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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.

 

jamestomlins_100

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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Sell in May and go away – does it work for European fixed income?

As is usually the case on 1 May, there was a plethora of articles and commentary on the “sell in May and go away” effect. If you are unfamiliar with this highly sophisticated trading strategy, it involves closing out any equity exposure you may have on 30 April and re-investing on 1 November. Historically, U.S. equities have underperformed in the six-month period commencing May and ending in October, compared to the six-month period from November to April. No one knows why this seasonal pattern exists, but some theories include lower trading volumes in the summer holiday months and increased investment flows when investors come back from holidays.

With this in mind, we thought it might be interesting to see if the same effect exists in European fixed income markets. In order to identify the sell in May effect, we generated total returns on a monthly basis for a portfolio of European government, investment grade and high yield bonds. We then generated a total return for a portfolio that was invested between the months of November and April and compared this with a portfolio that was invested between the months of May and October. In order to generate the maximum number of observations possible, we went back to the inception of the respective Merrill Lynch Bank of America indices. The results are below.

Slide1

There appears to be a seasonal effect in European high yield markets. This is the fixed income asset class that is most correlated to equity markets, and the analysis shows that a superior return was generated by only being invested between the months of November and April (199% total return). In fact, this strategy substantially outperformed a strategy of being invested over the whole period (1997 – April 2014). If an investor chose to only invest between the months of May and October, they would have suffered a 21% loss over the past 16 years.

Slide2

The natural extension of this analysis is to gauge how a trading strategy that was fully invested in European government bonds between the months of May and October and fully invested in European investment grade between November and April would have performed over the past 18 years. We can then assess how this strategy would have performed relative to portfolios that were fully invested in European government bonds, European investment grade corporate bonds and European equities only. The results show that a strategy of selling investment grade assets in May and buying government bonds has produced superior returns equal to 5.9% per annum, outperforming European equities by 56% in total or 2.5% p.a.

Slide3

The above chart shows the same analysis, this time looking at how the strategy would have performed in total return terms but we have replaced European investment grade exposure with European high yield. Following this strategy would have generated an annualised return of around 10.5% or 391% over 16 and a bit years. This is far superior to the returns on offer in the European high yield and European equity markets over the same time period, which were 155% and 43% respectively.

Our analysis shows that there is a strong seasonal effect evident in European high yield markets, where returns are more volatile and there can be large upside and downside contributions due to fluctuations in the capital value of high yield bonds. However, it should be acknowledged that the results have been biased by the fact that major risk-off events (like Lehman Brothers, the Asian financial crisis and the Russian financial crisis for example) have generally occurred between the months of May and October. Nonetheless, historical total returns suggest that there is a seasonal effect in European high yield markets that investors should probably be aware of. Ignoring transaction costs or tax implications which would eat into any total returns, a strategy of selling investment grade or high yield corporate bonds in May and buying government bonds until November would have produced superior returns relative to European government bonds, investment grade corporate bonds, high yield corporate bonds and European equities.

Whilst it is always dangerous to base a trading strategy around a nursery rhyme, based on historical total returns there does appear to be a bit of sense in selling risk assets in May, retreating into government bonds which would likely benefit most in a risk-off event, and adding risk back into fixed income portfolios in November. But of course, another old saying still rings true – past performance is not a guide to future performance.

Claudia_Calich_100

Playing Russian roulette

The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability but high impact game.

Slide1

I just returned from a trip to Moscow. You would not know there is the possibility of a war going on next door by walking around the city, if you didn’t turn to the news. Its picture perfect spring blue skies were in stark contrast to the dark clouds looming over the economy.

The transmission mechanism of the political impact into the economy is fairly predictable:

  1. Political-related risk premia and volatility remaining elevated, translating into weakening pressure on the ruble;
  2. Pressure for higher rates as the ruble weakens (the CBR has already hiked rates by 200 bps, including the unexpected 50bps hike last week, but more will be needed if demand for hard currency remains at the Q1 2014 level and pressure on the currency increases further);
  3. Downside pressure on growth as investment declines and through the impact of sanctions or expectation of additional sanctions (through higher cost of capital);
  4. Downward pressures on international reserves as the capital account deteriorates and CBR smoothens the currency move;
  5. Decline of the oil reserve fund should it be used for counter-cyclical fiscal purposes or refinancing of maturing debt (the $90 billion fund could theoretically cover one year of amortizations, but in that case, capital flight and dollarization would escalate further as the risk perception deteriorates).

All these elements are credit negative and it is not a surprise that S&P downgraded Russia’s rating to BBB-, while keeping it on a negative outlook. What is less predictable, however, is the magnitude of the deterioration of each of these elements, which will be determined by political events and the extent of economic sanctions.

My impression was that the locals’ perception of the geopolitical risks was not materially different from the foreigners’ perception shown above – i.e. that a major escalation in the confrontation remains a tail risk. The truth is, there is a high degree of subjectivity in these numbers and an over-reaction from either side (Russia, Ukraine, the West) can escalate this fluid situation fairly quickly. The locals are taking precautionary measures, including channelling savings into hard currency (either onshore or offshore), some pre-emptive stocking of non-perishable consumer goods, considering alternative solutions should financial sanctions escalate – including creating an alternative payment system and evaluating redirecting trade into other currencies, to the extent it can. Locals believe that capital flight peaked in Q1, assuming that the geopolitical situation stabilizes. Additional escalations could occur around 1st and 9th of May (Victory Day), as well as around the Ukrainian elections on 25th of May.

Slide2 Slide3

The table below assigns various CDS spread levels for each of the scenarios, with the probabilities given per the earlier survey. The weighted probability average is still wider than current levels, though we have corrected by a fair amount last week. I used CDS only as it is the best proxy hedge for the quasi-sovereign and corporate risk. Also, the ruble would be heavily controlled by the CBR should risk premia increase further, and may not work as an optimal hedge for a while, while liquidity on local bonds and swaps would suffer should the sanctions directly target key Russian banks.

Slide4

The risk-reward trade-off appears skewed to the downside in the near term.

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Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

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Video – some thoughts on emerging markets from Hong Kong and Singapore

I recently visited Hong Kong and Singapore to attend some conferences and meet clients in the region. While travelling, I put together a short video to share some of our views on Asian emerging economies and emerging markets in general.

As recently reported in Claudia’s Panoramic outlook here, following both the 2013 sell-off and the recent EMFX volatility experienced earlier this year, investors’ attitudes towards emerging markets have changed. Volatile capital flows, unsustainable growth models, a deterioration in current accounts, excessive credit growth and currency depreciation are key concerns for local and global investors. Some trends have become unsustainable and a rebalancing process has started. Emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

While adjustments take place, new opportunities present themselves. But not all emerging markets are equal. As emerging economies are on diverging paths, especially in Asia – some are deteriorating (eg China) while others are improving (eg Philippines or Sri Lanka) – asset allocation and stock selection will be key. Watch the video to find out our preferences.


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