Friday, April 28, 2017

28/4/17: Macron v Le Pen: Data Maps


The must-see set of data maps relating to upcoming Macron-Le Pen Presidential election (round 2) in France is available here: https://www.bloomberg.com/graphics/2017-french-election-maps/. Their relative positions (slightly changing since round 1) are explained here: http://trueeconomics.blogspot.com/2017/04/15417-naughty-and-not-very-nice-french.html.


28/4/17: The VUCA Markets


My regular column with the Cayman Financial Review covering the current development of the risk-uncertainty frameworks in the markets is now available here: http://www.caymanfinancialreview.com/2017/04/26/welcome-to-the-vuca-world/.


28/4/17: Euromoney on Italian Risks


Euromoney article on the continued evolution of the Italian crisis: http://www.euromoney.com/Article/3712913/Country-risk-Italy-is-the-volcano-waiting-to-erupt.html, quoting - amongst others - myself.


28/4/17: Trump Tax Plan: Impact on Ireland


My (quick) take on the potential impact of the U.S. corporate tax reforms for Ireland: https://www.thesun.ie/news/917087/ireland-could-benefit-from-donald-trumps-cuts-to-us-tax-rates-according-to-a-top-economist/. Hint: don't panic.


28/4/17: Russian Economy Update, Part 4: Aggregate Investment

The following is a transcript of my recent briefing on the Russian economy. 

This part (Part 4) covers outlook  for aggregate investment over 2017-2019. Part 1 covered general growth outlook (link here), part 2 covered two sectors of interest (link here) and part 3 concerned with monetary policy and the ruble (link here).

From the point of Russian economic growth, investment has been the weakest part of the overall ex-oil price dynamics in recent years.

Rosstat most recent data suggests that the recovery in seasonally adjusted total fixed investment continued in 1Q 2017, with positive growth in the aggregate now likely for the 2Q 2017:

  • 4Q16 investment was down about 1% from 2015
  • Total investment rose from 22.12% of GDP in 2015 to 25.63% in 2016, and is expected to moderate to 22.23% in 2017, before stabilsing around 22.9% in 2018-2019
    • The investment dynamics are, therefore, still weak going forward for a major recovery to take hold
    • However, 2017-2019 investment projections imply greater rate of investment in the economy compared to 2010-2014 average
  • However, last year fixed investment was down by 11% from 2014
    • This is primarily down to Rosstat revision of figures that deepened the drop in investment in 2015
  • About a quarter of total aggregate investment in Russia comes from small firms and the grey economy
    • Rosstat data suggests that such investment was roughly unchanged in 2016 compared to 2015
  • Other fixed investments, which are mostly investments of large and mid-sized companies, shrank by about 1% in 2016
    • This compounds the steep drops recorded in the previous three years (down 10% in 2015 alone), so the level of investment last year remained below that of the 2009 recession
    • Investments of large and mid-sized companies within oil & gas production sector rose robustly in 2016
      • This marked the third consecutive year of growth in the sector
      • Much of the increases was driven by LNG sub-sector investments which is associated (at current energy prices) with lower profit margins 
      • On the positive side, investments in LNG facilities helps diversify customer base for Russian gas exporters - a much-needed move, given the tightening of the energy markets in Europe
    • In contrast to LNG sub-sector, investment in oil refining continued to shrink, sharply, in 2016 for the second year in a row, 
    • Other manufacturing investment also recorded continued sharp declines
    • The same happened in the electricity sector
    • In contrast, following two years of contraction, investment in machinery and equipment stabilised for the mid- and large-sized corporates
    • Construction sector activity was down 4% y/y in 2016, marking third consecutive year of declines
      • Exacerbating declines in 2015, commercial and industrial buildings completions fell again in 2016
      • Apartments completions also fell y/y marking the first drop in housing completions since 2010

As the chart above illustrates:

  • The forecast if for 2017-2019 improvements in investment contribution to growth, with trend forecast to be above 2010-2014 average
  • However, historically over 2000-2016 period, investment has relatively weak/zero correlation (0.054) with overall real GDP growth, while investment relative contribution to growth (instrumented via investment/growth ratio) has negative correlation with growth even when we consider only periods of positive growth
  • This implies the need for structural rebalancing of investment toward supporting longer-term growth objectives in the economy, away from extraction sectors and building & construction

Going forward:

  • Russia's industrial / manufacturing production capacity is nearing full utilisation 
  • The economy is running close to full employment
  • Leading confidence indicators of business confidence are firming up
  • Corporate deleveraging has been pronounced and continues
  • Corporate profitability has improved 
  • Nonetheless, demand for corporate credit remains weak, primarily due to high cost of credit 
    • Most recent CBR signal is for loosening of monetary policy in 2017, with current rates expected to drop to 8.25-8.5 range by the end of 2017, down from 10% at the start of the year
  • Irrespective of the levels of interest rates, however, investment demand will continue to be subdued on foot of remaining weaknesses in structural growth and lack of reforms to improve business environment and institutions

Taken together, these factors imply that the recovery in fixed investment over 2017-2019 period is likely to be very slow, with investment recovery to pre-2015 levels only toward the end of forecast period.

Thematically, there is a significant investment gap remaining across a range of sectors with strong returns potential, including:

  • Food production, processing and associated SCM;
  • Transportation and logistics
  • Industrial machinery and equipment, especially in the areas of new technologies, including robotics
  • Chemicals
  • Pharmaceuticals and health technologies


28/4/17: Russia Cuts Headline Rate by 50bps


Bigger than forecast move by the Russian Central Bank to cut rates (down 50bps against consensus - and my own - forecast of 25bps cut) signals the CBR's comfort with inflationary expectations forward.


As noted in my regular advisory call on the Russian economy earlier this week (transcript here), inflation fell substantial in 1Q 2017, with current FY 2017 forecast sitting at around 4.3 percent. In line with this, CBR started cutting rates at the end of March, moving from 10% to 9.75% for its benchmark one-week auction rate. Today, the CBR lowered the rate to 9.25%.

According to CBR: "“Inflation is moving towards the target, inflation expectations are still declining and economic activity is recovering. Given the moderately tight monetary policy, the 4 percent inflation target will be achieved before the end of 2017 and will be maintained close to this level in 2018-2019.”

Median Bloomberg estimate is for the rate to fall to 8.5% by the end of the year. As I noted in the call: "I expect ...year-end (2017) rate target of around 8.25-8.5% if inflation remains on the path toward 4.3% annual rate, or 8.75-9% range if inflation stays around 4.6% annual rate".

The latest move helps the cause of the Federal budget (championed by the Economic Ministry) that needs to see ruble lose some of its attractiveness as a carry trade currency. In recent months, ruble has been the third best performing currency in the world, resulting in investors willing to borrow in foreign currencies to invest in rubles denominated assets. The net effect of this on the Russian economy is improving demand for imports and deteriorating budget dynamics (as Russian budget operates ruble-based expenditure, funded to a large extent by dollar and other forex revenues from exports of primary materials).

Nabiulina's move today, however, should not be interpreted as the CBR surrender to the Economic Ministry agenda of lowering ruble value. Instead, the rate cut is clearly in line with inflation targeting and also in line with previously stated CBR concerns about investment environment in Russia. Russian aggregate investment has been extremely weak in recent years, and economic recovery needs to involve a dramatic reversal of investment volumes to the upside, especially in areas of technology, R&D, and product and processes innovation. High interest rates tend to significantly reduce investment by making capital expenditure more expensive to fund.

Thursday, April 27, 2017

27/4/17: Russian Economy Update, Part 3: Ruble and CBR Rates


The following is a transcript of my recent briefing on the Russian economy. 

This part (Part 3) covers outlook  for ruble and monetary policy for Russia over 2017-2019. Part 1 covered general growth outlook (link here) and part 2 covered two sectors of interest (link here).

Outlook for the ruble and CB rates

The ruble has appreciated this year about 6.6% against the US dollar, from 61.15 at the start of 2017 to just above 57.10 so far, and 3% against the euro from 64.0 to 62.06, compared to the start of 2016, ruble is up on the dollar ca 21.3% and on the euro some 22.4%

  • The ruble has been supported by the strengthening in the trade surplus in late 2016 into early 2017, and by improved foreign investment inflows
  • The ruble has been on an upward trend after hitting the bottom at the start of 2016
  • However, rate of appreciation has fallen in recent months, while volatility has risen
  • March real effective (trade-weighted) exchange rate (RER) was up nearly 30% y/y, as reported by BOFIT (see chart below)
  • As noted by some researchers (e.g. BOFIT), “in Russia, exchange rate shifts tend to pass through relatively quickly and strongly to consumer prices, so ruble strengthening tends to curb inflation” which, in turn, increases private and fiscal purchasing power
  • Another effect of the ruble appreciation is that it lowers government ruble-denominated tax revenue through direct link between energy exporting taxes (oil and gas) and oil prices, which are denominated in dollars 


For domestic businesses, a stronger ruble:

  • Reduces their price competitiveness with respect to imports, but also 
  • Lowers the cost of imported capital, technology and intermediates
    • Majority of Russian manufacturers are relatively highly dependent on such imports and have very limited non-ruble exports


  • Stronger ruble has very limited effect on the volume of Russian exports, primarily due to heavy bias in exports in favour of dollar-denominated energy and other primary materials
  • Ruble appreciation reduces the costs of foreign debt service for firms (a positive for larger firms and banks) and can lead, over time, to lower borrowing costs within Russian credit markets (a positive for all firms)


In line with the export-import effects discussed above:

  • Volume of Russian exports grew by over 2 % last year (primarily driven by oil and gas prices recovery and continued elevated volumes of Russian production of primary materials), plus by another (second consecutive) year of grain harvests 
    • In 2017, export growth should slow as both harvest and energy prices effects dissipate
    • Volume of exports of goods and services fell 1.87% in 2014, 0.41% in 2015 and 0.68% in 2016. Current forecasts suggest that the volume of exports will rise 4.5-4.6% in 2017
  • Volume of imports was much harder hit by the crisis
    • Volume of imports of goods and services fell 7.6% in 2014, followed by 25.0 drop in 2015 and 4.0% decline in 2016
    • Current forecasts suggest strong, but only partial recovery in demand for imports, with volumes expected to rise 7.0-7.2% in 2017
    • Key driver for imports growth will be the recovery in aggregate demand, plus appreciation of the ruble
    • Key downward pressure on imports will continue to come (as in 2016) from trade sanctions and from ongoing reforms of public and SOEs procurement rules and systems (more on this later)
  • Russia’s current account surplus contracted last year to less than 2% of GDP, printing at USD 22.2 billion, down from USD69 billion in 2015
    • 2017 projections of the current account surplus range widely, although no analyst / forecaster projects a negative print, despite expected increase in imports
    • IMF’s most current (April 2017) projection is for 2017 CA surplus of USD51.5 billion
    • This level of CA surpluses would stand above the 2014-2016 average (USD 49.6 billion), but below 2010-2013 average (USD67.4 billion) and lower than 2000-2007 average (USD 55.7 billion)
    • If IMF projection comes through, CA surplus will be supportive of significantly tighter fiscal deficit than currently projected by Moscow
    • As a percentage of GDP, CA surplus is expected to come in at 3.30% in 2017, slightly above 2014-2016 average of 3.19% and slightly below the 2010-2013 average of 3.42% of GDP


Inflation


  • With Russian inflation falling and current account surplus strengthening, 2017 will witness further pressures on the ruble to appreciate vis-à-vis the dollar and the euro
  • Russia’s annual inflation fell below 5% in 1Q 2017
  • The CB of Russia has kept a relatively tight monetary stance, holding the key rate at nearly 10% through most of 1Q, as consistent with the CBR strict targeting of the inflation rate (4% inflation target set by the end of 2017)
    • CBR dropped rate to 9.75% at the end of March, noting a faster-than-expected drop in inflation and a slight decline in inflation expectations 
  • Inflation fell from 4.6% in February to 4.5% in March and 4.1% as of mid-April
    • 12-month forecast now at 4.3%
    • CBR governor Nabiullina said the central bank does not share the finance ministry's view of a overvalued ruble, which is consistent with her projecting continued cautious stance on inflation
    • Finance Minister, Anton Siluanov, recently stated that the ruble is overvalued by 10–12%
    • Consistent with this, I expect a 25 bps cut at April 28th meeting of CBR Council and year-end (2017) rate target of around 8.25-8.5% if inflation remains on the path toward 4.3% annual rate, or 8.75-9% range if inflation stays around 4.6% annual rate


27/4/17: Russian Economy Update, Part 2: Two Key Sectors

Two key sectors to watch

Now, looking at some sectors across the Russian economy

Manufacturing:

  • In 2015, total volume of manufacturing output dropped 5.4% and in 2016 it was basically unchanged on foot of robust growth in the chemical sector (+5.6% growth) and food sector (ca 2% growth)
  • Other positive growth sectors were Pulp & Paper and Rubber & plastics, Wood products and Machinery and Equipment. The latter sector has been in a free-fall since 2012
  • Negative growth continued in Transport vehicles (negative growth since 2014), Metals and products (also in decline since 2014)
  • Production of oil products fell, ending years of growth starting even before 2007
  • Construction materials experienced their second year of declining output
  • Electrical machinery & equipment continued to contract for the fourth year in a row
  • Corporate Leverage:
    • Overall, economy continued to deleverage out of debt, especially external debt. CBR data shows that by the end of 2016, private sector external debt stood at USD470 billion, of which more than ¾ was held by non-financial corporates and ¼ held by the banks.
    • The external debt/GDP ratio was stable and benign at 36%
    • Corporate debt is largely - 80% - non-ruble denominated, while the same number for the banks was around 87%
    • Corporate deleveraging slowed down substantially in 2016 as debt rollovers fell and debt renegotiations/restructurings declined
    • Changes in ruble valuations had positive effect on debt burden in the oil and gas sector (forex earnings) and negative effect on debt burden in domestic producers
    • If in 2014-2015, companies used receipts of funds from parent holding enterprises to roll over maturing debt, in 2016 these funds were increasingly used to pay down debt. In effect this means that the first part of the deleveraging cycle has swapped external debt for internal debt, while current phase of the cycle is witnessing overall debt levels reductions.



Banking sector:

  • In contrast to 2014-2015, the ruble valuations acted largely to reduce debt burdens in the banks, as ruble appreciation in 2016 supported the forex valuation of the foreign debt 
  • Banks deleveraging continued in 2016, at a pace that is roughly ½ the rate of 2015 and 2014 
  • Data from the CBR show total banking sector assets fell last year by 3.5% in nominal terms
  • Controlling for FX effects (ruble appreciation), total assets were up ca 2% at the end of 2016, compared to the end of 2015
    • Stock of loans outstanding to the corporate sector was down roughly 4%, while stock of loans to households rose by more than 1%
    • However, overall household credit contracted 7% in 2015, making 2016 recovery weak 
  • Non-performing loans (NPLs) are declining as a share of the assets base, with decline accelerating in recent months
    • NPL ratio for corporate loans still exceeded 6%
    • Household credit NPL ratio was about 8%
  • Aggregate banking sector 2016 profits rose five-fold to $15 billion y/y
  • Three large SOE banks (Sberbank, VTB and Gazprombank) accounted for over half of the banking sector profits
  • The CBR has continued to weed-out poorly run and non-performing banks using tools ranging from full shut down to forced mergers 
    • At the start of 2017 there were 623 active credit institutions in Russia, of which 205 institutions had general banking licenses
    • At the same time in 2016 there were 733 active credit institutions


26/4/17: Russian Economy Update, Part 1: Growth Outlook


The following is a transcript of my recent briefing on the Russian economy. This part (Part 1) covers general economic outlook for Russia over 2017-2019. 

Growth outlook and recovery analysis

Russia's Composite PMI = 56.7 in 1Q 2017, the strongest growth performance since 4Q 2006
  • In both Manufacturing and Services sectors, Russian economy has outperformed in 1Q 2017 global economic growth momentum
  • Russia is currently the strongest BRIC economy for the fourth consecutive quarter
  • Russian Manufacturing PMIs averaged 53.2 in 1Q 2017, unchanged on 4Q 2016 and up on 49.1 average for 1Q 2016  
  • 3rd consecutive quarterly PMI reading for Manufacturing that sits above 50.0 marker
  • Russia Services PMI for 1Q 2017 came in at a blistering pace of 56.8, up on already significant growth in 4Q 2016 at 54.6 and significantly above 1Q 2016 reading of 50
  • All in, this was the fourth consecutive quarter of Services PMIs above 50.0
  • Energy and commodities prices
  • Lack of structural reforms within Russia
  • Key support was higher output in natural gas and the broader extractive sector (+ more than 1% y/y in 1Q 2017)
  • Seasonally adjusted manufacturing output recovered in March, but still down almost 1 % y/y.
  • Growth will be led by private domestic demand which also stimulates imports; and
  • Firmer oil prices.
  • The latest forecasts of the CBR and Econ Ministry expect GDP increasing by 1–2% pa over 2017–2020
  • The forecasts assume the annual price of Urals crude to average USD40–50 a barrel
  • Key drivers for growth assumed to be household consumption and fixed investment (both expected to rise 2–3 % pa)
  • In contrast, imports are expected to outpace in growth terms exports, with current account surplus falling, although remaining in the ‘black’ at USD6-8 billion range
  • The financial account deficit (excluding currency reserves) is expected to be within the range of USD6–10 billion annually
  • GDP growth will be expected to fall to around 1% if Urals price falls to USD35 a barrel and zero growth will kick in at the USD25 per barrel. This astonishingly low level for zero growth oil price is a testament to aggressive deleveraging of fiscal and private sector balancesheets during the 2014-2016 recession
  • Approaching presidential elections of 2018 may put pressures on Moscow to increase public spending. While this would be running contrary to current budgetary plans, it will provide a short run boost to growth. However, such a boost would come at the expense of reducing Russian fiscal policy resilience in the longer term
  • Continued tensions in Syria can spillover into a [limited] conflict involving Russia and either Turkey or the U.S.-led coalition or even the U.S. forces. Such an event would trigger massive spike in geopolitical uncertainties and will undoubtedly severely disrupt markets and investment flows, as well as global trade flows
  • Emerging tensions (with growing Russian involvement) around North Korea, where Russian traditional role of being a distant secondary guarantor to China is gradually moving up the scale, just as China appears to be more accommodative of he Western demands
  • Currently stable, but nonetheless risky and ambiguous outlook in Eastern Ukraine, with continued risk spillovers (albeit much more subdued) to Easter European politics
  • Still evolving (and for now benign) re-alignment of powers in Central Asia that can spiral out of control 
  • Emerging and occasionally visible (albeit relatively benign) policy confrontations with Belarus
  • Potential for re-igniting of the Nagorno-Karabakh conflict
  • Internal protests focusing on lack of meaningful anti-corruption reforms, especially set against the backdrop of continued, but abating, internal power struggles, involving some close past allies of the Kremlin – struggles that occasionally involve accusations of corruption and graft
  • Internal issues relating to human rights abuses, especially and most recently, highly visible and robust accusations of suppression of LGBT minorities in Chechnya
Another factor is import recovery: 
  • Imports recovery can run stronger than forecast, hitting largely modest in scale, although rather successful in the short run in some sectors, policies aimed at import substitution
  • This stability suits both the West and Russia, where the sanctions are supporting domestic producer
  • Given these dynamics, there is no pressure for Russia to abandon its current trade sanctions stance, despite the public statements by the Government to the contrary
  • This is exemplified by the lack of changes in trade relations with Turkey post-normalisation of relations, and especially by March 2017 changes to Turkish tariffs on Russian exports of grains (corn and wheat)
  • In mid-March this year, Turkey imposed 130% import tariff on imports of certain food items from Russia, including wheat and corn imports
  • Although Turkey is one of the largest export markets for wheat and corn for Russian producers (Russian exports last year valued at roughly USD550 million), Russia did not attempt to trade food tariffs for its own import bans on Turkish products, including fruit and vegetables
  • A year-old ban is beneficial to both Turkey and Russia from geopolitical perspective, even though it fuels higher inflation in Russia so much so that instead of relaxing its own prohibitions, Russia expanded the imports ban for Turkish goods to a wider range of plant materials
Overall, in the long run, achieving faster sustainable and resilient growth will require deeper structural reforms. These include: improving the business environment and institutional structures, accelerating modernization of the capital base and adoption of new technologies, raising R&D and technological capital investments, accelerating modernization of management systems, and significantly reducing the state share of the economy, including the extent of the State Owned Enterprises (SOEs) dominance across a range of sectors
  • Implementation of such reforms will support private investment and raise productivity growth rates for both TFP and labour productivity
  • Structural reforms would also reduce economy’s dependence on extraction industries and, if targeted toward processing sectors, can significantly improve value added component of these sectors, helping to de-link economic growth from energy prices and commodities prices in general
  • While the Economic Ministry is now tasked with drafting a set of economic policy reforms to cover the period through 2035, to-date, we have no indications which reforms are being considered. We are unlikely to see any official drafts prior to the onset of the 2018 Presidential election campaigns, and the impact of any such reforms is unlikely to materialise before 2020.



Despite some robust numbers, the economy remains relatively exposed to the downside risks, including


Somewhat deflating the leading indicators, Rosstat reported that seasonally and workday-adjusted industrial output recovered in March on a relatively weaker February


After a two years-long recession, real GDP growth should be + 1.3-1.6% this year (mid-point 1.4-1.5%)


Continued sluggish performance in 2017-2019 is due to the economy already running near full capacity and lacking deeper structural reforms to boost long term growth potential. Thus, my expectation is for real GDP growth to remain around 1.4-1.5% mark over 2017-2019

Risks:

Biggest short-term risk (upside and downside): the price of oil


A second risk factor involves geopolitical and political triggers that could hit Russian growth outlook hard, either directly or indirectly via increased political instability and adverse investors’ and entrepreneurs’ perceptions


Relating to both, imports substitution drive and the issue of geopolitical risks, the current sanctions regime (for both Russian sanctions vis-a-vis Western producers and Western sanctions vis-a-vis Russian economy) appears to be stable






Stay tuned for more transcripts

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Tuesday, April 25, 2017

25/4/17: Couple of Things We Glimpsed from KW Europe 'Deal'


Yesterday, an interesting bit of newsflow came in from Irish markets-related Kennedy Wilson Europe operations: http://www.independent.ie/business/commercial-property/1bn-worth-of-irish-property-assets-in-kennedy-wilson-discounted-takeover-deal-35650134.html. Setting aside the details of the merger between Kennedy Wilson Inc (U.S. based parent) and Kennedy Wilson Europe (UK and Ireland-based subsidiary), the news have several important disclosures relating to the Irish property markets, Nama and the Irish economy.

Consider the following: 

"Kennedy Wilson Europe Real Estate, which is tax resident in Jersey, pays 25pc tax on taxable profits generated in its Spanish subsidiaries, and it pays income tax at 20pc on rental income derived from its UK investment properties. But the qualifying investor alternative investment funds (QIAIFs) it uses in Ireland to hold its assets were until this year entirely exempt from any Irish taxation on income and gains. The group's total tax bill last year was £7.3m (€8.6m) on profits of £73.3m."

Which implies:
  • Kennedy Wilson's Europe operations are running an effective tax rate of 10 percent. Not 12.5 percent, nor higher. Which shows the extent to which Irish operations tax exempt status drives the overall European tax exposures.
  • Kennedy Wilson's merger across the borders is, it appears, at least in part motivated by changes in the QIAIF regime, imposing new "20pc withholding tax on distributions from Irish property funds to overseas investors".  Bringing the, now more heavily taxed, subsidiary under the KW wing most likely create more efficient tax structure, making Irish taxes paid offsettable against global (U.S. parent) income, without the need to formally remit profits from Europe. Beyond that, the merger will facilitate avoidance of dual taxation (of dividends). Finally, running within a single company entity, KW operations in Europe will also be likely to avail of more tax efficient arrangements relating to transfer pricing.
Another bit worth focusing on: "Kennedy Wilson Europe pointed out in its recently-published annual report that in 2014 it acquired a €202.3m Irish loan book for €75.5m". Yes, that's right, the discount on Irish properties purchased by the KWE was in the range of 62.7 percent, almost double the 33.5 percent average haircut on loans purchased by Nama. Assuming EUR 202.3 million number refers to par value of the assets, this implies that Nama has foregone around EUR59 million, if average discount/haircut was used by Nama in buying these assets in the first place. Look no further than the KW own statement: ""The enterprise will benefit from greater scale and improved liquidity, which will enhance our ability to generate attractive risk-adjusted returns for our shareholders. The merger significantly improves our recurring cash flow profile". The improved cash flow profile is, most likely, at least in part will be attributable tot ax structure changes for the merged entity.

Which is exactly how vulture funds' arithmetic works: pay EUR1.00 to buy an asset that Nama purchased for EUR2.68, which was on the banks' books at EUR 3.58. The asset devalued (on average) to EUR1.43-1.79 in the market at the crisis peak, and the fund is in-the-money on this investment from day one to the tune of at least 43 percent. Without a single brick moved or a single can of paint spent...

Of course, there are other reasons for the deal, including steep discounts on asset valuations in the REITs markets for UK properties, but the potential tax gains are hard to ignore too. Whatever the nature of the deal synergies, one thing is clear - vulture-styled investments work magic for deep pockets investment funds, while traditional small scale investors are forced to absorb losses.



Saturday, April 22, 2017

22/4/17: Two Regimes of Whistle-Blower Protection


“Corporate fraud is a major challenge in both developing and advanced economies, and employee whistle-blowers play an important role in uncovering it.” A truism that is, despite being quite obvious, has been a subject of too little research to-date. One recent study by the Association of Certified Fraud Examiners (2014), found that the average loss to organisations experiencing fraud that occurs due to financial statement fraud, asset misappropriation, and corruption is estimated losses from impact of corporate fraud globally at around $3.7 trillion. Such estimates are, of course, only remotely accurate. The Global Fraud Report" (2016) showed that 75% of surveyed senior executives stated that their company was a fraud victim in the previous year and in 81% of those cases, at least one company insider was involved, with a large share of such perpetrators (36%) coming from the ranks of company senior or middle management.

Beyond aggregate losses, whistleblowers are significantly important to detection of fraud cases. A 2010 study showed that whistleblowers have been responsible for some 17 percent of fraud discoveries over the period of 1996-2004 for fraud occurrences amongst the large U.S. corporations. And, according to the Association of Certified Fraud Examiners (2014), “employees were the source in 49% of tips leading to the detection of fraud”.


In line with this and other evidence on the impact of fraud-induced economic and social costs, whistleblower protection has been promoted and advanced across a range of countries and institutional frameworks in recent years. An even more glaring gap in our empirical knowledge arises when we attempt to analyse the extent to which such protection has been effective in creating the right legal and operational conditions for whistleblowers to be able to provide our societies with improved information disclosure and corporate governance and regulatory enforcement.

Somewhat filling the latter research gap, a recent working paper, titled “Whistle-Blower Protection: Theory and Experimental Evidence” by Lydia Mechtenberg, Gerd Muehlheusser, and Andreas Roider (CESIFO WORKING PAPER NO. 6394, March 2017) performed “a theory-guided lab experiment in which we analyze the impact of introducing whistle-blower protection. In particular, we compare different legal regimes (“belief-based" versus “fact-based") with respect to their effects on employers' misbehavior, employees' truthful and fraudulent reports, prosecutors' investigations, and employers' retaliation.”

In basic terms, there are two key approaches to structuring whistleblowers protection: belief-based regime (with “less stringent requirements for granting protection to whistle-blowers”) and fact-based regime (with greater hurdles of proof required from whistleblowers in order to avail of the legal protection). The authors’ “results suggest that the latter lead to better outcomes in terms of reporting behavior and deterrence.” The reason is that “when protection is relatively easy to (obtain as under belief-based regimes), fraudulent claims [by whistleblowers] indeed become a prevalent issue. This reduces the informativeness of reports to which prosecutors respond with a lower propensity to investigate. As a consequence, the introduction of such whistle-blower protection schemes might not lead to the intended reduction of misbehavior. In contrast, these effects are mitigated under a fact-based regime where the requirements for protection are more stringent.”

In a sense, the model and the argument behind it is pretty straight forward and intuitive. However, the conclusions are far reaching, given that recent U.S. and UK direction in advancing whistleblowers protection has been in favour of belief-based systems, while european ‘continental’ tradition has been to support fact-based thresholds. As authors do note, we need more rigorous empirical analysis of the effectiveness of two regimes in delivering meaningful discoveries of fraud, while accounting for false cases of disclosures; analysis that captures financial, economic, institutional and social benefits of the former, and costs of the latter.

Friday, April 21, 2017

21/4/17: Any evidence that immigrants are undermining welfare of the natives?


Given current debates surrounding the impact of migrant labour on native (and previously arriving migrants) wages, jobs security, career prospects and other major motivations behind a wide range of migration regimes reforms proposed across a number of countries, including the U.S., it is worth revisiting research done by Giovanni Peri of University of California, Davis, USA, and IZA, Germany back in 2014.

Titled “Do immigrant workers depress the wages of native workers?” and published by IZA World of Labor 2014: 42 in May 2014, https://wol.iza.org/articles/do-immigrant-workers-depress-the-wages-of-native-workers/long, the paper reviews 27 original studies published between 1982 and 2013, covering the topic of immigration impact on wages of the natives. Chart below summarises:


In the above, the “values report the effects of a 1 percentage point increase in the share of immigrants in a labor market (whether a city, state, country, or a skill group within one of these areas) on the average wage of native workers in the same market.

For example, an estimated effect of 0.1 means that a 1 percentage point increase in immigrants in a labor market raises the average wage paid to native workers in that labor market by 0.1 percentage point. These studies used a variety of reduced-form estimation and structural estimation methods; all the estimates were converted into the elasticity described here.”

Here’s the summary of Peri’s findings and conclusions:



21/4/17: Millennials, Property ‘Ladders’ and Defaults


In a recent report, titled “Beyond the Bricks: The meaning of home”, HSBC lauded the virtues of the millennials in actively pursuing purchases of homes. Mind you - keep in mind the official definition of the millennials as someone born  1981 and 1998, or 28-36 years of age (the age when one is normally quite likely to acquire a mortgage and their first property).

So here are the HSBC stats:


As the above clearly shows, there is quite a range of variation across the geographies in terms of millennials propensity to purchase a house. However, two things jump out:

  1. Current generation is well behind the baby boomers (when the same age groups are taken for comparatives) in terms of home ownership in all advanced economies; and
  2. Millennials are finding it harder to purchase homes in the countries where homeownership is seen as the basic first step on the investment and savings ladder to the upper middle class (USA, Canada, UK and Australia).


All of which suggests that the millennials are severely lagging previous generations in terms of both savings and investment. This is especially true as the issues relating to preferences (as opposed to affordability) are clearly not at play here (see the gap between ‘ownership’ and intent to own).

That point - made above - concerning the lack of evidence that millennials are not purchasing homes because their preferences might have shifted in favour of renting and way from owning is also supported by a sky-high proportions of millennials who go to such lengths as borrow from parents and live with parents to save for the deposit on the house:


Now, normally, I would not spend so much time talking about property-related surveys by the banks. But here’s what is of added interest here. Recent evidence suggests that millennials are quite different to previous generations in terms of their willingness to default on loans. Watch U.S. car loans (https://www.ft.com/content/0f17d002-f3c1-11e6-8758-6876151821a6 and https://www.experian.com/blogs/insights/2017/02/auto-loan-delinquencies-extending-beyond-subprime-consumers/) going South and the millennials are behind the trend (http://newsroom.transunion.com/transunion-auto-loan-growth-driven-by-millennial-originations-auto-delinquencies-remain-stable) on the origination side and now on the default side too (http://www.zerohedge.com/news/2017-04-13/ubs-explains-whos-behind-surging-subprime-delinquencies-hint-rhymes-perennials).

Which, paired with the HSBC analysis that shows significant financial strains the millennials took on in an attempt to jump onto the homeownership ‘ladder’, suggests that we might be heading not only into another wave of high risk borrowing for property purchases, but that this time around, such borrowings are befalling and increasingly older cohort of first-time buyers (leaving them less time to recover from any adverse shock) and an increasingly willing to default cohort of first-time buyers (meaning they will shit some of the burden of default onto the banks, faster and more resolutely than the baby boomers before them). Of course, never pay any attention to the reality is the motto for the financial sector, where FHA mortgages drawdowns by the car loans and student loans defaulting millennials (https://debtorprotectors.com/lawyer/2017/04/06/Student-Loan-Debt/Student-Loan-Defaults-Rising,-Millions-Not-Making-Payments_bl29267.htm) are hitting all time highs (http://www.heraldtribune.com/news/20170326/kenneth-r-harney-why-millennials-are-flocking-to-fha-mortgages)

Good luck having a sturdy enough umbrella for that moment when that proverbial hits the fan… Or you can always hedge that risk by shorting the millennials' favourite Snapchat... no, wait...

Tuesday, April 18, 2017

18/4/17: S&P500 Concentration Risk Impact


Recently I posted on FactSet data relating earnings within S&P500 across U.S. vs global markets, commenting on the inherent risk of low degree sales/revenues base diversification present across a range of S&P500 companies and industries. The original post is provided here.

Now, FactSet have provided another illustration of the 'concentration risk' within the S&P500 by mapping earnings and revenues growth across two sets of S&P500 companies: those with more than 50% of earnings coming from outside the U.S. and those with less than 50% of earnings coming from the global markets.


The chart is pretty striking. More globally diversified S&P constituents (green bars) are posting vastly faster rates of growth in earnings and a notably faster growth in revenues than S&P500 constituents with less than 50% share of revenues from outside the U.S (light blue bars).

Impact of the concentration risk illustrated. Now, can we have an ETF for that?..

Sunday, April 16, 2017

15/4/17: Swift & Digital Money: Cybersecurity Questions


Swift, the interbank clearance system, has been the Constantinople of the financial world's fortresses for some time now. Last year, writing in the International Banker (see link here), I referenced one cybersecurity incident that involved Swift-linked banks, and came close to Swift itself, although it did not breach Swift own systems. The response from Swift was prompt, pointing out that there has never been a cybersecurity breach at Swift.

Well, it appears that the fortress is no more. Latest reports suggest that NSA (a state actor in cybersecurity world) has successfully breached Swift firewalls. Details are here:
http://www.reuters.com/article/us-usa-cyber-swift-idUSKBN17H0NX.

From financial services and economy perspective, this is huge. Take a macro view: for years we have been told that cash and physical gold and silver are not safe. And for years this argument has been juxtaposed by the alleged 'safety' of digital money (not the Bitcoin and other cryptos, which the Governments loath and are keen on declaring 'unsafe', but state-run Central-Banks-operated digital money). The very notion of e-finance or digital finance rests on the basic tenet of infallibility of Swift. That infallibility is now gone. Welcome to the brave new world where the Governments promise you safe digital money in exchange for privacy and liquidity, while delivering a holes-ridden dingy of a system that can and will be fully compromised by the various states' actors and private hackers.

Come here, doggie, doggie! Have a treat...

Saturday, April 15, 2017

15/4/17: Naughty and Not Very Nice: French Presidential Hopefuls


A neat summary (ignore polls numbers at the top - these are dated) of political platforms behind the key Presidential election candidates in France:




15/4/17: Unconventional monetary policies: a warning


Just as the Fed (and now with some grumbling on the horizon, possibly soon, ECB) tightens the rates, the legacy of the monetary adventurism that swept across both advanced and developing economies since 2007-2008 remains a towering rock, hard to climb, impossible to shift.

Back in July last year, Claudio Borio, of the BIS, with a co-author Anna Zabai authored a paper titled “Unconventional monetary policies: a re-appraisal” that attempts to gauge at least one slope of the monetarist mountain.

In it, the authors “explore the effectiveness and balance of benefits and costs of so-called “unconventional” monetary policy measures extensively implemented in the wake of the financial crisis: balance sheet policies (commonly termed “quantitative easing”), forward guidance and negative policy rates”.

The authors reach three main conclusions:

  1. “there is ample evidence that, to varying degrees, these measures have succeeded in influencing financial conditions even though their ultimate impact on output and inflation is harder to pin down”. Which is sort of like telling a patient that instead of a cataract surgery he got a lobotomy, but now that he is awake and out of the coma, everything is fine. Why? Because the monetary policy was not supposed to trigger financial conditions improvements. It was supposed to deploy such improvements in order to secure real economic gains.
  2. “the balance of the benefits and costs is likely to deteriorate over time”. Which means that the full cost of the monetary adventurism will be greater that the currently visible distortions suggest. And it will be long run.
  3. “the measures are generally best regarded as exceptional, for use in very specific circumstances. Whether this will turn out to be the case, however, is doubtful at best and depends on more fundamental features of monetary policy frameworks”. Wait, what? Ah, here it is explained somewhat better: “They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.”


You can see the permanence emerging in the trends (either continuously expanding or flat) when it comes to simply looking at the Central Banks’ balance sheets:


And the trend in terms of instrumentation:

The above two charts and the rest of Borio-Zabai analysis simply paints a picture of a sugar addicted kid who locked himself in a candy store. Good luck depriving him of that ‘just the last one, honest, ma!’ candy…

15/4/17: Thick Mud of Inflationary Expectations


The fortunes of U.S. and euro area inflation expectations are changing and changing fast. I recently wrote about the need for taking a more defensive stance in structuring investors' portfolios when it comes to dealing with potential inflation risk (see the post linked here), and I also noted the continued build up in inflationary momentum in the case of euro area (see the post linked here).

Of course, the current momentum comes off the weak levels of inflation, so the monetary policy remains largely cautious for the U.S. Fed and accommodative for the ECB:

More to the point, long term expectations with respect to inflation remain still below 1.7-1.8 percent for the euro area, despite rising above 2 percent for the U.S. And the dynamics of expectations are trending down:

In fact, last week, the Fed's consumer survey showed U.S. consumers expecting 2.7% inflation compared to 3% in last month's survey, for both one-year-ahead and three-years-ahead expectations. But to complicate the matters:

  • Euro area counterpart survey, released at the end of March, showed european households' inflationary expectations surging to a four-year high and actual inflation exceeding the ECB's 2 percent target for the first time (February reading came in at 2.1 percent, although the number was primarily driven by a jump in energy prices), and
  • In the U.S. survey, median inflation uncertainty (a reflection of the uncertainty regarding future inflation outcomes) declined at the one-year but increased at the three-year ahead horizon.
Confused? When it comes to inflationary pressures forward, things appear to be relatively subdued in the shorter term in the U.S. and much more subdued in the euro area. Except for one small matter at hand: as the chart above illustrates, a swing from 1.72 percent to above 2.35 percent for the U.S. inflation forward expectations by markets participants can take just a month in the uncertain and volatile markets when ambiguity around the underlying economic and policy fundamentals increases. Inflation expectations dynamics are almost as volatile in the euro area.

Which, in simple terms, means three things:

  1. From 'academic' point of view, we are in the world of uncertainty when it comes to inflationary pressures, not in the world of risk, which suggests that 'business as usual' for investors in terms of expecting moderate inflation and monetary accommodation to continue should be avoided;
  2. From immediate investor perspective: don't panic, yet; and 
  3. From more passive investor point of view: be prepared not to panic when everyone else starts panicking at last.

Thursday, April 13, 2017

Wednesday, April 12, 2017

12/4/17: European Economic Uncertainty Moderated in 1Q 2017


European Policy Uncertainty Index, an indicator of economic policy risks perception based on media references, has posted a significant moderation in the risk environment in the first quarter of 2017, falling from the 4Q 2016 average of 307.75 to 1Q 2017 average of 265.42, with the decline driven primarily by moderating uncertainty in the UK and Italy, against rising uncertainty in France and Spain. Germany's economic policy risks remained largely in line with 4Q 2016 readings. Despite the moderation, overall European policy uncertainty index in 1Q 2017 was still ahead of the levels recorded in 1Q 2016 (221.76).

  • German economic policy uncertainty index averaged 247.19 in 1Q 2017, up on 239.57 in 4Q 2016, but down on the 12-months peak of 331.78 in 3Q 2016. However, German economic uncertainty remained above 1Q 2016 level of 192.15.
  • Italian economic policy uncertainty index was running at 108.52 in 1Q 2017, down significantly from 157.31 reading in 4Q 2016 which also marked the peak for 12 months trailing period. Italian uncertainty index finished 1Q 2017 at virtually identical levels as in 1Q 2016 (106.92).
  • UK economic policy uncertainty index was down sharply at 411.04 in 1Q 2017 from 609.78 in 4Q 2016, with 3Q 2016 marking the local (12 months trailing) peak at 800.14. Nonetheless, in 1Q 2017, the UK index remained well above 1Q 2016 reading of 347.11.
  • French economic policy uncertainty rose sharply in 1Q 2017 to 454.65 from 371.16 in 4Q 2016. Latest quarterly average is the highest in the 12 months trailing period and is well above 273.05 reading for 1Q 2016.
  • Spain's economic policy uncertainty index moderated from 179.80 in 4Q 2016 to 137.78 in 1Q 2017, with the latest reading being the lowest over the five recent quarters. A year ago, the index stood at 209.12.

Despite some encouraging changes and some moderation, economic policy uncertainty remains highly elevated across the European economy as shown in the chart and highlighted in the chart below:
Of the Big 4 European economies, only Italy shows more recent trends consistent with decline in uncertainty relative to 2012-2015 period and this moderation is rather fragile. In every other big European economy, economic uncertainty is higher during 2016-present period than in any other period on record. 

12/4/17: German Economy Forecasts 2017-2018


The latest joint economic forecast for German economy is out and, in line with what Eurocoin has been signalling recently (see post here), the forecast upgrades outlook for Euro area's largest economy.

Here's the release, with some commentary added: Germany's "aggregate production capacities are now likely to have slightly exceeded their normal utilisation levels. However, cyclical dynamics remain low compared to earlier periods of recoveries, as consumption expenditures, which do not exhibit strong fluctuations, have been the main driving force so far. In addition, net migration increases potential output, counteracting a stronger capacity tightening."

  • German GDP) is expected to expand by 1.5% (1.8% adjusted for calendar effects) in 2017 and 1.8% in 2018
  • Unemployment is expected to fall to 6.1% in 2016, to 5.7% in 2017 and 5.4% in 2018 
  • "Inflation is expected to increase markedly over the forecast horizon. After an increase in consumer prices of only 0.5% in 2016, the inflation rate is expected to rise to 1.8% in 2017 and 1.7% in 2018". This would be consistent with the ECB starting to raise rates in late 2017 and continuing to hike into 2018. The forecast does not cover interest rates policy timing, but does state that "In the euro area, the institutes do not expect interest rates to rise during the forecast period. However, bond purchases are likely to be phased out next year." In my view, this position is not consistent with forecast inflation and growth dynamics.
  • "The public budget surplus will reduce only modestly. Public finances are slightly stimulating economic activity in the current year and are cyclically neutral in the year ahead." In simple terms, Germany will run budget surpluses in both 2017 and 2018, with cumulative surpluses around EUR36.6 billion over these two years, against a cumulative surplus of EUR44.6 billion in 2015 and 2016.
  • Current account surpluses are expected to remain above EUR250 billion per annum in 2017 and 2018, with cumulative current account surpluses for these two years forecast at EUR508 billion against EUR521 billion surpluses in 2015-2016.

Slight re-acceleration in both budgetary surplus and current account surplus over 2017-2018 will provide a very small amount of room for growth in imports and capital investment out of Germany to the rest of the euro area. 

Tuesday, April 11, 2017

11/4/17: S&P 500 Concentration Risk


Concentration risk is a concept that comes from banking. In simple terms, concentration risk reflects the extent to which bank's assets (loans) are distributed across the borrowers. Take an example of a bank which has 10 large borrowers with equivalent size loans extended to them. In this case, each borrower accounts for 10 percent of the bank total assets and bank's concentration ratio is 10% or 0.1. Now, suppose that another bank has 5 borrowers with equivalent loans. For the second bank, the concentration ratio is 0.2 or 20%. Concentration risk (exposure to a limited number of borrowers) is obviously higher in the latter bank than in the former.

Despite coming from banking, the concept of concentration risk applies to other organisations and sectors. For example, take suppliers of components to large companies, like Apple. For many of these suppliers, Apple represents the source of much of their revenues and, thus, they are exposed to the concentration risk. See this recent article for examples.

For sectors, as opposed to individual organisations, concentration risk relates to the distribution of sector earnings. And the latest FactSet report from April 7, 2017 shows just how concentrated the geographical distributions of earnings for S&P 500 are:


In summary:

  • With exception of Information Technology, not a single sector in the S&P 500 has aggregate revenues exposure to the U.S. market that is below 50%;
  • Seven out of 11 sectors covered within S&P 500 have exposure concentration to the U.S. market in excess of 70%; and
  • On the aggregate, 70% of revenues for the entire S&P 500 arise from within the U.S. markets.
In simple terms, S&P 500 is extremely vulnerable to the fortunes of the U.S. economy. Or put differently, there is a woeful lack of economic / revenue sources diversification in the S&P 500 companies.

11/4/17: Euro Area Growth Conditions Remain Robust in 1Q 17


Eurocoin, Banca d'Italia and CEPR's leading indicator of economic growth in the euro area has slipped in March to 0.72 from 0.75 in February, with indicator remaining at its second highest reading since 2Q 2010.


Combined 1Q 2017 growth indictor is now signalling approximately 0.7% quarterly GDP growth rates, carrying the breakout momentum from previous quarters (see chart above). This brings most recent growth forecast over the 2001-2007 average.

From growth dynamics perspective, the pressure is now on ECB to start tightening monetary policy:


Inflationary pressures are still relatively moderate, but rising: