Author: admin@hottinger.co.uk

By Tim Sharp, Managing Director, Hottinger Investment Management

A brave new world outside of the EU failed to materialise in the UK as deep-seated differences continue to prevent a majority in Parliament signing up to the withdrawal agreement. Prime Minister May has managed to secure a flexible extension, but there is a real possibility that the UK will participate in European elections on May 23 and Nigel Farage has risen again in the form of the Brexit Party.

The UK economy was strong during the first quarter, arguably due to inventory building and contingency measures aimed at mitigating any fallout from the prospect of EU withdrawal, but now we fall back into the continued uncertainty that causes corporate long-term planning to be kept on hold. The labour market remains strong and basic wages are on the increase so inflation prospects keep the Bank of England on its toes, although it is difficult to see how the central bank can plan economic measures with Brexit uncertainty potentially affecting the wider economy until October. Export orders fell to their lowest level since August 2018, and the second-lowest reading since October 2014, as there are indications that international businesses are re-routing their supply chains away from the UK. The pushing back of the exit date from the EU means that UK equities will remain unloved, although we think that the upside potential remains for when certainty over the environment in the UK returns.

Continued strength in equities and risk assets generally in April can largely be accredited to promising data emanating from attempts by the Chinese to stimulate their economy once more and continuing optimism regarding the imminent signing of a US–China trade agreement. We have previously highlighted the close ties between Chinese and European trade, so it is probably unsurprising that European equities enjoyed the most positive reaction, gaining 4.5% over the month compared to 2.25% for the FTSE UK All-share and 3.9% for the S&P 500. Eurozone GDP data also suggested that Italy has emerged from recession while Spain, Germany and France also showed healthy improvement despite the gilets jaunes protests.

Q1 US GDP figures in April came in strongly at 3.2% (annualized), but they obscured signs of underlying weakness. Contributions to GDP from consumption and non-residential investment declined markedly last quarter, with a collapse in imports and a rise in inventories artificially raising the GDP figure. Core US inflation has fallen from its 2% target, which we think is largely due to low producer price inflation in China that has passed through to US imports. On the plus side, this gives cover to the Fed to maintain its dovish stance, lowering the chance that it delivers a surprise interest rate hike during the year.

The April FOMC meeting failed to deliver the rate cut that would have proved the existence of a “Powell Put” to investors, thereby disappointing equity markets. After earnings expectations were revised sharply lower during Q1 2019, there was a solid start to the Q1 earnings with many companies able to deliver positive surprises as part of the usual analyst manipulations. This has led to the return of the outperformance of cyclicals vs. defensives in April but we would argue that the long-term prospects for consumption and investment will see earnings struggle in the second half of the year.

The fact that the S&P 500 is up over 17% so far this year – standing at 2,923.73 – leaves it close to the 2019 predictions of many investment bank analysts (which ranged between 2,400 and 3,000) despite evidence that all major equity markets have seen significant outflows this year. As the rally continues, there is a risk of investors feeling as if they have missed out on potential gains and re-entering at higher levels, thereby creating a “melt-up” in equity markets. Although irrational behaviour by market participants can never be ruled out, this is classic end of cycle anxiety and, should it occur, our discomfort with current dynamics will deepen further.

In previous reports, we have expressed a level of scepticism over the perceived opportunity in emerging markets due to our uncertainty surrounding the expected weakness in the US dollar. Over the past week, many FX analysts have reversed their position on dollar weakness (at least in the short-term) in the face of a stubbornness in the currency to yield. Three of the main currencies (USD, EUR and GBP) have all maintained their position on a trade-weighted basis largely at the expense of the Chinese Yuan over the last month, which has seen emerging markets underperform in dollar terms. 

We have raised awareness in the past of the potential impact of the growing level of passive investment in financial markets and we further suggest that this growing investment phenomenon is masking the fundamentals of price discovery in equity markets. More investigation is needed, but there are early signs that this may be affecting the effectiveness of factor investing generally. Long-short funds have been subject to negative momentum and high correlation with long-only equity, meaning that their risk-adjusted returns have been substandard. In the last month, we have re-balanced away from these long-short funds to corporate bonds and more traditional fixed income products.

By Economic Strategist, Hottinger Investment Management

Is total debt in the UK too high? Have governments borrowed too much? Are the balance sheets of British businesses too stretched? Does debt even matter?

The UK is a rich country. The Office for National Statistics found that at the end of 2017 the UK’s total net worth – which measures the difference between the country’s assets and its liabilities, including debts – stood at £10.2 trillion, or £155,000 per person. So in principle, if all debtholders called in their funds, there are more than enough assets to cover their claims.

Of course, it is not as simple as this. For one thing, such an occurrence would likely cause a liquidity event that would heavily cut the realisable value of the assets. Given that a big share of the UK’s net worth is based on land and housing (see Figure 1), assets whose value is determined by financial conditions and liquidity, this is not such a trivial point.

However, it is important to make this point because the UK is generally not insolvent. Even the government’s sub-£2 trillion excess of debts over its assets seems more manageable in this context.

What of course matters for economic performance is the distribution of debt, and it is here where the UK’s addiction to credit remains problematic. Figure 2 shows how skewed the UK’s wealth distribution is, where the net wealth belonging to the bottom half of the population amounts to a little over £1 trillion, or just 9% of the national total. People in this segment will not only have lower incomes but also have debt balances that are a greater share of their disposable income compared to people in higher deciles. Negative equity is likely to be a bigger problem for some individuals in the first two or three deciles of the wealth distribution. In general, levels of debt and interest will therefore bear more heavily on the consumption of the bottom half of the population, on which the economy relies to remain buoyant.

Where debt becomes too high, consumption can suffer, reducing demand in the economy. Tax revenues can therefore fall, making it harder for the government to honour its commitments to bondholders and increasing the likelihood that it turns to inflationary policies to ease the burden.

So when we learn that, according to the Trade Union Congress, unsecured borrowings in the UK are at an all-time high of over £430bn, with the average credit card balance standing at over £15,000 per household (or 30% of median income), that should make us sit up and take notice. For comparison, on the eve of the financial crisis, the equivalent figure was £286bn. The Bank for International Settlements finds that the UK’s total household debt to GDP ratio has increased modestly from 85% during 2015 to 86.5% last month.

It is in this context that we should consider this striking chart in Figure 3. The graphic shows the sectoral balances in the UK economy. Each series illustrates the net lending or borrowing of one of four economic sectors – households, corporations, governments and the rest of the world. As the world is a closed economy, the balances should sum to zero. Or in other words, the net lenders fund the net borrowers.

The chart shows two things. The first is that the foreign sector continues to fund the UK economy. This is a natural consequence of the UK’s running of a current account deficit for much of the last three decades. Since the Great Recession, finance sourced from outside the UK was funding UK government deficits and corporate borrowing. As households and corporates deleveraged after the crash, they were also net lenders to government until 2012, after which companies started borrowing again.

However, since 2015 a new trend has emerged, in which either foreigners or sales of foreign assets by UK residents are now funding households. There has been a collapse in household saving rates as wages have struggled to outstrip inflation in the last decade and poor households have received lower transfers and benefits from government.

The basic point here is that if the country as a whole chooses to live beyond its means – which is what a persistent trade deficit implies – then someone has to either borrow from the outside world or rely on sales of foreign assets held by domestic individuals or organisations. If government is cutting spending and corporates reduce their appetite for funds, then – logically – to maintain the excess of UK consumption over production that a trade deficit implies, households must use funds sourced from overseas to meet their demands.

In 2017, analysts at the Bank of England found that sales of foreign assets by British residents (amounting to £650bn of sales between 2012 and 2016) and not foreign direct investment have done most of the legwork for funding current account deficits. At the time they said that the UK’s stock of foreign assets stood at a vast 420% of GDP, so this trend of asset drawdown to fund consumption could be sustained. We might not, therefore, be concerned about a sudden stop that could have resulted if the UK relied on flows of hot money instead.

However, while it is possible for households to continue to lever up through further growth in credit demand for some time, that does not mean it is advisable. It is highly abnormal for an economy’s household sector to be a net borrower; even in the boom years of the 2000s this was not the case. Households should be accumulating assets and funding corporates and governments. Instead they are building up debts, and the reason for this is that the bottom 50% of households are struggling to meet the costs of living based on their labour incomes.

This is the fundamental reason why, in our view, the Bank of England cannot afford to raise rates too steeply. The global consensus is moving to lower for longer, and if the BoE pushes against the tide by tightening policy, it could engineer a recession irrespective of what is going on with Brexit.

We shouldn’t, however, be alarmist. First, it is possible for the trend to reverse if wages continue to grow above inflation, the government stimulates through tax cuts or spending increases, or businesses borrow to invest in productivity-raising projects. Second, the household debt to GDP ratio has been higher according to the Bank for Independent Settlements. In 2010, it was as high as 96% of GDP at the height of the mortgage boom. As it stands, however, household debt is on a rising trend that in the past has shown itself to be unsustainable.

By Economic Strategist, Hottinger Investment Management

Developments in the last 18 months have given us the impression that we live in a China-centric manufacturing world but a US-dollar centric financial world.  Europe is uniquely exposed to Chinese economic activity to the extent that investing in European industrials has now in part become a bet on the macroeconomic performance of China. Meanwhile, Europe’s banks are uniquely sensitive to global liquidity and dollar funding conditions.

Since mid-2016, as Figure 1 shows, Eurozone manufacturing PMIs have tracked China’s export orders index – an indicator of internationally focused industrial activity – with a three-month lag.

One manifestation of this new China-Europe link is the collapse in car sales in China. Annual growth in sales of automobiles has been consistently above 5% since at least 2014, and there is strong demand from Chinese consumers for German and European cars. Since summer last year, however, sales growth turned strongly negative.

Since the mid-2000s, the German economy has hitched its wagon to China, growing its exports to the country by over $70bn per year. In contrast, the combined increase in exports to China from Italy, France and Spain is just $29bn, according to World Bank figures. It is no surprise, therefore, that Germany and its manufacturing sector have been the worst hit by China’s slowdown. But we should not forget other essential states in the euro area.

With a $2 trillion economy, a public debt-to-GDP ratio of 130% and an unemployment rate at 10%, Italy plays a pivotal role in the fortunes of the euro area. Italy fell into technical recession in Q1 2019 as GDP fell by 0.1% for the second consecutive quarter. Italy’s macroeconomic problem is that its core inflation rate is too low. Except for very brief periods, the rate has sat below 1% since 2014. This creates problems because it keeps borrowing costs in real terms too high.

Figure 3 shows the divergence in real interest rates between Germany and Italy, illustrating the perversity of the ECB’s single interest-rate policy, which when adjusted for inflation can yield counter-productive results. The ECB is somewhat condemned to this situation because if it eases policy too much to suit Italy, it generates too much inflation for places like Germany, and if it tightens too much for Germany, it can push countries like Italy into deeper recession. The ECB could simply buy more Italian bonds to influence only Italian rates, but there would be significant push-back from Germany and other northern European states which worry that such a move would amount to debt-sharing by the back door.

But the ECB’s problems extend beyond Italy and focus on the bank’s preference for too-low inflation across the bloc. Low core inflation suppresses consumer demand and begets expectations of lower inflation in the future, as consumers delay their purchases and keep demand weak. Similar to the Bank of Japan’s inadequate efforts to reflate Japan in the 1990s, the ECB may have lost its credibility to deliver higher prices by being too slow and reluctant to respond to economic slowdowns in the past. Inflation expectations are much lower in Europe than they are in the US.

Italy and indeed Germany need stimulus, but they are unlikely to get it from an ECB that – due partly to the influence of anti-inflationary Northern European states that themselves enjoy higher inflation and partly to the ECB’s own ideological biases – is reluctant to implement a more suitably aggressive stimulus.  Further, the ECB has a proclivity for targeting headline inflation, which is influenced by volatile energy and food prices, instead of core inflation, which remains stubbornly low across the euro area. It wouldn’t be surprising if the ECB were to use rising headline inflation (that is likely to come through from higher oil prices) to justify their preference to tighten monetary conditions.

That would be a disastrous move, but one that befits an organisation which did just this when headline inflation accelerated during 2011 but growth was slowing and trouble was brewing in banks and within sovereign debt markets.

Interest rates in the euro area are now negative, but as a result of poor monetary policy decisions and delayed stimulus from the ECB in the last decade, the central bank has managed to create an environment of slow growth and low inflation despite low rates. This limits how much ordinary stimulus the Bank can apply if conditions in Europe remain weak. Easier Fed policy may help European banks to get dollar financing on easier terms, but that is unlikely to be enough to arrest what appears to be a sharp decline in euro area manufacturing activity that persisted over the last six months.

We think that Europe could enjoy a modest short-term recovery if the stimulus in China and the United States is large enough to raise demand for European exports and liquidity in global financial markets. But for more sustainable results, there needs to be greater public spending, not just in Italy but in Germany too. With Italy’s debt burden already very high, stimulus in that country will require assistance from its European partners.

Europe suffers from deficient demand and has relied on export growth to plug it. That strategy appears to be unsustainable. Even if China recovers, it plans to reduce its reliance on European imports under the Made in China 2025 programme. Therefore, there needs to be a rethink of the euro area’s governing ideology of low inflation, fiscal restraint and restrictions on debt sharing. Euro states need to allow the ECB to be more radical, national treasury departments to be more active and low-debt states such as Germany to help out high-debt states such as Italy. That is easier said than done.

By Economic Strategist, Hottinger Investment Management

It couldn’t happen again, could it? The financial crisis continues to cast a long shadow when it comes to global growth, debt and monetary policy.

In an enlightening piece last week, John Authers, writing for Bloomberg, documents that the so-called decade of deleveraging that was supposed to follow the 2008 crisis didn’t really happen, both globally and in the US. While American banks have trimmed their balance sheets, European banks have not. American households have tried to cut back but with limited effect. The level of total debt from all sources (household, government and corporate) in China, France and a panoply of emerging market countries has grown substantially over the last decade.

But the biggest take away from the piece was Authers’s comments on the big rise in U.S. corporate leverage.

“Big companies have enjoyed big profits, fattened by widening margins as wages stagnate. That’s allowed them to sustain a huge debt load. But drilling down shows that credit quality, as viewed by ratings companies, has tumbled. According to S&P Global Ratings, the companies rated BBB+, BBB, or BBB- (the three lowest investment grades before they would hit “junk” status and face much higher interest payments) now outnumber all of the companies with some level of A-rated debt. It looks as though companies are “gaming” the ratings companies, borrowing as much as they can get away with.”

Meanwhile, smaller companies in the U.S. have also massively increased their leverage, blowing up their net debt to profits ratios. Figure 1 illustrates Authers’s point that debt is rising faster than can be justified by strong earnings.

But there is something going on in the corner of the corporate loans market that merits attention. The catalyst for the 2007/8 financial crisis was the over-extension of sub-prime US residential mortgages which were pooled, sliced and diced, then sold onto to investors and investment banks. These products were called Collateralised Debt Obligations (CDOs), a form of structured finance or asset-backed security. When the underlying cash flows failed – i.e. when poor US borrowers defaulted on their payments as interest rates increased – those products failed, exposing investors and banks to huge, system-corrupting losses.

That model of loan origination and restructuring has returned, but this time to the corporate loan space. Managers of so-called Collateral Loan Obligations (CLOs) buy a collection of leverage loans that banks have issued to companies that typically have a poor credit score, low interest coverage and significant existing amounts of debt and slice them into tranches according to their risk. Investors can then buy these tranches from a CLO manager on behalf of their clients according to their appetite for risk and expectations of return.

The CLO manager receives cash flows from the bundle of loans as corporates repay their debts. She then pays out these cash flows to the tranches according to a pecking order. Investors that hold the senior trance (AAA) get paid first and suffer losses last; in return for this privilege they get paid a lower rate of return. Riskier trances (BB or B) get paid last and suffer losses from default first; if they get paid at all, their returns tend to be greater. Figure 2 illustrates.

Leverage loans are typically used to fund mergers and acquisitions (M&A), and in an environment of inflated valuations – based on inflated expectations of future profits – this can create serious problems for investors in CLOs if the implied Goodwill from these M&A transactions does not materialise in future profit streams. On top of this, it has been reported that up to 80% of leverage loans that are bundled into these CLOs are ‘covenant-lite’. This means that lenders are likely to be far back in the queue for assets if the borrower defaults; in some cases, the leverage lender has found no recourse to the lender’s assets. It is a borrower’s market because there is huge demand from investors searching for yield in an era where cheap liquidity has suppressed asset returns.

Investors therefore like CLOs, despite their provenance, because they have proven to generate impressive returns. Rates of return are typically tied to LIBOR plus a spread reflecting the risk. Compared to US high yield, which returned just 1% in the year to November 2018 on a total return basis, leverage loans were pushing 4% and were one of the best performing asset classes overall.

Supposing corporate defaults stay low (they are currently below 3%), leverage loans will continue to do well, fuelling demand for what many might consider as junk. Perversely, as the returns are tied to LIBOR, the asset class does better in a rate-rising environment, where you tend to find corporate defaults rising. It could all end in tears. Figure 3 shows how, according to SIMFA, the dollar amount of outstanding CLOs in the U.S. is approaching levels that we saw a decade ago with CDOs and structured finance products for the American sub-prime mortgage market.

If it does all end in tears, is there a broader risk to the financial system a la 2008? It appears that SIFIs – systemically important financial institutions, or big banks – have largely avoided the CLO market, but we cannot preclude that they or their subsidiaries have been getting involved through shadow banking techniques that are off balance-sheet. Alternatively, banks may simply be arranging leverage loans or originating them with the intention to sell them on to CLO investors.

Given the persistently low profitability rates of SIFIs, the temptation for banks to get involved is there. However, the application of Basel III and tougher risk-weighting rules for capital requirements should act as a strong deterrent. It is therefore institutional investors that may be more likely to get burned, either due to direct exposure or indirect exposure through the money markets.

It might be fine when the default rate is 3%. That was arguably true in 2006 in the US mortgage market. Trouble may come when interest rates and wages rise, earnings fall and over-leveraged borrowers drown in a rising tide of debt.

By Hottinger Investment Management

The significant bounce-back seen so far in 2019 has been finding it difficult to make further headway in March. Investors are seemingly reducing their exposure to developed equities, particularly in Europe where economies are struggling, especially in manufacturing. European equities managed to gain 1.09% over the month as the news from China, both with regards to the trade deal with the US and government attempts to reflate the economy, became quite optimistic. Indeed, Shanghai Stock Exchange A shares gained a further 4.8% in March on top of February’s 13.9% to be 27.03% better on the year in US dollar terms.

The sense of a slowdown has also seen the beginnings of a rotation from growth stocks into defensive, quality stocks where utilities, healthcare, consumer staples and industrials are seeing more investor interest. However, with bond yields still contracting this will remain tentative.

The month really was more about the march lower in government bond yields as central banks started to pull back from quantitative tightening. The most significant about-face was performed by Fed Chairman Jay Powell, who – significantly – stated that he would be prepared to run US inflation above trend in light of having had a period in which it has run below trend. The Fed also announced that it would commit to no rate hikes this year and would start tapering its balance sheet run-off policy.  This led to the US Treasury curve inverting, which is believed by many to be an early indication of a forthcoming recession; it is one thing for stocks to rally on an easing in Fed policy but quite another to do so in the face of rising anxiety over weakening technicals. Unless meaningful stimulus materialises in the coming months, the positive performance in equity markets is less likely to last.

Most developed market blocs saw government bonds outperform equities with US Treasuries gaining 1.99% vs 1.79% S&P 500; UK Gilts +3.36% vs. +2.30% UK FTSE All Share and Eurozone government bonds +1.80% vs. Eurobloc equities +1.09%.

A yield curve inversion basically means that investors are prepared to borrow long term at a lower rate than in the short term, indicating that they expect interest rates and / or inflation to be lower in the future – as would be expected during a period of recession. However, it could be argued that the predictive qualities of the government bond yield curve have become blunted by the interference of central bank QE that confuses market-driven investor demand flows. Even so, historically, any recession that the curve can foresee tends to take up to 18 months to 2 years to unfold and, therefore, there is time for central banks and governments to continue to try to manage expectations.

Our view is that we are in a late-cycle environment, a phase during which economic growth is still positive but declining and which can last for up to two years. In this phase, bonds tend to outperform stocks, and as the cycle evolves a bias to long duration bonds is preferable. Historically, defensive stocks outperform cyclical with healthcare, utilities and food & beverages typically doing well, and banks & financial services, tech and industrials performing poorly. The question is whether this cycle is different. We have struggled to see that classic rotation into defensives while the Fed’s new cautious stance, coupled with the neutral outlook for the dollar, could arrest the march to recession and create benign conditions for the bull market’s old favourites: stocks in the tech, lifestyle and retail sectors and the emerging market regions.

March saw the sharpest decline in global government bond yields since the aftermath of the Brexit referendum in June 2016, and by March 29 we were supposed to have engineered the UK’s exit from the EU. As we all know, we enter April no closer to this day than we were in 2016 and the UK economy remains largely on hold. We have written a couple of pieces on the value inherent in UK equities particularly for foreign investors in the event of a softer Brexit, but presently the outcome is far from predictable with many investors preferring to stay sidelined. 10-year UK Gilt yields finished the month back below 1%, but government bonds will be driven by whatever policies the Bank of England implements in the aftermath of Brexit negotiations.

In summary, March ends with equities, corporate bonds and government bonds in positive territory year-to-date thanks to more dovish tones from central banks, positive soundbites from the China–US trade negotiations and stronger China PMIs pointing to a recovering economy. We believe that the state of the Chinese economy, US monetary policy and the outcome of Brexit negotiations remain key to the next chapter of the global economy.

By Economic Strategist, Hottinger Investment Management

Last Friday, an important part of the US yield curve inverted, causing a sell-off in stock markets. The interest rate that investors demand on 10-year U.S. Treasuries fell to as low as 2.416%, at the end of a week during which the Federal Reserve hugely revised its monetary policy stance in response to indicators pointing to a global slowdown. Continued weakness in European and Chinese manufacturing has combined with data showing a deceleration in US activity.

Yield curve inversion is where the yield on a bond with a shorter maturity is higher than that on a bond with a longer maturity. History suggests that yield curve inversion can predict future recessions as investors bet on lower future interest rates, but those recessions have taken time to manifest. Figure 1 shows the difference in yield between a generic 10-year U.S. Treasury and a 2-year Treasury bond and a 3-month Treasury bill respectively since 1983. The last three occasions on which the yield curve inverted were early-1989, early-2000 and mid-2006; the last three recessions started in July 1990, March 2001 and December 2007.

This week, with markets pricing in rate cuts for some months, the Federal Reserve blinked and announced that it would commit to making no rate hikes this year and would start tapering its balance sheet run-off policy.

Why was this decision such a big deal for investors? The question is actually a more specific form of a broader one:  Why is monetary policy in the United States so important for the global financial system? In answering the second question, we can better understand the answer to the first.

Last year, economists Matteo Iacoviello and Navarro Gaston at the U.S. Federal Reserve asked this question and what they found was striking. Looking at macroeconomic data covering the period 1965-2016, they found that the effects on economic growth of monetary tightening from the Federal Reserve are almost as strong outside the U.S. as they are within it.

“A monetary policy-induced rise in U.S. rates of 100 basis points reduces GDP in advanced economies and in emerging economies by 0.5 and 0.8 percent, respectively, after three years. These magnitudes are in the same ballpark as the domestic effects of a U.S. monetary shock, which reduce U.S. GDP by about 0.7 percent after two years.”

The authors explain the transmission of US policy worldwide as occurring through standard exchange rate and trade channels, with countries that trade with the US and manage their currencies in line with the dollar more strongly affected. As US rates rise, the dollar appreciates. In countries for which a stronger dollar causes inflation to rise or balance sheets to deteriorate, or where the government has tied its currency to the dollar, there is pressure for interest rates to rise too. As the experience of 2018 showed, emerging market countries such as Turkey, South Africa and Argentina with high inflation, exposure to the dollar, current account deficits and low foreign reserves can be severely constrained by tight U.S monetary policy.

But what we have learned in recent years is the importance of the Federal Reserve being is at the heart of a global capital cycle that is fuelled by the US dollar. In a seminal paper – Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence – economist Hélène Rey argues strongly that the Federal Reserve can single-handedly direct global monetary policy.

She finds that there is a global financial cycle in capital flows, asset prices and credit growth. This cycle co‐moves with the VIX, a measure of the uncertainty and risk aversion of the markets. Asset markets in countries with more credit inflows are more sensitive to the global cycle, and this cycle is not necessarily in line with countries’ specific macroeconomic conditions.

Her analysis suggests that one of the determinants of the global financial cycle is monetary policy in the centre country – i.e., the US – which affects leverage of global banks, capital flows and the growth of credit in the global financial system. Investors have been so fixated by the Federal Reserve’s monetary policy because it has such a direct effect on global liquidity and the VIX.

Rey also finds that when capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime – fixed or floating.

An example is the relationship between Europe (the euro area) and the United States, whose currencies float against each other. European banks borrow significant dollar amounts partly to support companies with U.S. business investments but mostly to fund dollar investment in the United States and in emerging markets. Figure 2 shows the Euro-dollar cross-currency swap basis¹. The basis, if negative, shows the premium that euro investors have to pay to borrow dollars on top of the dollar interest rate. Banks tend to borrow on a short-term basis, so very large increases in US interest rates can create serious liquidity issues.

On two occasions, late 2008 and late 2011, the basis exceeded 150 basis points. In the first case, dollar investors were concerned about the exposure of European banks and hedge funds to sub-prime U.S. mortgages. In 2011, they were worried that a Eurozone struggling with recession and rising sovereign bond yields could lead to anything from bank failures to the break-up of the euro. On both occasions, it was only the Federal Reserve that could step in to provide dollar liquidity, and they did so using swap lines² – loans of hundreds of billions of dollars to the European Central Bank, which would then supply these funds to commercial banks.  

This example shows both how US financing conditions deeply influenced Europe and how the situation was essentially out of the hands of its central bank, the European Central Bank.

For the past few decades, international macroeconomics has advanced the idea of a policy “trilemma”. This trilemma says that free capital mobility and independent monetary policies are feasible only if exchange rates are floating. However, Rey shows that the global financial cycle transforms the trilemma into a dilemma. Independent monetary policies are possible only if the capital account is managed. Or, in other words, if a country is open to foreign capital, it will be influenced by the monetary policy of the Federal Reserve – whether or not it is a developed or emerging economy, and whether or not it has a high current account deficit.

Given that most countries are plugged into the global capital cycle, what the Fed does matters. Figure 3 shows that markets predict that the probability of interest rates being higher that 2.5% in January 2020 has fallen from 90% as recently as October last year to almost 0% today. Markets now think that rates will either be unchanged or lower at the turn of the year.

Part of this sentiment flows from the dovish attitudes from Fed Chair Jay Powell, who has indicted that he may be willing to reinterpret the mandate of the Federal Reserve, particularly in relation to its inflation target. Formally, the Federal Reserve has a price stability mandate that policymakers have long interpreted as targeting an inflation rate of 2%.

But a quick glance at Figure 4 reveals that this target has not been interpreted symmetrically. For most of the period since 2000, and especially since 2008, the central bank has allowed inflation to settle below the target rather than above. In a recent speech, Powell suggested that he may be willing to run the US economy hot to make up for years during which core inflation has been well below 2%. This could mean not responding to strong wage inflation and keeping monetary policy looser than usual.

Such a stance, should it materialise in policy actions, could provide a much needed boost in liquidity to the global economy at a time when Europe looks weak and China is managing a hard landing.

However, while a looser U.S. monetary policy may keep the global capital cycle going, it neither guarantees higher inflation nor deals with the substantial rise in leverage and debt as a result of the loose policies of the last decade and the lack of productivity growth and innovation in advanced economies. While investors have welcomed the more dovish Fed, they should not assume that risks to the downside have been pushed into the distant future.

¹ Formally, the euro-dollar cross-currency basis is approximately the difference between the forward euro-dollar exchange rate and the spot euro-dollar exchange rate minus the difference between US and euro interest rates.

²When the foreign central bank draws on the swap line, it sells a specified amount of its currency to the Federal Reserve in exchange for dollars at the prevailing market exchange rate. The Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction. In this transaction, the foreign central bank is obliged to repurchase its currency at a specified future date at the same exchange rate. The Fed charges interest on its swap lines, which the foreign central bank passes on to the end user. Source: Federal Reserve Bank of St. Louis.

By Economic Strategist, Hottinger Investment Management

In the United States, capital markets satisfy 70% of the external financing needs of businesses, according to the International Regulatory Strategy Group. In the EU, the International Monetary Fund (IMF) says that over half of external funding comes from bank loans. While there have been big moves in continental Europe in the direction of establishing liquid and efficient markets for corporate bonds, commercial banks still continue to provide the lion’s share of new financing in direct loans to firms that need them.

It is for this reason that analysts typically look at how well Europe’s banks are performing as an indicator of the health of the region’s wider economy. Share prices in European banks that fall significantly tend to reflect concerns over the quality of the affected banks’ books of loans, as these can feed into poor earnings performance. If banks build a book of bad investments, known as ‘non-performing loans’, they can put equity capital at risk if such investments need to be written off their balance sheets.

If banks are essentially underwriting whole national economies – as they do in the euro area – we can glean some insight into the performance of the latter by assessing the state of the former.

Figure 1 shows how European banks have underperformed US banks and the MSCI World Bank Index. European banks are down about a third from the start of 2018, compared to 15-20% in the US. This trend arguably mirrors the significant pullback in European economic performance as measured by the OECD’s leading indicator indices for key global regions in Figure 2.

The era of low interest rates has created a challenging environment for global banks to meet their earnings targets, but there has been a narrative for some time that European banks in particular have struggled with high levels of non-performing loans that they accumulated during the late 2000s and early 2010s. According to the European Banking Authority, Italy holds a stock of some €160bn in non-performing loans (NPLs), amounting to close to 10% of all loans outstanding. Across the euro area, while the average ratio of NPLs has fallen from 6.4% in December 2014 to 3.6% in June 2018, this is partly due to an increase in new loans in recent years on the back of monetary stimulus from the European Central Bank. It may take some time before these latest loans turn sour if they are to do so.

World Bank analysis puts non-performing loans in the United States and Japan at much lower levels, closer to 1%. By contrast, in October 2018 a study from the European Parliament revealed that NPL ratios were 4.2% in Spain, 12.4% in Portugal and 7.0% in Ireland, well above levels in Germany (1.7%). European banks deal intensively across borders, with many German and French banks exposed to debt in the European periphery, so the risks are pan-continental.

Italy is a problem case and has created headaches for bureaucrats at the ECB. In 2015, the IMF published an alarming paper that found that parts of southern Italy had NPL ratios as high as 40% while Italian banks had cover (or provisioning) for only about half of the bad loans on their books. The ECB is demanding that Italian banks increase their provisioning to 100% over a seven-year period, which promises to squeeze profitability and the return on equity for banks’ shareholders.

But there is a wider issue. Last week, the ECB announced a new round of targeted long-term refinancing operations (TLTRO) stimulus in an attempt to arrest the marked slowdown in the Eurozone economy in the last year. TLTROs enable banks to get funding at negative interest rates from the central bank on the condition that they then lend funds on to the real economy.

However, the issue is not really that banks need funding to encourage them to lend. Banks have already boosted lending on the back of previous rounds of TLTROs, which amounted to €724bn, over half of which has been taken up by Italian and Spanish banks. Rolling over maturing TLTRO loans from 2016 might help banks maintain their levels of stable funding but there is no need for new bank reserves for further lending.

The core problem is that banks struggle to find enough good projects that they can lend to at attractive interest rates without incurring undue risk, and this is a question of economic performance and policy. The clue lies in the fact that banks had needed to be paid to lend to the real economy in the first place; the lending rate on TLTROs is -0.4%. Figures 3 and 4 show what has gone wrong.

Between 1996 and 2007, in inflation-adjusted terms, productivity in the euro area grew on average by 1.25% annually. After the financial crisis that rate of growth has fallen to 0.75% per annum. If one is looking for a general reason why European banks are struggling, one can find it here. As productivity growth has slowed, firms (typically small and medium-sized) have found it tougher to grow their earnings, and those with leverage have struggled to make good on their loans. With banks looking to reduce their risk exposure, there is a limit on how many new loans they are willing to make to firms in an environment in which productivity growth is so weak.

And this is a failure of policy because the government is responsible for maintaining an adequate level of total demand in the economy. If there is too little total demand, there will be idle resources and productivity – a ratio of output to input – will logically be weak. The EU institutions have promoted a regime of fiscal restraint and ‘structural reforms’ that would in theory boost productivity and raise competitiveness.

This hasn’t really happened. An ageing society was always going to lead to slower economic and productivity growth as baby boomers retire and the rate of innovation falls, but these do not explain the entire step-down in productivity developments in the last 20 years in Europe. Instead it seems that policymakers have preferred to explain away persistently high rates of unemployment – particularly in Spain, Greece and Italy – as ‘structural’ or normal. This means that they are less likely to diagnose their economies as having deficient total demand meriting higher public spending.

For sustainable growth to return to Europe, the continent does not need more monetary policy measures such as TLTROs that simply push on a string. There needs to serious fiscal stimulus – led by Germany – that raises the inflation rate so that indebted countries such as Italy and Portugal can participate too. Figure 5 shows how Germany has a huge capacity to increase spending. Since 2012, the rate of growth in nominal GDP (which measures growth in real output plus inflation) has significantly outstripped the yield of 10-year Bunds. Since tax revenues grow organically at the same rate as nominal GDP – assuming no changes in tax rates – this situation means that Germany has been able to cover its public debt levels comfortably. 

For Italy, the situation is tougher. Figure 6 shows that risk-free interest rates on Italian public debt (BTPs) are currently higher than the rate of nominal GDP growth. This means that deficit spending would not necessarily be self-funding. Italy would have more fiscal space if there were an environment of higher inflation and real growth, and deficit spending itself can deliver these. But the problem is that Italy already has an extremely high debt-to-GDP ratio and the European Commission is nervous about allowing the Italians to spend more.

However, the impasse cannot last. The pressure on policymakers to stimulate effectively is likely to grow and as we think that as fiscal policy is the only game in town, we are likely to see measures – possibly even at the European level – to permit increased spending over the next couple of years.

A programme targeted at both public investments and raising consumers’ income through tax cuts could be the spur that crowds-in private investments, encourages bank lending and boosts productivity.

From an investor’s point of view, however, there are clear risks. While the purpose of fiscal stimulus is to raise the growth rate of the economy, which may feed through into higher earnings yields and returns on investments, there would likely be risks to certain investments in the short term. Fiscal spending would likely raise the rate of inflation, which could lead to a fall in the capital value of fixed income products such as government bonds. If the central bank responds by raising interest rates, the loss on these products could be compounded. An environment of fiscal stimulus is arguably likely to favour equities – which tend to have greater inflation protection – over bonds.

Weak banks in Europe are revealing a weak European economy. A recovery in China could keep Europe buoyant but it wouldn’t address the region’s underlying problem: that of low productivity and deficient demand. With monetary policy a spent force, the region needs fiscal stimulus and when policymakers realise there is no alternative, it is likely to get it. Until it does, however, the euro area could find itself returning to the slow lane.

 

By Economic Strategist, Hottinger Investment Management

Political pundits often describe the seemingly endless process of Brexit as a game of three-dimensional chess.

At the centre of the drama, we have the sitting Prime Minister, Theresa May. She perseveres with the deal she painstakingly negotiated with the European Union last year but which was resoundingly rejected by the British Parliament in January. Her hope is that as time passes, alternatives to her deal will fall away and Parliament will grudgingly approve her plan into law.

But there are also three other players – groups or individuals – with the power to shape the outcome of this process.

First, we have the European Research Group (ERG). On a good day, this group can command the support of up to 100 Tory MPs, but analysts put its core membership at around seventy. The ERG largely hates May’s Brexit deal and, up until a few weeks ago, it had privileged access to Downing Street. In exchange for their votes, the ERG wants the PM to renegotiate her deal with the EU to remove or put a time limit on the so-called ‘backstop’, which would indefinitely keep the UK in a customs arrangement with the EU if the two parties do not agree a comprehensive trade deal after Brexit. Otherwise, the ERG would try to force a no-deal exit, which economists predict would have damaging consequences for the UK.

However, the power of the ERG has significantly weakened in recent weeks as a result of moves by two other groups.

The first of these is what I call the ‘Tory-Remain caucus’. This is a group of thirty or so Conservative MPs – including ministers in the government – who would prefer either a second referendum or the softest possible Brexit. Last month, three MPs from this group – Heidi Allen, Anna Soubry and Sarah Wollaston – joined a new Parliamentary grouping called The Independent Group (TIG), formed by ex-Labour MPs who have similar views on Brexit and are dismayed by the Labour party’s official policy on it.

The third player is an individual in the mould of Jeremy Corbyn, Leader of the Opposition. Jeremy Corbyn leads a Labour party that mostly aches for either the softest Brexit or remaining in the EU. However, Corbyn has been averse to the club for most of his political life and his personal position, against that of the party, had empowered the ERG. But, with the emergence of TIG, Corbyn has been forced to promote a second referendum.

In recent weeks, two major events happened that make a soft Brexit more likely. The threat of resignation from three Tory government ministers has forced Theresa May, who has a working majority of just seven MPs, to concede the option of delaying Brexit if her deal does not pass. Further, with Labour committing to a second referendum during the delay period and enough Conservatives willing to consider it, the risk of ‘no Brexit’ has risen. Therefore, more members of the ERG are now more willing to support Theresa May’s deal as the risk of losing Brexit altogether has increased.

With Parliament supportive of a soft Brexit of some description, the likelihood of an orderly Brexit and a deal of some description eventually passing Parliament has risen. This could have significant consequences for UK assets, particularly from the perspective of foreign investors.

Opportunities for foreign investors in the UK

One could argue that for foreign investors there are three sources of value from UK equity assets: an undervalued pound, a discount in equity valuations, and the continuation of high dividend yields that many UK equities can offer. For domestic investors, the last two factors apply. Of course, nothing is guaranteed. Prices and currencies can rise and fall, while the occurrence of events does not necessarily lead to market movements in the expected direction.

Let’s now take each of these factors in turn.

On currency, Figure 1 shows the trade-weighted sterling index dating back to January 2000 to give an indication of its medium-run trading range. The median level for the index takes into account about half of the large depreciation in sterling during the financial crisis. The chart shows that before the EU referendum the pound was trading just below its median level before depreciating significantly. Since the referendum, sterling has been trading in a relatively narrow band, representing a discount of roughly 15% to the medium-run median.

The following three charts show the discount in the pound sterling against other currencies individually – the euro, dollar and Swiss franc, respectively. The start of each series reflects the median value of each currency pair since January 2000; these were £1 to $1.57 in May 2009, £1 to €1.28 in October 2008, and £1 to CHF 1.67 also in May 2009.

The three charts collectively corroborate Figure 1, showing that sterling is trading at about a 10% discount to its level on the eve of the EU referendum. Arguably, the discount reflects investor expectations that Brexit would lead to a deep rupture of the trading relations between the UK and the rest of Europe. If recent developments in Parliament suggest that the UK will maintain a closer relationship with the Continent than previously expected, there could be a post-Brexit recovery in sterling which would increase the foreign-currency value of UK assets.

The second factor that may suggest opportunities in UK equities is the trend in valuations over the last three years. Despite the bull market environment over the last few years in the US equity market, valuations in the UK have gone in the other direction. In the period running up to the EU referendum in 2016, UK stocks included in the FTSE All-Share index of 600 of the country’s largest companies were trading at over seventeen times (17x) their expected earnings or net profits. In the post-referendum period, this multiple has fallen to as low as 11.5x expected earnings during the fourth quarter of 2018, as Figure 5 represents. Multiples have since rebounded modestly.

The FTSE All-Share Index includes companies that have significant export exposure to the EU as well as domestically-focused companies that may have been swept up in the negative investor sentiment towards the UK as a result of the Brexit vote result.

Despite the UK being unloved, British company earnings and dividend yields continue to be strong, suggesting that their stocks are under-priced. Last year, UK companies made a record dividend pay-out of just under £100bn, up 5.1% on 2017. According to Morningstar, the average trailing yield on UK stocks last year was 4.8%, the highest level since March 2009 and significantly higher than the 30-year average trailing dividend yield of 3.5%. With 10-year gilts yielding 1.3% at the time of writing, and with little indication that the Bank of England will raise interest rates soon, it could be argued that a resolution to Brexit that alleviates uncertainty could push company valuations back up.

While valuations appear to be suppressed, the high dividend yield when reinvested has enabled UK companies to keep pace with global markets on a total return basis, as Figure 6 shows. January 2016, which marks the start of the data series for the chart, was the beginning of a synchronised upswing in global and UK equity prices. But it was also when UK relative valuations deviated from other markets, especially the U.S. S&P 500 stock market, as Figure 7 illustrates.

High dividend yields in the UK have, therefore, partially offset the effect of the fall in valuations on total returns. Nonetheless, even on a total return basis, the UK is still currently a bit behind world markets and has been for most of the period since the start of 2018.

Figure 6 informs us that looking at valuations alone to judge the size of the UK opportunity may be misleading. However, we should point out that as share prices rise, the yield from earnings and dividends for investors who come in at higher prices can fall.

One could therefore argue in conclusion that the now more likely event of an orderly Brexit, whether on March 29^th or after a short extension, could create an investment opportunity in UK markets. For foreign investors, there is possibly an additional benefit if sterling begins a period of strength that pushes the currency towards its median level.

By Hottinger Investment Management

Three factors that weighed on markets in 2018 were the trade tensions between China and the US which caught Europe on the crossfire, the significant slowdown in the Chinese economy that can only partially be attributed to tariff actions, and the fear of the Fed over-tightening interest rates in 2019. During January, Fed Governor Powell reversed his hawkish position and in February the US-China trade negotiations dominated global financial news. Enough progress was made to stop the planned increase in tariffs scheduled for March 1. If the promise of Chinese stimulus turns into fact, then it could be argued that the 3 factors have all been reversed during Q1 2019, which probably explains the optimism that currently surrounds risk assets.

The S&P 500 returned +2.97% in February, while the Nasdaq is currently undertaking its longest daily winning streak since 1999  – having gained 3.44% on the month outperforming the wider MSCI World Index that gained 2.82%. European equities gained 3.87% despite signs that economic momentum is still weaker, the ECB’s growing challenge to raise inflation to 2% and Eurozone politics continuing to cloud the issue as Spain becomes the latest country to call snap elections. On the positive side, the weaker euro – especially against sterling – will help earnings as already seen in the Q4 earnings reports. Any signs that the Chinese economy is recovering will be important to the European countries. However, our recent report on China suggested that without a US trade deal, fiscal stimulus and / or a more relaxed monetary policy we believe the negative momentum from China could persist with consequences for the global economy but particularly for emerging market recovery and the Eurozone.  Furthermore, the continued strength of oil, which returned +6.38% in February, pricing Brent Crude back at $65pb, became a focus of Presidential tweets suggesting that the global economy remains fragile and calling on OPEC to be vigilant.

The questions now being posed by market commentators are whether the significant slowdown in global economic growth in Q4 2018 (to approx. 3.4%) will prove to be a short-term trough and whether the continuing strength in labour markets will buoy consumer spending to underpin a recovery despite a general lack of capital expenditure depressing industrial activity.

Much depends on the direction of the dollar, which was stronger by 0.6% during February, leaving the dollar index flat on the year. Trading analysis indicates that the 50-day moving average for the dollar may be about to cross the 200-day moving average on the downside. This usually indicates that there is a selling momentum that would mean that the dollar is more likely to weaken than strengthen over the coming months. Nevertheless, the US remains a safe haven and if the world economy continues to weaken over the year, there could be a return to dollar strength that undermines the outlook for emerging markets. Equally, with the Federal Reserve’s Dot Plot forecast for interest rate changes still considerably more hawkish than the market expects, and with US fundamentals looking strong, there is a large amount of upside risk to the dollar. Dollar upside risk exists even despite the fact that Fed Chair Jay Powell suggested – during his semi-annual testimony to the Senate Banking Committee – that the central bank is willing to run the economy above the level required to deliver the Fed’s 2% inflation target.

Brexit uncertainty continues to weigh on business activity and UK financial markets. The FTSE All-Share index has bounced back at half the rate of other developed markets, gaining 1.65% in February, leaving it up only 5.82% on the year. The March 29 deadline is looming and there are a number of parliamentary votes mid-March that will clarify the view of the House of Commons. The market is increasingly convinced that an extension to Article 50 is likely and the currency, which has reflected the financial markets views all through this tortuous episode, strengthened 1.65% in February to bring the Pound Index’s year-to-date gain to 4.21%.  UK risk assets remain unowned and unloved but there are signs that they may be significantly under-valued should the outcome be more optimistic than what is currently priced in. A combination of relatively cheap assets and a strengthening currency could attract foreign investors back to the UK financial markets.

A solid Q4 earnings season in the US and Europe has underpinned the move back to optimism for risk assets, but company guidance has remained cautious. We retain a neutral stance towards equities in the belief that the snap back has once more brought shares back to the expensive valuations that caused us concerns in September. Without further catalysts, we feel it is hard to justify current levels.

By Economic Strategist, Hottinger Investment Management

Money and banking are essential social institutions. Both have a long history extending to 3000BC and the Babylonians of present-day Iraq. There, we find not just our first evidence of civilisation but also the first banking system. Under the Code of Hammurabi, ancient temples would accept surplus deposits of barley and silver and make interest-bearing loans. Priests would record these on cuneiform tablets, a forerunner to the balance sheets that banks use today to account for their assets and liabilities.

Fundamentally, not much has changed since then. Money still has two core functions. On the one hand, it is a commodity that serves as the medium of exchange, oiling the wheels of commerce. On the other, money is a form of debt that reflects a claim that its holders have on society. You are willing to hold cash or deposits in the bank because you expect that at some point in the future, you will be able to exchange them for valuable goods and services. Your bank account is like a social credit score, reflecting how much society owes you. But because it is not fully legally binding, you have to trust that the system will be maintained.

Trust has therefore always been a core part of finance and the bankers who underwrite the economy have a responsibility to maintain it. So when in 2008 queues of savers stood outside branches of Northern Rock, anxious to withdraw their cash on reports that the bank was struggling to fund itself, it was clear that trust had broken down. The run on Northern Rock was the first such event in the United Kingdom for over 150 years, and it revealed how precarious the world of banking can be.

How banking works

Whereas in Mesopotamia the state was the lender, today we rely on a network of private-sector banks to issue credit to fund productive activities. Observing how banks create credit in a modern economy, we can see how they enjoy an enormous privilege. Before discussing shadow banking, let us consider the ordinary model of bank lending, which Figure 1 illustrates.

Figure 1. A bank makes a new loan by creating deposits to fund it

Conventional wisdom says that banks simply lend out other people’s deposits, but while that is somewhat true, it is misleading. In most cases, banks simply create new deposits when they want to lend to a borrower, subject to some key constraints.

To ensure that trust is maintained in the financial system, governments have allowed private-sector banks to create money and enjoy lender of last resort facilities from the state’s Central Bank if they meet key regulatory requirements.

The main ones are reserve requirements and capital requirements; these essentially make it costly for banks to issue too many loans. Reserves are deposits that private-sector banks hold at Central Bank and regulations require that banks hold a minimum proportion of their assets as reserves at the Central Bank or in cash, so they can settle payments. Capital requirements state that banks should hold a minimum level of equity relative to the volume and risk of the assets they hold on their balance sheets. These ensure that owners of the bank absorb as much of the bank’s losses as possible, and not depositors.

Banks can meet their reserve requirements by borrowing reserves in the ‘inter-bank’ market. They can also borrow directly from the Central Bank, which sets the interest rate on reserves and promises to satisfy any excess demand for reserves. Banks need to do this if they want to keep issuing new loans, but it is costly. The state, through the Central Bank, can attempt to control the creation of private bank credit by changing the interest rate upon which it charges for loans of its reserves and which passes through into the inter-bank market and then onwards to the wider economy. When the economy is strong, the central bank raises interest rates, thereby making reserves more expensive and banks less willing to lend.

This model works when banks make good quality loans and investments in ventures that are at least likely to generate the return of the capital they provide. The problem with Northern Rock was that it was throwing good money after bad, borrowing resources in the ‘inter-bank’ market and investing in sub-prime US mortgage-backed securities (MBS) that it believed were much safer than they were. When it emerged that sub-prime borrowers couldn’t make good on their loans, Northern Rock struggled to repay its own inter-bank loans. With no other bank willing to lend to it, Northern Rock ran its reserves down and eventually called on the Bank of England for emergency funding.

Introducing shadow money to the banking system

But Northern Rock’s story is mostly one of bad banking, and less one of shadow banking. Shadow banking involves issuing shadow money, and both banks and non-banks can do this. Daniela Gabor and Jakob Vestergaard, who are experts in the field, define shadow money as “repo liabilities, promises backed by tradable collateral”. A ‘repo’ or repurchase agreement is a loan of funds for a short period to an institution that sends to the lender securities such as government bonds or asset-backed securities as collateral or security.

It is useful to think of currency, bank deposits and shadow money as parts of a hierarchy, as Gabor and Vestergaard introduce.  Banks that issue deposits promise to convert these deposits into state-issued currency at par or one-for-one. Likewise shadow money, reflected by repos, represents a promise to convert the asset that the lender holds as collateral, the reverse repo, into bank deposits at par.

Let’s begin with a bank issuing a repurchase agreement (or repo) to a money fund of an institutional investor. Figure 2 illustrates the situation.

 

Figure 2. A bank borrows from a money market fund. The arrows shows that the repo is backed by mortgage backed securities that the bank held prior to the transaction. The bank sends these securities to the money fund, which now becomes the legal holder of the securities until maturity

Here the bank is able to expand its balance sheet without needing to increase its reserves. It does this by borrowing the liquid funds from the institutional investor in a repurchase agreement and sending assets (here, mortgage-backed securities) to the lender as security. Bank X invests the cash from the fund in assets that yield a higher return than the rate it pays on the repo, and the institutional investor holds the ‘reverse repo’. In the early 2000s, before the crash, these assets were often mortgage-backed securities (MBS) – both pledged as security for and bought from the proceeds of repos.

Banks have clear incentives to issue repos; they can avoid the expense of acquiring more reserves and they can delay final settlement in bank deposits. Equally, cash-rich institutional investors – such as money market funds (MMFs), which invest the cash reserves of pension funds and insurers – enjoy benefits from financing repos. These funds like repos because they provide collateralised deposits for money that cannot qualify for the government guarantee for bank deposits (£85,000 per person in the UK) and they have features such as daily collateral valuation and shortfall correction, which provide security. The loans are also very short-term, often overnight, giving lenders greater control.

However, the problem arises, again, when the underlying asset fails to return capital. This explains why U.S. banks Bear Stearns and Lehman Brothers went under; they relied on $250bn in overnight repo financing for their portfolio of mortgage-backed securities. When the underlying assets failed to deliver, lenders refused to roll over funding. Northern Rock was also involved in sourcing funds from MMFs in wholesale markets.

Money market funds – which are supposed to be safe havens – infamously ‘broke the buck’, as net asset values fell below $1 per share. This meant $1 today did not yield at least a $1 tomorrow, breaking the cardinal rule of risk-free money.

When the underlying mortgages failed, these banks were also shut out of funding markets and triggered a global panic. Figure 3 shows how this can work.

Here, Bank A, which is speculating on sub-prime MBS, lends these securities in a repo agreement to Bank B, which – in return – sends cash to A by creating new deposits. Bank B has pre-existing loans to Bank C via the inter-bank market, which it used to buy its own sub-prime MBS.

In the extreme case that the value of sub-prime MBS falls significantly as the underlying mortgage holders default on their debts, it is possible for all three banks to fail because none of the banks has sufficient equity capital to absorb the losses. Even Bank C can fail if it can’t recover the loan from Bank B. That’s why banking markets seized up in 2007-8 and why central banks and treasury departments had to step in to restore trust.

Figure 3. An illustration of how shadow banking can create a systemic banking crisis

Research from SIFMA shows that while the US repo market is still a sizeable market, it relies on better collateral today than it did ten years ago. Furthermore, as a result of regulations after the financial crisis, such as the Volcker Rule in the U.S. and the global Basel III rules on capital adequacy, in theory speculation in large banks has rapidly declined and these banks hold much safer assets on their balance sheets, including government bonds.

However, shadow banking still matters because it has the potential to affect the stability of the financial system. This holds whether or not banks deal in shadow money with each other or with non-bank institutions such as hedge funds, money market funds and insurers. Banks still issue shadow money though repos to investors who buy securities in the market.

How shadow banking works among non-banks

As banks have reduced their role in repo markets, money market funds have increased funding, while real estate investment trusts (Reits), mutual funds and hedge funds have become more active borrowers. Yet the same issues of trust and financial stability apply to when both sides of the trade are non-banks. Figure 4, for example, demonstrates how hedge funds can dangerously scale up their balance sheets using a single asset as security.

Figure 4. A demonstration of how an asset used in a repo transaction can be ‘rehypothecated’ to generate leverage

Here, a low-risk hedge fund (A) wants to build up a  portfolio of investment-grade corporate bonds and engages in a repo agreement with another hedge fund (B), which exchanges some of its clients’ cash reserves for collateral from A. Hedge Fund A sends as security to B government bonds that it initially held. Hedge Fund B is now in a position to scale up its own portfolio of corporate bonds as it is now the legal owner of A’s security. B enters into its own repo agreement with another hedge fund (C), which provides client money to B again in exchange for the security over government bonds. However, B chooses to use the government bonds pledged by A as security for its repo in a process called ‘rehypothecation’ – i.e., the reuse by a creditor of collateral posted by a debtor.

In this scenario, Fund A is exposed to greater risk that its collateral is not returned because Fund C has first claim over it if Fund B fails to honour its repo agreement with C. Hedge Fund B may not be able to make good on its debts to the Fund C because it is already highly leveraged with repo agreements with other fund providers and has invested in corporate bonds that have a high default risk. In other words, if B’s corporate bonds go sour and B cannot make payment, then Fund C keeps Fund A’s bonds, while Fund A would have to attempt to salvage other assets from B’s balance sheet.

This is how shadow banking involving non-banks can create leverage, but banks can also turbo-charge this by issuing repos backed against new deposits. For example, Fund C could engage in its own round of rehypothecation with a commercial bank and use the proceeds to buy corporate bonds. This exposes Fund A to even more risk – to the health of Funds B and C, while Fund B is exposed to the activities of Fund C.

Risks can also work in the other direction if the collateral underpinning the repo is weak. For example, if the repos were backed with high-risk corporate debt and not government bonds, then each repo provider (B to A, C to B and the Bank to C) is exposed to not just the risk that the party to which it extended the repo fails to repay, but also the risk that the underlying collateral it holds falls in value and that the borrower cannot meet the shortfall.

In either scenario, one can see that shadow banking among non-banks can put clients’ money at risk even in funds that have sound investments.

The next bubble?

There are issues within corporate debt markets, particularly in the US. Companies have been increasing their leverage over recent years and there is risk that as interest rates rise and earnings fall, some firms could struggle to repay. The striking growth in collateralised loan obligations (CLOs), through which issuers pool together corporate loans from already highly indebted companies and sell them to institutional investors, has not escaped the attention of cautious investors, nor has the decline in overall credit quality. We need more research into who is financing these products and whether there is a dangerous connection between banks and non-banks that could lead to risks not just to investors but to the financial and economic system as a whole.

Despite its mysterious name, shadow banking is not inherently bad. It is, however, a financial innovation that does not escape the basic requirements of finance and money. The system works when good money chases good ideas, when risks and exposures are adequately understood, when debts are honoured and when there is transparency and accountability. The risk with shadow banking is that we cannot as easily guarantee those things, and until we get a grip on this new form of finance, we may continue to face unexpected events.

By Zac Tate, Economic Strategist, Hottinger Investment Management

Reports of troubles in the European economy usually focus on countries that lie on the periphery of the continent. Whether it was high public debt in Greece and Italy or private credit bubbles in Spain or Ireland, the implication from a lot of the commentary of recent years is that Europe’s debtors were sinful actors who needed to make amends.

But it takes two to tango, and where there are borrowers, there must also be lenders who want to lend. Few thinkers have challenged the received wisdom on why countries in Europe’s periphery chose to build up so much debt in the early years of the 21^st century and what borrowers did with the money. This matters because if policymakers have got the diagnosis wrong, they will continue to prescribe the wrong medicine, with consequences for the medium-term outlook for the European economy.

The narrative of sinful debtors finds its origin in Germany. The German view is that stability comes from keeping inflation low and debts under control. This leads to greater economic competitiveness, reflected in growing exports to other states. In promoting the policy of austerity as a solution to the euro crisis, Wolfgang Schäuble, the German finance minister through much of the period, exported this Stabilitätskultur (or stability culture) to other countries sharing the single currency.

But there is a fundamental flaw in this idea if one looks at Germany’s own performance in the context of the wider European economy in the 2000s and 2010s.

From 1999, when the euro replaced national currencies, until 2012, the euro area was effectively a ‘closed economy’. This means that it ran a roughly balanced trade account – neither importing from nor exporting to the rest of the world in significant volumes; see Figure 1. It implies that any country or countries within the euro area that ran a large trade surplus would have counterparts that ran large trade deficits.

Figure 1 – The monthly trade balance of the Eurozone nations with nations in the rest of the world.

Germany and other countries such as the Netherlands significantly grew their trade surplus with the rest of the euro area between 1999 and 2012. Figure 2 shows that Germany grew its net exports of goods and services to Eurozone partners by more than they grew them to non-Eurozone partners. Their European counterparts were France, Spain, Italy, Greece and Portugal, which all ran large trade deficits with Germany.

Figure 2 – The annual trade balance of Germany with the Eurozone nations and with nations in the rest of the world.

One then must ask how this was possible. The answer, in short, is wage restraint. Wage costs are a significant factor in how competitive a country’s firms are, but the measure that really matters is (nominal) unit labour costs or NULCs. NULCs describe the labour cost to produce one unit of output, whether it is a loaf of bread, a car or a package holiday. Two inputs go into this calculation: how much a worker is paid in wages and how productive that worker is. So German wages can be significantly higher than they are in Greece, but Germans can be more competitive than Greeks because they – on average – produce more stuff.

Figure 3 shows how Germany maintained a significant competitive advantage over other European nations during the first phase of the euro. By keeping wage growth lower than their European partners, through a concerted effort by employers and trade unions, Germany was able to make its price-sensitive products more attractive to other Europeans than their own domestic alternatives. This marked the beginning of the growth of Germany’s trade surplus with the rest of the Eurozone.

Figure 3 – Nominal unit labour costs for major European countries. Index is normalised at 100 in the year 1995. It shows that nominal unit labour costs grew by over 30% between 1995 and 2007 in Italy and Spain, but remained flat in Germany.

But this leads to the fundamental flaw of Stabilitätskultur. By running trade surpluses with other European states, Germany was effectively taking demand from other countries and therefore exporting unemployment to them. This, in turn, meant that those other countries either had to compete with Germany through wage restraint in what would be a zero-sum, race-to-the-bottom game because these countries were trading within a closed economy, or would have to allow credit expansion to support domestic demand.

In other words, the policies of Stabilitätskultur, if applied to all of Europe, would cease to yield the benefits they brought to Germany. In fact, Germany needed the higher inflation and the associated credit expansion in peripheral Europe to support the further growth of its export sector.

This month, Martin Höpner, a scholar at the Max-Planck-Institut in Cologne, published a paper on the history of what he calls Germany’s “undervaluation regime”. He describes how this regime started not with the euro but in 1944 with the Bretton Woods system of fixed global exchange rates, allowing Germany to run trade surpluses by keeping inflation low and limiting opportunities for others to respond by devaluing their currency. Whereas Bretton Woods permitted occasional currency adjustments, no such facility is afforded to members of the euro. Höpner claims that Germany’s undervaluation regime has brought the euro area close to collapse.

If Stabilitätskultur was ever going to work for the euro area, then the area as a whole needed to become a net exporter, which is what happened after 2012. With Europe struggling with austerity, Germany started to grow its exports to non-Eurozone partners, including China, the Middle East, the U.S. and the United Kingdom. Italy significantly increased exports to the United States. Spain, the poster child of economic reforms, has also vastly improved its trade position; in fact, since 2011, Spain has been one of Europe’s most competitive states for keeping labour costs low, explaining why it now runs a trade surplus with states within the euro area.

Europe as a whole is now a major net exporter in the world economy, but this naturally exposes it to forces outside its control. Not least is the ability of non-euro countries to manage their terms of trade with Europe by adjusting the value of their currencies against the euro. The improvement in the area’s trade balance overplays the success of this policy as it obscures the fact that suppressed demand in Europe for many of the years since 2008 – a core consequence of Stabilitätskultur – has led to weak import growth.

It would be incorrect to heap all the blame on Germany; its trade policy is only part of the story. The missing piece is the banking sector. Of course, states that run trade surpluses also generate surplus capital that can find its way through the banking system to the regions that need to fund their trade deficits with the likes of Germany and others. But this gets it somewhat back-to-front; funds to pay for exports can, and often do, come before the resulting trade imbalance, and most of those funds that flowed to the periphery in the 2000s did not come from Germany.

A study by Alexandr Hobza and Stefan Zeugner for the European Commission in 2014 reveals that huge volumes of funding came from banks in France and the Benelux countries as well as financial institutions operating out of the City of London. Ambitious organisations were active in the inter-bank and shadow banking markets where they would issue products such as asset-backed commercial paper and repurchase agreements to mainly professional clients from around the world, thus raising capital to fund their lending in the European periphery. Lower interest rates that came with euro accession created opportunities for banks and hungry borrowers. The upshot was a huge rise in the indebtedness of households, companies and local banks in countries such as Greece, Spain, Italy and Ireland. While much of the capital was funnelled into local real estate, significant volumes supported the German export boom.

While the role of banks in the European malaise does not centre on Germany, the response to the crisis has been led by a largely German narrative that is fatally flawed.

A revised narrative of the euro crisis needs to include a more critical assessment of the role of not just Germany but also those Northern European states that belong to the so-called Hanseatic League¹ and support the Stabilitätskultur. The policies that the European Union have promoted, focusing on fiscal restraint and structural reforms, came straight out of the playbook of German stability culture, which says that the German model is right for all.

But we have shown this to be impossible. The policies of the Stabilitätskultur are self-defeating and lock Europe in the slow lane of low-growth, persistently high unemployment and dependence on demand from the rest of the world. This, today, has made Europe vulnerable to the slowdown in China, trade protectionism from the United States and the prospect of a hard Brexit in the UK. With a sort of tragic irony, it has created a culture of instability, a lost generation of young, unemployed Europeans and the rise of populist forces that seek to exploit their grievances.

¹The Hanseatic League includes as its members the following countries: Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden