Recent posts


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.


S&P thinking about downgrading Moody’s

The ratings agencies are at it again. Yesterday, S&P (the largest credit ratings agency) announced that it has placed Moody’s (its biggest competitor) on credit watch negative. S&P cited one of the reasons as being the computer bug that is believed to have resulted in Moody’s accidentally giving AAA ratings to some Constant Proportion Debt Obligations (CPDOs), a form of structured credit. According to the Financial Times, Moody’s may have intended to rank the CPDOs as much as four notches lower.

Hang on a second. S&P gave the very same CPDOs an AAA rating, and that was without any computer bugs. So one agency is concerned another agency has failed in not coming to the same conclusion as itself. It would be a laughing matter, if not for the fact that investors and regulators rely on these agencies so heavily. It takes me back to February last year – see Stefan’s article here on the Icelandic debacle.


Northern Rock’s recovery plan doomed?

A great quote today from Northern Rock’s chairman, as reported here on Bloomberg : “If house price were to decline 5, 10 or 15 percent, that would seriously impede fulfilling the [recovery] plan”

UK Housing Minister Caroline Flint’s Cabinet briefing notes as at 13th May, as shown here : “Given present trends, [houses] will clearly show sizeable falls in prices later this year – at best down 5 per cent -10 per cent year on year”

If a UK government bailout can’t save Northern Rock, then I’m not quite sure what can.


Japanese economy booming? Perhaps not, because it’s a leap year

Figures announced on Friday showed that Japan’s economy grew at a headline-grabbing annualised rate of 3.3% in the first quarter of this year, way ahead of expectations of 2.5%. Commentators have focused on strong export growth, although one reason for the surprise may be because the Japanese don’t adjust their growth figures for leap years. The Japanese aren’t the only ones not to adjust for leap years – a quick internet search shows that as at 2004, New Zealand, Mexico, Ireland, Denmark, Portugal and Switzerland didn’t either.

Not adjusting for leap years seems a bit of an error. In a non leap year, Q1 has 90 days. In a leap year it has 91 days, so Q1 in a leap year is 1.1% longer. That’s 1.1% more time for consumers to spend money. In fact, with the exception of people getting paid by the hour or by the day, the world worked for free on February 29th. Not bad for companies’ profit margins.

Which leads onto quite an important point. Q1 corporate earnings have on the whole exceeded expectations (which is usually the case), but did the forecasters take account of the leap year in their various earnings models? Maybe some did, but it’s likely that many didn’t. If the leap year effect wasn’t incorporated into forecasts, then Q2 earnings estimates may be over-optimistic (reflecting the earnings surprise from Q1). This may lead to disappointment when Q2 earnings are announced (all other things being equal, of course).


Sainsbury’s (2%) vs the Office of National Statistics (6.6%) vs the Daily Mail (15.5%). Fight! Fight! Fight!

What is the real level of food price inflation? Are the official numbers released by the Office of National Statistics (ONS) understated? Well the ONS is under attack from both sides. On one front there’s J Sainsbury’s CEO, Justin King, who yesterday claimed that the official food inflation annual number of 6.6% is way too high. Real food inflation, he said, is just 2%. The discrepancy comes because the ONS doesn’t recognise the price cuts that customers achieve through supermarket BOGOF (Buy One Get One Free) deals and other voucher based promotions – the ONS simply compares the shelf price of a tin of beans from month to month. Tesco has also said that food price inflation is not as high as the headlines proclaim.

On the other front is the Daily Mail. The Mail has calculated its own food inflation index, and finds that inflation in its grocery basket is running at 15.5% per year. The 74 comments from readers (our world record on this blog is 3) are almost unanimous that this survey reflects their own experiences. “The Mail’s Cost of Living Index is a brilliant and simple idea. When can we expect to see the government repsonse to this and give an explanation why they still want to use the CPI instead?” (Derek from Hull). And this is a problem – for what its worth I think that the ONS data is pretty robust in comparison with the Mail’s snapshot of 40 odd items (you can read about the ONS food basket here) – but if people start believing that inflation is back, then it becomes much harder to fight it.

So bond fund managers find themselves in a difficult situation. There is no greater enemy to the fixed interest investor than inflation – what if we’re wrong in our view that a period of below trend growth coupled with the credit crunch will lead to disinflationary pressures reasserting themselves from 2009 onwards? So what’s our danger signal? We have to keep a close eye on wage growth. Workers’ real incomes have been stagnant now for four years, as Mervyn King discussed in the Q&A following yesterday’s Inflation Report briefing. Salaries haven’t kept track with productivity growth and inflation. As long as this remains the case, and earnings growth remains below 4.5% (it’s currently 4%), then it’s difficult to see how the UK can enter into an inflationary spiral. With profit growth deteriorating, and unemployment rising, why would employers give inflation busting wage hikes? And if wages hikes aren’t forthcoming, then higher food (and energy) costs are just going to hit incomes harder. In an economy where the savings rate is zero, and where credit is hard to come by, there aren’t many options. Consumption will have to fall – and consumption is 2/3rds of UK GDP. We all thought it would be housing that would tip the UK into recession – but could it be French bread (+44%), tea bags (+67%) and butter (+62%)?


What level of inflation is the UK bond market pricing in?

It was announced yesterday that UK consumer prices climbed 3.0% in April from a year earlier, ahead of expectations of 2.6% and a big jump from 2.5% recorded in March. The Bank of England today said that the inflation rate is likely to breach the 3% maximum limit for “several quarters” and that there could be a “number” of letters to the Chancellor explaining why inflation has breached this 3% upper limit. Gilts have sold off aggressively – 10 year gilt yields were at 4.6% immediately before the announcement, and broke above 4.8% today. That equates to a drop in price of about 1.7% in just two days.

Rising inflationary pressure has meant that we’ve had a growing number of queries from investors for our view on index-linked gilts. Index-linked gilts have significantly outperformed fixed interest gilts recently. Over the year up to the end of last week, the median return for the IMA Index-Linked Gilt sector was +11.7%, while the median return for the IMA UK Gilt sector was 5.0%. This outperformance is largely due to building inflationary pressure, but is also in no small part due to ongoing demand from pension fund managers, who seek to match long term assets with their long term liabilities.

Following this index-linked rally, what inflation rate is the market pricing in? Well we can see what the market is expecting by taking the yield on a fixed interest gilt, and then subtracting the yield on an index-linked gilt of the same maturity. This gives what is called the breakeven inflation rate (for more information on the breakeven inflation rate, click here for a paper on the Bank of England’s website, or click here for a very interesting speech by MPC member David Blanchflower).

This chart shows how both RPI and the market’s inflationary expectations have changed over time (note that index-linked gilt returns are still linked to RPI, rather than CPI). The red line shows that RPI was 4.2% in April, and has fallen back from the 4.8% hit in March last year (which was the highest recording since July 1991). However even though RPI has fallen a little, inflationary expectations have steadily risen since the beginning of 2003. Inflationary expectations over the next decade are the highest since 1997, when the Bank of England was made independent. Longer term expectations are higher still (though this breakeven inflation rate is being distorted a little by the pension funds).

So, are index-linked gilts attractive? If you believe that RPI will remain at current levels, or perhaps continue to rise over the long term, then yes – they look more attractive than fixed interest gilts. But if you share our view that disinflationary pressures will come to the fore over the next couple of years (see Jim’s comment here), and that RPI will fall back towards trend level (or lower), then fixed interest gilts look more attractive.


Scylla, Charybdis & the Horse Latitudes

Scylla & Charybdis were two sea monsters living on opposite sides of the Strait of Messina posing a very serious threat to passing sailors of the day. Avoiding one typically meant taking great risk passing too closely to the other. The phrase, believed to be the progenitor of the phrase ‘between a rock and a hard place’ is where the European Central Bank finds itself today; presiding over increasingly weak economic data and stubbornly high inflation readings.

Unlike the Fed whose psyche bears the scars of the Great Depression (and thus likely to risk inflation in favour of growth) the ECB remains eternally cognisant of the hyper inflationary years of the Weimar Republic. The ECB yesterday left its benchmark re-financing rate, as expected, at 4% and continue to focus, as per their mandate on the “upside risk to price stability.” However recent economic data has suggested the economy has begun to cool. Manufacturing ex-Germany continues to slow, whilst exports continue to be hampered by the strength of the Euro. The housing correction underway in countries like Spain, Italy & Ireland is undermining consumer confidence and consumption is hampered by real disposable income hits from surging energy and food prices.

Ultimately slower European and global growth should lead to lower European inflationary expectations enabling the ECB to respond with interest rate cuts, though perhaps not for some time yet. In fact if you go back a few years to 2003 you can find evidence of the ECB willing to cut rates despite inflation above its 2% comfort zone.

As an aside risk assets have been enjoying something of a renaissance since the Fed organised the bailout of Bear Stearns through JP Morgan in March. The Merrill Lynch European High Yield Constrained Index returned 5.31% during the month of April, recovering most of the losses it saw through the first quarter of the year. This week, however, feels somewhat range bound. In a report from earlier this week, Goldman Sachs used the analogy of the corporate bond markets heading for the ‘horse latitudes’- pretty apt I thought, once I’d looked it up!

This entry was posted in inflation and tagged , by . Bookmark the permalink.

Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.

Page 59 of 81« First...102030...5758596061...7080...Last »