Archive for October, 2011
Europe was the main focus of investor attention this week. For once the latest proposals from the continent’s leaders received a warm reception from markets. The catastrophic failure of the eurozone is not being taken quite so much for granted.
Amid the avalanche of comment on the expansion of the EFSF, the 50% haircut on Greek debt, the financial strength of the zone’s banks and so on, it has been easy to lose sight of what went wrong for Greece, and what might still go wrong for Italy and the others. To assess the risk of full scale catastrophe it is necessary to look in one place only: the bond market.
It was not the banks alone, or the recession alone, or the burden of government debt alone that did for the Greeks. It was the cost of debt. This cannot be emphasised enough. The idea in some quarters that a debt-to-GDP ratio of 100%+ is automatically unsustainable is simply wrong – and not just wrong for giants like Japan, or the US, but for lowly-rated borrowers like Lebanon. Or like Greece, which enjoyed an interest rate on its ten year bonds only 0.27% above that of Germany as recently as 2007. Today that would mean paying 2.5%; at that rate, debt to GDP of 300% would be perfectly affordable.
It was the bond market that broke Greece. The last emergency summit in Europe, remember, was convened back in July to agree a revised bailout for Greece: the continued effective closure of debt markets to the country made the refinancing pathway envisaged under the terms of the original 2010 deal impossible.
At the same time, concerns about contagion through the banking system do not convince. Those expecting lightning to strike in the same place twice need to remind themselves of the scale of banking losses suffered on the back of the subprime crisis: Bloomberg gives a figure of over $2.1trn in writedowns worldwide, with over $1.6trn of capital needing to be raised. For Europe alone the losses were over $730bn. And that crisis took the world largely by surprise. The restructuring of Greek debt, as well as being a much smaller event, is hardly coming out of left field. It is frankly obtuse to expect a comparable degree of systemic dislocation to ensue.
But the bond market is a different matter.
Italy tapped the market for just under €8bn of 3-, 8- and 10-year money this morning, paying rates in the 5-6% range for the privilege. Demand for the new bonds was weak, and this has received a lot of attention, but a rate of 6% is far from disastrous. Italy has about €300bn of debt to refinance next year; at 6% this would cost €18bn in interest per year. If rates were to rise to 10%, however, the cost of servicing the debt would increase by €12bn, wiping out the whole benefit of the austerity budget agreed last month.
Still, the very fact that today’s auctions took place shows that the bond market is still open to Italy. The bear case that the expansion of the EFSF to a hypothetical €1trn is “too little, too late” rests its logic on the size of Spain and Italy’s financing requirements (between them they are likely to need to raise that amount between now and end-2013 or so). But so long as they are able to raise debt without any assistance from the EFSF this is not entirely relevant.
It was hugely significant during the recent crash that Italy’s bond yields did not rise to dangerous levels. If they continue to hold their ground – or better yet, if confidence improves and they fall – catastrophic contagion in the eurozone is unlikely to occur. Talk about the banks, and haircuts, and credit derivatives is all very interesting. But if you really want to know how afraid to feel, just keep an eye on those bonds.
A couple of months ago we had a look at US economic data and concluded that the market was taking an unequivocally pessimistic view of fundamentals that were actually mixed. To modify the famous characterisation, the glass appeared almost empty rather than half empty. And this week, two stories showed that the current market similarly sees the glass as half empty even when it’s almost full.
First, we had some data out from China on Tuesday. As expected, this showed that GDP growth on the year to the end of September had slowed, to 9.1% from 9.5% the previous quarter. That 9.1%, of course, is comfortably the highest growth rate of any major economy. It’s over twice what’s expected for the world as a whole. In dollar terms it will see China alone account for between a fifth and a quarter of global output growth this year.
At the same time, September data for Chinese industrial production and retail sales beat expectations by showing a modest acceleration over the previous month.
Needless to say, the market took the “GDP slowdown” very bearishly and ignored the rest of the data completely.
The second story, also out on Tuesday, concerned the micro rather than the macro picture: Apple announced its results for the fourth quarter, and earnings per share of $7.05 disappointed relative to expectations of $7.31. The disappointment attracted much comment and dragged on the wider market.
Less attention was paid to the fact that this level of earnings represented a 52% increase on the previous year. Nor did markets care that disappointing earnings have been the exception, not the rule, so far this season: as of yesterday, 117 members of the S&P 500 had reported earnings, and of those, 85 had beaten analysts’ estimates. Twelve month earnings growth for all 117 companies averaged +14.7%.
There are fundamental concerns out there. There will be bad news. But GDP growth of 9%, and earnings growth of 50%, isn’t it.
Commodities, like equities, were having a rough time until recently. The S&P GSCI price index closed last quarter down 12%, and remains 18% below its high of the year. Pretty much everywhere you looked – oil, gas, industrial metals, precious metals – prices were falling. One or two of the soft commodities, such as cotton and rice, went sideways or posted modest gains. But almost everything else was having a terrible time.
Almost everything – except freight.
The Baltic Dry Index is a measure which tracks the price of shipping dry bulk cargo. This means coal, cereals, ores: anything which isn’t oil, liquid gas or containers. The Baltic Exchange in London, which publishes the index, estimates that such cargo comprises two thirds of seaborne trade. In their view, dry freight prices are driven by six factors: fleet availability (supply), commodity demand, seasonality, fuel prices, threats to choke points like Suez or Panama, and sentiment among freight market participants.
The last point touches on the key distinguishing feature of this index. Unlike oil, or copper, or gold, the price (or future price) of shipping capacity is not traded on financial markets. So there are no flows of speculative or investment capital to distance the index from its fundamentals.
And in the third quarter of this year, the Baltic Dry Index rose by 34%. It has put on over 13% since. In other words, the cost of transporting the greater part of the world’s raw materials – as negotiated solely by those involved in the trade – went up, and did so dramatically. This suggests a robust upturn in global activity – something which would put the world economy miles away from what the bear consensus believes.
As ever, there are caveats. The Baltic Dry is a volatile beast: it fell from a high of over 11,000 in May 2008 to a low of 663 later that same year (it now stands at 2,155). It is subject to a high level of distortion from events such as last winter’s flooding in Australia which have a significant short-term impact on the demand for freight while saying nothing about the behaviour of the world economy. And claims for its predictive power as an economic indicator stand up better over some periods than others.
Even in context of the stronger-than-expected economic data we have occasionally seen of late, therefore, it would not be appropriate to over-exaggerate the importance of this one indicator. The plunge of the exchange traded commodities might yet be proved a more reliable guide to the future. But the distance of the Baltic Dry Index from financial market sentiment makes it worth watching, and its sustained, rather contrarian rise over the last couple of months is interesting to say the least.
So Mervyn King and his team at the Bank have decided to carry on easing. Widely misrepresented by the shorthand of “injecting money into the economy”, we have looked before at what “quantitative easing” really entails and at the negligible effect it has had.
The justification supplied this time for the £75bn programme is that the UK economy has been growing terribly slowly and that it faces a serious financial crisis. Which is all very interesting, but is supposed to be secondary to the Bank of England’s mandate to keep prices stable, defined at present as delivering annual UK CPI inflation of 2.0%.
The Bank still pays lip service to this notion in a quarterly document it puts out called the Inflation Report which updates readers on its view of the economy and justifies whatever its current monetary stance happens to be by reference to its forecast for inflation. In November 2008, for example, when the base rate was cut by 1.5% (to 3.0%) in the wake of the Lehmans collapse, CPI was predicted on the Bank’s model to reach a woeful 1.0% by Q4 2010 (p. 47). In actual fact inflation averaged 3.4% over that period.
Now the end of 2008 was a rare old time. The financial system as we’d come to know it had burned to the ground, the world economy was in recession and stock markets were stampeding towards zero. Sterling had fallen sharply too. The Bank was on its way to a base rate of 0.5% and £200bn worth of bond purchases. So let’s look at the Inflation Report forecast of August 2009, at a time when the economy was returning to growth, stock markets were rallying, the pound had found a new level and the MPC had had nine months in which to refine their projections. Even with the unprecedented monetary stimulus, they said, inflation was going to fall steadily during the course of 2010 to about 1% before rising to a gentle 1.5% by August 2011 (p. 42).
Of course what happened was that inflation doubled over the next six months, has risen steadily since and by this August (the last count) stood at 4.5%. This level of inflation has decimated real wages and contributed to a double dip recession in the household sector. And it has proved the assumptions underlying Britain’s emergency monetary measures woefully wrong.
The Bank, in other words, has shown itself damagingly incapable of forecasting UK inflation. Another Inflation Report is due out next month. It is bound to project the return of CPI inflation to 2% in two years’ time – or even an undershoot requiring more QE. And who knows? Perhaps in August of 2013 we will have economic contraction, price inflation of 8% and Mr King’s successor throwing wads of fifties off the roof of Threadneedle Street, wondering why it all keeps going wrong.