My book of the year in 2015 was The Rise of the Robots by Martin Ford. I wasn’t alone in liking it; it was the FT McKinsey Business Book of the Year, and set the debate for a year of robotisation stories in financial markets. Last week we held a Bond Vigilantes x Technology conference here at M&G, with great speeches from Diane Coyle on Digitally Disruptive GDP (are we measuring growth or inflation “properly” in today’s online world?), our own Dr Wolfgang Bauer on advances in battery technology, solar and fission energy, and Martin on the robots. Tesla also brought along a couple of cars for us to play with – I mean examine the battery technology in.
If you haven’t read The Rise of the Robots yet, you must. In it Martin Ford shows how AI and advances in robotics are putting at threat huge numbers of jobs in both developed and developing markets. And whereas previous advances in machinery replaced mainly manual jobs, this next phase will also cause massive disruption to higher skilled workers, threatening both jobs and wages. The knock on impact will be a huge demand deficit – who will be able to afford to buy the goods that the robots make? In the book Martin suggests that the governments may have to expand the state safety net significantly to prevent societal disaster.
You can watch my brief interview with Martin below. And if you haven’t read the book, you can win a copy by entering our competition.
To win a copy of The Rise of the Robots, answer this simple question. Name these three robots.
The answers:
Robot 1: Metal Mickey
Robot 2: Optimus Prime
Robot 3: Number 5/Johnny Five
The winners of the competition are:
Simon Bird
Ian McCaig
Trevor Smith
Steven Smith
Graeme Wearden
Congratulations. Copies of Martin’s book will be sent to you shortly.
There’s no doubt that the oil industry has seen better days. Adding to present-day woes of price levels of $30-40 per barrel are questions about the long-term viability of the industry’s business model as a whole. Take for example the Rockefeller dynasty and Saudi Arabia, two names synonymous with gigantic fortunes built on oil. Well, the Rockefeller Family Fund just announced its intent to divest from Exxon Mobil, a direct descendant of John D. Rockefeller’s Standard Oil, and from other firms related to fossil fuels, stating that it made “little sense – financially or ethically – to continue holding investments in these companies”. Saudi Arabia made public its plans to launch a US$ 2 trillion investment fund, setting the course for the country’s post-oil future. Admittedly, it’s only anecdotal evidence but maybe the writing is indeed on the wall for the oil industry.
To be honest, as a chemist by training it has always puzzled me how fossil fuels have managed to acquire such a dominant position within the global energy landscape in the first place. They really aren’t such an obvious choice, when you think about it. At the core of it, burning fossil fuels is merely a long-winded and inefficient way of using nuclear energy (see chart below).
As a by-product of nuclear fusion processes in the sun, electromagnetic radiation (i.e., sunlight) is emitted. On earth, plants convert the energy contained in sunlight into chemical bonds by building up complex hydrocarbons that are metabolised (ie eaten) by animals and converted into further biomolecules. After plants and animals die, their organic matter is converted under certain circumstances over tens of millions of years into fossil fuels. In that sense, fossil fuels are renewable energy carriers, albeit running on an extremely long time-scale. We then dig up these fossil fuels, process them and eventually burn them in order to convert the energy stored in their chemical bonds into mechanical energy or heat. The whole process is hopelessly inefficient as energy is “lost” (not actually lost but partially transformed into rather useless energy forms, such as waste heat) at every single energy conversion step. The last step is particularly horrific as combustion engines have efficiencies well below 50%. And that’s not a problem that could be “engineered away” but a necessary consequence resulting directly from the laws of thermodynamics. Let’s stop there…
Oil has further severe disadvantages, for instance:
- Finite supply as the rate of consumption is so much higher than the rate of reproduction
- Environmental impact of extracting, transporting and burning oil (spillages, soil and ocean contamination, CO2 emissions, etc.)
- Complex infrastructure (pipelines, oil tankers, refineries, petrol stations, etc.) that is expensive to build and maintain
And there are opportunity costs to be considered. If we are willing to accept all the disadvantages of oil, shouldn’t we then at least try to make the best of it? Using the complex mixture of organic molecules as precursors in sophisticated polymer synthesis would be sensible from a chemist’s point of view. However, petrochemical feedstock only accounts for a small fraction (c. 2%) of products made from a barrel of U.S. crude oil (see chart below). More than 80% of the products (gasoline, diesel, heating oil and jet fuel) are simply burnt in combustion engines or furnaces, which, quite frankly, is pretty wasteful and savage.
But why are fossil fuels, and oil in particular, still so prevalent? Why are the vast majority of cars still propelled by internal combustion engines and not by electric engines? The key is energy storage, the one area where fossil fuels excel. This has profound practical implications, particularly for applications in transportation. Vehicles using oil-based fuels are relatively light. For any given range they need to carry around only a relatively small quantity of fuel. That’s the main bottleneck of “Electro Mobility” at the moment. One kilogram of electric batteries can only store a small fraction of the energy that is contained in one kilogram of gasoline, diesel or jet fuel. As long as batteries cannot be recharged while driving (still a long way off), users of electric vehicles either have to accept a smaller range or they have to carry lots of batteries, which increases weight and thus reduces efficiency.
Significant resources are currently committed to electric battery research to drive technological progress. As a consequence, batteries are catching up fast with fossil fuels (see Jim’s blog). Simultaneously, renewables, solar energy in particular, are becoming more and more cost-efficient. As soon as the energy storage gap is sufficiently small, we will reach a tipping point as there will no longer be any good reason to rely on fossil fuels. As with other large-scale technology disruptions in the past, the consequences will be significant (see chart below).
In the non-financial corporate bond space, the sectors most directly affected by the end of the fossil fuel age (energy, automotive, transportation and utilities) account for roughly a third of the U.S. investment grade (IG), nearly half of the European IG and around a quarter of the global high yield universes. There will also be ripple effects on other corporate sectors (e.g., chemicals), as well as on government bonds of petroleum exporting countries. Since energy costs are a meaningful part of price indices, there will be an impact on inflation break-even rates. And the list goes on. These developments won’t occur overnight, of course. But it is our job as long-term bond investors to think long and hard about this topic now and the opportunities and threats that go along with it.
Bond markets have reacted strongly to the 10th March announcement by the European Central Bank (ECB) of its new corporate sector purchase programme (CSPP). Credit spreads of euro-denominated investment grade (IG) corporate bonds have tightened by around 20 bps on average. Still, a lot of the CSPP’s particulars are anybody’s guess at this point. The publication of the account of the last monetary policy meeting yesterday hasn’t added much clarity. So far we only know that from the end of Q2 2016, the ECB will start buying IG EUR corporate bonds issued by non-bank corporations established in the euro area. The ECB has also stated that bonds eligible under the Eurosystem collateral framework would be a “starting point” for the eligible universe under the CSPP but that further rules and restrictions might apply.
There is a lot of uncertainty around the details, though. How much will they buy each month? Will the ECB be active both in the primary and the secondary market? Will there be any capital key allocation mechanism, like in the case of their sovereign bond purchase programme? What will be the maximum percentage of each eligible corporate bond issue that can be held by the ECB? Will the ECB become a forced seller if a bond held on its book is downgraded to sub-IG territory? All of these questions – and many more – are yet to be answered.
Applying a series of filter criteria, we have screened the corporate bond universe for potentially ECB eligible securities (see table below). Our analysis suggests there could be 971 bonds on the ECB’s radar, totalling around EUR 640 billion.
Some of our filter settings are pretty common-sense (e.g., euro-denomination, exclusion of banks, hybrids and (junior) subordinated instruments), others are entirely up for debate:
- Credit rating: We included all corporate bonds with an IG rating from at least one of the three main rating agencies (Moody’s, S&P and Fitch). This might be too generous as cross-over names / fallen angles with sub-IG composite ratings are included as long as their highest rating is BBB- or better. Or it might in fact be too strict since within its collateral framework the ECB also accepts credit ratings from DBRS as a fourth external agency.
- Country: The ECB announcement reads “non-bank corporations established in the euro area”. We tried to stick to the letter of the announcement and used “country of incorporation” as a filter criterion. This leads to an over-representation of the Netherlands as quite a few companies (e.g. BMW, DT) issue bonds from legal entities domiciled in the Netherlands. It also results in the inclusion of clearly non-Eurozone companies as long as the vehicle out of which bonds were issued had been incorporated within the Eurozone. It might be more useful to use “country of risk” as a filter setting (or as an additional filter). If any company, no matter where its headquarters, operations and main revenue generation are located, can simply set up a special purpose vehicle somewhere in the euro area to issue EUR denominated bonds, then in theory every IG non-bank corporation on the planet would be eligible.
- Sector: We know that banks will be excluded. But how about other financials? We have included bonds from insurance companies (but no T1s or T2s) and REITs into the eligible universe.
- Further criteria: We excluded smaller issue sizes (below EUR 200 million) and bonds maturing within one and a half years, as we wouldn’t expect the ECB to buy less liquid issues, or to want to be frequently reinvesting the proceeds from maturing bonds.
Keeping these major caveats in mind, we dissected our “best guess” ECB eligible bond universe (see chart below). The biggest beneficiaries, with particularly large amounts of potentially eligible bonds outstanding are EDF and Anheuser-Busch InBev, accounting for 3.7% and 3.6%, respectively, of the eligible universe. In terms of composite credit ratings, more than half of the universe consists of BBBs (51.1%), followed by single As (35.8%).
In terms of countries, French companies would be the biggest beneficiary (31.4%), as we had already predicted in 2014 (see Anjulie’s blog). The Netherlands (26.3%), benefitting from a large number of holding companies being domiciled there, and Germany (10.5%) follow in second and third place. Utilities (22.9%) are likely to be the dominant industry sector, ahead of consumer non-cyclicals (19.6%) and consumer cyclicals (12.5%). The EUR-denominated IG corporate bond space in general is relatively short in terms of duration compared to the USD IG space. Therefore, it is not surprising that c. half of our potentially eligible universe (48.5%) mature within 5 years.
So with a new buyer soon to be in the market, does this mean we should be hoovering up all the EUR credit we can get our hands on? Not necessarily. Whilst EUR credit does look good value relative to governments, spreads of EUR denominated corporate bonds, both investment and speculative grade, have been tightening since mid-February. The rally noticeably accelerated due to market euphoria around the ECB’s announcement. At this point a large portion of the expected benefits could be priced in. Valuations are arguably already stretched for certain issuers, when comparing underlying credit risk fundamentals and current spread levels.
Based on our bond screening, and assuming that the ECB can buy one third of every eligible corporate bond issue, the size of the accessible universe is “only” around EUR 210 billion. But total asset purchases will be EUR 80 billion per month, i.e., EUR 960 billion per year. When comparing these numbers, we believe that corporate bond purchases will likely be an incremental supplement to public securities purchases, perhaps to the tune of around EUR 5 billion per month. So it is entirely possible that the actual corporate bond quota, once it is communicated, could disappoint overly bullish market expectations.
Russian corporate bonds were one of the best performing asset classes last year, with a total return for the JPM CEMBI Russia index of +26%, despite Russia’s GDP dropping by -3.7% on the back of a hugely challenging economic backdrop and geopolitical headwinds. I recently spent a week in the cold of Moscow’s early spring, meeting banks and corporates to help me assess whether the economic sanctions and low oil prices would continue to, paradoxically, benefit bond investors in 2016. Here are some of the key takeaways.
The crisis is nothing like 1998 but the economy is struggling
Importantly, sanctions have had little impact in the short term compared to lower oil prices and the resulting depreciation of the Ruble, which has made imports more expensive, resulted in squeezed margins of businesses and lower living standards for millions of Russians. The locals I talked to said the current environment is nothing like the 1998 crisis though, when the country had no reserves and a large budget deficit. But most also recognise that the current crisis is more pernicious (as a slow, prolonged deterioration) and question where a rebound could come from in the near term should oil prices stay low and the sanctions remain in place.
At the micro level, talking to various local banks is always a good start to understand the real economy. Almost all the (public and private) financial institutions I met were concerned about asset quality deterioration, in particular for corporate loan books, with an expected rise in non-performing loans. Sectors such as construction, metals & mining, automotive, commercial real estate or transport have been hit hard. It’s not much better in retail lending and appetite for risk is small. The bright spots come from (i) exporters, which have been helped by the weaker Ruble as their costs are in local currency and their revenues are in US dollars, and (ii) the food agriculture business, which benefits from the Russian counter-sanctions on European food exports to the country.
Russian corporates are resilient and refinancing risk is low in the short term
My meetings with various non-financial bond issuers (oil & gas, metals & mining, telecom and transport) confirmed the above trend but gave me a different perspective. Management acknowledge the headwinds and most of them seem to be taking the necessary steps to optimise their business for this new environment. Military history is replete with examples of how incredibly resilient the Russian people are, and the corporates I met gave me the same impression.
With a primary market virtually closed for the past 18 months, the sanctions have pushed Russian corporate bond issuers to financial discipline by maintaining relatively low leverage and adequate cash levels in order to meet hard-currency debt maturities. The availability of the Ruble in the country’s financial system is another contributing factor explaining how well bond issuers have been able to weather the financing sanctions by the West. In the near term, and as can be seen in the above graph, the debt maturity schedule of Russian corporate issuers (including financials) looks manageable with the largest maturities due in 2017 being mainly bonds issued by state-owned banks.
Sanctions create scarcity value but valuations are very different from early 2015
From a bond supply perspective, the sanctions have been very supportive of bond returns in 2015 and continue to help the technical backdrop in 2016. While some issuers were able to issue bonds late last year and in 2016, the local market (RUB-denominated bank loans) is expanding and hard-currency bond issuance is expected to remain low this year. In terms of demand, I would expect the picture to be very different from early 2015, when spreads reached very attractive levels (around +1,000bps) on the back of external threats (geopolitical tensions, oil price, RUB) rather than imminent risk of defaults among Russian corporates. At about +520 bps, the Russian USD-denominated corporate bond market has now come back closer to fair value levels of spreads and total returns were 5.1% in the first quarter, which was justified in my view given the fundamental resilience of Russian issuers and relatively improved geopolitics. Looking forward and playing devil’s advocate, it’s questionable how sustainable this resilience can be in a prolonged period of crisis.
Credit differentiation will be critical in a period of low oil prices and sanctions
Assuming low oil prices and sanctions remain in place, corporate fundamentals should deteriorate more significantly throughout this year and in 2017. One of the main fundamental risks to corporate cash flows in the near future is Russia’s widening budget deficit.
First, low oil and gas prices have resulted in lower government revenues. And because oil & gas companies have actually been very resilient through the crisis due to their export-driven nature, the government is contemplating raising taxes on the sector.
Second, the sanctions have prevented Russia from tapping the bond market as much as needed to fill the budget gap. Hence, the government is considering increasing the dividend pay-out ratio of state companies to 50% from 25%. For oil & gas state companies, this could be another drag on cash flows. Indirectly, the private sector and in particular steel companies could also be affected if the stretch on corporate cash flows results in reduced public investment and lower underlying demand.
In light of this potential deterioration, corporates would have to draw on their cash balances and the refinancing of the >$20 billion of hard-currency corporate bonds maturing in 2018 could become more problematic for some issuers.
The bottom line is that credit differentiation will be critical. Unlike the 2015 macro call that took place in Russia, investors should be pickier in terms of bond selection as the long-term impacts are likely to result in credit profile divergence across the Russian corporate bond universe.
Finally, one may nevertheless not rule out another macro call this year if oil prices rebound materially (upside) or, bearing in mind that Russian politics have almost always caught investors by surprise, if geopolitical tensions with Ukraine revive (downside).
The world has seen negative interest rates before – Switzerland set interest rates below zero for foreigners in the 1970s in order to slow flows into the Franc. But today’s negative rate environment is far more widespread, with Switzerland, Denmark, Sweden, Japan, and the Eurozone all setting negative policy rates. Lots has been written about the intended transmission mechanisms of negative rates – cheaper direct borrowing costs for households and businesses leading to stronger economic activity, a portfolio rebalance effect in which investors sell low/negative yielding assets to buy riskier instruments, thus reducing funding costs for companies, and, controversially, reducing the attractiveness of an economy’s currency in a world in which competitive devaluation is seen as desirable. This blog however hopes to capture some of the other consequences of negative rates, some unintended, and some creating different problems for policymakers.
I’ve started this list with 10 observations, but I plan to update it periodically as we see how the Negative Rate World (NRW) develops over the months or years ahead. I’d like to ask for your help in spotting any interesting behavioural changes and historically important news stories. You can put them in the comments below, or send us links through Twitter (@bondvigilantes) or email. Sourced facts are the best facts, but I will also consider anecdata. Some links below may require subscriptions, most don’t.
- If you are an organisation that sits on large amounts of cash, negative rates are an unexpected cost. For example, insurance companies have been used to taking premia from customers and making a return on that invested cash. In a negative rate world, early payment of a premium is a drag on your returns. That’s true for all companies – late payers become your most valuable customers. It’s also true for the tax authorities. In Zug, the Swiss canton, the taxman has asked taxpayers to delay paying their bills for as long as possible. Zug calculates this will save the canton SFr2.5 million per year.
- Sales of safe deposit boxes are soaring. By removing your cash from a bank account and locking it away at home, or in a secure facility, you can guarantee that zero is the worse interest rate you will receive. You’ll also be immune from any bail-in of depositors if a banking sector gets into difficulty (Cyprus for example). Japanese hardware store Shimachu says that sales of safes are running at 2 ½ times what they were a year ago.
- It’s not just households that are stashing the cash in order to avoid paying to save. German insurance company Munich Re is experimenting with physical storage of banknotes. To start with it will store €10 million in notes.
- If storing physical cash disrupts the transmission mechanism, what can central banks do to make it difficult to do? Mario Draghi of the ECB has suggested that they might scrap the 500 euro note, which accounts for 30% of cash in circulation. He talked about the note being used as a store of value for organised crime, rather than as an inconvenience in the operation of monetary policy, but it’s clearly a factor.
- Financial authorities might also be preventing – either explicitly through regulation, or through the age old “raised eyebrows” method – the withdrawal of large sums of cash by banks, pension funds and insurers. In Switzerland a bank seems to have refused to allow a pension fund to remove a large sum of cash from its account in banknotes. The SNB has apparently asked banks to be “restrictive” with such payments, to the annoyance of the Swiss pension fund association.
- There’s a technology and administrative burden that comes with negative rates. Financial institutions have had to change computer systems, legal contracts have had to be altered (for example the ISDA swap agreements), bond documentation (floors on FRNs) redesigned.
- With 12 month Euribor turning negative in February 2016 for the first time ever, Spanish property owners – who generally have mortgage interest payments set on this measure, with no floors at zero – are seeing their outgoings collapse. Spanish Bankinter also offered mortgages linked to Swiss rates, and some customers are due payments from the bank each month (in practise the bank is reducing the principal owed rather than paying over the cash). The Spanish mortgage sector was often quoted as a reason the ECB would never go negative, as it would have a big P&L hit to the banks. A similar reason, related to the UK building society sector, has been used by the Bank of England to justify keeping rates at a relatively high 0.5%.
- A different scenario has had an impact on the Swiss banking sector. Perversely, mortgage rates in Switzerland offered by banks rose in the aftermath of rates turning negative. Retail banks there realised they would find it difficult to pass on the negative rates to depositors that they themselves were being charged on reserves by the SNB. In order to keep their profits at a similar level they therefore need to charge borrowers more, and lending rates rose. Swiss insurance companies also offer mortgages, and fund through longer dated bond issuance rather than deposits – thus they were able to pass on lower rates to investors, and have become relatively more competitive compared to the banks.
- As we’ve seen, the ability to remove banknotes from the official system can interfere with the operation of the monetary policy transmission mechanism, effectively flooring rates at zero for those who do it. This means that the topic of electronic money has become a live one. Modern economies are generally moving in this direction anyway: credit cards, mobile transactions, Paypal, e-banking have developed exponentially in recent years. In Sweden, cash now represents just 2% of the economy compared with 7.7% in the US and 10% in the Eurozone. In part, Sweden’s reduction in cash usage was driven by new rules aimed at reducing tax avoidance, although it is also an early adopter of new technologies. The reduction in cash in circulation means that there are fewer hiding places from negative rates. Could the authorities eliminate paper money entirely? It’s even something that the Bank of England’s Andy Haldane has discussed in the context of setting negative rates. I’d advise you never to discuss such a thing in public however, as it drives some people absolutely crazy.
- As mitigants to the unintended consequences of negative rates, most central banks have tried to minimise the damage that negative rates can do to banks’ profits by introducing tiered interest rates. Different levels of rates apply to different portions of banks’ reserves. In Japan’s case, reserves held before rates went negative would still earn 0.1% for example. Banks are generally incentivised not to convert reserves into banknotes as any such reduction is taken from the highest interest rate tier, rather than the most deeply negative.
What have we missed?
A few things that I’ve found interesting over the past week or so:
- I’m just back from a week’s holiday in France, and my news source whilst I was away was the hotel’s International New York Times. Terrible for English Championship football rumours, but lots about US politics and in particular the recent discussion about the Overton Window. Joseph Overton’s theory is that there is a limited range of policies acceptable to the voting public at any one time. To quote Wikipedia, “an idea’s political viability depends mainly on whether it falls within the window, rather than on politicians’ individual preferences”. One of the articles I read suggested that Trump’s success shows that the mainstream media has become weak at controlling the “limits of what is acceptable to say”. They no longer are aware of where the Overton Window is, and can’t act as “gatekeepers” of public opinion any more. Ideas around the limits of free trade (also coming from Sanders on the left), or the repatriation of illegal immigrants have perhaps moved into the Window without many of us noticing. It made me think – the Overton Window probably equally applies to monetary policy as to foreign or trade policy. Negative interest rates have already been normalised to many Europeans. What about helicopter money and debt monetisation? What about the electronicisation (electrification?) of money and the abolition of cash? Such ideas are still regarded as implausible by mainstream commentators, but in both academia (for example Modern Monetary Theory) and even within central banks (Bank of England’s Andy Haldane on negative rates, cash abolition) I think the Overton Window for monetary policy has shifted radically.
- The UK’s National Savings Certificates are an incredible free gift to those with the resources to buy them (generally higher rate taxpayers I’d imagine). The newspapers at the weekend told us sadly that the reinvestment rate for the National Savings Index Linked Savings Certificates has been cut to RPI (the generally higher measure of UK inflation, often 0.75% or more above the Bank of England’s targeted CPI) plus 0.01%, from RPI + 0.05%. 0.01% doesn’t sound very much I’ll admit. But RPI is running at 1.3% per year, and even at the lows of the oil price was still positive at 0.7%. And your return is tax free! To put this in perspective an index-linked gilt maturing in 2022, available to buy in the general bond market, pays me UK RPI minus 1.29%. You’d have to pay tax on that as an individual investor too. It’s unclear to me why the terms on these National Savings investments are so fantastically generous. I guess it’s the sticker shock of going below zero – and the attendant newspaper headlines that would attract.
- The Bank of England’s blog, Bank Underground, is a great read (as is the New York Fed’s blog, Liberty Street Economics). Last week it asked why sterling corporate bond issuance has collapsed. Issuance is half what it was in 2012, and sterling’s share of global corporate debt issuance is the lowest it has ever been. As a result the authors suggest that smaller UK companies without access to overseas bond markets could face higher borrowing costs. Why has sterling issuance fallen? They offer a few suggestions, including the recent ECB announcement that it would buy € denominated corporate debt, making that a “cheaper” currency to borrow in. The three main factors however might be mergers within the UK asset management industry making the investor base more concentrated; the reduced flow of cash into (credit heavy) annuities following pension reforms; and competition from euro issuance as that market finally got critical mass. The conclusion: better rated companies can borrow in euros or dollars and can swap the proceeds and coupon payments back to sterling, but lower rated companies cannot. The capital charges for the banks in entering into swaps with low rated entities are too high. So they may have to issue in “expensive” sterling, and the UK corporate bond market becomes a high yield focused one. Having said that, J P Morgan’s Daniel Lamy points out that there have been NO sterling high yield bonds at all issued this year.
- Opening my post on return from holiday I found that when a company tells you that something is “changing” it is always for the worse. It’s a euphemism for “becoming more expensive” or similar. Sky TV wrote to me to tell me that my “Sky subscription price is changing”, up £4.75 per month (about 7.5% versus CPI at +0.3%), and my credit card company tells me that the name of my credit card is changing from (bank name) Credit Card With Cashback, to (bank name) Credit Card. Grumble.
- Finally, Stefan Isaacs, deputy head of M&G’s Retail Fixed Income team amongst other things, is running the London Marathon. I know! If you’d like to sponsor him, you can find his fundraising page here. The aim is to beat the benchmark time of M&G’s Anthony Doyle in 2014 of 05:02:27 which he set wearing chainmail and pushing a cricket roller. Oh? No apparently that’s just how long he took running normally. Anyway, good luck Stefan.