Author: admin@hottinger.co.uk
Investment Review: September 2018
By Hottinger Investment Management
A booming economy has left the US equity markets well ahead of the other regions over the summer months and September has proved to be a month of retrospection with the first signs of a possible rotation from cyclicals into more defensive sectors. However, whenever this has happened previously it has proven to be short lived, but it is probably true to say that US markets have become a little more anxious as we head into October, which has always been a difficult month historically.
Economically, in September, JP Morgan report that US consumer confidence hit its highest level since 2000; initial jobless claims fell to the lowest monthly average level since 1969 while wage growth rose to the highest level since 2009 and retail sales grew more than 7% year-on-year. The level of fiscal stimulus announced by the Trump presidency is unprecedented this late in the cycle and when combined with the move from quantitative easing to quantitative and monetary tightening the threat of the US economy overheating has definitely increased as a risk. The US yield curve remains very flat with the 2 – 10yr curve only positive by 40 basis points, although the economic signals emanating from the bond market have been severely dulled by central bank intervention.
The Federal Open Market Committee’s meeting in September delivered a well-choreographed 25 basis points hike for the third time this year and a removal of the last of the QE wording that policy remains “accommodative” in the official statement paving the way for another 25bps in December. Indeed US Treasuries lost 1% over the month and 10yr Yields finished at 3.06% following this latest tightening round. So far the Fed has managed the expectations of financial markets very well with the gradual monetary tightening not shocking the market; every time the US 10yr Treasury breaks above 3% it fails to consolidate its positon to move towards 3.5% decisively despite the expectation that we may have passed peak growth. While core inflation risks remain under control, financial markets are unprepared for a more aggressive Fed approach and risk assets remain in favour.
During September the S&P500 printed another all-time high of 2940.91 but failed to hold that level into month-end finishing still positive +0.43% at 2913.98. The headline numbers do not tell the full story though as the fact that the NASDAQ fell 0.78% in September might suggest. The high valuations surrounding some cyclical stocks saw investors implement a certain level of rotation during the month as the FAANG+ index fell 4.19% and the S&P Banks Index fell 4.37% while defensive sectors such as Healthcare gained 2.80%. The narrowness of sector returns over the third quarter has seen many equity investors ride the IT wave (FAANG+ is still up 22% YTD vs. 9% S&P500) while the outperformance continues creating a lot of “froth” that is reliant upon earnings growth surprising on the upside into year end. Many market analysts including Absolute Strategy Research believe that earnings will fall significantly in Q4 bringing into question equity valuations. This rotation into value stocks is the most significant since the February hiccup but it could face headwinds if inflation fails to materialise and unemployment continues to fall.
In the UK, financial markets remain under pressure as fears of a no deal Brexit gain momentum as well as latest round of political party conferences got underway. The FTSE All-share gained +0.53% while Gilts fell 1.62% and sterling was flat. In theory a no-deal Brexit would be good for the equity market due to the expected fall in sterling depending on your opinion of what is already priced in. However, many are now more anxious of a pending Corbyn government than they are of the type of Brexit deal that is achievable leaving the outlook for UK financial markets cloudy at best. Elsewhere in Europe the banking system has been called into question twice over the summer due to exposure to Turkey and Italy which has added to wider market fears following last year’s significant outperformance. European equities fell 0.31% over the month as trade war rhetoric between the US and China continued to add to the forecasts of an already slowing Chinese economy, which will have a knock on effect to European exporters.
The highlight of the month was Japan which saw the Nikkei 225 rise 5.49% and $/Yen weaken 2.4% meaning that Japanese equities were stronger in dollar terms as well. The economic background of the strongest jobs market since 1974 and expanding bank lending have been equity supportive, but also the beginning of bi-lateral trade talks with the US and discussions in the Diet regarding a new fiscal package following Prime Minister Abe winning a third term has also helped create a positive backdrop.
From an asset allocation perspective, the favouring of US equities probably relates to their historical outperformance in poor market conditions due to the depth of diversification and liquidity while emerging markets as a bloc remain challenged by a strong dollar environment particularly those countries with large current account deficits that have increased their dollar-denominated debt. With regards to Europe, we think the end of ECB stimulus and limited fiscal support coupled with concerns over growing levels of household and corporate leverage heighten risk in investing in the region.
The value of a reserve currency
By Economic Strategist, Hottinger Investment Management
What’s the value in a reserve currency?
Being in possession of a global reserve currency is often seen as a privilege for a country and its citizens. In times of growth, the use of a reserve currency to grease the wheels of international trade can reduce the borrowing costs for that country. In times of panic, investors pile in to buy the currency, pushing its value up and making imports cheaper.
Reserve currencies are an essential feature of a global economy that relies on a basket of national currencies, and are an important asset for investors to manage the risks from their investments.
The best reserve currencies are those that perform the three essential functions of money best. A currency is strong when it acts as not just a medium of exchange and a unit of account, but also as a store of value. When investors choose to store some of their wealth in a foreign currency, they trust the government in charge to keep inflation low and public debts within manageable limits.
Reserve currencies can fall out of favour
Since the end of the Second World War, the United States has managed the world’s dominant reserve currency, the dollar. But today, that status may be under threat as the US government under Donald Trump abuses its privileged status by running large budget deficits and putting trading sanctions on other countries in a way that runs against international agreements.
Are we therefore seeing the beginning of a shift away from the dollar to other global currencies? One way we can begin to form an answer is to look to history. During much of the 19th century and the first part of the 20th century, the British pound was the world’s reserve currency. Many of Britain’s colonies and trading partners pegged their currencies to gold sterling; the City of London was the world’s banker, with the Bank of England its line of last defence. In 1914, according to Barry Eichengreen of the University of California, sterling accounted for almost 90% of global foreign-denominated debt. By the end of WWII, still up to 60% of foreign-denominated debt was in sterling as the US dollar came to ascendancy. Many countries, however, maintained sterling pegs well into the 1950s.
The rise of the United States to prominence in the global economy throughout the 20th century naturally made it both able and willing to provide the reserve currency, and it was essential that it did. Eichengreen claims that the dollar overtook sterling in the 1920s if one excludes Commonwealth countries but well after WWII if one does not.
The political arrangements of Bretton-Woods that followed WWII and paved the way for US dominance as well as the high debts that burdened the UK after the war provided the death knell for sterling. This, alongside the decline of the British Empire, weakened sterling’s grip within the Commonwealth and made it infeasible for the UK to remain the head of a global fixed-exchange rate system, as it required a tight monetary policy at a time when domestically the opposite was called for and demanded.
The chart below shows the effects of the sterling-dollar transition that took place in the 1940s. Since that period, the real value of the British pound has been around 20% lower than what it was during the first half of the 20th century. The nominal value has fallen further. One pound bought five dollars at the start of the 20th century; today it buys less than $1.30, a 70% devaluation that is due both to the loss of sterling’s status as the global currency but importantly also the UK’s higher long-term inflation rate compared to the US.
Dollar reserves rose from 30% of global reserves in 1950 to just under 70% by the mid 1960s. Peak dollar came just after the end of the Bretton-Woods system in 1973, at which 80% of reserves were held in dollars.
Which currency dominates today?
Today, the dollar is still considered dominant part of a basket of global reserve currencies, some of which could grow in prominence in coming decades. Over 60% of reserves are still held in dollars, with the rest shared across the euro (20%), the yen (5%), sterling (5%), the renminbi (1%) and swiss franc (0.2%).
It’s a diversified mix that suggests that in an age in which most exchange rates float against each other rather than remaining fixed against that of a global leader, there is more scope for competition for leadership as investors can choose which nation offers the most stable currency.
Over the last thirty years, the Japanese Yen and the Swiss Franc have been popular choices, as attested by the real strength (see chart). Sterling did well between 2009 and 2016 as the UK built a reputation for fiscal restraint. However, none of these currencies can serve as the dominant reserve currency as the economies that back them are too small, which means that investors come up against valuation and liquidity issues when these currencies essentially become too popular.
Competition for reserve currency status will ultimately be between the world’s big three economies: the US, the EU and China.
Despite greater competition, the dollar has held its value through most of the post-Bretton Woods period, as the chart above shows. Fluctuations aside, a dollar today buys more or less in real terms what it did in 1980. Indeed, all of the major global currencies have fluctuated around parity over the period, which can be expected for currencies that float against each other – the so called Law of One Price ensures that nominal exchange rates move in opposition to differences in inflation across countries.
The exception is the Chinese renminbi, which has weakened by up to 60% in real terms since 1980, as a result of a conscious decision by the Chinese authorities to peg its currency against others at a weak rate to boost the country’s export sector.
Many consider the Chinese renminbi to be the natural successor to the dollar as China grows to become the world’s largest economy later this century. It’s possible, but it would require China to either open up its financial markets to global capital, providing a safe asset, or impose itself as the new figurehead of a fixed rate currency system. Neither of these looks likely for some time, so the dollar is likely to keep its preferred status over the renminbi.
The fate of the euro is potentially more interesting. With the Trump administration using the dollar’s important role in facilitating international business to impose crippling sanction on adversaries such as Iran, Europe is beginning to consider ways to circumvent the dollar payment system for its businesses.
There is nothing theoretically stopping the euro rivalling the dollar as a reserve currency, especially between those countries that have a close trading relationship with the Eurozone. Emerging market economies may also find a more diversified global reserve system to their advantage, as it would reduce the sensitivity of their economies to US interest rates.
However, until reforms are made to put the single currency on a more sustainable footing, allaying fears that the Eurozone could one day break up, that prospect looks unlikely for some time.
It looks therefore as if the US will continue to benefit from having the most popular global currency. It is in US interests to maintain dollar primacy, keeping funding costs and import prices low, and having what amounts to the best defence against the vicissitudes of the global economy. One group that does badly from this deal is US exporters and manufacturers, as a strong dollar undermines their competitiveness. This group has the sympathy of the US President, who has a preference for a weak dollar.
Investing in currencies
Having access to a range of currencies with safe-haven status is extremely valuable to investors. While first and foremost, any investor should consider her personal requirements – such as her preferred home currency, the balance of her international investments, her liquidity needs and the nature of her liabilities – there is value in considering which currencies are emerging as safe havens. For example, holding Yen between 1980 up until any time before the financial crisis would have yielded an average real return of over 40% (see chart), excluding any return on the investments held in those currencies. Holding the Swiss Franc between the financial crisis and 2015 would have yielded an average return of close to 40% on the currency alone.
With the global situation more volatile than it has been since the end of the Cold War, and with so many things that we once thought of certainties now in doubt, now is a good time to reconsider where the best places are to hold and preserve capital. Those places will have strong, responsible governments with open and liquid capital markets, low and stable public debt, and a willingness to accept a strong currency. And in today’s world, all of those things are contingent.
Hottinger Hike or Bike Charity Challenge
By Emily Woolard, General Manager of Hottinger Capital Partners
Colleagues from Hottinger’s London and Dublin offices spent Saturday 8th September on the beautiful South Downs, hiking or biking their way to Devil’s Dyke to raise money for well respected charity Macmillan Cancer Support.
Thankfully, the weather was kind and the far-reaching views provided ample reward for their exertions.
The team split into two groups, with six cyclists setting off from Hampton Court Palace in the early morning and covering over 60 miles in total including some challenging climbs. They battled through pain and fatigue (some more than others!) and finally reached Devil’s Dyke around 5:15pm, where they were treated to some excellent views and a welcome drink.
Meanwhile, an intrepid collection of seven hikers set out from the Sussex town of Lewes and covered 13 miles, eventually reaching the top of Devil’s Dyke and meeting up with the team of cyclists.
After recovering at Devil’s Dyke, the team headed into Brighton to complete their journey and celebrate as a group.
As well as spending time together and tackling a sporting challenge, the teams were raising money for Macmillan Cancer Support. Macmillan is an excellent charity which provides advice and practical help to those suffering from cancer. The cause is close to many of the team’s hearts as a number of colleagues, friends and family have benefited from Macmillan’s services.
There is still time to sponsor the teams if you wish to do so: https://uk.virginmoneygiving.com/fundraiser-display/showROFundraiserPage?userUrl=Hottinger&pageUrl=3
Watch this space for information on next year’s team charity challenge!
Investment Review: August 2018
By Hottinger Investment Management
August tends to be a quiet month due to the holiday season with problems only arising when major events combine with low volumes and reduced liquidity. In recent history, this has meant that the month has become one of the more turbulent of the year; however, the anticipated increase in volatility particularly in the US stock market largely failed to materialise. The major earnings figures released in July showed equities performing well in the US, Europe and Asia, most likely reflecting the strong economic tailwinds that have seen most global regions performing well. However, the rather benign 1% increase in the MSCI World Index masked quite different performances at regional level.
The US stock markets continued to play a significant, positive part with the S&P500 finally surpassing the January high to print a new all-time high of 2,916.50, and, the current equity bull-run became the longest in history on August, 22 2018 at 3,453 days beating the rally of the 1990s that ended with the dot-com crash in 2000. The S&P500 rose 3.03% during August but continues to be surpassed by the NASDAQ (+5.70%), driven by the small selection of consumer technology companies as represented of the FAANG+ Index.
US Treasury yields having momentarily hit 3% in 10 year maturities at the beginning of the month recovered to closer to 2.82% during the month, as fears of an overshoot by the Fed in raising rates or an inflation surprise failed to weigh on investors’ worries. Interestingly, as Morgan Stanley point out, the yield spread for US investment grade corporate bonds has failed to fully re-tighten after they widened out during the equity weakness in March, even though equities have recovered all their lost ground. Such divergences do not tend to last for long, and if they do they tend to signal the end of an economic cycle. This situation underlines our cautious equity stance at present.
Europe was again the main region to see investor outflows over the month as European equities weakened 2.7% and the trials and tribulations in Italy also caused Eurozone Government Bond yields to edge higher. The European banking sector has a significant exposure to Turkey, which provided the month’s emerging market shock by announcing the fastest pace of inflation since 2003, causing the Turkish Lira to collapse 40% vs. the USD. The US Dollar Index gained 3.79% over the month and other vulnerable EM currencies such as Argentina Peso, Brazilian Real and South African Rand suffered contagion while Emerging Market equities lost 2.9% over the month. The on-going trade dispute between the US and China continues to undermine the Chinese Yuan but the more robust Asian markets only gave up 1.25% over the month.
During the UK House of Commons summer recess the frailties of both Conservative and Labour parties managed to dominate domestic headlines while sterling lost ground against the Euro (-.51%) and the USD (-1.28%). Brexit headlines continue to exploit deep divisions within the ruling Conservative Party, and many industries are becoming noticeably anxious about maintaining trade with the Eurozone after March 2019 when the UK is supposed to leave the EU. UK domestic orientated stocks have tended to lag the large cap global exporters this year so there are possible opportunities for UK investors amongst depressed valuations; however, the UK FTSE All-Share index fell 3.46% over August.
The macroeconomic focus was largely on the thinking of the Federal Reserve and the proceedings of the Jackson Hole summit. There, we learned that while Fed Governor Jay Powell believes that the ‘gradual process of normalization remains appropriate’, he also said that ‘there does not seem to be a risk of inflation acceleration’. He expressed the view that monetary policy should respond not to academic models of where interest rates should be but instead to conditions in the actual economy. This was an important statement because many models such as the Taylor Rule point to much higher interest rates than the market expects over the next 18 months. The median FOMC member, often using these models as a guide, expects the Fed Funds Rate to be 3.5% by the end of 2019, which would mean a 25bp rise each quarter (or another 6 rate rises). Markets think that two or three are more likely. Fed overshooting provides the greatest risk to the US economy in the near- and medium-term.
If the Fed is moving in a more flexible direction, and they see signs that productivity is picking up (which would subdue inflation), then it is possible that the long recovery will not be choked off by monetary policy. However, we have yet to see enough evidence that this is indeed the dominant Fed view; combined with the tightening bias in other regions and concerns over debt and the easiness of financial conditions, we still think that monetary headwinds will strengthen in 2019, creating less favourable and more volatile conditions for risk assets.
England beat the United States in the Westchester Cup
By Alastair Hunter, Hottinger Capital Partners
On Saturday 28th July England took on the United States in the prestigious Westchester Cup. The event, also known as the International Day, was hosted by the Hurlingham Polo Association, the UK’s governing body for polo, at the Royal County of Berkshire Polo Club. The day was very well supported, with Hottinger guests joining Ally Hunter. They and the assembled spectators saw England, whose line-up included three of the winners of the 2018 Gold Cup El Remanso, retain the cup with a 12-6 win over the United States.
The game pitted evenly matched teams in a contest that was bound to be a close encounter, but in the end a stellar performance from Ollie Cudmore, who scored seven goals, proved the difference in what was a game of ebbs and flows, but England prevailed.
“I’d like to congratulate the English team on an amazing win today,” said Robert Puetz, CEO of the United States Polo Association, the body responsible for the game in the United States. “They played solid polo, were strategic, well-organized and well prepared. Additionally, I would like to thank the Hurlingham Polo Association, who provided amazing and welcoming hospitality to our team.” The Hottinger Group was delighted to represent the England team as an official shirt sponsor along with Flannels; other event partners include De Vere, Globe-Trotter and the Financial Times’ How to Spend It.
Plans are already in place for the next match to take place in the United States during 2019, the first time that the Westchester Cup will be played in consecutive years since the outbreak of the First World War. It’s interesting to consider the parallels with golf and the Ryder Cup in the late 70’s. We see the opportunity for the Westchester Cup to develop and become a fixture in the polo calendar.
It’s worth dwelling for a second on the trophy itself which is well over 100 years old and is a magnificent prize for such a great fixture. Tiffany & Co were entrusted with the production and as you can see from the picture below it is a beautiful trophy which has a few stories to tell!
We expect the match will be just our first major involvement with the game of polo. At the time of writing, we are preparing a deal for new investments that will support the launch of a range of branded sports apparel products for sale in the UK and abroad. The company plans to license the Hurlingham Polo Association brand as its standard bearer for a new range of products.
With incomes and wealth rising around the world, there has been a rise in interest in elite sports and luxury consumer goods, a trend first exploited by Ralph Lauren in the 1970s. The Hurlingham Polo Association is the oldest such body in the game with an illustrious history and an esteemed reputation. The business case is compelling and we look forward to inviting interested parties to take part in what promises to be an exciting venture.
The Hurlingham Polo Association is a natural partner for the Hottinger Group. Both organisations share a culture that promotes sustainable activities and relationships that provide enduring value to a range of stakeholders in society. Soon after British tea planters discovered the game of polo on the Indian-Myanmar border in the 1850s, Hurlingham began to shape all aspects of the game, from the rule book to the handicap system. Today it boasts close to 3,000 members, and is involved with coaching and development, as well as providing scholarships to promising young players. That shared belief in nurturing a legacy is what makes Hurlingham and Hottinger a natural fit.
We hope that this is just the start and we look forward to updating you with further developments in the coming months as the relationship evolves.
Investment Review: July 2018
By Hottinger Investment Management
World Cup fever and trade wars made for an exciting July within the financial sector just before the usually quiet days of August as the majority of the industry goes on vacation. This can lead to much lower volumes causing higher volatility should important events ignore the summer recess. For those left behind, investment opportunities can become apparent from unwarranted price volatility, but more often than not this is over-played.
The phenomenal strength of corporate earnings reported during quarterly earnings season was enough to push equity markets higher across the developed world. Over the course of the month, the S&P 500 gained 3.6% and European equities rose 3.5% and are now up on the year. Good economic news also pushed the 10-year US Treasury yield back towards 3% as the markets anticipated an August rate hike.
It is very difficult not to be impressed by corporate America with year-on-year earnings growth of 23.3% and growth in earnings of 8.7%; 91% of S&P 500 companies beat earnings-per-share (EPS) estimates and with regards to overall sales 74% of companies beat estimates. Despite the narrowness of stock returns that we have been discussing, especially the dominance of the FAANG stocks, there is nothing narrow about these statistics with all major sectors bar utilities seeing analysts raise forward guidance. As John Authers pointed out in the Financial Times, the FAANG’s have accounted for approximately 50% of the US stock market returns over the last 6 months, but it is still the fact that the number of stock price winners and losers overall is very similar.
European earnings have also impressed with 56% of the Euro Stoxx 600 Index beating EPS estimates and economic surveys in July suggest activity is stabilising at a level that is still consistent with growth of around 2%, which is above trend. Trade tensions eased between the US and EU after EU President Jean-Claude Juncker visited Washington adding to the good news surrounding equity markets. They agreed to work together and plans for new tariffs on other EU goods are on hold while talks take place. It is true to say that the bulk of the European recovery in financial markets was a 2017 story and European markets have been struggling this year with higher oil prices – Europe is a net importer of energy – and weakness in its chief exporting markets in Asia.
Brexit continues to dominate the UK headlines as the deadline for an agreement approaches. The market clearly remains nervous about the prime minister’s ability to strike a deal with Europe that will be sufficient to win a parliamentary vote. The continuing uncertainty is clearly affecting corporate investment and the cost of a weaker pound is also hitting the pockets of consumers. The FTSE All-Share gained 1.2% during July while the pound lost ground against major currencies over the course of the month down 0.5% vs the dollar and -0.67% vs the Euro. Despite general media marvelling at the strength of UK equities since the referendum the fact is that investment in foreign equities far outweighs the return in domestic markets. In sterling terms the S&P500 gained 4.1% in July to be up 8.5% YTD while European stocks returned 3.9% in sterling terms in July although YTD figures are very similar to UK stocks, up less than 1%. We note that a significant Brexit discount remains in the price of risk assets; we stand ready to respond should the outcome of the Brexit negotiations be favourable for risk markets.
Meanwhile Japanese equities only managed a 1% gain in July leaving the Nikkei 225 still down 0.7% YTD. While a case can be made for Japanese equities on a fundamentals basis, we believe that the currency risk remains too strong. The Yen’s safe haven status leaves it exposed to a deterioration of the trade skirmishes between the United States, Europe and Asia and until hostilities settle down, Japanese risk assets look unattractive. Trade relations between the US and China deteriorated further in July as the US government upped the rhetoric despite industry becoming more vocal about the impact of tariffs on trade. Having put the brakes on since the beginning of the year causing a noticeable slowdown in the Chinese economy the PBC cut the reserve requirement in July to encourage bank lending and the government announced a new package of fiscal policies that will affect many different Chinese companies. Ironically the 3% fall in the Yuan will help Chinese exporters overcome the effects of US tariffs which will do little to mollify Mr Trump.
India has become the single country globally to show the strongest economic growth (+7.7%) amongst large developing countries but, while emerging markets continue to provide a large part of global growth, financial markets will remain under pressure for as long as the dollar stays strong. The 6% correction in MSCI EM Index year to date is an indication of the effect of the dollar and the sharp slowdown in China this year but there are signs that equities markets are stabilising at current levels assuming there is no further deterioration in global conditions.
We entered the summer months feeling a little cautious regarding valuations and the ability of the global economy to continue at its current strength in the light of the extent of monetary tightening being undertaken and as such expect equities to be challenged in the second half of the year. We will, therefore, look to take some risk off the table in the medium term and increase cash balances in the expectation of more attractive valuations to come.
Volatility returns to emerging markets
By Economic Strategist, Hottinger Investment Management
A few years ago, the management consulting firm McKinsey produced a striking graphic. It showed how the economic centre of gravity has shifted over the millennia. In AD 1, the place to be was Asia. China and India produced about 70% of world GDP, with the rest shared by the Ancient world (Greece, Egypt, Turkey and Iran), Europe and Africa. That centre of gravity only really started to move in the 1500s, after the Black Death had transformed Europe’s social and economic institutions. By WW2 it was at its most westerly point, between Western Europe and the United States, as those two places accounted for 70% of world GDP. By 2025, McKinsey expects the world to be back to where it was in AD 1.
China and India will soon again account for the lion’s share of the world economy as the trend for countries with large, well-educated populations with strong governance systems to dominate takes hold. The French essayist Paul Valery was probably the first to notice this trend, writing in the aftermath of the first world war:
“So, the classification of the habitable regions of the world is becoming one in which gross material size, mere statistics and figures (e.g., population, area, raw materials) finally and alone determine the rating of the various sections of the globe.”
In the coming decades, it will make sense from an investment point of view to have an Asia-first focus, with the deliberations of the Central Bank of India and the People’s Bank of China carrying the weight that the decisions of the Federal Reserve and the European Central Bank have today. The International Monetary Fund predicts that in the next few years at least the continent of Asia will grow at 5.5% per year and account for two-thirds of all the world’s growth. By contrast, the U.S and Europe will struggle to grow faster than 2.5% per year.
It is in this context that we should see the rise in volatility in emerging markets in the last few months (see chart below). Over the last five years, there has been remarkable convergence between market volatility in the G7 and that in the emerging markets. Usually, emerging markets are attractive for investors who have long time horizons and a preference for growth over income in their portfolios, but in 2016 and 2017, according to the JP Morgan indices for volatility, emerging markets had as much average risk as that in G7 countries.
This year, emerging market volatility has risen sharply. Some of it is on the back of concerns over the fiscal sustainability of particular countries such as Turkey and Argentina; both of these countries have low levels of foreign reserves to support public debt in the event that tax revenues come up short. Similar to the situation in the United States, there is concern about over-leverage in corporate debt in some developing countries.
But much of the explanation lies with what developed-market central banks are doing with their monetary policies. The Federal Reserve has raised rates significantly in the last year, and have the intention to continue increasing rates until 2020. It is also selling Treasury bonds that it holds on its balance sheet at the time when the Trump Administration is planning to run $1trn annual budget deficits, funded by sales of new bonds to the public. With US interest rates still seen as a benchmark for the global economy, all these developments mean that global yields are rising on government and corporate bonds; additionally, the supply of dollars is more limited, strengthening the dollar exchange rate and making it harder for emerging markets to service their dollar debts.
This latter explanation reflects emerging markets’ vulnerability to external factors more than fundamental unsoundness with the direction of economic policy and development. It is why in the medium-run we should still expect relatively higher volatility to be the price to pay for exposure to developing countries, and why–although we should be concerned with the big uptick in EM volatility–we should place it in its proper perspective. As emerging economies grow, they will develop policy independence and less sensitivity to global events.
Political risk returns to Europe as the ECB tightens
It has been an eventful few weeks in Europe. Markets have been actively following the unfolding situation in Italy, as the new 5 Star-Lega coalition of populist parties took office. Things have quietened down as the members of the new government have reassured investors that it has no intention of leaving the euro, or breaking EU-mandated public spending limits that might have led to the same event.
But this is not the end of the story because there are a range of possible events stemming from Italy that could unnerve markets in the coming months and test the political foundations of the eurozone.
The bold macroeconomic policies of the new Italian government are the central issue, and will create headaches in Europe. The recently agreed 5 Star-Lega populist administration has plans to sharply increase benefits to the unemployed, radically cut taxes, reduce the retirement age, and increase infrastructure spending. Independent estimates put the increase in spending at over €100bn per year, or 6% of GDP.
Italy is not a profligate country. It has run a primary budget surplus since 1992 and only has overall budget deficits due to the interest charges on its extremely large public debts – currently around 130% of GDP. Much of that debt accrued in the 1970s and 1980s as Italy raised funds to develop its welfare state and to invest in the country’s poorer and more agricultural south through the Cassa per il Mezzogiorno programme. Interest rates also rose sharply in the 1980s as the Bank of Italy clamped down on high inflation, raising the debt burden further.
There are two short-to-medium term problems with the new government’s fiscal plans, the first exists irrespective of whether one believes bigger deficits would lead to the growth and additional tax revenues that would make the new debt sustainable. But both problems potentially lead to conflict between Italy and Europe’s creditor nations such as Germany and the Netherlands.
The first issue is both legal and political. Under the EU’s Fiscal Compact, countries cannot run a budget deficit greater than 3% of GDP, and if they insist on doing so they forfeit the right to assistance from the European Stability Mechanism in times of crisis. Being told by Europe that Italy cannot implement its economic policies is unlikely to reduce populist feeling in the country. Lega’s Matteo Salvini recently said that Italy will not be “slaves of Brussels or Berlin”, while 5-Star’s leader Luigi Di Maio suggested that he will go to “European tables” to fund his spending plans. That means either ignoring or revoking the Fiscal Compact.
The second issue is practical. Running large deficits means issuing quantities of bonds into the market at a time when the central bank is not an active player on the demand side and when interest rates are rising. Italy then would become exposed to significant political risk that could sharply push up yields further and thus the cost of borrowing. That in turn makes servicing Italy’s enormous debt pile even harder and could create centrifugal forces that make the state’s position in the euro area unsustainable. It is the feared ‘debt-crisis’ scenario.
This second issue assumes that markets believe that more state spending would not boost growth, and thus cut the debt-to-GDP ratio in the long-term; that is open for debate. But it also assumes that there are no meaningful political reforms in the euro area. Meaningful reforms include either significant moves to share risk across the region, such as introducing a Eurobond or a “safe European asset” that is backed by all euro area states; or agreeing to a banking union that consists of universal deposit insurance and a fiscal backstop for failed banks. In short, it assumes that Germany and other creditor states in Northern Europe do not agree to any form of risk sharing that ranges from debt guarantees to fully-fledged fiscal transfers.
Northern Europe and particularly Germany remain resistant. Last month, over 150 ordo-liberal German economists warned in a public letter against what they called a “debt union,” which would mean German taxpayers implicitly supporting other states. Chancellor Angela Merkel wants only limited reforms, including a European Monetary Fund that restructures debt and gives loaned assistance only if there are Eurozone-wide systemic risks and recipient countries implement structural reforms. This means exposing investors in troubled states’ bonds to haircuts and lengthened maturities during times of stress.
Unfortunately the German proposals, supported by the Netherlands and Austria, as they stand serve only to crystallise all of the problems that arose from the euro crisis of 2011-15. Merkel’s debt restructuring plan would weaken private sector confidence in peripheral sovereign bonds and reopen the possibility of self-fulfilling fiscal crises. It enacts punishing and self-defeating austerity regimes on troubled debtors, and strengthens the position of German Bunds as a safe asset. Italy will want a bolder approach, and they are likely to push for that ahead of the next EU summit on June 19th. France too will expect bigger concessions after implementing domestic reforms in labour markets and public spending as a quid-pro-quo for more economic integration.
The risk of a future Italian debt crisis also assumes that the ECB will not continue to backstop Italy’s sovereign bonds. This happens by default if the bank eventually moves into a phase of shrinking its balance sheet, but if the next governor of the bank, who takes office in October 2019, takes a more hawkish point of view, as is the preference of the German government, support for Southern European sovereign bonds in a future crisis scenario may not be there. Considering that it was Mario Draghi’s commitment in 2012 to do “whatever it takes” to contain the last crisis, a reversal of that commitment would create clear dangers.
We therefore face the possibility that the political ambitions of Italy’s new government could be thwarted by other countries and the European institutions. The question then becomes whether the populist government could credibly threaten to leave the euro and throw Europe into turmoil to extract concessions from the other countries. The answer is probably ‘no’ as euro-exit would decimate the Italian middle class. However, the systemic importance of Italy in the euro area and the recent shock of Brexit should focus policymakers.
Events in Europe in the last month show that there are still significant tensions between member states that cannot be solved by a short-term burst in economic growth across the region. Yet as that growth starts to slow and the ECB tightens policy, conditions will not be more favourable than they are today to agree the necessary reforms.
What is needed is a greater sense of pan-European solidarity in which your typical German Bavarian thinks of the concerns of the Italian Neapolitan with the same empathy with which she considers the problems of her immediate compatriots. That’s a multi-generational project. In the absence of that, Europe will continue to evolve through crisis, yet always carrying with it the tail risk of breakup. Political risk in the region has clearly not gone away.
How will Brexit affect family offices?
There has been much concern about the effect of Brexit on the UK’s financial services industry and the position of the City of London. Both Paris and Frankfurt have been seeking to attract people and business from London post-Brexit. European regulators have warned of restricted access to the EU if Britain leaves the single market, as it is likely to do.
One would expect that the dire warnings about the City’s future would cause a fall in business activity ahead of the UK’s exit, but that does not appear to be happening. Last year, cross-border lending by UK-based banks significantly increased for the first time since 2014. Foreign claims by the UK banking sector rose by $300bn last year to $5.1trillion, the biggest one-year increase since 2007 (see chart). The UK’s foreign banking exposure is about the same size as France and Germany’s combined. The upswing in global activity has played a part, but that only serves to underpin a broader point about London’s resilience as a venue for finance beyond Europe.
Since the Brexit referendum in 2016, London has maintained its position as the world’s premier centre for financial services, ahead of New York, Hong Kong and Singapore. It remains the case that London provides not just very deep capital markets, but a trusted legal structure; a whole range of ancillary services, covering insurance, tax and business consultancy; and world-beating cultural amenities.
There are strategic threats to the financial services industry of many large cities. An incompetently arranged Brexit is of course one only for London, but the rise of FinTech and the trend of large institutions spreading out their operations beyond the big cities also provide challenges.
What does this all mean for family offices? Whilst genuine family offices provide a broad range of financial and non-financial services, the impact of Brexit would only have the potential to affect cross-border financial services such as investment management, capital raising and private equity transactions. Many of these services in the UK operate outside the scope of European regulation and will remain so after Brexit. The UK will be an attractive place for European families who wish to base some or all of their operations outside of Europe and benefit from any regulatory divergence that the UK makes post-Brexit.
There have been worries over whether the lack of so-called passporting rights for UK firms to operate in Europe post-Brexit and restrictions on the delegation of European business to the UK could harm business with EU citizens. However, in recent weeks, Brussels has begun to recognise that any serious trade restrictions would hit both sides if they were effective, or could be nullified by new UK regulatory and tax laws that create strong incentives for European firms and clients to relocate.
One particular area of the industry which is booming is private equity. The total amount spent by private equity firms on new buyouts in Europe hit €90.2bn last year, a rise of 50%. Much of this was driven by the UK, where total deal value almost doubled from €14.7bn last year to €27.1bn this year.
Aspects of the UK private equity industry fall under the regulatory auspices of the FCA and with international investors frequently participating in such investments it is important to consider the impact any change in passporting rights might bring.
Interestingly, however, the vast majority of countries where investors reside exempt either the sophisticated, professional and High Net-Worth investor or the private equity industry from regulatory oversight. Single family offices are exempt for regulations from both the UK and EU. UK-based family offices are therefore well placed to facilitate deals, benefitting from high deal flow, deep capital markets and decades of institutional experience.
We cannot be sure yet what the specific outcomes from the Brexit negotiations will be, but whatever they are, the UK will continue to be an attractive place to do business. London has been at the heart of the global economy for three hundred years and has survived all manner of events including the US War of Independence, the French and Russian Revolutions, and the cataclysms of the 20th century. Brexit cannot really be compared to events of this magnitude. Modern family offices, which have been around since the 5th century, will adapt too, always to the benefit of the clients they serve.
Britain can lead the world in green finance
“I care nothing about the line or what is done with the money. If the East India Company choose to throw the money away, it is nothing to us.” This was how a British investor described the opportunity to fund a railway connecting the lush cotton fields of Gujarat to the port-city of Dholera, reported in an edition of Herapath’s Railway Journal in 1851.
Investors in London almost exclusively financed India’s first railways, but knowledge of the opportunities was scarce. All that mattered was that the British Raj guaranteed a 5% return, and if that meant taxing the Indian people when real returns fell short, then so be it.
It’s been some time since London could rely on the hard power of the British Empire to maintain its position as a dominant financial centre. The City today offers a deep pool of capital precisely because it depends on people who have an intimate knowledge of foreign markets and boasts decades of institutional experience. This makes capital cheaper and attracts worldwide business.
That is why last year, the Indian Railways came back to London Stock Exchange to raise $500m in green bonds to fund the electrification of their network and the replacement of their diesel trains.
That the state-backed company issued green bonds is significant. Britain’s trailblazing approach to climate change and London’s role as a financial hub present a golden opportunity for the UK to be a world-leader in financing the transition to low-carbon economies.
Financial instruments that are ‘green’ are those that fund projects that are defined as environmentally sustainable. As states implement the COP21 Paris Agreement to limit global warming to below 2°C, including regulatory actions that restrict high-carbon activities, the demand from governments and corporates for finance to support sustainable investment will grow.
Savers also increasingly care about how their money is used beyond its financial return. According to State Street Global Advisors, a quarter of all professionally managed assets (or $23trn) has an ESG mandate, growing by over 10% last year.
The OECD estimates that $44trn is needed in additional investments until 2050 to put the world on a sustainable footing. The investment opportunities are huge, from funding low-carbon infrastructure in booming African cities such as Lagos, to supporting China’s plans to build a vast renewable electricity grid across Eurasia, powering its Belt and Road project.
Low carbon investment more than pays for itself in the long-run through fuel savings but the infrastructure requires more up-front capital than dirty alternatives. Providing capital efficiently therefore matters.
London’s opportunity is to arrange and structure global green investments, and to manage assets with green mandates. The world needs deep, liquid, information-rich and well-regulated capital markets for green investments. Global investors want green financial products they can trust.
While Brexit threatens to weaken London’s lucrative role in underwriting European debt, it is unlikely to preclude steps to make the City attractive for emerging markets.
The Government’s Green Finance Taskforce recently presented a range of proposals that would advance London’s position. These include leading on regulatory standards in sustainable finance and on the corporate disclosure of climate risks and opportunities, as well as supporting research into the new field of green finance.
By providing these services, London can attract new business while keeping capital costs low for issuers, quickening the green transition.
The UK also needs to promote green finance at home. Britain has led the world in cutting emissions, down 43% on 1990, but it needs to go further. The next steps in decarbonisation, which include improvements in electricity storage and the development of hydrogen fuels for industry, will be harder to achieve and require more concerted support from the state.
The Green Finance Taskforce recommends that the government issue its own sovereign green bond, but it could go further.
In support of its Industrial Strategy, the government should set up a national development bank to allocate the proceeds of multiple green bond issuances, supporting research, the development of early-stage technologies, and emerging companies. It would create further opportunities for private capital to support.
Bank of England Governor Mark Carney last week spoke about the risks to financial stability posed by a delayed transition to sustainable economies. There is a case for reviewing the Bank’s mandate to allow it to favour green bonds in its asset purchasing programme. Boosting the availability of green finance through the central bank looks prudent.
The government through its Brexit strategy wants a Global Britain. Its 25-Year Environmental Plan aims for a green Britain, too. Green finance connects the two. It offers a new role for the nation that introduced the world to the industrial method and whose imperial legacy still touches billions of people.
Green finance presents an opportunity for the London and the wider UK to lead, at home and abroad, on the biggest issue facing our shared home. It’s time to seize it.
Fine Wine, Low Volatility
By Rodney Birrell, Founding Director of The Wine Investment Fund
The dramatic return of market volatility to equity markets in February 2018 was felt across the world. The VIX index (Wall Street’s “fear gauge”) had its greatest percentage jump on record, as stock markets in the US, Europe and Asia suddenly dropped. Concerns over returning inflation is putting pressure on interest rates and as a result, investors are turning to alternative assets as a means of financial diversification.
The fine wine market is characterised by relatively low volatility (annualised volatility of 10.2% – see chart, Liv-ex Investables), and even though precious metals such as gold (15.9%) have traditionally been considered safe haven assets, volatility within this asset class limits its ability to be considered as a store-of-value. Other commodities such as oil have also shown high volatility. The FTSE has an annualised volatility of 14.1%.
Stability of fine wine is a result of the unique features of this physical asset. Using The Wine Investment Fund’s definition of investment grade wine, the total market size is some £6bn with annual inflows (new production) and outflows (consumption) of around £1 billion. Therefore, the stock of fine wine is not only relatively constant, but is appreciated all over the world and sought after by a growing number of consumers regardless of economic and social conditions – a truly global market.
As a physical asset, wine has a defined inherent value and may therefore be used as a hedge against inflation. Similarly, to gold, fine wine is also an incredibly stable asset, with quality improving rather than depreciating over time as it matures, unlike other alternative investments. Uniquely, the quantity of any vintage decreases naturally, through consumption, as its quality improves as the wine matures and demand therefore increases.
Fine wine is also uncorrelated with other mainstream investment markets such as equities. Shocks in these markets have relatively small – if any – impact on fine wine prices in normal market conditions. For example, with the volatility seen in equities at the start of February 2018, the daily Liv-ex 50 index has remained within a 0.5% range (currently down 0.1% (at 27/02/2018) since the end of January), while the FTSE is currently down 3.04% since the start of the month (at 27/02/2018). This low volatility can also be seen historically using the longest available reliable index, the Liv-ex Investables – see graph.
Long term low volatility and high returns in the fine wine market can also be seen in the market’s risk-adjusted returns (see Sharpe ratio chart).
The introduction of centralised exchanges (such as Liv-ex in 2000) and the use of technology has markedly improved market liquidity and transparency. This has created a sophisticated space for fine wine as an alternative investable asset. Enhanced price discovery and security has allowed the market to develop an infrastructure similar to that of mainstream investment markets such as equities, with a success not yet seen in other collectibles such as art, cars and jewellrey. This has led to dramatic improvements in liquidity (the average market spread of the Liv-ex 50 index – Bordeaux First Growths – is approximately 3.5%) and a stable market environment.
As a store of value fine wine is also much more accessible than other alternative investments/collectibles such as classic cars. There is a wide range of investment grade wines available in the market. The Wine Investment Fund’s universe from which it stock picks the wines held in its portfolios (and which satisfies the Fund’s strict liquidity and quality criteria), amounts to 350 individual wines, with an average price per case of £3,000 per 12x75cl. In contrast, the average price of the 50 classic car models which comprise the HAGI Top index is £619,000 – not exactly within the range of most investors. Furthermore, investors may efficiently gain access to the wine market (i.e. invest in a well-diversified portfolio) through funds such as The Wine Investment Fund, the oldest publicly available wine fund launched in 2003, where the minimum subscription is £10,000.
Given the low volatility, the low correlation, the high liquidity and the high returns, all on a relative basis compared to other asset classes, an investment in wine becomes a must have for investors looking to establish or to maintain a well-balanced investment portfolio.
Could wages in the US remain subdued?
The consensus view in markets is that the United States is in the late stage of its economy cycle, that it is very close to full employment and that inflation will accelerate this year. On the back of this, many expect that the Federal Reserve – anticipating an overheating economy – will raise interest rates multiple times this year and scale back their asset purchases.
But what if this view is wrong? While we do see signs that indicate inflationary pressures in the US–from lagged PMI trends and capacity utilisation figures – we have repeatedly pointed out that unemployment is a misleading indicator of tightness in the US labour market. This is because the measure is blind to the large volumes of people who left the labour force after the Great Recession of 2007-9 and who are now returning. Official unemployment is a measure for only those people who are in the labour force at any given point in time but do not have a job.
This is the position that Martin Sandbu at the Financial Times (£) takes yesterday, and it can best be illustrated in the chart below.
Sandbu’s basic idea is that it is possible for the US economy to continue hiring people but for wages to remain muted as more people return to the labour market. We can see in the chart above that labour force participation – the proportion in the population of 25-54 year olds which takes part in the jobs market – is still well below its 1990s-peak, while the employment rate – the proportion of the population that has a job – is below its cyclical peaks in 2001 and 2007. The message, Sandbu concludes, is that there is still spare capacity in the US economy even though unemployment is low; and wage (and price) inflation is subdued because both employment and labour force participation are rising.
How likely is this? There is reason for doubt. Unemployment among 25-54 year-olds as a proportion of the population, implied by the gap between labour force participation and the employment rate in the chart, is also near the cyclical lows of 2001 and 2007. This is not the official measure of unemployment, which measures the proportion of the labour force that is unemployed, as opposed to the proportion of the population. However, official unemployment is also at similar cyclical lows. In both 2001 and 2007 for both measures, unemployment turned upwards within twelve months of peaking. This behaviour can be seen in the chart below at the peak of almost every economic cycle in the US since 1948. The only exceptions are in the late 1950s and late 1960s, when unemployment held steady as the economy added new jobs.
The question then is: which is the better cyclical predictor for labour market tightness – employment or unemployment? While Sandbu’s argument for the employment rate is plausible, it implicitly assumes that the damage wrought by the Great Recession can be largely if not fully unwound. On that point, we are sceptical.
There is evidence that during recessions, firms are more likely not just to fire workers but replace them with technology. Technological change has made large numbers of middle-aged Blue Collar men redundant. 90% of jobs in clothing manufacturing and 40% of jobs in electronics in the US have disappeared since 1990. Indeed, the labour force participation rate itself has been trending down since 2000. These jobs are not coming back and for many of the workers who are affected it is not possible technically or mentally to reskill. The scale of the opioid crisis points to the despair that many of these people feel with regards to their situation.
We don’t know what the scale of the damage has been, but there is good reason to believe that the labour force will not reach the size it did in the late 1990s. This doesn’t mean that labour force participation cannot continue rising in the short-term, delaying inflationary pressures; or that we should not pay attention to other measures of labour market tightness such as employment. But Sandbu’s implicit suggestion that, because employment remains low compared to the last 20 years, the US is necessarily still far from full employment is too easy. It is possible that the US economy has exhausted the gains from increased labour force participation, meaning that employment cannot continue to rise without pushing down unemployment, which is at cyclical lows. And this would most likely be inflationary.
We still therefore expect wage and price inflation to pick up this year as the US labour market tightens, but we would not be surprised if the process takes a bit longer than it does under the consensus view, with signs manifesting only during H2 2018. The Trump Administration’s fiscal stimulus program will, however, act only to hasten inflation’s arrival.
Positive Territory for the Third Consecutive Year for Fine Wine
By Rodney Birrell, Founding Director of The Wine Investment Fund
The fine wine market ended 2017 in positive territory for the third consecutive year with the Liv-ex 100 index, the industry leading benchmark, closing +5.66% and the Liv-ex Investables index gaining a similar 5.68%. It was also a year of records on Liv-ex, the fine wine exchange. Market exposure, the value of all live bids and offers, reached £48m and the bid-to-offer ratio remained above 1 throughout the year; for Bordeaux wines the ratio now stands at 1.8 with almost twice as much value on the buy-side (a bid:offer ratio of 0.5 or higher has historically indicated an upward trend in the market or at least acted as a signal for price stability). Trade on Liv-ex also broadened in 2017 with over 8000 active markets and more merchants than ever before trading on the exchange. The returning demand of traditional markets such as the USA and Asia has continued to be driven by weakness of GBP Sterling relative to the US Dollar and Euro (important because the secondary market for investment grade wines is GBP denominated) and the ever-growing demand for the world’s best wines. UK merchant BI Wines and Spirits “have seen a continued increase in volume sales of physical vintages, especially of Bordeaux, particularly to Asia” in 2017.
Increased attendance (up 2.3% on 2016) at the 2017 Hong Kong International Wine & Spirits Fair and the newly introduced preferential measures for wine imports from Hong Kong into mainland China (an increase in the number of ports available, expediting clearance improvements and developments in the accounting of duty, recognising the growth in wine imports to China) are positive signs of stable demand in the Far-East. In addition, the European Union and Japan have reached agreement on a free-trade deal which will eliminate tariffs on imports of EU goods, including wine, to Japan. The country is already one of the top 5 markets for EU wine in general and Bordeaux in particular and any increase in demand could have significant positive effects on prices. Demand from the Far-East has not just been for the purchase of fine wines, but also for the purchase of chateaux, with over 100 properties in Bordeaux now under Asian ownership, suggesting a continuing commitment to the region.
Results from the main auction houses throughout 2017 (Sotheby’s, Christie’s and Bonham’s) have repeatedly been above the high estimates and global demand has been a prominent feature: the Sotheby’s (sales of $64m in 2017) sale in New York in December reported strong bidding from North American (50% of sales) and Asian buyers (45%) and First Growth Bordeaux were sold at 20% over the high estimate. Luxury goods group LVMH (owners of chateaux Cheval Blanc and d’Yquem) reported growth in revenue and profits in its Wines & Spirits division, including “very strong” sales in the US and China. This suggests that demand for the most prestigious drinks brands continues to grow amongst the world’s wealthiest. These are also strong indicators of traditional collectors having returned to the market in 2017.
The Knight Frank Luxury Investment index, which tracks the price growth in the major categories of collectables found that wine has replaced cars as the top collectables, thanks to the performance of French wines. Compiled by Wine Owners, a business and collector trading platform, it reported “Wine’s performance was driven by exceptionally strong growth in key areas across the world and in particular the resurgence of the top Bordeaux chateaux, which form the backbone of most investment cellars”.
Despite a successful en-primeur (the top 20 merchants sold approximately £85m – up 46% on 2016 – with US wine merchant JJ Buckley reporting their largest ever campaign), Bordeaux producers have continually been reported to be holding back the majority of production and tightened supply of new vintages. For example, the 2016 vintage was larger in volume than 2015, but only a similar number of cases have ended up in the UK. This has driven demand across a range of physical vintages. Paul Pong of Hong Kong based merchant Altaya Wines found difficulties sourcing volume and believes “chateaux are releasing little to no supply for their first tranche”. The tightening of supply and rejuvenated demand emphasises the markets low volatility and we believe this will continue to put upward pressure on pricing. Optimism surrounding the 2015/16 vintages and a broadening market make it an attractive time to invest in fine wine and it offers an important opportunity to diversify into an asset-backed market and a hedge against returning inflation.
Inflationary pressures in Europe are the hidden danger
Much has been made of how the recent wage data coming from the US was the cause of the correction we saw in asset markets last week. It suggested that the Phillips curve may finally be asserting itself at a time when producer and commodity prices have been rising and the temporary factors cited by the Federal Reserve as holding inflation back are easing.
However, a bigger risk is that inflationary pressures are building in the euro area. The ECB has engineered a huge export of capital from Europe to the United States with its programme of asset purchases since 2016. The ECB’s bond buying programme pushed European yields down and encouraged investors to ‘search for yield’ in relatively more mature US markets that offered higher returns.
Markets got jittery in January after the release of the minutes of the ECB’s Governing Council most recent meeting, indicating that inflation may come through sooner than expected and that the central bank was willing to change its language with regard to its future policies. Investors up until then more or less believed Mario Draghi’s commitment to easy policy for as long as necessary to support the euro area’s recovery and the convergence of inflation towards the bank’s 2.0% target. Very little activity on rates is priced in.
However, there are good reasons to believe that inflation will pick up this year in Europe. Since 2014, capacity utilisation, a measure of the degree to which firms are using their resources, has been creeping up. Part of this reflected the low level of capital expenditure in the bloc and weak bank lending. The acceleration in EZ growth in 2017 caught a lot of manufacturers by surprise, with many increasing capex spending. Imports into the euro area in the year to November 2017 grew by over 7%, with the largest increases in import volumes in machinery from capital goods exporters such as China and South Korea, as well as in energy from Russia.
Nevertheless, capacity remains constrained and inflation is currently much lower than it should be as suggested by the level of utilisation (see chart below). It certainly has the potential to break through the 2% target-level within the next 12 months.
The other indicator that points to a pick-up in inflation is the level of unemployment. It is easy to be deceived by the European jobs market. In most Anglo-Saxon countries, unemployment typically has to fall below 5% before signs of price pressures emerge.
Anglo-Saxon economies tend to have more flexible labour markets that support people who have generalist skills. This means firms tend to report shortages when most people who want a job already have one.
In continental Europe, employment is typically more exclusive. To break into many parts of the French, Italian and German labour market, workers typically need to have specialist skills that cannot be easily transferred to other occupations and require years of training to acquire. Further, the costs of employing workers are typically higher due to taxes and regulation, which encourage firms to substitute workers for machines. Higher rates of unionisation can protect insiders at the expense of outsiders. And more recently, the scale and length of the euro crisis have increased the long-term unemployment of young people. All these factors mean that firms across the EZ are reporting skill shortages despite headline figures of unemployment of around 8.5%.
As the chart below shows, there is a relatively tight relationship between trends in HICP CPI inflation, which the ECB targets through its policies, and the level of unemployment six months prior. It shows that inflation starts to accelerate when unemployment falls below 8.5%, roughly where it is today. It also suggests that based on the steady reductions in unemployment since 2013, inflation is likely to pick up later this year. It is not out of the question that it could break through the ECB’s inflation target.
Together then, both capacity utilisation and unemployment figures point to upward price pressures that are unlikely to be offset by the downward pressures of a stronger euro on import prices. Add to that the strong EZ-wide PMI data and we think there is a strong case for a change in the ECB’s stance in the second half of this year.
Last week’s correction was healthy for equity markets which looked overstretched. But it did little to change the extraordinary fact that more than 15% of bonds on global markets trade with negative interest rates, according to Deutsche Bank. As central banks move from quantitative easing to quantitative tightening in the second half of 2018, that situation will have to change, which would at the very least create a more unstable and volatile market environment as both bonds and equities adjust to their fair values.
