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Letter from Toyko

I was in Tokyo with Richard Woolnough-san last week. We think the perma-bears on the Japanese economy are wrong, and that some of the official economic statistics are masking an underlying recovery. There are some significant structural changes happening in the economy: for example, participation in the labour force by younger women is increasing dramatically, and immigration is increasing (albeit from an extremely low level). Both of these things could mitigate the problems of the ageing population that we are all familar with. The privatisation of the Japanese Post Office last Monday also has big implications – particularly for the Japanese Government Bond (JGB) market. Most Japanese people have savings accounts at the Post Office, paying, on average, a measley 18 bps per year. Japan Post typically invests these deposits in JGBs. But money has started to flow away from postal deposits (towards mutual funds – hoorah!) and this long term bid for JGBs could fade away. This is still very much a domestically owned market.

Elsewhere, whilst Japan has slipped back into deflation this year, we see this as a temporary trend. In particular there is a lot of criticism about the statistical methods used by the authorities. The price of housing and rents (a quarter of the CPI) is referenced on increasingly rare wooden homes, rather than the condo blocks where most people live. A regulated rebalancing of mobile phone bills away from handset subsidies towards lower monthly tarrifs will also have a massive deflationary impact in months to come, even though the net cost to consumers is likely to be a wash. And we learnt that the inflation stats haven’t coped well with the grocers reducing portion sizes (e.g. on pot noodle meals) whilst keeping prices unchanged (which should show up as inflation, but doesn’t). Positive inflation should be back in 2008 – another reason to underweight JGBs, although we think the nacent index-linked market looks to have value.

What could derail a Japanese recovery? Well 40% of Japanese GDP by value added is from the auto sector, and another 40% from electronics. Both of these sectors are big exporters, and a recession in the US would likely see Japanese growth slow back to below trend. The other risk is political – the radicals (economically liberal, global facing) appear to have been defeated and there is a risk of a return to "big government" and pork barrel politics (pointless state funded road building projects to appease regional interests). Further rises in the oil price would also be bad news for a nation which doesn’t have any of it – although it is somewhat protected by having 50% of domestic power generated from nuclear.

Finally, no trip to Japan would be complete without a gadget update. The next generation of TV screens are organic, and just 3 millimetres thin (and the picture quality is amazing); electronic purses have taken off dramatically for smaller purchases (Japan Rail runs one of the most popular schemes – you simply touch a pre-loaded card on a scanner to pay – no PINs or signatures); and Sony’s latest, er, thing, is called the Rolly, and it appeared to be a combination of dancing robot, lightshow and stereo speaker. Yours for 40,000 Yen (about £175).


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High 'real' interest rates will slow the UK economy

When the Bank of England meets every month, market commentators always focus on the nominal interest rate. But what many people fail to realise is that it’s not the nominal interest rate that matters, it’s the real interest rate (ie nominal interest rates minus the inflation rate). If nominal interest rates rise from 5% to 6%, but inflation jumps from 2% to 4%, then real interest rates have actually fallen. Consumers will react by borrowing more, not less.

I was bearish on UK bonds through 2006 and the first half of 2007. Even though the Bank of England has steadily increased nominal interest rates from a low of 3.5% in 2003, real interest rates were at the same level in 2006 (about 2%). In reality, monetary policy at the beginning of this year was just as expansionary as in 2003, but four years ago the Bank of England was trying to avert recession and was worried about deflation. The Bank of England needed to raise rates this year, and it was little surprise that it has done so.

Since May this year, however, real interest rates have climbed rapidly higher. Even though the Bank of England has only raised nominal interest rates by 0.25% since May, the drop in inflation has meant that real interest rates have jumped by 1% (as shown by the yellow line on the graph). If you measure real interest rates using 3 month LIBOR, which is the rate at which banks lend to eachother and is therefore the rate that matters most to the man on the street, then real interest rates have jumped by 1.2% (as shown by the green line).

In reality, therefore, there has been a dramatic tightening of monetary policy over the past few months. High real interest rates will serve to reduce consumer borrowing, cut corporate investment, slow the housing market, and slow the economy. There is currently no need for the Bank of England to raise interest rates, and the next movement is likely to be downwards. The timing depends on how quickly and to what extent US woes afflict the UK, and how the UK housing market pans out (see my previous blog comment)


Head Scratching Stuff

The dichotomy in asset markets has many, myself included, scratching their heads. Whilst the last four months have seen falls in the European and US high yield bond markets of approximately 1.3% and 2.9% respectively, equity markets have continued their upward trend. In fact, over the same time period the DAX has returned circa 0.8%, the S&P 0.9%, the DOW 3% and the MSCI Emerging Markets Index a whopping 20%. All are at, or near, their all time highs.

It would seem unlikely that both markets can ultimately be proven right. Whilst the equity market is no doubt aware that there are real pitfalls ahead, it appears supremely confident that central banks will be willing and able to reinflate their economies. I’m not so sure.

As an aside I spent a few days in the US last week trying to gauge the tone in the US bond market. The mood it must be said was somewhat mixed. Some argued that what we are seeing is more a mid cycle slowdown and were hesitant to talk too much about the dreaded ‘R’ word. Readers of this blog will be acutely aware of our bearish thoughts and I must admit the bulls failed to convince me otherwise.

Since Jim’s teleconference (see here) the asset backed and interbank markets have so far failed to normalise and US housing data has continued to come in below consensus (August pending home sales fell -6.5% yesterday). I fail to see how this withdrawal of liquidity and continued poor housing data won’t have wider implications for the US economy.

Finally the technical picture continues to look unappealing – several hundred billion dollars worth of pre-committed leveraged loans have yet to be sold, there is a risk of various structured vehicles having to unwind, and new issuers need to come to market.


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Is the UK housing market on the brink?

The housing market is the transmission mechanism between Bank of England base rates and the UK consumer. The B of E cuts interest rates to encourage borrowing, which causes house prices to rise and homeowners’ pockets to swell. Higher interest rates slow the economy by restricting borrowing and suppressing the housing market. The state of the UK housing market is therefore one of the most important determinants of UK interest rates.

We have had another look at some of our favourite housing market charts, and while these suggest that the UK housing market is still fairly rosy, I believe that we are at a critical point.

The first two graphs below examine whether the UK housing market is overvalued. Graphs three and four look at two leading indicators that have proven to be very reliable at predicting the strength of the housing market half a year into the future.

1. UK house prices look expensive on a P/E measure

The housing market chart that people are most familiar with shows the average UK house price divided by average earnings, which is effectively a P/E ratio. There is no question that under this measure, UK house prices look the most expensive they’ve ever been. But is this an accurate measure of affordability? I believe it’s more important to look at how much Joe Public is spending on mortgage payments as a proportion of income, as that’s what determines whether people can afford to buy a house or not.

2. Mortgage payments still a relatively small portion of average earnings
The mortgage burden isn’t that great at the moment. As at the end of June, mortgage payments formed 16.6% of average income (quarterly data). Monthly figures for the end of July have mortgage payments at 16.9%, the highest level since Q3 1992, but still not much above the long term average of 15.4% (figures go back to 1974). It’s easy to see what caused the last UK housing market crash – UK interest rates were increased to 15% in October 1989, and as a result, mortgage payments had soared to 26.7% of average income by Q2 1990.

3. Mortgage approvals suggest demand for houses will remain strong
Lead indicators suggest that UK house prices will remain buoyant over at least the next half year. This chart shows the number of mortgage approvals taken out by individuals each month. The rationale for looking at mortgage approvals is that people who seek to take out a mortgage are almost certainly going to buy a house in the next few months. The lines have diverged a little since over the past 2-3 years, and we therefore look more at the direction of mortgage approvals rather than the absolute number in order to predict changes in UK house prices. Yesterday it was announced that the number of mortgage approvals fell to 109,000 in August (a four month low), but the drop was only slight.

4. Supply of houses is failing to meet demand
The RICS sales/stocks ratio is a very accurate indicator of future house price movements, as it encompasses both the demand and supply of houses. It is a measure of the number of sales that estate agents have made over a rolling 3 month period, divided by the total number of houses that estate agents are advertising for sale. So a high ratio indicates that a lot of houses that come onto the market are being sold straight away (demand exceeds supply), while a low ratio indicates there is a big overhang of houses on the market (excess supply). When the ratio is high, house prices have traditionally risen, and when the ratio is low, house prices have traditionally fallen. At the moment this indicator also suggests the housing market will be fairly buoyant going into 2008, although the rate of growth is likely to slow a little.

All in all, therefore, the available data suggests that there is little danger of collapse in the short term, but the story from the middle of next year could be very different.

The fallout from the credit crunch, the drying up of money markets and the Northern Rock debacle caused 3-month LIBOR (the rate that banks lend to eachother) to rise to 6.9% at the beginning of September. This rate has since fallen back to 6.3%, but it’s still way above the 5.75% target rate set by the B of E. In reality therefore, banks have experienced a sudden jump in interest rates, and this will inevitably be passed onto the consumer in the form of higher mortgage rates.

Just how much mortgage rates will jump remains to be seen, but if there is a sudden move, this should be picked up in the two lead indicators mentioned above. A rise in mortgage rates will result in the number of mortgage approvals falling sharply, and the RICS sales/stocks ratio would start to decline. Any sign of this occurring will result in me taking a much more bearish view on the UK housing market.


Beware of falling rocks

The Bank of England’s controversial decision to bail out Northern Rock depositors, which was probably necessary to prevent a UK banking sector collapse, has done very little to halt the slide in Northern Rock’s equity price and for good reason. The Bank of England has been clear that its rescue is only a temporary measure, and Northern Rock’s potential to write new business and take deposits is therefore very limited, meaning that Northern Rock’s business model is no longer valid.


New Greenspan interview – well worth reading

Greenspan’s interview in today’s Daily Telegraph can be read here. It’s pretty bearish on the problems in the financial markets (and he thinks the problems will be greater in the UK than in the US, thanks to the number of variable rate loans), and also on the prospects for long term inflation, which could stabilise around 5%. Putting aside the issue of who created many of the problems in the first place, and we’ve pointed the finger in his direction several times before on these pages, he could well be right on both counts. Ambrose Evans-Pritchard, in an adjacent column to this interview in the print edition of today’s Telegraph, does an excellent job of dismantling the Greenspan myth. He quotes from Greenspan’s 1966 paper Gold and Economic Freedom: "The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late: by 1929 the speculative imbalances had become overwhelming."

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"The Bank of England is a paper tiger" over Northern Rock – former MPC member Willem Buiter

Former MPC member Willem Buiter has laid into the bail out of Northern Rock by the Bank of England, just a couple of days after it talked tough about the importance of not supporting lenders who made risky decisions.

“Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us.”

You can read his full (lengthy and technical) comments here on his blog. Thanks to Citywire for initially highlighting them.


86.4% of statistics are made up on the spot

I am told that 75% of City traders hadn’t even started in the world of work at the time of the LTCM crisis (less than ten years ago in 1998). I don’t know if this is true or not, but it does put this (real, and not said ironically) quote from the senior swaps trader at a top 5 investment bank into perspective:

"In the 3 1/2 years I’ve been trading these markets, I’ve never seen it so bad".

Ho hum. Elsewhere, it appears the US mortgage market is not completely closed for business, and a few other lenders could probably take some marketing lessons from Ric Flair Finance.


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