With food inflation hitting record highs, and oil at over $115 per barrel, it’s difficult to see that policy makers might be more worried about deflation than inflation. In fact a bit more inflation in the global economy might be secretly felt to be a good thing – anything that erodes the consumer’s debt burden could help economic growth get back towards trend. But as Jim pointed out (see article here) credit and banking crises are always disinflationary, or outright deflationary – and ditto recessions. We still expect lower rates, but also that other non-monetary policy measures will continue to be used (tax refunds, bank bailouts etc.). This fascinating 2002 Fed paper by Ben Bernanke (“Deflation: Making Sure “It” Doesn’t Happen Here“) sets out what the current Fed Chairman thinks can be done when interest rates hit zero, and deflation threatens.
Sunday night’s TV showing of The Aviator told the remarkable story of Howard Hughes, who as well as being an engineer, Academy Award winning film director, and a little nuts, was also one of the world’s richest men. It covers the early years of the airline industry, focusing on TWA‘s battle with Pan-Am (Hughes had to take on Pan-Am and the US government in attempt to end Pan-Am’s monopoly as an international carrier).
The film chronicles Hughes’ constant battle to prevent TWA from going bankrupt, and in the 60 years that have since passed, very little seems to have changed in the airline industry. The industry is a graveyard – Pan-Am went bust in 1991, while TWA entered bankruptcy in 1992, 1995 and finally in 2001 (after which it was taken over by American Airlines). Other high profile bankruptcies have been Swissair and Sabena (Belgium’s national carrier). Numerous airlines have filed for bankruptcy protection and re-emerged after restructuring (eg Delta Airlines, Northwest Airlines, United Airlines, Air Canada). See here for a comprehensive list of defunct airlines.
We’ve written on this blog before about how global defaults have remained remarkably low, partly because companies that would have gone bust in previous cycles managed to escape in the recent liquidity fuelled cycle (see article). But now that money is no longer being thrown at unprofitable companies, we’re starting to see the number of defaults pick up. The airline industry is unsurprisingly being hit particularly hard. In the last few weeks alone, four US airlines have filed for bankruptcy protection (budget carrier Frontier Airlines, Aloha Airlines, ATA and Skybus). Hong-Kong based airline Oasis also collapsed recently. Silvio Berlusconi is desperately trying to find a buyer for Alitalia, and Aeroflot are the current favourites (some match up that will be).
This chart (click to enlarge) shows the 5 year CDS on some of the world’s best known airlines. Lufthansa (which is BBB rated) and British Airways (BB rated) are holding up OK, but Continental Airlines, United Airlines and American Airlines are all trading at distressed levels. Record high oil prices, competition from low cost carriers, high operational leverage, environmental concerns/costs and of course the big threat of economic recession are likely to make matters a whole lot worse.
Warren Buffet had a point when he said that (as at 1992) “the money that had been made since the dawn of aviation by all of this country’s airline companies was zero. Absolutely zero.”
The government’s official unemployment rate (which looks just at the number of people claiming benefits) stands at 2.5%, the lowest rate since 1975. The UK unemployment rate under the International Labour Organisation’s measure stands at a slightly more realistic 5.2%, which is higher that 2003-06, but still way below the long term historical average.
A widely held view is that the UK economy will be OK, because unemployment is low. This view is misplaced. History suggests that unemployment is a lagging indicator – that is, it’s one of the last things to turn in an economic slowdown. What has normally happened in the past is that house prices fall, then consumer spending falls (and economic growth therefore slows), then unemployment rises, and finally inflation starts to fall as spare capacity is created in the economy.
This graph (click to enlarge) shows what happened in the UK’s last recession. House prices are represented by the blue line, and we’ve looked at house price changes on a rolling 3 months (and annualised). UK unemployment is the red line, and is plotted against the right hand axis (inverted). Last time around, UK house prices started falling in mid- 1989, but unemployment didn’t start rising until mid-1990.
Unemployment is a lagging indicator because it takes companies a while to realise that the economy is slowing. Once companies realise this, it then takes them a while to lay people off. So if you want to get an idea of what’s going to happen to the UK economy (or indeed the US economy), look at the housing market, not the unemployment rate. Anyone who’s focusing on unemployment as a measure of the state of the economy is likely to be well behind the curve
So how far could UK house prices fall? The IMF said last autumn that UK house prices were 50% above where their models suggested house prices should be, although this month they toned it down to 30%. The honest answer is that nobody knows how far prices could fall, as there is a huge margin for error on long term economic predictions. We tend to stick to shorter term projections, and look at things like mortgage approvals. Mortgage approvals are a reliable predictor of UK house prices six or seven months ahead, and current data implies year-on-year falls of between 5% and 10% by early autumn (and this projection is likely to worsen, because the banks are becoming increasingly reluctant to lend, which means that mortgage approvals and hence house prices could fall much further).
If we were to have a longer term guesstimate, history suggests that when the UK housing market crashes, it tends to fall about 25%-30% from peak to trough in real terms. But given that UK house prices rose about 270% from 1995 to the end of 2007, there’s a risk that this current crash (and it is a crash) could be worse.
Let’s assume, then, that UK house prices fall by 30%. How much do homeowners stand to lose? A lot of homeowners will think that they’ll lose 30%, but they’re wrong. It’s actually a lot more. Buying a house is a leveraged investment, and the degree of leverage depends upon how big your mortgage is in relation to the value of the house. Consider someone who has a house worth £400k, and whose charitable parents have coughed up £200k for a deposit. If house prices fall by 30% (so their house falls to £280k in value), they’ve lost £120k. Unfortunately house price falls don’t make mortgages smaller, so if they sold their house, they’d only get £80k of their £200k deposit back. This means that they’ve lost 60% of their money.
Then consider someone who put up a deposit of £80k to buy this hypothetical £400k house (so that’s an 80% mortgage). A 30% fall in the value of their house leaves them in negative equity – their £80k deposit is wiped out, and they owe £40k. Maybe this person is one of the 20,000 people in the City who are forecast to lose their jobs. This wouldn’t have been a big problem in the 1990s, when the government generously agreed to pay the interest on anyone’s mortgage if they were made unemployed (no matter how big your mortgage). Now, you can only receive assistance on the first £100,000, and you’re not eligible to mortgage relief if your partner works more than 24 hours per week or if you have more than £16k of savings.
You can see from the examples above how a house price crash would have severe consequences for the economy. Due to the leveraged nature of home buying, a housing crash can greatly reduce the spending power of consumers. It’s no coincidence that house price crashes result in (or occur at the same time as) recessions. The only way out is for central banks to slash interest rates in order to encourage borrowing again, which will eventually revive the housing market.
The UK bond market is being a little more aggressive, with three 0.25% rate cuts fully priced in by June 2009. This is because UK inflation is more under control that in Europe (prices in February were 2.5% higher than they were a year earlier), and because the UK economy is looking very vulnerable (figures from Nationwide show that UK house prices have fallen five months on the trot).
Do the UK and European bond markets’ expectations look reasonable?
If you believe that the effects of the credit crunch will be contained in the US, and that inflationary pressure will remain (or get worse), then yes. But if you buy into our view that economic growth is set to weaken (possibly dramatically), and that inflationary pressure will subside (see Jim’s recent article here), then good quality bonds look rather attractive right now.
*Historically approximately 0.16% has needed to be subtracted from UK and European interest rate futures to arrive at implied interest rate expectations. However, recent distortions in the money market have made interest rate futures analysis a little less reliable, particularly over the very short term. The market may therefore be pricing in slightly more in the way of rate cuts than mentioned above.
We’re heading into the ninth month of the credit crunch, and there still hasn’t been any issuance in the European high yield market. Investment grade companies are also having serious problems getting anything done in Europe, and any brief rally in risky assets is being viewed as a window of opportunity to issue bonds. On Wednesday, for example, we saw £500m of issuance from Citigroup, £500m from Standard Chartered, €850m from Dutch telecom company KPN and €650m from French supermarket company Casino. Yesterday, Diageo jumped in with a €850m deal, Thames Water issued £400m, AT&T issued €1.25bn and BNP Paribas issued €3bn. These deals are coming to the market at a significant premium to where CDS and existing bond issues trade from these companies, and at considerably wider levels than seen over the last few years.
There is still a huge number of companies desperate to raise finance. A number of companies have sought alternative means. Richard recently wrote here about how Porsche managed to draw on a bank overdraft facility at very favourable terms. Last week, the battered US consumer finance company CIT Group announced that it was drawing on a $7.3bn credit facility from its banks, for which they are rumoured to be paying around 0.4% to 0.7% over LIBOR. This bank facility is a bit of a coup for CIT Group, if you consider that CIT Group 5 year credit default swaps are currently trading at 990 basis points, and CIT bonds maturing in 2012 yield about 13%. (Incidentally, S&P and Moody’s rate this bond A- and A3 respectively, suggesting that either the ratings agencies or the market has got it a bit wrong).
The clear losers from these credit facilities are the banks. The banks offered credit facilities to companies when times were good. Now that times are bad, banks are contractually obliged (subject to ratings downgrades, which may void this contract) to lend to borrowers that may be distressed, and they are lending to vulnerable companies at rates that AAA rated corporates would struggle to achieve in the bond market right now. Clearly the implications for banks is a further squeeze on profits.
Helicopter Ben yesterday announced that the Fed would lend $200bn of Treasuries to banks in return for AAA rated collateral. Equity markets were delirious – the S&P recorded its biggest one day jump in over five years. Risky credit also staged a rally, but the reaction was a bit more muted. The iTraxx Europe Crossover Index, an index measuring the default risk of the most liquid European high yield names (see here for more info) rallied from its all time high but spreads are still higher than at the end of February.
What difference will the Fed’s actions make? The liquidity injection is certainly helpful to all the banks that were having liquidity problems, and the extra liquidity will help the market determine the fair price of some of the more esoteric debt instruments. Much of the distressed selling we’ve seen in the past few months has been because investors are trying to sell but nobody’s willing to buy, and prices have spiralled downwards.
But will the Fed’s actions get the global economy out of a hole? No, not really. The value of AAA rated mortgage securities are ultimately determined by house prices and delinquencies. Banks may react to the liquidity injection by slashing mortgage rates, but this is unlikely given that banks are currently trying to rein in lending and patch up their balance sheets. The Fed’s actions will therefore do little to tempt US citizens into buying houses again, and US house prices will therefore continue falling until some of the near-record supply of houses for sale is reduced. I can’t see the Fed’s actions resulting in the US avoiding recession – at very best, it might make things slightly less bad.
The Fed’s decision to allow AAA-rated mortgage securities to be posted as collateral raises some interesting political questions. It’s very hard to imagine that S&P and Moody’s will implement a wave of downgrades any time soon, because this would completely undermine yesterday’s actions from the Fed. As yesterday’s excellent article on Bloomberg explains, none of the 80 AAA securities in the ABX indices (these track subprime bonds) meet the ratings agencies’ normal AAA criteria. Helicopter Ben is loading up with assets that are very heavy in risk. This is alleviating the liquidity pain of the financial system, but is risking his ability to pilot the Fed. If these AAA assets start to turn sour, then the Fed will be yet another bank burdened with the woes of the US housing market.
Firstly there’s evidence that there is a lot of speculation in commodity markets, with hot money having flooded into the asset class. In contrast with speculation in paper assets like shares and bonds however, if you’ve bought a million pork bellies for delivery in June, you better have a plan for getting them out to people who actually want to eat them. You can’t hoard ham for long. Secondly there’s good evidence that commodity prices are a lagging indicator of past economic growth. Goldman Sachs have looked at their own commodity index (the GSCI) over the past couple of recessions and found that once growth slows, prices fall significantly. In the 1990-91 recession the index fell by 28%, and in the 2001 recession by 37%. The slowing global growth picture is what concerns central banks the most – the recent elevated commodity prices will not prevent them from cutting rates aggressively in 2008.
An interesting set of events was set in motion a fortnight ago, though its roots lay somewhere in late February 2007. A recent trip by an anonymous team member to double Michelin-starred Tom Aiken’s latest venture, Tom’s Place; in essence a posh chippy, bemoaned the lack of cod & suggested that the pollock wasn’t up to much. AA Gill agreed in his unique indomitable fashion the following Sunday & all the talk of cod had me thinking of the Icelandic banks.
Almost exactly a year previous, Moody’s released the results of its widespread review of the banking sector. Its JDA (Joint Default Analysis) allowed ratings to take into account the potential for government support. As a consequence the three largest Icelandic banks, Kaupthing, Landsbanki & Glitnir were upgraded several notches from A1 to Aaa by Moody’s. I wrote at the time that this was a load of Codswallop (see here). “Investors have questioned for example whether a country such as Iceland (with a population similar in size to Hull, and an economy based around cod) has the ability to support banks which has liabilities three times the nation’s Gross Domestic Product.”
The market initially bought into Moodys’ story, pricing five year credit default swaps at around sixty basis points back in February 2007 (the cost of ‘insuring’ against default). A mere six months later and Moody’s had lowered the rating three notches. A year to the day after my initial blog the whole affair had come full circle with Moody’s returning the bank to its A1 rating. At the time of writing, five year credit default swaps are trading between 500 & 700 basis points, much more in line with a high yield credit carrying significantly lower ratings, and the Icelandic Prime Minister plans to conduct a ‘confidence boosting’ investor roadshow. Fish and chips sales may benefit from a recession, Icelandic banks clearly don’t!
The chain of events that led to the Great Depression were extremely similar to the ones that led to the ‘lost decade’ in Japan. Firstly loose monetary and fiscal policy led to real estate and stock market bubbles. Then the bubbles popped, which resulted in a sharp fall in demand for housing (and a fall in housing investment), bank failure (since the banks had become reliant on asset prices rising), a credit crunch, a sharp drop in consumer spending, and recession.
In both cases, the authorities’ reaction to the crisis served to turn what would probably have been a ‘normal’ recession into something a lot worse. The US government of the early 1930s tried to stick to a balanced budget and this fiscal tightening resulted in the US money supply falling 25% from 1929 to 1933. The drop in the money supply caused deflation, which is the worst thing that can happen to a heavily indebted economy since it increases the real value of debts.
Quite unbelievably, the Japanese didn’t learn the lessons from the 1930s. They too tried balancing the budget in the face of a sharp economic slowdown and actually increased taxes (John Maynard Keynes would have been turning in his grave). The result? A drop in Japanese money supply, deflation, followed by a prolonged and severe recession.
The global economy today is following a very similar path to that which led to the Great Depression and Japan’s woes, but there’s one big thing missing – money supply is still rising. Ben Bernanke, one of the world’s leading authorities on recessions and depressions, has slashed rates to maintain liquidity in the system and US money supply has held up so far. The European Central Bank hasn’t cut rates yet, though, which could spell trouble for the Eurozone.
Why has the ECB been so slow? The reason is that its sole mandate is to control inflation and at the moment inflation indicators (which includes ‘M3′ money supply) are suggesting that, if anything, higher interest rates are needed. Figures this week show that the money supply is growing at a healthy clip, with the ‘M3′ measure rising by around 11.5% at the last release. This seems to more than contradict those that fear the supply of credit is falling, doesn’t it?
Well, a UBS analyst questioned the meaningfulness of this measure at the moment, for very interesting reasons: all these SIVs, CDOs, VIEs etc that have long been ‘hidden’ away in the Cayman Islands, Bermuda and Jersey and have been off European banks’ balance sheets, are now rapidly finding their way back onto banks’ books. And thus, as they come back onshore, the ‘M3′ money supply figure is rather artificially showing an inflation in the amount of corporate credit being provided to the economy.
So, let’s watch and see what happens, but it wouldn’t be that surprising for someone at the ECB to discover that this ‘growth’ in credit is not actually growth in any real, prospective sense, but is backwards looking credit growth. It may be that actual loans being made to corporates and people in the EU are not quite as healthy as the figures suggest. This realisation could cause a very quick about-turn in the rhetoric coming from the ECB regarding the future direction of inflation and hence interest rates.