Income & Fixed Interest commentary May 2012May saw a continuation of the bond rally that started in Chart 1: US 10-year treasury yieldmid-March as the European crisis lurched further towardsthe abyss. In the main developed markets bond priceshave moved steadily higher over the last few months (ourfavoured markets of Germany and Australia were thestrongest performers this month) while peripheral bondssuffered.The moves in March saw yields hit new all-time lowswithin a number of markets and yet we remain prettymuch max long in bonds here and are convinced yieldshave much further to fall. In terms of performance, wehad another strong month in May with all fundssignificantly ahead of monthly targets. In fact, it was thestrongest month since inception for our Pure Alpha FixedIncome Fund, a very pleasing result given the event risk Source: Bloombergdominating markets right now. Our internal trackingnumbers indicate our Australian peer-group has had a It’s always mentally tough in environments like these torough couple of months, and now show us mid Q2 year- manage bond portfolios; to run bullish positions, as weto-date and back at the top of the rankings on a rolling have done, means you are bearish on the globalone-year basis. economy and will profit as the world suffers. A friend ofAt the risk of labouring the point we cant understand mine said to me last week that outperforming in theseportfolio managers who run massive short duration conditions is like winning on the card tables on the Titanicpositions relative to benchmark saying they are trying to – you are happy to be making cash but its obvious thatpreserve capital. In our view if you invest in a bond fund everything is sinking around you. In that regard I havewith an underlying benchmark (other than cash) you are always tried to be as pragmatic as possible: I try to controlasking your manager explicitly to manage to and the things I can and let go of the stuff over which I havehopefully outperform that benchmark as you want that no influence. In terms of the long-run outlook, I am slowlynegative correlation to equities the underlying beta turning Austrian. The more I look at the current worldprovides you. If you wanted capital preservation you situation, the more concerned I am about the growingwould put your money in an absolute return fund, leave it instability of the financial system and the reliance onin the bank or even under your mattress. What that money-printing to drive even modest growth. The deathmeans is that we are singularly focused on generating of the fiat-money system is something I once thoughtoutperformance against our mandated benchmarks, and laughable but, in my humble opinion, as we continue tohopefully the performance numbers we are generating stagger through this crisis it is gaining morewill help to offset some of the losses on the other side of credence. No doubt you dont want to hear that. Youthe ledger. want me to be upbeat and tell you equities are going to the moon and bonds have to sell-off, but unfortunately I. can’t help you there. www.btim.com.au
I was on the road visiting all the main centres with Crispin curve” and urging us to sell bonds or enter into curveover the last couple of weeks on the BTIM Adviser Forum, flatteners (in this market – lazy shorts). This has been thewhich was themed ‘Equities & Bonds - Dangerous same story for the past year, and despite every protestLiaisons’ (view our presentations). The key take-away for we heard about Australian bonds being expensive, theyme was how much everyone hated my asset class. Most keep on getting more expensive, just as we have beenof the comments I received were something along the predicting. Part of this attitude was a lazy home bias inlines of “bond yields are so low that they have to rise and terms of economic forecasting, another part was ayou are stupid not to see it” – I am paraphrasing here but favourable historical economic view on Australia givennot by much. For me the key point is that its very easy to that it had avoided a technical recession during the worstsay something is expensive, but to expect it to cheapen of the crisis and, finally and probably most importantly, awithout offering any reason apart from its ‘obvious strong belief in the continued growth of China and theexpensiveness’ isn’t really an argument that I will use mining capex story.when deciding my investment positioning. I was alwaystaught that an asset is never too expensive to buy nor too This fundamental view can be partially excused becausecheap to sell, i.e. something has to happen to change the our own central bank pushed that line for a long period oftrajectory of the price. And that ‘something’ is nearly time, even after the European events and a grab for safe-always the medium-term supply-demand dynamic. Over haven assets affected the pricing of our interest ratethe short term extraneous factors certainly affect pricing curve, to the point where it became very clear that thingsbut the medium- to long-term driver of prices is always were worse than they thought. Two key things have nowsupply and demand. It is very clear to us that in bonds changed in this fundamental view. The global stock ofcurrently there is a massive supply-demand imbalance safe haven assets has reduced markedly because of theand that the pain trade is to much lower yields in the mass downgrading of sovereigns all around the world,medium term. Obviously in the long term (ten years out) primarily in Europe. The second was the initial crowdingwe agree that bonds offer little value, but in an out of the non-mining domestic economy due to a highenvironment like the current one, high-quality AAA Australian Dollar and slowing credit growth and then thegovernment bonds remain the safest of safe havens, gradual slowing of China and its effect on commoditywhich goes a long way in explaining why they are in such prices. We have remained long Australian bondshigh demand. throughout this entire period because of the expectation that imbalances in Europe would have an effect onTo be clear I am not trying to be bullish bonds because I Australia through the financial system and markets, andam contrarian by nature or trying to be different or even to that China would unsuccessfully make the transition to atry to make this Newsletter a more interesting read. I am more developed economy growth rate.bullish because it is what our process is tellingme. Regular readers will know that the nirvana for us in These are hardly viewpoints that point to the destructionterms of positioning is when our Core-Scorecard models of the world financial system even though we get brandedline up with both our qualitative views and the technical with having this attitude. Being long bonds at this point ininput. This is exactly the position we are in now but we time does not mean the world will end. As long as wealso have the added kicker of market positioning which is think the markets aren’t priced for the potentialskewed against us thereby making the technical backdrop ramifications of what we envisage happening, then we willeven more positive. In terms of our investment process it remain in this position. We haven’t expressed ouris rare for all four factors to line up so consistently and viewpoint on Europe or China in any depth in a fewwhen they do we have to take note and run with the months, opting instead to provide some thought on issuespositions: for if not then, when? that aren’t as well covered. May saw the threat of a near- term Greek exit and Chinese slowdown come to theThe key thing for you as clients though is the forefront and the story of these two economies is playingdiversification we offer. If we are wrong and bonds sell out in front of us, but there is further to go with simpleoff it is likely that equities are strong and therefore that economics being the undoing of both.your total portfolio will be performing well. If we are rightand equities come under stress in the coming few months Europe has again found itself at a crossroads. The Greekthen your bond allocation needs to perform to help offset election early this month was under-priced in terms of thethose losses. That doesn’t mean for one minute that we risk of triggering an early negotiation (I was going to saywill be blindly long in a rising yield environment as our re-negotiation, but there was no negotiation in the firsttechnical filters will take us out of our trades in short instance to speak of). New Democracy and PASOK (theorder. Ultimately you pay your money and you take your pro-bailout, pro-Eurozone parties) couldn’t muster achoice, for us the risk-reward screams in favour of long sufficient majority after the unexpected performance ofbond positions right now. their main competitor, SYRIZA (anti-bailout, pro- Eurozone). The anti-bailout, anti-Eurozone parties weren’tSo the pain trade is still for lower yields; It has been since significant enough to really challenge the more centreFebruary, probably even since August last year. May was aligned parties. After several failed attempts to form aa month punctuated by a surprising Greek election result coalition from either side, eventually it was decided aand poor Chinese economic data which resulted in a second election would be held on June 17. Polls up untilmassive 85bp rally in Australian 3-year bond yields. To the end of the month are split between the two outcomesput that number into perspective the average monthly and varying interpretations are just making the marketmove of the 3-year bond since the GFC began is less more volatile while not delivering any clarity. Again, thisthan 30bp. The move has been impressive, and our days event risk is another reason why you should be holdingdon’t pass without another sell-side analyst expressing bonds.how the RBA “would never cut rates as implied by the
The election has been declared a vote on Eurozone only is Europe as a whole giving MORE money to Greecemembership but we are not really sure this is the case. in addition to the bailout amounts, but it is actually givingWe are convinced that Greece will have to forfeit money directly to those Greek people who are smartEurozone membership at some point in the future, with enough to move their deposits. Why? If we assumethis election merely being a vote on whether that happens Greece is to leave the Eurozone and the Drachma isnow or later. For the record we think there is a 90% worth a fraction of the Euro (let’s say 50%, even though itchance of a Greek exit in the next six months. Due to the will likely be much less than this) then the smart puntersindecision of the Greek people and the Troika’s lack of are getting 1 real Euro for every Greek Euro, instead ofpatience with this, all cash disbursements under the only 0.5. When the Drachma comes back these peoplebailout agreement have been suspended with the will keep their existing wealth in Euros. But for everyexception of cash for interest payments paid into the winner, there is a loser – and the loser in this case is theagreed escrow account. Since all Greek debt is Eurosystem which gets to enjoy having all of its depositsessentially official debt post the PSI, the Troika are really turned into the Drachma, losing half of their value. Thejust paying themselves. What isn’t being paid though is smart Greek depositor is having money given to them forthe primary deficit, i.e. the Government’s budget deficit the pleasure of the EU having their fixed currency live on.excluding interest payments. This was forecasted to be a The ultimate FX trade.surplus for 2012 by Papademos and Merkel only eightmonths ago but the theme in Europe (most notably in There is a lot of talk that deposit guarantees may beSpain) that austerity plans rarely hit their intended targets introduced to try and stem the flow of deposits fromcontinues here. peripheral countries. Ignore this. Aside from the obvious question of who is actually going to pay for theseThe deficit has been reduced so far in the first quarter guarantees, they do not address the problem at handagainst 2011 but will likely finish the year somewhere which is not about the solvency of the banks in thebetween 1% and 2% of GDP, if Greece stays within the periphery (although this is clearly a problem) but thatEurozone. The problem now is that tax revenues have people are worried that their deposits are going to changefallen off a cliff while in the limbo of a caretaker from a Euro into a Drachma or a Peseta or an Escudo.government and encouraged by the possibility of paying No deposit guarantee will account for this, ensuring thetax liabilities in a few months in a currency that’s worth continual flow of Euros out of the periphery. There areonly a fraction of the Euro held now. This means the rumours of structured deposit guarantees that will evenfunding requirement skyrockets while uncertainty prevails, insure against a change in currency, but the chances ofand this has led the Greek Government to cancel the the Eurozone paying out insurance on deposits after aequivalent of the Pharmaceutical Benefits Scheme country has left the monetary union are almost non-(among other things) until bailout payments resume. Not existent, and depositors are realising this.being able to afford your necessary medication is a quickway to send your vote towards the anti-bailout parties,even if the economic considerations aren’t fully Chart 2: Target2 balancesunderstood by the electorate.In addition to funds provided under the terms of thebailout, Europe is offering another convenience to theGreek people in the form of a free put option of the valueof their savings in return for the ability to boot the candown the road another time. Since Greece is still in theEurozone, all banking assets and liabilities are stilldenominated in the Euro. As the probability of exit andthe return of the Drachma increases, more and morepeople will likely get worried and move their savingscross-border to a German bank, or perhaps to the nearestmattress. In any other sovereign failure (Argentina in2000 being a prime example) once this started Source: Barclayshappening, the banks would fail and the breaking of afixed currency peg (in this case the Euro) would have to It also seems that the number of smart people isbe brought forward and realised. increasing. The election has spurred deposit redemptions not seen since the crisis in Greece started. ForgetAs Bank of England Governor, Mervyn King, said election polls, or politicians rambling on. Unless Europerecently: “it may not be rational to start a bank run, but it wants to be funding not only the government but theis rational to participate in one.” The banking system is entire banking system of Greece indefinitely, somethingthe link between the likelihood of a country will have to give. European leaders will only want to keepdefaulting/breaking a peg increasing, and it actually kicking the can until an appropriate firewall has been sethappening. The TARGET2 (as it’s known) settlement up between themselves and Greece, but the problemsystem in the EU allows deposits to cross borders and here is that, as with the austerity targets, the longer theany deposits that leave, for example, a Greek bank and reality is forestalled other problems – like Spain and Italymake their way to a German bank are replaced with a – make the firewall job even more difficult. The Eurobonddeposit indirectly from the German central bank. This is (a bond issued jointly by all EU members to fund allgreat for banking stability because it means a bank countries within the EU) would be the ultimate time buyercannot experience a bank run because deposit amounts if the periphery was able to restructure to becomeare guaranteed. Wonderful! However all this means is not competitive again. Sadly the adjustments necessary are
immense, and the core is unwilling to attract more liability simple economic principles and bet against both the UKin such a transparent way that it is obvious to the staying inside the ERM and the politicians who tried toelectorate. This would help in the adjustment however – if keep the status quo. The same will likely happen here.the interest rate on this new Eurobond was the currentaverage of all the individual country yields, Italy would Chart 3: Current Account imbalance in Europesave 2.4% of GDP per year and Spain 1.7%. A biggerwinner would be Portugal, which would save 8.7% ofGDP on new debt issued. Obviously the core would paymore, but it would go a long way to fix the imbalances aswell as buy time.For the Spanish the threat of the return of the Peseta is inaddition to a banking system that, outside the big twobanks, is insolvent. The recent revelation of therecapitalisation requirement for Bankia (itself anamalgamation of 2 smaller failed banks) at €19 billionhighlights the difficulty of having exposure to a still fallinghousing market that is far from a base. The Spanishgovernment attempted to get the ECB to indirectly take Source: IMFthe risk on this recapitalisation, as well as through someclever transactions to recapitalise the bank. This was China was the other key theme for the month, and thedenied by the ECB, and the resistance by Germany and extraordinarily weak economic data super-chargedFinland late in the month to the previous plan of using the returns for Australian bonds. China is not too dissimilarESM to help Eurozone banks, highlights the ongoing lack from Europe in that persistent imbalances during theof interest in the core of taking the needed steps to share decade leading up to the GFC has culminated in athe debts of the periphery. With avenues for domestic situation where reversion to the balanced situation isbank recapitalisation closing, we expect a Spanish bailout impossible without collapsing the economy. China ranwill be a certainty in the near future. current account surpluses for all of this period by having two things – a low cost base for manufacturing, and aWe have written about the non-competitiveness of the policy to hold down the value of the Yuan to make sureperiphery versus the core on a number of occasions. This that its competitiveness against Europe and the USposition came about due to Germany joining with anovervalued exchange rate which forced them to become wasn’t eroded by a rising currency. Holding a currencyextremely competitive during the pre-crisis years and this peg means accumulating foreign currency reservesentrenched current account surpluses for Germany and through printing the domestic currency. This depressesdeficits for the mostly non-competitive periphery. Since domestic interest rates, causing all sorts of trouble when itrates were accommodative and as they were catering for comes to investment. As a result the Chinese GDP isthe low inflation environment in Germany rather than the nearly half investment. When economists talk ofstrongly growing periphery, debt was cheap and plentiful. “investment” they refer to the money spent on buildingA current account deficit isn’t a problem unless it can’t be factories, equipment, infrastructure and housing and thefunded, so the great debt accumulation continued. requirement for these things has been strong due to theTurning around a competitiveness problem in one year urbanisation of the Chinese workforce and strong exportthat has built up over the last ten, whilst also having a demand. A bubble always needs a strong underlying truthwhole lot of debt to repay, isn’t an easy task. It’s almost for it to perpetuate, and the urbanisation theme is aan impossible one for Greece, and the problem isn’t too strong one. There are many stories indicating thedifferent in Spain. imbalances caused by the currency policy have carried on well past the effect of urbanisation, and the housingSpain was another country that had run current account market is now approaching that tipping point. The housingdeficits for the years leading up to the crisis. In fact the industry in China is a primary driver of AustralianSpanish economy added 56% of GDP in debt in the years commodity demand and has large ramifications for us. Itof 2000-2008 from current account balance data supplied was also 13% of total GDP in 2011 (being approximatelyby the IMF. Most of this was through the banks, with thisdebt funding a huge jump in house prices and a a quarter of investment).construction boom. The unwinding of this excess isincredibly painful. Spain however is large enough to posea problem as the losses from an exit here would be toobig for the system to handle. Restructure of the domesticeconomy is the only solution. This will mean falling wagesand thus living standards for the Spanish people, with nodomestic currency to help take some of the load. In thissituation, if things don’t go right, Spain may not be able toleave, but the core may decide that they don’t want topay. Instead of the weak leaving and trying to get theircompetitiveness up, the strong would leave to try andbring their competitiveness down through an upwardcurrency valuation. George Soros realised how difficult itwas for the UK to maintain this peg because of these
Chart 4: China electricity output and GDP growth This picture highlights that the unravelling is beginning. We have started to see Required Reserve Ratio (RRR) cuts to help stimulate credit growth which has also stagnated. Rumours of another fiscal stimulus package pledging greater infrastructure spending is the last thing that is needed as it will increase the imbalances further. We are aware that it is likely to have a positive impact on risk assets in the short run and we will manage our exposures accordingly. The inflation picture, closely correlated but lagged to credit growth, has slowed sufficiently to allow directed fiscal stimulus. A change in the leadership scheduled for late this year would increase the probability of such stimulus, especially if the universally weak data seen in May is the new trend. This slowing in the housing market is occurringSource: Bloomberg simultaneously as China is moving towards running a current account deficit. Rising import prices coupled with slowing exports will result in capital eventually starting toChinese real estate investment is still growing at an flow out of the country, when the modern experience hasextraordinary rate. The latest figures are still above 20% been for current account surpluses and capital movinggrowth from the year prior, however this has slowed from into the country. While a movement to a more balancedgrowth rates above 35% as the economy emerged from trade environment is good for competitiveness the worldthe GFC with big fiscal stimulus. These growth rates are over, it would also mean China’s enviable $3.3 trillionphenomenal, and apart from slowing slightly, show a foreign currency reserve would start being depleted andstrong housing sector. When comparing against home squeezing monetary conditions domestically. This maysales however, the picture becomes slightly more grim. make China’s job to maintain the current growth rate evenChinese home sales are now contracting at a yearly rate more difficult. More importantly though, it means thatof sub 10% after plateauing at a 20% growth rate for most China will need to sell its stock of US treasury bonds,of 2010-2011. This has caused developers to rush to lifting US bond yields and de-railing the fragile recoverycomplete projects and get their properties out the door there. Will this mean more quantitative easing? If growthbefore others do, causing a massive spike in completions was affected we think yes but the bigger consideration forin the first quarter of 2012. This rush has caused pressure the US is if interest costs start climbing, then austerity –on house prices with 67 out of 70 cities now experiencing something they’ve been able to avoid – may come aroundflat or falling house prices. The inventory of unsold real more quickly than the market is pricing in.estate is increasing, with the pipeline now approaching 36months in duration. S&P has outlined that the property The run up in credit growth in most developed nations indevelopers it covers are becoming more financially the last 20 years before the crisis was a last dash, desperate grab for easy growth and wealth when all thestressed as high leverage ratios are starting to bite. As a traditional growth drivers (population growth andresult, land sales have collapsed by more than 50% in productivity) stopped occurring. The developed world hasApril from the previous year. The provinces rely on land now found itself in a situation where the immense wealthsales for most of their revenue, and this revenue is generated over centuries of successful capitalism isneeded as most of the debt that funded the huge Chinese getting more difficult to employ to make good returns, andfiscal stimulus from 2009 remains at this level of as a result has led to this part of the world going ‘ex-government. growth’. The US and Europe are definitely there already, and the path of recent data suggests Australia may be heading that way as well. While we got away unscathedChart 5: China real estate investment, home sales and the first time around, that was with a starting point of acompletion current account surplus. In this environment, deflation is the most likely outcome as demand growth softens. Many are worried about the printing of trillions in quantitative easing packages the world over affecting inflation in the near future. This is a real worry to be sure, but as long as the demand for credit remains as low as it is then the probability of this extra money making it into general circulation is limited, and it will likely continue to remain where it was initially created on the central bank balance sheet, not hurting anyone. Keep holding bonds as they will be your best investment, as growth and inflation remain lower than the consensus expects. Vimal Gor Head of Income & Fixed InterestSource: Bloomberg BT Investment Management
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