Archive for November, 2013

The Price Is Wrong

When it comes to UK energy supply, this seems to be one thing on which most of our politicians can agree. Ever since Ed Miliband made his commitment to freeze household energy bills two months ago the issue has remained topical to one degree or another. The government’s response to this challenge has been to fob it off with talk of competition, suggest that people wear jumpers, approach the industry with plans for its own price freeze (or possibly not), and most recently to trumpet a reduction in inflationary green levies to be announced in next week’s Autumn Statement.

For while the politics of this issue has been by turns fascinating, brazen and depressing, the inflationary impact of green policy is undeniable. This is quite difficult to quantify, however, since energy policy in the post-Climate Change Act (CCA) world is bogglingly complex. The current estimated impact on bills is of the order of 4%, attributed as follows:

  1. To the Renewables Obligation, which is set to rise sharply;
  2. To feed-in tariffs, currently co-existing with the Renewables Obligation but which are planned to supersede it, and to rise sharply both during and after the overlap period;
  3. To new boy the Carbon Price Floor, which operates by tacking a Carbon Price Support rate to the existing Climate Change Levy in certain cases, and is expected to rise sharply;
  4. To the rollout of “smart meters“, which will enable energy providers to charge more highly for consumption at times of peak demand, thus incentivizing people to change their ways (and as a byproduct, make it much easier to disconnect the supply to customers).

As well as noting that this low-seeming figure of 4% arose ultimately from zero – and is projected to rise sharply, in line with the requirements of the CCA – we should also note that there are costs which are not picked up by these quasi-transparent figures. For example, there might well be man hours associated with having to negotiate the various areas of 21st-century energy policy. And while some generating costs associated with the CCA are (probably, and for now) not figured on household bills – such as Carbon Capture and Storage – others, such as “biomass co-firing“, probably eventually sometimes are. Oh, and there are always new costs to consider of course, such as the subsidy for new nuclear.

Even what is measurable has already added billions to household costs, is forecast to add tens of billions more in coming decades, and might continue right up until we arrive at the CCA goal of an 80% carbon emissions reduction by 2050.

Back to data, markets, and cleaner information.

The Fuel & Light sub index of the RPI has been rising at an average rate of over 7% over the last five years. By October this component had gone up more over the previous twelve months than any of the other fifteen sub indices except Clothing & Footwear and Seasonal Food.

Some of this will be due to currency movements and some to energy prices. Using the near month ICE Natural Gas Future, the gas price is up by 7.7% over the past year – and some in government have pinned the blame for higher bills on this. Yet the sterling price of oil is 1.4% lower, and the Bloomberg composite price of ARA (Amsterdam, Rotterdam, Antwerp) Steam Coal in sterling has fallen by more than 13%. To attribute all of the inflation to the price of gas is therefore incorrect. (In fact it might also be pointed out in this context that shutting down coal generation on environmental grounds has not been helping.)

The government has a choice: to continue the commitment to inflate energy prices, however marginally, as a matter of policy; or to change policy in an attempt to ease concerns over inflation.

The situation is highly reminiscent of the VAT hikes of 2010 and 2011, which pushed real wages down and the UK household sector back into recession. There is no benefit to this. (Regular readers will know that the “inflation kills debt overhangs” thesis is addled and lazy.) Price inflation is inimical to growth and further impoverishes the poorest.

Which brings us to the Bank of England.

This blog has been scathing about the Bank’s record of forecasting inflation and keeping it contained. Now the Old Lady deserves to be partly exonerated when troublesome price behaviour comes about as a result of government rather than monetary intervention. But to salvage credibility as an inflation fighter – especially as growth returns to a world not used to problem prices – it would not do for her to stand completely idle.

Now for the really exciting news.

Only yesterday, the Governor of the Bank of England announced that he was taking action to rein in some of the recently observed surge in house prices. After all, while a lodestone of the British economy, higher house prices are themselves inflationary.

It is too early to say whether or not this makes Mark Carney more of a hawk than his immediate predecessor. But it does at least suggest a preparedness to take responsibility for price behaviour.

The Bank was careful to distance its manoeuvre from the government’s recently ignited Help to Buy mortgage guarantee scheme, but the coincidence is noteworthy – and has been widely noted, with several reports carrying Mr Carney’s correct assertion that he cannot “veto” the programme to stave off a housing bubble.

The Bank could, however, put up interest rates. And that might well have a dampening, if not deleterious effect on the housing market.

Early signs from the new Governor were not encouraging. Nor would it help those threatened by higher prices for energy – a price inelastic good if ever there was one – to add higher mortgage payments to their burden. But if our government has any intelligence, it will connect the Bank’s move on housing to the current debate on energy, and act accordingly.

With lower price pressure from the fiscal as well as monetary side the outlook for the UK’s economy could just get a little brighter.

29/11/2013 at 5:20 pm

Enigmatic Outlook

Winston Churchill famously observed of Russia in 1939 that it was “a riddle, wrapped in a mystery, inside an enigma”. To outside investors, much the same can be said of Japan. Can Abenomics, which in policy terms amounts to the same again (but this time with feeling), really change the dreary landscape of Japan’s lost decades for the better? Is this a question we can even answer yet?

Last week’s GDP data certainly confirmed the Japanese recovery. And just as interestingly, consensus forecast data compiled by Bloomberg a few days earlier showed that inflation expectations for next year ticked up to 2.4%. That would be the highest rate since 1997. Together with a consensus forecast of 1.6% for 2015 this would represent the strongest rate of sustained price growth since the opening years of the 1990s – finally, a real end to deflation.

There is the matter of an increase in sales taxes to account for, of course. Coming in next April this is expected to have a material impact on GDP over the first two quarters and on prices over the year as a whole. (The consumption tax is being increased as a nod to containing the national debt.) Even so, the change in sentiment since former Prime Minister Yoshihiko Noda dissolved parliament – almost exactly a year ago now – is significant.

There is arguably something of a contrast between expectations for prices and growth, however. While inflation is expected to return to a much happier level, GDP is only forecast to put on 1.6% next year and 1.2% in 2015. This is below the average for the five years leading up to the Great Recession, and well below the 4% level of growth seen in the boom years of the 1980s (when inflation averaged a not especially troubling 2.6%).

This is difficult to weave together into sense. On the one hand, Abenomics is expected to put an end to decades of deflation. On the other, the growth impact is expected to be disappointing. Given the history of the last 30 years it actually seems very bearish to expect Japanese inflation to take off without growth picking up at the same time. And yet with the stock market up 68% over the last 12 months investor sentiment in Tokyo has been anything but.

We should not read too much into this since economic forecasts are works of fiction. It is possible that Abenomics disappoints, as some expect, and what Japan actually gets is disappointing growth, a significant fall back in prices after the effect of the sales tax wears off and a return to conversations about the stratospheric level of gross government debt and the demographic death spiral. It is equally possible that Abenomics succeeds and that the Japanese economy motors back into life. After all, the country’s share of global GDP increased from 10.6% in 1979 to 18.1% in 1994, according to World Bank figures. Since then it has slipped back down to 8.3%: a shade lower than where it stood all the way back in 1972.

If the economic outlook is enigmatic though the prospect for Japanese asset prices is even more so. Inflation expectations have risen considerably, yet the ten-year government bond yields 0.6% – a little below where it stood a year ago, well under the 1.1% averaged since the beginning of the Great Recession and a million miles away from the 5.5% averaged over the late 1980s and early 1990s. There is the faster pace of central bank buying to take into account, at least for the moment; but with deflation killed off this should surely be expected to unwind. Unless deflation is not killed off after all …

On the equity side of things the picture is even less certain. Japanese equity market valuations are a law unto themselves. Bloomberg puts the p/e for the Nikkei 225 at 22x. While this beats every other major market, it is actually rather low for Tokyo. Even when bond yields and inflation were at more “normal” levels a quarter of a century ago, the market was still comfortable with multiples of 60x and higher for several years. A lot of this reflected hysterical optimism of course, but still. An earnings yield of 4.5% compares favourably with a risk free rate of 0.6% and inflation of 1.5-2%. Yet the fact that the earnings yield was quite often under 1% while bonds were at 5% suggests that the Japanese market pays these valuation niceties very little attention whatsoever. And who is to say a p/e of 60x will not become the new normal again, whatever happens to interest rates and inflation – if Abenomics should work, after all …

It is not really possible to write off the world’s third-largest economy as an investment destination. But if we think we should understand what we are investing in, Japan presents us with a particularly steep challenge. Despite the stock market optimism of the recent past, this has if anything got worse: everyone seems to be expecting Abenomics to have a bracing effect, but there is little clarity on how this will translate into outcomes. And there is no clarity at all on how the major asset classes should behave no matter what the eventual outcome is.

Stock pickers will find some names of interest and bond investors have little to lose by staying away. But it is very difficult indeed to put together a medium term case for either loving or loathing Japanese assets – and that, in itself, should augur caution.

18/11/2013 at 5:36 pm

Bond Watching

The latest Italian government bond auctions took place a few days ago. They were maxed out on low yields against high demand. In fact at a yield of 4.1% the Italian ten year is within sight of its spring low, and trading at around the levels seen before the Greek debacle began in 2010. Only two years ago it was looking as if the bond market might break Italy. How times change.

Looking further around the eurozone periphery there are some other points of note too. In Spain, which has not seen the same political upheaval as Italy has done of late, the ten year yield dipped below 4% on Friday – again, the lowest level since the Greek crisis started to unfold. In Greece itself, ten year paper currently yields 7.7%, down from 12% at the beginning of the year.

There is some truth in the argument that this reflects relief in the wake of the worst of the temper tantrum. It is also impossible to reject with complete certainty – as ever – the warnings that Europe could still collapse in a default hurricane, its pseudo-currency breaking into pieces round its feet, etc. Look around the rest of the global bond market, however, and it is possible we are seeing signs of something else.

Let’s start with the safe havens. Ten year US debt at 2.6% has come down from a taper tantrum high of 3%, but remains over 120bp above its 2012 low and is back within the range seen prior to the stock market crash of 2011. In Germany, by contrast, the market never sold off so much in the first place. The current ten year yield of 1.7% is about 30bp under where it got to in August but only 50bp off the bottom. It has quite some distance to go before reaching the range it saw in 2010.

In fact, if we look at the spread between the two markets over time, we see that it is normal for US yields to push much higher than German ones in times of recovery and to fall below them in periods of economic weakness and poor market sentiment. Growth and inflation are typically higher in the US, especially in the good times, and it is in the bad times that treasuries tend to have strongest investor appeal. In other words, the relationship between the two markets has been normalizing.

Turning to credit, the iTraxx Europe index stands at 84bp, meaning that on average an investment-grade 5-year corporate note should be expected to yield 84bp over LIBOR. In line with equity markets the Europe index has more than made up the ground lost in 2011, though it remains above the 50bp level seen at the end of 2007 and the 25-30bp area it was rooted to before the credit crunch earlier that year.

The equivalent high yield index, the iTraxx crossover, has followed equity more closely. Its spread of 345bp is in line with the end-’07 level and it is not far off the 200bp it averaged in the six months before the crunch. Not all high yield credit is equal, however. Emerging market sovereign spreads at about 330bp are still above the level seen prior to the 2011 crash and remain some distance away from 2007 territory.

Markets have certainly been nervous on occasion this year, and shown inconsistency in some respects. But what we have seen in bond world as elsewhere has been more generally a function of recovery and normalizing market conditions. It is arguably this “bigger picture” which allows us to judge whether episodes of volatility and incongruity present us with opportunities – and take advantage of them accordingly.

04/11/2013 at 5:57 pm


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