Global Market Insights | A Fisher Investments Blog

Gilt Watch

10-year gilt yields closed Thursday at 1.86%—25 basis points lower than their close on downgrade day (February 22).

So much for higher debt risk in a post-downgrade UK.

(Source: Bloomberg, UK Govt Bonds 10 Year Note Generic Bid Yield as of 3/21/2013)

 

The UK Downgrade in Three Charts

Nearly two weeks after Moody’s downgraded the UK’s credit rating, markets still seem to be taking the news in stride: The FTSE All-Share Index is up, and 10-year gilt yields were back below 2% on Tuesday (per Bloomberg).

Why don’t markets much care about the downgrade?

Well, for one, Moody’s and the other ratings agencies (Fitch and Standard & Poor’s) don’t have a great track record for accurate, forward-looking forecasts of credit risk. Instead, their opinions often seem based on backward-looking information or political, rather than economic, factors. For example, S&P downgraded the US due to heated political debate over the US’s arbitrary debt limit—which has no bearing on the US’s solvency.

True to form, Moody’s decision cited the UK’s likely delay in reaching some deficit targets—it’s self-imposed, politically driven, economically arbitrary deficit targets. But a one-year delay in reaching austerity targets doesn’t really alter the UK’s credit risk—the deficit’s still expected to fall over the next few years. Credit markets care more about overall progress than whether the deficit is 1.2% of GDP in 2017 (as projected in 2011) or 2.6% (latest projection). Granted, the delay’s not ideal—an extra year of deficit reduction won’t be easy on those people impacted by tax hikes, public sector job cuts and real (i.e., inflation-adjusted) cuts to pension benefits, but this is ancillary from the UK’s credit risk. Markets understand this.

Markets also understand the UK is, in fact, one of the most stable, solvent nations on the planet, and its default risk is exceedingly low. We can see this in three charts.

First, Exhibit 1 shows net public debt (total debt excluding intra-governmental holdings, which effectively cancel) as a percentage of GDP.

 

Exhibit 1: Net Public Debt as a Percentage of GDP, 1692 – 2012 (Estimated)

 

Source: HM Treasury, as of 02/21/2013. Includes official 2012 estimate. All others are actual outturn.

 

Though net debt has increased relative to the size of the economy in recent years, it still remains well under points seen during much of the past three centuries.

And this debt is plenty affordable. Exhibit 2 shows UK interest costs as a percentage of GDP.

 

Exhibit 2: Debt Interest Costs as a Percentage of GDP, 1946 – 2012

 

Source: Office for National Statistics, as of 02/27/2013.

The ratio has increased since 2008, but it remains near 20^th-century cyclical lows. In fact, interest payments were much higher during the 1990s, which featured robust economic gains.

Interest costs as a percentage of tax revenue, shown in Exhibit 5, tell a similar story.

 

Exhibit 5: Debt Interest Costs as a Percentage of Tax Revenue, 1946 – 2012

Source: Office for National Statistics, as of 02/27/2013.

Here, too, UK debt appears very affordable by historical standards. And, as even Moody’s admitted, debt service can likely withstand even higher yields. According to Treasury forecasts, if 10-year gilt yields were to rise to 5% and stay there for years—a seemingly unlikely scenario given the UK’s fiscal strength and cumulative deficit reduction progress—the ratio of interest costs to expected tax revenue would rise just north of 10% of GDP over the next three years. That’s still plenty manageable.

Simply put, with very affordable debt and some of the world’s deepest, most liquid and most stable credit markets, the UK doesn’t appear to have heightened credit risk.

For All Would-Be Gold Buyers

The following sentence leads off a recent Bloomberg story on gold prices:

“Gold futures slumped below $1,600 an ounce for the first time since August as signals on the US economy spurred optimism, eroding demand for the precious metal as a store of value.”

Public service announcement: If something can “slump,” it is not a “store of value.”

That’s true of gold. Because of its historical role as a currency backer, many investors see gold as an inflation hedge or stable investment when stocks are falling. In reality though, it’s neither—it’s just a commodity, and like all commodities, it’s volatile. It doesn’t always rise or hold value when inflation’s high, and there’s no historical correlation between gold and equity price movement—sometimes they rise at the same time, sometimes they fall at the same time, sometimes they move in opposite directions.

So if you’re thinking about gold, don’t be fooled by those common tropes. 

Grassroots Greek Capitalism

While Greece ’s government muddles through austerity and slow-going market reforms, some Greek citizens have taken it upon themselves to revolutionize their economy from the ground up. They’re starting businesses, organizing new markets and local trading systems, and filling the void left by public services cuts. Jon Henley at The Guardian gives an in-depth look:

Greece’s Cut-Price Potato Movement Shows Greeks Chipping in

In short, it’s capitalism at its finest: Free of a heavy regulatory hand, these innovative folks have found ways to literally cut out middle men and other commercial burdens—and the result is lower prices, more efficient allocation of resources, and easier access to goods and services. Makes one wonder what Greece could be if its government put the same effort into liberalizing the economy from the top down. 

 

Merlin’s Magic

The Bank of England announced the results of Project Merlin on Monday. As you may recall, this was PM Cameron and Chancellor Osborne’s scheme, introduced in 2010, to increase lending (particularly to small businesses) after corporate lending took a hit in and after the 2008 credit crisis.

Project Merlin had a healthy, sensible goal—help businesses finance expansion and hiring, theoretically boosting GDP growth and employment over time. The government sought to accomplish this through lending targets. The UK’s largest banks signed a pledge to lend £190 billion in 2011, with £76 billion going to small businesses. The results? Banks exceeded the total lending quota by nearly £25 billion but fell short of the small-to-medium business goal by £1.1 billion.

Some are saying the small-business lending shortfall rendered Project Merlin an abject failure, but we’re inclined to disagree—it’s a very small miss, and the overall lending increase is a much bigger positive. Lending more to larger outfits might not have been the goal, but despite governments’ best intentions and efforts to foster certain economic activity, sometimes markets still behave otherwise.

Why’d that happen in this case? Remember, there are two sides to every loan: lender and borrower. Banks made credit available—there was sufficient supply. Small-business demand is what fell a bit short. Neither banks nor the government can force firms to take out loans; they’ll borrow if it makes sense in light of interest rates and borrowing terms. Otherwise, they’ll probably delay financing or find alternative means. And that’s likely what was at work over the last year: A few less small firms than hoped found conditions favorable, while more large companies found the lending terms perfectly palatable. Sometimes, that’s just how capitalism works.

 

Gaining Notice

Hat-tip to Hamish McRae at The Independent for his excellent piece on underappreciated positives in the UK :

You’d Better Sit Down—Stock Markets Are Doing Rather Well

As he points out, January’s improving manufacturing numbers and narrower deficit suggest Britain ’s economic and fiscal situations are firming up a bit. January’s robust service sector expansion, reported Friday, seems like further evidence of this—services, after all, comprise about two-thirds of the British economy. Granted, one month’s data don’t mean a long-term trend is unfolding, but a strong January is encouraging after Q4 2011’s small GDP contraction.

And, just as important for global equity investors, he mentions some sensible reasons to be optimistic about shares—like strong economic growth in Emerging Markets and the US , which we also think are two factors likely to help equities’ recent momentum continue. And the momentum is even stronger than the article suggests. Not only did global markets rise more than 5% in January, but the MSCI World index is up over 17% since the recent correctional low on October 4, 2011 ( in US dollars, as of market close last week). That fact might make even more people need to sit down!

India’s Retail Fakeout

Poor India has had a terrible time attracting foreign investment in recent years. Of the four BRIC nations ( Brazil , Russia , India and China ), it’s the only one whose foreign capital inflows fell in 2010, and the drop-off has continued this year.

Domestic economic reforms could change this, making India a more attractive destination for foreign capital. Prime Minister Manmohan Singh tried to move in this direction in late November, when he announced his cabinet’s decision to open India ’s borders to foreign retailers. Under the proposed new rules, foreign-owned hypermarkets, grocery stores and single-brand retailers would be allowed to open in India , provided participating firms invested at least $100 million, with at least $50 million going to infrastructure, transport and storage.

This could have carried huge benefits for Indian society over time. India has long struggled with high malnourishment due to its aging food storage and transportation infrastructure. Its agricultural sector is vast, but much of the harvest rots before it can reach households, causing supply shortages and higher prices. The government believes the influx of foreign investment could spur massive upgrades in agricultural productivity and efficiency, eventually putting cheaper food on people’s plates.

Unfortunately, this proved too tough a sell for the Indian public. Small business owners staged a national protest last week, and the opposition parties have forced Parliament to adjourn since the Prime Minister’s announcement (the new rules required only cabinet, not parliamentary approval). Why was it so unpopular? Small shops are the lifeblood of Indian retail, comprising around 90% of the $450 to $500 billion sector. It’s estimated there’s one shop for every 10 people. Naturally, these merchants fear they’ll be chased out of business by giant foreign superstores, and opposition lawmakers are rallying to their defense.

The government held its ground for over a week, but it has now bowed to political pressure, as a government official said the plans were on hold—no doubt a disappointment to the retailers that already lined up to enter. Whether the about-face is temporary or permanent is uncertain—the government understands the benefits of these reforms and wants to move forward, but if the political costs are too high, the changes may get stuck in limbo. Pushing the reforms through would likely use most or all of the government’s political capital, but backing off permanently could erode confidence in the cabinet’s ability to govern. We’ll be watching to see how this plays out.  

Stop Me if You Think You’ve Heard This One Before*

Hamish McRae at the Independent has a sound take on the recent slew of seemingly negative news about Britain ’s economy: “The best way to make sense of this constant barrage of information, most of it negative, is to keep asking what is actually new and what is a rehash of stuff we already know.”

This is always a sensible approach. By the time information is widely known, markets have typically already reacted to it. Even when old information is spun in different ways, it usually doesn’t have much power to move equities meaningfully, in either direction. Markets have already moved past it and are pricing in new information and the probabilities of different events happening. It’s a lot like driving a car: Looking only in the rear view mirror doesn’t tell you what’s on the road ahead of you.

To borrow one of Mr. McRae’s examples, consider last week’s news that Moody’s downgraded the credit ratings of 12 British banks. The downgrade, of course, was a new event. However, it was long expected and—importantly—based on things we already knew about these institutions. If smaller banks come under stress, the government will probably let them fail, while larger banks, with deeper ties to the British and global financial systems, will more likely receive some government support in order to lower the risk of their troubles spilling over. The government has been heading in this direction for a while, as demonstrated by the Independent Commission on Banking’s recent proposals for financial sector reforms. Moody’s simply took this old news and gave it new clothes, in the form of a rating downgrade. And to perhaps confirm the downgrades don’t really change anything, Moody’s vouched for the UK banking system’s overall health: “The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”

Another recently repackaged item is the UK ’s second quarter 2011 economic growth. Last week, the Office for National Statistics announced the economy grew only 0.1% from April through June, less than originally estimated. Though flattish growth isn’t great news, it’s important to put it in context: the number is now more than three months old. As highlighted in our last post, some key economic indicators suggest growth picked up in the third quarter. Mr. McRae adds, “our service industries are still expecting growth and, what is more, are still profitable.” Looking at only the second quarter’s reading doesn’t really tell us what’s happened in the three-plus months since—and, much less, what will happen from here.

It wouldn’t be surprising for negative economic news to continue. But taking a minute to distinguish well-known stories from those with new information can give us all a healthier perspective, and a better sense of how the economy is truly progressing.

*The Smiths, 1987

 

Suggested Reading

Last Friday’s Financial Times has a good, informative piece on Chancellor Osborne’s efforts to oppose two EU financial proposals. Recommended reading, regardless of one’s views on Britain’s EU membership.

UK Faces Defeat Over Derivatives Clearing

Alex Barker, Jeremy Grant and George Parker, The Financial Times

A recent article on Fisher Investments MarketMinder, “Trifling With Transaction Taxes,” also discusses the EU financial transaction tax proposal in detail. 

 

Euro Rich, Cash Poor

Last week, five central banks joined to announce a plan to grant European banks easier access to US dollars. At least in the near term, this should help relieve some of the pressure on European banks, which have found it increasingly hard to borrow dollars over the past year.

European banks still have plenty of capital (as Fisher Investments explained recently in this article on The Street), but much of it is in euros and other assets. Since a good deal of international business is conducted in dollars, European banks need an ample supply of dollars for lending and other normal operations. Historically, they have borrowed significant amounts of these dollars from U.S. domiciled money-market funds, using euros as collateral.  However, as US lenders have grown increasingly concerned in recent months about the eurozone periphery’s ongoing debt problems, they’ve been less willing to accept euros as collateral.  This in turn has driven up interest rates for dollar loans collateralized by euros, making these loans more expensive for European banks.

These dollar funding difficulties have caused some to speculate about the potential for an oncoming self-fulfilling prophesy: If a bank can’t access funding, it may be perceived as too risky to lend to, and it may not receive the capital it needs to continue doing business, which could cause a liquidity shortage. If this happened many times in a short period, Europe could find itself in a banking crisis.

No one wants this, and the central banks believe they have a solution. In a coordinated action, the US Federal Reserve and European Central Bank, along with the central banks of Britain, Switzerland and Japan, will provide unlimited dollar liquidity for any bank that asks for it. The central banks will swap dollars for other eligible collateral, with terms of approximately three months, at a low fixed rate. This will happen three times, on October 12, November 9 and December 7.

Though this move won’t solve Europe’s peripheral debt problems, it should help ease lending risk in the near term, which is a positive development. Additionally, it demonstrates financial leaders’ resolve to help global capital markets function as smoothly as possible while European leaders continue working on a solution, which could boost the market’s confidence.