Friday, November 30, 2012

Low systemic risks & low nominal growth

I have published a short presentation "Low systemic risks & low nominal growth". This is a brief update to my strategy presentation from August "Life in a negative real yield environment".
There are three key points I want to make which I think so far have gone underrepresented:
1. Inflation pressures in the Eurozone are highly overstated. I adjust the Eurozone inflation figures for the effects of restrictive fiscal policy (via higher prices for administered goods and higher taxes on consumer goods). This adjusted core measure runs only at around 0.5% yoy! Hence inflation for the private domestic economy is almost non-existing. I think this is so far not really recognized but should come as no surprise given the high level of unused capacity/record high unemployment and the subdued development of monetary aggregates and loan growth (loans to non-financial corporates have been falling by 1.8% in October yoy). As "true" inflation is lower, "true" real yields are somewhat higher than those traded in the market (which also focus on HICP) and hence the safety premia inherent in Bunds is lower. I do expect Bund yields to rise over the medium term as real growth improves and the stress in peripheral bond markets eases, however, nominal growth will remain subdued and hence upward potential for 10y Bunds is limited (I expect 1.75% 6m).
2. Markets have shifted their trading behaviour. Ever since the financial crisis broke out, RORO (risk-on, risk-off) dominated market developments. Equities, credit spreads, volatility, commodities, growth currencies have all moved in sync and opposite to safe-haven assets (Bunds, UST, JPY, USD). RORO was dominated by changing perceptions of systemic risks (which then drove also the expectations for growth and inflation). Now, however, systemic risks have been dropping significantly (as the ECB has turned itself into the lender-of-last resort for sovereigns) and RORO has given way to GOGO (growth-on vs. growth-off). In this environment it is changes for nominal growth which drives market performance while systemic risks remain low. In turn, equities, commodities and growth currencies move in sync while credit spreads and volatility remain low even during periods where the other markets correct.
3. In an environment of limited volatility and anchored short end rates (as central bank target rates remain unchanged), so-called Horizon Returns gain in importance as a tool to direct investment/as a relative value tool. It is not only carry that is important but also roll-down on the yield curves. Horizon Returns measure both.
My investment views remain unchanged: Systemic risks remain low favouring carry products. The long-term trend towards lower nominal yields on safe products is over (i.e. Bund yields most likely have hit bottom) but upside potential on safe yields is moderate in the short term. The long-term trend towards lower nominal yields on carry products is not over (and hence semi-core/peripheral bonds have more potential). The global growth cycle should have bottomed with Asia ex Japan improving and the slow improvement of the US economy only being temporarily interrupted by the fiscal cliff. Growth currencies should be bought and safe-haven currencies should be sold on uptics (with the Euro being between these two groups).

Wednesday, November 7, 2012

No inflation pressures in the Eurozone

Amid the zero rate policy of the ECB, its significant balance sheet lengthening with the help of the 3y LTROs as well as the introduction of Outright Monetary Transactions (should a country apply for help of the ESM) some commentators (especially in Germany) fear that the ECB has become too tolerant of higher inflation and see inflation pressures as being just around the corner. Currently, Eurozone headline HICP stands at 2.6% yoy and core inflation at 1.5%. Amid the weak state of the economy this would at first sight confirm that inflation might become a serious issue once growth starts to recover. However, this is largely due to tighter fiscal policy and as I will show below domestic inflation pressures in the core countries are limited and the periphery is even flirting with deflation. Given that at present private sector loans in the Eurozone are collapsing (the annual growth rate of loans to non-financial corporations stood at -1.4% in September, down from -0,7% in August) and unused capacity is substantial, domestically generated inflation does not promise to become too high within the next few years even with a zero rate policy by the ECB for much longer.

The chart below shows the development of various Eurozone HICP inflation measures. Headline HICP is currently running above target (blue) while core HICP (black) of 1.5% is close to the ECB's target of "close to but below 2%". However, amid the widespread fiscal tightening - especially in the periphery - prices for administered goods and services as well as taxes such as VAT have gone up and hence have a strong impact on current inflation rates. I calculate a core HICP measure excluding administered prices (red) which is currently running at only 1.0% (just one caveat: the basket of administered goods and services as well as the basket of energy and food might partially overlap and hence it is not a perfect measure but just an estimate). Hence, 0.5% of current inflation is due to changes in prices of administered goods and services. Furthermore, I used Eurostats constant taxes inflation measures to also deduct tax changes from the inflation rates. This core HICP CT ex admin prices inflation rate currently stands at only 0.7% (green, this series is only available with a one-month delay). Hence, another 0.3% of current inflation are due to tax changes.
As a result, at present approx. 0.8% out of the 1.5% core inflation rate are due to fiscal tightening! The real domestic inflation rate currently stands at a much lower 0.7% and does not show any meaningful risk of rising inflation pressures. Clearly, the ECB should c.p. rather ease monetary policy in an environment of tighter fiscal policy even if the tighter fiscal policy temporarily leads to a higher measured HICP.

Eurozone inflation rates

Source: Eurostat, ResearchAhead

In the chart below I show the core HICP measures for the four largest Eurozone countries (Germany, France, Italy and Spain). Looking at this measure one would conclude that inflation rates are close to each other and close to target. Furthermore, Spanish inflation has risen significantly over the past months.

Country core HICP

Source: Eurostat

However, looking at the core HICP CT ex admin prices for these countries leads to very different conclusions: A) inflation rates between the core and the periphery have started to diverge significantly (this should be seen as a positive factor as it helps the Eurozone to rebalance). B) Spain and to a lesser extent Italy are flirting with deflation.

Country core HICP CT ex admin prices

Source: Eurostat, ResearchAhead

Overall, inflation pressures in the Eurozone are low. However, the risks of deflation in the periphery are significant. In this environment, the ECB can conduct more monetary easing without threatening price stability. Amid the high level of unused capacity, significant fiscal tightening and very restrictive monetary environment in the periphery (high level of real yields, low credit availability) a renationalisation of monetary policy seems very sensible. The sooner the ECB eases the monetary environment in the peripheral countries (for example via buying peripheral debt), the better.