Bridgewater Associates: The British Question - January 2009

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 01/26/2009 Bridgewater® Daily Observations January 26, 2009 © 2009 Bridgewater Associates, Inc. (203) 226-3030 Greg Jensen Noah Yechiely The British Question: The pound collapse and the very recent rise in gilt yields raise some important and challenging questions, the answers to which will have repercussions globally. On the one hand, the best case view of the UK is essentially that the UK today mirrors the UK of 1931. Back then, it was the most aggressive major developed country in dealing with the deflationary pressures of the depression. It was the first to delink from gold to create liquidity and reflation. Its depression was significantly shorter in duration and magnitude than most of the other countries in the developed world. Today, the UK enjoys arguably the most reflationary stimulus in the developed world. The collapse of the pound along with the collapse of interest rates and the activist government fiscal and monetary measures put it on the cutting edge of dealing with the global financial crisis. On the other hand, nowhere in the major developed world are the problems more complex and potentially out of the government’s control as the UK. Virtually all of the ills hitting the US today are similar in the UK (massive debt build up, real estate bubble, income and employment collapse). But, on top of that, the UK shoulders an incredible share of the global banking crisis. Roughly speaking, the US and UK banking systems are about the same size in dollar terms, but the economy and government’s ability to absorb the losses are of radically different sizes. Our extremely rough estimates of aggregate banking system losses in the US are $1.8 trln compared with about $1.9 trln in UK banks. These losses are proving extremely hard to bear in the US, and if they are close to right (i.e. unless there is a rapid recovery we expect they will prove close to right) they would appear near impossible for the UK to bear. If these types of losses come to pass, the possibility needs to be considered that the UK, due to pressure on both the currency and gilt markets, will begin to back away from some of its guarantees of the major global institutions in its midst. This would likely create further global financial chaos as other governments would have to step in to fill the void in some manner because the British banks are likely too big to fail globally, but also too big to save domestically. It is unlikely this can be handled gracefully. The Fed has already taken on large exposures to these banks by opening their facilities to domestic arms of international banks. The following tables show the losses in the commercial banking sector for UK and US based banks. Covering the estimated losses in the UK would be roughly 70% of UK GDP and more than 170% of the current government debt. These numbers are astounding and dwarf the problems the US faces. Total Assets 10,533 Estimated Loss as % of Assets -15% Estimated Loss in US$ blns -1,530 UK GDP 2,229 UK Public Debt 892 Bank Assets / GDP 473% Estimated Bank Losses, as % of GDP -69% Estimated Bank Losses, as % of Public Debt -172% UK Commercial Banks and Building Societies
  • 2. 2 Bridgewater ® Daily Observations 01/26/2009 Total Assets 10,749 Estimated Loss as % of Assets -15% Estimated Loss in US$ blns -1,562 US GDP 14,413 US Public Debt 5,765 Bank Assets / GDP 75% Estimated Bank Losses, as % of GDP -11% Estimated Bank Losses, as % of Public Debt -27% US Commercial Banks Furthermore, while the US banking problem can be resolved in part by printing dollars, the UK’s losses are global and, more often than not, are in currencies other than sterling. The following chart highlights the massive growth of foreign currency denominated assets and liabilities on the balance sheets of British banks. This activity has tripled since 2000. 50% 100% 150% 200% 250% 300% 350% 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% UK Banks Liabilities in Foreign Currencies as % of NGDP UK Banks Assets in Foreign Currencies as % of NGDP UK Banks Liabilities in Foreign Currencies (Netting out Interbank Positions) US$ Blns In terms of balance sheet, 3 of the top 5 banks in the world are UK domiciled. Formerly viewed as a blessing, this is now a financial disaster of unprecedented magnitude. 10 Biggest Banks in the World Name Country Assets ($bn) 1 Royal Bank of Scotland United Kingdom 3,879 2 Deutsche Bank Germany 2,898 3 BNP Paribas France 2,860 4 Barclays United Kingdom 2,719 5 HSBC United Kingdom 2,547 6 Credit Agricole France 2,305 7 JP Morgan Chase US 2,175 8 Citigroup US 1,945 9 Misubishi UFJ Japan 1,827 10 Bank of America US 1,818
  • 3. 3 Bridgewater ® Daily Observations 01/26/2009 The following table highlights the aggressive actions by the British government so far. The government has guaranteed far more than it has spent, and much more appears to be coming as the losses on those guarantees roll in. Intervention Date Announced Assets (if acquired institution) Deposits (if acquired institution) Size of Government Commitment Northern Rock 22-Sep-07 £113.5bn £24bn £25bn (initially a loan, then takeover) Additional Long-Term Repo Operations Dec-07 Unlimited/ Undefined Special Liquidity Scheme 21-Apr-08 at least £200bn HBOS Sep-08 £681bn £305bn £11.5bn Bradford & Bingley 29-Sep-08 £52bn £21bn Lloyds Oct-08 £5.5bn Unlimited Dollar Liquidity 13-Oct-08 Unlimited/ Undefined RBS Oct-08 £1949bn £889bn £20bn Discount Window Facility 20-Oct-08 Unlimited/ Undefined Stimulus Package Nov-08 £20bn Loan Guarantee Expanded on Dec 15, 2008 £250bn Asset Protection Scheme Jan-08 Undefined High-Quality Assset Purchase Program 19-Jan-08 £50bn Bank Recapitalization Funds Still Available (from £50bn pool) Currently £13bn Total Defined Government Interventions Outstanding £570bn With RBS nationalized, and Barclays and Lloyds knocking on the door, the equity value of the major UK banks has evaporated.
  • 4. 4 Bridgewater ® Daily Observations 01/26/2009 Equity Prices (1/1/2007=100) -20 0 20 40 60 80 100 120 140 160 1/1/07 4/1/07 7/1/07 10/1/07 1/1/08 4/1/08 7/1/08 10/1/08 1/1/09 RBS Barclays HSBC Lloyds Standard Chartered The risk of default, however, is priced to be very modest (around 150 bps annualized for the near nationalized entities) because the assumption that nationalization will prevent bankruptcy is widely held. The implied risk that the government steps away from its commitments in the UK is roughly analogous to the risk of that happening in the US. We think it is more likely in the UK due to the relative magnitude of the problems. 5yr CDS Spreads (bp) -50 0 50 100 150 200 250 300 350 1/2/07 4/2/07 7/2/07 10/2/07 1/2/08 4/2/08 7/2/08 10/2/08 1/2/09 RBS Barclays HSBC Lloyds Standard Chartered The pound has been in free fall, and is getting close to its lows in the mid 70’s. From a going forward income perspective this is reflationary, simulative, and necessary, but the collapse in the pound increases the burden of the portion of the banking problem which is international. -40% -30% -20% -10% 0% 10% 20% 30% 1/1/70 1/1/74 1/1/78 1/1/82 1/1/86 1/1/90 1/1/94 1/1/98 1/1/02 1/1/06 1/1/10 GBR Trade-Weighted Real FX
  • 5. 5 Bridgewater ® Daily Observations 01/26/2009 When we add it all up, we are concerned that the UK banking problem will be too big to save by the British government and that the markets and the government authorities have still not fully added up the picture. Other Industrialized Countries Short Rate Pricing Target rates in the majority of the developed world are now close to their possible bottom of 0%. The current market expectations priced in the OIS curve suggest the easing cycle to end in the first quarter and modest tightening, with the exception of Australia, should start as soon as the third quarter of 2009. To some extent this pricing reflects risk premiums and the asymmetry of the bet (rates can’t fall below zero, so even if expectations were flat rates the curve would be slightly upward sloping). However, we don’t expect the easing to date and other government actions to be enough to reverse the credit cycle and produce normal growth or offset the deflationary forces. Central banks that still have room to ease, such as the ECB and the RBA are likely to continue to ease, and we expect the others to not tighten as is priced in but instead keep rates close to zero. The difference between the LIBOR and the OIS curve points to continued improvement in the inter-bank lending spread. This is a positive development, but given that banks in many countries can now issue government guaranteed debt or at least have a significant amount of support, the fact that spreads aren’t even lower is a sign of the strains in the financial system. While being long short-term bank deposit rates has the risk of widening spreads , we believe a further narrowing is more likely (even if credit conditions don’t improve). Below we show the current pricing for central bank rates. The first chart shows the current target rate and the priced-in bottom. 0.25% 1.08% 0.10% 0.62% 0.64% 2.18% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% USA EUR JPN GBR AUS CAN Current Target Rates Target Bottom The next chart shows the change in policy through the end of 2009 using the OIS curve. The US curve suggests gradual tightening probably starting in the first quarter of 2009. Most other developed countries are priced in to start to tightening in the third quarter, with little to no easing over the next nine months. Australia is the only country priced to ease meaningfully, from a higher level though.
  • 6. 6 Bridgewater ® Daily Observations 01/26/2009 Expected Change in Central Bank Target Rate From Current Target -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4% 0.6% 0.8% Current Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 US EUR JPN GBR AUS CAN The next chart shows the curve in level terms. Europe and Australia still have room to ease and we believe the odds of further easing in the countries which still have room to do so are higher than tightening. Expected Monetary Policy 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% Current Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 USA EUR JPN GBR AUS CAN One of the primary goals of the global aggressive easing was to lower inter-bank lending and revive private lending. The LIBOR spread, calculated form the spread between the LIBOR and OIS rates, has been trending down. The next chart shows further priced-in improvement in the spreads. The goal of lowering LIBOR spread has been achieved primarily through government guarantees of bank debt, but the ultimate goal of reviving credit growth has not yet been achieved because borrowers are delevering rather than seeking new loans and banks are focused on improving balance sheet and not new loans.
  • 7. 7 Bridgewater ® Daily Observations 01/26/2009 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 USD LIBOR Spread EUR LIBOR Spread LIBOR Spread Expected USD LIBOR Spread Expected EUR LIBOR Spread Meanwhile conditions call for significantly more easing. Of course, this is not really possible through conventional means, but it does indicate how remote the possibility of tightening is in the near future. Our reading of current developed word growth is roughly -4% with no signs of immediate expansion. -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Develped World Real Grow th Core inflation is either flat (Europe) or falling (US and the UK) with more excess capacity building up globally with falling growth. The current de-leveraging process is extremely deflationary, and while governments (particularly the US) are trying to offset these pressures, for now we believe the net pressure remains very deflationary.
  • 8. 8 Bridgewater ® Daily Observations 01/26/2009 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 World Core Inflation [Annualized 3m Change] The synchronized global growth that pushed commodity prices since 2003 has since turned into a precipitous global decline causing commodity prices to turn sharply lower. As a result, headline inflation collapsed and shows levels of about 0.5% yoy through the third quarter (extrapolated with constant commodity prices and flat core inflation). 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Developed World Headline Inflation Projected Headline Inflation Growth, inflation and credit growth conditions call for significant further easing. This should mean that the countries that still can will do so and move rates towards zero, while tightening (as is priced in) is extremely remote everywhere. So despite the low levels of central bank rates we remain bullish.
  • 9. 9 Bridgewater ® Daily Observations 01/26/2009 Conclusions Credit Markets N. America US US Canadian Bonds Euro$ Short rates Strongly Strongly Strongly Bullish Bullish Bullish Europe UK Euroland UK Euroland Gilts Bonds Euro£ Short rates Strongly Strongly Strongly Strongly Bullish Bullish Bullish Bullish Asia Japanese Australian Japanese Australian Bonds Bonds Euro¥ Bank Bills Strongly Moderately Strongly Strongly Bullish Bearish Bullish Bullish Currency Markets CAD v USD EUR v USD GBP v USD JPY v USD AUD v USD Strongly Neutral Neutral Neutral Bullish Neutral Equity Markets US Japanese German UK French Canadian Australian Equities Equities Equities Equities Equities Equities Equities Neutral Neutral Neutral Neutral Neutral Neutral Neutral Note: Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it does not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.