Recap 2015-03-03: It’s time for Optimism for Europe

Commentary:

One of the things I remember from the dark days of 2011 and 2012 was Lloyd Blankfein’s comment that a lot of people are talking about things that could go wrong, but they shouldn’t ignore the possibility that a lot of things could go right.

With respect to Europe, pessimism has been widespread for basically 5 years now, with a small interlude in late 2010 / early 2011. Following the EU crisis, much has been written about the flaws of the Euro, the structural problems, the liquidity trap, the demographic overhangs, etc, etc. These structural issues were often listed as primary reasons why the Eurozone will never be able to grow sustainably at rates anywhere close to the US. Indeed, that is what current market pricing confirms.

There, is however, another potential explanation that is much less dependent on ‘this time it’s different’ hypothesis, and much less secular. The very simple explanation is that, for the past 3 years, European sovereign yields were simply too high relative to the nominal growth rate. The chart below illustrates that for a 3 year period, sovereign interest rates were at the most constrictive levels since the Lehman crisis, and before that, the mid 90’s. On average, sovereign yields were almost 200 basis points too high over that period:

In light of that context, it really should’ve been no surprise that EU growth has been as weak as it has been. For comparison, below is a chart of the spread between US nominal growth and 10y yields. Rather than 200bps above, US yields were close to 200bps below nominal growth.

The fact that EU yields are now roughly equal to current nominal growth rates, and well below forecasted growth rates, for the first time since 2007 should be a source of enormous optimism for Europe. In fact, it should be noted that EU data has already been picking up for quite some time now. I want to highlight a few in particular.

First, over the past year, Spanish Unemployment has been improving at the best rate since 1999:

This is a story that is broadly confirmed by surging EU consumer confidence. In fact, the trend since mid 2013 suggests that EU-wide unemployment levels could decline to 9.8% by early 2018. That was the level that coincided with the last ECB hike to 1.25%:

Relative to that possibility, the EUR swaps market is discounting a 3y rate, 3y forward of just 0.59%.

Now, extrapolating far into the future is often foolhardy. The unreliability of consensus macro forecasts is well known. But the point I want to make here is that there is a very large dichotomy between consensus expectations and the plausible distribution of outcomes. The market seems quite focused on the things can go wrong, and still quite dismissive of the things that can go right.

On a related note, a friend noted that higher EU yields would be negative for EU equities, and hence would be resisted by the ECB. That’s a reasonable point that is worth going into.

First, a large portion of the decline in EU yields has been due to the massive drop in the inflation breakeven component, with the 10 segment at just 1.25% and the 30y at 1.8%, respectively. A partial reversion to the ECB’s long term target could occur without damage to EU equities. Arguably, it would help.

Second, there is a fair bit of room for EU equities to improve earnings. Better earnings => cheaper equities, which would offset cheaper bonds. In fact, current model outputs for Eurostoxx earnings suggest that consensus estimates remain a bit low:

Third, if a move up in yields were driven by German yields, the subsequent narrowing of periphery spreads is also equity positive. Note that this is exactly what the fine print of the ECB QE program intends. The issuer limit and the small size of the German debt stock relative to GDP means that the longer the ECB maintains its QE program, the more non-German debt it will wind up buying. Ipso facto, the ECB program is insurance for not just EU sovereign yields overall, but the SPREAD between them. As a side note, that is one reason why IMO periphery tighteners remain attractive, despite the fact that potential credit losses may exceed the spread.

Notable:

  • RBA kept the cash rate steady at 2.25% in March after cutting in February. The Board had declined to offer much in the way of guidance following the last cut, but have made it clear today that another easing is a reasonable chance: "it was appropriate to hold interest rates steady for the time being. Further easing of policy may be appropriate over the period ahead.” A 60% probability had been priced in for a cut.
  • AU Building Approvals jumped 7.9% MoM vs -2.0% exp and -3.3% prev
  • Canada 4Q GDP rose 2.4% SAAR vs 2.0% exp. The prior print was revised up to 3.2% from 2.8% prev.
  • Spain – unemployment fell 13.5K people vs. the St looking for a 2.9K decline. Reuters/Bloomberg
  • Japan January total cash wages rose 1.3% yoy, marking a significant increase in line with December, a period supported by winter bonuses. Contribution from special wages contracted to +0.5 pp in January from +1.1 pp in December, but basic wages rose sharply by 0.8% (December: +0.2%), contributing +0.7 pp to total cash wage growth in January. Real wages record a smaller decline on slower CPI: Real wages (nominal wages less the CPI inflation) came in at -1.5% yoy (December: -1.7%), as the extent of the decline contracted in step with the slowdown in CPI.
  • Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3 billion in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55 billion bought a year earlier.
  • China investigates second top officer for graft – Reuters

Upcoming:

  • Tue: Australia GDP, Japan Services PMI, China HSBC Services PMI
  • Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance
  • Thu: BoE, ECB,
  • Fri: EU 4Q GDP, US Employment
  • Mon: ChinaTrade, Japan Eco Watchers Survey, Australia Business Confidence, China CPI,
  • Tue: Japan Machine Tool Orders, US NFIB Survey, USDA Ag report, AU Home Loans

Recap 2015-03-02

Commentary:

Interesting Links:

http://www.bloomberg.com/news/articles/2015-02-27/bridgewater-is-said-to-start-artificial-intelligence-team

http://www.berkshirehathaway.com/2014ar/2014ar.pdf

http://www.bloombergview.com/articles/2015-02-28/warren-buffett-explains-his-cozy-embrace

http://blogs.ft.com/gavyndavies/2015/03/01/reasons-to-worry-about-us-equities/

Notable:

  • The PBOC cut interest rates for the second time in four months amid worries about slowing growth; one-year lending rate will be cut to 5.35% from 5.6% and its one-year deposit rate was lowered to 2.5% from 2.75%. Banks will now be able to offer deposit rates 130% of the max, up from 120% previously.
  • Australia Mfg PMI declined to 45.4 vs 49 prev
  • UK Mfg PMI improved to 54.1 vs 53.3 exp and 53.0 prev
  • Italy Mfg PMI improved to 51.9 vs 50.2 exp and 49.9 prev
  • EU Unemployment declined to 11.2% vs 11.4% exp and prev
  • CPI estimate improved to -0.3% vs -0.4% exp and -0.6% prev
  • US Markit PMI was revised up to 55.1 vs 54.3 exp and prev
  • US ISM declined to 52.9 vs 53.0 exp and 53.5 prev
  • Canada Mfg PMI declined to 48.7 vs 51 prev
  • The Fed’s Fischer suggests it may be time to inject more mystery into the policy-making process as he warns about providing too much guidance. Fischer hints that the Fed may be moving into an era where it will be less explicit in providing guidance.
  • The global deflationary wave is about to break said JPM. Global consumer prices are falling and central banks are easing. However, this deflationary tide looks set to recede if oil prices remain near current levels. Central bank easing should continue, and we have added more rate policy cuts in our forecast. But with 2H15 set to see global inflation rise back to a 2% pace and the Fed normalizing, the global easing cycle should end around midyear.
  • Bond ETFs took in $32 billion globally this year through Feb. 26, according to data from Bloomberg LP, in what has been the strongest start to any year since the funds began in 2002. – WSJ

Upcoming:

  • Mon: RBA, AU Building Approvals
  • Tue: Canada GDP, Australia GDP, Japan Services PMI, China HSBC Services PMI
  • Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance
  • Thu: BoE, ECB,
  • Fri: EU 4Q GDP, US Employment
  • Mon: ChinaTrade, Japan Eco Watchers Survey, Australia Business Confidence, China CPI,

Recap 2015-02-27

Commentary:

On EUR fixed income demand destruction: The NYT ran an article on it today. Highlights:

German bonds maturing in seven years traded at a negative interest rate for the first time on Thursday, meaning investors are willing to temporarily lose money for the privilege of owning the bonds. And the German insurance giant Allianz, which traditionally invests mainly in bonds and other securities, announced on Thursday that it would invest billions of euros more in property, adding to a portfolio that includes a British military garrison and a French shopping mall… “Negative yields are for me a typical sign of bubble mania,” Maximilian Zimmerer, the chief investment officer of Allianz, said by telephone on Thursday. So beginning several years ago, when interest rates began their slide, the company began looking for alternatives. Among other things, Allianz, based in Munich, invested in wind parks; a shopping mall in Nice, France; and a military garrison in Colchester, England, which it owns and operates for the British Ministry of Defense. Allianz said on Thursday that it would aim to increase its alternative portfolio to €110 billion, up from €74 billion at the end of 2014. “I would like to do even more,” Mr. Zimmerer said, but noted that the company was limited by regulations.

In addition to stories like these, note that the EU deflation forever story is facing a setback. German HICP was much stronger than expected, ticking up to -0.1% YoY vs -0.5% exp. Italy HICP rose to +0.1% YoY vs -0.3% exp. Spain HICP surprised to the upside at -1.2% vs -1.5% prev. In aggregate, these are some of the largest upside inflation surprises in years.

Finally, Dudley made some pretty interesting remarks today:

“The fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market’s valuation, that are more supportive to economic growth,” Mr. Dudley said. If those very low market-based rates were to continue after the Fed began raising rates, “it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher,” he said… But he did say “I believe that the risks of lifting the federal funds rate off of the zero lower bound a bit early are higher than the risks of lifting off a bit late,”

He also said to not overemphasize uncertainty to justify low rates.

Fischer also spoke, noting that one their studies’ “results suggest that the Fed’s balance sheet programs are currently depressing 10-year Treasury yields by about 110 basis points. And, with the Fed continuing to hold these securities, they should apply downward pressure on rates for some time.”

That is quite interesting. The forward US treasury curve is essentially discounting a similar but smaller rise. In other words, the current forwards are pricing in less than a normalization of the term premium estimate above, even before adjusting for the rise in Fed Funds.

Notable:

  • Chicago PMI dropped to 45.8 vs 58 exp and 59.4 prev. The commentary released with the survey results suggests that harsh winter weather in the Midwest and the strike at West Coast ports were at least partially to blame for unexpected drop.
  • US Pending Home Sales rose 1.7% MoM vs 2.0% exp
  • German CPI rose to -0.1% vs -0.5% exp and prev
  • UK GfK Consumer Confidence was stable at 1 vs 2 exp
  • Japan Jobless Rate ticked up to 3.6% vs 3.4% exp and prev
  • Japan IP declined to -2.6% YoY vs -3.1% exp and 0.1% prev
  • Japan CPI was stable at 2.4% YoY, with the core measure stable at 2.1% as exp
  • NZ Business Confidence ticked up to 34.4 vs 30.4 prev
  • Fed’s Williams said there is a “disconnect” between Fed officials’ and markets’ expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices. WSJ
  • ECB QE-induced yield collapse in Europe creates headaches for buyers of safe assets. Massive insurers such as Allianz are reducing their allocations to gov’t bonds and seeking out assets such as property. NYT

Upcoming:

  • Weekend: ChinaMfg PMI, Australia Mfg PMI, New Home Sales, Japan Markit Mfg PMI
  • Mon: Italy Mfg PMI, EU Final PMI, UK Mfg PMI, EU Unemployment, CPI estimate, US Personal Income, Canada Mfg PMI, US Markit PMI, ISM, RBA, AU Building Approvals
  • Tue: Canada GDP, Australia GDP, Japan Services PMI, China HSBC Services PMI
  • Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance
  • Thu: BoE, ECB,
  • Fri:

Recap 2015-02-26: On EU green shoots, and a comparison of net issuance after QE in Europe vs Japan

Commentary:

EU growth and inflation pessimism remains very widespread. Reuters reports that a poll conducted by ratings agency Fitch yesterday showed that only 27% of surveyed investors believe that the European Central Bank’s quantitative easing programme (to be started in March) will lift inflation. This survey, which polled managers of over EUR8trn of fixed-income assets, also showed an all-time high of 65% seeing a risk of deflation taking hold in the Euro area, up from a total of 53% back in October.

EU bond markets reflect this pessimism quite thoroughly. It seems that since most investors expect QE to fail, they are not willing to sell their bonds to the ECB. EUR 30y real swap yields are at zero.

Having said that, the growth green shoots are now quite visible. Money growth is at or above levels not seen since 2009/2010. Loan growth is now in positive territory for the first time since 2012.

 

I noted earlier that EU wide consumer confidence is very strong. That is not limited to the core – Italian Consumer Confidence hit the highest level since early 2010:

 

Of course German confidence is already very high, but it may surprise you that Consumer Confidence in Spain is almost as high as it is in Germany. The only laggard is France, but even there, things have been picking up.

With respect to the effect of the ECB QE program, EUR bond bulls seem to be focusing on the net flow, rather than the stock effect. I’ve already gone over my views on the former yesterday, so I won’t rehash them here. But it probably is worth comparing the net flow effect vs Japan, where, it is noted, long end yields remain above well Europe’s.

Europe (bn €) Japan (tn ¥) Notes
Net Supply (ex Coupons) 243.0 31.7 Gross Supply – Redemptions. Est via Budget Deficit * Nominal GDP
Assumed Purchases 430 80 Citi Estimates, BoJ Statement
Annualized 645 80 Assuming ECB starts in March,
Net Supply After QE -402.0 -48.3
Nominal GDP 10,124 488
Net Issuance in % of GDP -4.0% -9.9%
Budget Deficit F’cast -2.4 -6.5
times NGDP 243.0 31.7

Readers are encouraged to check my math, but I think it’s in the ball park. The point is, QE-adjusted net issuance in Japan is well below Europe’s, so flow arguments alone are not likely to be a complete explanation of current yield levels here.

With respect to the stock effect, many commentators have already noted that the size with respect to GDP is reasonably modest.

 

The point is that stock and flow effects do not seem to be sufficient explanations for the current low yields in the European long end.

Notable:

  • German GfK Consumer Confidence improved to 9.7 vs 9.5 exp and 9.3 prev
  • EU Money Supply was very strong, see chart above
  • UK 4Q GDP rose 0.5% as exp, and 2.7% prev
  • Italy Consumer Confidence jumped to 110.9 vs 104.4 exp and 104 prev. This was the highest print since early 2010
  • US Core CPI was stable at 1.6% as exp. The Headline figure declined to -0.1% as ep vs +0.8% prev
  • Durable Goods Orders rose 2.8% vs 1.6% exp. The core measure rose 0.6% vs 0.4% exp
  • Canada Core CPI was stable at 2.2% vs 2.1% exp

Upcoming:

  • Thu: Japan Employment, CPI
  • Fri: Month End, German CPI, ChicagoPMI, US Pending Home Sales
  • Weekend: ChinaMfg PMI, Australia Mfg PMI, New Home Sales, Japan Markit Mfg PMI
  • Mon: Italy Mfg PMI, EU Final PMI, UK Mfg PMI, EU Unemployment, CPI estimate, US Personal Income, Canada Mfg PMI, US Markit PMI, ISM, RBA, AU Building Approvals
  • Tue: Canada GDP, Australia GDP, Japan Services PMI, China HSBC Services PMI
  • Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance
  • Thu: BoE, ECB,

Recap 2015-02-25: On the ECB running out of bonds to buy

Commentary:

There has been a fair bit of commentary recently about how the ECB may not be able to buy all the bonds it wants because they are purchasing more than the net supply. (i.e. gross issuance net of coupons & rolling over of existing debt) Ergo, the thinking goes, EU yield curves will continue to flatten.

IMO, there is a major point missing in this analysis that renders it inaccurate. Specifically, it only looks at one side of the supply / demand balance, and only part of it also. In other words, not only does it ignore the aggregate supply analysis, but it also ignores substitution effects on the demand side. The fact of the matter is that price / yield provides information for market participants to make trade offs. By definition, supply and demand has to balance, so the whole point of price moving is so that neither side is rationed. Put more simply, price / yield changes themselves create and destroy demand / supply.

In fact, we are seeing all those effects playing out already. Here is a limited list:

  • EU investors are already flocking to buy USD debt. That is clearly substitution effect at work, and clearly that reduces demand for EUR debt
  • EU investors are buying EU equities. It is potentially less comparable to EUR debt than USD debt, but clearly asset allocation away from debt and toward equities reduces demand
  • EU sovereign debt issuance duration has been increasing. The EUR iBoxx index, for example, is set to undergo a big duration extension of 0.09 years at the end of the month, well above average. A universe of debt with a longer duration implies more aggregate DV01 supply
  • EU corporate debt issuance is picking up. Global corporations with pricing power seem especially interested to issue in EUR
  • The EU High Yield market covenants have weakened so much that a consortium of the largest fund managers has written a letter complaining about it. (h/t Danny)

We’ve seen these effects play out many times before. This recent FTA post has some charts that highlight the changing debt universe. Aggregate EUR and USD fixed income outstanding has already doubled from pre crisis levels.

While universe duration extended by roughly 1 year, or 20%:

The bulk of the growth was driven by the US High Grade market, but note how growth really picked up in late 2010 / early 2011, and again starting in late 2012 on.

Now look at this chart of US yields… see what happened in mid 2010 and mid 2012??

Here is a very short list of other instances where ex-ante supply / demand analysis would’ve likely resulted in incorrect market forecasts:

  • US yields rose during the first few instances of Fed QE
  • US yields fell in 2010 despite the fact that the US budget deficit gapped up to 10% of GDP by the end of 2009 from 1% two years earlier.
  • Oil prices

The fact of the matter is, a simple supply / demand analysis only works in controlled conditions, with inelasticity and limited 2nd and 3rd round effects. Liquid assets in developed markets do not exhibit any of those characteristics.

The data on debt growth is fairly clear, in that it lags economic growth. Here is a chart of US commercial loans & leases in white vs the US Industrial Production Index:

Now, to be fair, the EU growth data thus far does not engender much enthusiasm: (loans to corporates in white, EU IP in orange)

But the data in train area quite unambiguously pointing to a growth pick up. I’ll have a bit more to write on this tomorrow.

Notable:

  • France Consumer Confidence improved to 92 vs 91 exp and 90 prev
  • China HSBC Mfg PMI improved to 50.1 vs 49.5 exp
  • Petrobras was lowered two levels to junk by Moody’s last night. Fitch (negative watch) and S&P (stable) still have the company at the lowest investment grade status. Spreads are 35-70 basis points wider this morning.
  • Warren Buffett: "We are definitely interested in buying more German companies….Germany is a great market: lots of people, lots of purchasing power and Germans are productive. We also like the regulatory and legal framework.”
  • The Eurozone’s chief banking supervisor has warned that the industry may be forced to raise more (and higher quality) equity as control becomes more centralized and national capital rule exceptions get eliminated.

Upcoming:

  • Thu: German GfK Consumer Confidence, EU Money Supply, UK GDP, Italy Consumer Confidence, US CPI, Durable Goods, Jobless Claims, Japan Employment, CPI
  • Fri: Month End, German CPI, ChicagoPMI, US Pending Home Sales
  • Weekend: ChinaMfg PMI, Australia Mfg PMI, New Home Sales, Japan Markit Mfg PMI
  • Mon: Italy Mfg PMI, EU Final PMI, UK Mfg PMI, EU Unemployment, CPI estimate, US Personal Income, Canada Mfg PMI, US Markit PMI, ISM, RBA, AU Building Approvals
  • Tue: Canada GDP, Australia GDP, Japan Services PMI, China HSBC Services PMI
  • Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance

Recap 2015-02-24

Commentary:

Interesting:

http://www.nytimes.com/interactive/2015/02/23/business/economy/the-changing-nature-of-middle-class-jobs.html

Notable:

  • Humphery-Hawkins was not particularly surprising
  • US Markit US Services PMI jumped to 57 vs 54.5 exp and 54.2 prev
  • US Consumer Confidence, declined to 96.4 vs 99.5 exp and 102.9 prev
  • according to the Nikkei, relations between Abe and Kuroda appear to be fraying as the BOJ pressures the government to tackle Japan’s debt problems

Upcoming:

  • Tue: China HSBC Mfg PMI
  • Wed: France Consumer Confidence, US New home Sales, Oil Inventories, Draghi Testifies to EU Parliament
  • Thu: German GfK Consumer Confidence, EU Money Supply, UK GDP, Italy Consumer Confidence, US CPI, Durable Goods, Jobless Claims, Japan Employment, CPI
  • Fri: Month End, German CPI, ChicagoPMI, US Pending Home Sales
  • Weekend: ChinaMfg PMI, Australia Mfg PMI, New Home Sales, Japan Markit Mfg PMI
  • Mon: Italy Mfg PMI, EU Final PMI, UK Mfg PMI, EU Unemployment, CPI estimate, US Personal Income, Canada Mfg PMI, US Markit PMI, ISM, RBA, AU Building Approvals

Recap 2015-02-20

Commentary:

None

Notable:

  • Greece came to a 4 month agreement with the Eurogroup. There were some reports that the ECB will make Greek debt eligible as collateral again.
  • EU Mfg PMI was stable at 51.1 vs 51.5 exp and 51.0 prev. Germany was stable at 50.9 vs 51.5 exp. France was weak at 47.7 vs 49.6 exp and 49.2 prev
  • EU Services PMI jumped to 53.9 vs 53 exp and 52.7 prev. Germany and especially France was strong
  • US Markit Mfg PMI improved to 54.3 vs 53.6 exp and 53.9 prev
  • Japan Markit Mfg PMI declined to 51.5 vs 52.5 exp and 52.2 prev
  • Mexico GDP grew 0.7% QoQ vs 0.9% exp
  • Hilsenrath talks about the challenges the Fed faces with the removal of “patient” from the statement. The Fed bond dealer survey revealed that several of the 22 surveyed are taking a very narrow view of what it will mean when the Fed removes patient. They responded that patient will be dropped “exactly two meetings prior to liftoff.” "Many dealers indicated that they expect that the forward guidance change would result in a tightening of financial conditions," the survey said.

Upcoming:

  • Mon: German IFO, Chicago Fed National Activity Index, US Existing Home Sales
  • Tue: US Markit US Services PMI, Humphery-Hawkins, US Consumer Confidence, China HSBC Mfg PMI
  • Wed: France Consumer Confidence, US New home Sales, Oil Inventories, Draghi Testifies to EU Parliament
  • Thu: German GfK Consumer Confidence, EU Money Supply, UK GDP, Italy Consumer Confidence, US CPI, Durable Goods, Jobless Claims, Japan Employment, CPI
  • Fri: Month End, German CPI, ChicagoPMI, US Pending Home Sales