Category: Uncategorized

By Economic Strategist, Hottinger Investment Management

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

By Economic Strategist, Hottinger Investment Management

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

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

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

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

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

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

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

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

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

Opportunities for foreign investors in the UK

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

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

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

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

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

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

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

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

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

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

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

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

By Hottinger Investment Management

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

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

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

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

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

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

By Economic Strategist, Hottinger Investment Management

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

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

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

How banking works

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

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

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

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

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

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

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

Introducing shadow money to the banking system

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

How shadow banking works among non-banks

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

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

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

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

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

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

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

The next bubble?

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

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

By Zac Tate, Economic Strategist, Hottinger Investment Management

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

By Hottinger Investment Management

After one of the most torrid Decembers on record for equity markets, valuations returned to attractive levels while geo-political events aligned to create a good environment for risk assets in January. The MSCI World index bounced 7.68% during the month, the best start to a year since 1987, having lost 10.44% over 2018. Emerging markets have been the recovery story of the month, albeit from a low base, gaining 8.7% in USD terms. This recovery has been helped by the Dollar Index weakening 0.62% and oil bouncing 12.62%, leaving Brent once more above $60 per barrel.

However, we are not convinced that the environment is right for a sustained outperformance of emerging markets. China’s growth prospects surprised on the downside in December with the Chinese economy during Q4 2018 expanding at 6.4% annualised. Meanwhile, despite the euro area as a whole growing at 1.5% annualised in Q4 2018, Italy is in recession and other major economies such as Germany are teetering on the edge of recession. Both China and Europe are important trading partners for developing economies.

Furthermore, the performance of emerging financial markets is negatively correlated to the US dollar. The weak start to the year for the dollar, we believe, represents the recalibration of the Fed’s interest rate policy as outlined by Governor Powell at the January Federal Open Markets Committee (FOMC) meeting.

In the January meeting of the FOMC, Jay Powell announced that the central bank remains neutral on interest rates, which means that the next move could be a rate rise or a rate cut. This is now in line with the most recent investor expectations. He also said that sales of bonds on the Federal Reserve’s balance sheet could be ended at the bank’s discretion and therefore earlier than originally expected.

This means that the pressure for the dollar to appreciate has weakened, supporting sterling strength during the year and limiting any weakness in the euro against the dollar. One might say that this is supportive of emerging markets which have a large share of dollar-denominated debt, central banks that are depending on the Federal Reserve’s interest rate policy, and companies with a currency mismatch on their balance sheets.

However, with financial markets now pricing in no move in Fed rates this year, the risk for the dollar is to the upside. The fundamentals of the US economy could see the Fed stick to the dot plot and move twice in 2019, which is now no longer priced into the currency markets.

Figure 1: Data accurate up to and including 25th January 2019. Source: Bloomberg

It could therefore be argued that there is no further justification for increasing emerging market positions, but some would consider this a contrarian view.

Brexit uncertainty continues to dominate in the UK, with Theresa May suffering a major defeat in Parliament over her deal and signs that MPs are trying to take control of the process. The important points from the market’s perspective are that there is a majority amongst MPs against a no-deal Brexit and it would seem that if the Irish backstop could be re-negotiated then there is a possibility of the May deal being passed. Any sign that the final scenario will not undermine the economy significantly will be taken well by markets as the 2.52% gain in the Pound Index in January shows. However, the underperformance of equities (FTSE All-share was up only 4.10%) suggests that UK risk assets remain unpopular with investors.

It was also the best start to a year since 1987 for the S&P 500, gaining 7.87%, with all sectors in positive territory and many value stocks performing well. Somewhat inevitably, the FANG+ index gained 13.10%, outperforming the main indices and showing that many of the same stocks continue to lead a market that is fuelled by momentum and still not working off fundamentals. This has all the makings of a “V” shaped recovery in equities, investment grade and high yield credit – much like the aftermath of the February correction in 2018 – leaving us still feeling a little cautious.

Central banks are reported to have been amongst the largest buyers of gold in 2018 and gold was up another 3.02% in January, taking it through the psychological level of $1,300. This shows, perhaps, that we are not the only ones feeling a little restrained with regards to the medium-term outlook.

 

 

By Economic Strategist, Hottinger Investment Management

Since the UK voted to leave the European Union in 2016, investors have often looked to currency markets as a barometer of how the final outcome is likely to affect its economy. A narrative has taken hold that a stronger pound indicates a softer, more business-friendly Brexit while a weaker pound portends a no-deal rupture or hard Brexit.

The value of the pound against the euro and the dollar has increased this month, despite the rejection of Prime Minister Theresa May’s deal on January 15th. Since then, enterprising MPs have introduced legislative amendments that carry a number of aims, including allowing Parliament to take control of the Brexit process, delaying the exit date past March 29th, and providing for a second referendum. The upshot, many have concluded, is that a “no-deal” exit is now less likely. Short-term prospects for the UK economy, according to this view, now look better and the stronger pound reflects this.

While there is some truth to this, the picture, as always, is never this simple. Take, for example, the dollar-sterling currency pair. Since the middle of November, when the pound was at its weakest (at around $1.25 per pound) sterling has steadily strengthened, reaching about $1.30 per pound at the time of writing (see Figure 1). One could say this coincides with the news of the UK-EU Withdrawal Agreement, the emergence of which many thought unlikely. However, there was no corresponding bounce in the euro-dollar pair at the time (see Figure 3): that came during December.

A more likely explanation for the stronger pound against the dollar is the growing gap between UK and US interest rate expectations. Since November, investors have been pricing in less monetary tightening in the US and more in the UK. Expectations for the Federal Funds Rate in one year’s time fell from just shy of 3% in November to 2.35% today. Meanwhile, investors now expect the UK’s Bank Rate to be about 5 basis points higher than they did in November. This has made the dollar relatively less attractive and sterling a bit more so.

Figure 1. The grey line shows the price of £1 in terms of dollars (LHS). The blue line shows the difference between UK and US interest rates in one year’s time. Figures valid up until Friday 25^th January 2019.

Interest rate developments also explain why investors have been pricing in further strengthening of the pound against the dollar over this calendar year (see Figure 2) but not as much against the euro (Figure 3). The rise in the pound against the euro during December was in line with investors’ expectations for the currency pair at the end of the year.

With the European economy facing recessionary forces, interest rates there are unlikely to rise any time soon. Indeed, last week, on the back of concerns over the state of European banks, we heard Mario Draghi remind the market that the European Central Bank (ECB) carries a number of fire-fighting tools such as targeted longer-term refinancing operations (TLTROs), which are designed to make credit cheaper. TLTROs provide banks with a cheap funding lifeline when their assets are stressed, their credit default spreads on the assets rise and they find it more expensive to borrow against the assets in inter-bank markets. The ECB wheels out TLTROs only when the situation is dire. Draghi said that while there were no plans for a fresh round of TLTRO stimulus, if he were to deploy them he would do so only if they lowered interest rates in the market.

However, with interest rates in the Eurozone already at a record low of -0.4%, it is hard to see how they could go much lower in such a way that would boost sterling. Together with little change in the outlook for UK interest rates, it is no surprise that expectations for the pound-euro pair remain flat.

Figure 2. The grey line shows expected price of £1 in terms of dollars during the fourth quarter of 2019. The blue line shows the current price of £1 in terms of dollars. Figures valid up until Friday 25^th January 2019.

Therefore, while currency traders have reacted broadly positively to recent Brexit news, they have not really reflected these developments in their exchange rate expectations for the year. The bounce in sterling during Q4 2018 may simply have allowed the currency to better reflect wider economic fundamentals. Within the general frame of the UK’s leaving the European Union this year, there appears to be little room for further good Brexit-related news to affect exchange rates more than they already have. However, we can’t rule out a big move in both expectations for sterling and its current strength if news emerges that the UK’s trading relationship with Europe will remain as it is for an extended period of time, either through a Norway-style agreement or the announcement of a second referendum with Remain as the favourite. Both of these options seem relatively unlikely at present.

Figure 3. The grey line shows expected price of £1 in terms of euros during the fourth quarter of 2019. The blue line shows the current price of £1 in terms of euros. Figures valid up until Friday 25^th January 2019.

Meanwhile, investors still see downside risks associated with a chaotic outcome, but we have to look at the market for gilts to find them. Investors have raised their expectations for UK inflation since the EU referendum. Before the vote, the 5-year breakeven swap – a device that is used to ensure no-arbitrage between ordinary gilts and inflation-linked gilts, and therefore an estimate of annual inflation expectations – was around the Bank of England’s 2% target. Since then, the rate has risen to 3%, suggesting that uncertainty remains heightened (see Figure 4). In particular, it means that bond investors are discounting a possible inflation shock that is delivered by a fall in the value of sterling. In other words, if no-deal becomes likely, investors think sterling could weaken considerably against both the dollar and the euro.

Figure 4. The blue line shows the 5-year UK inflation breakeven swap. This is a market indicator of UK inflation expectations which investors use to ensure that the value of inflation-linked gilts and non-inflation linked gilts is the same. Figures valid up until Friday 25^th January 2019.

Therefore, things may be looking up for sterling now, but it is not just good Brexit news that is driving it. Downside risk is still there and we would be wise to avoid complacency.

By Economic Strategist, Hottinger Investment Management

When French people take to the streets, the world usually notices. It was the uneasy alliance of Robespierre’s Montagnards, Brissot’s Girondins, and working class ‘sans-culottes’ that in the sixty years between 1789 and 1848 stirred the liberal, egalitarian but ultimately nationalistic Giovine Europa movement across Europe. These inspired the likes of Giuseppe Mazzini in Italy and the Chartists in England. We see the legacy of these efforts in the flags of countless nation states around the world which have adopted a tricolour motif of some description, embodying – at least in theory – the values of liberté, égalité and fraternité.

For the last nine weeks, French cities have been sites of mass protests. People who feel that the Parisian elites in government are not listening to them have been donning yellow high-visibility vests. Ostensibly, the catalyst for the protests was the levy of new taxes on fuel that would lead to intolerable increases in the cost of living, particularly for those in the provinces. But it has since transpired that the group has come with a somewhat amorphous list of demands that range from lowering taxes to raising state spending on social security, defaulting on public debt, leaving the European Union and reducing immigration.

The gilets jaunes movement is often compared to the Paris student uprisings in the 1960s against consumerism and American imperialism; indeed some of the current participants say they took part in both. But this analogy is not convincing. The gilets jaunes movement seems to have something more in common with the 18^th century resentment against the fermiers-généraux – the unpopular urban tax farmers who collected levies on salt (a factor in the revolution of 1789) – and the 19^th century nationalism that culminated in the uprisings of 1848.

The difference now is that while bourgeois urban liberalism was the ascendant and liberating force railing against the arbitrary and oftentimes oppressive rule of the ancien regime,  it is urban liberalism that today’s gilets jaunes see as the oppressor.

There is a new cleavage in the politics of nation states between the city and the region, and it is not clear that the nation state – that device of earlier revolutions – can contain it. World cities such as London, Paris, Shanghai and Berlin have more in common in wealth and culture with each other than their respective hinterlands, and this has all served to undermine the communal feeling that many, particularly those of the hinterland, still have.

Part of explanation is economic. Since the 1980s, cities have, as a rule, grown much faster and from a higher base than distant regions in a process that economists call agglomeration. It makes sense to have your business in – for example – London or Dublin if your suppliers, employees and customers are there too. There are valuable services in London because people want to live there.  And people want to live in London because they can access valuable services. It’s a virtuous cycle and it will probably survive acts of nationalist assertion such as Brexit.

Figure 1 shows that parts of the UK that saw slower GDP growth per head between 1998 and 2016 were more likely to support Brexit. An interpretation of the slogan ‘take back control’ that defined the Brexit vote is that it is about redressing the regional imbalance in wealth between city and region that has made life harder for those who do not live or work in the city.

A large part of the explanation, however – especially in rich developed countries – is essentially not economic. It’s about identity and community.

Western societies have – for quite some time, and certainly since 1998 – solved the economic problem. Almost everyone has a roof over their head, access to heating, good food, advanced healthcare, and jobs that can buy consumer delights and a generous supply of leisure. In this sense, Western countries have succeeded in meeting the speculations of John Maynard Keynes, who predicted in 1930 that the societies of his grandchildren would be multiple times richer than his generation. He was wrong in suggesting we would use the wealth dividend to cut work to fifteen hours a week and spend the time making art, literature and love. The activities of the Bloomsbury Set have remained a niche pastime.

However, the spread of material comfort has facilitated a rise in the post-materialist politics of autonomy and self-expression within large cities, which are the flag carriers for globalisation. Some opponents perceive urban-liberal attitudes on issues relating to gender and multiculturalism as merely extensions to urban-liberal attitudes to the market. The same globalist, city-centred elite which oversaw and celebrated deindustrialisation in regional towns and cities is also blamed for eroding long-established community ties. Yet, even here, wealth is not the determining factor. Many rich ruralists want little to do with this brave new cultural world because they have little contact with it. It was, after all, an alliance of affluent Southern eurosceptics and the post-industrial working class that delivered Brexit.

For many voters, cultural developments have been positive and welcome, but for those – rich or poor – who live on the edge of this new politics and feel excluded, change is threatening and manifests in unrecognisable towns, disturbed customs, precarious employment and in toto the perception of contempt from the city for the way they live their lives. As Robert Putnam wrote in his seminal Bowling Alone, “social dislocation can easily breed a reactionary form of nostalgia”. It’s no surprise, then, that we are seeing growing support for parties that define themselves in opposition to globalisation and promote a communitarian politics that strike a deep chord.

The rise in populism can be understood as a reaction to the decline of religion in Europe, the spread of post-materialist urban values, and the drain of power and prestige from regional working-class industrial centres in favour of the new, service-dominated centres of the global economy. Populism can take expressions in both left- and right-wing forms of communitarianism that are rooted in national sovereignty. In this sense, one should see the likes of Jacob Rees-Mogg and Jeremy Corbyn not just as throwbacks to a distant past but as thoroughly contemporary advocates of the nationalist zeitgeist.

The late Benedict Anderson wrote in Imagined Communities, his exegesis on nationalism, that “for whatever superhuman feats capitalism is capable of, it found in death and languages two tenacious adversaries.” Capitalism, through open trade, can bring the peoples of the world closer together, but through its core methods – specialisation and the division of labour – it offers little to placate the spiritual demands that we all have. Individualism and cultural diversity are answers to this, but so too is solid nationalism.

By creating a mass market for the many vernacular languages of Europe in the decades after the creation of the Gutenberg press in the 15th century, capitalism facilitated the decline of Christendom and replaced it with the imagined communities we call nations. The nation is a disinterested and – ideally – immortal entity. For most of its constituents, the nation neither chooses nor is chosen, and because it moves as one through history and offers a way to handle the fatality and contingency of life in the way the great religions have done, it can call for and expect sacrifices from its members.

The nation therefore both transcends the individual and embodies their collective customs, hopes and imaginings.  Being a meaningful entity worth believing in, the nation remains an essential comfort. The idea of the unchanging nation – even if it has little basis in reality – offers a layer of emotional security and convinces some that, whatever our plight, we are all in it together.

The distinction between the liberal city and the conservative region is a simplification; it is possible to be a conservative in the city or a liberal in the region. But the cleavage between the two groups exists and could be here to stay. To the extent that the tensions within nation states remain unresolved, they will continue to lead not just to movements such as the gilets jaunes, but also to events that can disrupt the world economy. One can see the election of Donald Trump, the rise of populism in Italy and the more nationalist politics of Xi’s China in this context. The common thread in all of these is the liberalism of the city and the anti-liberal nationalism of the region.

Brexit is part of this theme too, but perhaps the concept is misplaced. The trend for the 21^st century may not be the removal of a nation state from a club of nation states such as the EU, but the detachment of major cities from the nations that made them. The stark difference in how those in London voted in the EU referendum compared to those in other regions reflects the different outlooks of each place.

These huge political trends will continue to affect the economic and investment environment; they are interesting in their own right, but we cannot afford to take our eyes off of them.

By Economic Strategist, Hottinger Investment Management

Last week, the People’s Bank of China announced that it would cut the reserve ratio requirement (RRR) by a further 100 basis points, the fifth cut since the start of 2018.

Higher reserve requirements for commerical banks not only directly constrain how much credit banks can create for a given level of deposits but also raise the cost for banks to lend if they do not have sufficient deposits. In order to lend, they first need to borrow from the central bank to meet the reserve requirements.

The PBoC hopes the reduction will stimulate over $100bn in extra lending. In the last twelve months, the central bank has taken a nimble approach to monetary policy. At the end of 2017, there was an expectation that the clamp-down on excess credit and leverage – particularly in smaller banks and within the shadow banking sector – would cross over into a broader policy of making finance more expensive by raising interest rates. As it became clear during 2018 that global supply chain activity was slowing and Chinese firms were reducing their inventories, however, the PBoC changed course and cut the RRR.

In recent weeks, new economic data shows that China’s privately-owned manufacturing sector shrank in December for the first time in almost two years. In November, industrial profits fell. The Chinese government, facing uncertainty over the outcome of tariff negotiations with the United States and slowing export and import volumes, is keen to do anything to prevent a so-called ‘hard landing’ of its economy, which could also have damaging political effects.

The RRR for smaller banks has fallen along with that for mainstream banks despite the risks that the former institutions pose for Chinese financial stability due to their weaker capital positions, opaque lending practices and dependence on interbank lending. This is because smaller banks have been a key provider of capital to private-sector small businesses and to less advanced but more politically autonomous regions in the west and north of the country.

Larger banks tend to prefer supporting state-owned enterprises on the implicit understanding that they are underwritten by the central  government.  However, smaller private firms provide the bulk of urban employment and are the backbone of China’s supply chains. It seems, therefore, that China’s central bank is prioritising the stability of the real economy over that of the financial system insofar as it can isolate the effects of each of these institutions on the other.

Last week, the Federal Reserve’s Chairman, Jay Powell, took the chance to clarify the Federal Reserve’s monetary policy for this year at the American Economic Association’s annual conference. Markets wanted Powell to follow the PBoC and say that the Fed will keep a close eye on the state of the economy and react accordingly. This is not surprising, since the loose monetary policy of the last six years has underpinned asset price inflation in the United States, as Figure 1 shows.

Figure 1: Taking an equal-weighted index of balance sheet expansion in the U.S., Eurozone and Japan shows deliver a close correlation with the S&P500 index.

On a fundamental basis, one might argue that the US economy merits higher interest rates. Unemployment could fall further, the labour force participation rate could rise further (as the most recent employment data attest) and wages are growing above 3%. While core inflation has dipped below 2.0% recently, it is not unreasonable to suggest that if the US sustains above-trend growth, stronger inflation will result and justify higher interest rates.

However, observing the performance of Europe in 2018 affirms the wise advice that past performance is no guarantee of future outcomes. The PMI data for December suggest that business activity in the US could decelerate signifcantly in Q1 2019 on the back of reports from manufacturers that consumer demand is slowing, tariff-related costs are rising and weaker activity in China has put downward pressure on inflation expectations. Markets therefore responded positively when Powell declared that he is open to pausing interest rate rises and changing the pace of balance sheet reduction.

Despite the decision last month to reduce the number of expected rate rises from three to two during 2019 to move closer to market expectations, investors have cut further the amount of tightening that they expect the Fed will do. Figure 2 shows the spread of what the market thinks a three month Treasury bill (T-Bill) will yield in 18 months’ time over the yield on the current 3M T-Bill. A negative spread implies that interest rates will start falling by the middle of next year.

Figure 2: A negative difference between the yield of a three-month Treasury bill starting in 18 months’ time and the yield of a three-month Treasury bill starting today suggests lower interest rates in 2020.

Last week, the spread turned negative for the first time since before the financial crisis, suggesting that markets think the Fed will start cutting rates in 2020. Much of this change happened after the last meeting of the Federal Open Markets Committee, which announced a more dovish strategy, indicating that investors think the economy could slow over the next year and that the Bank’s policy of two rate rises this year could be a cause of that slowdown. Further, lower expectations for future inflation due to both higher rates and other factors such as weaker demand mean higher real yields for a given nominal interest rate, meaning that less monetary tightening is required to normalise the economy.

Looking at futures markets, it would appear that markets would like the Federal Reserve to call off further rate rises altogether and take a leaf out of the PBoC’s book. Last week’s comments from Jay Powell suggest that he is listening. Markets will keep a close eye on what the Bank does next, and if investors are not satisfied, the recent market turbulence could continue.

By Hottinger Investment Management

The calendar year 2018 was a difficult year for investors – particularly multi-asset investors – due to the number of different asset classes offering a negative real return. This was particularly true for US equity markets, especially following the anxiety exhibited in December. Markets had to come to terms with the prospect of a significant slowing in earnings growth in the 4^th quarter of 2018; the US fiscal tailwind has weakened and some direct talking by Federal Reserve Governor Powell has caused a reassessment of the global outlook. The December sell-off currently appears to be a snap reaction to the belief that Fed tightening is now ahead of the curve, however if an economic downturn does arrive in 2019 it may start to look justified.

The S&P 500 suffered the worst December contraction in its history, falling by 9.18% and taking US equities into negative territory for the year (-6.24%) as investors lost their nerve. Notably, the weakness in global banks that has seen many European and Chinese banks fall into bear market territory this year (down 20% from their previous peak) has spread more widely in the US. This left the S&P Banks Index down 14.88% in December and down 18.37% overall in 2018.

Banks are seen as the most influential value sector and the performance of the sector has masked any rotation away from cyclical stocks. The final quarter of 2018 saw a more traditional flight to quality, for example in utilities, despite the prospect of rising interest rates. Our caution as we entered the summer trading months was triggered by high valuations and narrow dispersion of positive returns, which was highlighted by the performance of consumer technology as represented by the FAANG Index. Interestingly, the index rallied 36.83% to its year high on June 20 before returning -36.75% into year-end, but was still narrowly net positive (0.08%) for the full year!

US Treasuries were up 2.29% on the month and physical gold rallied 4.90%, although the latter still failed to offer a real return over 2018 (falling 1.58% as the metal struggles to break through $1,300/oz). Despite the yield on the 10-year US Treasury reaching 3.25% in October – when the outlook for US rates was deemed too aggressive – this has quickly rallied to 2.65% as US equities have suffered. At inflection points, it is often the case that previously uncorrelated assets move together through short-term stress, (as seen in February and October) so the resumption of a traditional relationship between US bonds and equities is encouraging.

UK equities may look relatively cheap on a global basis, but they remain unloved and under-owned. The lack of a consensus in Parliament led to Prime Minister May postponing the crucial vote on the deal negotiated with the EU, and it now looks as if negotiations are going to go down to the wire. The increased probability of a “no-deal” Brexit – which would be very harmful to the UK economy, at least in the medium term – pushed sterling another 0.70% weaker over the month and the FTSE All-share down 3.88%,. This also impacted EU economies already struggling with a China slowdown and US protectionism, reflected in the fact that European equities lost a further 5.96% on the month. The ECB’s decision no longer to expand QE has added to the global tightening bias, removing significant global liquidity and adding domestic financial pressure to the geo-political pressure suppressing European growth.

Looking forward, it is likely that 2019 will see slowing earnings, slowing growth and continuing high levels of central bank and government influence over financial markets. This leaves investors vulnerable to higher volatility in distressed conditions, and a cautious approach may be necessary if we are to preserve capital in the medium term.

 

By Economic Strategist, Hottinger Investment Management

One of the ideas that lie at the heart of the theory of economics in a world in which capital can flow seamlessly across borders is that there is only one global price for money. The price of money is the real interest rate; it is the amount of real economic resources that have to be given up to borrow a sum of money or received for lending it. Since investors can move the capital freely, so the theory goes, any differences in real interest rates in different countries, excluding the premium that reflects country and market risk, will be traded away.

Another theory is that of ‘uncovered interest parity’ (UIP) and it describes the relationship between the difference in interest rates between two reference countries and the movement of their exchange rate pair. It is an arbitrage relationship that states that investors accommodate different nominal interest rates between states by acting in the foreign exchange market to prevent any one country offering more attractive terms than another. One country can only offer higher interest rates in their currency than another if investors expect that country’s currency to depreciate over the period of the investment. If that country continues to offer greater interest rates adjusted for expected exchange rate movements, money will pour into it until the incentive to do so disappears.

This idea is best demonstrated by way of an example. Suppose that the current (Year 1) exchange rate between the pound and the dollar is parity or $1:£1 but that the US offers a 3% interest rate in dollars and the UK offers a 1% interest rate in pounds sterling.

	Year 1 (Current)	Year 2
US (3% interest rate)	$1.00	$1.03
UK (1% interest rate)	£1.00	£1.01
Exchange rate	£1:$1	$1:£0.98 or £1:$1.0198

UIP theory says that there should be no opportunity to profit from this difference because the exchange rate adjusts from $1:£1 to $1.03:£1.01. This means that the dollar depreciates, or becomes less valuable, over the period and correspondingly the pound appreciates. The new theoretical exchange rate is $1:£0.98. Thus the gains for a sterling investor of buying in dollars in Year 1 and gaining a superior interest spread of 2% over the pound are wiped out by a completely offsetting depreciation of the dollar when the investor transfers those dollar gains back into sterling.

The conclusion is that according to the theory of UIP the strategy of investing in other countries to return a superior return in your home currency is futile. Further, the idea there is one global price of money (or real interest rate) means that the theory of UIP implies that the difference between interest rates between any two countries reflects merely differences in inflation, which are offset by subsequent movements in their currency pair. This is because the nominal interest rate in a country is approximately the sum of the real interest rate and the expected rate of inflation. In the final round, UIP simply embodies the idea that because the difference between interest rates across countries is accounted for entirely by differences in inflation, exchange rates are affected only by these differences because they must move to offset them.

It’s a neat theory but it is substantially flawed, as is the idea that real interest rates cannot vary between countries. Exchange rates are influenced by a range of factors, including economic and political uncertainty, trade flows, investment opportunities and speculative reasons. Additionally, exchange rates are influenced precisely because real interest rates can differ across territories. Countries can have high real interest rates because they offer attractive investment opportunities and not the other way round as global capital mobility theory implies. It is possible therefore for rising interest rates in one territory to correspond to its currency strengthening, either structurally or coincidentally. International money flows in keeping that country’s currency strong and yet real interest rates can remain high in regions with strong growth and good opportunities.

We see this in global markets today. Figure 1 shows how since the middle of 2016, US interest rates have divorced from UK rates, driven by the earlier rate hiking cycle of the Federal Reserve compared to the continued low rates supported by the Bank of England. With US inflation rising by less in this period, it can be said that real interest rates in the United States have risen in the last two years.

Figure 1: US and UK T-Bill yields since November 2015

Since mid-2016, sterling investor may have been attracted to US interest-bearing assets, but the currency worked against them. Between then and early 2018, the dollar weakened against sterling and something close to UIP held. However, since March 2018, this relationship has broken down as Figure 2 shows.

Figure 2: The dollar strengthens against the pound from March 2018 despite positive interest differentials.

The interest rate differential between US and UK assets continued to rise as the Federal Reserve pursued its rate-hiking policy and US real yields furthered their upward rise, yet the dollar also strengthened against the pound. Indeed, the dollar strengthened against most currencies (including the euro; see Figure 3) as global investors first responded to investment opportunities in the US at attractive interest rates and more lately on the back of rising uncertainty due to ongoing trade tensions.

Figure 3: The situation also exists for euro investors.

This means that a sterling or euro investor who took investments out of their own short-dated government bonds and placed them into US short-dated T-Bills would have made both a superior interest yield but also profited further when they transferred the gains back into their local currency. Those investments of course would have been fully exposed to exchange rate risk, but its outcome would not have been achievable had the currency risk been hedged in FX markets.

Recent experience shows we should throw out the theory of UIP*. It’s a neat, logical idea that just doesn’t hold over any reasonable time period in a complex real world. However, we should be clear; unhedged investment strategies carry significant risk and are attractive only if the investor has conviction on the direction of exchange rates.

If one believes the dollar will weaken in the next few months then an unhedged position in US fixed income is not prudent. If however one believes that the dollar will remain strong then such as position makes more sense. Indeed, it could be argued that there is a good case for this belief; with China and Europe showing signs of slowing down, there could well be a flight of capital to the US, keeping the dollar strong.

UIP therefore can break down over the short term because there is no such thing as a single global real interest rate, because global capital is not fully mobile and global investment opportunities are not fully substitutable. However, in the longer term something like UIP is more likely to hold as investment opportunities appear in different places. Today, it could be said that the US offers the attractive play. Tomorrow, it will be someplace else.

*Note: Covered Interest Parity (CIP), assuming there is no cross-currency basis, does hold by definition. Futures contracts and FX swaps that entities use to hedge currency risk are designed so that the gains from interest rate differentials are wiped out in exchange based on expectations of exchange rates at the end of the period of the contract. These expectations are governed by the basic interest parity relation described in the table. Market exchange rates can of course differ at the end of the contract meaning one party in the hedge could gain from the contract and the other could lose. If there is cross-currency basis, meaning that a premium is charged to borrow in another currency, CIP does not hold. 

By Economic Strategist, Hottinger Investment Management

Until last week, it seemed that the slowing European economy was apparent to everyone except the officials at the European Central Bank (ECB). Autumn passed and meeting after meeting of the ECB’s governing council yielded conclusions that had become almost platitudinous. Quantitative Easing (QE) was coming to an end; core inflation would continue to rise; unemployment would keep trending downwards and the slowdown in European growth was merely a reversion to a long-term, demographically determined trend rate.

With many countries having experienced weak or even negative economic growth in the third quarter and few indications that this will be short-lived, policymakers at the ECB have started to change their tune. The Bank has downgraded growth and short-term inflation forecasts in line with investor expectations (see chart below) and while QE will still end this month, the latest policy guidance from outgoing president Mario Draghi was more dovish. In his monthly press conference last week, following a meeting of the ECB’s Governing Council, Draghi highlighted a risk environment that is “moving to the downside”, with rising protectionism, emerging-market stresses and prolonged financial-market volatility bearing down on economic activity.

Analogous to the falling expectations for inflation, expectations for short-term interest rates in December 2019 have fallen throughout this year (see chart below) and now imply that the first rate rise from the ECB is now more likely to arrive in the first quarter of 2020 rather than in the second half of next year.

Draghi seemed to imply that the Bank is not dogmatically wedded to a 2019 rate hike; however, he did suggest that investors who have now put back their expectations for a rate rise into 2020 – after he will have left the Bank –  could pave the way for an earlier tightening than that. The idea is that investors – by pricing in later rate hikes – make financial conditions today easier. This, apparently, could not only offset the weakening economic environment but stimulate the economy sufficiently that official interest rate rises in 2019 do indeed become necessary. It’s a tenuous argument from a Bank that has a penchant for optimistic predictions and a President who is keen to secure his legacy.

While the controversial QE policy is ending for now, Draghi did mention that the option to restart it remains, and the Bank will extend the period over which it reinvests maturing debt from one year to three years; 200 billion euros of bonds mature next year. This betrays the broader likelihood that an extended ECB balance sheet and the policy of QE are here to stay, as is the sizeable stake that the Bank has in the public debt of Italy and France.

Enter the politics of the ECB and QE

One controversial aspect of the Eurosystem will change at the beginning of 2019 when the ECB will make changes to its capital key schedule. Capital key is a weighting schedule that assigns proportions of its bond buying programme across the various member states according to the size of their economy and population. The table below shows the schedule that has existed since January 2015 and the changes the Bank will make next month.

The table shows that the shares of ECB bond buying (or, more accurately, reinvestment of maturing bonds) allotted to countries such as Germany, France, Austria and the Netherlands have increased, while those allotted to countries such as Italy, Greece, Portugal and Spain have fallen. This is problematic for general macroeconomic reasons and specific political, market and technical reasons pertaining to this period.

In the first instance, the policy is ‘pro-cyclical’; it exacerbates the strength of economies that are doing well and the weakness of one that are doing poorly. It therefore proposes that the Bank buy more bonds from countries whose economies are growing faster (which until recently included all those countries in the first group), easing financial conditions and lowering bond yields for them. It correspondingly proposes that the Bank buy fewer bonds from countries whose economies are struggling, such as Italy and Greece, tightening financial conditions and raising interest rates and bond yields.

In other words, the policy compounds a founding problem of the euro area that it somehow has to implement a single monetary policy that is suitable for 19 different national economies. Using the capital key schedule intelligently could serve that objective, but it would mean doing precisely the opposite of what is planned next year. The ECB should be buying relatively more Italian and Greek bonds and relatively fewer German and Dutch bonds in what would amount to a counter-cyclical policy.

The new capital key assumptions could inflame existing political and market tensions within the Eurozone. Reallocating ECB investments away from Italy, especially at a time when political uncertainty has led to elevated Italian BTP yields, could push funding costs of the Italian state to an unsustainable level. Analysts think yields of 5% would make servicing Italian debts much more challenging as the state reissues maturing debt. It could also aggravate the Italian government’s sense of grievance over its treatment by Brussels and make agreement over the 2019 budget harder to achieve.

The technical issues with the new pro-cyclical capital key centre around the fact that it proposes buying more bonds from surplus-generating countries that by implication do not have net new marketable bonds to offer. This would mean the ECB owning a greater share of these countries’ public debt as redemptions are rolled over. Such a development rubs up against political economy concerns, not least from Germany, over the legitimacy not just of the ECB’s operations but also the ECB’s increasing ownership of German sovereign debt.

In summary, the ECB will need to act adroitly to exit smoothly from its QE programme. Deteriorating global economic conditions suggest moves to tighten monetary conditions by either shrinking balance sheets or raising interest rates are premature. Further, the political reluctance of some surplus countries to continue QE, particularly after the term of progressive ECB President Mario Draghi ends, will create difficulties for the Bank to restart a similar programme of monetary expansion should conditions worsen further.

At some point, both the European political establishment and the ECB will need to come to terms with the fact that the central bank’s involvement with the public debt is likely to become necessarily permanent, and that the actions of the ECB will therefore need to come under broader democratic scrutiny. As such, an agreement on how the Bank should run would have to have support from both surplus and deficit countries within the Eurozone.

In the meantime, the way the ECB handles its decision to maintain its balance sheet, especially through its policy on capital key, will in large part determine the success of the European economy in 2019. In addition, we should keep a close eye on the process by which the ECB chooses Draghi’s successor. A sharp reversal of the Bank’s philosophical outlook to the Germanic and pre-Draghi low-inflationary model may come at a bad time – economically and politically – for the region.

 

By Hottinger Investment Management

November saw global equity markets bounce back after the global correction seen in October, suggesting that in many regions the negative sentiment was felt to be overdone. Emerging markets benefitted after having registered year lows in October gaining 4.06% over the month despite a flattish US dollar but assisted by a 21% fall in the price of oil to $59 and policies to stimulate the flagging Chinese economy. From a developed market perspective the bounce largely benefitted the US S&P500 (+1.79%) and Japan’s Nikkei 225 (+1.96%) but largely missed Europe and the UK.

The Chinese have been trying to stimulate their economy by cutting reserve ratios for small and large banks after earlier efforts to tighten monetary conditions and de-lever banks’ balance sheets hit industrial companies and state-owned enterprises hard. Chinese factory growth has stalled, with the index for manufacturing purchasing managers falling to 50.0; the index for Chinese manufacturers’ import orders also shrank, from 47.6 to 47.1.

This matters for Europe because over the last few years the continent in general and manufacturing countries such as Germany, Switzerland and Italy in particular, have relied upon export growth which is largely driven by China not the US, and easy money from the ECB in order to make up for weak domestic demand. At the end of the year, that stimulus from the ECB will come to an end, with Governor Mario Draghi committing only to roll over maturing bonds. With Eurozone growth falling significantly since the summer and headline inflation heading down along with the oil price, any indication that the ECB will follow the Federal Reserve in 2019 in tightening policy could harm Europe at a time when external demand is weakening and compensatory fiscal policy action is made difficult by the EU’s intergovernmental rules. The second estimate of Q3 GDP growth was lower than expected due to a persisting slowdown in vehicle production and slowing industrial production in Germany. European PMI’s for November were also disappointing and on-going political uncertainty will no doubt dampen corporate activity.

Fed Chair Powell upset markets in October with his directness but the November meeting proved largely uneventful. There exists an 80% probability in markets for a US December rate hike but the expectation for further hikes next year has receded again after Powell’s speech at the Economic Club in New York spoke of rates being “just below” the neutral level. However, we are worried that markets may still be too sanguine; the Federal Reserve’s own models of inflationary pressures indicate that those pressures are still increasing and interestingly, the spread between US Libor 3M and Euribor 3M has approached 300 basis points. The last times US interest rates became this detached from European rates were before the Dot Com crash and the financial crisis. The effects of higher rates on the US consumer typically suppress US import demand, which by its nature has a knock-on effect on other countries.

We still believe UK markets are unloved and have been discounted since the Brexit referendum. UK economic expectations are still wholly conditional on the type of Brexit agreed by parliament. Although unemployment rose slightly to 4.1% in September wage growth is slowly picking up while headline inflation is steady at 2.4% yoy. We note that the single biggest driver of UK economic growth since the Great Recession has been population expansion driven by increases in net migration, the risks to the British economy as a result of a chaotic no deal Brexit are not just trade frictions but also negative net migration both as a result of political choice and due to the active choice of persons responding to the new economic climate. The FTSE All-share and FTSE 100 indices both fell 2.04% in November indicating that there was no real outperformance by different size companies which may be due to the fact that sterling only declined 0.36% or that the whole market is reacting to the political news flow.

We believe the more defensive approach continued during the month of November remains the right course of action as market volatility; price discovery and the uncertain economic outlook create a more uncomfortable environment for capital preservation. The relatively solid fundamentals being reported today are being undermined by fears of corporate earnings slowdown in the future and there is little doubt that the geopolitical environment that includes Brexit, China-US trade tensions, Italian budgetary issues and Middle Eastern tensions are leaving investor risk appetite subdued.

By Economic Strategist, Hottinger Investment Management  

Last week saw the release of the minutes from the Federal Reserve’s November FOMC meeting and public statements by Fed Chair Jay Powell on the future path of monetary policy. With most global financial markets except the United States experiencing a negative year to date, all eyes have been on the monetary policy of the US, the recent direction of which has been a significant cause of market instability in the last two months.

The spread between US Libor 3M and Euribor 3M, measures of three-month lending rates in the United States and Europe respectively, has approached 300 basis points (see chart). The last times US interest rates became this detached from European rates were before the Dot Com crash and the financial crisis; it’s a sign that the US economic cycle might be nearing a downturn.  The US economic cycle tends to lead those of other countries and regions – especially Europe – and this means that US rates tend to rise earlier than they do in other places and you get these US/EU Libor spread peaks, as the chart shows.

The importance of the Federal Reserve and the US dollar not just for the US economy but for the global economy too underlies the phenomenon of this ‘US-first’ economic cycle. Europe, in particular, relies heavily on dollar funding to conduct both financial activity and real trade. Other central banks tend to follow the Federal Reserve if they wish to preserve the value of their currency against the dollar and maintain adequate dollar funding for their international activities. In emerging market countries with current account deficits and external finance requirements, higher US rates and dollar strength tend to push up the cost of borrowing independently of local central bank policy.

Further, the effects of higher rates on the US consumer typically suppress US import demand, which by its nature has a knock-on effect on other countries. In recent decades, the US has occupied the position of ‘consumer of last resort’ due to its high current account deficits, with consequences for aggregate demand in other countries. This position has changed in this decade as the rise of China and the value of their imports have made other regions, especially export-oriented Europe, less dependent on the United States.

It is therefore more likely the first factor (global dependence on the Fed) rather than the second (global dependence on the American consumer) that has had the greater negative contribution on international financial markets in recent months.

Will there be a Powell put?

With global markets and economies sensitive to US rates, there has been much speculation in recent weeks about whether there would be a so-called “Powell Put”, following the tradition of Fed Governors Alan Greenspan, Ben Bernanke and Janet Yellen who have often delayed policy changes or adapted their forward guidance on policy in response to events in US and global equity and bond markets. A “put” from the US central bank is essentially a commitment to prevent financial markets going below levels that could harm the real economy. In their most extreme and well documented guise, the ‘Fed put’ has resulted in a sharp cut in interest rates (as it did under the Greenspan put) or in the policy of Quantitative Easing (as it did under Bernanke).

Greenspan puts (1999 and 2001); Bernanke Put (2007)

Figure 1 shows the three occasions during which the Federal Reserve reduced interest rates in response to fading economic strength and deteriorating market: after the LTCM crisis in 1999, during the bear market in 2000 and 2001, and after the start of the financial crisis in 2007. The Federal Reserve also injected funds after the 1987 stock market crash and the Asian financial crisis in 1997. SPX Index is the S&P 500 and FDTR is the Federal Funds Target Rate, or the basic interest rate in the United States.

Figure 1: Federal Reserve puts. Source: Bloomberg

Bernanke QE Put (2008)

In the first iteration of the Bernanke Put, interest rates reached their ‘zero-lower bound’ which limited further monetary stimulus without introducing the controversial measure of negative nominal interest rates. In response, Bernanke initiated QE1, the first round of quantitative easing that consisted of buying US Treasuries and mortgage-backed securities. This started the long-bull run in equity markets that may only now be coming to an end. The next chart, Figure 2, shows how the S&P 500 index closely matched the volume of assets that the Federal Reserve owned in the years during which the policy of QE was in effect (2008-2013).

Figure 2: Bernanke’s QE put. Source: Bloomberg 

Yellen Put (2013, 2015)

The market turbulence, known as the ‘taper tantrum’, in response to suggestions from the Federal Reserve in 2013 that it would withdraw QE led to the bank delaying that policy for 16 months. In 2015, concerns over growth in China and a bear market in emerging market equities caused the Federal Reserve to delay its first rate rise to December 2015 and to abandon three of the four rate hikes it planned in 2016.

Figure 3: Yellen’s put. Source: Bloomberg

In recent statements from the Federal Reserve and Jay Powell indeed, there was no specific indication of a Powell put; on this matter the minutes of the November FOMC meeting stated: “the turbulence in equity markets did not leave much imprint on near-term U.S. monetary policy expectations”.

However, markets have however interpreted last week’s policy guidance from the Federal Reserve as indicating that the bank is now not necessarily wedded to the three interest rate rises in 2019 that the September FOMC’s dot plot suggested; “monetary policy is not on a preset course,” the minutes state. This form of words gives the Federal Reserve the space in which to conduct what effectively amounts to a ‘put’ even if they don’t say it is one. With inflation breakevens indicating that markets think economic activity could be softening and with the slowdown in activity in China and Europe on their minds, this more dovish tone from the bank has settled some nerves.

However, markets may still be too sanguine; the Federal Reserve’s own models of inflationary pressures indicate that those pressures are still increasing (see Figure 4). Unemployment is below the level  and wages are now growing at 3.5% per annum. The bank is mandated to respond to these first before taking into account the wider situation in the global economy.

Figure 4: The Federal Reserve’s economic models predict higher rates. Source: Federal Reserve Bank of New York; Bloomberg.

Is the US economic cycle less important this time?

As indicated above, the relationship between US and European interest rates and the reliance of global economic cycle on the US cycle may be less important today because of the rise of China. Both Germany (-0.2% Q3) and Italy (-0.1% Q3, revised) announced weak third quarter economic growth figures last week. There are individual explanations for the poor performance of each of Italy and China. Emissions regulations have held up German car production and exports, while political uncertainty in addition to low inflation and, concomitantly, high real interest rates in Italy could explain that country’s problem. However, with Q3 growth figures in Switzerland (-0.2%) and Sweden (-0.2%) also surprising on the downside, something else seems to be afoot. The common denominator could be China.

The Chinese have been trying to stimulate their economy by cutting reserve ratios for small and large banks after earlier efforts to tighten monetary conditions and de-lever banks’ balance sheets hit industrial companies and state-owned enterprises Nevertheless,  Chinese factory growth continues to stall, with the index for manufacturing purchasing managers falling to 50.0 last week. The index for Chinese manufacturers’ import orders also shrank, from 47.6 to 47.1 (numbers below 50 indicate falling orders).

This matters for Europe because over the last few years the continent in general and manufacturing countries such as Germany, Switzerland and Italy in particular have solved their deficient demand problem with a combination of export growth – driven by growth in exports to China, and not to the US – and easy money from the ECB.

At the end of this year, that stimulus from the ECB will come to an end, with Governor Mario Draghi committing last week just to rolling over maturing bonds and not renewing stimulus on the grounds that the recent slowdown is due only to temporary factors and that Eurozone was merely returning to trend growth.  Sabine Lautenschlaeger, a German member of the ECB’s executive board, said she sees nothing on the horizon that could alter the decision to phase out QE and was confident that the ECB would start raising short-term interest rates, currently set at minus 0.4%, next year.

However, if Eurozone growth continues to remain soft and headline inflation comes down further along with oil prices, any indication that the ECB will follow the Federal Reserve in 2019 in tightening policy could harm Europe at a time when external demand faces negative risks from rising interest rates in the US and contraction in China, and when compensatory fiscal policy action is heavily proscribed by the EU’s intergovernmental rules.

The global economy is at a delicate moment with uncertainty, slowdown or stagnation respectively in its three largest engines – the US, China and Europe. How things develop for economies over the next few months and into 2019 will depend largely on whether central banks overshoot on rate rises, and how things for markets will go will depend on whether monetary policy pivots towards a schedule that investors think the economy can handle.