Graham Secker, Morgan Stanley’s equity strategist came in to give us his top down views on markets last week. I’ve attached an interesting chart that he produced (click on chart to enlarge). You’ve probably read a lot about the forthcoming wave of mortgage refixes in the UK – rising rates mean that those coming off old "cheap" deals are re-financing at higher rates, and Morgan Stanley have tried to quantify the impact of this on consumer spending. From the third quarter of this year onwards, assuming rates at 5.75% (which is the market’s expectation) the household sector will be between £250 million and £350 million a quarter worse off. The chart also shows what happened the last time the consumer sector took a similar (albeit smaller) hit: non-food retail sales collapsed. With higher fuel and energy bills, higher council taxes, and higher food prices eroding incomes, this bodes badly for discretionary spending over the next couple of years. Wages aren’t keeping up with workers’ costs. Perhaps we are seeing the first signs of the slowdown with Tesco and Sainsbury reporting weaker than expected non-food sales, and also with reported weakness in demand for budget airline flights (holidays being an early casualty when times get tough). I’d expect house price inflation to moderate too (predicting outright UK house price falls is a mug’s game!). Perhaps Gordon Brown’s inheritance will be a dour household sector?
Just a quick one to point out Roger Bootle’s article in this morning’s Telegraph. He wonders whether the MPC will lose credibility if the Governor is consistently on the wrong side of the interest rate vote. It’s only happened twice so far (most recently at the start of this month when he was in the minority calling for a hike), but Bootle thinks that his position becomes untenable if it becomes a common event. The other thing that Bootle comments on is the strength of money supply growth – he points out that the money supply plays no role in the Bank’s economic forecast models. However, we perhaps shouldn’t be too surprised about this given the breakdown in the relationship between money growth and inflation in the past couple of decades. As you probably know the relationship broke down shortly after the politicans and central bankers started targetting it (some might call this Sod’s Law, but we economists call it Goodhart’s Law after the former Bank of England advisor who noted this phenomenon).
On Wednesday, Mervyn King took on the role of the central bank’s chief toast master at the Lord Mayor of London’s Banquet – cue fine dining, full formal dress, a large hall and obviously fine wines. Central bankers are not known for their singing talent, so he entertained the audience with a slice of his views on the outlook for monetary policy in the UK, ranging from the practical (how to improve the quality of £5 notes in circulation) to the central inflationary conundrum (the impact of money supply growth on inflation).
From the perspective of us bond investors, the interesting part of his speech referred to loose monetary conditions. He warned about the corporate demand for credit and the readiness of financial institutions to lend, and was particularly concerned about the development of complex financial instruments and the spate of loan arrangements without traditional covenants. "It may say Champagne – AAA – on the label of an increasing number of structured credit instruments. But by the time investors get to what’s left in the bottle, it could taste rather flat" (David commented on precisely these concerns in our blog last week).
At first the choice of wine to accompany his speech appears appropriate for such a grand occasion. Or maybe we have a central banker with a sense of humour who compares the credit markets to a fancy bottle of bubbly, that goes POP.
I’m reading The Black Swan by Nassim Taleb. Before Australia was discovered by Europeans, the idea that a swan could be anything other than white did not exist. The book’s premise is that we are deluded in using historical models to predict future events, be they world changing political moments, or risk and return in financial markets. He talks about the ludic fallacy – "believing that the structured randomness found in games resembles the unstructured randomness found in life". When we look at risk, we draw bell curve distributions, or test our portfolios against maximum expected losses – for example by modelling the impact of a 1987 style crash on our equity holdings. Yet it is the "black swans" that make the big differences to long term portfolio performance – the disappearance of the Chinese and Russian stock markets at the start of the last century for example. Taleb gives the example of measuring a thousand days in the life of a turkey, and measuring its happiness and comfort over that period: for the first 999 days, the bird’s utility gradually increases as it becomes happy in its surroundings (only if free range, obviously) and gets fatter. Chart this and you have an uptrend with fairly low volatility (a nice Sharpe Ratio). On the 1000th day it is killed and eaten. We should stop thinking of financial markets as having predictable, casino style returns. Even casinos don’t have predictable casino style returns. Casino owners have models which analyse the odds of all the games they offer, with overlays that predict some big swings if a big hitter walks through the door and wins heavily on "black". They also carefully model fraud risk, either from employees or cheating customers, and thus spend a fortune on video cameras and security guards. Here then are the actual 4 biggest losses or near losses suffered by one Las Vegas casino, as told in the book:
1. They lost $100 million when their star entertainer (either Siegfried or Roy) got mauled by a tiger on stage
2. A builder tried to blow up the casino with dynamite after being injured during its construction
3. An administrative employee failed to post several years worth of tax forms to the IRS, resulting in a massive fine
4. The casino owner’s daughter was kidnapped, and casino takings were used (illegally) to pay the ransom
A "black swan" has three characteristics – it is unpredictable, its impact is huge, and after it has happened we try to explain it in order for us to make it feel as if it was not so unpredictable (9/11 for example). Moving back to bonds, as we must do from time to time, the book rubbishes the historical "fact" that the First World War was both inevitable and universally anticipated. He cites Niall Ferguson‘s study of British and European bond prices in the months leading up to the start of the conflict; even though a coming Great War would surely destroy both public finances and the wider economy, the bond prices saw no movement. The fact that volatility in global markets is at record lows right now tells us nothing about future events. We must expect the unexpected, and position portfolios to benefit from black swans – how we do that is the hard bit.
For monetary policy to work, it is essential that central banks target the correct inflation measure. There are a number of differences in the way that inflation can be calculated – for example, the Bank of England and the ECB target headline inflation, while the Federal Reserve focuses on core inflation (which strips out energy and food prices). If central banks are looking at the wrong inflation measures, and there is a real risk that they are, then there could be serious implications for global bond markets.
Why does the Fed only focus on core inflation, when food comprises 15% of ‘total’ US inflation and energy forms nearly 9%? The answer is not that the central bank is pretending that food and energy don’t exist – rather it is because these components tend to be very volatile and very short lived, being more to do with whether there’s been a political scare or a hot summer than being part of any long term economic trend. Food and energy can therefore distort the ‘true’ picture of inflation, and given the lag involved (at least 12 months) between changes in monetary policy and its effect on the wider economy, an overreaction to a short term fluctuations could be disastrous.
But what if the recent change in food prices and energy prices is not actually temporary at all? Soaring food and energy prices have meant that headline inflation has averaged around 0.5% higher in OECD countries since the beginning of 2003, and if you believe that the long term trend is for food prices to climb higher (think global warming) or for oil prices to continue rising (perhaps because of Peak Oil), then there is a real risk that the Federal Reserve is significantly underestimating inflationary pressure. One high profile critic of the Fed’s focus on core inflation is Charlie Bean, who was formerly my personal tutor at LSE in the 1980s but is now the Bank of England’s Chief Economist. He argued last year that higher food and energy costs are a by-product of Chinese demand and globalisation, so in calculating inflation, it makes little sense ignoring the higher inflationary effects of globalisation (energy costs) while at the same time including the disinflationary benefits of globalisation (cheaper manufactured goods).
Even if we assume that the recent rise in food and energy prices are here to stay, the ECB and the Bank of England will most likely only begin to take firm action when these inflationary pressures turn into so called ‘second round effects’ in the form of higher wages. Wage growth in the developed world has been incredibly low over the past five years, with real wage growth in most of the developed world being negative as a result of global competition and immigration. However, there is evidence that the workers are demanding more (we first commented on this back in December), and if wages do rise then central banks will certainly clamp down with higher interest rates.
OK, I actually just invented this term myself, but I think it very accurately captures what’s currently going on in the bond and equity markets around the world. For a few years now, private equity funds have taken advantage of low bond yields and high equity earnings yields by issuing lots of debt very cheaply and taking companies private. Finance directors of companies still publicly listed have finally woken up to the threat posed by private equity, and are now increasing leverage voluntarily.
Expedia, the online travel company, has done precisely this, announcing that it is taking advantage of cheap debt to leverage up in an effort to enhance earnings. The company proposed that it would buy back a whopping $3.5bn of its equity, which is about 40% of its outstanding shares. Great news for equity holders – Expedia’s share price is up about 20% so far this month – but leveraging up is the last thing that bond holders want, and the spread on Expedia’s bonds maturing in 2018 shot up from 90 basis points to 210 basis points (a 10% drop in the bonds’ price) after S&P downgraded the bonds to high yield status.
Expedia is a slightly unusual case, in that leveraging up is normally what you’d expect from a company that has a high equity earnings yield (ie a low Price/Earnings ratio). At the beginning of June, though, Expedia’s leading P/E ratio was 21, implying a relatively low equity earnings yield of 4.7%. At this level, the need to leverage up is less apparent, and bond and equity markets alike were taken aback by Expedia’s announcement. Clearly, Expedia’s management behaviour suggests that the market is grossly underestimating the company’s future earnings growth.
A company where leveraging up has more obvious benefits is Home Depot, the giant US DIY firm. I first wrote about the possibility of Home Depot becoming a target for private equity in December last year and currently own Home Depot equity in the M&G Optimal Income Fund. The view was that Home Depot was under-leveraged and was a prime target for an LBO, albeit the company was (and still is) beyond the reach of private equity funds because of its $80bn market cap. Half a year later, and management has clearly bowed to shareholder pressure to enhance earnings. Home Depot today announced that it is seeking to buy back 30% of its outstanding equity, in a deal that will be partly funded by issuing $12bn of bonds. Again, great news for equity holders, and Home Depot’s equity is up 7% today. Bad news for bond holders though – Fitch ratings agency downgraded Home Depot’s bonds from A+ to A-, while both Moody’s and S&P have said they may downgrade the company’s credit rating.
I expect many more ‘LBIs’ and LBOs over the next 12 months, and continue to believe that the yield premium available on a number of corporate bonds is insufficient for the risk taken on.
Rating agencies have come under fire recently. A number of perceived gaffs haven’t helped the agencies’ credibility (we covered Moody’s changes to its bank rating methodology on this blog), but the biggest concern at present is regarding structured credit.
Some investors have always treated ratings agencies with a degree of scepticism, arguing that there must be a conflict of interest when companies are the ones who pay agencies to rate their own bonds and deals. This scepticism has grown with structured credit, because agencies can earn twice as much as they could for rating a conventional corporate bond. There is also widespread concern that the agencies lack the resources to properly analyse complicated structured credit, because the best brains at the ratings agencies often get snatched up by the investment banks and fund managers.
S&P yesterday hit back, releasing a report entitled "The Covenant Lite Juggernaut is Raising CLO Risks – And Standard & Poor’s is Responding". The background to this report was that ratings agencies had been criticised over their lack of action over what are perceived to be increasingly risky leveraged loan deals. An increase in risk of leveraged loans meant that the credit ratings given to CLOs, which are asset backed securities backed by a pool of leveraged loans, were perhaps not reflecting the true credit risk. "Covenant Lite" deals, where the legal protections for investors are weaker, worry us (see here for my earlier blog article).
Without going into too much detail, S&P have made changes to their criteria for rating CLOs, including assuming a 10% lower recovery rate for leveraged loans that come with the "covenant lite" tag. While this is an improvement, we remain cautious over covenant lite deals – the great attraction of the leveraged loan asset class to us has always been its seniority and high recovery rates in event of default, and anything that jepodises this makes us nervous.
We’re hearing rumours that the new French government is about to announce a big rise in the VAT rate, perhaps by 5% (Germany hiked its VAT rate by 3% at the start of this year). This would add a full percent to French inflation. Short dated French inflation linked bonds have rallied relative to nominal bonds as a result. Apart from the impact on price inflation, higher consumption taxes will damage consumer spending. We have seen German retail sales growth turn negative so far this year – the French consumer has been slowly recovering since 2004 and tax hikes put this recovery at risk. We all remember the damage that a Japanese consumption tax hike did that their fragile economy a decade ago. It will be interesting to see just how robust the recent Eurozone strength really is, and also interesting to see how the French public and unions react to this, and other structural reforms from the new right wing government under Nicolas Sarkozy. Are we about to see economic reforms on the same scale as Thatcher’s in the 1980s? Talking of which, if you get the chance to see Andrew Marr’s History of Modern Britain on BBC Two, please watch it – it’s by far the best thing on telly (now The Apprentice has finished anyway). Tuesday’s episode focused on the Thatcher revolution, and the social upheaval that the UK went through – from the 3,000,000+ unemployment rates and industrial unrest at the start of the 80s through to our discovery of consumer credit and the yuppy a few years later. Do the French want to swap a large state and social cohesion, but low levels of growth and high unemployment for a more dynamic, Anglo-Saxon style economy, but one where "there is no such thing as society"? By the look of the election results the answer is "yes" – but as the UK showed, the transition period is exceptionally painful.
1. Technical analysis
You may well disapprove of the theory that lines drawn with a ruler and a pencil on a chart of bond yields can help predict the future, but like it or not, enough people in the bond market have been looking at the 5% level in 10 year US Treasuries to make it a big deal. This marked the support trend line of the bond bull market that had gone back to 1987. The market has broken through this level, opening the way for further significant falls (if you believe in this mumbo jumbo).
2. Convexity selling
Long dated fixed rate mortgages – although less popular now than they were a few years ago – are a big part of the US property market. These are then repackaged as Mortgage Backed Securities (MBS) and sold on to bond portfolios, with cashflows from homeowners (interest payments and capital repayments) flowing through to the bond investors. Unfortunately these bonds have "negative convexity". This means that they perform badly when yields rise, and badly when yields fall – you only outperform government bonds in relatively stable yield environments. Why? Well when yields fall, the homeowner can pay back the mortgage early and remortage at a lower rate. This means that the MBS owner gets repaid, and the duration of his portfolio falls in a rallying market, making him underperform. In a bear market, as we have now, nobody refinances their mortgages as the new rates are higher. This means that the prepayment rate assumed for the investors’ portfolios is too high, and they end up being longer duration than they wanted in a falling market. As a result many will sell bonds to reduce their duration back to the assumed level ("convexity hedging") and a vicious circle can follow.
Some well known bond houses and investment banks in the US have publically changed their formerly bullish views on the market. Both PIMCO and Merrill Lynch have reversed their expectations for Fed rate cuts in 2007. Additionally former Fed Chairman Greenspan has today talked about higher bond yields being likely – a couple of months ago he was talking of the "possibility" of a US recession.
I talked yesterday about the risk of Asian Central Bank selling of their US Treasury Bond holdings. Well the market’s also worried about Chinese inflation, which has just come in at a 27 month high, albeit at only 3.4%. What really scared markets was the food component, which is rising at over 8% pa (meat and eggs showing 25%+ hikes). With Chinese living standards rising at the same time as biofuel use is raising the costs of crops, is this the start of a global inflationary food trend?
5. The economy, stoopid
US retail sales were very strong today, and economists reckon that second quarter US GDP growth will be back on track after nearly a year of sub-trend growth. Whereas Fed rate cuts were expected earlier this year, the Eurodollar futures strip now prices in a good chance of a hike by the end of this year.
Tim Bond, head of Global Asset Allocation at Barclays Capital, wrote a well-timed piece panning bond markets in the FT on Thursday last week
. He argues that bond yields are much lower, and yield curves much flatter than would normally be expected given the current economic environment, and estimates that long dated bond yields are around 1% below equilibrium value. This has occurred because of a combination of foreign exchange reserve growth and regulatory changes that forced pension fund investors to purchase more long dated assets.
As a result of this demand/supply imbalance, bond yields are very low. Meanwhile equity earnings yields remain reasonably high, spurring companies to releverage. Finance directors with any sense have reacted to the market conditions by issuing debt very cheaply, and buying back their equity. Those that haven’t releveraged have found hungry private equity investors circling their firms. We’ve commented quite a bit about corporate releveraging in our blog (such as here).
Tim Bond believes that foreign exchange reserve growth is prompting global reserve managers to diversify away from low risk bonds and into higher risk assets, and suggests that China will redirect some $300-400bn away from bonds and into equities. Foreign exchange reserves certainly go some way to explaining why bond yields remain so low, but the projections for China appear a little aggressive. The US Treasury publishes this lengthy analysis of foreign ownership of US securities. It shows that overseas investors own more than half of the outstanding US government bond market, up sharply from 22% in 1989. China’s holdings of US Treasuries have risen very steadily from around $80bn at the beginning of 2002 up to $420bn at the end of March, which is second only to Japan’s $612bn. There is little sign of China’s build up of Treasuries slowing, never mind falling back down to 2002 levels, but I agree with the general conclusions of Tim’s article – bond yields have been depressed by significant and continuous Asian central bank buying, but if these foreign buyers stop turning up to the Treasury’s bond auctions this bear market might have further to run.
I see the Chinese buying of US bonds as a form of vendor financing. China produces goods, but doesn’t (yet) have the domestic demand to purchase them. The US consumer has massive demand for goods, but doesn’t have the means to pay for them. So the Chinese give the Americans cheap credit in order for them to keep buying, and keep the Asian factories in business. As long as the current global demand imbalances persist this should keep the US bond market stable. But what happens if Asian domestic demand grows to an extent that they don’t need to rely on the US consumer? Or if European domestic demand finally starts to recover, creating another big market for Asian goods? Finally what about the losses that the Asian central banks are suffering on their US bond portfolios? In this quarter alone so far the Treasury bond market is down 1.2%, so the Chinese will have suffered mark to market losses of $5bn, and the Japanese over $7bn. Might there be a mass running to the door?