MSCI Europe ex UK index is down 1.3% at the time of writing whereas the more concentrated DJ Euro Stoxx 50 is showing a negative 8.4% return.

Accordingly, whilst high yield returns will always be sensitive to the economic cycle and market sentiment, in a world of zero interest rates, financial repression, deleveraging and slow growth, we continue to believe that the relationship between equities and high yield bonds has shifted in a subtle but meaningful way.

 

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