Archive for October, 2014

Unbalanced Books

A while ago, we looked at the re-entry of Greece into the bond market and noted that it could mark the beginning of the end of the sovereign debt crisis. This week, new borrowing figures for the UK reminded us how big a millstone borrowing can be around a country’s neck

The government is borrowing more this fiscal year than it did last time. This was not supposed to happen: the economy is growing at a fair lick, unemployment is falling, welfare spending and public sector pay has been capped and so on. Reasons for the disappointing outcome include weak earnings growth, a slower-than-expected housing market and the lower oil price. (It is worth observing that real wage compression in particular has been a persistent affliction here in Britain, with inflation-adjusted wages at the whole economy level almost 10% lower today than they were five years ago.)

It is still likely that our debt to GDP will peak in the next three years or so and gradually climb down below 90% again (on a Maastricht basis). But even at this level, and with very low rates, interest payments for 2015-16 are forecast at £59bn – more than the education budget and about 8% of total government spending.

Of course Britain is not alone in this position. Look around the developed world and sovereign balance sheets are, as a rule, stretched. The increase in US debt to GDP, which saw it rise from 63% in 2007 to over 100% five years later, has levelled off, but in money terms the country owes the staggering sum of $17.9trn. For the American fiscal year just ended, interest on this debt amounted to just under $431bn. That is getting on for an eighth of the Federal budget.

Eurozone debt was 90.9% of GDP last year and it still likely to rise with growth in the economy as anaemic as it is. In Japan, debt to GDP stands at over 210%, and last year the Japanese were still running a massive budget deficit (over 9%). Controlling this has consequences, as we saw earlier in the year when the sales tax increase came in and shrank the economy.

Japan is an interesting case for another reason, however. It is one of the world’s largest holders of reserve assets, with some $1.2trn in the bank. Only China has more (almost $4trn). Another country with huge reserves relative to GDP is Saudi Arabia, with $735bn worth against total output last year of $745bn. Neither China nor Saudi have a material level of sovereign debt (22% and 12% of GDP respectively).

Some of the results of this situation are obvious. On the one hand, highly indebted nations will spend many years paying huge amounts of interest and struggling to grow their way to more manageable debt positions. On the other, those nations with little debt and healthy reserves will profit from the interest payments. China owns about $1.3trn of US government debt. If this reflected the market as a whole the average coupon would be around 2.5%, so Uncle Sam would be paying the Chinese $32.5bn per year.

More interesting, perhaps, are the less obvious effects. It might come as a surprise but Saudi Arabia increased production of oil by 50,000 barrels a day last month. The IMF estimates that the Kingdom requires a price of $83.60 per barrel to balance its budget, which is about where oil is at the moment, but with no debt to speak of and huge reserves the Saudis can manage a few years of low prices. After all, their oil is still very profitable to extract at this level. And if it hurts the competition in Russia, poses a distant threat to shale exploitation in the US and possibly destabilizes Iran, it seems unlikely that Saudi Arabia will mind very much.

The global debt position has changed the balance of economic power. In addition to political consequences there have been and inevitably will be consequences for markets, not all of which will be intuitive. Finally, it is rather gloomy to reflect that the UK is not among the stronger nations on any measure now: our high debt ratio is accompanied by lower reserve assets than Poland and less gold than Venezuela.

24/10/2014 at 5:40 pm

A Period Of Turbulence

What an interesting start we have had to the final quarter of 2014. The FTSE 100 index has skittered down to a 15-month low; the ten year German bund yield has plumbed record depths; crude oil has broken back down to 2010 prices; Greek bond yields peaked at over 9% today, up from 6.5% at the start of the week. A lot of people are worried, which is understandable. The key question is: do we understand why this has happened?

Whatever the true level of our understanding of the causes of recent volatility, we have not been short of explanations. There have been mutterings about growth from both the OECD and IMF in recent weeks. Fears persist over European deflation. Ebola remains uncontained in West Africa and has spread to more countries outside that region. The Islamic State has threatened to take a town on the Turkish border. Negotiations between Russia and the West over Ukraine remain tense and at a seeming stalemate. And what of China? And interest rates? And tapering?

Try to relate these concerns to market behaviour, however, and one hits something of a brick wall. We knew that the US contraction in Q1 and the eurozone slowdown in Q2 were worse than expected months ago. Japan’s policy-driven deceleration was widely expected, and planned for, well in advance. None of the changes to OECD and IMF forecasts reflect any new data seen over recent weeks. Connecting the very familiar global growth picture to the rather sharp repricing we have seen looks otiose.

Indeed, only yesterday, eurozone data showed annual inflation stable at a low 0.3%, while the index went up by 0.4% in September – the biggest monthly gain since March – after an 0.1% rise in August. Core inflation actually came in at an annual 0.8%, a touch higher than expected. And even if we grant bond markets perfect foresight, and believe that they are efficiently discounting the near-future reality of deflation in Europe, what did the ten year bund think it was doing at 0.7%? In the 2000s, when Japan actually went through protracted deflation, its ten year paper averaged 1.5% and closed above 1% for over 90% of that decade.

Then there is oil. Increased turmoil in the Middle East is not generally associated with soft oil prices – never mind spikes down. Now oil had a terrible third quarter this year, and at least some of this can be attributed to the strength of the dollar over the period. But the dollar is weaker this month, and the Brent crude future down by 9%.

Let’s look at the increase in concern over the spread of the Ebola virus. Ebola – a terrifying disease with a high mortality rate and no reliable cure – was first diagnosed in the USA on 30 September. The S&P 500 is 4% lower now than it was then. Perhaps it is fears over the illness which are to blame for market nerves. So why in London, where Ebola has yet to be found, has the market wound up falling 5%? And the Euro Stoxx 50 has fallen by 8%. In fact, though there is only a hair’s breadth in it, the main stock index in Spain – where the virus recently broke containment – has outperformed.

Some have been joining the dots between oil, growth, and emerging markets. China, of course, is always good for a scare story. And yet the Shanghai Composite has hardly budged and the yuan has continued its sluggish appreciation against the dollar. Even in Brazil, where growth concerns have been more readily supportable for some time, the stock market is up – by 3% at the time of writing. The real is unchanged against the dollar so far this month. Russia has seen some muted weakness (equity down 1.9%, rouble off 2.6%), and at least there is a clear causal link here between the oil price and one of the world’s most significant energy exporters. But as should be pretty clear by now, a lot of the explanation which has been offered for market behaviour lately has been specious.

What we have been seeing, then, is an uneven, unexplained and – if we are honest – not terribly remarkable funk. Between 7 July and 10 August 2011 the FTSE 100 fell by more than 17%. Now that’s volatility. The VIX index of volatility in the US was almost twice as high in those days as it is today.

Most importantly, the world economy was in a very different place back then. For much of the autumn of that year there was the very real chance that the bond market would bankrupt Italy. Should that have happened it would probably have crashed the global banking system and ushered in chaos across the world. Sentiment was universally weak: even in the US there was still talk of a “jobless recovery”.

Times have changed – thankfully – and the fundamentals have improved. Nor have they shown the slightest sign of measurable deterioration since mid-September! Tail risk is always with us, but specific black swan events represent perfectly unknowable outcomes. Portfolios cannot be built on that basis.

Sensible practitioners realise this and there has been some cautious sanity quietly issuing from bank research rooms over the last few days. It is never pleasant to have one’s flight jolted by turbulence for a prolonged period. We have, however, seen much worse than this in recent years – with good reason, too. This is not to say that the storm won’t worsen; of course it may. The only rational thing we can do is to weather it.

17/10/2014 at 5:26 pm

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