Insane in the brain. Dangerous precedents being set in Cyprus

Posted on 18 March 2013 by Stefan Isaacs

Depositors in Cypriot banks awoke on Saturday morning to learn a harsh lesson. A guarantee is only as strong as your counterparty. With the Cypriot banking system requiring €10-12 billion of bailout funds – some 60% of GDP – the government has been forced to accept burden sharing with depositors. Depositors who went to bed Friday night believing their savings were safe awoke Saturday to find that it has been proposed that those with deposits below €100k in the bank will be “taxed” at 6.75%; those with deposits above €100k will be “taxed” at 9.9%, contributing approximately €6bn to the bank bailout in total. This is regardless of supposed depositor insurance schemes. Depositors will receive equity in their respective banks by way of compensation and potentially bonds entitling those who leave their money in the banks for 2 years to a share of Cyprus’ future gas revenues. The remaining €4-6 billion will likely come from the Troika.

If press reports are to be believed this was a ‘take it or leave it offer’ from the Troika with German and Finnish finance ministers unwilling to go to their respective parliaments without depositor burden sharing. This highlights the very real current challenges of domestic politics within the European Economic and Monetary Union and raises further issues.

Firstly, there are significant political challenges to be faced. Domestic opposition to this deal is likely to be significant, not least as it will be seen to be disproportionately harsh on domestic savers – who had believed their deposits were protected up to €100k, and favourable to wealthy non-Cypriot depositors who reportedly hold huge sums offshore in the banks. It can be argued that those with over €100k in deposits with the banks should bear the brunt of any proposed bail-in. With a small parliamentary majority, the Cypriot government may struggle to pass the necessary legislation. Approval will also need to be sought from Eurozone member states.

Secondly, alongside the recent expropriation of junior bond holders at SNS Reaal the attitude towards tax funded bailouts appears to be hardening. Whilst this crisis has already witnessed both equity and debt written down, the rubicon of depositor burden sharing has now been crossed. Precedent now exists for this approach over the socialisation of losses across the Eurozone as a whole. Whilst the Troika will endeavour to play its significance down, unintended consequences may still materialise.

Thirdly, the Cypriot situation serves as a reminder of the current fragmented approach of depositor guarantee schemes across Europe. Depositor guarantees are only as strong as the sovereigns providing them. In the case of Cyprus with a banking system seven times the size of its economy, clearly those guarantees were worth very little. With depositor rates currently paying very little across Europe it is unlikely to take much to prompt a change in investor behaviour.

Fourthly, it raises real questions about depositor preference. With only circa €2bn of Cypriot bank debt outstanding, policymakers have judged this too small in and of itself to recapitalise the banking system. That may be true. However by favouring senior debt over depositors it does beg the question whether the individual on the street is in theory better off owning higher yielding bank debt than depositing cash.

Fifthly, the ECB has apparently threatened that if the measures are not agreed, then it would withdraw European Liquidity Assistance (ELA) funding for Laiki Bank, Cyprus’ second largest bank, leaving the Cypriot sovereign with the bill for the entire banking sector and having to pay out on deposit insurance in full. This highlights the extent to which a number of banks in Europe remain reliant on ECB funding, and that if that funding is withdrawn then their collapse is inevitable.

Finally, we have yet another example of a country being forced to face a stark choice between ceding sovereignty to Brussels or facing financial ruin. The Eurozone project continues to ask a great deal of its citizens. Bailouts don’t – and won’t – come cheap.

The Cyprus deal will be in the headlines for the next few days. We can’t help but think that the markets will be listening to Cypress Hill – Insane In The Brain for the next week or so. Maybe the Troika should too.

Competition: win one of 20 copies of The Sterling Bonds and Fixed Income Handbook

Posted on 15 March 2013 by Jim Leaviss

Mark Glowrey has written an excellent guide to the UK’s bond markets, covering everything from gilts, linkers, corporate bonds and high yield, to dealing, settlement, tax and covenants. There’s also some great bond market history and anecdote – I like the story of the two brothers who worked as bond brokers at the London Stock Exchange. Both had been awarded the Military Cross in World War 2, but the second brother had been awarded the Military Cross and bar. The nickname of the first brother was “The Coward”.

We have 20 copies of the book to give away. You can win one by tweeting us (we’re @bondvigilantes) the answer to this question. Add the hashtag #BVbook to help us find your entry in our inbox please.

What’s the highest coupon currently available on a UK gilt?

See here for terms and conditions. Tweet us your entries by midday on Friday 22nd March. The 20 winners will be contacted shortly afterwards.

HY default rates showing the divergence in the Eurozone

Posted on 15 March 2013 by Matthew Russell

2012 was not a good year for peripheral European defaults in the high yield market. Spain’s default rate doubled from 7% to 14%, while Italy’s went from 5.7% to 9.5%. Clearly, that the Spanish and Italian economies are under stress is not news, but what I thought was interesting though was that German defaults have continued to fall. It is important to point out that this is not just the public high yield market, it also includes private bank loans and it has been those that account for the majority of the defaults.

As the chart below shows, in 2010 Germany had the highest level of defaults of the three countries but over the subsequent years the situation there has improved. The opposite has been the case in the periphery with last year’s jump in defaults looking particularly worrisome.

We have been speaking for a while about the strain that operating under inappropriate policies puts on an economy, and this looks like empirical evidence of just that. Italy and Spain need looser monetary policy and less constrictive fiscal policies. In a pre-euro world these countries would have had full control of these policy tools, been able to devalue their currencies, relieve some of the strain and increase the competitiveness of their economies. This is not an option open to them now (short of leaving the euro) and I can see no way the situation will improve anytime soon. Even with Mario Draghi and the ECB willing to do whatever it takes to save the euro, the only outcome I can see for the next few years is the strong getting stronger and the weak getting weaker.

Irish eyes are crying when they look at the economy

Posted on 13 March 2013 by Anthony Doyle

With St. Patrick’s Day around the corner, we thought there would be no better time to do an economic update on Ireland.

In November 2010, Ireland found itself bankrupt. Dublin’s promise to keep bank creditors whole resulted in a massive increase in its debt obligations – too big for the government to remain solvent; especially after yields on 8 year government bonds rose to over 7% (they would later increase to over 15%). In desperation, Ireland turned to the European Commission, the European Union and the International Monetary Fund (the so-called “Troika”) for assistance.

After lengthy negotiations, Ireland received a €67.5bn international bail-out from the Troika, after yields on Irish government bonds rose to record levels. In return, the Irish government agreed to downsize and reorganise the banking sector so that it became proportionate to the size of the economy. The government also agreed to significant fiscal and structural reform, including austerity measures of €15bn over four years. This adjustment was to be made up of €10 billion in expenditure savings and €5 billion in taxes. This three year assistance programme is due to conclude at the end of 2013.

It was hoped that by implementing these reforms that Ireland would be able to return to the international capital markets and that investors would again lend to the Irish government. And that is indeed what has happened. As recently as January, Ireland issued €2.5bn of bonds maturing in 2017 at 3.32%. There are now hopes to issue a benchmark 10-year bond and possibly a linker in 2013.

Ireland cannot use the billions of euros it received from the Troika to embark on stimulatory policies for the economy. The money loaned to Ireland is sent to Dublin by the Troika, pumped into the Irish banks, and then channelled to Irish bank bondholders. The man on the street doesn’t see a cent. It was hoped that the bailout would benefit the Irish taxpayer by preventing even harsher austerity.

With that in mind, how has the real economy performed?

As would be expected, the evidence suggests a weak recovery at best. Ireland expanded at a pace of 0.8% over the year to September 2012 despite an environment of high unemployment and fiscal austerity. Looking at the sectors that contribute to GDP, we can see some improvement in the combined distribution, transport, software and communication sectors. At around 25% of the economy the Irish government is hoping that an increase in demand for Irish goods, particularly within the pharmaceuticals and information technology sectors, will support growth over the medium term. A weaker euro will help, particularly against the US dollar (the US is a big market for Irish exports – around 24%), but it is not weak enough.

Given that many of Ireland’s major industries – like pharmaceuticals – are highly capital-intensive they tend to employ few people. Additionally, the capital used in these industries is largely owned by foreigners and hence the benefits of profits are repatriated out of Ireland. Thus gross national product, which deducts income paid to foreigners, is a more relevant gauge of how the economy is performing. And on this measure, the Irish economy isn’t too cash hot, remaining significantly below the pre-crisis trend.

The above chart is a good illustration of the housing and construction boom that occurred in the run-up to the financial crisis of 2008. Housing and construction peaked in March 2007 and has since contracted by 65% in real terms. Despite only being around 7.5% of the economy at its peak in 2006, the boom and subsequent bust in this sector highlights the significant multiplier effects that the housing market can have on an economy (and is something we have highlighted here).

Turning to the labour market, it is true that the deterioration in labour market has stopped over the past year. The unemployment rate peaked at 15.0% and has now fallen to 14.2%. Many are pointing to the improvement in the labour market as a sign that the Irish economy is healing. We are less sure.

Holding the participation rate steady at September 2008 levels, the unemployment rate is closer to 19.5%, a full 5.3% higher than the current unemployment number of 14.2% suggests. This equates to around 140 thousand people. Where have they gone?

Net migration figures show that between the years of 2009-2012, a total of 87 thousand people left Ireland and predominantly between the ages of 15-44. Net migration, a declining participation rate and an increase in discouraged workers goes some way to explain the reduction in the Irish unemployment rate. The labour market isn’t healing; in fact the number of employed people in Ireland has fallen from a peak of 2.16 million in the third quarter of 2007 to 1.85 million at the end of 2012.

We have heard much about the internal devaluation going on in Ireland, which has been seen as a sign that Ireland is becoming more competitive in the global economy. True, unit labour costs (ULC) fell by 16% from the peak in Q4 2008 to Q3 2012. But this is misleading of the more recent trend. From Q1 2010 to Q3 2012, unit labour costs fell by only 3.4% and from Q1 2011 to Q3 2012 unit labour costs have actually been flat. This very slow reduction in unit labour costs in recent years suggests that it will be a decade or more before it is competitive. Ireland is seen as a nation with one of the more flexible labour markets in the Eurozone. What hope is there for Italy, Greece, Spain or Portugal with their relatively inflexible labour markets?

We fear for the Irish economy. What is required is stimulus, not austerity. Without some form of stimulus package, the Irish economy will experience sub-trend growth for the foreseeable future (in contradiction to the IMF’s forecasts – see here). A good place to start would be to use using some of the proceeds from borrowing at record low interest rates in the capital markets to stimulate the economy. The €2.25bn stimulus package was a good start last July but much, much more is needed. For example, how about a helicopter drop of cash into the economy Bernanke style? Give the estimated 4.5 million inhabitants of Ireland €200 each? It would only cost €900 million. Cut income tax. Encourage investment and lending. Build infrastructure. Create jobs. Reverse austerity.

Or how about using the money raised to embark on a programme of debt forgiveness in order to provide homeowner relief. Find a way for homeowners to take advantage of low interest rates and refinance despite having limited/negative equity in their homes. Allow refinancing to occur on a mass scale.

I know, I know. What about the loss of faith in Ireland’s credit rating? What about the spike in government bond yields? Well hopefully the stimulus package would work. Besides, ECB President Mario Draghi will do “whatever it takes”. And we believe him when he said “And believe me, it will be enough”.

If Ireland continues to tie its flag to the austerity mast, it is difficult to see a time in the next decade when the economy will cause Irish eyes to smile again.

Wage inflation: Upward pressure on German labour costs in 2013

Posted on 13 March 2013 by Markus Peters

When I left Germany more than three and a half years ago, it was a good place to live. Germany’s polarising football superpower Bayern Munich had just failed to win the Bundesliga, horse meat was deliberately eaten in form of “Rheinischer Sauerbraten” and circa 40 million Germans were in employment. Despite all the bad news today – Bayern Munich has a strong lead in the Bundesliga table and horse meat is a basic ingredient in nearly every ready-to-eat meal available – Germany has not become a worse place to live. Employment is at record highs in absolute terms and the unemployment rate stands steady at 6.9%.

Although some of the peripheral countries have made some progress to lower their unit labour costs through harsh austerity measures (as projected by the Organisation for Economic Co-operation and Development (OECD)), Germany’s competitiveness still stands out as exceptionally high within Europe. Austerity is a tough medicine to take, so I doubt that the Greeks, Spanish and especially Italians (as the recent electoral outcome confirmed) are willing to take their prescribed doses all the way through until they reach a similar level of competitiveness to Germany.

For this reason, it is generally argued that the Eurozone rebalancing has to come not only through structural reforms in the periphery, but also through internal devaluation in the core of Europe. Unlike peripheral Europe which is attempting to reduce labour costs, in 2012, Germany’s economy saw annual real wage growth for the third consecutive year. Employees keep demanding higher salaries after cutting back for years. Hiring intentions and business confidence have not even dropped considerably after the economy’s slowdown in the last quarter. But most importantly, it’s electoral season in Germany.

At the start of March, the SPD, Greens and “Die Linke” (The Left) officially kick-started their electoral campaign around the topic ‘social justice’ (Soziale Gerechtigkeit). In Germany’s upper chamber (Bundesrat), where they now hold the majority of the votes, the three parties voted in favour of a statutory minimum wage of EUR 8.50/hour (or circa EUR 1,300 per month if we assume an average weekly working time of 35 hours for full-time workers).

Germany is one of the few countries in Europe which has not got a statutory minimum wage. The proposed minimum wage would roughly equal the minimum wage level of the United Kingdom and would be below the minimum wage of France, the Netherlands – and Ireland (looking at the below chart, I have been wondering if this is one of the reasons why we have not seen as many Irish people on the streets as Spaniards or Greeks). The proposed law is still subject to the approval by the CDU/FDP-led German Parliament though. It is very unlikely that it will be approved in its current form, but it puts considerable pressure on Angela Merkel to make concessions on this topic and to somehow set a floor level to German wages.

The main source for wage pressure in Germany though stems from expiring labour agreements between the powerful trade unions and industrial employers. It is estimated that labour agreements concerning up to 12.5 million workers, or around 30% of the German labour force, are subject to re-negotiation in 2013. Trade unions Ver.di and IG Metall represent the interests of around 9 million German workers alone this year. The wage negotiations with the biggest impact take place for compensation in the metal and electronics industries (concerning circa 3.4 million employees), in the retail industry (1.3 million), in the wholesale commerce sector (780,000), and in the main construction sector (650,000).

So what are they asking for? One of the very first renewed agreements was concluded last weekend. Labour union Ver.di and the public sector representatives agreed on a 5.6% wage rise throughout 2013 (+2.65%) and 2014 (+2.95%) for around 800,000 public sector employees. Furthermore, job guarantees were granted for all public sector trainees and a uniform holiday allowance of 30 days per year was agreed. Elsewhere, IG Metall currently aims at a nominal wage growth in the metal and electronics industries of 5.5% and IG Bau has demanded wage growth of 6.6% for workers in the construction sector. Beyond doubt, this could mean significant real wage growth for a considerable part of Germany’s 41.7 million labour force.

The power of German trade unions, particularly in electoral times, must not be underestimated. The German “blue collar” workers are the traditional voters of the left parties, so the social democrats will do everything to support the trade union efforts. Angela Merkel has to find a way to accommodate the unions’ demand for higher wages because she will not be able to afford an outright electoral recommendation for her competitors to 12.5 million blue collar workers.

Wage inflation is certainly on its way in Germany. And it might come at exactly the right time for the German economy. In an environment in which we can’t see Eurozone demand for German goods picking up and Chinese demand for German goods is increasingly likely to slow down, it strikes me as a positive development that German workers have more money in their pockets and can stimulate domestic consumption, making the German economy less dependent on the export sector. But the German economy clearly walks a fine line here. Excessive wage growth might decrease German competitiveness too much. We don’t see this danger stemming from the suggested minimum wage which seems to be too low to have a significant immediate negative impact. In the longer run, there is the risk though that the minimum wage level could prove to be an enticing lever for governments to please the electorate ahead of general elections.

In the shorter run, the impact on overall wage levels from labour union agreements might prove to be more considerable. The rigid Bundesbank models suggest that a 2% increase in real wages in the German economy would translate into a ¾% decline in the rate of GDP growth and a 1% increase in unemployment. The same models say that the effect for the peripheral nations from the decreased competitiveness of the German economy would be close to zero because of the structure of trade flows. So the net negative effect to European trade overall is attributable to what Bundesbank president Jens Weidmann phrases as the realisation that “Europe is not an island, but part of a globalised world”. In our opinion, it would be interesting to see what the models say when you feed them with a 30% Yen depreciation and 20% sterling depreciation against the euro and what the Bundesbank’s suggested reaction to such a scenario might be.

The bond vigilantes are being zombified, but the currency vigilantes are rampant

Posted on 12 March 2013 by Mike Riddell

We have written extensively on this blog in the last year about what we’ve termed ‘central bank regime change’ (eg see Jim’s article here from a year ago), where we have argued that in the years ahead, central banks would care less about inflation and more about growth and unemployment. We have since seen a number of examples of this playing out – the Federal Reserve has started targeting the unemployment rate, the Bank of Japan is trying to generate inflation, and the ECB has said it will do “whatever it takes to preserve the euro”.

More recently we’ve seen the Bank of England join the party, where 3 of the 9 members of the MPC voted for additional asset purchases despite forecasting that inflation is likely to remain above the 2% target for the next two years. And then last week we had the bombshell in the Financial Times that conversations are being had about changing the BoE’s remit, which looks suspiciously like a leak (again today it was reported that Carney has met with the Treasury to discuss remit change).

Richard wrote about the ‘currency vigilantes’ in 2010 (see here), where he discussed how QE was taming the bond vigilantes, how in the new topsy turvy world the highest inflation economies could have the lowest bond yields, and how the currency vigilantes will take the bond vigilantes’ place to enforce discipline. If you look at FX performance year to date then the currency vigilantes are clearly on the hunt – the world’s worst performing major currency at the time of writing is the Japanese Yen (-9.7% vs USD) and the second worst is the British Pound (-8.5% vs USD).

Meanwhile, QE has successfully turned the bond vigilantes into bond zombies. Market participants no longer appear to be forcing up profligate countries’ nominal government bond yields; they are instead buying up these countries’ inflation linked bonds. So in another topsy turvy development, it is becoming cheaper rather than more expensive for these governments to borrow. Cynics would argue that was the whole idea.

The result is that as real yields fall versus nominal bond yields, market implied inflation expectations are by definition increasing. One measure of market implied inflation expectations is the 10 year breakeven inflation rate, which is the gap between the 10 year real yields and 10 year nominal yields. The chart below shows that US 10 year inflation expectations are at the highs of the range of the last 15 years. Today the UK 10 year breakeven inflation rate hit 3.36%, the highest since September 2008. If you consider that the UK breakeven inflation rate is priced off RPI, and RPI is likely to be around 1% higher than CPI over the long term, then the UK bond market is still only pricing in a 10 year CPI average of just over the current 2% target. We think this still has a lot further to go – and we still hate sterling.

The Real Income Enigma

Posted on 12 March 2013 by James Tomlins

“The question isn’t at what age I want to retire, it’s at what income.”

George Foreman

The carry trade, the grab for yield – call it what you will, but this has been a persistent fact of life in today’s investment climate, especially as larger cohorts of the developed world join the ranks of the retired. As Mr Foreman points out above, the financial aspect of retirement isn’t really dominated by how much capital you might have, but how much income can be generated from your savings and various entitlements. Furthermore, safeguarding this income from the rapacious grasp of inflation is crucial. Real income is the goal.

While there is plenty of demand for real income, the supply of assets that can provide this is now dwindling. The chart below is a very simple one (and arguably too simplistic), but it paints a stark picture for income hungry investors. On the left hand side is the nominal income yield from various asset classes (dividend yield in the case of equities, yield to maturity for fixed income). The right hand side merely takes away the last inflation number to give you a snapshot of real income yields. This does not take into account the possibility of earnings and dividend growth from the equity markets (an important aspect) or indeed any changes in the inflation rate. For any income orientated investor, this essentially gives you the menu of options for generating inflation beating income in the here and now.

One thing that should come as no surprise is that cash and government bonds offer negative real returns on a buy and hold basis, but what is less obvious perhaps is that the number of asset classes that offer a positive real return has shrunk dramatically. Indeed, only high yield bonds offer a significant pick up above and beyond the inflation rate. (This pick up is there in part to compensate investors for the risk of default, volatility and lack of liquidity). Whilst we do not expect dramatic capital gains from high yield in the near future, absent a major negative shock for risk appetite, this context provides very powerful structural and technical support for the asset class. Investors, particularly those seeking income, ignore this at their peril.

Asian currency wars; is China really the ‘currency manipulator’?

Posted on 11 March 2013 by Mike Riddell

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

Chile research video: a brighter mañana?

Posted on 7 March 2013 by Ana Gil

Last week Anthony was back on the road headed for South America’s hottest economy: Chile.

With a population of more than 17 million and nominal GDP over $248bn, Chile’s economy is currently the 6th largest in the Latin American continent, after Brazil, Mexico, Argentina, Colombia and Venezuela.

Yet, Chile’s economy delivered a growth rate over 4.6% in 2012, comfortably outpacing the regional average of 3.2%. Chile’s booming economy is characterised by near-full employment, strong foreign trade relationships and sound economic policy. Global exports account for 32% of Chile’s GDP, with China being its largest trade destination. But could a Chinese slowdown, fuelled by a buildup in China’s private sector credit, have major implications for this South American nation?

Video – The new normal: the thin line between deflation and inflation

Posted on 4 March 2013 by Gordon Harding

Last week Jim took part in an Asset.tv masterclass. The panel discussion was hosted by the BBC’s economics editor Stephanie Flanders with the main theme tackling one of the big conundrums of the past few years – whether we’re heading into an era of deflation or inflation and indeed whether central bankers really care about inflation anymore. The video also covers a range of related topics, such as the efficacy of QE, currency wars and the implications for markets if and when central banks begin their exit strategies.

To view the video you will need to enter your Asset.tv registered email address. This is required by Asset.tv as part of the broadcasting rights for this masterclass. If you do not have an Asset.tv email address you can register on the Asset.tv website and then return.

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