Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 28 March 2013

Plutocratic Revival of London Housing

A rising tide of QE has raised only yachts. This is quite apparent from the London housing market. Even as the UK economy is moribund and financial services industry is shrinking, the London housing market is defying gravity. However, not all areas share in the bounty. This is in stark contrast to the pre-financial crisis period when prices for all London boroughs rose in tandem (Graph-1). Since 1997 average prices hardly fluctuated from the peak and falls were mostly not more than 5% and of short duration.

Graph-1: 1997-2007 was NICE for everyone
Deviation from peak (1.00 = Peak)
Source: Landregistry.co.uk, Author’s calculations

The financial crisis caused prices to correct by 15-20% before massive monetary easing by panicked central bankers halted the decline. Graph-2 shows the life support provided by BoE. Due to aggressive rate cutting, the index measuring cost of mortgage interest payments is now at levels last seen a decade ago. This not only allows indebted homeowners to hang on (thus decreasing supply) but also provides a huge incentive for homeownership versus renting since rents have kept rising. Adding to the demand is the safe haven/trophy bid from abroad. This combination of reduced supply and increased demand has caused prices to go up even as transactions are at a low (Graph-3).

Graph-2: UK homeowners on BoE sponsored life-support
Source: ONS

Graph-3: Rising prices on falling volumes
Source: landregistry.co.uk

Price rises are not backed by fundamentals since gains from housing “recovery” have largely gone to the wealthy (as opposed to the pre-crisis decade). As graphs 4&5 show, more expensive boroughs have seen the largest gains relative to their pre-crisis peak. The cut-off for houses regaining their previous peak price is around £300,000 in nominal terms and £600,000 in real terms. To put these in perspective, the average gross total pay in London is £38,315[Footnote 1].

Graph-4: High-end property revival
Source: landregistry.co.uk, Author’s calculations

Graph-5: Real returns come to those with money
Source: Source: landregistry.co.uk, Author’s calculations

This divergence in the London housing market is merely another symptom of how policies have benefited the plutocracy at the expense of the general public. QE’s ineffectiveness in reviving the economy but juicing up asset prices is clear to most people except doctrinaires locked up in ivory towers on Threadneedle Street. One can only watch horrified as the experiment progresses further. On a more positive note, at least the Chancellor has promised everyone some cake if they can’t have bread through his ill-thought house buying incentive plan.


[Footnote 1] A household with two earning members both on the average pay and paying tax at 25% (including NI) would be left with £28,737 each. If they save 10% of their net pay (more than triple the national average) then it would take them 10 years to save a 20% deposit on a £300,000 house.

Tuesday, 26 March 2013

Gun to the template

Notable points have been obscured amidst all the meaningless discussion on whether Cyprus is a template or a unique case and whether depositors in Italy need to go to the mattresses. The following signals should be picked up from the noise:

  1. Northern Europe is running out of patience – The pounds of flesh demanded per Northern European Euro is rising fairly dramatically. The spin that Cyprus was a special case targeted because it was politically impossible to be seen supporting a “Russian money laundering haven” should be taken with a pinch of salt. Given prevalent southern European stereotypes and voter disenchantment with bailouts in Northen Europe, it is going to be as hard if not progressively harder to hand out money to Italy or Spain or anyone else. In fact given the size that Italy and Spain might require, private sector bail-in is guaranteed.
  2. IMF is running out of patience – Despite a European head it seems that voices inside the institution are attempting to stem its rising exposure to a sinking Eurozone. This puts the burden of support on Northern Europeans and based on the observation above, it makes private sector bail-in more likely in future.
  3. Poor decision making without regard to consequences is the only constant amongst “unique” cases – Very little has changed since beginning of 2010 when Greece first discovered it needed some money. If an infinite number of politicians were put in a room, one of them might come up with a solution but that is not what will be finally adopted by the Eurozone. Expect great albeit contradictory soundbites, few solutions and much volatility.
  4. Invocation of force majeure is likely to be more frequent – Capital controls are prohibited by Article 63 of the Lisbon Treaty but Article 66 allows them in “exceptional circumstances”. As fundamentals keep worsening, presumed legal rights and protections are going to be torn up by a desperate elite in their bid to keep the grand design alive.
  5. OMT is empty – Actions speak louder than words and ECB just became the backstabber of last resort. Northern European hard money influence is unlikely to allow emulation of Ben’s ‘money for nothing’ policies. Yet again expect great soundbites but little help.
The upshot is that private investors are increasingly on shaky ground. Unless growth miraculously arrives or a change of heart leads to fiscal transfers it looks as if political will is about to meet its match in economic won’t. 

Thursday, 21 March 2013

Icelandic Lessons For Cyprus

The deleterious effects of the single currency and surrendering sovereignty to Eurocrats are now clear in Cyprus. Broadly its predicament is similar to the one faced by Iceland in 2008 (Graph 1). The dream of becoming a global financial centre is exhilarating but when consciousness dawns all one finds are over-levered banks and a shattered economy.

Graph 1: Global Financial Centre Side-Effects

Source: IMF, ECB, Central Bank of Iceland

After Lehman’s demise Iceland resorted to the following measures to save itself from the implosion of its banks:

  1. Capital controls – These were enacted in October 2008 just before Iceland placed its three largest banks (Kaupthing, Landsbanki, Glitnir) into receivership.
  2. No bailout – Bank creditors and equity holders were left high and dry.
  3. Protecting domestic depositors – The state performed its duty by guaranteeing in full the deposits of its citizens. However, foreign depositors were left to fend for themselves (they were made whole by their respective governments).
  4. Foreign aid – To cope with the fallout, a $5.1bn aid package (approx. 40% of GDP) was arranged by the IMF ($2.1bn) and Nordic countries ($3bn).
The measures seem to have worked as graph-2 illustrates.

Graph 2: Non-EU Approved Measures Work Better

Source: IMF World Economic Outlook Database October 2012

IMF support ended in August 2011 and Iceland has regained market access. It is projected to have a primary surplus in 2012 and start lowering its debt/GDP ratio (Graph-3).

Graph 3: Not Bailing Out Financial Institutions Works

Source: IMF World Economic Outlook Database October 2012

Of course capital controls have still not been lifted but given Iceland’s present trajectory it can only be a matter of time before these stabilisers are also removed.

As Cyprus mulls over the ECB ultimatum it may help to study the Icelandic model. The ill-thought depositor tax and consequent backpedalling and recriminations have probably made it impossible for even a tweaked Plan A to work (Europe doesn’t do Plan B). Even if depositors are not “taxed”, the destruction of trust makes depositor flight almost certain when banks open. Unless the EU/ECB increase their support in anticipation, the current package will not be enough (this shouldn’t come as a surprise given the trend of botched rescues and bigger cheques which started with Greece in 2010). But this seems unlikely given their current intransigence.

Therefore Cyprus can do worse than follow the Icelandic playbook. Unlike the EU inspired one, it avoids grinding austerity without end. Unfortunately this means leaving the Eurozone since the solution calls for capital controls which are prohibited under Article 63 of the Lisbon Treaty (“Within the framework of the provisions set out in this chapter, all restrictions on the movement of capital between Member States and third countries shall be prohibited.”). Moreover exchange rate adjustment which helped Iceland (Krona dropped from 62 to 121 against USD in 2008) cannot be achieved within the Euro.

The problem Cyprus faces is that there is no one offering external aid like the Nordics and IMF did to Iceland helping it avoid default and tiding it over the shock. Russia is the last hope but since the solution involves burning Russian money, help may not be forthcoming. That is unless the Russian government wants to grab some gas reserves and simultaneously teach its oligarchs a lesson in offshoring risks.

Tuesday, 19 March 2013

Cyprus June-13 Bonds - Buying Opportunity?

Cyprus June-13 bond price has fallen on fears of expropriation/default. However, the EMTN offering circular gives reasons to be greedy when the market is fearfully pricing the bonds around 92 (down about 3-3.5pts). Consider the following:

  1. The bonds are under English law: This makes it difficult to haircut bondholders through local law changes.
  2. A tax is very difficult to impose: As per the offering document (italics inserted) – “All payments in respect of the Notes and the Coupons will be made free and clear of, and without withholding or deduction for, or on account of, any taxes, duties, assessments or governmental charges (together, the “Taxes”) of whatever nature imposed, levied, collected, withheld or assessed by or within any jurisdiction in, from or through which such payments are made or any authority therein or thereof having power to tax, unless such withholding or deduction is required by law. In such event, the Republic shall pay such additional amounts as will result in receipt by the Noteholders or, as the case may be, the Couponholders of such amounts as would have been received by them had no such withholding or deduction been required…” There are exceptions but realistically there is little room for legal trickery within the scope of the document. An overarching European law is a different matter (see this FT Alphaville piece).
  3. The precedent of paying foreign investors to keep them in good humour: Along with EU's desire for haircuts to remain “unique” to Greece, a desire to ensure investors don’t take fright from the rest of the peripheral is presumably why depositors were raided. Moreover, the messiness and pain (eg. Argentina) involved in restructuring foreign law bonds means that Cyprus’ foreign law bonds are likely to paid out in full as well.
Of course there are risks in buying the June bonds. The three main ones are:

  1. Cy-exit or disorderly default: An irate citizenry and the prospect of years of austerity may yet cause politicians to reconsider their position in EU. The miffed Russian bear can easily provide the loose change required to prop up the system in return for burning bondholders instead of depositors (Although denied, Gazprom may have made such an overture earlier). Even if the Cypriots choose to stay in and rebuff Russia, the deal can fall apart due to political intransigence on all sides leading to disorderly default.
  2. Angry Russian response: The EU assumption that Russia would ease the terms of its bilateral loan is now likely to be belied. However in itself this will not pose a great burden as long as the EU is ready to pay a little extra. However there is also a hidden risk due to the bilateral loan between Cyprus and Russia. This is purely speculative but if there are provisions such as obligation acceleration in the loan contract and they are triggered then cross-default may occur. The EMTN documentation states that an event of default is triggered when: “Any present or future External Indebtedness becomes due and payable prior to the stated maturity thereof by reason of default…provided that the aggregate amount of all External Indebtedness in respect of which one or more of the events mentioned above in this paragraph (iii) have occurred equals or exceeds U.S.$25,000,000 or its equivalent in any other currency or currencies.” Again, this is unlikely otherwise the Russians would have threatened it already.
  3. EU grab: European leaders may tire of feeding “locusts” (in their view) and enact an EU-wide law to grab part of the principal repayment in guise of a “tax” or “special levy”. However the probability of this is low given the demonstrated desire to keep investors in good humour.
The main risk is of an exit but if one believes that Europe is Hotel California then buying these bonds maturing in less than 3-months makes sense.

Monday, 18 March 2013

Three Takeaways From Cyprus

Over the weekend, the gas which European leaders had managed to pump into markets escaped causing a stink and collapsing their bubble. The three takeaways from the latest “unique” case (it is small wonder that a coherent union is proving difficult since so many unique cases abound):

1. Formalisation of the concept of private sector bail-in

The Cypriot “unique” case furthers the precedent established by other “unique” cases of burning private investors before any administration of state aid. The recent nationalisation of SNS Bank by the Netherlands had already shown that subordinated debt holders were likely to be bailed in. Now the deposit grab in Cyprus shatters the illusion that senior bank debt holders and depositors are safe. A quote from an unnamed ‘senior Eurozone official’ in this FT article, says it all: “If this is successful then it will be used in the future,” said the dejected official, predicting Spanish and Italian banks could face similar levies. “If this is not successful then who cares about Cyprus.”

 2. Return of the sovereign-bank feedback loop

Indebted sovereigns caught in the straitjacket of monetary union need debt reduction. This would deliver losses to their banking sector which is already stressed due to either low growth or collapsed property bubble or both. In turn, banks would require state support which cannot be given. Draghi’s empty-OMT was supposed to break this loop by convincing the markets that there was no threat of forcible sovereign debt reduction. It worked for a while but now Cyprus has lifted the veil to reveal unsolved fundamental problems bedevilling Europe.  Graph-1 shows the sovereign bond holdings of Eurozone banks according to the Bruegel database of sovereign bond holdings developed in Merler and Pisani-Ferry (2012).

Graph 1 
NB: Data pertains to March 2012 except Belgium, Portugal and Finland for which it is for 2011 year end.
Source: Merler. S, Pisani-Ferry. J, Who’s afraid of sovereign bonds?, Bruegel Policy Contribution February 2012

Graph-2 shows the exposure of a country’s banking sector to the general government sector as a percentage of its capital and reserves. This captures holdings of non-domestic sovereign debt and thus better illustrates vulnerability to contagion due to forced debt reduction (the Cypriot banking sector was brought down its exposure to Greece).

Graph 2: Loans and holdings of general government securities as a percentage of capital and reserves
NB: Data pertain to Jan-13
Source: ECB

Graph-3 shows the leverage in the banking system by comparing total assets to GDP and total assets to capital and reserves.
NB: Data pertain to Jan-13
Source: ECB

Among the highly indebted countries, Spain and Italy clearly don’t look too good and neither do France and Belgium. It is also interesting to note that the troika of Germany, Netherlands and Finland have three of the most highly levered banking systems. Let’s just hope that their banks haven’t stuffed the books with high yielding garbage.

3. Employment of legal tricks to achieve political objectives

In Cyprus, an illegal confiscation of private property has been made immune to legal challenge through levying a tax on deposits which is legal and within the power of a government. The tax also circumvents deposit insurance guarantees. This may have ramifications for future debt restructurings. Until now, sovereign debt under foreign law (mainly English law) has been seen to be protected from restructuring and writedown in case of local law changes. However, there is nothing stopping a sovereign nation from taxing interest payments or the return of principal to investors. Unlike hard restructuring/default where there is a breach of contract and thus investors’ case can be admitted in a foreign court (eg. Argentina), taxation is a sovereign right and it is therefore highly unlikely that foreign courts will admit such cases for hearing (unless they can argue that the tax is high enough to be viewed as confiscatory - a legal grey area). Investors holding foreign-law bonds should start reading bond documentation and figuring out their legal position. In the interim it might be a good idea to get some coffee to neutralise the last remnants of hopium from the body. 

Thursday, 14 March 2013

US Stocks: Buy or Sell?

As ‘all-time-high’ euphoria builds up, is it time to buy more or start reducing exposure?

Leave aside Ben Bernanke’s financial engineering for a moment and look at some fundamental indicators. P/E ratios look reasonable compared to share of profits in national income (Graph-1). Even though corporate profits have rebounded from the crash and are near all time highs, P/E ratios haven’t followed suit. As Graph-2 shows and one would expect, the relationship between change in corporate profit and S&P500 return is fairly close.

Graph-1: P/E and Profits
Source: Bureau of Economic Analysis, www.multpl.com

Graph-2: S&P500 Return and Change in Profits
Source: Bureau of Economic Analysis

Perhaps the fear engendered by the recent crash is keeping price rises in check relative to earnings (similar to the 2003-07 period). This seems to suggest that stocks have further to go as fear dissipates and multiples expand.

However, before clicking the buy button have a look at Graphs 3 & 4 which show the share of various factors in US national income.

Graph-3: Labour vs Capital
Source: Bureau of Economic Analysis

Graph-4: Entrepreneur, Rentier and Net Taxes
Source: Bureau of Economic Analysis

Share of corporate profits is near its 60-year high in stark contrast to every other income class. This is unlikely to be sustained given the inherent cyclicality of capitalism. Even then, a falling share is not negative for equities per-se since corporate earnings can still expand albeit more slowly than other income classes. Therefore as long as national income is growing equity valuations may still be supported.

Unfortunately this is where it gets iffy. Growth is dependent on income in the current period and additional debt incurred. Repayment of debt reduces demand for goods and services and tends to act as a drag on growth. The good news is that personal savings rate has dipped back to 2.4% from a high of 8.3% in May 2008. The bad news is that the crisis had very little affect on the mountain of debt outstanding (Graph-5) which makes a debt-fuelled recovery unlikely. Household and corporate debt has gone off its exponentially rising path but the government has stepped in to take up the slack. This explains the recovery and bounce in corporate profits (consistent with Minsky's theory).

Graph-5: Non-financial Debt
Source: FRED

Unless there is a productivity surge, a higher growth trajectory demands a continuing exponential rise in debt. This would soon become untenable given the current debt burden even for the US government despite ‘reserve currency’ and ‘safe haven’ status. However, at what point will the debt barrier be hit is hard to predict. QEasy policy has made the overall debt burden more sustainable and encouraged debt growth not to mention the beneficial effect on equities. Moreover, regulation and the European Economic Disaster Area have ensured investors keep the faith. As a result equity markets are going up more because of peripheral issues than core economic factors. Profits may be near all time highs but the current situation is not stable. In this situation traders can ‘buy and pray’ and investors can wisely stay away.

Tuesday, 12 March 2013

Smelling salts not steroids needed Mr. Chancellor

As the Chancellor looks to experimentally test whether Einstein's definition of insanity holds up, the consequences of easy money policy are fairly clear (graph below). The main beneficiary from debauching the currency seems to be the London housing market. Maybe its time for King and company to abandon their neoclassical dogma? (Given Rt. Hon. George Osborne's lack of Economics education he can take refuge in the excuse that he is being extremely ill advised)
Source: Office of National Statistics, Landregistry.gov.uk, Oanda.com

Monday, 4 March 2013

Currency Wars: Who Occupies Higher Ground

As central bankers vow to do whatever it takes and politicians fret about their currency’s strength, I chanced upon a study done by the World Bank on import price elasticities [See footnote for explanation on price elasticity].

Although the authors were looking at trade restrictiveness and consequent welfare losses, their estimates for import elasticities are useful to consider in the context of currency wars. The object in these wars is to induce a depreciation in ones currency against ones main trading partners. This is assumed to lead to lower imports and higher exports, thus achieving a cherished mercantilist goal. Whether such mercantilism is justified is debatable but since ours is not to question why, we should content ourselves in gauging the lay of the land to figure out which armies are advantageously positioned and which are marching towards disaster.

A higher import price elasticity (i.e. a more negative number) implies that a country can reduce its imports more than in proportion to the depreciation it effects in its currency. In addition, if its main exports have high elasticities then it can also increase its exports more than in proportion. The table below gives trade weighted import price elasticities of some countries and the weighted average elasticities of their main export partners. The score is the square of the two elasticities. A higher score indicates a bigger impact of currency depreciation.

Import elasticity
Weighted avg. elasticity of main export partners

Currency change since 1-Jan-12 against main export partners (wt. avg.)
Source: Based on the import price elasticities given in Kee, Hiau Looi, Alessandro Nicita, Marcelo Olarreaga, “Import Demand Elasticities and Trade Distortions”, Review of Economic and Statistics, 2008 Vol. 90 No. 4, p666-682

The same can be seen in the graph below. The more to the left a country is, the more its imports reduce in response to currency depreciation. Therefore, a net importer like the US can benefit from currency depreciation even if its exports are not very elastic. Similarly, the lower down a country is, the more its exports increase in response to currency depreciation. This benefits net exporters in supercharging their trade surpluses. Those in the middle reap gains from both these effects.

Source: Based on the import price elasticities given in Kee, Hiau Looi, Alessandro Nicita, Marcelo Olarreaga, “Import Demand Elasticities and Trade Distortions”, Review of Economic and Statistics, 2008 Vol. 90 No. 4, p666-682

Looking at data, it is clear that the armies of Abe and Kuroda occupy the high ground which will be to their advantage as their 20% Yen depreciation hits opponents. The Fed is building a fort on USA's elevated territory by pursuing a strategy of import substitution given USA's relatively high import elasticity. Within the Eurozone, the bickering among generals becomes clearer. Since French exports would benefit more if the Euro weakens, France is complaining about an overvalued Euro while Germany is content. It is ironic that Draghi’s bazooka squad has safeguarded German positions more than the exposed periphery. Finally, the futile attempts of British central bank generals to kickstart an export-led recovery are laid bare. The UK has no advantage in pressing on the fight and should re-examine its strategy.

Mercenaries trying to discern which side has the best chance of winning should stick with Abe-Kuroda (although the recent advance has seemingly left their lines overstretched and ripe for retreat). Fortune hunters more eager for the spoils of war than honour can also join the Euro camp and seek to exploit the implosion of its armies.

Caveat: Since an enormous number of assumptions go into calculating elasticities and elasticities are not constant, the numbers above are illustrative only. Moreover export elasticities calculated above do not take into account the differences in product mix (this is not a problem with the import elasticities since they are for the whole country and not just for a few main trading partners). A better method would have been to look at each product’s elasticity and then aggregate based on actual trade data. However this is a blog not an academic journal and as investors we’re only looking for rough ideas to guide us through the smokescreen.

Price elasticity measures the responsiveness of demand for a good to a change in its price. Mathematically: Elasticity (e) = (dQ/Q) / (dP/P). It is expressed as a negative number based on the assumption of a downward sloping demand curve, i.e. an increase in price leads to a reduction in quantity demanded and vice versa. If quantity demanded changes more than in proportion to the change in price then the good is said to have elastic demand (dQ/Q > dP/P), otherwise it is said to have inelastic demand (dQ/Q < dP/P). Unit elastic demand is when quantity demanded changes by the same amount (dQ/Q = dP/P). In case of elastic demand a reduction in price causes total revenue (price x quantity) to increase. It is the opposite for inelastic demand.