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Letter from the Governor to the Chancellor, July 2009 – "sorry about the deflation"?

It’s difficult to remain relaxed about the outlook for inflation in the UK given today’s strong CPI and RPI numbers (all above expectations), but, if oil is still at $145 a barrel, and food prices remain at these levels in a year’s time, we’ll be facing deflation. Not because these elevated prices levels will cause a collapse in consumer spending and reduce the demand for discretionary goods – though that too will happen – but because of simple mathematics.

Core inflation, which strips out food and energy prices, is at 1.6% in the UK. It’s been at, or about, this level now for 7 years, averaging 1.4%. Headline inflation is at 3.8%, above the Bank of England’s target because of the strength of the food and energy component. Food accounts for 10.9% of headline inflation, and energy is 7.3%. Put together then, food and energy are 18.2% of headline inflation. Now let’s assume that oil stays up at $145 for the next year, and that food prices also stay at current levels. Although those prices will still be hurting us as consumers, the food and energy inflation rate will fall to 0% – it’s all about the year on year comparisons. Now let’s also assume that core inflation keeps rising at its seven year average rate of 1.4%. Simple maths shows that if core is 81.8% of the headline rate, and is increasing at 1.4%, and the remaining 18.2% is at zero, then the headline rate of inflation in the UK in a year’s time could be as low as 1.1%.

The Governor of the Bank has to write a letter to the Chancellor if that headline rate falls below 1%, explaining why he is allowing the economy to flirt with deflation. If the oil price starts to come off, perhaps in response to the slowing global economy, then that letter might just get written at some point in 2009, and we’ll be asking ourselves how a major modern economy copes with deflation – just don’t ask Japan, a decade after its own bubble burst it’s only now starting to move back into positive inflation, albeit tentatively.


European banks – things may not be what they seem

Spectators at recent ECB press conferences may well have come away thinking that there is little, if any, evidence of a credit crunch in Europe. According to the ECB, ‘the growth of bank loans to non-financial corporations has remained very robust despite the rises in short-term rates’ and ‘the availability of bank credit has, as yet, not been significantly affected by the tensions.’

We suspect that the reported numbers significantly overstate banks’ willingness and ability to lend. To understand why, it’s worth having a look at a comment that Richard wrote in February about how Porsche outmanoeuvred the banks. In short, earlier this year, Porsche took advantage of a credit facility with a bank, where the facility had been set up before the credit crunch hit. The bank was forced to lend billions to Porsche at unprofitable rates for the bank.

Credit facility drawdowns are becoming more and more widespread. A report released this week by JP Morgan estimates that over the first five months of 2008, circa 46% or $165bn, of credit growth in the Euro area could be attributed to the drawing down on such credit lines. Despite the best efforts of banks to incentivise companies not to use these facilities, irrevocable credit facilities (often made at the height of the credit bubble) remain some of the most attractive funding available for companies. The report estimates that if the entirety of the $4.6 trillion of credit lines outstanding at the end of 2007 were drawn during the next 12 months, capital in the region of $184 billion would have to be posted by the banks.

Clearly the potential for further drawdowns is another in a long line of headaches for the banking sector. All is not well, despite noises to the contrary from the ECB. Banks have raised $320 billion of capital since Q3 2007. As this chart shows, banks still need to raise another $80bn to cover losses and write-downs that have occurred to date (and they’ll need to raise even more to cover bank losses and write-downs that occur in future) . Add in the credit facility problem, and it seems that banks will continue to hoard capital and see their profit margins challenged.


Stagflation? Watch wages

The soaring oil price has meant that UK National newspapers and the trade press are rife with stagflation fears. The fears are understandable – following the 1973 oil crisis, UK inflation surged, reaching an all time high of 26.9% by August 1975. By the beginning of 1979, UK inflation had fallen below 10%, but the 1979 oil crisis helped propel UK inflation back up to 21.9% by May 1980. The oil price shock we are experiencing now is far more severe in nominal terms, and on a similar scale in real terms, so comparisons with the experience of the 1970s are inevitable.

Inflation was nasty in the 1970s because of what’s called a ‘cost-push inflationary spiral’. As the chart shows, the surge in the oil price was a supply shock, and represented a jump in costs for companies. Producer prices surged. Companies then shunted these higher costs onto consumers by putting up prices. Consumer prices surged. The workers and trade unions reacted by negotiating higher wages. Higher wages formed another jump in costs for producers, producers prices rose higher, consumer prices rose higher, wage demands were increased, and so on.

Is something similar happening today? So far, it doesn’t appear so. We’ve had a major oil shock, and producer prices have risen sharply. UK Producer Price Inflation (PPI) was 2.4% in August 2007 and leapt up to 8.9% in the year to this May, the highest figure since March 1982. And yet companies are only having limited success in passing this onto consumers. The Bank of England’s official inflation measure of consumer prices is at 3.3% – worryingly high, but only 0.8% higher than a year ago. Inflation according to the Retail Price Index (RPI) was actually 4.3% in May, the same rate as a year earlier. The gap between RPI and PPI is now the biggest since 1975 (as an aside, if companies aren’t able to pass on costs, then it doesn’t bode very well for profit margins or credit quality).

Perhaps even more importantly, the moderately higher consumer prices don’t appear to be translating into higher wages either. As this chart shows, nominal wage growth has barely moved in the last year, and is a bit below the average rate for the last ten years. Real wage growth has in fact been negative in the UK since the second half of 2006. In other words, workers have generally failed to negotiate wages even in line with inflation, let alone in excess of inflation.

It’s a similar story in the rest of the western world. This chart illustrates that nominal wages have increased at a greater rate in the western economies than in the UK, but real wage growth is either flat or negative (all figures as at end Q1). The economic picture is hardly that of a 1970s style inflationary rout. Labour market reforms (eg reduced trade union power) have combined with greater worker mobility (eg Polish builders) to prevent this oil shock from turning into an inflationary spiral – so far. If long term inflationary expectations rise, which is probably the central banks’ biggest fear, then we may start to see wages creeping up. But for wages to rise from here, workers will need greater negotiating power. This scenario seems unlikely, given the financial deleveraging going on and the rapidly deteriorating UK and global economic outlook. If workers aren’t happy with their pay, there will be soon be quite a few people without jobs who are willing to work for less.

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How much should investors expect to get back if a bond defaults?

In March last year we wrote a blog comment explaining how the trend for so called ‘covenant lite’ deals would result in marginally lower default rates, but would result in recovery rates being lower when a company did actually go bust (see article). We were talking about the leveraged loan market, although the same thing appears to be playing out in the bond market.

Moody’s rating agency recently released an interesting (if not a little belated) paper arguing that recovery rates on both defaulted loans and bonds in the US will be significantly lower than has historically been the case. In the past few years, the appetite for senior secured loans and corporate bonds has increased dramatically, due to leveraged borrowers being only too happy to fill their boots given the relatively cheap and abundant financing available. Loans, therefore, now form a greater portion of capital structures than has traditionally been the case. As a result, the recovery rate on loans, which occupy a senior position in a company’s capital structure, are likely to be lower. Holders of defaulted loans have historically got 87% of their money back, but this is forecast to drop to 68%.

There are implications for high yield bond holders too. As a result of the average bond having more loans ahead of it in the capital structure, bond holders are further back in the queue for the company’s assets if the company defaults. Moody’s believe that recovery rates on US senior unsecured high yield bonds will drop from 40% to 32%, while the recovery rate on subordinated bonds will drop from 28% to 18%. These numbers may be on the conservative side, judging by the involvement of non-traditional players (eg hedge funds) in the senior bank loan market who may well act in a more aggressive fashion to the detriment of subordinated lenders.

Moody’s specifically refer to the US bond market, where both loan issuance and covenant-lite loan issuance has been heavier than in Europe. We’d therefore expect recovery rates in Europe to be a bit higher than in the US. Nevertheless, for a given bond, the prospect of a lower recovery rate means that we should be compensated in the form of higher yields. Thorough analysis of the capital structure and covenants of every bond we invest in becomes ever more important.

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I came across a slightly tongue-in-cheek website this week collecting signatories to petition against the ECB’s ‘intent to increase rates.’ It hasn’t had a great deal of success so far; a mere 5468 signatories out of a European Union population of around 500 million. Spain, which incidentally is likely to suffer more than most from a rate rise, has provided more than its fair share of the 5468 votes. Whilst the petition does highlight a couple of serious issues, pointing to weak consumer sentiment and retail sales for example, I’ve got a sneaking suspicion the petition won’t way too heavily on the minds of the ECB Governing Council when they meet next month.


Free falling

Today’s mortgage approvals numbers came out at a record low (see this comment for why we love mortgage approvals so much). Weakening mortgage approvals is no surprise – the housing psychology is moving to a bear market from a buyers perspective, and the mortgage lenders are strapped for cash so the number of willing providers of finance is collapsing. But it’s the pace of the decline that is startling. This free fall in lending creates a vicious spiral, with a subsequent free fall in house prices. Our adjusted mortgage approvals number now predicts that UK house prices will be dropping by at least 15% year-on year by December this year (see chart).

Like any free fall, the damage is a function of where you jump from. Sadly for the UK economy, we start from the highest point in the western world. Recent research from the Bank for International Settlements (BIS, see graph 3B) looked at the house price to income per capita ratio (this is the housing market equivalent of the P/E ratio) across a selection of economies. They then compared the ratio to the 1995-2005 trend to get an idea of how far each country’s housing market has deviated from its historical ratio. As at 2007, the UK housing market was the most overvalued, closely followed by Spain. The UK housing market was twice as overvalued as the US housing market, so we certainly shouldn’t rule out the possibility of the UK having a property meltdown worse than that in the US.

Housing market crashes historically take two to three years to work their way through, and given that the past decade has seen the biggest housing boom, there is every reason to expect that the following bust will be bigger and will take longer than has been the norm. If things continue deteriorating at the current pace, then pain in the financials and construction sectors will spread way beyond the likes of Bradford & Bingley or Taylor Wimpey.


Cracks appearing in Euroland

Jean-Claude Trichet at the European Central Bank has the same headache as Ben Bernanke and Mervyn King. Economic growth is set to slow sharply, at least if Tuesday’s ZEW survey of Eurozone growth expectations is anything to go by. Weakening growth would normally mean lower interest rates, but the ECB’s hands are tied because European inflation leapt to 3.7% in May, the highest rate since June 1992.

Trichet’s recent tough talk suggests that the ECB will hike rates to pull back inflationary expectations, and the European bond market has responded by pricing in at least two rate rises by this time next year. Higher interest rates will help bring eurozone inflation down, but it will also put the weaker eurozone countries under a lot of pressure.

Add into the mix Ireland’s ‘no vote’, and it’s clear that there are some big challenges ahead for Europe. As this chart shows, the default risk of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) has started creeping up again. In fact, there are already signs that euro notes aren’t homogenous any more – notes printed in Germany appear to be carrying more value than euros printed elsewhere (see article).

The breakup of the euro is still very unlikely, but just an increase in the perceived risk of the currency failing has big implications. For example, if Italy decided it would be beneficial to drop out of the euro and introduce a new lira, then you can be sure that Italian government bonds would have a much bigger risk premium relative to German bunds, and companies such as Telecom Italia won’t be trading where they are now. What we’ve seen in the past few months is that the bond market is starting to price in this risk.


Record sell off in European bunds

Short dated European bonds experienced a huge sell off last Thursday, after Jean-Claude Trichet surprised the market by stating that the ECB is now on ‘heightened alert,’ interpreted by many to mean a rate hike is very much on the cards next month. The yield on two year German bunds jumped by 29 basis points, or 0.29%, which was easily the biggest daily jump in 2 year bund yields since the index began in 1990 (this is still some way below the US record of 4th October 1982, when 2 year Treasury yields soared by a record 146 basis points). This chart shows how the German yield curve has dramatically flattened since Bear Stearn’s rescue in March, and as can be seen by the returns on the chart, medium dated bunds have been hurt the most (note that this is in local currency terms).

Whilst Trichet appeared to prepare the market for a rate hike next month, he stopped short of pre-committing to such an action. This is no doubt a lesson learnt from last autumn, when the credit crunch forced the ECB to pull out of a rate hike that had been pre-signalled the previous month. The hawkish tone demonstrates that the ECB are clearly very concerned about inflation running considerably above its 2% target – indeed, inflation has been above 3% since last year. However, the change in tone seems to have been borne out of a fear that Europe could begin to witness second round effects, as wages adjust higher to keep pace with headline inflation and longer term inflation expectations lose their anchors.

The likelihood is that inflation will remain above the ECB’s comfort zone at the same time as growth begins to slow markedly, undoubtedly posing a significant dilemma for the Central Bank. The combination of a weakening labour & housing market, tighter credit conditions, a strong euro, further banking sector writedowns and a weakening European consumer mean tough decisions lie ahead.


Letter from New York

 Stefan and I have just got back from a trip to visit our counterparties in New York. The mood is almost universally gloomy with – predictably – housing and gas prices the dominant themes. The TV news channels run an almost constant stream of features on the cost of motoring (a gallon went through the $4 mark for the first time at the weekend, up from $3.10 a year ago, a 30% rise), with interviews with disgruntled car owners explaining why they are staying at home during the driving season. One news channel has a permanent banner at the bottom of the screen saying “America’s Oil Crisis” – it’s as big a deal as “America’s War on Terror” post 9/11.

It’s difficult to see that this (and higher food prices) in an environment of plummeting house prices (down over 14% year-on-year) won’t lead to a collapse in consumption. As consumption is over two-thirds of US growth, a recession still looks likely. But there are a couple of things that do mitigate the doom and gloom for the US consumer. Firstly is the fiscal stimulus from the tax rebate cheques which have given most families anything from around $600 to $1500. About 30-40% of this money is likely to be spent rather than saved or used to repay debt. So retail sales numbers for May, June and July could look surprisingly strong and keep GDP growth in positive territory. There are rumours of a further tax stimulus package later this year too.

Secondly, employment is much stronger than it was at the time of the 2001 downturn. Then, the economy was regularly shedding from 150,000 to over 300,000 jobs monthly. Last month’s reading was a loss of 49,000 jobs and the biggest monthly fall so far was March’s 88,000. We’ve talked before about the possibility of big negative revisions to these recent data, but nevertheless the employment background is less of a headwind to growth than it has been historically. Why? Well the 2001 recession was a corporate recession – companies had spent too much on capex (during the tech bubble) and had got their balance sheets in a mess, taking on too much debt. Corporate recovery was about sorting out balance sheets (hence the rally in corporate bonds incidentally) and about downsizing the workforce. As a result they are going into this downturn with a much leaner labour force and won’t need to cull like they did last time.

So what we are seeing is that firms are not laying off employees like they did in the early 1990s. But they are cutting back on hours worked, and more importantly, for those people who don’t have a job, finding one is becoming extremely difficult. The persistancy of unemployment is increasing. The unemployment rate is rising (to 5.5%) and the jobs slowdown is spreading to all sectors of the economy – but for the time being it is the cost of living increase that is hurting, not (yet) the loss of income.

A couple of final thoughts. The strains in the financial system persist despite the Fed’s bailout of Bear Stearns. Banks still won’t lend to each other, even at rates significantly above official market rates. There remains a stigma about using the Fed’s new discount window (open to brokers as well as banks) – nobody wants to be the next Bear Stearns, and rumours can still bring down weaker players. Inflation (and stagflation) worriers can, however, take heart that the Fed has not yet been using the most powerful piece of technology known to man (to paraphrase Ben Bernanke) – the printing press – to create US dollars. The size of its balance sheet remains almost unchanged since July 2007, and it has plenty of ammunition left to respond to further liquidity needs by the market before it has to start cranking up the handle and printing dollar bills.

On the credit front, the days of easy money are over for companies, and not only because of wider credit spreads. A feature of the corporate markets over the past few years has been the ease by which companies have been able to waive covenants on their debt when they got into difficulties. With the wall of capital having disappeared, bankers are playing hardball. Not only is the number of requests for covenant ammendments increasing, but the costs are too. Permission might have been granted for free a year or so ago – now, for covenant renogotiations relating to financial performance a typical waiver “fee” might be 2.25% of the loan value, or an increase in the lending spread by 150 basis points per year. The Fed’s Senior Loan Officer Survey shows that lending standards more generally are tightening: 70% of the 100 odd banks surveyed in April had increased loan pricing to their corporate customers. Default rates remain super low – but for how long?

We only had time for one quick beer before heading back to the airport, at Welcome to the Johnsons in the Lower East Side. A year ago a can of Pabst Blue Ribbon there was $1. Now it’s a punitive $1.50. A sad indication of the global food price inflation trend. Elsewhere in the Manhattan bar scene we heard that prohibition style speakeasies are making a comeback, with drinking dens hidden behind, for example, telephone booths. The US prohibition ran from 1920 to 1933, covering the period of the Wall Street Crash and early years of the Great Depression – but that is surely coincidental.


US housing crash now worse than during the Great Depression

US data released last week showed that US house prices fell by 14.4% in the year to the end of March (this is the S&P/Case-Shiller Composite-20 Index, which the market tends to focus more on – the S&P/Case-Shiller Composite-10 Index was down 15.3%). The track record of these indices is not very long though – the composite-20 index goes back to 2000, while the composite-10 index began in 1987. So Robert Shiller, who is the cofounder of the index, has calculated the change in both nominal and real US house prices going back to 1890 (see the second bullet point in this link for the data). As shown on our chart and reported in this week’s Economist (see here), US house prices are now falling faster than the -10.5% rate witnessed in 1932. Given the month-on-month declines of more than 2% that we’re currently seeing, it should only be a few more months until the year-on-year record of -16.1% is broken, which dates back to 1901.

US nominal house price falls are bad enough, but the picture is even worse in real terms (ie adjusted for inflation). Real US house prices are currently falling by 16.6%, which is easily the worst figure on record. In 1932 for example, the US economy was experiencing deflation of 10.1%, so real house prices were only falling by 0.4%. The US housing market doesn’t appear to be anywhere nearer reaching the bottom either – the supply of houses on the market is very close to all time records, and house prices will have to continue falling until this is cleared.

The UK housing market looks like it is rapidly following the path set by the US. Nationwide have UK house prices falling by 4.4% in the year to the end of May, while HBOS today reported that house prices are down 3.8% over the same period. Taking the last three months of the Nationwide index and annualising it shows that UK house prices are dropping at an annual rate of 17.0%. HBOS’s index has registered monthly falls of -2.5% in March, -1.5% in April and -2.4% in May, which equates to an annualised rate of -25.1%. And unfortunately, UK house prices are set to fall a lot further. We’ve charted the progress of mortgage approvals over the past 18 months (see here for Richard’s comment at the end of April), and as you can see from our updated chart, our adjusted mortgage approvals number is predicting a year on year house price decline of 15% by the end of 2008.

The central banks’ inflationary concerns are preventing interest rates from coming down as fast as they otherwise would do. This, combined with banks’ unwillingness to lend, means that demand for houses continues to wane, and a rebound in house prices is exceptionally unlikely in the foreseeable future. A collapsing housing market will inevitably have a severe knock on effect for the wider economy.

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