Cut Italy some slack

In the last few days the market has been getting worked up about the new Italian government and its deficit plans. Italy is well known to have the largest debt burden in the EU, and the largest as a % of GDP after Greece, and after all the problems Greece caused it is not surprising that expansion of Italy’s budget deficit is view with concern. But a bit of perspective is necessary. First of all, the proposed rise in the deficit is only to 2.4% of GDP – below the EU guideline limit of 3%. The Italian deficit has only been lower than this in three years since 2000, so this is hardly an unprecedented blowout. But the EU will not be criticising Italy for exceeding deficit guidelines, but for failing to do enough reduce their debt – which is currently at 130% of GDP, well above the EU guideline of 60%. To that extent, EU concern is understandable, but looking a little more closely it is hard to argue that this debt should be a major concern.

The debt level is a concern if it is rising year on year and starts to spiral out of control. But this is currently not the case in Italy, where the debt level has been stable since 2014, partly because Italy is running a primary budget surplus, as it has for many years, partly because the yield on Italy’s debt, and consequently Italian debt interest payments, have been falling steadily. So much so, that even though the debt level is close to its highs at 130% of GDP, net debt interest payments are at the lowest level since 2000 (and long before that) at 3.5% of GDP.

To determine the level of the deficit that is needed to reduce the debt level we need to do a little maths. Leaving aside some technicalities, the primary surplus needs to be greater than the debt level multiplied by the difference between the nominal growth rate and the nominal interest rate. Or:-

p > D(g-i) where p is the primary surplus, D is the debt level, g is the growth rate and i is the average debt yield.

In Italy’s case, D=130, and i=2.7%. g is the biggest problem, as this is averaging only around 2% in the last few years. Still, on that basis we need p> 130(0.02-0.027) = 0.91.

If Italy runs a deficit of 2.4% of GDP, with debt interest payments of 3.5% of GDP, it is running a primary surplus of 1.1% of GDP. This is lower than we have seen in recent years, but still greater than 0.91% and enough to keep the debt level stable, albeit barely reduce it.

Now, this is all very well for now while yields are low, but, you may ask, what happens if yields go up in the coming years as they seem likely to do when the ECB stops its QE and starts raising rates? This is a fair question, but Italy has protected itself to some extent by extending the average maturity of its debt to 7 years, so that any rise in yields will take some time to have a major effect.

But the bigger picture is this. The best way for Italy to exit the debt trap is to boost its (nominal) growth rate. While we can argue about the best way to do that, a modest fiscal boost won’t do any harm, while the impression that they are subject to an EU strait-jacket will not help. There are some minor signs of improvement in the Italian economy. The long term unemployment rate has started to fall, the growth rate has picked up modestly, and the current account is in increasing surplus. This, by the way, suggests that the Italian private sector is saving too much and holding back growth. A little more government spending and some boost to consumer confidence could be what is needed to keep growth accelerating.

While Italy’s debt does need to be dealt with in the longer run, the EU should see that attempting to impose austerity is not going to work either economically or politically. Trying to slap the new government into line will only foment more disaffection with the EU and likely create an even more anti-EU political movement. In any case, there isn’t much the EU can do to stop Italy’s government doing what it plans in the short-term. Things like the excessive deficit procedure take a long time to kick in and are pretty ineffective anyway. The biggest discipline on Italy will be the markets, and the best way for the EU to help Italy is to encourage the markets to cut Italy a little slack.

 

 

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GBPSEK selling opportunity

The Turkish crisis and Brexit muddle create an opportunity to sell GBP/SEK

 

Turkish crisis dominates the action

This month global markets are mostly concerned with Turkey, with the sharp fall in the currency the main driver of concerns about deteriorating credit quality due to large net external liabilities. The degree to which foreign currency debt of Turkish entities is currency hedged is unclear, but is key for determining their solvency. Other than the weakness of the currency, the economic situation is in any case vulnerable, but has been for some time. But from a baseline of vulnerable, conditions have deteriorated steadily in the last year or two, with inflation rising and the current account deficit widening, in part because the central bank has not been allowed to make the rate rises required to stem these trends. This political aspect of the problem makes it much more intractable, especially when you throw in the pastor and the aggressive tariff response from Trump.

It is hard to see the endgame at this stage. Funding the current account deficit will remain very difficult as long as there is no action. Even significant interest rate rises may not help much at this stage. Capital controls may come in, and there are risks of default on external debt. However, most of the risk is not government debt, as in previous crises, but corporate debt. This makes a bailout unlikely and difficult, but also probably reduces contagion risks. While there is significant exposure to Turkish debt among European banks, it is not game changing – even the most exposed banks would survive the worst case scenario as long as the problems remain isolated to Turkey.

Which leads to the main question, which is one of contagion. Most commentators argue that this is the primary risk, citing parallels with previous EM crises, notably Asia 97. And they are right, because markets are never entirely predictable, and if appetite for risk disappears what currently appears a perfectly solid investment can quickly become vulnerable. (Almost) everyone needs to raise money, and in such circumstances even perfectly solvent entities can struggle to refinance if markets suddenly become unprepared to fund. As Hamlet says “there is nothing good or bad but thinking makes it so”, and shocks like Turkey can lead to some pretty muddled thinking.

Nevertheless, we doubt that the Turkish situation will lead to a big global meltdown in EM, or a renewal of the Eurozone crisis. Even worst case scenarios should remain contained.  While we may have a period of pressure on some EM currencies and higher EM yields, in the end the global economy is starting from a position of reasonable health driven by good US growth and improving Eurozone growth, combined with a generally more solid global banking system. There are savings looking to be deployed towards higher yielding assets in a world of still very low yields. There are no certainties, but this episode looks likely to present an opportunity to buy risky assets. Of course, care is required, as especially in August things can go a lot further than we would expect before turning. Things that look cheap may yet get a lot cheaper, so technical signals that the market has completed its rout need to be awaited.

Opportunities created by Turkish crisis

The obvious opportunities are the emerging markets that have suffered in sympathy with the Turkish Lira. The ZAR, BRL, and even MXN have all weakened, and there may well be value there. But getting these right requires good timing and a clarity that the crisis is over. In these situations it is often better from a risk/reward standpoint to consider the less obvious collateral damage. In the G10 space the two currencies that have suffered the most since early August are the NZD and SEK. The NZD is understandable as it can be considered the closest thing to an emerging market in the G10 space. But the SEK? Sweden has a current account surplus, very low interest rates and inflation, the strongest growth in Europe and a very secure budget and banking system. It is no-one’s idea of an emerging market. Nevertheless, the SEK does tend to exhibit characteristics of a risk positive currency. This is in part a historic issue harking back to the days when Ericsson made up 30% of the value of the Swedish equity market and it was strongly identified with the tech boom and bubble. But nowadays, while still showing one of the strongest growth rates in the EU, there is no particular dependence on tech. Both EUR/SEK and USD/SEK have risen to levels that have to be considered excellent longer term value regardless of which way the Turkish crisis is resolved, but GBP/SEK may represent the best trade, given the risks involved in the run up to the Conservative Party conference and the October EU Summit.

With the UK parliament on holiday, there have been no significant developments in the last couple of weeks, but there has been more and more noise suggesting that the risk of a “no deal” Brexit is increasing. The main upcoming events are the UK Conservative Party conference from September 30 to October 3 and the EU Summit on October 18/19. Neither looks likely to provide any real progress on Brexit, and the prospect of “no deal” will consequently become even more probable, at least as far markets are concerned.

There are several reasons for the lack of progress, but the two main ones are the lack of any majority in the UK parliament for ANY Brexit plan, and the perception on both sides that the threat of “no deal” – and the brinkmanship involved in that – is necessary in order to get the “best” deal for their side. It may be that an apparent increase in the probability of “no deal” is actually a necessary condition for a deal to be done, but the process will nevertheless have continued market impact.

For what it’s worth, we believe that a free trade deal of some sort is the most likely eventual outcome in the Brexit process. Probably the best reason for this is Ireland. “No deal” would require a hard border, and that is anathema to both sides as well as effectively contravening the Good Friday agreement. But even though a free trade deal is likely eventually, that doesn’t matter right now because it isn’t the most likely next step. More stress is required to produce that outcome.

From a trading perspective, the battleground is GBP. We look to play this from the short side not only because the next events look likely to be GBP negative, but because GBP is starting from a position which we regard as barely below fair value. The current price does not adequately reflect the risks of Brexit.

GBP/SEK looks an attractive vehicle to express GBP weakness here.

Time to buy European equities

First, I admit to having been a bull on European equities for the last couple of years. This was right at the beginning of last year, but since then there has not been much progress, and lately we have seen a major slide back to the middle of the ranges seen in recent years.

Looked at in isolation, European equities are not hugely attractive by historic standards. The Eurostoxx 50 has a P/E close to long-term averages at 15 and a dividend yield that is only modestly attractive at 2.5%. Dividend growth has been conspicuous by its absence since the financial crisis. But you can’t look at these things in isolation. The attractiveness of European equities has to be compared to other assets, and in the context of the current condition of the European and global economy. The main reasons for optimism about European equities are their relatively attractive valuation compared to other major equity markets, the extremely low level of European bond yields, the comparative health of the European economy (and the prospect of decent co-ordinated global growth for the first time in a while), and the relative insulation of the Eurozone from any protectionist pressures from the US, both because they are not particularly directed at Europe and because the size of the Eurozone economy means it is less dependent on external trade than smaller countries.

While European bond yields have risen a little from the lows alongside US yields, they remain very, very low by historic standards. The chart of the French 10 year yield below illustrates this.

france 10 year

The French 10 year is a reasonable proxy for European yields as a whole. While we have probably seen the lows, as the economy is now growing reasonably robustly, inflation has probably bottomed and the ECB has stopped easing, the ECB are not about to raise rate any time soon. This makes European equities look particularly attractive, as they yield more than bonds but should also rise with any rise in nominal GDP. The combination of low European yields and a stagnant equity market suggests the equity risk premium in Europe is very, very high, and this is hard to justify given the improving fundamental economic conditions.

Europe is nothing like as expensive as the US, with European indices now only in the middle of the range seen in recent years, while the US has continued to make multi-year highs. The chart below shows the Eurostoxx 50 relative to the S&P 500 rebased to 2003 so that they are comparable.

Eurostoxx and S&P

On a P/E basis, the Eurostoxx 50 is trading around 15 compared to 22 for the S&P 500, and yielding 2.5%. The underperformance of Eurostoxx in recent years is in large part  due to the lack of dividend growth compared to the strength of dividend growth in other markets. However, European corporate profits are rising and are above where they were at the peak of the market in 2007, suggesting dividend growth will come, while exceptionally low yields mean the discount factor for future dividends makes them all the more attractive.

Currently, the market is concerned about trade wars and the prospect of tightening financial conditions , especially in the US, especially in the context of extended US valuations. European markets have also tended to suffer from EUR strength against the USD, though in reality there is not much evidence that this has a negative effect on European company profits. The impact on import prices and the global nature of many companies means exchange rate moves do not have clear implications.  In practice, it is hard to be too positive about the US market at these levels given rising US rates, so there is a case for partially hedging a long Eurostoxx position with an S&P short. But there should nevertheless be substantial upside for European equities from here.

 

GBPJPY hitting selling area

Forget about Brexit for the moment. We don’t know what it will look like, when it will happen or what the global story will be when it does happen. Let’s just look at where the currencies and economies are now, and ask if that position makes sense. In the case of GBPJPY, it doesn’t.

The market is being asked to finance an annual  relative current account position between the UK and Japan of more than $300bn in Japan’s favour, but is being offered no real yield advantage to do so, and GBP/JPY is already relatively expensive relative to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

GBPJPY is currently trading around 152. Is that high or low? Well, if you just look at a normal chart, you might think it’s low, because GBPJPY has been falling for the past – well – forever. Even in the past 20 years it has round about halved in value. Though it is around 30 figures above its all-time low (see chart below).

gbpjpy

But this is entirely a nominal picture that ignores inflation. Most of the reason for GBP/JPY’s decline in recent years has been the higher inflation in the UK relative to Japan. The easiest way to illustrate this is to look at GBP/JPY relative to GBP/JPY PPP, as shown in the chart below.

 

gbpjpy and ppp

Source: OECD, FX Economics

So although GBP/JPY has been falling steadily, it is now trading above PPP, and is further above PPP than its average over the last 20 years, as shown in the chart below.

gbpjpyppp

Source: OECD, FX Economics

So, in real terms GBPJPY actually looks quite high compared to history.

Is this justified? Looking at the data, the simple answer is no. UK real yields are not relatively attractive. At the 10 year tenor, the nominal spread is 1.2% in favour of the UK. But the inflation differential in 2017 was 2.6%. Even though this is expected to narrow in 2018, it is still expected to be 1.6% according to OECD forecasts. So real yields actually favour Japan and the JPY (even more so at the short end of the curve where nominal spreads are smaller).

What about other determinants of cross border flows? The current account position implies a need for a cross border flow, and the UK was in deficit in 2017 to the tune of about 4.7% of GDP, while Japan was in surplus by 3.9% of GDP. This difference is only expected to narrow very marginally in 2018.

So the market is being asked to finance a relative current account position of more than $300bn, but is being offered no real yield advantage to do so, and the currency is already relatively expensive to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

If we add Brexit into the mix, it’s worth noting that GBPJPY is now above the high it traded the week before the Brexit referendum. Whatever you think about Brexit, it is pretty hard to argue that it currently justifies a stronger currency.

So much for valuation. But a large part of this story is about the weakness of the yen rather than the strength of sterling, and the weakness of the yen has historically been well correlated with positive risk appetite, reflecting the historic tendency for the surplus country to be keener to place money abroad at times of positive risk sentiment. But this makes far less sense than it used to when the real yields available outside Japan are no greater than the yields available inside Japan.

So it seems to me that these represent excellent levels to sell GBPJPY for the medium to long term. For the technical minded. 153.80 represents the 76.4% retracement of the move from the 164 May 2016 high to the 123 October 16 low.

USDMXN way out of line with fundamentals

I am far from being an expert on Mexico, but I am aware of the basic story behind the weakness of the MXN in the last few years. General USD strength, concerns about protectionism under Trump and weakness in the oil price have all contributed, while related NAFTA negotiations and the election this year are helping to prevent a major recovery. But the extent of MXN weakness just looks way out of line with the available evidence. Of course, it is possible that trade arrangements with the US become more problematic, but the MXN is around 25% weaker than you would expect relative to “normal” valuation. That is, USD/MXN has typically traded around 70% above PPP in the last 20 years. With PPP currently around 8.90, this suggests the “normal” level would be around 15.15. The current price near 19 just seems to price in all but the very worst bad news, so that the risks from here lie overwhelmingly on the upside for the MXN.

The chart below illustrates just how far away from normal the MXN is. The only time in the last 30 years that we saw the MXN as weak as this was during the “Tequila crisis” of 1994/1995. This was a proper crisis. The current account started off with a deficit of nearly 6% of GDP and the liberalisation of markets led to a devaluation of the peso, a loss of confidence in the economy, a balance of payments crisis, a 6% decline in GDP in 1995 and ultimately a US led bailout. The current situation is comparatively benign. While the current account deficit has increased, it is not in worrying territory, and growth, though a little weaker than desirable, is reasonable. GDP per capita is around 30% higher relative to the US now than it was then. There are of course concerns surrounding the relationship with the US, but markets in general are no longer expecting Trump to carry through his more aggressive threats.

I’m not going to predict the outcomes of NAFTA negotiations, or the Mexican elections. As I say, I’m no expert on these issues. But valuations say that the MXN is substantially undervalued unless we get a replay of the Tequila Crisis, and even the pessimists aren’t forecasting that.

 

usdmxn

Source: OECD

Mexico current account

Source: World Bank, OECD

 

Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

Riksbank policy – dangerous, myopic and unsustainable.

I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.

Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-

” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”

In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.

Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.

This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.

But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.

sek

Source: Riksbank, BIS