Thursday, 8 March 2018

Duration losses on banks, political push backs and the EUs coming existential crisis.

Governments have been the big borrowers in this cycle, effectively reinflating the pre-08 credit bubble as opposed to dealing with the structural problems. 

Has anyone seen research on how big the duration losses would be if US rates go through 3% and flat to positive term structure? I haven't seen much if any.

The banks, if they are holding duration as a carry trade, will have negative NIMs/ carry plus mark to market losses. 

For example, European banks bought >$600bn of Treasuries since 2012. For now, I think most of the US curve near-term sell-off has happened, in fact, we could even have a counter-trend position clear out/ rally, but into year end perhaps we see another sell-off. 

In the interview below Yannis Varoufakis talks about the mark to market triggers in Europe. European banks are currently relying on EUR760bn in ECB LTRO funding which is collateralised and EUR800bn of TARGET2 funding which is un-collateralised at the moment. Most of that borrowing is by periphery banks. 

I have maintained that the real existential crisis in Europe will be politically triggered by a core member, Italy, France or Spain are the only real candidates, aside from Germany obviously. 

In this recent election, 57% of Italians under 44 years of age voted for M5S or Lega, both anti-EU parties. 

Mark Blythe and David Kertzer discuss Italy below:

We just have to see what happens in terms of a coalition in Italy and whether they are serious this time around (I doubt it) or whether we need to a see a few more years of Germany product dumping into the rest of the EU as the US and UK reduce imports.  Perhaps Italy has a short parliament now based on coalition and then another election in 9 to 18 months time. 

Trade wars

The US is a fairly closed economy and while their trade deficit hurts certain parts of the economy (suppressing low wage earnings and the manufacturing sector), a trade war cant really have that big a negative impact and there are positive impacts associated with the wage/inflation/ investment cycle rebalancing. 

Germany, on the other hand, is operating an intra-EU supply chain and labour arb business model and exports total over 45% of GDP. 

(Discussed here: and here:

Germany's trade balance with some of its largest trading partners:

Germany's export surplus to the top 3 alone is EUR145bn a year alone in 2016. That 4.1% of Germany's GDP just in trade surplus to 3 countries. 

If the US and UK impose tariffs/ hard Brexit tariffs what will happen?

Will, as Varoufakis suggests, the EU use the EIB to support EUR500bn of pan-EU infrastructure spending? Will the EU engage in a Belt and Road initiative in East Europe, the Middle East and Africa? 

Of course not, the private sector will immediately product dump into France, Italy and Spain. Maybe after an existential crisis, the EU's politburo will do the EIB infra plan. 

The political, business and employment consequences of Germany's private sector product dumping tens of billions of Euros in products principally into 3 EU countries will be the trigger for real EU crisis. 

So assuming nothing much happens stemming from this Italian election as whoever is in charge probably wont have enough authority to do anything serious, then we have Brexit in Q2 next year and the potential for an EU crisis going into year end or early 2020 triggered by the onsequences of German product dumping. The Fed should have raised rates into the 2.5-3% range as well by then.


Tuesday, 6 March 2018

Toronto off 17% in under a year

Coming to a global mega city near you soon..

Worth bearing in mind that people who bought at the top of the bubble in 1997 in Hong Kong had negative equity until 2011. The market more than halved before bottoming in mid-2003. And FWIW the Hong Kong bubble is bigger now than it was then.

Thursday, 1 March 2018

Core-PCE starts to firm up

Core-PCE has been held back in the last year by weakness in autos, durable goods, apparel and food, while the service parts of the economy were seeing inflation more in the 2-2.5% range. I wrote an article on what was holding back the numbrs last year:

The BEA stopped publishing sub-tables last August but some are in the CPI release. January numbers suggest prices improving in the durable goods sector, while apparel has also improved. 

The Census Bureau also shows durable goods orders/ shipments up 8/9% YoY with broad-based growth.  

Without hedonic adjustments and the few pockets of weakness, some of which seem to now be improving, Core-PCE would already be above 2%, maybe closer to 2.5%, vs 1.5% Fed funds. If we get some improvement in wages it will further underpin it. 

Wages grew faster than GDP the first half of last year but then seemed to stall in the second half and grow more or less inline with GDP resulting in onlt a small increase in wages/ GDP in the second half. 

You simply cant 'MAGA' without wages growing as a % of  GDP. Seems to be off the bottom, but there is a long way to go yet. 

Government transfers muddies the picture on total income, but put simply, higher domstic manufacturing, less imorts, higher savings, more capex and more domestic high quality jobs will increase wages as a % of GDP and also reduce transfer payment bills for the government. 


Monday, 26 February 2018

Corporate savings and credit spreads

The corporate savings rate rose in Q3 as per the Z1 survey and looks like it has probably risen more since. 

It's a bit weird as capital formation ie capex, was rising into year end. 

As per the chart below business loans picked up a little in Jan and are flat in the first week of Feb so far having gone negative for a few weeks in Q4. 

Good job Yellen didnt hike rates to a neutral level before leaving the Fed as I think that would probably be enough to trigger a recession. 

Instead we have continuing very loose rates trying to underwrite, in my view, a transition between economic cycles without a recession in the middle.

The new cycle will involve lower corporate margins and more defaults. So how do you play credit spreads widening over time? 

One simple solution is CLO equity. If during the two year reinvestment period leveraged loan spreads widen, then as the CLO reinvests excess cashflows and early repayments the spread between the collateral pool yield and the CLO note funding costs widens, increasing the return to the CLO equity. 

Obviously the CLO manager has to avoid defaults or stopping out of deteriorating credits at marked down prices to generate an overall benefit. 

This credit spread widening benefitting CLO equity is exactly what happened in the 2 year period into March 2016, and in my view this cycle could potentially happen several times over the next 10 years or so.

Wednesday, 21 February 2018

Egypt enters a rate cutting cycle

So similar to my comments on Turkey, Egypt has had many problems over the last few years, compounded by the fall in the oil price and fall in tourism, two major hard currency earners.

An IMF loan and high interest rates attracting flows seem to have stabilised things. Inflation has peaked and the central bank cut interest rates 100bps this month. The new inflation target is 10-16%, vs 5% GDP growth.

Revenues and volume numbers from both tourism and oil production look like they are picking up.

The balance of trade is picking up off the lows. But what the country needs is a sustained period of cheap currency and domestic investment in manufacturing and job creation.

The country exported less than $1bn in 2016 to China and Germany combined while importing $7.6bn and $5.1bn respectively. Very similar trade balance problem to Turkey. Yet again China and Germany have exported their saving surplusses and undermined the domestic manufacturing base of a country.

The yield curve is also reflecting expectations of compression.

With 5% GDP growth and a double digit inflation target, buying long duration bonds now is really a bet on inflation falling to below target levels.

The stock maket as per the ETF on the other hand has a 25% RoE despite all of these problems and is on a forwards P/E of only 10x.

Looking at the CPI history it has been low before but generally ranged between about 5% and 12%.

If set against a 5% GDP growth inflation falls to high single digits then both the stock and bond markets may perform well.

Tuesday, 20 February 2018

The Federal deficit and the 'LBO Whitehouse'

The US Federal govt burnt through $666bn in cash and $1.16Tn in actuarial type deficits last year, 8 years into the cycle. 666 coincidentally being the number the S&P bottomed at in 2009. 

Primary dealers are forecasting roughly $1Tn cash deficits in the next two years on tax reform. Much worse than the old forecasts in the chart below.

100bps rise in Treasury financing costs is worth $150bn a year.

You have to wonder how bad the long term cyclically adjusted deficit is, $1.5Tn?

The government shows $3.5Tn of assets and $24Tn of liabilities, so this cash flow based lending par excellence.

So in the 'LBO Whitehouse', the focus will be growing the top line (nominal GDP) while capping interest costs at a relatively low level and compounding up the spread. Pretty much what China is also doing.

Turkey in line for a 'peace dividend'

Turkey has been caught between slow growth in Europe, the EM downturn through to 2016, conflicts in Iraq and Syria and with its own Kurds, Erdogan's nationalism and recently with inflation from imported commodities.  

The stock market has lagged the EM recovery and the iShares ETF/ local market in USD is basically flat since inception. It's on 10-11x P/E and 1.6x P/B. Within that a few growth/ compounder names are on 20 something P/Es and the banks are on single digits. Halkbank is priced at a discount, but others are priced a little over book value. Halkbank's situation is complicated by a trial in the US related to Iran sanctions breaches but it is still growing domestic lending in 2018. 

With ISIS gone, hopefully the security situation can settle down and Turkey may enjoy a 'peace dividend'. The FX is cheap and offers a decent carry pick up over Euros, while inflation is likely to start to fall if the currency stabilises and the central bank would probably try and get rates down to 6% or so from the current 8%, the expectation of which should attract fixed income portfolio flows. Receiving rates should be a fairy high Sharpe ratio trade. The FX is normally OK until after the summer where the tourism revenues drop off and that had in recent years been the catalyst for a devaluation. With the Euro having been strong against the USD and the Ruble also recovering, a flat USDTRY rate represents a further devaluation. 

If equity investor perceptions change and they perceive Turkey as a large, relatively high growth country with a cheap currency on the outskirts of Europe then the market as a whole and the banks should reprice higher. 

Turkish companies should also benefit from any rebuilding in Syria and there are many in the constriction/ aggregates sector that will be well positioned despite the complicated political situation in the border region. Perhap's Turkey's border incursions are more about positioning the ethnic Turk Syrians for the coming government negotiations and ensuring Turkish companies are benefitted from the economic recovery and spending than anything broader, whilst also trying to prevent emboldened Kurds from trying to change the siutation within Turkey.

 Chart Sources: variously FRED,, MSCI.