The Fed announced this week that it will spend $300 billion buying US treasuries, presumably to bring down interest rates and to increase market liquidity (weren’t treasuries already liquid?). In the same week we have seen a drop in the Dollar and a significant rise in the oil price, the gold price and other commodity prices. OPEC probably can’t believe their luck, having only just announced that they would not be cutting production quotas further in light of the severity of the economic downturn.
Whilst it is early days, the rise in commodity prices raises some significant questions about the targeting and validity of the Fed policy. As well as bringing down interest rates the buying of treasuries is also another way of putting money back into the financial system, with the aim of feeding through to the wider economy and keeping inflation alive (specifically to avoid deflation).
Real world inflation is generally driven by two factors (ignoring specific supply bottlenecks) that cause prices to rise: wage growth and credit expansion. The 10 year US treasury yield is currently 2.6% which would suggest that it is not high interest rates that are stopping credit expansion. Extra liquidity in the system could help but what is really needed would be widespread take up of new credit by companies and consumers (not just a rolling over of existing debt, which wouldn’t be expansion). I would argue that most companies and consumers are still in deleveraging mode and will be for some time. I think credit expansion on a meaningful scale is unlikely to happen yet, maybe not for a long time.
Will the new Fed spending encourage wage growth? Not unless companies start experiencing increased demand (which won’t happen without greater disposable income for consumers, which itself would be a result of higher wages or lower outgoings). Wage demands that are satisfied by employers, are driven by rising prices in an economy but only where they arise from increased demand for goods and services. In the current environment workers will want higher wages because the cost of basic materials such as food and energy are rising but will employers be inclined to give them without a commensurate rise in demand for the goods they produce? Long gone are the days when an employer such as Henry Ford believed that paying higher wages to his employees would enable more of them to buy his cars.
So what if the Fed’s policy actually turns out to be damaging to the economy? In the period of a few short days the net result of the Feds treasury-buying policy is that it has pushed up oil, metal and various other food and energy commodities. The costs of production just got higher. So far, investor demand for inflation-hedging commodities has been sufficient to move their prices in anticipation of the higher inflation rates that could follow. However, if the net result of the Fed’s policy is to push up commodity prices initially, but it doesn’t feed into wages or credit expansion for the reasons mentioned above, then it is likely to put a brake on any hint of economic recovery that might have been occurring.
We are in unprecedented times and it is entirely feasible, in my humble opinion (!), that the Fed may be on the wrong path and it may actually prolong the pain of a recession. Higher prices are only desirable in the current situation if they lead to wage growth and reasonable credit expansion but if they only succeed in pushing up producer input prices before economic demand recovers then they are unlikely to get a warm welcome from either consumers or companies.
Friday, March 20, 2009
Monday, September 8, 2008
Is the luxury car market facing long-term decline?
When you were little and you wanted to buy something your parents gave you the money, if you were lucky. Life was so much simpler when you didn’t have to worry about where the money came from, you just had to ask nicely for it (and do your homework). For many adults the first few years of the 21st century have seen this easy approach to shopping return and if you wanted to buy a car, the manufacturer or the dealer would offer you the money to buy it. If you look in detail at the car industry you see how cheap and easily available credit oils the wheels of this particular brand of commerce at so many levels and it has been especially successful at elevating the luxury end of the market into the mainstream.
The premium car market has boomed during the last decade, to the extent that in the UK the BMW 3 Series now outsells the Ford Mondeo, the Vauxhall Vectra and the Renault Clio. Throughout Europe BMW only sold 5000 less 3 Series than Ford sold Fiestas. The cars in the premium sector, even though they are considerably more expensive than their rivals, have enjoyed huge sales increases at the expense of the more mundane brands as people have been able to upgrade due to easily available finance. Some of the main beneficiaries of this step change in spending habits has been BMW, Mercedes (owned by Daimler) and Audi, all of whom have seen their luxury car ranges move into the mainstream. BMW and Mercedes in particular have benefited from the increase in demand for SUVs with their popular X5 and ML models, with Audi coming late to the game. According to the Society of Motor Manufacturers and Traders either Mercedes or BMW take the top place for sales in the Upper Medium, Luxury Saloon and Executive sectors of the UK car market. 4 out of the top 5 Sports cars on sales in the UK are German. In fact, German-owned marques dominate the top of all these sectors despite the fact that they tend to be more expensive than the equivalent models from other marques.
The expansion of the German car manufacturer’s sales in the last decade has come about as a direct consequence of rising aspirations and the ability to achieve them. Whilst ownership of a BMW or Mercedes used to signify a certain level of success, today these marques are accessible to a far more wide ranging section of society and they are a lot less exclusive than they used to be. In addition, new car ownership has increased in the UK so that we now have the youngest fleet of cars on the roads in Europe. This is probably best explained by the fact that the UK has the highest proportion of cars purchased with loans and it is this reason that explains why the premium car sector has been able to increase its market share.
Globally, one in three Daimler Group vehicles is bought on finance that is provided by the company itself. As well as being a major car manufacturer the Daimler Group is also the world’s largest manufacturer of trucks, and as economic activity around the world has increased, so has demand for their trucks. At BMW, nearly one in two vehicles is purchased using BMW-supplied finance and they also offer their own credit cards, home insurance and savings accounts in certain markets. To drive expansion of the distribution network they lend money to dealers to enable them to make property purchases and to buy stock and equipment. Last year nearly 20% of BMW Group profits came directly from their own financial services division. It’s clear that the ability to lend and borrow money is a crucial part of the business model for the major car companies.
However, the credit crunch has changed the dynamics of car retailing. Buyers are finding it more difficult to get credit, the credit is more expensive when they do get it and there are less people who can afford the monthly payments for a luxury car. Buyers are trading down or postponing their purchase. In the US, used car prices have plummeted, especially for large luxury cars and SUVs that tend to consume more fuel than smaller cars. This means that when clients who leased their cars trade them in, the residual values are much lower than had been forecast at the outset of the lease period. This is bad news for the car companies as it means they sell each leased car at a lower price and they have been forced to write down the value of their leasing books. Leased assets at BMW totalled $20 billion in 2007 and this year they have already increased their risk provisions for residual value risks and bad debts to €695 million.
BMW lent €8 billion to dealers last year and this money must also be at risk as car dealers fight weaker demand and higher operating costs. Pendragon, the UK’s largest car dealership group, recently announced that trading conditions were deteriorating and they have been cutting staff and other overheads to reduce costs. National car sales were down 18.6% in August compared to a year ago. Potentially more worrying, according to their 6 month statement of results Pendragon has in recent years made significant profits from the sale of its properties but the credit crunch has cut a swathe through the UK commercial property sector and this source of revenue is likely to be very weak, if not non-existent, for at least the next couple of years. The dealer’s best business hope is that revenue from parts and servicing continues to be strong but even this is likely to decline as people use their cars less frequently and more people take public transport rather than pay high petrol prices.
The modern day car business is one that is completely reliant on the availability of cheap and easily available credit. It drives almost every part of the business model, either directly or indirectly, and without this finance the industry could go into serious decline if the credit market fails to return to its former glory. The huge growth in the market for the luxury brands is going to reverse as people trade down and the major luxury manufacturers, especially the German marques, are going to see their business model come under severe pressure. It is possible to envisage a luxury car industry that experiences declining demand for years to come as UK consumers pay down debt, face rising unemployment and as a weak Pound pushes up import prices. A ‘luxury’ may once again become just that, rather than something that everyone can afford
The premium car market has boomed during the last decade, to the extent that in the UK the BMW 3 Series now outsells the Ford Mondeo, the Vauxhall Vectra and the Renault Clio. Throughout Europe BMW only sold 5000 less 3 Series than Ford sold Fiestas. The cars in the premium sector, even though they are considerably more expensive than their rivals, have enjoyed huge sales increases at the expense of the more mundane brands as people have been able to upgrade due to easily available finance. Some of the main beneficiaries of this step change in spending habits has been BMW, Mercedes (owned by Daimler) and Audi, all of whom have seen their luxury car ranges move into the mainstream. BMW and Mercedes in particular have benefited from the increase in demand for SUVs with their popular X5 and ML models, with Audi coming late to the game. According to the Society of Motor Manufacturers and Traders either Mercedes or BMW take the top place for sales in the Upper Medium, Luxury Saloon and Executive sectors of the UK car market. 4 out of the top 5 Sports cars on sales in the UK are German. In fact, German-owned marques dominate the top of all these sectors despite the fact that they tend to be more expensive than the equivalent models from other marques.
The expansion of the German car manufacturer’s sales in the last decade has come about as a direct consequence of rising aspirations and the ability to achieve them. Whilst ownership of a BMW or Mercedes used to signify a certain level of success, today these marques are accessible to a far more wide ranging section of society and they are a lot less exclusive than they used to be. In addition, new car ownership has increased in the UK so that we now have the youngest fleet of cars on the roads in Europe. This is probably best explained by the fact that the UK has the highest proportion of cars purchased with loans and it is this reason that explains why the premium car sector has been able to increase its market share.
Globally, one in three Daimler Group vehicles is bought on finance that is provided by the company itself. As well as being a major car manufacturer the Daimler Group is also the world’s largest manufacturer of trucks, and as economic activity around the world has increased, so has demand for their trucks. At BMW, nearly one in two vehicles is purchased using BMW-supplied finance and they also offer their own credit cards, home insurance and savings accounts in certain markets. To drive expansion of the distribution network they lend money to dealers to enable them to make property purchases and to buy stock and equipment. Last year nearly 20% of BMW Group profits came directly from their own financial services division. It’s clear that the ability to lend and borrow money is a crucial part of the business model for the major car companies.
However, the credit crunch has changed the dynamics of car retailing. Buyers are finding it more difficult to get credit, the credit is more expensive when they do get it and there are less people who can afford the monthly payments for a luxury car. Buyers are trading down or postponing their purchase. In the US, used car prices have plummeted, especially for large luxury cars and SUVs that tend to consume more fuel than smaller cars. This means that when clients who leased their cars trade them in, the residual values are much lower than had been forecast at the outset of the lease period. This is bad news for the car companies as it means they sell each leased car at a lower price and they have been forced to write down the value of their leasing books. Leased assets at BMW totalled $20 billion in 2007 and this year they have already increased their risk provisions for residual value risks and bad debts to €695 million.
BMW lent €8 billion to dealers last year and this money must also be at risk as car dealers fight weaker demand and higher operating costs. Pendragon, the UK’s largest car dealership group, recently announced that trading conditions were deteriorating and they have been cutting staff and other overheads to reduce costs. National car sales were down 18.6% in August compared to a year ago. Potentially more worrying, according to their 6 month statement of results Pendragon has in recent years made significant profits from the sale of its properties but the credit crunch has cut a swathe through the UK commercial property sector and this source of revenue is likely to be very weak, if not non-existent, for at least the next couple of years. The dealer’s best business hope is that revenue from parts and servicing continues to be strong but even this is likely to decline as people use their cars less frequently and more people take public transport rather than pay high petrol prices.
The modern day car business is one that is completely reliant on the availability of cheap and easily available credit. It drives almost every part of the business model, either directly or indirectly, and without this finance the industry could go into serious decline if the credit market fails to return to its former glory. The huge growth in the market for the luxury brands is going to reverse as people trade down and the major luxury manufacturers, especially the German marques, are going to see their business model come under severe pressure. It is possible to envisage a luxury car industry that experiences declining demand for years to come as UK consumers pay down debt, face rising unemployment and as a weak Pound pushes up import prices. A ‘luxury’ may once again become just that, rather than something that everyone can afford
Thursday, July 24, 2008
Why US debt makes the country vulnerable.
The US government now has $2061billion of Treasury Bills in circulation. This is effectively the size of the loan it has taken from the rest of the world in order to finance its economy and is one of the reasons that the US Dollar has depreciated so significantly against many other currencies over the last few years. Since 2001 the US Dollar has depreciated 43% against the Swiss Franc and 47% against the Euro. This depreciation has been fairly orderly but there are increasingly important reasons why a disorderly depreciation, or even a run on the currency, could occur.
The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with Dollars as oil is primarily priced in US Dollars. China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using Dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don’t publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be Dollar-denominated. US Dollars and Dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America.
There are several reasons why the US Dollar is exposed to geopolitical and investment risk in a way that hasn’t been seen before:
1) Several countries are now pursuing a policy of diversification away from the US Dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The Euro is a potential beneficiary or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from Dollar assets that begins to become obvious to markets and which could cause other investors to panic. Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.
2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the Dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further Dollar weakness. The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.
3) Several middle-eastern and Asian countries have pegged their currencies to the US Dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi 10%, UAE 11%. They are not suffering from the same economic woes as the US so interest rates of 2% are totally inappropriate. Middle-eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the Dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely Dollar-negative.
4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could infer that it was going to reduce its Dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the Dollar and the US economy and is something the US would be keen to avoid.
It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China’s rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation there hasn’t really been a significant dispute with the US. But what if this was to change one day? In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.
In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence. Whilst this would mean that the value of all China’s Dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US Dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world’s most important economy and as the world’s premier superpower.
If China was to sell its US Dollar holdings at an accelerated rate then the value of the Dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem. A stable currency is essential for any country to attract foreign investment and the Dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying Dollars the deficit could balloon to unmanageable proportions. America’s role as the greatest economic power in the world would be at an end.
Other holders of Dollar-denominated assets such as Japan and the OPEC members would also suffer and they would certainly condemn China for taking such action but are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.
Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging. Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between Communism and Capitalism hasn’t completely disappeared after all and the Chinese have been merely biding their time.
The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong Dollar policy but the reality is somewhat different and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the Dollar was what they wanted all along. However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating. A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don’t want to be holding US Dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.
The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with Dollars as oil is primarily priced in US Dollars. China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using Dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don’t publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be Dollar-denominated. US Dollars and Dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America.
There are several reasons why the US Dollar is exposed to geopolitical and investment risk in a way that hasn’t been seen before:
1) Several countries are now pursuing a policy of diversification away from the US Dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The Euro is a potential beneficiary or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from Dollar assets that begins to become obvious to markets and which could cause other investors to panic. Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.
2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the Dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further Dollar weakness. The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.
3) Several middle-eastern and Asian countries have pegged their currencies to the US Dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi 10%, UAE 11%. They are not suffering from the same economic woes as the US so interest rates of 2% are totally inappropriate. Middle-eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the Dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely Dollar-negative.
4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could infer that it was going to reduce its Dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the Dollar and the US economy and is something the US would be keen to avoid.
It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China’s rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation there hasn’t really been a significant dispute with the US. But what if this was to change one day? In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.
In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence. Whilst this would mean that the value of all China’s Dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US Dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world’s most important economy and as the world’s premier superpower.
If China was to sell its US Dollar holdings at an accelerated rate then the value of the Dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem. A stable currency is essential for any country to attract foreign investment and the Dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying Dollars the deficit could balloon to unmanageable proportions. America’s role as the greatest economic power in the world would be at an end.
Other holders of Dollar-denominated assets such as Japan and the OPEC members would also suffer and they would certainly condemn China for taking such action but are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.
Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging. Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between Communism and Capitalism hasn’t completely disappeared after all and the Chinese have been merely biding their time.
The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong Dollar policy but the reality is somewhat different and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the Dollar was what they wanted all along. However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating. A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don’t want to be holding US Dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.
Wednesday, July 9, 2008
Who will pull out of the Euro first?
Ireland, Spain or Italy? It might sound a bit far fetched to some people but actions speak louder than words. In Germany savers are drawing money out of the bank and demanding that the Euro notes are German Euro notes. Is this a sign that some Europeans are starting to worry about the validity of their currency?
Each member of the Eurozone prints its own banknotes, according to its economic weight, and they are numbered in such a way as to make their country of origin identifiable. According to Ambrose Evans-Pritchard in the UK’s Telegraph newspaper, Germans are avoiding notes with serial numbers from Italy, Spain, Portugal and Ireland, instead demanding notes with the German numbers that start with an ‘X’.
It may seem unusual to still think of the Euro as a combination of different currencies but the same approach is applied to the government bonds that are issued by each country in the Eurozone. For instance, 10 year bonds issued by the Italian government are yielding 5.034% compared to 4.422% for German 10 year bonds. French bonds are offering just 4.636% compared to 5.089% for Greek bonds. It is the financial strength of these countries that effectively combine to underpin the stability of the Euro currency but there are clearly some variations in the governments doing the underpinning. However, a default on interest payments on government bonds would have a devastating effect on the currency and it is unlikely it would be allowed to happen in the Eurozone, the ECB would most likely step in.
But in the same way that investors are applying different ratings to government bonds from different issuers, German consumers are now applying the same approach to bank notes from different issues. In a world where currencies are no longer backed by hard assets such as gold, and rely completely on public confidence, it is not inconceivable that one country’s people might panic and stop accepting notes that are issued by another country. It might be wrong to do this, purely as a result of a lack of understanding of how the Euro is supported by the combined strength of the Eurozone members, but crowd mentality is a powerful force and if people think they are at risk of losing all their money, they will react to save their skins. A run on the notes of a specific country is not totally inconceivable.
The most likely trigger for a run on a currency formed through monetary union is if the chances one country dropping out were to increase significantly. There have been some weak rumours already about Italy dropping out of the Euro but nothing that has caused a tangible effect. However, the economic problems that some countries are experiencing are only going to get worse and investors need to be looking ahead. We could be on the verge of the greatest stress test the Euro currency has ever undergone during its short life.
Over the past few years there has been massive expansion of the financial system in Spain, Ireland and Greece. Low interest rates, combined with a big increase in the number of available financial products on offer such as mortgages and personal loans, has propelled a huge and unprecedented take up in credit in these countries. Borrowing has been available on a scale never seen before. Effectively the interest rate set by the ECB was too low for these high growth countries, having been kept down to support the much larger economy of struggling Germany, and this fuelled a boom in construction, housing and consumer spending.
However, higher inflation and higher lending rates brought about by the credit crunch have turned off the tap of cheap and easy credit and this is causing the economies of the PIGS countries (Portugal, Italy, Greece and Spain), along with Ireland, a great deal of pain. These countries could now do with lower interest rates to help their rapidly-slowing economies but the ECB has to focus on the bigger picture and is compelled to fight high inflation and to take into account much better growth in Germany.
An economic recovery in Germany couldn’t have come at a worse time. There has been a two-speed Europe for some time now but the players have recently changed places and it is the former growth stars that are now in dire need of lower interest rates. In the past, at times of severe economic weakness, a country always had the option of lowering interest rates, just as the US has done. However, even though Spanish GDP growth is expected to more than halve this year and Spain will struggle to avoid recession in 2009, it has no option but to accept the interest rates set by the ECB. The Italian economy is also being crippled by a strong Euro and in pre-Euro days it would almost certainly be considering either lowering interest rates significantly or devaluing the currency.
The real question is, how bad will things get for these countries that are suffering from a huge property crash, a sharp drop in consumer spending and declining demand for their exports? Will political pressure to do the right thing for the country be stronger than the desire to remain as part of the single currency? Many people already blame the Euro for the price rises they have experienced over the last few years, rightly or wrongly, and would probably be keen to see it broken up. If property prices keep falling in Spain and unemployment keeps rising, it will be very difficult to stomach more interest rate rises that are designed to keep external inflation under control, especially as 90% of Spain’s financial borrowing is on variable rates.
If the economy in Ireland or Italy is struggling under the weight of a strong currency and high interest rates, how long will it be before a politician latches onto the idea of proposing a swift exit from the Euro to boost jobs and production, to revitalise the home economy? This might seem like a narrow-minded and short term policy to pursue but you can see how it might be very popular with an electorate who are feeling betrayed by Europe and who blame the people in Brussels for their hardship.
In reality, it might not even need to go that far before the Euro is put under pressure and starts to weaken of its own accord. A serious threat to its stability, with the risk of one departure being followed by others in quick succession, would be enough to undermine confidence in the currency and to see a sharp move in its value against other currencies. Whilst this would ultimately be damaging for those invested heavily in Euros, it could also present a very interesting opportunity for those Euro-based investors who were ready and waiting for such a move. George Soros made over $1billion when the Pound was forced out of the Exchange Rate Mechanism in 1992. Some people will also do very well if a currency pulls out of the Euro today, it’s simply a case of watching and waiting for the signs and ultimately being open to the possibility that this could happen. Even though several European countries could go into recession in the next couple of years there is always money to be made by investors if they think ahead and prepare for possible opportunities.
Each member of the Eurozone prints its own banknotes, according to its economic weight, and they are numbered in such a way as to make their country of origin identifiable. According to Ambrose Evans-Pritchard in the UK’s Telegraph newspaper, Germans are avoiding notes with serial numbers from Italy, Spain, Portugal and Ireland, instead demanding notes with the German numbers that start with an ‘X’.
It may seem unusual to still think of the Euro as a combination of different currencies but the same approach is applied to the government bonds that are issued by each country in the Eurozone. For instance, 10 year bonds issued by the Italian government are yielding 5.034% compared to 4.422% for German 10 year bonds. French bonds are offering just 4.636% compared to 5.089% for Greek bonds. It is the financial strength of these countries that effectively combine to underpin the stability of the Euro currency but there are clearly some variations in the governments doing the underpinning. However, a default on interest payments on government bonds would have a devastating effect on the currency and it is unlikely it would be allowed to happen in the Eurozone, the ECB would most likely step in.
But in the same way that investors are applying different ratings to government bonds from different issuers, German consumers are now applying the same approach to bank notes from different issues. In a world where currencies are no longer backed by hard assets such as gold, and rely completely on public confidence, it is not inconceivable that one country’s people might panic and stop accepting notes that are issued by another country. It might be wrong to do this, purely as a result of a lack of understanding of how the Euro is supported by the combined strength of the Eurozone members, but crowd mentality is a powerful force and if people think they are at risk of losing all their money, they will react to save their skins. A run on the notes of a specific country is not totally inconceivable.
The most likely trigger for a run on a currency formed through monetary union is if the chances one country dropping out were to increase significantly. There have been some weak rumours already about Italy dropping out of the Euro but nothing that has caused a tangible effect. However, the economic problems that some countries are experiencing are only going to get worse and investors need to be looking ahead. We could be on the verge of the greatest stress test the Euro currency has ever undergone during its short life.
Over the past few years there has been massive expansion of the financial system in Spain, Ireland and Greece. Low interest rates, combined with a big increase in the number of available financial products on offer such as mortgages and personal loans, has propelled a huge and unprecedented take up in credit in these countries. Borrowing has been available on a scale never seen before. Effectively the interest rate set by the ECB was too low for these high growth countries, having been kept down to support the much larger economy of struggling Germany, and this fuelled a boom in construction, housing and consumer spending.
However, higher inflation and higher lending rates brought about by the credit crunch have turned off the tap of cheap and easy credit and this is causing the economies of the PIGS countries (Portugal, Italy, Greece and Spain), along with Ireland, a great deal of pain. These countries could now do with lower interest rates to help their rapidly-slowing economies but the ECB has to focus on the bigger picture and is compelled to fight high inflation and to take into account much better growth in Germany.
An economic recovery in Germany couldn’t have come at a worse time. There has been a two-speed Europe for some time now but the players have recently changed places and it is the former growth stars that are now in dire need of lower interest rates. In the past, at times of severe economic weakness, a country always had the option of lowering interest rates, just as the US has done. However, even though Spanish GDP growth is expected to more than halve this year and Spain will struggle to avoid recession in 2009, it has no option but to accept the interest rates set by the ECB. The Italian economy is also being crippled by a strong Euro and in pre-Euro days it would almost certainly be considering either lowering interest rates significantly or devaluing the currency.
The real question is, how bad will things get for these countries that are suffering from a huge property crash, a sharp drop in consumer spending and declining demand for their exports? Will political pressure to do the right thing for the country be stronger than the desire to remain as part of the single currency? Many people already blame the Euro for the price rises they have experienced over the last few years, rightly or wrongly, and would probably be keen to see it broken up. If property prices keep falling in Spain and unemployment keeps rising, it will be very difficult to stomach more interest rate rises that are designed to keep external inflation under control, especially as 90% of Spain’s financial borrowing is on variable rates.
If the economy in Ireland or Italy is struggling under the weight of a strong currency and high interest rates, how long will it be before a politician latches onto the idea of proposing a swift exit from the Euro to boost jobs and production, to revitalise the home economy? This might seem like a narrow-minded and short term policy to pursue but you can see how it might be very popular with an electorate who are feeling betrayed by Europe and who blame the people in Brussels for their hardship.
In reality, it might not even need to go that far before the Euro is put under pressure and starts to weaken of its own accord. A serious threat to its stability, with the risk of one departure being followed by others in quick succession, would be enough to undermine confidence in the currency and to see a sharp move in its value against other currencies. Whilst this would ultimately be damaging for those invested heavily in Euros, it could also present a very interesting opportunity for those Euro-based investors who were ready and waiting for such a move. George Soros made over $1billion when the Pound was forced out of the Exchange Rate Mechanism in 1992. Some people will also do very well if a currency pulls out of the Euro today, it’s simply a case of watching and waiting for the signs and ultimately being open to the possibility that this could happen. Even though several European countries could go into recession in the next couple of years there is always money to be made by investors if they think ahead and prepare for possible opportunities.
Wednesday, June 25, 2008
Investing in bonds in an inflationary environment.
With inflation figures reaching worrying levels in the US, UK and Europe, not to mention most emerging markets where they look as though they are getting out of control, this might seem to be an odd time to be looking at bonds as an investment. Index-linked bonds have been popular for some time now because they protect investors from future inflation rises but they don’t offer very compelling value at current price levels. However, fixed rate bonds now look appealing.
It has been difficult to find good value investments for some time, even though stock markets have fallen in recent months. The worst hit sectors of the main stock markets are financials and construction stocks, some of which have gone bust or been rescued by the State, such as Northern Rock and Bear Stearns, and where share prices have fallen over 60% in other cases. It is debatable whether these stocks represent good value because we are probably not near the end of the credit crunch yet, with problems in Europe and the UK still only just starting to unfold, and the property market is going to have to fight a lack of buyer confidence plus a huge oversupply in some areas for several years to come. They are cheap but for a good reason and they could struggle to grow earnings for some time.
An investment in bonds at a time such as this is based on the belief that inflationary expectations are priced into current bond yields and there are many bonds that offer what looks like good value, in a world of rapidly rising prices where value is difficult to find. It is also possible that the recent inflation scare has caused prices to overshoot on the downside.
Bonds also offer good visibility, if we stick with investment grade bonds, as they are rated for security (unlike stocks) and we can usually assume that the capital will be repaid at maturity if the company doesn’t go bust or default on its debts. In the event of a serious problem appearing out of the blue there is also a better chance of getting paid if you are holding bonds compared to shares as you are higher up the list of creditors.
To reduce the risk of default, or its effects on a portfolio, you can:
1) diversify across a number of different bonds
2) stick to investment grade bonds only
3) focus on blue chip companies.
By doing this we reduce the risk of loss from default as much as possible. This provides a great level of security, if we can assume that capital will be repaid at maturity. We can add another level of security to the investment by choosing securities with a short to medium term maturity date such as a minimum of 2 years up to a maximum of 5 years. This means that we could probably hold a bond to maturity if inflation does get out of control and bond prices drop even more sharply from here.
However, current investment grade corporate bond prices provide us with a margin of safety. There has recently been a reversal of interest rate expectations in the US, EU and UK which has seen bond prices fall sharply and yields have moved up to very interesting levels. Many corporate bonds are trading at below par and are offering yields more than 100 basis points above base rates.
Here are some examples:
Bayer AG 2012 €. Yield 5.79%.
Unilever 2012 €. Yield 5.29%.
Gaz de France 2013 €. Yield 5.44%.
Tesco 2010 £. Yield 6.27%.
AT&T 2012 US$. Yield 5.20%.
Since March this year, less than 12 weeks, the Gaz de France bond has seen its yield rise from 4% to 5.44% and the Tesco bond has seen its yield rise from 4.7% to 6.27% over the same period. In my opinion, neither of these companies are likely to default before the bonds reach maturity yet they are now offering very interesting yields above base rates.
A portfolio of investment grade corporate bonds at these prices can boost returns on money that was previously sitting in cash (in very short dated maturities) and could provide a capital return if economic growth slows more rapidly and starts to become the main focus of central banks and their governments once more (in longer dated maturities). If investors feel the chance of this happening is significant then they can also buy much longer dated bonds that will rise more if interest rate expectations weaken. A staggered portfolio will provide the best risk/reward ratio. These bonds should remain fairly liquid and will also have defensive properties if stock markets fall further or if the geo-political situation in the Middle East worsens. If the price is right, bonds can be worth buying in an inflationary environment.
It has been difficult to find good value investments for some time, even though stock markets have fallen in recent months. The worst hit sectors of the main stock markets are financials and construction stocks, some of which have gone bust or been rescued by the State, such as Northern Rock and Bear Stearns, and where share prices have fallen over 60% in other cases. It is debatable whether these stocks represent good value because we are probably not near the end of the credit crunch yet, with problems in Europe and the UK still only just starting to unfold, and the property market is going to have to fight a lack of buyer confidence plus a huge oversupply in some areas for several years to come. They are cheap but for a good reason and they could struggle to grow earnings for some time.
An investment in bonds at a time such as this is based on the belief that inflationary expectations are priced into current bond yields and there are many bonds that offer what looks like good value, in a world of rapidly rising prices where value is difficult to find. It is also possible that the recent inflation scare has caused prices to overshoot on the downside.
Bonds also offer good visibility, if we stick with investment grade bonds, as they are rated for security (unlike stocks) and we can usually assume that the capital will be repaid at maturity if the company doesn’t go bust or default on its debts. In the event of a serious problem appearing out of the blue there is also a better chance of getting paid if you are holding bonds compared to shares as you are higher up the list of creditors.
To reduce the risk of default, or its effects on a portfolio, you can:
1) diversify across a number of different bonds
2) stick to investment grade bonds only
3) focus on blue chip companies.
By doing this we reduce the risk of loss from default as much as possible. This provides a great level of security, if we can assume that capital will be repaid at maturity. We can add another level of security to the investment by choosing securities with a short to medium term maturity date such as a minimum of 2 years up to a maximum of 5 years. This means that we could probably hold a bond to maturity if inflation does get out of control and bond prices drop even more sharply from here.
However, current investment grade corporate bond prices provide us with a margin of safety. There has recently been a reversal of interest rate expectations in the US, EU and UK which has seen bond prices fall sharply and yields have moved up to very interesting levels. Many corporate bonds are trading at below par and are offering yields more than 100 basis points above base rates.
Here are some examples:
Bayer AG 2012 €. Yield 5.79%.
Unilever 2012 €. Yield 5.29%.
Gaz de France 2013 €. Yield 5.44%.
Tesco 2010 £. Yield 6.27%.
AT&T 2012 US$. Yield 5.20%.
Since March this year, less than 12 weeks, the Gaz de France bond has seen its yield rise from 4% to 5.44% and the Tesco bond has seen its yield rise from 4.7% to 6.27% over the same period. In my opinion, neither of these companies are likely to default before the bonds reach maturity yet they are now offering very interesting yields above base rates.
A portfolio of investment grade corporate bonds at these prices can boost returns on money that was previously sitting in cash (in very short dated maturities) and could provide a capital return if economic growth slows more rapidly and starts to become the main focus of central banks and their governments once more (in longer dated maturities). If investors feel the chance of this happening is significant then they can also buy much longer dated bonds that will rise more if interest rate expectations weaken. A staggered portfolio will provide the best risk/reward ratio. These bonds should remain fairly liquid and will also have defensive properties if stock markets fall further or if the geo-political situation in the Middle East worsens. If the price is right, bonds can be worth buying in an inflationary environment.
Thursday, June 12, 2008
The Domino Effect
If someone offered you the chance to have your future salaries right now, rather than having to wait until you had earned them, would you take them? If you were told that you could spend this money today and not have to wait for all the things you wanted to buy, would you leap at the chance? Even if you were told that you would be charged for this opportunity, would it still look like it was too good to miss?
This is effectively what happened to people everywhere who found that they could borrow large sums of money much more easily than they’d been able to in the past, and ordinary people in many countries around the world took up this offer and started spending their future earnings. It is this extra spending capacity that has largely powered the economies of the western world for the past decade. The average person has seen their spending power explode, and they have been shopping like a lucky lottery winner.
The BMW 3-series now outsells the Ford Mondeo in the UK, as buyers have traded up. It has become common place to spend over £1000 on a plasma screen, compared to a few hundred pounds that we used to pay for a television. Designer clothes are no longer the preserve of the wealthy and people have been able to copy the look of their favourite celebrities. Harvey Nichols, the ‘international luxury lifestyle store’, has found new custom in places outside of London, such as Leeds and Manchester. Shopping in the UK and the US has changed in less than a decade, all because of the instant boost to spending power that credit has provided.
This was always going to be a one-off hit, a step increase in spending rather than a gradual increase made possible due to rising productivity, innovation or plain old hard work, and therefore it was never going to be sustainable indefinitely. Eventually the money tap was shut off as confidence in the concept diminished and this left a stark contrast between the before and after situations. Since the dotcom bubble popped there has hardly been any let up in the increased spending of people in Europe, the UK and the US. Even in the mini recession that the US experienced after 2001 US retail sales kept growing. “Never under-estimate the resilience of the American consumer” is what they say.
For the last few years incomes have grown very gradually in the developed economies of the west, rising slightly faster than the official inflation figures. If you believe the official statistics of 2-3% inflation then real incomes have probably increased by 1-2% per year. If you don’t believe the official inflation figures (and many people don’t) then you would see that real incomes for many people, depending on their spending patterns, have probably decreased in recent years, meaning that people have actually become poorer in terms of their earning power. But not in terms of their spending power or their ability to raise money. Rising property prices have made people feel wealthier and have enabled them to borrow money more easily against their assets. They have ‘money’ but it is tied up in their homes so they have to borrow from banks etc to release it. Technically, even though they are deemed to have this money, they have to pay someone else (in the form of interest and other loan fees) in order to be able to spend it. Is this real wealth if you have to pay someone else to access it? Isn’t it still just borrowing someone else’s money?
In any event, borrowing has increased massively in all parts of our daily life. Loans are now used regularly to buy cars, televisions, stocks, holidays, even plastic surgery. Almost anything can be bought on a credit card and, whereas in France you have to buy a credit card from your bank, in the UK they are positively throwing them at customers. Or at least they were until the credit crunch arrived. Lenders have started to realise that offering people such huge spending power with little regard for their ability to repay the debt could be bad business practise, and now new credit card approvals have diminished significantly and some card providers have cancelled the cards of their existing customers. Lending volumes for car finance, personal unsecured loans and mortgages has shrunk significantly.
The end of the credit boom has been accompanied by the rapidly rising cost of living for many people as food and energy costs have shot up at the same time as lending rates. People are finding their disposable incomes are shrinking rapidly and are struggling to maintain their former lifestyles. In the US credit cards are increasingly being used to pay for bare necessities such as food because more people are finding it difficult to make their salary last the entire month, and this has recently started happening in the UK. Traditionally supermarkets are usually busiest at the start of the month, shortly after people have been paid, but Walmart has said that they are finding their stores are less and less busy towards the end of the month and this monthly decline in spending is starting earlier and earlier. Consumers are also making a conscious effort to use their cars less because the cost of a tank of petrol is starting to look a bit scary. Everyone is cutting back.
This leads me on to the domino effect that we are seeing around the world, and that we will continue to see for some time. The credit crunch was triggered by defaults on sub-prime mortgages but this is only the tip of the iceberg, the iceberg being the huge amount of debt that has been taken on by consumers. Defaults on US sub-prime debt caused panic in credit markets and pushed up interest rates or caused financial institutions to reign in their lending practices. Higher interest rates are bad for new homeowners and existing homeowners trying to refinance, something that has become commonplace. Some homeowners don’t immediately want to refinance but they are on short-term fixed rates that are coming off very low teaser rates and they are being reset at much higher rates, forcing the borrower to take some form of action as their repayments start to balloon. It isn’t just sub-prime borrowers that are finding higher lending rates a problem.
Higher rates and a lack of available borrowing have hit many areas of the real economy. People are handing the keys of their house to the lenders and walking away if they can’t make the payments on the mortgage and they have gone into negative equity. Defaults on car loans, credit cards, home equity withdrawal loans and personal loans are all rising and could be a new wave of problems for the financial markets to rival sub-prime mortgages. Borrowing against certain smaller cap stocks has been withdrawn or loan-to-value ratios have been decreased for those trading on margin.
The commercial property market in the UK has experienced a large drop in valuations as consumers slow their spending and job losses start to look more likely, reducing the demand for shopping centres and office blocks. The speculative element of this market has almost been wiped out as investors find it difficult to raise finance. The same thing is happening across much of the globe.
The dearth of mortgage products, coupled with reduced ability to afford monthly payments for luxuries, has seen a big drop in demand for overseas property. An area such as the South of France where more than half of property purchases have been made by foreigners is hit particularly hard as supply suddenly begins to outstrip demand. It almost becomes a downward spiral because the lack of demand from new buyers starts to hit valuations of existing properties and once prices are falling, as they are in Spain, France, Ireland and the US, people realise that property prices don’t only go up. Falling property prices and rising interest rates are a killer combination for a society raised on property ownership, such as the UK, and owning a second home starts to look like an expensive millstone around the neck.
Risk aversion in financial markets has also caused big swings in exchange rates and has seen safe haven currencies appreciate against less fundamentally sound currencies. One place this has important ramifications is Eastern Europe where many home buyers have taken mortgages in low-yielding Swiss Francs, to reduce their interest payments compared to borrowing in the local currency. 85% of household and corporate borrowing in Latvia, for example, is in foreign currencies. 80% of mortgages taken out in Hungary in 2007 were in Swiss Francs. The problem comes when the exchange rate moves and the Swiss Franc appreciates. This effectively increases the size of the loan when converted back into the home currency and at some point the banks start to worry when the size of the loan moves closer to the value of the property against which it is backed. I wouldn’t be surprised if some lenders are attempting to postpone having to value their loan-to-value ratios on mortgages they have given because they could be forced to call in those loans where the equity in the property has been wiped out. Foreign currency mortgages were always considered high risk but they appear to have proliferated in some Eastern Europe countries as immature financial service industries expanded at breakneck speeds and we could still see a serious issue emerge for those lenders who are the big players in these markets.
The domino effect has seen sub-primes losses spill over into prime mortgages, credit cards, car finance and personal loan losses. It has hit residential property, commercial property, holiday homes, private equity borrowing and corporate lending. The impact in the property and financial markets has also had a knock-on effect on spending on the high street and is affecting every sector where people spend money. After years of very low consumer price inflation alongside high asset price inflation, we are now seeing the opposite: high consumer price inflation and asset price deflation. This is not good news for countries such as the UK and US where domestic consumer spending makes up the bulk of economic activity.
The domino effect is also evident across borders because problems in the US have had huge impacts in other countries. Swiss banks have written off billions from their investments, the Spanish property market has been left with a massive oversupply of stock it can’t shift, the Irish stock market has lost one third of its value since last summer because of its focus on financial and construction stocks and the UK is facing a crisis of confidence in the economy because the mortgage market has dried up.
According to some economists, Asian and Middle Eastern countries appear to have decoupled from the problems elsewhere but many of these countries have currencies that are pegged to the US Dollar. Prices are rising at above 10% per year in Saudi Arabi, Qatar and the UAE. Even with inflation raging at danger levels, these countries have been forced to lower interest rates as the US has done, even though their economies have been overheating. One wonders how long this anomaly can last before something snaps.
The financial world today is an incredibly complex array of different flows of money, it is all far more connected than people realise. Pensioners in Norway were shocked to find their retirement funds had been invested in US sub-prime mortgages. The residents of Vallejo, California, were definitely surprised when their town filed for bankruptcy in May this year, blaming a big decline in housing-related tax revenues. Confidence in property markets has taken a knock all over the world as investors have been painfully reminded that property prices are not a one-way bet. A common phrase in the financial world is “when the US sneezes, the rest of the world catches a cold.” This is still true today and the only cure for a world hooked on credit is for it to go ‘cold turkey’. Painful, but almost certainly necessary.
This is effectively what happened to people everywhere who found that they could borrow large sums of money much more easily than they’d been able to in the past, and ordinary people in many countries around the world took up this offer and started spending their future earnings. It is this extra spending capacity that has largely powered the economies of the western world for the past decade. The average person has seen their spending power explode, and they have been shopping like a lucky lottery winner.
The BMW 3-series now outsells the Ford Mondeo in the UK, as buyers have traded up. It has become common place to spend over £1000 on a plasma screen, compared to a few hundred pounds that we used to pay for a television. Designer clothes are no longer the preserve of the wealthy and people have been able to copy the look of their favourite celebrities. Harvey Nichols, the ‘international luxury lifestyle store’, has found new custom in places outside of London, such as Leeds and Manchester. Shopping in the UK and the US has changed in less than a decade, all because of the instant boost to spending power that credit has provided.
This was always going to be a one-off hit, a step increase in spending rather than a gradual increase made possible due to rising productivity, innovation or plain old hard work, and therefore it was never going to be sustainable indefinitely. Eventually the money tap was shut off as confidence in the concept diminished and this left a stark contrast between the before and after situations. Since the dotcom bubble popped there has hardly been any let up in the increased spending of people in Europe, the UK and the US. Even in the mini recession that the US experienced after 2001 US retail sales kept growing. “Never under-estimate the resilience of the American consumer” is what they say.
For the last few years incomes have grown very gradually in the developed economies of the west, rising slightly faster than the official inflation figures. If you believe the official statistics of 2-3% inflation then real incomes have probably increased by 1-2% per year. If you don’t believe the official inflation figures (and many people don’t) then you would see that real incomes for many people, depending on their spending patterns, have probably decreased in recent years, meaning that people have actually become poorer in terms of their earning power. But not in terms of their spending power or their ability to raise money. Rising property prices have made people feel wealthier and have enabled them to borrow money more easily against their assets. They have ‘money’ but it is tied up in their homes so they have to borrow from banks etc to release it. Technically, even though they are deemed to have this money, they have to pay someone else (in the form of interest and other loan fees) in order to be able to spend it. Is this real wealth if you have to pay someone else to access it? Isn’t it still just borrowing someone else’s money?
In any event, borrowing has increased massively in all parts of our daily life. Loans are now used regularly to buy cars, televisions, stocks, holidays, even plastic surgery. Almost anything can be bought on a credit card and, whereas in France you have to buy a credit card from your bank, in the UK they are positively throwing them at customers. Or at least they were until the credit crunch arrived. Lenders have started to realise that offering people such huge spending power with little regard for their ability to repay the debt could be bad business practise, and now new credit card approvals have diminished significantly and some card providers have cancelled the cards of their existing customers. Lending volumes for car finance, personal unsecured loans and mortgages has shrunk significantly.
The end of the credit boom has been accompanied by the rapidly rising cost of living for many people as food and energy costs have shot up at the same time as lending rates. People are finding their disposable incomes are shrinking rapidly and are struggling to maintain their former lifestyles. In the US credit cards are increasingly being used to pay for bare necessities such as food because more people are finding it difficult to make their salary last the entire month, and this has recently started happening in the UK. Traditionally supermarkets are usually busiest at the start of the month, shortly after people have been paid, but Walmart has said that they are finding their stores are less and less busy towards the end of the month and this monthly decline in spending is starting earlier and earlier. Consumers are also making a conscious effort to use their cars less because the cost of a tank of petrol is starting to look a bit scary. Everyone is cutting back.
This leads me on to the domino effect that we are seeing around the world, and that we will continue to see for some time. The credit crunch was triggered by defaults on sub-prime mortgages but this is only the tip of the iceberg, the iceberg being the huge amount of debt that has been taken on by consumers. Defaults on US sub-prime debt caused panic in credit markets and pushed up interest rates or caused financial institutions to reign in their lending practices. Higher interest rates are bad for new homeowners and existing homeowners trying to refinance, something that has become commonplace. Some homeowners don’t immediately want to refinance but they are on short-term fixed rates that are coming off very low teaser rates and they are being reset at much higher rates, forcing the borrower to take some form of action as their repayments start to balloon. It isn’t just sub-prime borrowers that are finding higher lending rates a problem.
Higher rates and a lack of available borrowing have hit many areas of the real economy. People are handing the keys of their house to the lenders and walking away if they can’t make the payments on the mortgage and they have gone into negative equity. Defaults on car loans, credit cards, home equity withdrawal loans and personal loans are all rising and could be a new wave of problems for the financial markets to rival sub-prime mortgages. Borrowing against certain smaller cap stocks has been withdrawn or loan-to-value ratios have been decreased for those trading on margin.
The commercial property market in the UK has experienced a large drop in valuations as consumers slow their spending and job losses start to look more likely, reducing the demand for shopping centres and office blocks. The speculative element of this market has almost been wiped out as investors find it difficult to raise finance. The same thing is happening across much of the globe.
The dearth of mortgage products, coupled with reduced ability to afford monthly payments for luxuries, has seen a big drop in demand for overseas property. An area such as the South of France where more than half of property purchases have been made by foreigners is hit particularly hard as supply suddenly begins to outstrip demand. It almost becomes a downward spiral because the lack of demand from new buyers starts to hit valuations of existing properties and once prices are falling, as they are in Spain, France, Ireland and the US, people realise that property prices don’t only go up. Falling property prices and rising interest rates are a killer combination for a society raised on property ownership, such as the UK, and owning a second home starts to look like an expensive millstone around the neck.
Risk aversion in financial markets has also caused big swings in exchange rates and has seen safe haven currencies appreciate against less fundamentally sound currencies. One place this has important ramifications is Eastern Europe where many home buyers have taken mortgages in low-yielding Swiss Francs, to reduce their interest payments compared to borrowing in the local currency. 85% of household and corporate borrowing in Latvia, for example, is in foreign currencies. 80% of mortgages taken out in Hungary in 2007 were in Swiss Francs. The problem comes when the exchange rate moves and the Swiss Franc appreciates. This effectively increases the size of the loan when converted back into the home currency and at some point the banks start to worry when the size of the loan moves closer to the value of the property against which it is backed. I wouldn’t be surprised if some lenders are attempting to postpone having to value their loan-to-value ratios on mortgages they have given because they could be forced to call in those loans where the equity in the property has been wiped out. Foreign currency mortgages were always considered high risk but they appear to have proliferated in some Eastern Europe countries as immature financial service industries expanded at breakneck speeds and we could still see a serious issue emerge for those lenders who are the big players in these markets.
The domino effect has seen sub-primes losses spill over into prime mortgages, credit cards, car finance and personal loan losses. It has hit residential property, commercial property, holiday homes, private equity borrowing and corporate lending. The impact in the property and financial markets has also had a knock-on effect on spending on the high street and is affecting every sector where people spend money. After years of very low consumer price inflation alongside high asset price inflation, we are now seeing the opposite: high consumer price inflation and asset price deflation. This is not good news for countries such as the UK and US where domestic consumer spending makes up the bulk of economic activity.
The domino effect is also evident across borders because problems in the US have had huge impacts in other countries. Swiss banks have written off billions from their investments, the Spanish property market has been left with a massive oversupply of stock it can’t shift, the Irish stock market has lost one third of its value since last summer because of its focus on financial and construction stocks and the UK is facing a crisis of confidence in the economy because the mortgage market has dried up.
According to some economists, Asian and Middle Eastern countries appear to have decoupled from the problems elsewhere but many of these countries have currencies that are pegged to the US Dollar. Prices are rising at above 10% per year in Saudi Arabi, Qatar and the UAE. Even with inflation raging at danger levels, these countries have been forced to lower interest rates as the US has done, even though their economies have been overheating. One wonders how long this anomaly can last before something snaps.
The financial world today is an incredibly complex array of different flows of money, it is all far more connected than people realise. Pensioners in Norway were shocked to find their retirement funds had been invested in US sub-prime mortgages. The residents of Vallejo, California, were definitely surprised when their town filed for bankruptcy in May this year, blaming a big decline in housing-related tax revenues. Confidence in property markets has taken a knock all over the world as investors have been painfully reminded that property prices are not a one-way bet. A common phrase in the financial world is “when the US sneezes, the rest of the world catches a cold.” This is still true today and the only cure for a world hooked on credit is for it to go ‘cold turkey’. Painful, but almost certainly necessary.
Wednesday, May 14, 2008
Inflation, deflation, stagflation.
Food prices are rising, property prices are falling and economic growth is stalling. The ultimate balance of these factors will determine whether the global economy will be ravaged by surging prices or whether the economy will slow sufficiently to depress asset prices for years to come. Currently we appear to be in that state of limbo known as ‘stagflation’, an extremely devastating condition that is bad for everything and everyone.
Prices are rising for many agricultural products as demand increases from the rapidly growing economies of India, China and other developing countries such as Brazil and those in Eastern Europe. As people in these countries become wealthier they tend to progress from a subsistence diet (rice, potatoes etc) to a more protein based diet (meat, fish etc) and that requires more food for animal feed. The overall demand for agricultural products increases and that pushes up prices. Whereas this is inconvenient for us in the West it is positively disastrous for those living in poverty who can’t afford the higher prices. Some countries have seen food riots and have started hoarding their own agricultural stocks rather than trading it. India has banned futures trading in several food commodities to reduce speculation.
The oil price has hit a new high and has risen over 900% in the last 10 years (from $12 in 1998 to $125 today), again partly driven by demand from developing countries but also helped along the way by speculators around the world who can now easily buy derivatives based on the oil price. Gas and electricity prices have also increased, uranium for nuclear power has shot up, even the price of coal has made a comeback. Prices of metals have been rising sharply for several years now because the supply/demand balance has remained tight, pushing up the price of everything they feed into.
In spite of rising prices in these raw materials, inflation for many people in the West has been low for years, often around 2-3% according to official government figures. However, most economists take those figures with a pinch of salt because they tend to exclude certain volatile items, depending on which country’s figures you are looking at, such as food, oil and even ignoring mortgage payments. The official (core) figures have tended to give prominence to goods that have seen falling prices such as clothing, electronics and airfares. The difference between these goods and those that are seeing rising prices is that they are usually non-essentials and they have been one of the main beneficiaries of the extra money that the financial system has created in recent years. As people have gone out to ‘shop til they drop’ they have been buying these goods and haven’t had to worry very much about the rising prices of essentials such as food and warmth. It is families and pensioners, the people who spend a greater proportion of their income on these essentials, that have experienced much higher rates of rising prices than someone who shops regularly for leisure items.
Inflation takes time to feed through and now it is starting to register for a greater number of people in the West. This pushes up demands for higher wages which in turn fuels higher inflation expectations. Rising credit costs, coming after a decade of splurging on debt, is starting to get worrying and people are feeling their finances being pinched. They can cut back on shopping for non-essentials but they struggle to cut down on electricity, petrol and food. If prices of basic goods and services keep rising then they find that their ability to control their spending is diminished, it is taken out of their hands.
Rapidly rising inflation is a tangible and noticeable problem and as people cut back on their spending of non-essential or luxury goods this tends to have a negative effect on the wider economy. Economic growth is slowing or becoming negative whilst prices of many things are still rising. This is stagflation and is difficult for central banks to deal with effectively. They can’t easily cut rates to stimulate growth because this then exacerbates inflation. If they raise rates to cool inflation then they risk choking off any remaining consumer confidence. In reality most governments will make a decision to prioritise the fight against inflation or stopping economic decline and they will either lower interest rates (as in the US) or raise rates (as in Australia) accordingly.
Having experienced inflation and stagflation, the next big worry is deflation. There are some who believe that lowering interest rates to stimulate economic growth could be ineffective at this stage in the economic cycle. Most people would agree that it was low interest rates that created a credit bubble in the first place, making credit cheap and easy to obtain, leading to an unsustainable situation and too much leverage in the financial system. Whilst it could be regarded as reckless to lower rates again, it is quite likely that lower rates will no longer provide the incentive to borrow and invest once more as many people and countries are still heavily indebted, and there has also been a huge shift in emphasis on credit quality by lenders regardless of the cost of money (as illustrated by the credit crunch).
On the way up through the cycle extra financing provided greater purchasing power which in turn pushed up prices, as witnessed in the markets for commodities, property, art and luxury goods. An attempt to sell a diamond-encrusted skull for $50m could only happen at the top of an economic boom. Conversely, a retraction of spending power (due to less credit) coupled with a greater focus by lenders on securing their borrowing is likely to see prices pushed lower. We are already seeing this most prominently in the property markets of Spain, Ireland, the UK and the US where prices are coming down. In simple terms, prices are falling and people expect them to be lower in the foreseeable future, a view that is likely to be applied to a growing number of sectors such as consumer electronics, cars and furniture. Anything that is related to real estate or anything that is considered discretionary is going to come under severe price pressure as more people find they have less disposable income. And as consumers find themselves under more financial pressure they are going to start saving money again and paying down debt, not spending it.
This is where Japanese history becomes interesting and it won’t just be Ben Bernanke who will be looking closely at the Japanese experience of the 1990s. This is often known as the Lost Decade because Japan experienced damaging deflation from the beginning of the 90s after the twin bubbles in the stock market and real estate market burst, causing a downward spiral in asset prices. Japanese people stopped spending money, afraid of the consequences of doing so and conscious that if they postponed their spending decisions they would probably find prices lower in the future anyway. This attitude is very bad for the domestic economy and Japan proved that interest rates as low as zero are not necessarily going to encourage people to borrow and spend again, not once they have already had their fingers burnt. Economists usually say that the problems in Japan were different from today’s problems but years of working in the financial industry teaches you that the financial whiz kids can always come up with new ways to lose money and no two financial disasters are exactly the same.
The world has just been through a massive expansionary phase in money creation within the financial system and this has fed through into the prices of stocks, commodities and real estate. The long-term global bull market in equities probably ended in 2000, the bull market in real estate probably ended in 2007 and we have yet to see what happens to the bull market in commodities. Whilst these market peaks have not occurred simultaneously they can’t be dismissed and the similarities with the Japanese problem certainly deserve some respect from investors and central bank governors. We might be experiencing inflation, we might be facing the prospect of deflation but what we know for sure is that we are currently in the grip of stagflation and it is this which is possibly the scariest because it takes control away from the policymakers and reduces their ability to act. If we are on the brink of a major step change in the pace of the global economy then it is likely that one of these forces will assert itself and if it is deflation then we should be worried, we have already seen what that did to Japan.
Prices are rising for many agricultural products as demand increases from the rapidly growing economies of India, China and other developing countries such as Brazil and those in Eastern Europe. As people in these countries become wealthier they tend to progress from a subsistence diet (rice, potatoes etc) to a more protein based diet (meat, fish etc) and that requires more food for animal feed. The overall demand for agricultural products increases and that pushes up prices. Whereas this is inconvenient for us in the West it is positively disastrous for those living in poverty who can’t afford the higher prices. Some countries have seen food riots and have started hoarding their own agricultural stocks rather than trading it. India has banned futures trading in several food commodities to reduce speculation.
The oil price has hit a new high and has risen over 900% in the last 10 years (from $12 in 1998 to $125 today), again partly driven by demand from developing countries but also helped along the way by speculators around the world who can now easily buy derivatives based on the oil price. Gas and electricity prices have also increased, uranium for nuclear power has shot up, even the price of coal has made a comeback. Prices of metals have been rising sharply for several years now because the supply/demand balance has remained tight, pushing up the price of everything they feed into.
In spite of rising prices in these raw materials, inflation for many people in the West has been low for years, often around 2-3% according to official government figures. However, most economists take those figures with a pinch of salt because they tend to exclude certain volatile items, depending on which country’s figures you are looking at, such as food, oil and even ignoring mortgage payments. The official (core) figures have tended to give prominence to goods that have seen falling prices such as clothing, electronics and airfares. The difference between these goods and those that are seeing rising prices is that they are usually non-essentials and they have been one of the main beneficiaries of the extra money that the financial system has created in recent years. As people have gone out to ‘shop til they drop’ they have been buying these goods and haven’t had to worry very much about the rising prices of essentials such as food and warmth. It is families and pensioners, the people who spend a greater proportion of their income on these essentials, that have experienced much higher rates of rising prices than someone who shops regularly for leisure items.
Inflation takes time to feed through and now it is starting to register for a greater number of people in the West. This pushes up demands for higher wages which in turn fuels higher inflation expectations. Rising credit costs, coming after a decade of splurging on debt, is starting to get worrying and people are feeling their finances being pinched. They can cut back on shopping for non-essentials but they struggle to cut down on electricity, petrol and food. If prices of basic goods and services keep rising then they find that their ability to control their spending is diminished, it is taken out of their hands.
Rapidly rising inflation is a tangible and noticeable problem and as people cut back on their spending of non-essential or luxury goods this tends to have a negative effect on the wider economy. Economic growth is slowing or becoming negative whilst prices of many things are still rising. This is stagflation and is difficult for central banks to deal with effectively. They can’t easily cut rates to stimulate growth because this then exacerbates inflation. If they raise rates to cool inflation then they risk choking off any remaining consumer confidence. In reality most governments will make a decision to prioritise the fight against inflation or stopping economic decline and they will either lower interest rates (as in the US) or raise rates (as in Australia) accordingly.
Having experienced inflation and stagflation, the next big worry is deflation. There are some who believe that lowering interest rates to stimulate economic growth could be ineffective at this stage in the economic cycle. Most people would agree that it was low interest rates that created a credit bubble in the first place, making credit cheap and easy to obtain, leading to an unsustainable situation and too much leverage in the financial system. Whilst it could be regarded as reckless to lower rates again, it is quite likely that lower rates will no longer provide the incentive to borrow and invest once more as many people and countries are still heavily indebted, and there has also been a huge shift in emphasis on credit quality by lenders regardless of the cost of money (as illustrated by the credit crunch).
On the way up through the cycle extra financing provided greater purchasing power which in turn pushed up prices, as witnessed in the markets for commodities, property, art and luxury goods. An attempt to sell a diamond-encrusted skull for $50m could only happen at the top of an economic boom. Conversely, a retraction of spending power (due to less credit) coupled with a greater focus by lenders on securing their borrowing is likely to see prices pushed lower. We are already seeing this most prominently in the property markets of Spain, Ireland, the UK and the US where prices are coming down. In simple terms, prices are falling and people expect them to be lower in the foreseeable future, a view that is likely to be applied to a growing number of sectors such as consumer electronics, cars and furniture. Anything that is related to real estate or anything that is considered discretionary is going to come under severe price pressure as more people find they have less disposable income. And as consumers find themselves under more financial pressure they are going to start saving money again and paying down debt, not spending it.
This is where Japanese history becomes interesting and it won’t just be Ben Bernanke who will be looking closely at the Japanese experience of the 1990s. This is often known as the Lost Decade because Japan experienced damaging deflation from the beginning of the 90s after the twin bubbles in the stock market and real estate market burst, causing a downward spiral in asset prices. Japanese people stopped spending money, afraid of the consequences of doing so and conscious that if they postponed their spending decisions they would probably find prices lower in the future anyway. This attitude is very bad for the domestic economy and Japan proved that interest rates as low as zero are not necessarily going to encourage people to borrow and spend again, not once they have already had their fingers burnt. Economists usually say that the problems in Japan were different from today’s problems but years of working in the financial industry teaches you that the financial whiz kids can always come up with new ways to lose money and no two financial disasters are exactly the same.
The world has just been through a massive expansionary phase in money creation within the financial system and this has fed through into the prices of stocks, commodities and real estate. The long-term global bull market in equities probably ended in 2000, the bull market in real estate probably ended in 2007 and we have yet to see what happens to the bull market in commodities. Whilst these market peaks have not occurred simultaneously they can’t be dismissed and the similarities with the Japanese problem certainly deserve some respect from investors and central bank governors. We might be experiencing inflation, we might be facing the prospect of deflation but what we know for sure is that we are currently in the grip of stagflation and it is this which is possibly the scariest because it takes control away from the policymakers and reduces their ability to act. If we are on the brink of a major step change in the pace of the global economy then it is likely that one of these forces will assert itself and if it is deflation then we should be worried, we have already seen what that did to Japan.
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