WILLIAM DE VIJLDER Blog - in English

Are we facing a government bond bubble?

Earlier this week the Bloomberg website featured some interesting viewing: a video showing a US asset manager speaking about a bubble in government bonds, another video featuring a US investor telling us about “rationally fearful” investors, and finally an interview with commodities specialist Jim Rogers who argued that a new financial collapse could spark a commodities boom as the money tap is invariably turned wide open to fight such collapses. So you can take your pick. It makes you wonder: how disparate can opinions be?

 

The bit about “rational fear” is the least controversial: the US data have weakened considerably in the past weeks and, more generally, more and more figures are lagging behind economists’ expectations – even in the growth countries. Small wonder that investors are getting nervous.

 

The assertion that we are facing a government bond bubble is a little more contentious. A bubble entails that an asset (usually equities, property or gold, but in this case government bonds) is significantly more expensive than is justified by the “fundamentals”. Some currently contend that bond prices are too high, which would mean that long-term interest rates are far too low. With German ten-year interest rates close to 2.00% and the US equivalent now below 2.50%, it is tempting to agree that - given our historical knowledge of where long-term interest rates used to be -  “this is far too low, so a bubble is clearly in the making”.

 

Few would claim that current interest rates are at a normal level (‘normal’ being defined as the average over an economic cycle). The customary rule of thumb is that nominal long-term interest rates may not diverge too far from nominal GDP growth. Clearly, we are currently not living through an average period of the economic cycle: a lot of production capacity is lying idle, unemployment is high and substantial sums of money were spent on kick-starting the economic engine - which is already starting to splutter again, at least in the USA. I discussed this matter with my colleague Guy Williams, chief bond manager at FFTW, part of BNP Paribas Investment Partners, and he reckons that based on the fundamentals (macro-economic variables such as inflation, economic momentum and so on) the theoretical ten-year interest rate in the USA should be 3.3%. That is certainly higher than the current interest rate, but the difference is no way nearly enough to be termed a bubble. Assuming a further deceleration in inflation and economic activity (a realistic hypothesis), then the “fair value” will decrease. So we are not in bubble territory, because the economic environment is far from booming. Interest rates for Germany are even lower and the economic indicators are stronger, so you could argue that the market is more expensive there than in the USA. Expectations of slower growth due to headwind from the USA and the use of Bunds as a safe haven on account of the troubles in the eurozone several months ago are at the heart of these low interest rates.

 

The investor’s reaction to these conditions depends strongly on the individual’s horizon. An extremely active investor can respond to the likelihood of a further slowing of US growth which will push long-term interest rates even lower. A “buy and hold” investor who buys today with the intention to keep the bonds for the next ten years is implicitly assuming a “Japan scenario”: years of weak growth, a flattening yield curve and deflation, so that even a nominal interest rate of e.g. 2% with deflation of e.g. 1% would yield an attractive real return of 3%. I still struggle to accept such a scenario. What’s more, we shouldn’t forget that the fall in long-term interest rates has made bond prices more sensitive to interest rate movements (the “duration” has lengthened), so if the economic environment were to improve, then the negative impact on bond prices would be much greater. Another consideration is that lower long-term interest rates should eventually stimulate the economy (empirical evidence shows that spending is much more sensitive to movements in long-term interest rates than to changes in the central bank’s official rates). It is interesting to note, incidentally, that the futures market is pricing in an increase in long-term interest rates: the Euro ten-year swap rate within five years is quoted at 3.2% which is 85 basis points higher than the current ten-year swap rate. Don’t take that 3.2% as a forecast for interest rates in ten years’ time, but look at the direction: the market is still convinced that long-term interest rates will not remain at their current low levels forever. Conclusion: an investor who buys ten-year government paper today with the fixed intention to keep it until maturity is being extremely bearish about the economy’s progress, not only in 2011 but for many years thereafter. Just to make it absolutely clear: this is not our scenario. Certainly, long-term interest rates may fall further first, but they must then start to rise again.

 

I will return to Jim Rogers’ view that a new financial collapse may lead to a commodities boom in a later article.

 

William De Vijlder

27 August 2010

Is the USA heading for a “double dip”?

At the end of every recession, the same heated debate invariably flares up: what shape will the recovery take? Will it be a V shape, with a speedy climb out of the trough? Or a U shape, with a more prolonged bottoming-out process? Pessimists speak of an L shape, where there is no real recovery at all, as in the Japanese scenario. And just for good measure, there is also a W shape, where a short-lived recovery is followed by a fresh period of contraction. This scenario, which is also known as a “double dip”, has gained in popularity in recent weeks.

 

Let me start by saying that double dips are extremely rare. A recession is usually followed by mutually-reinforcing processes that lead to a sustainable recovery. Of all the recessions which according to the National Bureau of Economic Research – the official recession arbiter in the USA – have beset the USA since 1900, only two can be regarded as double dips. The recession in 1913-1914 occurred only twelve months after its precursor. The same applied to the recession of 1981-1982. Given that there have been a total of 23 recessions since 1900, two is not such a large number. What’s more, the double dip in the early 1980s was clearly man-made. The then chairman of the Federal Reserve hiked official interest rates to almost 20% in order to curb inflation which had soared above 10% - a far cry from the current interest rates of about 0% in the USA and 1% in the eurozone. Fiscal tightening can also trigger a new recession but, as I argued in an earlier column, the long-term consequences are uncertain and need not be negative. The USA has not yet resorted to fiscal tightening but after the congressional elections in November a decision will definitely need to be taken on the tax cuts that former president Bush introduced and are due to end on 1 January 2011. No decision, in this case, means a hefty tax rise.

 

However, many economic data coming out of the USA in the past weeks have been a lot worse than expected. The housing market has slumped again after a temporary fiscal injection. Consumer spending surged early this year but has meanwhile significantly decelerated due to high unemployment and moderate income growth. The labour market shows the same picture: strong jobs growth earlier this year followed by disappointing figures in the past three months. Companies are reporting splendid profit figures and are investing too, but they are also holding on to enormous amounts of cash and are very reluctant to engage staff. Confidence among consumers, house builders and other SME businesses is still rock bottom. And optimism among large companies, who gained the most from the revival of industry and world trade, is also on the wane. Ominously, applications for new unemployment benefits also rose in the past weeks.

 

So is the USA heading for a double dip after all? I think not. As I said, double dips are rare and usually result from policy errors. To make a new recession really likely, the leading indicators also need to fall a lot further from their current levels. Companies  already reduced their staff and investments so sharply during the recession that further cuts seem unlikely. New home construction can hardly fall much lower than its current level. I do think we are at the start of a period with low growth figures. The credit crisis has left its mark on the economy. In terms of investment policy, this means that caution is essential. It is precisely in view of this lower growth in the second half of the year, that we steadily reduced our allocation to risky investments in the past months.

 

William De Vijlder

Global Chief Investment Officer, Partners and Alternative Investments

BNP Paribas Investment Partners

Emerging countries help to avoid double dip

The fear of a double-dip recession seems to have returned with a vengeance. Paul Krugman and Nouriel Roubini recently warned about such as a scenario. Does the low economic growth make the double-dip scenario more likely again?

Nearly every slowing of US economic growth is accompanied by fears of a double-dip recession. However, historically we have very little experience with double dips. They are quite rare, and when they do occur they tend to be caused by economic policy (the double dip in the early 1980s induced by Paul Volcker’s anti-inflation policy springs to mind). The fears have escalated again because analysts and the financial markets have come to the conclusion that the aftershocks of the “Great Recession” will be felt for a long time to come. Problems in the housing market and with banks’ balance sheets, for instance. Moreover, there is the prospect of very tight fiscal policies, which will depress growth over the short term. Given the current modest growth, any additional negative impulse will quite understandably fuel fears. By the way, the markets will use a looser definition: a substantial growth deceleration without landing into a real recession (two quarters of negative growth) would be awkward enough to sow doubts about equity prices, for instance. The fact that the emerging economies are booming (albeit not as much as before the crisis) and that not all countries will slam down the brakes at the same time should smooth out the effects of these negative impulses and thus help to avoid a double dip proper.

A growth deceleration is like braking on a bike: if the original speed was not too high, applying the brakes will quickly make you worried about falling over.

Do policymakers still have instruments to avoid a double-dip recession?

They certainly do not have any fiscal instruments, at least not in most western countries. The instrument they will have to resort to is quantitative easing, printing money in other words.

Will the recovery in the emerging countries suffer from the sluggish recovery in the West?

Yes, but don’t forget the strength of local domestic demand. In a globalised world a full decoupling of economic cycles is not possible. But the difference in growth rates will remain, and that in turn is an important factor for investors.

You implied above that you do not believe in a deflation scenario, nor in a scenario of rising inflation. What are the factors shoring up the status quo?

Proper deflation presupposes a significant contraction of final demand and surging unemployment. Inflation in the western world would then be imported from the emerging countries, directly because the latter’s currencies would appreciate, so that their exports would become more expensive (unless the invoices are denominated in euros or dollars), or indirectly through higher commodity prices. A slowing growth momentum reduces the risk of commodity pride-driven inflation. Locally generated inflation in the western world should create bottlenecks, but the output gap is so wide at the moment, or the production factors are so underutilised, that we can rule out this kind of inflation.

How can individual investors best deal with this unclear situation?

We are in a sideways-moving market characterised by great volatility and a nagging fear that it could all go wrong. In this situation investors can do several things:

1. shorten the investment horizon and take advantage of short-term movements, so more momentum investing (not forgetting the stop-loss discipline in this context);
2. extend the investment horizon by switching to intrinsically attractive investment forms and to accept any volatility over the short run; valuation is what matters here;
3. invest some of the assets in instruments with an asymmetrical return profile (absolute return funds, funds of hedge funds, funds with partial or full capital protection);
4. spread purchases over time; if you win the lottery on Saturday and you want to invest your prize, it would be better to spread this over several months.

What asset classes should investors concentrate on in the current situation?

Equities from companies with high dividend returns and sound balance sheets; corporate bonds with high yields; emerging country bond funds investing in bonds denominated in local currencies; equities from emerging countries.

Are there any “safe havens”?

Short-dated paper denominated in euro and issued by creditworthy debtors. This provides support in the most diverging circumstances, but the downside is low yields. However, “safe haven” by definition implies capital protection rather than return. Other investments may be safe in some circumstances but not in others: examples are long-dated government bonds, the dollar, gold…

"Emerging countries help to avoid double dip",  Netto/De Tijd, "5 questions to", 24 September 2010

Pinball machine markets

Now that the holiday season is upon us (less congestion on the roads, more tourists than commuters on the Paris underground), I recently thought back nostalgically to an annual ritual of my youth, the school trip, and more specifically to the lunch stops during these day trips. During these stops we always sought out a cafe where we could drink a coke or, as we got older, a beer, all the while playing the pinball machine. Looking at the stock market performances in the past few weeks made me think of these times. In a pinball machine, a spring is tightened and when it is released a metal ball is propelled into the sloped playfield; as the ball descends, shooting sideways, backwards and forwards, it hits obstacles (scoring points) and eventually hits the bottom of the playfield and disappears into the drawer. Replace the spring by “news” and the ball by “share prices”, and you get a picture of a wildly volatile market without offering investors much satisfaction.

The response to the recent economic data illustrates this perfectly. Whereas a few months ago investors were worried about the Chinese economy overheating, they are now fearful that, as the slowdown becomes evident, the cooling will turn into a deep freeze. And the Americans seem to be gripped by a “double-dip paranoia” in response to the weaker ISM and employment figures published at the start of this month. It is true that the labour market disappointed, but to conclude from this that we are falling back into recession – the definition of “double dip” – seems rather premature. This applies even more to the ISM indicator. A measurement of sentiment among purchasing managers, it has the statistically very intriguing quality of tending to the mean: values well above the average are followed by weaker figures, while poor figures are followed by better ones, generating an economic “heartbeat”, as it were. This is shown in figure 1.

Figure 1

Source : BNP Paribas Investment Partners

The benefit of such a chart pattern is the certainty that as the figures rise, a fall becomes more likely. But this does not mean that we will end up in another recession. I have marked the recessions of the past 35 years with a circle. This shows clearly that there have been many downward phases in the ISM index that did not herald a recession. Moreover, our experience with double dips is even more limited. We have to go back to the early 1980s, and that one was caused by the anti-inflationary policies pursued by the then Fed governor, Paul Volcker.

All this does not really help the stock markets. For history shows that changes in the ISM index correlate closely with changes in equity prices. Figures 2 and 3 illustrate this by demonstrating the link between, respectively, the cumulative changes in the ISM index over the previous three months and six months and the cumulative changes in the S&P-500 index over the previous three months and six months.

Figure 2

Source : BNP Paribas Investment Partners

Figure 3

Source : BNP Paribas Investment Partners

The correlation is striking, and the message for equity investors who want to apply market timing is clear: keep an eye on the momentum in the ISM index. Downward momentum is accompanied by falling equity prices. But this downswing does not need to imply a downward trend. Figure 4 illustrates this. In five of the eight cases, four months after a peak in the ISM index the S&P-500 index was trading at the same or a higher level than at the time of the ISM peak.

Figure 4

Source : BNP Paribas Investment Partners

Another way of looking at this is as follows. The start of a downward trend in the ISM index is important news for investors: it marks the switch from “fair” to “stormy” in barometer terms, or the time when bad news becomes available. This usually leads to a fall in equity prices; but after the initial, relatively brief, reaction, this news is discounted in equity prices, and investors look for new information to guide their buying and selling decisions.

However, this tendency towards rapid shifts in sentiment, supported by a “double dip” scenario for which there is no sound basis, illustrates the strength of the fears that the whole recovery is not as solid as generally thought. Risk aversion among investors remains strong.

William De Vijlder
15 July 2010

The other exit strategy

Late last year the forecasts for 2010 contained many references to the uncertainties surrounding the exit strategy: how would markets respond to any initial monetary tightening? Today, a different exit strategy is exercising many people’s minds: what kind of budgetary tightening is desirable? Quick or gradual? Some time ago we could read in various articles that Keynes was dead, This meant that Keynesian antidotes (i.e. budgetary stimuli) were no longer the right medicine and that the reins needed to be tightened because the money had run out. This is the conclusion that several European countries have reached, either because pressure from the financial markets has left them no other option (Greece, for instance) or because they believe this will be beneficial in the long term (Germany has enshrined the ambition of a (quasi) balanced budget in a special law). A similarly hard line is being taken in the United Kingdom, where the decision of the new Minister of Finance to raise VAT was greeted with jeers in Parliament.

Opponents of rapid budget deficit reduction point to the danger of triggering a double dip recession similar to the one witnessed in the US at the end of the 1930s. In the 1990s, Japan managed to nip its nascent recovery in the bud by hiking VAT. Proponents of a short bout of painful measures argue that action cannot be delayed indefinitely, that any postponement now will translate into a relentlessly rising debt/GDP ratio, and that history shows that countries with a very high debt ratio (above 90%) suffer structurally lower growth.

Curiously, given the importance of this debate, there are fairly few concrete analyses that can help us make up our minds and choose between “fast” or “slow”. My search produced the following. Several years ago the IMF carried out a model-based simulation showing that budget deficit reduction significantly constrains growth in year 1, but then leads to higher growth compared to unchanged policy. The reason for this is that debt reduction causes interest rates and the exchange rate to decrease. This is good for investments, while households take a rosier view of the future because they anticipate lower taxation. Morgan Stanley recently published its own calculations: budget deficit reduction of 1% of GDP in the eurozone will have a negative impact of -1.2% in year 1 and of -0.7% in both year 2 and year 3. JP Morgan recently published an interesting analysis based on the experiences of countries that considerably reduced their debts. The analysis looked at average GDP growth in the period coinciding with the deficit reduction measures. Surprisingly enough, there was no clear correlation between the size of the debt reduction and economic growth in the 1980s and 1990s for the 19 countries analysed. Belgium, Germany, Greece and Portugal implemented swingeing budgetary cuts, leading to weak growth, but an equally aggressive stance in the Netherlands was accompanied by strong growth. And the same applied to Ireland.

Conclusion: though cuts have a negative growth impact in the short term, their long-term effect depends largely on specific local conditions. Against the current backdrop, there is both good and bad news. The bad news is that central banks have no scope for relaxing their monetary policy to compensate for the budget cuts; the good news is that the negative growth impact will be tempered, at least in the eurozone, by the recent weakening of the euro (according to Morgan Stanley a 10% depreciation of the euro has a positive growth impact of 0.7%). Other helpful factors are the ongoing strong expansion in the high-growth countries and the fact that it will take time for the USA to cut its coat according to its cloth.

William De Vijlder
Global Chief Investment Officer, Partners and Alternative Investments
BNP Paribas Investment Partners

Reflections on a week in Asia

‘What surprises you the most?’ asked the CEO of our joint venture in South Korea, his eyes lighting up with curiosity when he learned that this was my first visit to his country. I replied that many things had struck me on the way in from the airport to Seoul, for example the sophisticated motorway information panels, the comparatively few Western cars on the roads and the sight of luxury Korean models (ones not sold in Europe). However, the most striking thing was the number of cranes in the capital. Here people clearly have confidence in the future. This is, in fact, true of Hong Kong and Shanghai as well, my other destinations during my week in Asia.  

The principal theme of the past week was the wage trend in China following a 30% pay rise at Foxconn and strikes for better pay and conditions at Honda’s plant in China. There was a touch of ‘Schadenfreude’ about the international media coverage of these events, an attitude of ‘There, you see, cracks are appearing in the Chinese model after all’. But let’s face it, the Chinese growth rate may be slowing, but it is still enviably high and in terms of competitiveness the difference remains enormous. In its edition of 3 June the China Daily reported that the typical monthly wage in the Honda factories is 1,900 yuan (about 190 euros) and that in manufacturing the average working week in central China is 60 hours.

Despite the soundness of the economy in the Asian region people are following developments in Europe with mounting concern. Never have I seen as much interest in Europe as in the conversations I had in Asia during this trip. It is also ironic that after the Asian crisis of 1997-98, a very cautious policy was pursued, which produced the very low debt levels in most Asian countries. In the West this policy resulted, through the low interest rates, in the known excesses (i.e. leverage effect and debt accumulation in the private sector) and crisis, and ultimately in enormous budgetary problems. In other words, one crisis led to another. The financial markets fear that Europe may cause contamination in Asia. In view of the share of European imports in Asian exports, the only possible conclusion is that the effect through trade will not be great. The concern is at a deeper level: what will be the impact on capital movements to the region if international investors begin to display a greater aversion to risk? What will be the impact on international bank financing? However, one thing remains clear: investors want an economy that generates sufficiently strong structural growth and for this they must look to the Asian growth countries.

My last destination during my trip was Tokyo, a gigantic city criss-crossed by motorways. There, discipline and politeness are the keywords: even the policeman who stopped my taxi to check the photo on my travel pass gave me a solemn bow. Economically, things have been going rather better recently due to exports (the Japanese economy has become a kind of derivative of the Chinese economy) and household consumption, which has been boosted by government measures. My day in Tokyo was the very day that a new prime minister was chosen, the former finance minister. Our analysts told me that he is accustomed to working closely with the administration, which is reassuring because this is where that the conceptual work is being done on the economic strategy to be pursued. The key points are the need to gain control of the debt spiral (ratio of government debt to GDP is over 200%) and, if at all possible, to have a weaker yen. ‘So should I buy Japanese equities?’ I asked them. Their answer was in the affirmative, not because of the new prime minister but more specifically because of the prospects for small cap stocks. These will produce very strong earnings growth this year (a good deal more than the large caps), and they are clearly cheaper in terms of valuation (price-to-book ratio of 0.84). Just right for the patient investor!

Excessive volatility: investment implications

Looking at the financial markets in the past weeks, I was reminded of the days (many years ago) when we, as a young family, used to visit amusement parks and could never resist the temptation of a ride on the rollercoaster. Besides all the stomach-churning dips and rises and twists and turns, preferably in a narrow dimly-lit tunnel, you were (and probably still are today) treated to spooky figures popping up out of nowhere amidst deafening squeals and shrieks to make you even more terrified than you already were. At the end of the ride, you heaved a sigh of relief at having “survived” the ordeal. The financial markets sometimes offer a very similar experience. Take last week for instance. Besides the usual ups and downs (the economic cycles, interest rate movements, etc.), investors also had to contend with some news reports that emerged from out of the blue and caused quite a few jitters. Financial Times Alphaville helpfully pointed out that Bild Zeitung had published details about the eurozone rescue plan, notably about the conditions attached, which caused doubts to creep back in (perhaps I should ask our CEO to get us a subscription to Bild). And then certain statements from the China Investment Corporation seemed to hint that China was reviewing its attitude towards investments in the eurozone. A sell-off ensued but denials the next day brought the buyers back in droves.

The general impression we get is one of excessive volatility. Which is nothing new in itself:  back in 1990 Robert Shiller (the same Shiller of the Case-Shiller home prices index in the USA) published a book entitled Market Volatility showing that share prices fluctuate much more violently than the “fundamentals” measured on the basis of the dividends. What’s new today is that the excessive volatility…actually feels excessive; everything is happening much faster and everything is impacted: we live in a world of excessive volatility with extreme correlation. Several factors explain this phenomenon: firstly, extreme investor sensitivity to downside risk (memories of post-Lehman experiences are still fresh); secondly, the nagging question: are there more skeletons in the cupboard?; thirdly, the sense that “there’s no money left” – in other words, if anything serious happens, do we still have the means to glue the pieces together?; and fourthly, the excess liquidity and leverage that is still in the system encourages herd behaviour, which is why news about Chinese investments in the euro can cause the Australian dollar to fall three per cent one day and rise three per cent the next …

How do you cope with all this as an investor? First of all, you need to choose your investment horizon. Do you go for a short horizon and become a momentum-led investor by responding to the short-term trend (beware of the “saloon doors” because the last person to buy in a rally is the first person to complain when the tide turns)? If so, you have enough time to spare, because one thing is clear: volatility will remain the watchword in the coming months. Or do you go for the long term, based on fundamentals? The golden counsel is to resist the temptation to check your portfolio’s performance ten times a day. You are far better off watching Roland Garros and the World Cup than 24/7 news stations like CNBC.

So are there any investments left with interesting fundamentals? Certainly. Here are two examples from the list. I recently visited our team in Amsterdam that specialises in managing high-dividend shares. These shares are carefully filtered for quality (to avoid “value traps”) and their European portfolio currently boasts a dividend yield of 4.1% and an expected dividend yield of 4.7% for the coming twelve months. The expected price/earnings ratio is lower (so cheaper) than that of the general European index (MSCI Europe) (10.7% versus 12.1%) and the long-term debt in percentages of equity is barely higher (42.8% versus 39.8%). For someone considering buying 10-year government bonds of countries such as Germany (yield about 2.6%), Italy (yield 4.11%) or Spain (yield 4.24%) and holding them until maturity, a high-dividend equity portfolio is an alternative worth considering. What’s more, such a portfolio is more resistant to possible inflation shocks and offers upward potential due to the corporate earnings cycle, while the risk that the ex-dividend prices of European quality stocks are lower in 10 years time than today strikes me as very small (albeit not zero).

A second example concerns high-yield USD corporate bonds. Last week my colleague Marty Fridson, a seasoned expert in high-yield bonds who is based at our New York office, gave me an update of his calculation of the expected high-yield bond return for the coming twelve months. Based on the consensus forecast of the movement of long-term interest rates for government bonds, the current spread between corporate and government bonds and the predicted change (source: Moody’s) in the default rate, he foresees an expected return of about 11% in USD for the coming twelve months. This is a forecast, so the usual warnings must be heeded, but it still looks like an interesting investment, all the more so against a background of growing stock exchange concerns in the coming months and a weakening euro.

Markets last week: yet more volatile

Whereas at the start of the week we could still hope that the stock markets would stabilize after the previous Friday’s plunge, they have actually slipped steadily and sharply further since then. Several factors account for this movement:

1. The measures by the German authorities with regard to “naked short selling” left a nasty aftertaste among investors:
- there had been no consultation with the European partners, while investors are actually counting on concerted European efforts to tackle the crisis;
- there is a fear that the measures were introduced in anticipation of further bad news (this at least was the market interpretation on the ban on naked short selling of bank stocks).
Both factors are prompting investors to switch to safer investments.

2. The markets are becoming ever more aware of the impact that the measures required to deal with fiscal deficits and to get the debt spiral under control will have on economic growth, in the eurozone, in the EU and beyond. Via international trade a growth deceleration in the eurozone will automatically affect growth among the trade partners, all the more so if exchange rates change significantly, as happened with the downswing in the euro’s value.

3. The sense of an acceleration on the regulatory front (Germany, United States) is also weighing on sentiment.

4. US economic data (e.g. the unexpected fall in the index of leading indicators) fuel the impression of slowing momentum in economic growth. Some analysts believe that a “double dip” recession has become more likely; but fortunately it is still not the basic scenario.

5. Otherwise we have seen the traditional pattern of an increase in correlations, with one asset class confirming and reinforcing a movement in another. Western stock markets are falling, high-growth countries see even more profit taking, the Australian dollar is being sold, and short positions in the euro are being closed. We can expect the opposite when sentiment picks up again.

Outlook for the short term

1. Markets will be primarily sentiment-driven: as regards key macro-economic figures, we are waiting for the US employment figures in early June.

2. Given the size of the downswing, there may have been an overreaction, and this should lead to a stabilisation, albeit in an environment of high volatility.

3. This high volatility will be fueled by fear of bad news (at macro or company level) and other unforeseen elements (comments by politicians, for instance, or currency market interventions, about which rumours were circulating earlier this week).

The “broad picture”

1. The dominant theme at macro level is whether the world economy is heading for a phase of slower growth. Public spending cuts and higher taxes will depress growth over the coming years, but European and US monetary policies will remain unchanged for a long time to come, and steep yield curves are good for bank profits and hence for the supply of credit.

2. We live in a two-speed world, so we should not forget that the high-growth countries are still doing well economically, which is of course positive for the rest of the world.

3. The key question is whether the heightened volatility and falling markets will compromise businesses’ and households’ willingness to take risks and spend more. Consequently investors will take a greater than usual interest in indicators such as the ISM and IFO and those for consumer confidence. If these remain encouraging, then the markets will inevitably bounce back. In the meantime, we must hope for a stabilisation as a reaction to a perceived overreaction.

4. The high volatility and the sense that the stock markets could head in any direction over the short term suggest that a wait-and-see attitude is appropriate.

Europe takes leap in the dark

A round trip to our office in Stockholm gave me enough time in the plane to go through the press and merchant bank reports about the eurozone rescue plan. My reading matter hardly filled me with joy. The editorial in the International Herald Tribune narrated in colourful, and almost cinematic, terms how, on Sunday morning, Angela Merkel had attended the parade on Moscow’s Red Square marking the 65th anniversary of the end of the Second World War, while the North Rhine-Westphalian electorate was giving her a battering and her fellow government leaders were in Brussels frenetically hammering out a solution to the crisis (the Herald Tribune’s description of three parallel events even surpassed Francis Ford Coppola’s tour de force in The Godfather), but the dominating mood was bearish or, should we say, realistic? The good news that came out of the past weekend was that a major crisis was being fought with very heavy weaponry by the European Union (the balance of payments facility), the eurozone (the “special purpose vehicle” for bailing out beleaguered nations), the IMF and the ECB. The critical tone in the media mainly concerned two points: the intervention of the ECB and the fact that the package of measures did not make the debt reduction efforts any easier.

The argument regarding the ECB is that the central bank is at risk of incurring losses if a member state were to default or if, to avoid this contingency, it were forced to keep on buying debt from the “weaker brethren”. For the country in question, this is basically a form of monetary financing; but this is not the case at eurozone level as the ECB sterilises the purchases. Theoretically, however, the risk of monetary financing does exist, so you can expect the ECB to start speaking with a louder voice when it comes to assessing budgetary policies in the eurozone. This will prevent ECB debt financing from leading to slacker budget policies with the attendant risk of “moral hazard”. Against this risk, we can set the advantages of the central bank’s willingness to intervene: when the market for debt paper dries up entirely and the country in question ends up in a vicious circle (inability to raise sufficient funding in the capital market, leading to higher interest rates which, in turn, accelerates the increase in the debt/GDP ratio), the ECB purchases can stabilise the market and normalise the interest rate conditions.

In addition, the analyses also place strong emphasis on the fact that the package of measures does not relieve the burden of debt reduction. Several considerations can be made in this connection. First of all, the normalisation of interest rate conditions (witness the enormous fall in the Greek long-term interest rates last Monday) takes some pressure off the budget, which would otherwise not be the case. This impact is not to be underestimated. Secondly, the decisions of the past weekend have obviously not caused the budget policy theme to disappear. Far from it: in the years ahead national budgets will continue to dominate the economic-political debate and will remain very much on the radar screens of the financial markets. Countries will be judged on their ability to actually carry out ambitious budgetary plans, and the existence or absence of national policy consensus will be an important factor in this connection. I foresee recurring eruptions of market nerves about this theme. Thirdly, you could say that Europe has taken a leap in the dark. Once the “special purpose vehicle” is used to help a member state, the gross debt burden of all eurozone members together will increase, which may in due course affect their interest rate conditions and creditworthiness. For this reason, it is important to use this SPV as sparingly as possible, but it is also inevitable that fairly intense debates will arise between the “donor countries” and the beneficiaries about the latter’s budgetary austerity. This, too, is sure to cause market volatility.

One consideration that inevitably asserts itself is that all this must ultimately push up inflation: the scale of the budgetary restructuring, it is claimed, would be such that an exaggeratedly relaxed monetary policy – or even pure monetary financing – would be deployed. However, this reasoning does not hold water for the eurozone: the ECB is independent and stressed that its widely-criticised decision last weekend to purchase government bonds, if necessary, would have a neutral effect on the money supply. Even so, inflationary fears remain very much in evidence (witness the gold price) and governments, both in and outside the European Union, may need to consider issuing more inflation-linked bonds. This would signal a strong commitment to never resort to the inflationary emergency brake and would also push down – or at least prevent an increase in – the inflation premium on long-term interest rates.

Finally, a brief word about the magnitude of the efforts required. The challenge is to improve the primary budget balance, i.e. the budget balance excluding interest payments. If the average nominal interest rate on the public debt is greater than the nominal growth rate (which is a legitimate hypothesis for the coming years given the prospects of low growth, the planned austerity measures and the high long-term interest rates due to the large budget deficits), then a sufficiently large primary surplus must be realised. The actual size of this surplus depends on the objective that the country sets itself: at what level should the debt/GDP ratio be stabilised and within how many years? Some scenarios bravely speak of “stabilising the debt/GBP ratio at 60% of GDP within five years”. Even without detailed analysis, intuition tells you this is an impossible feat. In a recent paper of the Bank for International Settlements, revealingly entitled “The future of public debt”, Stephen Cecchetti and colleagues adopt a more realistic approach: what primary surplus is required, given realistic growth hypotheses, to stabilise the debt/GDP ratio at pre-crisis (i.e. 2007) levels after x years? Comparison with the primary balance forecast for 2011 shows the efforts required to achieve this. If we give ourselves 20 years to do the job, this yields results which, depending on the country, range from reasonably feasible (Germany: 4.4%) to pretty ambitious (UK: 12.5%) (see table). Clearly, a shorter time span will demand proportionately more arduous efforts.

in % of GDP	Forecasted primary balance 2011	Required balance in 20 years time	Difference = required budgetary contraction to stabilise the debt/GDP ratio
Austria	-2,9%	2,0%	4,9%
France	-5,1%	2,8%	7,9%
Germany	-2,0%	2,4%	4,4%
Greece	-5,3%	1,5%	6,8%
Ireland	-9,2%	2,2%	11,4%
Italy	0,0%	2,5%	2,5%
Japan	-8,0%	4,5%	12,5%
Netherlands	-3,4%	2,3%	5,7%
Portugal	-4,4%	1,8%	6,2%
Spain	-6,6%	1,3%	7,9%
United  Kingdom	-9,0%	3,5%	12,5%
United States	-7,1%	2,4%	9,5%

Source: Cecchetti, Mohanty & Zampoli, The future of public debt, BIS Working Paper 300, March 2010

Which brings us back to the events in the past weekend: budgetary restructuring is a process for the long haul, requiring persistent efforts, engagement and credibility. So governments are looking at a long horizon. Any doubts about the credibility of their engagement will lead to a shortening of the investors’ horizon. The decisions made on Sunday night sought to remedy this “horizon mismatch”. Governments must now truly engage in the challenge and start restructuring their budgets. This, incidentally, is not just a task for eurozone countries. Others, such as the US and the UK, are in the same position. Countries that tackle the problem with resolution will be rewarded with lower long-term interest rates and a stronger exchange rate. Any slackening of discipline will lead to a weaker currency and a rising risk premium. As the exchange rate argument, by definition, plays no role within the eurozone, the pressure will be reflected in the interest rate spreads versus Germany, but also in the rate of the euro versus other currencies.

William De Vijlder
12 May 2010

10 May 2010: dawn of a new era in Europe

The decisions taken last Sunday night in response to the eurozone crisis will go down in history as the dawn of a new era. A clear line was drawn in the sand, conveying the message that the eurozone must be protected and that steps must therefore be taken to ensure that governments unable to fund their debt in a normal manner – in other words, on their own merits – are given help in raising the funding they require. Some aspects of these decisions were a welcome surprise, such as the size of the package (EUR 750 billion), the flexibility of the balance of payments facility (EUR 60 billion), the substantial IMF contribution (EUR 220 billion), the liquidity the ECB will direct towards the money market and the reactivating of USD swap lines at the Federal Reserve. The most striking elements, however, are the decision to create a EUR 440 billion European lending facility and, above all, the ECB’s decision to purchase government bonds.

The importance of the European lending facility goes far beyond merely providing capital. In essence, it establishes a degree of solidarity, allowing countries with financial problems to be assisted by the other member states. The latter will borrow more than they require to cover their own needs and then on-lend the surplus funds to the former. It also creates a solidarity within budgetary policy, since through the conditions attached to such lending, the member states acting as lenders will effectively ensure that it is they who are doing the steering (and braking if necessary) in those countries with substantial deficits.

The biggest surprise, however, was the European Central Bank’s decision to declare itself willing to buy government bonds. It should be noted, for the sake of clarity, that these are sterilised interventions, since any purchase of government bonds will be offset by sales of assets. As a result, there will be no increase in the ECB balance sheet total. This in turn means that there will be no need to print money to fund the cost of purchasing government bonds and hence no recourse to quantitative easing. The measure may nevertheless prove extremely effective. In countries where quantitative easing has been used, such as the US and UK, the central bank sets out to depress long-term interest rates by printing new money to fund purchases of government bonds. The ECB’s action will reduce the interest spread on loans to problem countries compared with that on loans to Germany. And the economic effects of this will be analogous to those achieved by quantitative easing (in other words, lower interest, albeit not in Germany).

This decision was surprising for a number of reasons. To begin with, only last Thursday Jean-Claude Trichet had asserted that the ECB was not even considering the possibility of purchasing government bonds. What is more, some will still see this step as a willingness by the ECB to take risks with inflation (although we should not forget what could have happened if last week’s crisis had continued). The latter argument, however, does not hold much water since the purchases will be sterilised, while the decision means above all that the ECB has drawn a line in the sand. This metaphor is often used to describe currency market interventions: the central bank intervenes robustly and resolutely to send out a ‘stop here’ signal. Indeed, the term ‘sterilised intervention’ has its origins in the currency markets.

I have deliberately chosen to use the metaphor of ‘drawing a line in the sand’. The ECB now has the opportunity to intervene in the government bond market. That means there is now a ‘purchaser of last resort’, and the realisation that this role exists should in itself be enough to significantly reduce market volatility, waves of speculation, a vicious circle, lack of liquidity caused by a disinclination to buy and the risk of one country becoming contaminated by another. Assuming that an awareness of the existence of this role is sufficient, there will be no need to deploy huge sums of money, with the threat effectively reducing the need for action.

Last night’s decisions mean that bond prices have effectively become one of the European Central Bank’s tasks. And that is certainly something we should welcome in the interests of maintaining stability within the EU economies.

William De Vijlder
10 May 2010