Tuesday, 24 June 2014


Putting aside the drama of the football world cup (if that's possible!?), the week was characterised by two big stories; 1. Renewed concerns about energy supply disruption due to Iraq and the Ukraine; 2. The US central bank's policy setting Open Market Committee (the Federal Reserve's monthly meeting) left interest rates unchanged, continued to reduce additional monetary support, and downgraded their 2014 growth forecast.

Perhaps surprisingly over the week, equity markets rallied, reversing the last week's decline, and pushing some indices to new all-time highs. Markets seem to be pretty resilient, driven by continuing strong economic data flow and a lack of alternatives for investors (!) in light of continuingly low return perspectives on less risky investments.

The Iraq situation deteriorated towards civil war and Russia finally reduced gas flow to the Ukraine (and thereby the rest of Europe) because of massive outstanding payments. The resulting concerns over global energy supply security pushed oil prices up a good 5%.This is less than might have been expected; Europe has built up a gas reserve approximately equalling a year's supply from the pipes crossing Ukraine. Meanwhile, there seems to be a general expectation that the ISIS/Sunni forces in Northern Iraq will be stopped in their advance into the Shia-dominated oil producing areas. It is reassuring to see markets react relatively calmly. Still, the spread of the sectarian violence beyond the Syrian civil war into the wider Middle-East is an increasing geopolitical risk with the potential to disturb 2014's upsurge in the global economy.

After their meeting, the FOMC's written statements went down reasonably well. The Fed chairman Janet Yellen's comments in the press conference were received particularly positively.

While remaining confident about the US continued economic recovery, she noted that wage inflation remained "very low" at 2%. Markets took comfort in the expectation that, while short-term rates may rise, long-term monetary conditions will remain accommodative. With the impact of the US's cold winter on the first half of the year, it was no surprise that overall 2014 growth forecasts were reduced. The Fed still expects growth for the remainder of 2014 to continue at strong (weather-unaffected) levels. Indeed, the Fed's own expectation for the timing of first rate rise is now more hawkish (read: earlier) than the markets had priced before the meeting. This is a reversal of last year's situation, when the Fed guided that the first rate rise was likely to be later than the markets were anticipating. It appears that, as is often the case, markets have overshot the target on the other side now.

I see the Fed's communication as being similar to the Bank of England governor Mark Carney's Mansion House speech last week; an attempt to discourage credit being offered at too low a rate over the short term (0-3 years), while ensuring that longer-term rates (5-10 years) still stimulate capital investment. Both US and UK central banks seem to be concerned that cheap short-term money could rekindle market behaviours that led to the 2008 financial crisis. It is good to see our central bankers being proactive, which should help to bring stability over the medium term.

Of course, there is still potential for some volatility in risk assets over the coming months as investors try to get their heads around the confusing environment of strong economic growth accompanied by an unusually supportive monetary environment. Of particular interest for us, when looking at the overall construction of a client's portfolio, is the relative value of asset classes. Corporate bonds look increasingly expensive, driven by the huge base of captive "bond-only" investors and their need for extra yield. They now offer little incremental return over safer government bonds. Of course, this situation may remain for some time; if so, corporate bonds would outperform government bonds, albeit by a small amount. Whether that extra return is enough to pay for the extra risk is the question.

In other news this week, investors in Japan welcomed the Abe government's announcement of a 'third arrow' for their economic development program. Unlike the first two 'arrows' which were single initiatives, this was an array of smaller initiatives. It was greeted positively, despite being an attempt to change engrained Japanese company and individual behaviours. Getting companies to invest their cash piles and more women into work are worthwhile structural measures and can have big impacts, but such things take a long time to feed into the economy.

The prospect of another default by Argentina on its government debt somewhat unsettled emerging markets. In fact this episode is a remnant of the previous default and so Argentina shouldn't be in major trouble; it's a legal wrangle over the way the previous debt-restructuring, agreed by the majority bond holders, dealt with the rights of individual (minority) bond holders. Still, it will be important to watch this space – not so much because of Argentina – but because of the precedent it sets for restructuring processes in general, and the potential it has to add to future emerging market problems.

For more stories, visit: http://www.kassiusannuities.co.uk/html/site-pages/news.php

Tuesday, 17 June 2014


The much improved confidence levels of market participants took a bit of a hit this past week, as the sectarian conflict in the Middle East flared up in Iraq and UK's BoE governor Mark Carney hinted that it may be necessary to raise rates earlier than markets currently anticipate. Stock markets across Europe dropped as a result, but it was clearly the UK which gave back the most gains, losing up to 1% on Friday, following Mr Carney's speech at the annual Mansion House gathering

 Carney surprised markets with his remarks and they reacted accordingly: Sterling gained versus other currencies, while bonds and equities fell as yields rose across the maturity spectrum. Higher yields make credit finance more expensive and can thereby reduce the growth prospects. This can be desirable when the economy is at the risk of overheating, but at the moment we are still far from it. However, in the aftermath of the financial crisis, interest rates are still at such exceptionally low levels that we are witnessing various negative side effects, which could themselves become economic issues further down the line. UK house price rises on the back of low mortgage rates and a shortage of homes is one such example, the general tendency for assets to become overvalued is another. Here government and corporate bond prices can be identified. Raising rates would counteract these undesirable side effects, but at the same time they risk choking off the recovery which is only just getting properly started.

 I believe Carney's surprising and sudden change to his previous forward guidance is that he is quite possibly trying to adopt Mario Draghi's (ECB) approach of threatening the markets with some penalising action, which then becomes unnecessary, because markets react in the desired direction as if the penal action had been taken. Draghi's 'whatever it takes' pledge for keeping the Eurozone afloat was the most successful example for this strategy: The ECB never had to intervene, because market participants stopped to speculate with a break-up. Carney's warning had a similar effect – yields which are deemed too low at the moment (see previous issues of our Weekly) promptly rose, thereby delivering a cooling effect for the asset price inflation catalysts. So, by threatening an earlier first rate rise he has the potential to actually prevent such action, if yields rise enough to dampen the mentioned negative side effects, then interest rates can possibly remain low in support of the ongoing economic recovery. In any event it is good to see that our Bank of England leadership is determined to take action, rather than let things fester. History and experience shows that it is the unaddressed and surprise issues that derail economic progress – once risks have been identified and are addressed they rarely deteriorate further. This is as much true in the UK and the Eurozone, as it is in faraway places like China, whose government is equally tackling misallocation of capital.

 The new troubles in Iraq are caused by Sunni Muslims overrunning numerous cities in the oil rich North in an attempt to regain influence from the now governing Shia Muslims. What at first hand appears as a localised conflict in Iraq which has been ravaged by civil conflicts ever since the US led overthrow of Saddam Hussein, has in reality the same roots as the Syrian civil war, which is the centuries old animosities between the Sunni and Shia Muslims. This latest unrest is further destabilising an already deeply troubled region and it is therefore not surprising that oil prices increased on the surprise news. This could potentially be a set back to the European growth prospects, which has a higher dependency on the Middle East's oil than the US. However, given the oil exploration in Iraq's North is not particularly meaningful, the overall impact was less pronounced than one might expected. Regardless, the renewed increase in economic outlook uncertainty should be sufficient to prevent European equity markets from becoming too exuberant and overshoot on the otherwise strengthening growth prospects

For more stories, visit: www.kassiusannuities.co.uk

Tuesday, 10 June 2014


The 70th anniversary celebrations of WWII D-day marked the week's historic dimension for the broader public, while capital markets noted the first time that any major central bank has taken interest rates negative. The European Central Bank (ECB) cut interest rates by a very incremental 0.1%, which took the rate at which commercial banks can park their cash surpluses with the Central Bank from 0% to -0.1%, meaning their deposits gradually shrink rather than grow. The rate at which banks can borrow from the ECB for the short term was lowered from 0.25% to 0.15%. While technically marking a historical point (although Denmark recently experimented with a negative rate on a smaller scale), the move is in my opinion more aimed at making a statement rather than making much of a difference. Here is why: In theory the negative rate should encourage banks to lend out the money, rather than deposit it with the central bank and also to pass the negative rate on to their customers, thereby encouraging those to spend the money or invest it. In practice, banks will not be able to pass on the negative rate to privates (because they may choose to hold the deposits in actual notes in safe deposit boxes) or corporates. On the contrary they may increase rather than decrease what they charge for short term loans in order to recover what they lose on their cash surpluses with the central bank. In any case, at such a small scale of change (0.1%!) any real effect ought to be marginal, unless market participants see it as a signal for a change in direction. In this respect - for the readers of the fine print – there were some signs that the ECB may have overcome Germany's past rejection to conduct outright quantitative easing (QE) – more about this further below. Because of the lack of any real surprises, beyond what had been widely expected after specific hints last month, markets appeared underwhelmed and just continued where they had left off before the announcement. This was a gradual advance of stock markets, taking them in the case of Germany and the US to new historical highs, while the UK's is still struggling with the FTSE's 7,000 mark (reminding me of the struggle with the 6,000 mark over the course of 2012!).

Bond yields had finally been moving in parallel to equity markets, until US job market data on Friday came in slightly mediocre (but as expected). This put downward pressure again on yields because bond markets appear to be ricocheting between their own belief that the economy is expanding at a higher rate than Central Banks like to admit which will see rates go up much sooner than advised and on the other hand agreeing with central bankers' view that the expansion is still quite pedestrian, which will not warrant rate rises at least until the middle of 2015 and then only very gradually. The US job growth number aligned with the latter scenario and as a result equity markets and bond markets moved up again in unison in expectation of continued cheap credit fuel.

Economic outlook data from the UK services and construction sectors provided continued evidence of the persistency of the UK's economic revival. At the same time Nationwide's house price index reading showed a slowing of the growth rate compared to April, however, this still makes an unsustainable annual growth rate of 11%. Unsustainable not because current mortgage costs are decimating UK homeowners' disposable incomes – they are not - no more than the historical average anyway, see our special at the end – but because they have the potential to become a formidable millstone for consumers in the future, when interest rates eventually have to rise. This is unless the economy can continue to grow unconstrained of fears of premature rate rises which should finally feed into improving real wages, making higher mortgage burdens less threatening.  We therefore expect the Bank of England to make further use of their macro prudential intervention toolbox fairly soon and force banks to put even higher minimum requirements in the way of mortgage seekers, but leave rates unchanged. It can also not be long now before the government will have to restrict the second part of its Help to Buy scheme of mortgage guarantees for any home purchase to just new builds.

For more news, visit: www.kassiusannuities.co.uk

Tuesday, 3 June 2014


The 2014 government bond conundrum continues: Bonds and equities continued to rise in unison, while economic logic and history suggests that they should move against each other. The chart above illustrates this through the comparison between stock market moves and yield changes (which move inverse to bond values). Normally when stock markets rise, bond yields rise as well. This is the result of selling pressure on the lower risk, lower return potential bonds in favour of equities, which drives down bond values. This reduced value increases the relative yield their fixed coupons payments constitute vs the market value of the bond.

Since the beginning of 2014 this rationale appears to have broken down and particularly in the past weeks yields have fallen, bond values rallied while stock markets have also reached new highs. So the question many market players are asking is: Who is wrong (and therefor in for a fall) the bond markets or the stock markets?

There are a number of explanations for what we are experiencing:

1.    A previously failing economy is recovering, reversing earlier parallel falls of equities and bonds
2.    Bond investors foresee trouble that equity investors don’t see
3.    Markets expect quantitative easing measures in the future, driving up bond demand and pushing investors up the risk curve into equities
4.    Correction of a previous overreaction of inflation fears by bond investors
5.    Fiscal repression: Financial institutions are ‘forced’ to purchase government bonds

All of the above are currently hotly debated and as stated before, I believe that we are experiencing a temporary correction of bond yields after bond investors have come to realise that inflation is going to rise less quickly than they anticipated during the 2013 government bond sell off. As always it is most likely not a single reason explaining market action. There are good arguments that banks, insurers and pension funds are forced by regulation to stock up their government bond holdings, while there is a supply shortage as governments are borrowing less and central banks are still holding vast amounts of the existing stock as a consequence of their QE programs. There is a bit of fear as well, resulting from the disappointing Q1 growth figures around the world, which some interpret as the harbinger of a turning of the economic cycle, while most see it as a temporary blip as a result of adverse weather in the Northern hemisphere.

During the past week, argument 3 received some additional support, when Eurozone money supply figures showed that the monetary base in the currency union is still shrinking (see chart below), while the economy is clearly expanding once again. This has made additional monetary easing by the ECB all but a certainty, following their announcement last month that they would do so in their next meeting should the deflationary pressures persist.

I somewhat suspect that markets are overestimating the likely ECB announcement for Thursday next week. Clearly there will be some sort of action, but I believe it far more likely that the first step will be a tinkering with the already low interest rates towards an experiment with marginally negative rates for bank deposits. In combination with the further improving macroeconomic environment I am expecting the ‘bond-conundrum’ of 2014 to pass in the foreseeable future. So bonds are the asset class more likely to retreat over the summer, however that is not to say they are wrong at the moment, but rather that they were wrong last year, when they fell far more than the slow economic progress warranted.

Visit http://www.kassiusannuities.co.uk/html/site-pages/news.php for more up-to-date news.