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Wolfgang Bauer

Seeking relative value in USD, EUR and GBP corporate bonds

In terms of investment grade credit, it has been a common theme for global fixed income investors to think of EUR denominated credit as relatively expensive versus USD credit. Conversely, many see GBP corporate bonds as relatively cheap. But can it really be as simple and clear-cut as this? To answer this question, I have compared monthly asset swap (ASW) spreads of IG credit, issued in these three currencies, both on an absolute spread and a relative spread differential (EUR vs. USD and GBP vs. USD) basis.

At first, I looked at the three BoAML corporate master indices for publicly issued IG debt, denominated in USD, EUR and GBP. As shown below, until the onset of the financial crisis in the middle of 2007, USD IG credit was trading at spread levels of around 50 bps, which is almost exactly in line with GBP and on average only 15 bps wider than EUR IG credit. During the financial crisis, USD spreads widened more dramatically than EUR and GBP spreads. At peak levels in November 2008, when USD spreads reached 485 bps, EUR and GBP credit spreads were significantly tighter (by 215 bps and 123 bps, respectively). Subsequently, GBP IG spreads surpassed USD spreads again in May 2009 and have been wider ever since.

Slide1

In contrast, EUR IG credit spreads have been consistently tighter than USD spreads. Even at the height of the Eurozone crisis in late 2011, the EUR vs. USD credit spread differential was negative, if only marginally. Over the past three years, USD IG credit has been trading on average at a spread level of 166 bps, i.e., nearly 30 bps wider than EUR IG credit (137 bps average spread) and c. 50 bps tighter than GBP IG credit (215 bps average spread). Hence, when only looking at an IG corporate master index level, it is justified to say that subsequent to the financial crisis EUR credit has been looking relatively expensive and GBP credit relatively cheap compared to USD credit.

Taking only headline master index spreads into consideration is an overly simplistic approach. A direct comparison between the USD, EUR and GBP corporate master indices is distorted by two main factors: index duration and credit rating composition. As shown below, there are substantial differences in terms of effective index duration between the three master indices. Over the past ten years, the effective duration of the USD master index has been on average 6.2, whereas the EUR and the GBP indices exhibited values of 4.4 and 7.3, respectively. Currently, index duration differentials account for -2.1 (EUR vs. USD) and 1.4 (GBP vs. USD).

Slide2

These significant deviations in duration, and thus sensitivity of bond prices towards changes in interest rate, render a like-for-like index comparison problematic. The same applies to differences in credit rating composition. Take, for example, the rating structures of the USD and the EUR master indices in March 2010. Whereas the USD index hardly contained any AAA (below 1%) and only c. 18% AA rated bonds, the EUR index comprised nearly 6% AAA and c. 26% AA bonds. In contrast, the ratio of BBB bonds was significantly higher in the USD index (almost 40%) than in the EUR index (c. 22%). The credit quality on that date was distinctly higher for the EUR index than for the USD index, and directly comparing both indices would therefore be a bit like comparing apples to… well, not necessarily oranges but maybe overripe apples, for lack of a more imaginative metaphor.

Duration and credit rating biases can be removed from the analysis – or at least materially reduced – by using bond indices with narrow maturity and credit rating bands. As an example, I plotted relative spread differentials (i.e., EUR vs. USD and GBP vs. USD) for the past 10 years, based on the respective BoAML 5-10 year BBB corporate indices. To add another layer of complexity, this time I did not use headline corporate index level spreads but differentiated between financials and industrials instead. As only relative spread differences are shown, positive values indicate relatively cheap credit versus USD credit and, conversely, negative values signal relatively expensive credit.

Slide3

Until October 2010, the graphs follow a very similar path, EUR and GBP credit spreads trade fairly in line with USD spreads up to the financial crisis, when USD spreads widen more strongly than both EUR and GBP spreads, pushing spread differentials temporarily into deeply negative territory (below -220 bps in the case of financials). Then things got more interesting as spread differentials seem to decouple to a certain extent from October 2010 onwards. At this level of granularity it becomes clear that it is an inaccurate generalisation to refer to EUR credit as expensive and GBP credit as cheap versus USD credit.

In terms of 5-10 year BBB credit, EUR financials have in fact been trading consistently wider than USD financials, although the spread difference has been falling considerably from its peak Eurozone crisis level of 201 bps in November 2011 to currently only 10 bps. EUR industrials have been looking more expensive than USD industrials since early 2007 (c. 35 bps tighter on average over the past 3 years). The trajectory of GBP financials spread differentials has been broadly following the EUR financials’ humped pattern since late 2010, rising steeply to a maximum value of 259 bps in May 2012 and subsequently falling to current values at around 115 bps. GBP industrials have been looking moderately cheap compared to USD industrials since late 2010 (c. 37 bps wider on average over the past 3 years), but the spread differential has recently vanished. Hence, regarding 5-10 year BBB credit, currently only GBP financials are looking cheap and EUR industrials expensive versus the respective USD credit categories, whereas GBP industrials and EUR financials are trading in-line with USD credit.

To sum things up, when comparing USD, EUR and GBP IG credit, headline spreads are merely broad-brush indicators. To get a greater understanding of true relative value, it is worth analysing more granular data subsets to understand the underlying dynamics and the evolution of relative credit spread differences.

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jim_leaviss_100

The M&G Central Bank Credibility Survey – the Carney impact?

Whilst YouGov is surveying consumers around the UK, Europe and Asia for the M&G YouGov Inflation Expectations Survey, we thought it would be useful for them also ask some questions about how people perceive both their central bank’s ability to hit the inflation target, and the likely effectiveness of government fiscal policy.  You probably won’t be surprised to hear that Europeans generally don’t think highly of the ECB or their politicians (although France is striking in its low levels of confidence in both, reflecting a degree of economic stagnation there, even as other areas of the Eurozone see signs of recovery).  But it’s the UK that’s seen the biggest improvement in sentiment towards its central bank, the Bank of England.

Mark Carney was announced as the 120th Governor of the Bank of England at the end of November 2012, at the start of our first survey quarter.  At the time, only 28% of the 2000+ people surveyed who had a view (stripping out “don’t knows”) were confident that the “central bank is currently pursuing the correct policies in order to meet its target of price stability (i.e. inflation around 2%) over the medium term (i.e. the next 3-5 years)”.  Our latest survey shows that in every quarter since then – and Mark Carney arrived at his desk on 1 July 2013 – this percentage has increased.  The latest quarter shows the biggest increase yet, with 55% of respondents confident that the Bank is following the right policies to achieve medium term price stability.

The M&G Central Bank Credibility Survey

And this is against a backdrop of a fair few raspberries about the Bank’s forward guidance regime (gilt yields tended to rise, and the pound strengthened every time Carney did some more communicating).  So why the almost doubling in the confidence in the Bank of England amongst the UK population?  Well, it’s the economy.  The UK has been one of the developed world’s fastest growing economies over the past year, with GDP growth at 2.7% year on year, after a couple of years where it felt as if it would be stuck at or below 1% forever.  Crucially when it comes to thinking about credibility, for the very first time since the depths of the financial crisis in 2009, CPI inflation is back below the Bank of England’s 2% inflation target.  At one point in 2011 CPI was running at over 5% year on year. And whilst real wages are still falling, nominal wages have started to perk up in the past few months, so the hit to workers’ pay is lessening.

Goldilocks? CPI falling, wages rising in the UK

Our survey isn’t the only measure that shows that the Bank of England’s credibility is strong and improving.  Central banks like to use index linked bonds to derive a market participant view of whether inflation expectations are anchored.  Remembering that UK index linked gilts are priced from RPI rather than CPI, and that estimates are that the long term “wedge” between the two measures is somewhere around 1.1% over the medium term (it could be higher in a rate rising environment as RPI contains a big chunk of mortgage interest payments).  The current 5 year 5 year forward breakeven inflation rate – the market’s price for average inflation over the five years from 2019 to 2024, i.e. taking out the current cycle and looking at a medium term expectation for inflation – stands at 3.35%, down from 3.65% at the end of November last year.  If you subtract the wedge you end up with a market CPI inflation forecast of 2.25% over the medium term.  This is a little above target, but given the Bank’s history in recent years of large upside misses, could reflect improving credibility.  It should be said however that this measure has generally been pretty stable (5 year average of 3.5%) so it doesn’t feel as if there is a significant signal on King Bank versus Carney Bank credibility here.

UK 5 year 5 year forward breakeven inflation rate

You can see the full M&G YouGov Inflation Expectations Survey here, and the M&G Central Bank Credibility Survey is within that report on page 6.

anthony_doyle_100

France and Ireland – a look at the economic scorecard before the big game this weekend

The 6 Nations Rugby Championship comes to a conclusion this weekend, with three teams still in the running to win. The key game to watch will be France versus Ireland, as a French win would open the door for France or England to win. Of course, England will still have to beat the Azzuri in Rome. An Irish win would see the “boys in green” send record-breaking captain Brian O’Driscoll home to Dublin with the Championship trophy in his final game of rugby.

In the spirit of competition, here is a look at the economic scorecard for France and Ireland. Will it provide an indication of who will win Saturday’s match?

Round 1 – Real gross domestic product per capita

Slide1

Despite a large deceleration in output from the Irish between the years of 2007-2010, the Irish are still producing around €6,000 more per capita more than the French. IMF forecasts suggest that by 2018, Irish GDP per capita will be around €38,000 while the French equivalent is estimated to be around €30,000. The IMF forecasts suggest that the Irish workforce is expected to remain more efficient and productive than the French in coming years. For the entire Eurozone, the Irish currently rank second behind Luxembourg on this measure. The French are ranked seventh.

On this measure, it is a clear win for Ireland.

Round 2 – The unemployment rate

Slide2

Based on recent trends, the unemployment rates in France and Ireland appear to be converging. The Irish unemployment rate has fallen from a peak of 15.1% in January 2012 to sit at 11.9% only two years later. Over the same time period, the French unemployment rate has risen from 9.9 to 10.9%. The deterioration in the labour market in France reflects the general stagnation of economic growth. In recent months, the French government has been attempting to tackle the problem of the deteriorating labour market through its active employment policies such as sponsored contracts and training positions for the unemployed.

Despite the improving unemployment rate in Ireland, and worsening unemployment rate in France, round two goes to France on account of the unemployment rate being 1% lower than Ireland. Unless France can generate better growth, it may be the case that in twelve months’ time the Irish unemployment rate is actually lower than the French equivalent. For now, it’s a French win.

Round 3 – Household saving rate

Slide3

French households have consistently saved between 15-16% of their gross disposable income over the past ten years, suggesting that there is some scope for French consumers to stimulate their economy should confidence pick-up. The Irish household saving rate has been more volatile, falling and rising as one would expect given the concerns around the economic outlook for the country. More recently, Irish households have been spending more and supporting the economic recovery. This is a tough one to call, as the fall in household savings suggests stronger economic growth in Ireland in the short-term. However, because of the potential for French consumer to spend some of their savings in the future, France wins this round.

Round 4 – Percentage of the population with tertiary education

Slide4

Since 2004 there has been a substantial increase in the percentage of the population that has attained a tertiary level of education in Ireland, with an increase from 24.9 to 35.9%. France, whilst improving, has not been able to generate the same increase and in 2013 the percentage of the population that had obtained a tertiary level of education was 28.7%. Ireland ranks number one while France is at number twelve in the EU on this key measure. There is widespread recognition that tertiary education is a major driver of economic competitiveness in an increasingly knowledge-driven global economy. Ireland’s well educated workforce has certainly assisted the economy in recovering from the financial crisis. It has become increasingly difficult for industries in the west to compete with the emerging nations in terms of manufacturing products; a flexible, highly-educated and competitive labour force is vital in our globalised world.

Ireland’s workforce looks like a winger, whereas the French workforce could be compared to a prop forward. Ireland wins this round.

Looking at measures like real GDP per capita, the unemployment rate, household savings and the level of education in the workforce for Ireland and France is interesting. It shows that Ireland appears very well positioned to generate positive economic growth over the medium term. The old way of categorising European economies as “core” or “peripheral (or worse – PIIGS)” appears no longer relevant, as “peripheral” nations have taken a lot of vital steps to become more competitive through internal devaluation and lower wages. Improved export performance has been reflected in an improvement in current account balances in recent years. Today, the French economy appears cumbersome; it is hampered with a relatively inflexible and rigid labour market and is struggling to become more competitive in a globalised economy as we previously mentioned here.

Final round – the rugby statistics

Slide5

After a 2-2 economic scorecard, the final round had to focus on the rugby itself. Unfortunately for the French, the Irish rugby team appear superior in 16 out of 20 key rugby statistics including total points, metres gained and lineouts won. The French have home advantage which is a big positive; though this will be mitigated by the emotion felt by the Irish players given it is Brian O’Driscoll’s last match.

This leaves a 3-2 economic and rugby scorecard win to Ireland over France. That said, it would take a brave pundit to discount Les Bleus, who have a habit of rising for the big occasions. If you don’t believe me, just ask any New Zealander.

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jim_leaviss_100

Win a place in the Prudential RideLondon-Surrey 100 bike ride!

We have two exclusive places available for the Prudential RideLondon-Surrey 100 on Sunday 10 August 2014! Those of you who rode it in 2013 will know what an incredible day out it was. Starting in the Queen Elizabeth Olympic Park, this is a tough 100 mile cycle on closed roads through London and out to the famous climbs of the Surrey Alps before returning to the capital and finishing on the Mall. Later in the day you’ll be able to watch the 150 professional riders sprint in after they have ridden the same route in the Prudential RideLondon-Surrey Classic.

You can read all about the Prudential RideLondon-Surrey 100 here.

Over 80,000 people registered for places so many cyclists were unlucky in the ballot. The good news is that our parent company Prudential has kindly given us the chance for readers of the Bond Vigilantes blog to win a place. We have two packages available which include:

  • Entry to the Prudential RideLondon-Surrey 100
  • Team Prudential cycling jersey and goodie bag
  • Access to the VIP start area

Whilst it’s a fun day out, don’t underestimate the challenge of riding 100 miles. You should ideally commit to at least 10 weeks of training leading up to the event, and be confident of finishing within 8 ½ hours (by which time the pro peleton will be hammering along the course at an average of 40 kph!). But it’s only March now, so you’ve plenty of time to train. A few of us from the M&G bond team will be taking part – I’ll be heading out to the Surrey Hills this weekend. Unless it rains.

So the question. Which double Olympic cycling champion is the ambassador for Prudential RideLondon, and won the inaugural Prudential RideLondon Grand Prix in 2013?

Please click here to enter, and here for terms and conditions.

If you aren’t lucky enough to win, you can still take part by joining up with one of the charities which still have guaranteed places (see here for a list) or by entering as part of a team through your local British Cycling club. Good luck!

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stefan_isaacs_100

High yield: bullish or blinkered?

I recently attended JP Morgan’s annual US high yield conference. It’s one of the best conferences around: well attended, and with more than 150 companies, panel discussions and specialist presentations. As such, the topics covered give a good flavour of the market’s latest thinking.

Unsurprisingly, many of the well-rehearsed arguments in favour of high yield resurfaced once again, with presentations focused on the following:

  • The structurally low default rate (see chart below), largely a function of accommodative central bank policy, limited refinancing risk and growing investor maturity, with spreads over-compensating as a result.

Slide1

  • Projections that US high yield will outperform other fixed interest asset classes in 2014, returning 5%-6% (leveraged loans likely to deliver 4.5%).
  • Room for spreads to tighten further given that they remain over 100+ bps back of the lows in 2007. Currently 378bps vs 241bps in May 2007.
  • How refinancing, rather than new borrowing, is driving the majority of issuance in the US. Refinancing accounted for 56% of issuance in 2013, though down from 60% in 2012.
  • The need for income in a low interest rate world is providing a strong technical support, evidenced by $2bn+ of mutual fund inflows into the US high yield market year to date. Significant oversubscription for the vast majority of new issues has also been a notable feature of the market for some time now.
  • The short duration nature of the asset class – particularly attractive in an environment of potentially rising rates. Modified duration for US and European high yield is 3.5 years and 3 years respectively. This compares to 6.5 and 4.5 years for the investment grade equivalents.

Now these are all relevant arguments in favour of the asset class, and indeed I believe that US high yield will likely be one of fixed income’s winners in 2014. What did surprise me, though, was the almost total absence of discussion around some of the headwinds that it faces.

For example, presentations seemed to gloss over the fact that much of the good news, from the perspective of default rates at least, has arguably already been priced in. The market is unlikely to be surprised by another year of sub-2% defaults, rather the risk lies in an outcome that sees a higher default rate than anticipated by the consensus, even if that is difficult to envisage right now.

Other challenges are presented by liquidity (while this has improved since the immediate aftermath of the credit crunch, investment banks are still reluctant to offer liquidity given the high capital charges they face and the low yields currently on offer); by the lack of leverage available to end investors compared to 2006-7, when banks had the ability, strength and desire to lend to those investors on margin; and by the increasing negative convexity the market faces at the moment.

Slide2

With US high yield paper already trading at an average price of 105 and as high as 107 in Europe (see chart above), the threat of bonds being called will act as a cap on further capital appreciation. And, of course, the flip side of these high prices is low all-in yields. With these standing around 3.8% on the European non-financial high yield index and 5.2% on the US high yield index, investors can only question how much lower they can go.

Slide3

Perhaps in this environment, with inflation ticking along comfortably below 2%, investors should accept that a nominal return of 5-6% looks decent. That said, returns this year are likely to be driven by income rather than capital appreciation, and may well look skinny versus previous years. As I said before, I’m still constructive on high yield, but after the stellar returns in the past few years, we must be careful to avoid being blinkered.

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matt_russell_100

Opportunities in Spanish ABS

As fund managers it’s our job to take risk when and where we are being paid (preferably overpaid) to do so. One area where I feel that this is currently the case is European residential mortgage backed securities (RMBS), particularly Spanish RMBS.

It’s fairly easy to find senior Spanish RMBS trading as much as 100bps wide of equivalent covered bonds at the moment. The collateral in these deals was originated by the same banks as in the covereds, they return the principal over a comparable time horizon, and contain features that will be beneficial to investors if the Spanish housing market begins to weaken again.

The chart below shows this relationship nicely. Here we have plotted (minus the names of the individual bonds) short-dated covered bonds issued by three Spanish banks and what we consider to be similar quality senior RMBS. The pickup I mentioned earlier is clearly evident in the 2.5-5yr maturity/weighted-average life area:

Spanish RMBS blog

The main reason for this discrepancy is regulation. Financial regulators have deemed RMBS to be more risky than covered bonds and they therefore require banks and insurance companies to hold more capital on their balance sheets to compensate.

While I appreciate that covered bonds give investors dual recourse and that covered bond legislation in Spain is strong, I’m not sure how much the extra senior unsecured claim in a failed Spanish bank would actually be worth. Hence in general I prefer to hold a senior note in an RMBS deal where we have good visibility of the collateral, and which includes structural provisions that mean senior note holders potentially get their capital back sooner if the housing market deteriorates.

The ECB apparently takes the same view as the regulators and charges anyone wishing to use RMBS as collateral for repo transactions more than they do for covered bonds. They apply a haircut of 10% to RMBS but only 4.5-6% to covered bonds for investment grade quality instruments, assuming a five to seven year maturity. What I’m really saying is that I disagree with the regulators, and therefore see this as an opportunity to generate a higher return for a similar level of risk.

Interestingly the Bank of England applies the same haircut of 12-15% to both short-dated RMBS and covered bonds. The spread difference exists here too – albeit with both markets trading considerably tighter – which I think shows that it’s the regulation that is really skewing these markets.

I’m not arguing that investing in the Spanish mortgage market is without risk. But I do believe that investors who, like us, don’t repo their bonds or need to hold capital against them can and should take advantage of these kinds of unintended regulatory consequences.

jim_leaviss_100

Japan hikes consumption tax in April – will retail sales spike in March, only to collapse afterwards?

Next month, Japan will raise its consumption tax from 5% to 8% as a step towards reducing the nation’s 200%+ debt to GDP ratio by moving towards a budget surplus in 2020.  This may be the first of two hikes in the sales tax, with a further rise to 10% planned for October 2015.  Prime Minister Abe has said that the second hike will be dependent on an economic recovery, rightly realising that only a significant increase in Japan’s growth rate will make any impact on the national debt.  He’s said that the data from July to September 2014 will determine whether or not the second VAT hike goes ahead.

We’ve looked at the impact of pre-announced sales tax hikes before when I wondered whether the UK’s rises from 15% to 17.5% (at the start of 2010), and then again from 17.5% to 20% (at the start of 2011) would impact retail sales.  History had shown us that when Japan raised consumption tax in 1997, and when Australia did the same in 2000, retailers saw a huge boost to sales in the month before the hike (12% year on year rises in both cases) but when the higher prices came in retail sales collapsed to near, or below zero.  Rational consumers front loaded consumption ahead of the known price rises.

I thought that we would see something similar in the UK, but there is little sign of it in the data – after the 2010 VAT hike, sales did turn negative, but in neither case did we see any of the “rational frontloading” that Japan and Australia saw.  Perhaps the very weak period of GDP growth (averaging below 1.5%, and at times as low as 0.5% year on year over 2010 and 2011), and the UK’s famous squeeze on real incomes through higher inflation than wage growth meant that there was no ability to frontload consumption.  Or perhaps we are not as rational as the Japanese and Australians.

What happens when you pre-announce a consumption tax hike?

So the implications for Japan in 2014 are not clear cut.  But I was surprised to see that Japanese retail sales growth is already running much higher than in any of the historical examples at the same stage of the VAT hiking cycle, with a 4.4% year on year increase.  Cars and machinery equipment led the way – the big ticket items that you might expect to make most sense for consumers to buy in advance of higher prices.  Economists have attributed this to front loading, but it is also worth exploring alternative explanations.  Today’s release of Japanese wage data showed the first rise in base pay for nearly two years, so perhaps the recent improvement in some economic data, and the psychological impact of Abenomics are producing a real increase in consumer sentiment.  But pay is still only growing at 0.1% on an annual basis, and including bonuses and overtime it is negative.  Also the recent exit from deflation is squeezing real incomes.  The Japanese economy, and consumer, remains fragile – Abe will be hoping that this doesn’t end up being a replay of 1997.

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anthony_doyle_100

Europe’s debt/GDP levels are worse today than during the Euro crisis. So why are bond yields falling?

Two and a half years ago, there was a real fear in the marketplace that the euro would not survive. It appeared unlikely that Greece would be able to remain in the Eurozone and that some of the larger distressed economies like Italy and Spain may follow them out. High levels of government debt, unemployment and a banking system creaking under all this pressure did not bode well for the future. The mere possibility of a Eurozone nation leaving triggered massive volatility in asset markets from government bonds to equities, as investors grappled with the consequences of such an event occurring.

Of course, the bearish forecast for Europe did not eventuate. Perceptions had shifted significantly from the darkest days of the euro crisis. Politicians and central bankers have shown significant determination in keeping the euro intact, despite often only acting at the darkest hour. In markets, confidence returned after ECB President Mario Draghi’s now famous “whatever it takes” comment and it had a real effect on government bond yields with spreads over German bunds collapsing across the Eurozone.

Unfortunately for European government bond investors, the Eurozone could re-emerge as a source of risk. The reason is, since 2011 European government and economic fundamentals have generally gotten worse and not better.

2014-02 blog

When we look at the above table – which measure fundamental indicators like total investment, the unemployment rate and gross levels of government debt to GDP from 2011 and compares it to now – we can see a lot more red (which indicates a deterioration) than green (which indicates an improvement). Yet what is striking is that apart from Germany and the Netherlands who have seen their 10 year government bond yields increase slightly, all other European nations have seen their yields fall. This is not what we would expect to see given that various metrics like GDP, the unemployment rate, output gap and government debt to GDP are actually worse now than they were at the height of the Eurozone crisis.

I can see three main reasons why yields have fallen across the Eurozone despite a worsening in the economic statistics. The first is that confidence has returned and the credit risk premium demanded by bond investors has fallen. Investors in European bonds now believe that default risk has fallen from the dark days of 2011, despite a general worsening in conditions which would imply higher – and not lower – default risk. When Draghi said the ECB would do “whatever it takes”, the market believed him.

Secondly, the inflation risk premium that investors demand has collapsed as Eurozone inflation has collapsed. Low inflation in the Eurozone is largely the result of painful internal devaluation, high unemployment and government austerity. Countries like Ireland, Portugal and Greece are feeling this the most, having experienced deflation over the last couple of years. As we can see in the table, austerity has meant that budget deficits have improved across the Eurozone, but this has also resulted in deflationary forces becoming more pronounced. Lower European inflation means higher real yields, and this has contributed to nominal yields falling or remaining low in Eurozone government bonds. However, the danger for the periphery is that lower inflation implies lower nominal growth rates, and this means even greater pressure on the Eurozone periphery’s huge debt burdens. Markets should react to lower nominal growth rates by questioning these counties’ solvency, pushing bond yields higher.

Thirdly, the other main reason that peripheral yields have converged is that there are genuine signs of rebalancing, as indicated by improving current account balances and falling unit labour costs. The majority of Eurozone nations are now running a current account surplus, including Spain, Portugal, and Ireland. Despite being locked into the single exchange rate which is arguably way too high for these countries, global competitiveness has improved and exports have increased.

There are good reasons the euro will survive. However, it is important to question whether the market is charging a high enough credit risk premium given the challenges that continue to face the Eurozone. Increasingly, bond investors need to assess the risks of deflation in Europe as well. Arguably a lot of good news is priced in to government bond markets at the moment, and we remain hesitant to lend to those European countries displaying weaker financial metrics at this point in the cycle. With the IMF recently finding “no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised”, it suggests that there are many more important things to bond investors than the public debt/GDP ratio (like credit growth, labour markets and inflation). Public debt/GDP ratios are what investors have been fixated on since the financial crisis, but they are a lazy and incomplete way of assessing the risks in government bond markets.

richard_woolnough_100

Deflating the deflation myth

There is currently a huge economic fear of deflation. This fear is basically built on the following three pillars.

First, that deflation would result in consumers delaying any purchases of goods and services as they will be cheaper tomorrow than they are today. Secondly, that debt will become unsustainable for borrowers as the debt will not be inflated away, creating defaults, recession and further deflation. And finally, that monetary policy will no longer be effective as interest rates have hit the zero bound, once again resulting in a deflationary spiral.

The first point is an example of economic theory not translating into economic practice. Individuals are not perfectly rational on timing when to buy discretionary goods. For example, people will borrow at a high interest rate to consume goods now that they could consume later at a cheaper price. One can also see how individuals constantly purchase discretionary consumer goods that are going to be cheaper and better quality in the future (for example: computers, phones, and televisions). Therefore the argument that deflation stops purchases does not hold up in the real world.

The second point that borrowers will go bust is also wrong. We have had a huge period of disinflation over the last 30 years in the G7 due to technological advances and globalisation. Yet individuals and corporates have not defaulted as their future earnings disappointed due to lower than expected inflation.

The third point that monetary policy becomes unworkable with negative inflation is harder to explore, as there are few recent real world examples. In a deflationary world, real interest rates will likely be positive which would limit the stimulatory effects of monetary policy. This is problematic, as monetary policy loses its potency at both the zero bound and if inflation is very high. This makes the job of targeting a particular inflation rate (normally 2%) much more difficult.

What should the central bank do if there is naturally low deflation, perhaps due to technological progress and globalisation? One response could be to head this off by running very loose monetary policy to stop the economy experiencing deflation, meaning the central bank would attempt to move GDP growth up from trend to hit an inflation goal. Consequences of this loose monetary policy may include a large increase in investment or an overly tight labour market. Such a policy stance would have dangers in itself, as we saw post 2001. Interest rates that were too low contributed to a credit bubble that exploded in 2008.

Price levels need to adjust relative to each other to allow the marketplace to move resources, innovate, and attempt to allocate labour and capital efficiently. We are used to this happening in a positive inflation world. If naturally good deflation is being generated maybe authorities should welcome a world of zero inflation or deflation if it is accompanied by acceptable economic growth. Central banks need to take into account real world inflationary and deflationary trends that are not a monetary phenomenon and set their policies around that. Central bankers should be as relaxed undershooting their inflation target as they are about overshooting.

Under certain circumstances central banks should be prepared to permit deflation. This includes an environment with a naturally deflating price level and acceptable economic growth. By accepting deflation, central banks may generate a more stable and efficient economic outcome in the long run.

mike_riddell_100

China’s investment/GDP ratio soars to a totally unsustainable 54.4%. Be afraid.

Once upon a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets of unlimited civil liberties. They asserted with increasing self-confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economies, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again” – a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The passage is the opening to the highly readable and hugely influential 1994 paper The Myth of Asia’s Miracle. The period referenced is the early 1960s, the dynamic president was John F. Kennedy (read Bill Clinton), and the rapidly growing Eastern economies were the Soviet Union and its satellite nations (read East Asia). Author Paul Krugman took on the prevalent East Asian euphoria by drawing disturbing parallels between the unsustainable way that the Asian Tigers were managing to generate supersonic growth, and how the recently obsolete Soviet Union had also once achieved seemingly miraculous growth rates. Krugman’s paper gained widespread attention at the time (even more so post the 1997 Asian crisis), and succeeded in refocusing attention on the concept of productivity. It mattered not what the growth rate was, but how it was achieved.

To explain this and briefly summarise, consider what actually drives economic growth. Growth accounting shows that GDP per capita growth comes from two main sources; inputs and efficiency. The ‘inputs’ can be split into labour (e.g. growth in employment) and capital (e.g. the accumulation of physical capital stock such as machines and buildings). But long term, sustained per capita economic growth tends to come not from increases in the ‘inputs’, but from increases in efficiency, of which the main driver is technological progress. Nobel Laureate Robert Solow showed in his seminal 1956 paper that technological progress had accounted for 80% of US per capita growth between 1909 and 1949, although more recent studies have suggested a still substantial figure of more like 45-55% thereafter.

Krugman pointed to previous research showing that the Soviet Union’s rapid growth had not been due to efficiency gains. Indeed, the USSR was considerably less efficient than the US, and showed no signs of closing the gap. Soviet growth had been solely due to the ‘inputs’, and input-driven growth has diminishing returns (e.g. there is a finite number of workers you can educate). The USSR’s growth was largely ‘built on perspiration rather than inspiration’.

In a similar way, the Asian Tigers’ rapid growth was due to an ability to mobilise resources. There was no great improvement in efficiency, and no ‘miracle’ – it could be fully explained by the employed share of the population rocketing, education improving dramatically, and an enormous investment in physical capital (in Singapore, investment as a share of output jumped from 11% to more than 40% at its peak). But these were one time changes; they weren’t repeatable.

Fast forward to 21st century China.

There is a perception that China’s rocketing growth rate has always been reliant on heavy investment, but that’s not the case. Investment, or capital formation, has of course been an important driver, but the ‘pre 2008’ China did achieve rapid productivity gains thanks to the rise of the private sector and technological catch-up as the economy slowly began to open its borders.

In the chart below, I’ve looked at how much the world’s biggest economies have invested as a percentage of their GDP, and compared this to the countries’ GDP per capita growth rates. Countries with higher investment rates tend to have higher GDP growth rates and vice versa, which is intuitive and supports the discussion above. Since the 1990s, most (but not all) emerging/developing countries have been positioned towards the top right hand side with higher investment and higher growth rates, and the more advanced economies have typically been towards the bottom left with lower investment and lower growth rates. In one extreme you have China, where investment has averaged over 40% of GDP, and the GDP per capita growth has averaged a phenomenal 9.5%. The fact that China’s growth rate is well above the trend line in the chart is indicative of the productivity gains that China has achieved over the period as a whole on average. The country with the weakest investment rate is the UK.

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‘Post 2008’ China looks a different animal. Productivity and efficiency seem to be plummeting, where GDP growth is becoming dangerously reliant on the ‘inputs’, namely soaring investment. We’ve all heard about how China’s leaders desire a more sustainable growth model, featuring a rebalancing of China’s economy away from investment and export dependence and towards one that is more reliant on domestic demand and consumer spending (e.g. see the 12th 5 year plan covering 2011-2015 or the Third Plennum). In practice, what we’ve instead consistently seen is an inability or unwillingness to meaningfully reform, where any dip in economic growth has been met with yet another wave of state-sponsored overinvestment. (Jim recently blogged about economist Michael Pettis’ expectation that China long term growth could fall to 3-4%, a view with which I have a lot of sympathy. Please see also If China’s economy rebalances and growth slows, as it really must, then who’s screwed? for an additional analysis of the implications of China’s economic slowdown).

It was widely reported earlier this week that China’s 2013 GDP growth rate fell to a 13 year low of 7.7%, a slowdown that seems to have continued into 2014 with the release of weak PMI manufacturing reading yesterday. But much more alarming is how the makeup of China’s growth has changed: last year investment leapt from 48% of China’s GDP to over 54%, the biggest surge in the ratio since 1993.

The chart below puts China’s problems into perspective. As already demonstrated, there is a strong correlation between different countries’ investment rates and GDP growth rate. There also tends to be a reasonable correlation over time between an individual country’s investment rate and its GDP growth rate (Japan’s experience from 1971-2011 is a good example, as shown previously on this blog). Over time, therefore, a country should be broadly travelling between the bottom left and top right of the chart, with the precise location determined by the country’s economic model, its stage of development and location in the business cycle.

It should be a concern if a country experiences a surge in its investment rate over a number of years, but has little or no accompanying improvement in its GDP growth rate, i.e. the historical time series would appear as a horizontal line in the chart below. This suggests that the investment surge is not productive, and if accompanied by a credit bubble (as is often the case), then the banking sector is at risk (e.g. Ireland and Croatia followed this pattern pre 2008, Indonesia pre 1997).

But it’s more concerning still if there is an investment surge accompanied by a GDP growth rate that is falling. This is where China finds itself, as shown by the red arrow.

Part of China’s growth rate decline is likely to be explained by declining labour productivity – the Conference Board, a think tank, has estimated that labour productivity growth slowed from 8.8% in 2011 to 7.4% in 2012 and 7.1% in 2013. Maybe this is due to rural-urban migration slowing to a trickle, meaning fewer workers are shifting from low productivity agriculture to higher productivity manufacturing, i.e. China is approaching or has arrived at the Lewis Turning Point (see more on this under China – much weaker long term growth prospects from page 4 of our July 2012 Panoramic).

However the most likely explanation for China’s surging investment being coupled with a weaker growth rate is that China is experiencing a major decline in capital efficiency. Countries that have made the rare move from the top left of the chart towards the bottom right include the Soviet Union (1973-1989), Spain (1997-2007), South Korea (1986-1996), Thailand (1988-1996) and Iceland (2004-2006). Needless to say, these investment bubbles didn’t end well. In the face of a labour productivity slowdown, China is trying to hit unsustainably high GDP growth rates by generating bigger and bigger credit and investment bubbles. And as the IMF succinctly put it in its Global Financial Stability Report from October 2013, ‘containing the risks to China’s financial system is as important as it is challenging’. China’s economy is becoming progressively unhinged, and it’s hard to see how it won’t end badly.

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