Category: Uncategorized

By Hottinger Investment Management

A new conventional wisdom has emerged in recent weeks among people who want the equity bull market to run on and on, and it goes like this: The rally in global bonds and race to loosen monetary policy may be reactions to slowing global trade and activity passing through to sluggish earnings, but this does not mean that the great bull market in equities must come to an end. On the contrary, this view holds that lower bond yields boost valuations and should allow the party to keep going.

Usually, when central banks cut rates it is because economies are in ‘late-cycle’, which means growth starts to slow and company earnings soften. It is usually too late for central banks to stop this deceleration and their cuts to interest rates often kick in only once the economy is in a state of recession. Equities therefore typically fall as rates go down, which is evident in the charts below for two periods in the 2000s. In other words, during ‘late cycle’, there is a negative correlation between the total returns of bonds and equities.

People who hold this view are implictly saying that the positive correlation between total returns of stocks and bonds – something we have not seen much during the period of independent central banking – could be here to stay. They could be right. Although we are not convinced, it is worth mentioning four reasons which may support their case. While they may not be right today, they could be in the not-too-distant future.

The first is that recent US history shows rate cuts can coincide with sustained expansion in US equity markets. When the Federal Reserve cut rates in the mid- and late-1990s, first amid concerns of growth slowdown and then to fight any contagion from the Asian financial crisis and the Russian debt default, equity markets continued to rally. In 1995, the then Fed Chairman Alan Greenspan spoke of ‘insurance cuts’: pre-emptive reductions in interest rates to engineer a soft landing for economic growth. It seemed to work; it wasn’t until 2001 that the US next experienced a recession.

We could be in a similar situation today. There is again talk that the Fed will make an ‘insurance cut’ later this month and at least one more in the Autumn, but markets want four such cuts by Spring next year.  As in 1995, when Greenspan speculated that US inflation was “being held down by events in the rest of the world,” today global factors – emanating in China in late 2017 before passing through Europe last year – have acted as headwinds to an American economy that has been growing at above 3% per year for a considerable period of time.

A bout of monetary easing could reveal a US economy that remains resilient to global factors, one that is mid-cycle rather than late-cycle. The Fed would then have successfully permitted the party to go on. Many, however, are skeptical that the US economy has been immune to global events – particularly the trade war; US corporates that have high revenue exposure to China have performed relatively poorly in recent months.

A key reason for the global slowdown reaching the US last is the country’s unconventional fiscal policy – with the Trump adminstration presiding over a pro-cyclical fiscal deficit that recently exceeded 4% of GDP, according to the US Congressional Budget Office. Unconventional fiscal policy is the second factor that could support the idea that equity markets can stay strong as interest rates and bond yields fall.

Fiscal-monetary coordination is a dry phrase describing a concept that is in vogue within international policy-making circles.  Most notably, President Trump has been keen to politicise the Federal Reserve’s activities through the medium of Twitter, but the idea that central banks should work with government treasuries is one that is popular among serious policymakers too.

The incoming ECB governor, Christine Lagarde, has previously spoken about the need for fiscal-monetary coordination. She will play an important role in encouraging European governments to spend more and persuading EU institutions to let them do so. What this means is that lower interest rates could provide the fiscal space for governments to spend more as they would be able to borrow more cheaply. Extra spending could then translate into stronger nominal GDP growth that feeds into earnings and valuations. In this scenario, share prices would rise. We have previously argued that such a switch to policies of ‘fiscal dominance’ could drive inflation in a way that means that stocks and bonds move in the same direction.

The third reason supporting the equity bulls lies in the possibility that central banks will in the future support equity markets directly. There has been speculation that in the event of a serious downturn, central banks may directly intervene in the equity markets by taking stakes in public companies. The Bank of Japan has already implemented such a policy, last year purchasing 5.6 trillion yen ($50bn) in Japanese equity ETFs, taking its total ETF balance to around $300bn. The central bank aims to use ETF purchases to stoke inflation by spurring gains in asset values, as well as promoting active private consumption.

We are not convinced that outright direct equity purchases do more than just aggravate inequality, but governments could design sensible equity purchase policies where their central banks would buy equities when they have suffered a drawdown, sell them as the market recovers and distribute the gains to the public ahead of the next downturn. The point, however, is that this policy would support an environment where rising equity prices could coincide with falling bond yields, as the central bank would be active in both markets.

Lastly, the Federal Reserve is arguably the world’s central bank. Anyone who has read Crashed by the peerless Adam Tooze can appreciate how it was the Fed, not the ECB, which bailed out European banks during the 2008 crash through its liberal supply of dollar swap lines. The Fed’s interest rate policy is also closely tracked by a great many emerging market economies, whether or not they peg their currency to the US dollar.  

Last year, economists Matteo Iacoviello and Navarro Gaston studied the global transmission of the U.S. Federal Reserve’s interest rate policy and what they found was striking. Looking at macroeconomic data covering the period 1965-2016, they found that the effects of monetary tightening from the Federal Reserve on economic growth 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 with exposure to the dollar, current account deficits and low foreign reserves – such as Turkey, South Africa and Argentina – can be severely constrained by tight U.S monetary policy.

Certainly, then, lower US bond yields and interest rates can be very positive for dollar liquidity in emerging markets (EM). They can support  EM companies’ balance sheets and ultimately asset prices too. Given the growing weight of EM in global markets, there could be positive feedback for US equities too.

So, there we have it. The equity bulls may be right, but we think the rally in global bonds is more likely a reflection of the hard economic data pointing to a moderately slowing world economy, which should be negative for equities as earnings fail to meet ambitious expectations. In time, therefore, equities should come down even as interest rates do too.

However, there are good reasons to suggest that investment dynamics could change in favour of equity bulls over the longer term, but only if the political-economy environment changes too: If the policy regime changes to one involving deep fiscal and monetary coordination, if central banks start directly supporting equity markets, or if emerging markets increasingly become dependent on dollar liquidity delivered through a low interest rate policy from the Federal Reserve, the picture could look very different.

By Hottinger Investment Management

Last week, the Italian treasury issued €3bn in 50-year bonds. According to Reuters, the issue drew over €17bn of bids, 80% of which were from foreign investors, with Germany the single biggest source of capital. The final yield came out at 2.877%.

International interest in Italian bonds comes in the context of a general scramble for government bonds amid fears of a widespread global slowdown. In the belief that interest rates are broadly coming down and the ECB will stand behind Italy’s public debt, investors appear to have parked their concerns about Italy’s political situation.

Last May, Italian 2-year yields spiked above 2.7% and 10-year yields rose to over 3.5% in the following months as the Italian government threatened to break the EU’s budget rules in order to increase public spending. Even though Italy’s de-facto leader Matteo Salvini and others in his administration have since toned down their rhetoric, it is hard to make the case that Italian public debt is now a safe asset. Investors may come to regret piling into global government bonds generally and Italian bonds specifically.

Who can blame the Italian debt management office for capitalising on the great rally in global bonds? Academic research by Martin Ellison and Andrew Scott finds that issuing long-dated bonds actually costs most governments more over the long-term compared with rolling over shorter-dated bonds as they fall due. This is because the premium that investors charge for duration risk, combined with the fact that we live in an environment in which central banks have anchored inflation at low and stable levels, amounts to a subsidy from the government to investors. Italy, however, is a different case and we should ask why the country might be interested in issuing more longer-duration bonds.

Issuing large amounts of very long-dated debt only really makes sense if you cannot rely on the market to offer you stable short-term rates, if you are planning to announce a big spending programme and do not want refinancing costs on your existing debts to rise, or – more perversely – if you are intending to generate a bout of surprise inflation in the future to reduce the real value of the debt you have issued. This last reason does not really apply to Italy because it does not have control over its money supply and – as a member of the eurozone – it has only a limited ability to generate inflation in its own country independent of the European Central Bank.

Nevertheless, this lack of independence makes the situation for Italy quite interesting. Italy currently carries a debt-to-GDP ratio of over 130%. That ratio is high not because the Italian government has been feckless in recent years; in fact, since the early 1990s, in every year except 2009, Italy has run a primary budget surplus. Italy’s problems lie in the fact that it built up huge debts in the 1960s and 70s as it expanded its welfare state; since then, it has simply rolled those debts over rather than paying them back. Italy has had difficulty repaying legacy borrowing as economic growth and inflation have struggled to exceed the rate of interest that investors charge on bonds. Even today, Italy’s economy is still smaller than it was in 2008 and not much larger than it was in 2001. The German economy, by contrast, is over 50% bigger than it was at the turn of the millennium.

With Italian growth anaemic and the ECB conducting a monetary policy that is too deflationary for the country, Italy’s indebtedness is a problem for markets, which tend to react sensitively to developments in Italy’s economy and politics, quickly repricing Italian debt. It is also problematic for the Italian government, as high legacy debts constrain its ability to vary fiscal policy, either according to movements in the economic cycle or according to structural requirements such as the need to invest in infrastructure and education.

It therefore makes sense for the Italian government to reduce its reliance on short-term debt as it cannot know in advance whether maturing bonds will come due in a period in which the markets have very little confidence in the Italian economy and the Italian government wants to spend more money – such as during the euro crisis. Issuing longer-dated bonds can therefore reduce repricing risk and thus default risk.

Even still, it is costly. The 2.8% yield on the 50-year bonds is a little above the peak of the spike in 2-year yields, which occurred after the announcement of the Italian government’s intentions rapidly to increase spending in May 2018. So, the second and third justifications for issuing long-dated debt also still stand: future spending and higher inflation. If the Italian government is secretly preparing a large fiscal stimulus or thinks that an Italy-friendly ECB will generate inflation that exceeds the spread between 50-year and 2-year bonds, then the Italian government will benefit from issuing long-dated bonds. This is because, in the first instance, markets will have less ability to punish Italy for pushing its debt level higher by increasing interest rates; and in the second instance, the eroding effect of higher inflation will help bring down Italy’s debt burden by forcing real-terms losses on long-term bondholders. If any rise in public spending pushes debt beyond sustainable levels, then long-term bondholders could face capital losses as the risk of default and haircuts rises.

It is too much to infer intentions from relatively small issues of long-dated debt, but if this trend continues as other existing bonds mature in the coming months and years, alarm bells ought to start ringing among the foreign investors who are piling into Italian debt today in the search for ‘safe’ assets. The expectation that a dearth of safer German bunds will force the ECB to hold more Italian bonds in any future round of quantitative easing is not the strongest insurance against any possible long-term erosion in the real value of Italian sovereign debt.

The narrowing of the 30yr-2yr spread appears to suggest that investors are more comfortable in Italian bonds that mature well into the future, or at least after the passing of the current, populist administration. They appear to be less concerned about long-term Italian inflation and debt dynamics than they are about the risk of a sudden re-emergence of a budget crisis in Italy. With 10-year bonds now yielding less than they did before the Italian government took on the EU over public spending whilst 2-year yields are still above their pre-event levels, one could argue that shorter dated Italian debt continues to carry a small risk premium.

We think there is also a general possibility that this global bond rally is a bit overdone. Investors are scarred by the financial crisis and have seized on the link between the ongoing trade tensions and slowing global manufacturing as foreboding a global recession à la 2008. If we learn that at worst, any coming recession will be shallow and that at best fundamentals are still actually okay, then all those who are piling into bonds today could quickly get burned. This applies to Italy too, but the more pressing concern is an escalating political disaster that pits Italy against the EU in a future crisis over its budget. In that situation, investors who are scooping up 50-year Italian debt at under 3% may come to regret it.

By Tim Sharp, Hottinger Investment Management

The S&P 500 has had its most successful half year since 1997, rising 17.35% following signals from Fed Chairman Jay Powell that the Federal Open Market Committee (FOMC) is on the verge of a rate cutting cycle. Based on 12-month earnings estimates, the index is trading at 17x, vs its 10-year average of 14.8x, last reached just before the sell-off in 2018. This shows that upward revisions in earnings have not been forthcoming, as Philip Georgiadis reported today in the Financial Times.

Markets have been pricing in more aggressive monetary easing from the Federal Reserve, as indicated during the June FOMC meeting mid-month, when Powell was quoted as saying “an ounce of prevention is worth a pound of cure”. The S&P 500 gained 6.89% on the month, leaving the Euro bloc (4.93%), the UK FTSE 100 (3.68%) and Japan’s Nikkei 225 (3.27%) languishing in its wake. Markets now expect three or four 25bps rate cuts by the end of December, which may mean a cut at four of the next five meetings of the Federal Reserve Board. Despite falling inflation in the US providing cover for rate cuts, the Committee expressed scepticism about the likelihood of the expected 100bps in cuts happening, which, if it turns out to be well-founded, could cause a tanrtrum in equity markets and a rise in bond yields.

The move by markets to expect central banks once more to bail out risk asset markets was matched by the European Central Bank (ECB), indicating that further stimulus could be forthcoming. Regardless of whether investors bought equities, corporate bonds, developed market government bonds or indeed gold, the latter of which rallied 7.96% to $1409/oz, these investment decisions would have yielded a positive return in June. The threat of lower rates in the US pushed the dollar index down 1.66%, which partly explains the rise in gold and the strong performance from emerging market equities, which were up 5.70%.

This leaves the financial markets with a dilemma as to whether the global economy is in late cycle or indeed mid-cycle. This is because the timing of the next round of stimulus will either catch the falling global economy and keep the expansion going, or it will merely soften the effects of the weaker environment now showing itself but fail to prevent an economic downturn. In line with research from Morgan Stanley, we think that interest rate cuts in late cycle will likely coincide with declines in equity markets shortly afterwards. Central banks often overshoot with rate rises and these take time to work their way through the economy; by the time the rate cuts come through, the economy is often in a slower gear. If, however, we are mid-cycle, rate cuts – such as those seen in the 1990s – might actually support equity markets.

Global manufacturing Purchasing Managers’ Indices (PMIs) remain suppressed, as hard data on shipping volumes and inventories suggest that global trade is slowing. Export and import growth in China has dimmed, and European industrials in major exporting countries continue to disappoint despite a brief glimmer of hope in April. Notwithstanding a boost to the US growth outlook through retail trade and industrial production prints, the country is unlikely to sustain the current 3%+ annualized rate of growth.

The extent of the effect of the US-China trade war on the global economy became more evident in June with the release of global manufacturing statistics. Manufacturing surveys around the world have been falling – most notably in the US, China, Japan and Europe – leaving global new orders at the lowest point on record and business optimism pointing to falling output. South Korea, often used as an indication for the global market, saw exports fall year-on-year by the biggest margin for 3 years. In the UK, the PMI data fell to 48 in June vs 49.4 in May, the lowest level since 2013, suggesting a fall in output for 2 consecutive months. Many industries are suffering from the continued Brexit hangover as inventories are run down after the build-up prior to the original leave date in March, but many are also pointing to continued weakness in global export markets.

The UK continues to be dominated by the Brexit narrative and the Conservative leadership campaign that will decide the next Prime Minister before the deadline to leave the EU on 31 October. It remains to be seen whether and how either candidate will be able to negotiate a deal with the EU, persuade Parliament to leave without a deal or indeed unite the Conservative party to solve the impasse. Effective government has largely ceased in the UK, so companies will be relying on the Bank of England to join the central bank moves to add further stimulus to reinvigorate the economy. Uncertainty saw the pound fall back into negative territory for the year in June, weakening -0.65%, and gilts were unchanged despite the rally in sovereign bonds in other developed countries.

The G20 meeting on the last weekend of June saw the US and China agreeing to continue trade talks with no escalation in tariffs, taking away the immediate fears of financial markets, with the added good news that the US softened its rhetoric surrounding the security questions of trading with Huawei. The ongoing uncertainty will continue to weigh on sentiment, but we can expect short-term relief that the can has been kicked a little further down the road.

We join the many investors who have decided to wait and see whether central bank policy manages to reaccelerate global growth or fails to prevent it slowing further, which will offer an indication as to how late in the economic cycle we currently find ourselves. Equity valuations are elevated and US 10-year bond yields have reacted to the Fed’s comments by dropping from 2.26% at the end of May to 2% by the end of June, as asset classes once more become correlated and some traditional relationships break down. A rate cut in July is likely, which should provide opportunities for profit-taking, however the longer-term outlook from the Fed meeting should really inform the global picture for the second half of the year.

By Hottinger Investment Management

 

There has been a rise in interest in what one might ordinarily consider to be a mundane subject: the correlation between stock market returns and bond returns. It is an important topic because portfolio asset allocation since the turn of the century has been built using assumptions about the correlation between market movements in stocks and bonds that are beginning to look a bit weaker. If these assumptions break down, then the consequences for investment strategy and performance could be profound.

First, we must be clear on the concepts because it is easy to get confused. Analysts often use terms such as prices, returns and yields inconsistently when talking about correlations between stocks and bonds. When thinking about the subject, one should therefore bear the following in mind:

1. The price of a fixed coupon bond is always negatively correlated with the yield of the bond. A more expensive bond “yields” less as the interest payments (or coupons) are usually fixed against, in this example, the higher cost of purchasing the bond. Exceptions may apply to inflation-linked bonds, where higher inflation could raise coupons and therefore yields in a way that attracts demand from investors that pushes bond prices higher.
2. The total return of a fixed coupon bond is always positively correlated with the price of the bond. The total return of a bond comprises both interest income received from the bond and any gains or losses in the capital value of the bond, measured by its price. Interest income is often – and confusingly – referred to as yield, but – as explained above – this is usually a fixed amount determined in advance of purchase.
3. The total return of an equity comprises both dividend income and any gains or losses in the capital value of the equity, again measured by its price. The total return of an equity is usually positively correlated with the price of that equity unless companies explicitly tie their dividends to share price performance.

So if, for example, an analyst says that stock prices are negatively correlated with bond yields, they are almost certainly also saying that (i) stock prices are positively correlated with bond prices and (ii) total stock returns are positively correlated with total bond returns.  

Analysts have been studying the long-run stock/bond correlation data and believe that an important recent trend is coming to an end.

As Figure 1 shows, during most of the period since 1937 in the United States, the correlation in total returns has been positive, meaning that neither asset class offers protection from poor performance within the other. However, since the late 1990s, the correlation between total returns of stocks and bonds has been sharply negative, supporting a popular portfolio allocation model that puts roughly 60% of capital in equities or stocks and 40% in bonds. This is done with the expectation that when one asset class performs badly, the losses can be capped by stronger performance in the other asset class.

Alternative data series show that strong positive correlations in total returns were the norm not just in the U.S. but also in developed economies going back to the 1800s before turning negative in the 1990s. However, this era of negative correlations may be coming to an end everywhere.

Our view, shared by others in the investment community, is that the period of negative total returns correlation has a proximate cause in low inflation, which the US has experienced since the late 1990s. We think the causes of low inflation are central bank independence – which only really took hold in the late 1990s and early 2000s – and weak bargaining power of labour, which is a trend that goes back to the 1970s. The share of national income in the US (and other developed economies) to wages has fallen from about 52% in 1970 to about 43% today, according to the Bureau of Economic Analysis.

In the last 20 years, monetary policy has prioritised low inflation and has typically taken the lead over fiscal policy when economies slow down or move into recession. It makes sense, therefore, for bond prices to rise as stock prices fall in the period before a recession as central banks prepare to cut interest rates. And it makes sense for this to unwind as economies recover. With anti-inflation central banks keeping a lid on demand and fewer opportunities for labour to push for higher wages, inflation has recently barely registered as a factor compared to how it has done throughout most of the rest of post-WW1 history.

Take, for example, the 1960s, the only period on historical record during which the correlation flipped from negative to positive. CPI inflation rose from around 1.2% in 1964 to 5.5% in 1969. According to Federal Reserve Economic Data, over the whole five-year period between 1965 and 1969, US 10-year Treasuries returned just 0.06%, a strongly negative real return given the high inflation. The S&P 500 returned 27%, which was not significantly more than the cumulative inflation – of 19.7% – over the period. Inflation may have affected both asset classes negatively; in the previous five-year period between 1959 and 1963, the S&P 500 returned 59.2% and US Treasuries rose by 19.2%. As both bonds and equities struggled together, the correlation between the two became positive and the historical 10-year correlation as shown in Figure 1 steadily rose. 

This may have been a singular case, but it is worth investigating whether there are any lessons for today.

Populist demands for a higher share of national income to be reallocated from capital to labour could create a structural shift which, combined with inflationary pressures, would push down returns across asset classes as higher labour costs cut into companies’ margins.  This appears to be what happened in the 1960s. Unemployment was below 4% – as it is today – which is considered a level that represents a tight labour market and raises the risk of wage-inflation.

This is a view developed in some detail in a recent paper by Marco Pericoli for the Bank of Italy¹. In it, Pericoli claims that before the 1990s, inflation and economic growth were negatively correlated as it was typically supply shocks that pushed up costs and brought about recessions. He found that in the stagflation period of the 1970s to 1990s, “good” news regarding future cash flows to equity was correlated with lower expected future inflation; in other words, supply factors such as labour or input costs were driving inflation higher and hitting company margins. Since 2000, however, inflation and economic growth have been positively correlated as demand shocks have driven the business cycle.   

Equally, populist demands for more active fiscal policies could generate higher wage inflation during stress periods for the economy. If wage inflation rises in response to a fiscal stimulus, stocks could fall as costs rise; bonds would be hit by higher price inflation. Therefore, total returns for bonds would tend to move in the same direction as total equity returns.  With increasing demands for fiscal stimulus at a time when unemployment is at record lows, it is not surprising that the stock/bond total return correlation is moving back towards positive territory.

The implications for asset allocation are potentially significant. If total returns between stocks and bonds stop offsetting each other, then the justification for running portfolios around the 60/40 model of roughly equal weightings to equities and bonds will start to fall away. Attention then ought to turn to judging each asset class on its own merits and allocating capital according to attitudes to risk and tolerance for drawdown. This may well be good news for active asset allocation and bad news for those who are simply resting on their laurels.  

¹The paper also shows that the trends for historical stock-bond correlations apply for other developed economies such as the UK, France and Germany.

By Hottinger Investment Management

Investors are not impressed with Europe’s escape from near-recession. Traders have pushed down the Forward 5y5y Inflation Swap Index, a proxy for future expectations for inflation, towards 1% this week. This is the lowest level for inflation expectations since at least 2004 and reflects the rally in several European government bonds, including the sovereign paper of Italy and Greece.

The movement has, at best, shot to pieces the ECB’s hope that the market would take the reversal of QE and higher interest rates in its stride. At worst, it suggests that the ECB’s Governing Council may have to start thinking creatively about the next round of stimulus, starting from the unenviable position in which interest rates are already negative.

We have previously argued that Europe’s manufacturing sector has been at the heart of the region’s weakening economy as a slowing China and trade tensions weigh on global demand and exports. It appears that despite some good news in recent months, the European economy remains highly sensitive to global developments and this is what is causing concern among investors.

Last week, Germany’s Federal Statistics Office announced the biggest monthly fall in German industrial production in four years, with factory output in April 1.9% lower than it was in the previous month. Shortly after the German industry report, the Bundesbank issued its latest forecast for the economy, cutting its 2019 prediction from 1.6% to 0.6%.

According to Eurostat, during April eurozone industrial production shrank at a month-on-month pace of 0.5%, a greater rate than the consensus of -0.3%. Among the bloc’s other economies output was weaker in the Netherlands (-1.7%) and Italy (-0.7%) while in France (0.4%) and Spain (1.7%), it was higher. However, compared to a year ago, industrial output across the eurozone is 0.4% lower.

Export-facing categories of goods have fared particularly badly. Output of durable consumer goods was the weakest, shrinking by 1.7%, followed by a decline of 1.4% in the production of capital goods such as factory tools and machinery. With the euro area building up a large trade surplus to recover from the region’s extended financial crisis, there are renewed fears that weaker exports could infect the domestic economy and its services sector, which have so far shown a resilience supported by strong real wage growth and falling unemployment.

So what can the ECB do? In recent weeks, Mario Draghi has talked about targeted long-term refinancing operations or TLTROs. These are loans that the central bank offers to commercial banks at attractive rates on the condition that they use the resources to lend these funds on to the real economy. We have previously argued that TLTROs as currently designed are somewhat impotent. The implicit subsidy in the TLTRO lending rate of -0.4% is not large enough to incentivise big increases in lending to the kind of risky economic projects that generate growth. Chronically weak productivity growth and soft demand in the eurozone mean that banks struggle to find good ventures with an acceptable level of risk.

Eric Lonergan, a macro fund manager at M&G, has been promoting a novel tweak to TLTROs that would turn one of the central notions of banking on its head. The first principal of banking is that the bank charges a higher interest rate on its loans than it pays on its deposits, generating revenue on the spread between these two rates.  Central banks such as the ECB replicate this idea by setting their deposit rate below their borrowing (or refinancing rate).

Lonergan’s suggestion is that central banks flip this order, lending to commercial banks at steeply negative rates and allowing them to deposit reserves at zero or positive rates. The ECB could introduce simple rules to prevent churning (i.e., redepositing borrowed funds) by requesting that, similar to the rules for TLTROs, any borrowed funds be on-lent to the real economy. Such an idea is radical and amounts to potentially a huge subsidy to commercial banks. If the ECB set a sharply positive deposit rate, the central bank would be subsidising consumers too if the ECB were to request commercial banks pass the returns to savers. Lonergan considers this as a ‘dual interest rate’ policy, where the central bank sets two interest rates and allowing them to diverge from one another at certain parts of the cycle. 

The idea is interesting but is not without its problems. Sharply negative rates potentially encourage speculative bubbles and by subsidising possibly unproductive projects they could lead to a waste of resources. However, such an idea could go far in re-establishing the ECB’s credibility at a time when inflation expectations are falling and the ECB’s Governing Council is flirting with the appointment of perma-hawk Jens Weidmann as its leader.

Conversely, a Weidmann ECB could ensure that Lonergan’s dual interest rates idea never gets off the ground. If so, the Eurozone could be more reliant on fiscal stimulus than ever before. 

By Hottinger Investment Management

As we discussed recently, we have seen signs in the last couple of months that the global economy may have put the recent slowdown in activity behind it. Shipping volumes have picked up after cratering towards the end of 2018. There has been a big rise in Chinese export orders, which bodes well for Europe. The US dollar has remained strong, dampening the appeal of emerging markets as the Federal Reserve’s feet-dragging on rate cuts keeps the dollar attractive for global investors.

Leading economic indicators out of China have turned positive. According to the World Steel Association, China’s crude steel production for April 2019 was 85.0 Mt, an increase of 12.7% compared to April 2018, the fastest rate of growth since at least November 2017. Inventories of iron ore fell by almost 20% between mid-April and mid-May, possibly suggesting increased demands from industrial companies.

However, there are some signs of negative pressures. The CSI 300 index of leading Chinese stocks has struggled despite a good start to the year. We have also seen that MSCI World companies with high revenue exposure to China – especially semiconductor producers – have become more volatile as the trade war between the US and China intensifies, and they performed particularly badly last month.

In Europe, domestic factors have withstood the headwinds from a challenging global trading environment. Strong wage growth of 2.3% has been in excess of inflation and has therefore undergirded consumer spending and the domestic-facing industries. However, signs of strength may be misleading. The most recent German sales figures show a decline on the month (although still 4% up on the year).

We have discussed possible opportunities for value investing in Europe, given the attractive valuations of such stocks. Research suggests, however, that periods of value outperformance do occur but can be short-lived. Where they occur and persist, this is due to supportive macroeconomic policies that prioritise full employment over inflation control.

Therefore, with inflation expectations in the Eurozone trending towards 1% as measured by the 5y5y forward inflation swap, and with the prospect of a hawkish ECB governor following Mario Draghi later in the year, we don’t see conditions in which the long-favoured return of European value outperformance can be sustained, if indeed it happens at all.

We note that the market is pricing in 40bps of rate cuts in the US by the end of the year, the most aggressive expectation for monetary easing in this cycle. The Federal Reserve, however, remains neutral and will continue to respond to economic conditions. With core inflation falling in the US, growth and consumer spending decelerating, retail and auto sales weakening, and companies refraining from investing due to fears over the international trade, there is good reason to think that the Fed will comply with the market’s demands. However, it is moot whether the Fed will fully comply and cut interest rates twice this year, especially if inflation rebounds or is pushed higher by the effect of China’s retaliatory tariffs.

If the Fed fails to meet market expectations, negative sentiment could emerge and affect US equities, especially in the “Cyclicals” segment of the market, which has outperformed the “Defensives” segment in the last couple of months.

Nevertheless, the US remains an attractive market. The dollar is strong on a trade-weighted basis, defying market predictions for a move downwards. Persistently high relative US interest rates, coupled with America’s deep and broad capital markets, have kept the dollar strong. We have also seen that US markets have outperformed other global developed markets even once the popular Technology sector companies have been stripped out of the S&P 500 index.

In the UK, we discussed how the flattening gilt curve seems to be impervious to domestic political risk, possibly reflecting a global trend towards fixed income products with 10-year gilt yields falling in line with German bunds and US Treasuries. The yield on German bunds has fallen to record lows below -0.2%.

However, our view is that with the situation in UK politics as it is, there could be considerable downside risk to buying long-dated gilts. We also believe that while there may be a significant value discount in UK equities, high payout ratios (implying low investment rates) and low dividend growth rates represent headwinds. Nevertheless, we think that sterling remains at a discount to fair value, especially against the US dollar and a favourable resolution of the Brexit question later this year will on balance provide impetus for the currency to strengthen towards its long-run median level.

By Harry Hill, Hottinger Investment Management

May 2019 marked another month in which markets were more driven by political noise than by fundamentals, however, that’s not to say that fundamentals were completely ignored.

As Theresa May handed in her resignation effective June 7^th, Donald Trump fuelled the fire by slapping further tariffs on the Chinese and surprised markets with 5% tariffs on Mexico in his latest attempt to curb ‘illegal aliens’ crossing its territory. May was therefore an eventful month to say the least. Global equities were down 5.66%, making May the first month this year that has exhibited negative returns. The VIX, a measure of volatility, reached a 4-month peak at 20.55, which compares to a broader average of 15.8 since January.

Theresa May’s departure announcement did not come as a huge surprise, but the uncertainty around her successor, the likelihood of a general election and the possibility of a no-deal Brexit outcome have had noticeable effects on the currency market.  The currency movements of sterling demonstrate investors’ indecisive predictions surrounding Brexit. The depreciation of sterling began on the 3^rd May at $1.317, following the collapse of cross-party Brexit talks and the results of the UK local elections, which saw big losses by the Conservative party. The GBP-USD rate currently sits at $1.267.

Unlike the aftermath of the 2016 referendum, depreciation in sterling no longer proves to be the tailwind it once was. The FTSE 100 fell 3.5% in May, which is counter-intuitive given that a large portion of these companies’ incomes are repatriated from overseas and as such should feed through to enhance bottom-line growth. This move reflects broader concerns about policy changes such as re-nationalisation of utilities should Labour win a general election.

The UK 10-year gilt started the month yielding 1.15% but has subsequently fallen to 0.87%. This is more of a flight to safety trade given the political environment and a broad consensus that interest rates will remain stable at 75bps until the Brexit situation has been resolved. The 10-year gilt will likely remain a safe haven, with longer-dated bonds at risk of inflation – even more of a risk now given the currency depreciation. 

Meanwhile, overseas the spat between the US and China continues. Donald Trump raised tariffs on $200bn worth of goods from 10% to 25%. The tariffs have so far slowed global trade and reduced business confidence as corporations hold back from investment. Purchasing Managers’ Indices (PMIs) in the US, EU and Japan all continued their downward trend, suggesting a sluggish outlook for manufacturing. Whilst the current figures are not a material cause for concern, any additional policy potentially used in retaliation, which may include non-tariff measures such as discouraging consumers from buying US goods, could be worrying.  Ironically, US exports to China are down 30% year-on-year compared to Chinese exports to the US, down only 13% year-on-year. Should the talks escalate, Donald Trump has threatened to impose tariffs on all Chinese imports, covering over $530bn of goods.

Politics aside, labour markets and consumer sentiment continue to be strong with modest fiscal support in China and Europe, whilst the US Federal Reserve remains dovish. Data for the month of May showed encouraging job growth in the US, EU and Canada. Europe continues to be heavily reliant on export demand from China, so it comes as no surprise that it has been caught in the crossfire between US-China trade talks. Risk asset valuations look reasonable at current levels following negative returns over the month, compared to a rally in sovereign bonds across the developed world (except for Italy). US Investment Grade and High Yield spreads widened by 15bps and 75bps respectively, according to JP Morgan, reinforcing the move into low risk assets. Most major developed markets ended the month down 5%-8%, with technology stocks leading the decline. Defensives outperformed cyclicals.

Performance during May was undoubtedly driven by political headlines, namely Brexit and US-China talks. Volatility is unlikely to go away and as bonds continue to deliver a negative real yield, investors will continue to look to risky assets for returns.

By Economic Strategist, Hottinger Investment Management

The last few weeks have seen a slew of promising news about the world economy. In the UK, first quarter GDP growth, at 0.5% (or approximately 2% annualised), surprised on the upside. The US confounded analysts by putting in another quarter of more than 3% annualised growth. Italy exited technical recession and Germany returned growth of 0.4% during Q1.

In Europe, output has recovered on the back of resilience within the domestic-facing sectors of the economy, as retail sales and services take up the slack from a manufacturing sector that has struggled to deal with a challenging global environment over the last six months. Wage growth has exceeded inflation and unemployment – by European standards – remains low.

As Figure 1 shows, China has been leading the global economic cycle for the last seven years. Movements in important leading indicators of output – such as overseas orders, steel production and consumer confidence – have tended to run ahead of their US and European counterparts.

During 2018, Chinese manufacturers ran down inventories of raw materials, a signal of softening demand. With China now the focal point for global manufacturing, this had a knock-on effect for the world trade in goods; global shipping volumes most likely collapsed for this reason during the second half of 2018 (see Figure 3) and have since partly recovered. The likely cause of this slowdown was the earlier attempts by the Chinese government and the People’s Bank of China to tighten financial conditions in response to concerns over high levels of debt in state-owned enterprises and local governments. They had also sought to clamp down on a shadow banking sector that was proving hard to control, yet it was an increasingly important source of finance for private firms.

In China there have been signs that stimulus has come through. The central bank cut reserve requirements for commercial banks by 350 basis points – equivalent to over 5 trillion yuan (or over $700bn) of capacity for new lending – since April 2018 and the effects have been passing through. Whereas in the past the Chinese authorities have preferred stimulus measures that raise investment spending, this time they have focused on domestic measures that raise consumption, including tax cuts amounting to $300bn. Value-added tax (VAT) for transportation and construction sectors will be cut from 10% to 9%, and VAT for manufacturers will fall from 16% to 13%.

The euro area appears to be particularly sensitive to China’s industrial cycle, as Figure 2 illustrates. European producers will therefore welcome the fact that Chinese export orders have been rising in recent weeks, which should boost the demand for European exports of capital goods and semi-finished goods.

The Eurozone consumer economy nevertheless remains strong. German retail sales growth has averaged 3.5% per annum since 2015; and for the euro area as a whole, the figure is 2.5% per annum. By Eurozone standards, unemployment across the region is relatively low. Wage growth has been rising modestly towards 2.5% per annum. At the same time, headline inflation has come down to closer to 1.5% on the back of lower oil prices. It is no surprise, therefore, that in Europe there is a divergence between the services PMIs and the manufacturing PMIs, although the hard industrial data in Germany has not matched the gloomy mood of factory managers (Figure 4). Domestic activity and consumption, on the back of rising wages, have driven a moderate turnaround in Europe. More favourable global tailwinds resulting from Chinese stimulus could boost the external sector and raise European growth in the coming months.

Q1 US GDP figures 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. Forecasts for Q2 GDP growth issued by the Federal Reserve Bank of Atlanta indicate a slowdown to around 1-2% annualised growth – see Figure 5. This is largely on the back of weakening manufacturing sentiment and softer retail trade and auto sales reflecting stricter financing conditions for buyers.

Core US inflation has fallen from its 2% target. We think lower inflation has been largely imported through the low producer price inflation in China that has passed through to US imports. This could, however, be reversed as firms pass on the effect of US tariffs on Chinese imports onto consumers and there are signs that this is already happening.  If overall inflation remains low, that would give cover to the Fed to maintain its dovish stance, lowering the chance that it delivers a surprise interest rate hike during the year. Financial market participants have now priced in 80% probability of a rate cut by the end of the year, and it will prove hard for Fed Chair Jay Powell to reign in these expectations without causing trauma in the markets. 

There are signs of a stabilising world economy. Stimulus in China is coming through; Europe’s domestic economy is holding up while the slowdown in the US could simply be a reversion to a sustainable trend after a year of stellar performance. Nevertheless, the risks are still there.  Corporate debt is high and rising in the US, Europe and China. Collateralised loan obligations continue to be popular. US equity markets appear to have reversed out of late-cycle behaviour in the perhaps misguided belief that the Federal Reserve will keep credit cheap. Then there is the unresolved trade standoff between the US and China. There are plenty of reasons not to be complacent with this favourable turn in global economic events.

By Economic Strategist, Hottinger Investment Management

In 431 BC, Athenian historian Thucydides wrote in his History of the Peloponnesian War that: “It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable.” Modern history too is replete with examples of a rising world power challenging a ruling power in a way that forces the two powers into war.

In 1519, the election of King Charles of Spain as Holy Roman Emperor pushed the then preeminent France into 40 years of conflict in the Habsburg-Valois Wars. In the 17^th century, the rise of England as a global naval power with a foothold in North America set off twenty years of Anglo-Dutch wars. The wars of the 20^th century were at their heart about land, naval and ideological supremacy as Germany and Japan challenged the existing order. Yet war is not inevitable, as the decades-long stand-off between the US and the Soviet Union eventually proved.  

With the rise of China to global superpower status, the United States must contend with Thucydides’s trap and it is hard not to see the events of last week in this context.

Last week, the US government announced that the tariff rate on roughly $200bn of Chinese imports will rise from 10% to 25%. The Trump administration will also begin preparing for 25% tariffs on a further $325bn of imports that – together with the $200bn – make up almost all exports that China sends to the United States. Although China responded yesterday with tariffs of its own, it is still possible that the two sides could agree a trade deal that unwinds these measures.

However, it is clear that the Chinese side has significantly underestimated the force of conviction in the United States for measures of some sort to curb China’s ascendancy as an economic superpower. Support for being tough on China is cross-party. Senior US Democratic Senator Chuck Schumer took to Twitter to encourage the President to “hang tough… and don’t back down” during the negotiations.

Over the last 18 months, the American state has come to a realisation that the terms on which China joined the World Trade Organisation in 2001 are unfair; they have permitted China to provide huge state subsidies to its own firms and to discriminate against foreign firms operating in its territory. The naïve hope in the early 2000s was that China, by joining the global trading system, would become a liberal democracy yet remain subordinate to the United States. That hasn’t happened.

Instead, what has happened is that China has grown to become the world’s largest economy measured by purchasing parity, harbouring grand ambitions – through its Made in China 2025 strategy and its Belt and Road Inititaive – to dominate the Eurasian continent. The current standoff between the US and Iran over its nuclear policies has a Chinese element too, with investment in Iran planned as China’s land bridge between Europe and Asia.

The original impetus for the stand-off, however, was domestic in origin and about the US trade deficit with China.  A trade deficit is not necessarily bad for a country; it is often the flip-side of net flows of foreign investment, a vote of confidence in the strength of that country’s economy. For a country like the United States, which issues the world’s dominant reserve currency and offers the world’s safest asset, US Treasuries, there are structural reasons for its persistent trade (or current account) deficits.

Since global capital markets became liberalised after the breakdown of the Bretton Woods system of fixed exchange rates and capital controls in 1973, the US has broadly always run a current account deficit of around 1-4% of GDP (see Figure 1). With international business dominated by dollars and global investors attracted to dynamic US markets, the country enjoys what economists call an ‘exorbitant privilege’, where US borrowers and consumers can access capital on cheaper terms and US households can buy more than they make in a more sustainable manner than other countries.

One could claim that the trade deficit does not matter because it simply represents an excess of national consumption over national production; no one loses out if Americans buy more stuff from China using funds borrowed from China (see Figure 2). In fact, the argument goes, US consumers benefit from cheaper household goods, computers and smartphones.  This line of thought, however, is misleading because it ignores the distributional impact. The growth of Chinese imports of some items, while small in the context of total imports volumes from China, has harmed US producers of the same goods.

According to the US Census Bureau, imports of iron and steel products have doubled from $1.1bn in 2009 to $2.2bn in 2018. Imports of engine parts, such as carburettors, pistons and valves, have more than trebled to $2bn in 2018. Imports of parts for aircraft and trains have increased by a factor of 2-3.  Imports of trucks have grown by a factor of 8 and passenger cars by a factor of 20 (from $66m in 2009 to $1.4bn in 2018).

While these items do not make up a significant portion of total Chinese exports to the US, they matter for US producers who must compete with them. The US manufacturing Rust Belt built its wealth through making things like steel, machine parts and engines. It reflects areas that swung behind Donald Trump in the 2016 presidential election. An influential study by Autor et al in 2017 concludes that the states of Michigan, Wisconsin, and Pennsylvania would have voted Democrat rather than Republican in that election if the growth of Chinese import penetration in their region had been 50 percent lower than what it actually was. This would have resulted in a victory for Clinton over Trump.

While industrial towns and cities are today part of Trumpland, they are working-class and have traditionally been Democratic fiefdoms, many of which chose Barack Obama in 2008 and 2012. The Democratic Party knows that its route back to the White House runs through these places, which is why there is cross-party support on pushing back on America’s growing trade deficit with China.

Higher tariffs will be disruptive to both US and Chinese equity markets. While many multi-national US firms have been rerouting their supply chains away from China in recent years, due more to rising labour costs than the threat of tariffs, the process is far from complete – and may never be. Companies such as Apple Inc. have built their entire business model around China. US consumers will likely treat higher tariffs as a tax if companies pass them on, which could raise inflation and reduce spending at a time when consumer activity already looks to be softening. In an environment where US earnings already look to be weakening, rising import costs coupled with falling demand could add to the squeeze and could signal the end to the equity market rally in 2019.

However, with equity markets near all-time highs, it will still require a big fallout from these new tariffs to spur the Federal Reserve into action. Earlier this month, with markets widely predicting rate cuts over the next 18 months, Fed Chair Jay Powell has tried to row back from his dovish tone earlier in the year. With core US inflation low and falling, any positive inflationary effect of tariffs could – counter-intuitively – make rate cuts less likely.

Meanwhile, the tariffs could do more damage to China. According to the World Bank, exports accounted for just under 20% of China’s GDP in 2017. The US is also China’s largest trading partner, buying 20% of its exports. If US consumers significantly reduce their purchases of Chinese exports, there would be a material impact on the economy. China has only recently managed to staunch the slowdown of the last six months through tax cuts and monetary stimulus and turn around last year’s poor performance in its stock markets. And as we have mentioned before, what is bad for China is now often bad for Europe.

The US-China trade stand-off is not just about the US Rust Belt; it is also about technology and intellectual property. The US administration is aware that it is engaged in a technological arms race with China that is not just about trade, jobs and GDP but also about the projection of global power, defence and security.  The ongoing dispute involving Huawei and their worldwide 5G footprint could be just the start of a US-China cold war centered on technology and global reach.

Conflict is not inevitable. The Treaty of Tordesillas, brokered by Pope Alexander VI, prevented war between Spain and Portugal over the Americas in the 15^th century. The US surpassed the UK as a world power in the 20^th century yet the two remained allies throughout. And war between the US and the Soviet Union in the late 20^th century never materialised. In all three of these cases, both sides calculated that the costs of conflict were too high.

We should have hope that China and the US are so interdependent that more troubling forms of conflict never come to pass. There is still a good chance that the two sides will agree a trade deal. Nevertheless, for now relations between the two superpowers will remain fraught, which will bear on the outlook for risk assets.

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.