After last month’s 3.1% print for UK CPI
caused Mervyn King to write a letter to the Chancellor, there was a bit of relief today as it fell back to 2.8%, in line with the market’s forecasts. This is still higher than the Bank will be comfortable with, and inflation has now been above the 2% target level for a year. The "old" RPI number also fell back, from 4.8% in March to 4.5% in April. Food and non-alcoholic drinks prices remained strong, as did clothing costs. We’ve talked about this before, but it’s worth mentioning that milk prices are very strong at the moment
– this is partly due to weak prices and discounting a year ago (this factor should persist until September), but in the medium term we have wider concerns about upwards pressure on agricultural produce. The high cost of oil makes biofuels more viable (especially as there are big subsidies to farmers to produce ethanol), which in turn makes corn prices rise for other uses (food for both humans and cattle feed), and also means that farmers are likely to turn land used by animals over to grain production – making the price of beef and milk rise too. Elsewhere, and more positively, the electricity price cuts are starting to feed through, and these reduced the CPI number by 0.2%.
Short dated gilts performed well this morning (yields down by 5 bps) , but the market still anticipates that we will get another rate hike in the next few months. Whilst Richard Woolnough (our corporate bond fund manager) thinks this is both inevitable and desirable, I’m a little more cautious. Wage settlements have continued to be subdued (and are below inflation, so real incomes look like they will fall for a second year), and the housing market (outside London at least) appears to be cooling down. Finally, we have had 3 rate hikes in the last year, and the full impact has yet to be felt (monetary policy typically acts with a lag of up to a year), and with a large volume of expiring fixed rate mortgage deals having to be refinanced at higher levels, I fear that the UK consumer is only just starting to feel the pain. So I’m left worrying about both inflation and growth – not a nice place to be.
Last week it was announced that the number of new UK mortgage approvals fell to 113k, resulting in much media speculation that the UK housing market is in danger of collapsing. I strongly disagree with this view and expect the UK housing market to remain buoyant over at least the next half year.
The image here (click to enlarge) shows the close correlation between mortgage approvals and UK house price growth. There is a lag of seven months between mortgage approvals and the rate of house price changes, so I’ve moved the mortgage approvals data forward by seven months so you can predict where house prices will be in seven months time. While mortgage approvals have fallen slightly, a level of 113k has historically corresponded to annual house price growth of over 15% seven months later.
Our bullish view on the UK housing market is enforced by this image (click to enlarge), which shows the RICS sales/stock ratio against UK house price changes. The sales/stock ratio is measured over a rolling three months and shows the number of estate agent sales divided by the number of unsold houses that estate agents have on their books. The sales/stock ratio is a measure of both demand and supply (mortgage approvals is only a demand measure), and the ratio is an even better predictor of UK house prices. Crucially, the sales/stock ratio is still rising and the current level suggests that annual UK house price growth will move from around 10% now to at least 15% in six months.
Looking forward, the key question is whether the slight fall in mortgage approvals is the beginning of a downward trend as in 2005 (when a sustained drop in mortgage approvals data very accurately predicted the sharp slowdown in the housing market and prompted the Bank of England to cut rates), or whether the recent fall in mortgage approvals is just a blip along the same lines as the beginning of 2006 (when mortgage approvals dropped from 119k to 107k but then rebounded). Based on historical correlations, mortgage approvals data below about 100k and sales/stocks of about 0.35 indicate that the housing market is slowing, but at the moment there is no evidence of this happening.
Indeed, UK house price growth is, if anything, accelerating. The London property market is extremely hot – figures from the Department of Communities and Local Government show that London prices rose 16.7% in the year to the end of February. Traditionally, London is at the epicentre of the UK housing market, and price gains (or losses) in London gradually ripple outwards. The only way to slow the housing market is hike rates.
The pollsters reckon that the Scottish National Party will become the single biggest party in Scotland following the elections later this week. This has understandably led to thoughts that a subsequent referendum could result in a majority in favour of leaving the 300 year union between England and Scotland, and have Scotland becoming an independent state within the EU. This led me to think that the billions of pounds of UK government gilts we own in our portfolios might end up being something very different by the time that they mature. As in any divorce, a breakup of the UK will lead to some redistribution of assets and liabilities (I remember the Czech and Slovak governments arguing over who got the tastiest embassies after their separation). Scotland accounts for around 9% of the UK population, and slightly less as a share of GDP, so would 9% of my gilt portfolio turn into Scottish Government Bonds overnight? And would Scotland adopt the Euro, in which case the yield on those Scottish bonds might fall from over 5% (UK 10 year yields) to 4.3% (EU 10 year yields), or would they create their own Scottish Pound, in which case you might guess that yields would rise on account of newness and uncertainty. On a stand alone basis would the Scottish economy be AAA rated like the UK? Would Scottish ratings be helped by oil revenues? Or would they suffer to reflect a mediocre GDP record and static population growth? I don’t know the answers, but I’ll want to as the prospect of independence grows. In the meantime, William Hill is offering 101 to 1 on Scottish independence by May 2012, which might be worth a very small wager. 11 to 1 by 2057 sounds a much better proposition, although 50 years worth of inflation and counterparty risk probably erode the attractiveness of the bet.
Provisional figures just out show that the US economy grew at an annualised rate of 1.3% in Q1, the slowest pace in four years, as construction fell at an annual rate of 17%. Q1 GDP was way below expectations, which had been for an annualised growth rate of 1.8%.
At the same time it was announced that the Federal Reserve’s preferred measure of inflation rose at an annual rate of 2.2%, up from 1.8% in Q4 2006. Ben Bernanke had previously said that inflation should ideally sit between 1% and 2%.
The effects of lower than expected growth coupled with higher than expected inflation meant that US Treasury yields have not moved much at the time of writing, since the effects of higher inflation do not make it any more likely that US interest rates will be cut (US markets are pricing in one rate cut by the end of 2007). Gilt yields have risen however, with the 5 year gilt yield now standing at 5.34%, the highest since March 2002.
Equity markets have fallen on the news, with the FTSE 100 dropping around 30 points. Corporate bonds have unsurprisingly weakened – the iTraxx Crossover Index has widened out about 6 basis points. The data from the US is bad news for credit risk and at least in terms of the UK bond market it is bad news for duration. My funds continue to be positioned short duration and with a focus on highly rated corporate bonds.
Moody’s monthly default report shows that the global speculative grade default rate fell to the lowest level since April 1997. March’s figure was 1.41%, down from 1.58% in February, which means that just 1.41% of all high yield issuers defaulted in the 12 months to the end of March. These incredibly low default statistics have been made possible by a combination of strong corporate earnings and relatively cheap available finance, which have also helped equity markets to rally (the Dow Jones broke through 13,000 for the first time on Tuesday).
However Moody’s predict that the global speculative default rate will rise fairly steadily from current levels up to 3.5% by March 2008. To be fair, their model’s credibility has fallen a little recently (it has been predicting a rise in defaults for about a year, while defaults have in fact fallen), but there is growing evidence elsewhere that spreads could widen soon, and a sharp correction is possible.
A fascinating note from Tim Bond, a very influential global strategist at Barclays Capital, paints precisely this picture. He argues that US companies are spending much more on buying back equity than on capital expenditure relative to in previous cycles (in Q4, US non-financials bought back the equivalent of 6% of total market capitalisation – by far the largest corporate buying spree on record). This expenditure is being financed by heavy issuance in the bond markets as companies take advantage of historically low yields and record tight spreads to raise finance cheaply, behaviour which has historically resulted in companies’ balance sheets being leveraged up and higher defaults. Companies are purchasing equities with borrowed money, and this cannot enhance earnings growth in the long run – while it can boost a company’s earnings growth in the short term, it does nothing for productivity.
Perhaps the scariest chart in Tim Bond’s note for investors heavily exposed to high yield is one that plots the global speculative grade default rate against the corporate sector’s borrowing (in relation to profits). There is a very strong relationship between the two variables – when corporate borrowing increases, the default rate follows suit about 18 months later. Corporate borrowing has shot up over the past 12 months, and this suggests that the default rate will rise sharply anytime from this summer onwards.
Higher defaults means wider spreads, and we retain a cautious positioned with regards to credit rating throughout the bond fund range at M&G.
There was further evidence of a slowdown in the US housing market yesterday, as sub-prime mortgage woes contributed to existing home sales falling 8.4% in March, the largest monthly decline since records began in 1999 and significantly below expectations of a 4.3% decline.
The US is not the only country with a wobbly housing market – Spanish house price inflation slowed to an annual rate of 7.1% in Q1, down from 9.1% in Q4 2006. The Bank of Spain has previously said that the Spanish housing market is 40% overvalued and fears of impending doom saw Spanish real estate stocks close as much as 25% lower yesterday. Concerns have spread to the Spanish banking sector, much of which is hugely levered and has considerable exposure to the real estate sector. Meanwhile, Denmark yesterday announced that house price inflation slowed to 1.2% in Q1, a fairly worrying slowdown considering that Denmark had the strongest house price inflation in Europe in both 2005 (20%) and 2006 (20%).
So far there is no evidence of a slowdown in the UK housing market, and the pressure is therefore on the Bank of England to raise rates. But if housing markets around the world continue to stall then global growth will inevitably follow, and this is something we are keeping a keen eye on.
You may have read today about the story of Alec Holden
, who ten years ago bet £100 on himself that he’d live to 100. William Hill offered him odds of 250-1, and he’s now celebrating a £25,000 win. It seems that old age hasn’t dimmed Mr Holden’s wit – the secret is apparently not to worry about anything, do as little work as possible and go on lots of holidays (and in recent months he’s been keeping watch for "any hooded groups from William Hill standing in the street").
Interestingly, William Hill has now slashed the odds on the same bet from 250/1 to 10/1, which is a good indicator of how life expectancy has changed over just one decade. When it comes to pension funds, companies have been far too slow at upwards revising life expectancy over the past few decades, and this has very serious consequences for the bond market. If workers’ ages are being systematically underestimated (and there is no doubt that they are – see Jim’s note here from last November), then companies are grossly underestimating their future pension fund liabilities. Pension fund deficits are therefore significantly bigger than current estimates suggest.
The only way to fund this shortfall is for pension funds to dramatically increase exposure to long dated assets. Long dated bonds and long dated inflation-linked bonds will be the biggest beneficiaries, and this is why I believe the UK yield curve will invert further.
You may be surprised to know that although short dated gilt yields have moved higher this week, 10 year gilt yields are in fact lower than when the market opened on Monday, despite Tuesday’s announcement of a horrific set of UK inflation numbers. Why is this?
The reason is that medium dated gilts are very closely correlated to global government bond yields. In fact the 10-year gilt yield is actually slightly closer correlated to the US government bond market than to the UK base rate. This week the US government bond market has performed reasonably well, with the 10 year US Treasury yield falling from 4.74% to 4.66% on the back of some slightly weaker than expected industrial production and jobless numbers.
Long dated gilts tend to be influenced more by pension fund demand, and 30 year gilts have a significantly lower correlation to both UK base rates and global government bond markets than medium dated gilts. 30-year gilts have enjoyed a mini-rally this week, with the benchmark 30-year gilt yield falling from 4.58% to 4.50%.
I have positioned my corporate bond funds to benefit from an inverting UK yield curve, and this has had a large positive impact on fund performance. My view of the last 18 months has been that UK interest rates will rise by more than the market has expected, global government bond yields will rise, and pension fund demand will support long dated bonds. Both the M&G Corporate Bond Fund and the M&G Strategic Corporate Bond Fund have consistently held:
- over 20% in floating rate notes, which benefit from rising interest rates
- a large underweight in short and medium dated bonds, which I have expected to perform poorly due to the background of rising global interest rates
- a market weight position in long dated bonds
At various stages in the past three years both the M&G Corporate Bond Fund and the M&G Strategic Corporate Bond Fund have had large overweights in long dated bonds, but in a long-only fund it’s not possible to have a large overweight in long dated bonds while still being short duration.
Within the M&G Optimal Income Fund, I am able to create a duration-neutral yield curve view by using derivatives, so it doesn’t matter what direction the market as a whole moves. This has been achieved by:
- selling interest rate futures to benefit from UK interest rates rising
- selling medium dated gilt futures to benefit from medium dated UK gilt yields rising
- buying long dated gilts to benefit from pension fund demand
This position has made money for the M&G Optimal Income Fund, despite the very difficult environment for government bonds over the past few months.
Just back from a day trip to Guernsey to visit clients (and now realising that I have a pocket full of non-legal tender coins to dispose of somehow – perhaps I should melt them down for their nickel content, given the 150% rally in that metal’s price over the last year). The Bank had just written its "Dear Gordon" letter after the 3.1% CPI/4.8% RPI
print, and inflation was the topic of the trip. In particular food prices came up time and time again, and they are worth a mention here. A big part of March’s upwards pressure came from food and non-alcoholic drinks, and milk in particular saw big price hikes, with the year on year rate looking huge thanks to aggressive price discounting a year ago. But other seasonal foods were also robust – and more widely people are becoming concerned about the recent rally in "soft" commodities.
It all comes down to the price of oil – in fact an old school friend who is a scientist in East Anglia for a sugar company says that the oil price is the first thing he looks at every day. This is because with petrol prices so high, it pays to convert food crops (corn, sugar beet etc) to ethanol
rather than see it end up in human or animal bellies. You can mix ethanol into petrol at a 5% level and it will work fine in your car, and in Brazil and Mexico many cars can run exclusively on the stuff. In addition large subsidies exist in the USA for ethanol production. So food producers and cattle farmers have to compete with the new ethanol producers and the price of grain has rocketed (causing riots in some poor areas of Latin America). This article from The Independent
is worth a read – it claims that using corn for ethanol production is misguided. It quotes an estimate that corn needs 30% more energy to produce (transport, fertiliser etc) that the fuel it produces, and that the grain needed to fill the tank of a car with ethanol would feed a human for a year. With food having roughly a 10% weighting in the inflation data continued price rises will have a significant impact. Also worth watching is the news of the Australian drought
. The government there is considering turning off the nation’s Murray-Darling basin irrigation system if it doesn’t rain soon. This is home to 55,000 farmers, and it would devastate the nation’s agriculture and send food prices higher. As an aside Prime Minister John Howard doesn’t believe in climate change and didn’t sign the Kyoto Agreement. The last year has been the driest there in 115 years.
For the first time since it was granted independence in 1997, the Bank of England’s Monetary Policy Committee has had to write an open letter to the Chancellor explaining why inflation has breached the government’s target. CPI inflation rose by 3.1%
year-on-year in March, more than 1% away from the 2% level. This was up from 2.8% in February. The drivers of this unexpected increase were food, non-alcoholic drinks, furniture and household goods. The RPI print was even higher, at 4.8%, thanks to rising house prices and mortgage interest payments which are not included in the CPI target. Fortunately the bulk of this year’s pay round – which tends to focus on RPI as a benchmark – has already gone though, at modest levels of increases. Nevertheless today’s numbers make further UK rate rises a certainty, and short dated gilts have sold off heavily this morning.
You can read Governor Mervyn King’s letter to the Chancellor here
, and Gordon Brown’s response here
. In brief, King states that inflation is higher than expected due to domestic energy price hikes, and a weather related global food price hike. However he states that this only explains around half of the problem and that money and credit growth are growing too strongly, and capacity issues are growing – these, to some extent, were within his remit to control, whereas the oil and food prices issues were external shocks. So is he admitting that he should have set tighter policy? No – he talks a lot about lags in policy setting, and about unforeseen volatility in the inflation numbers, as well as other temporary factors. In particular he expects household gas and electricity prices to fall back later this year, bringing inflation back within target. He says that the MPC will assess these inflation numbers at its May meeting (flagging a hike then). His final quote is probably quite reasonable – “when the MPC was set up in 1997, the chances of going almost ten years without an open letter beig triggered seemed negligible”. And the Bank has done a good job – but whereas inflation was consistently below the government’s target in the first half of the decade since independence (under Lord George), it has been stubbonly above it in more recent years.