No easy way out for Eurozone peripherals

Earlier this week, I made the case for a multi-year outperformance of the German economy (see A German history lesson). The restoring of corporate competitiveness over the current decade coupled with some structural reforms and a relatively healthy situation in government finances before the crisis hit has brought Germany out of its place as the 'sick man of Europe' and has restored the ability to conduct an accommodative monetary as well as fiscal policy to counteract the economic downturn.
However, just as Germany has improved its relative position, the former high-flying Eurozone peripherals look as bad as Germany at the start of this decade, if not worse. In general, the Eurozone peripherals joined the Euro at an undervalued exchange rate and with a below-average price level. Both helped the corporate sector via an effectively easy monetary policy stance. Furthermore, the lower price level meant a higher than average inflation rate and therefore low real yields. This in turn fuelled a housing and construction boom and overall peripheral countries in general exhibited high growth rates. But now the price has to be paid for this artificial boom created via easy money and high lending growth. The general price level increased faster than for the trading partners, meaning that corporates over time lost their competitive position. Furthermore, corporates suffer from a significant financial deficit, which is especially worrisome during a period where banks are unwilling and unable to lend. Households also piled massively into debt and are now left overindebted and in possession of depreciating housing assets. Finally, governments have in general not made enough use of this artificial boom to bring their fiscal house in order. And just as Germany had to learn at the start of this decade, a high price level and a poor fiscal situation take away the ability to generate an easy monetary and fiscal policy environment just at the time where cash-strapped corporates are cutting back sharply and the resulting surge in unemployment pressures the overindebted households ever more to restrain consumption.
Unfortunately there is no easy way out of this situation as Germany had to learn and it will take years to improve the underlying economic fundamentals. A subdued absolute economic showing as well as economic underperformance vs. the core of the Eurozone promises to be with us for several years. The fundamental health of the sovereign will deteriorate further in the foreseeable future not least because as of yet the acceptance that harsh structural reforms have the potential to speed up the healing process still seems to be low. In turn, the downward rating cycle has further to run and the latest negative rating actions do not promise to be the last ones by far. Last week Fitch downgraded Greece's sovereign rating to A- from A with a negative outlook and just yesterday Moody's put Greece on review for a possible downgrade as well (currently A1) and changed the outloook on Portugal's Aa2 rating to negative.

Eurozone govy spreads vs. Bunds: watch out for increasing discrimination between issuers

Source: Bloomberg, ResearchAhead

These negative rating actions have also not gone unnoticed by the bond markets. As the chart above shows 10y Greek government bonds have been underperforming again significantly over the past weeks, not only vs. Bunds but vs. the rest of the Eurozone. But what should investors do? The yield pick-up available by swichting from Bunds into Greece is high with some 140bp. Compared to the 3.25% yield on the 10y Bund that is equal to a yield enhancement of roughly 40%. However, I think that over the medium-term spreads for several peripherly issuers will remain high and risk widening again amid the increasing rating differences vs. the core of the Eurozone and ongoing high refinancing needs. I think that before significant structural reforms are undertaken switching back into some of the 'high-yield' Eurozone sovereigns is premature. Rather I would be switching into high-grade corporate bond issuers of the core countries to achieve a yield pick-up.
Overall, I stick to my view presented on Oct 1 in Rates Strategy: A look at credit yields and spreads: 'Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Italy, Austria and Belgium and be neutral on Spain (amid the poor fundamentals) as well as Germany and France (amid the lack of yield pick-up). On the other side I would be underweight in Ireland, Greece and Portugal amid poor fundamentals and a lack of liquidity despite the yield pick-up. Finally, I would continue to overweight covered bonds in general as well.'
The only change at the moment would be to move Spain to a small underweight as I see an increasing risk for a renewed period of underperformance.

Last day of Fed Treasury purchases: do as the Fed does?

Today, the Fed is completing its 300bn Treasury purchase programme. In turn, the Fed's demand for USTs is evaporating. Should one behave as the Fed does and stop buying govies to move to a short duration position? I do not think so! While tactically, I have been proposing a neutral stance since Oct 12, I doubt that the end of the buying programme will have a significant effect on market valuations and see no convincing reason to change my strategic government bond-bullish stance.

Maturity distribution of Fed Treasury Purchase Programme (in bn USD)

Source: Atlanta Federal Reserve, ResearchAhead

Today, the US Fed will finish its 300bn USD Treasury purchase programme via the buying of USD 2bn in 4-7yr UST. The chart above shows the maturity distribution of the purchased Treasuries so far. The 4-7yr and 7-10yr part of the curve have seen the biggest demand where almost half the buying has been taking place. The above 10y sector has seen a relatively smaller share with a total of USD41bn being purchased. Additionally, TIPS only saw USD4.5bn in buying. Given that this demand is falling away some market participants have been looking for a more challenging environment for UST. I personally, doubt that it will have significant medium-term effects on UST valuations. I am convinced that a) macro-economic developments play a much more important role and b) demand by households and banks/institutional investors is likely to increase.
The medium-term macro-economic outlook is still bond market supportive. My base case remains for an extended period of on average subdued real growth amid the ongoing private sector deleveraging and unwinding of macro-economic imbalances which promises to take several years. Real trend growth should be markedly below the experience of the past decade. Furthermore, current growth is still far away from being self-sustainable. Rather it remains dependent on the life support provided by accommodative monetary and fiscal policy. While this has helped to move back into a positive growth environment for Q3, one should not forget that the effects of the fiscal measures on growth evaporates not once the fiscal stimulus is taken away but already much sooner when the fiscal stimulus has hit its maximum level as it is the change in the size of the fiscal stimulus that is important for growth. Once the maximum level of fiscal stimulus has been reached, the effect on growth drops to 0! So overall, I expect real growth to fluctuate in between roughly -1% to +4% per quarter for several years with a low average of around 2%. Moreover and as I have written frequently, inflation pressures should remain subdued for a prolonged period of time amid ongoing credit destruction and significant excess capacity. In turn, yearly nominal growth rates are likely to average close to 3-3.5% for quite some time which should keep nominal bond yields at historically low levels for the next years.

Medium-term nominal growth is the key driver for nominal bond yields

Source: Bloomberg, ResearchAhead

With respect to demand for US Treasuries, I think that private households as well as institutional investors are likely to increase their appetite despite the low yields. First, households need to restore their balance sheets and reduce indebtedness. This should go hand in hand with a higher savings ratio and should also see an increase in investable funds. In light of the difficult economic environment and the disappointing experience with equity investments I expect the demand for the safe-haven of government bonds to increase. Also important institutional investors should see increasing pressures to change their structural asset allocation. Pension funds in a host of countries including the US have had large shares of equity investments. However, as equity performance over the past decade has been poor while the rates used to discount the future pension liabilities have decreased, there is an increasing underfunding problematic for these future pension liabilities. This reduces the risk-taking capabilities of the pension funds - and similarily for life insurers - and in turn is likely to force them to adapt a higher fixed income share in their portfolios. Finally, banks' balance sheets remain in a difficult position and coupled with the subdued economic outlook, the ability and the willingness to lend is low. In turn, banks are more likely to use their excess reserves to conduct carry strategies via UST than to increase their lending actitivities.

Therefore, fundamentally as well as from the demand side I do not see a good enough reason to change my bond bullish strategic stance. Stick to strategic longs in the US and the Eurozone!

A German history lesson

I am convinced that the German experience of the past decade holds interesting lessons in the economic, political and social sphere of society and I want to provide a deeper insight into the German situation.
Looking ahead and as I have written previously, I expect trend growth for the upcoming decade to fall significantly in the US, the UK but also in the periphery of the Eurozone. However, I am more optimistic with respect to Germany and Switzerland. In light of the new government's plans for the upcoming legislative period and the prospects for a net fiscal easing at the start of 2010 and again in 2011, I see myself confirmed in my view of a relative outperformance of Germany within the developed economies' universe.

Below I try to put the situation of the German economy in a much broader historical perspective, tackling as well on some political and socio-economic issues. It is mainly qualitative but can be backed-up with much more data.

Following the burst of the reunification inspired housing bubble in Germany in the mid-90s, the domestic economy essentially went into a downturn. German corporates, instead of restructuring, tried to profit from the building TMT bubble and went on a debt-financed buying spree (largely to buy foreign companies as well as finance UMTS licences). At the turn of the millennium, German corporates were over-indebted and had a massive financial deficit. This financial deficit of the corporate sector amounted to 8% of GDP in early 2000, far outweighing the Eurozone average (including Germany) as well as the US', both at around 3%. Furthermore, the hope for a bright TMT future in conjunction with a significantly weaker trade-weighted Euro (see chart below) took off the pressure for German corporates to restructure.

Trade-weighted Euro: Strong tailwind into the TMT bubble reversed early this decade

Source: Bloomberg

Additionally, with the birth of the Euro in 1999, exchange rates within the Eurozone were fixed at an overvalued level for Germany which was only overshadowed temporarily by the TMT bubble and the ongoing fall of the external value of the Euro. So at the time when the TMT bubble burst and the Euro reversed its fortune, the shortcomings of the German corporate sector (uncompetitive within the Eurozone, high costs basis, overindebted, too high financial deficit) were unveiled. Additionally, the German economy at the beginning of this decade suffered from a high price level, especially vs. the other Eurozone members. Besides the negative impact on competitiveness, this led to a lower inflation rate than the Eurozone average and therefore to higher real yields. This is one of the problems in the Eurozone, the country with the cyclically weakest economy and therefore relatively low inflation gets the highest real yields. Furthermore, labour markets were very rigid and finally, the government suffered from a significant structural budget deficit which was only temporarily overshadowed by the huge UMTS-licence receipts in 2000. Moreover, the cyclical global economic downturn also unveiled the structural shortcomings of the German banking sector. First, the re-unification construction boom and subsequent bust meant that German banks' balance sheets were significantly burdened by non-performing assets. Second, the German banking market was extremely fragmented, rendering it difficult to generate profits for the private banks from their home market.

Germany saddled by relatively high real interest rates early this decade - but not anymore

Source: Bloomberg, ResearchAhead

Taken together, at the beginning of this decade when the economic downturn started, Germany suffered from a high price level, high social security contributions and taxes (amongst others the reunification is thought to still cost approx. 5% of GDP per year), a weak domestic economy following the bust of the reunification construction bubble, an uncompetitive and overindebted corporate sector, inflexible labour markets, a substantial structural budget deficit and a lowly profitable banking sector burdened with high non-performing assets. Furthermore, the ability for accommodative macro-economic policies was limited to non-existent as German inflation was falling faster than the Eurozone average and therefore the ECB rate cuts had only a small influence of German realised real yields. Furthermore, the rise in the Euro more than offset this monetary easing. Furthermore, the Maastricht Treaty in conjunction with a significant structural budget deficit meant the possibility for fiscal easing to cushion the downturn was limited as well.
The chart below tries to highlight the real yield problematic for the German economy. It shows the difference between the Eurozone core inflation rate and the German core inflation (in blue). Furthermore, it shows 10y Bund real yields defined as 10y Bund yields minus realised core inflation and 10y swap real yields (as a proxy for the Eurozone average) defined as 10y swap rates minus realised Eurozone core inflation. Into the cyclical downswing, German core inflation fell by more than the Eurozone average, therefore, limiting the fall in German real yields. Whereas at the turn of the millennium 10y swap and 10y Bund real yields were the same, in early 2003, 10y Eurozone real yields had fallen by some 300bp to roughly 2% whereas 10y Bund real yields were around 3.35%.
In turn, it what this horrible macro-economic environment with no ability for an effective accommodative monetary or fiscal policy which led corporates to restructure (i.e. move from a financial deficit into a surplus to pay down debt, cut costs via downsizing & offshoring) and forced the government into structural reforms where amongst others labour market flexibility was increased (via for example the so-called Hartz reforms) and social benefits were partially reduced (via for example a raise in the statutory retirement age which means that one has to either work longer or take a significant cut in pensions).
This combination of a significant rise in unemployment (amid the corporate restructuring), a more flexible labour market and a reduction in social benefits led to some rational consequences for private households/consumers.
- a rise in the savings ratio amid lower social benefits
- downside wage pressures especially for lowly educated people amid higher unemployment and a more flexible labour market coupled with higher hurdles to be granted extended unemployment benefits
- an ongoing weak housing market amid record unemployment and high real yields
- an increasing divergence between the domestic economy and the export-led corporate sector once the global economy was recovering and corporates re-established their competitiveness

Politically and economically, a focus on structural reforms was the only promising way out (this is not to say that the reforms could not have been designed much better). On the positive side, the competitiveness of the German corporate sector improved considerably and labour market flexibility increased also while tax rates have been lowered. Furthermore, the relatively healthy situation of government finances at the beginning of the current crisis as well as the much lower relative price level of Germany vs. its Eurozone partners than some 10 years ago means that the ability to conduct an accommodative monetary and fiscal policy has improved considerably. This can also be seen in the chart above where 10y Bund real yields have dropped to the lowest since the existence of the Euro ( to around 2%, almost 150bp lower than in early 2003) whereas Eurozone average 10y real yields are at similar levels than in 2003. This reduction in real yields coupled with the prospects for more fiscal easing over the next two years as well as only a limited rise in the unemployment rate suggest that the prospects for a domestically generated economic upswing are relatively good. Low real yields but no further significant cuts in social security benefits should reduce the inclination to save and I expect a drop in the German savings ratio over the next 2-3 years. Coupled with tax cuts, this will go a long way to rebalance the German economy with a relatively higher share of consumption to GDP, reducing the dependency on exports.
On the negative side in economic terms, the country is still too focused on exports. However and as just mentioned I see a good probability that the economy can become more balanced. More serious is that the domestic banking market remains only lowly profitable. While some mergers have taken place in the private banking segment as well as with Landesbanken over the past year, so far it is still a very fragmented banking market.
I see the most important negative aspect of the German experience, though, in the socio-economic sphere. Downside wage pressures at the low end of the income scale persists as the 'supply' of lowly educated people is still larger than the demand. The improved situation of the corporate sector - at least up to the start of the financial crisis - on the one side and lower social benefits for longer-term unemployed/lower wages for the low-income earners on the other side has led to a deep rift in society and the political landscape. In turn, the perception is that the structural reforms were 'paid' by the low income earners/unemployed which seems to be a key reason for the poor fate of the SPD at the last election.

A quick update on some economic and market themes

On Oct 2 in Autumn growth weakness is finally becoming evident, I wrote that macro-economic data for September/October should disappoint mostly due to technical factors as the upswing following the summer holiday period should be less pronounced than seasonal factors assume. The chart below shows the economic surprise indicators as provided by Citigroup and defined as the weighted historical standard deviations of data surprises.

EUR, USD and GBP eco surprises becoming less positive

Source: Citigroup

As the chart shows since the beginning of September, economic data surprises have become negative/less positive with especially UK data surprising on the downside (most notably the GDP release last week). Furthermore, also EUR data on average has surprised negatively whereas US negative data surprises have been limited.
In turn, these data continue to support the picture of a less-pronounced-than-usual economic rebound into autum and I look for an ongoing tendency of seasonally adjusted economic data to undershoot expectations in the near-term. However, overall the expectations undershoot is not very pronounced so far.
Additionally, especially the UK GDP report also supports my cautious stance with respect to the economic outlook for the UK and the performance of UK-related assets, most notably GBP (for more details see for example UK: New data, same problem). I still do not see any reason to change my medium to longer term negative assesment of UK-related assets.

With respect to market behaviour, the slight downturn in economic data has not been sufficient to significantly alter market dynamics. Equity markets are trading almost exactly where they were when I left two weeks ago. However, commodities broke out of the sideways trading pattern which guided trading during the summer months which led me to close my tactical long duration positions (see Rates Strategy: Back to neutral) just ahead of the two-weeks break. Since then, both commodity indices and government bond yields have moved significantly higher.

Government bond yields continue to trade more with commodities than with equities

Source: Bloomberg

In turn, cross-market wise we either need to see a much more pronounced fall in equities or a setback in commodity prices for government bond yields to retrace again and it seems that just a softish tone by economic data alone is not enough. Therefore, for the time being I stick with the tactically neutral stance.

Taking a short break

I am taking a short break (school vacation for my three kids) and am looking to return towards the end of next week.

Rates Strategy Update: Back to neutral

Subsequent to my post on Friday Rates Strategy Update: A first warning shot for the bond bulls, government bonds have sold off into Friday evening with further losses today. On the other side, equity markets are trading to new highs. Furthermore, commodities as measured by the CRB index have broken through a two-months downward trend last Thursday and a move above the August 6 high would suggest that the consolidation period is over. As argued on Friday, it is especially the latter which threatens government bonds as it raises the prospects that a renewed inflation scare might be priced into markets.
To be sure, my fundamental outlook has not changed and I still see very little upcoming inflation pressures. Yes, headline inflation rates will rise over the next months as the base-effects from the previous commodity sell-off into early this year fades. However, core inflation rates should continue to slowly fall further amid the high level of unused capacity (aka the output gap) as well as a credit creation process which is far from working properly. Still, if markets chose to refocus again on the risk of rising inflation, bonds will weaken.
Unfortunately also the latest positioning data raise the propability for lower government bond prices. Last week's JP Morgan investor sentiment survey showed a marked surge of net-longs to 15% from 1% the previous week, a multi-month high. Additionally, pvbp-weighted non-commercial positions in US bond futures (2y, 5y, 10y & 30y) for the first time since late 2008 have moved back to neutral. Non-commercials hold essentially a steepener with longs in 2y&5y vs. shorts in 10y&30y. This short position at the long end of the curve (10y&30y), though, is the smallest since January (i.e. around the time the 10y yield hit its record low). As a consequence, the short-covering by non-commercial accounts promises to be over while the net-longs according to the JPM survey suggests as well that there is little near-term buying in store.

Nr. of net contracts by non-commercials in US 10y futures: Short-covering is over

Source: CFTC

Overall, therefore, the near-term outlook for government bonds has become more uncertain amid the ongoing recovery in risky assets, the renewed surge in commodity prices which raises the threat that markets refocus on the risk of higher inflation and the significant shifts in investor positioning. While sticking to my strategic bond-bullish outlook, I think it is prudent in the light of this uncertainty to move the tactical stance back to neutral for the time being.

Rates Strategy Update: A first warning shot for the bond bulls

On Monday I maintained my tactical bullish bond outlook and suggested that following a brief consolidation, the market would be able to take another leg higher. This is exactly, how things played out in the Bund future. On Monday and Tuesday the Bund future moved slightly lower, losing approx. 30 tics. On Wednesday and Thursday it was able to move higher again and printed a new high above 123 yesterday afternoon. However, the subsequent sell-off raises a warning flag about its future prospects. For one, the 10y US TNote future - while showing the same pattern - was not able to make a new high yesterday. Additionally, the 30y TBond auction was rather poor. Furthermore, several market commentators suggested the sell-off was largely due to comments by Fed president Bernanke. However, I am less worried about his speech and what it might suggest for future policy action than by the latest moves in the commodity area. With respect to Bernanke, he stated that the Fed would be ready to tighten monetary policy when the outlook for the economy "has improved sufficiently". Furthermore, he said "At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road." To me these statements tell the obvious: Monetary policy accommodation needs to be reduced if the economic rebound is gaining traction (i.e. is becoming self-sustainable). This is always the case. The question is rather, when will that happen (I personally continue to doubt that a meaningful self-sustaining recovery can take hold soon). In turn, given the conditionality of his statements, I do not see any news by Bernanke's comments.
What makes me worried, though, are the latest developments in commodity markets. I used the chart below previoiusly. It shows the development of equity markets (here the EStoxx index), 10y Bund yields and the CRB-index. The EStoxx index and the CRB-index are both set at 100 for March 8 (the day of the equity low) in order to improve readability.

Commodities are sending a warning shot for government bond bulls

Source: Bloomberg, ResearchAhead

As can be seen, government bond yields and commodities exhibited a relatively good co-movement during the past 7 months and both deviated significantly from the equity market performance. I suggested previously (see for example Commodities and related markets to fall first? dated August 26) that equities would be rallying amid the improved outlook for real growth whereas bond yields would be falling amid easing inflation fears which is also evident in the lacklustre performance of commodity prices. Just to repeat, theoretically and empirically it is nominal growth which matters for the level of nominal bond yields. And while the real growth outlook has been improving, expectations for nominal growth have not really moved higher as inflation in general (again, the UK is the big exception) has surprised on the downside. In turn, nominal bond yields were able to fall. Unfortunately, the latest signal being emitted by the commodity complex are looking worrisome for government bonds. Not only do equity markets continue to rise, but now also commodity prices seem to have moved back on a rising path, drawing a wedge between the performance of bond yields and the CRB index (marked in yellow in the chart above).
Looking at the commodity index itself, it seems that it has moved out of a consolidation phase yesterday, breaking a short-term downward trend to the upside while the medium-term upward trend has remained intact (see chart below).

The end of the consolidation period in commodities?

Source: Bloomberg

Furthermore, this move higher is being confirmed by the recent development in the Baltic Dry Index which has also rebounded since the start of this month:

Source: Bloomberg, ResearchAhead

In turn, the prospects of rising equity markets in conjunction with rising commodity prices would constitute a serious headwind for government bonds and currently send a warning flag for government bond bulls and I do take this development seriously. For the time being, I stick with the proposed tactical longs. The reason is that I continue to look for technical factors (see Autumn growth weakness is finally becoming evident) to lead to a relative worsening of the seasonally adjusted economic data for September/October which will weaken the growth recovery story. However, should the CRB index break above its August 6 high at 269.18 while equity markets continue to rally, I would need to reconsider my bullish stance.

Smalll business job creation, personal income & consumption: Weak

A) More worries about small businesses: Following yesterday's post on the difficulties of external financing for small businesses and what it implies for trend growth I was pointed to a speech New York Fed President Dudley held this Monday (A Bit Better, but Very far from Best). Dudley sees three major forces restraining the pace of the recovery: The net wealth shock, the fiscal outlook and the banking system. With respect to the last point, besides the outlook for commercial real estate loans he seems especially worried about small businesses: "For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector." I couldn't agree more!
Furthermore, the Atlanta Fed's macroblog as well looked into the relationship between the health of small businesses and the outlook for job growth in a post published yesterday evening (Prospects for a small business-fueled employment recovery): "During periods when national employment levels were expanding since 1992 (when this data series began), firms with less than 50 employees have made up approximately one-third of the nation's employment growth. During the employment declines associated with the 2001 recession, these firms made up only 9 percent of job losses. In the current recession, though, these very small firms have made up 45 percent of the nation's job losses. Looking ahead, it's not clear whether small businesses will continue to play their traditional role in hiring staff and helping to fuel an employment recovery. However, if the above-mentioned financial constraints are a major contributor to the disproportionately large employment contractions for very small firms, then the post-recession employment boost these firms typically provide may be less robust than in previous recoveries."
The chart below is also taken from this blog and highlights the job gains/losses by firm size.
Again to repeat: I think small businesses will continue to face a difficult financing environment which will render it more challenging to grow operations and furthermore limits business start-ups. This in turn hinders job growth to a significant degree, reduces the flexibility of the US economy and negatively impacts trend growth.

B) The evolution of personal income looks worrisome: Over the past months I highlighted several times my index of weekly nominal earnings (see for example Consumer deleveraging spiral still getting worse). This is derived from multiplying average hourly earnings with the index of aggregate weekly hours worked. Because these data are published with the monthly payroll report, they are the most timely indicator of the development of personal finances. Given that the growth in hourly earnings has been declining (+2.5% yoy in September vs. +4% yoy in December 2008) while unemployment and underemployment has been rising sharply, nominal weekly earnings growth has collapsed at an unprecedented speed (see chart).

Nominal weekly earnings are collapsing at an unprecedented speed

Source: Bloomberg, ResearchAhead

Now for the outlook for consumption growth, one key determinant usually mentioned is the development of disposable personal income (besides the savings ratio). Personal income constitutes of the compensation of employees (accounting for roughly two-thirds of income), proprietors income, receipts on assets as well as transfer payments. Deduct tax payments from personal income and you get disposable personal income. Unfortunately as shown above wage income is dropping significantly. Furthermore, also proprietors income has been falling as have receipts on assets (interest and dividend income). This leaves a poor development of disposable income less transfer receipts (see chart below, yoy %-change).

Also disposable income less transfer receipts is falling at an unprecedent post WWII speed

Source: BEA; ResearchAhead

This leaves alll the heavy lifting for the government and the increase in transfer payments as well as the reduction in taxes are the only reasons why disposable personal income so far has not fallen more.

yoy% change in disposable personal income has been supported by government support

Source: BEA, ResearchAhead

However, the outlook here is very poor. First, given the downbeat prospects for the job market not least amid the difficulties in the small business segments, nominal wage incomes are unlikely to grow meaningfully (amid ongoing job destruction and weakening wage growth). Furthermore, as rents are now falling, proprietors income does not promise to stage a rebound and should rather remain under pressure. Additionally, in the current low yield environment, dividend and interest payments are also unlikely to increase. Therefore, also for the forseeable future, growth in personal disposable income needs government assistance. However, the fiscal deficit situation does not suggest that substantial further actions to reduce tax pamyents or increase transfer entitlements - besides ever-extending unemployment benefits - are on the cards. In turn, the positive effects on disposable income growth by state actions are likely to weaken in the quarters ahead. Therefore, the growth in disposable income is very likely to drop at an even faster rate going into next year. Coupled with a rising savings ratio, as households restore their balance sheets, this promises to keep consumption growth more subdued than is currently anticipated.

The rebalancing of the real economy has only just begun and promises to be a multi-year affair which will keep real growth rates subdued and inflation pressures in check. In turn, nominal growth as the key determinant for nominal bond yields should remain at low levels for an extended period of time!

Lack of credit availability for small corporates threatens trend growth

Small and mid-sized businesses are an important part of most economies. They are responsible for providing the largest share of jobs and more importantly job growth and are also credited for significant innovation. In turn, they are a key driver of growth for an economy. If it gets more difficult to open up new businesses, then that promises to slow down growth to a significant extent. Certainly, there are numerous factors impacting the rate at which new businesses are being formed, ranging from the economic outlook to bureaucratic obstacles and many more. Additionally, access to external financing is frequently a necessary condition in order to be able to start a new business. However, here the news - especially out of the US - is far from encouraging.
While large enterprises do have access to the capital markets for external debt financing and debt issuance has been running high this year, small and mid sized corporations are much more dependent on bank lending. For the US, Meredith Whitney in this article entitled The credit crunch continues states that: "Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan....Small business loans are hard to find, and credit-card lines (a critical funding source to small businesses) have been cut by 25% since last year." She then goes on: "In the U.S., small businesses employ 50% of the country's workforce and contribute 38% of GDP. Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business...Small businesses primarily fund themselves through credit cards and loans from local lenders. In the past two years, credit-card lines have been cut by over $1.25 trillion."
If existing small businesses cannot get access to bank credit and given their size cannot access the capital markets directly, their owners have either to invest more or they face increasing risks of a liquidity shortage which threatens to force the company into bankruptcy. Furthermore, if credit for small-sized business is very hard to come by, then it will be more difficult to found a new business. In turn and as mentioned above, the job creation by new businesses slows and also the flexibility of the economy suffers.
However, job creation by new businesses as calculated by the Bureau of Labour Statistics does not mirror this reality. The chart below shows the development of the so-called birth-death adjustment. This adjustment should indicate the jobs created by new businesses minus the jobs lost by business closing. Given that the BLS estimates the data via statistical analysis based on historical time series it has been causing doubts about the reliability of the payroll report numbers. In short, the BLS uses an estimation procedure with two components: the first component excludes employment losses from business deaths from sample-based estimation in order to offset the missing employment gains from business births. This is incorporated into the sample-based estimate procedure by simply not reflecting sample units going out of business, but imputing to them the same trend as the other firms in the sample. This step accounts for most of the net birth/death employment. The second component is an ARIMA time series model designed to estimate the residual net birth/death employment not accounted for by the imputation. So effectively, it is largely based on longer-term historical data and not on actual (hard to measure) job gains and losses.
The data below are not seasonally adjusted and always show a large drop in January followed by an upsurge into spring and moderate payroll growth in H2. Since the start of 2007, the accumulated birth-death adjustment is not showing a trend change (it is up by more than 2mln jobs over the past 2.5 years). Given the difficulty for small businesses to obtain credit - and therefore higher hurdles to start a business - this does not seem plausible at all.

BLS birth-death adjustment does not show a slowing trend

Source: BLS

In turn, as the birth-death adjustment most likely overstates job creation by new businesses, job destruction in the current recession looks understated. Furthermore, I do regard the increasing difficulty to open new businesses as one reason why trend growth in the US is likely to slow markedly for the next several years as the flexibility of the economy is being reduced. The only positive aspect I can see behind this is for existing businesses with enough liquidity as they do face a lower risk of new entrants eating away market share and/or cutting into their margins.

Interestingly, according to the Ifo institute the situation in Germany is different. According to their latest survey (released on Sep 29, see here): "Credit constraints for German trade and industry weakened slightly in September. Of the surveyed firms, 43.7% now assess bank lending polices as restrictive. In August 44.2% of the survey participants complained of difficult access to bank credit. However, there are differences among the economic sectors of the survey. Of special note is the favourable development in wholesale/retail, where the credit hurdle fell from August to September from 41.7% to 39.9%. In construction the lending situation remains unchanged. A different tendency is observable in manufacturing. Here the bar of the credit hurdle rose from 45.9% to 46.5%. For large manufacturers in particular, the credit hurdle was again higher, from 51.8% in August to 54.5% now." As the chart below shows this survey suggests that small and medium-sized businesses face less tight credit conditions than their larger counterparts. Usually, this is just the other way around. Furthermore, compared to the 'German crisis' in the earlier part of this decade, overall credit conditions for small and mid sized manufacturers do not appear overly tight.

Credit constraints in German manufacturing according to company size

Source: Ifo Business Survey

But why do we see such a difference between credit availability for small and mid sized corporates in the US and Germany and what is it telling us about the likely economic prospects?
First, in general especially small corporates are very much a local affair and depend on the state of the domestic economy whereas large corporates usually have large sized international operations and are therefore more export dependent. Given that the outlook for consumption is bleak in the US and because bank balance-sheets are still far from healthy, banks seem to shy away from increasing their credit commitments towards domestic operations. This is also what happened in Germany earlier this decade. The weak state and outlook for the domestic economy let banks be especially restrictive with credit for the smaller locally-focused corporates whereas the export-oriented larger manufacturers had much easier access to credit. However, given that the situation in Germany's export markets deteriorated significantly, the export-oriented corporates seem to be facing a tight credit environment. The locally-oriented small/mid-sized businesses on the other side as well as the wholesale/retail industries face a relatively better economic outlook given that there has been neither a housing nor a consumption bubble within Germany. In order for the German economy to shift its focus away from a very high export dependency towards a larger domestic focus, relatively easy credit availability for the domestic-economy focused companies is a necessary - but again not a sufficient - condition. The news on this front at least looks promising.

Rates Strategy Update: Still long

The 30y US TBond has provided a good leading signal for the government bonds universe as I suggested a week ago (see: Rates Strategy Update: Here comes the bull flattener). Following the break of the 4.10-4.20% support area Friday a week ago, the 10y Bund future traded to a new high last Monday and the 10y US TNote yield finally could break through the 4.304% double bottom reached on July 10 and September 2 (see chart below). So, technically, the bond-bull market looks healthy.

10y TNote yield finally breks through strong support at 3.304%Source: Bloomberg, ResearchAhead

In terms of positioning, the CFTC data relating to the US futures markets suggest that non-commercial accounts have reduced their short positions slightly compared to end August. however, they remain net short, even though only moderatly so. Furthermore, they still hold a curve steepening position with longs in the 2y and 5y futures offset by shorts in the 10y and 30y futures. In turn, also positioning does not seem to stand in the way of further price gains.
Most importantly, fundamentals do suggest that further falls in government bond yields are in store for the next few weeks. For one, inflation continues to surprise on the downside as evidenced for example by the German September CPI release where the EU harmonised measure fell by 0.4% yoy vs. expectations of a 0.2% drop and following -0.1% in August. Key, however, is the renewed weakness in economic data releases. Just on Friday I wrote in Autumn growth weakness finally becoming apparent that the recent economic data releases do support the picture of a less-pronounced-than-usual economic rebound into autum and I believe we should look for further negative surprises from September and October seasonally adjusted economic data. This should dampen the optimistic growth outlook which has become consensus over the past months.
Therefore, technicals as well as fundamentals should become increasingly supportive of further gains in government bond prices over the next few weeks and positioning does not seem to stand in its way. In the ultra-short-term, i.e. over the next few days, the picture is less clear as following the recent gains bond futures look short-term a bit overbought and additionally there are not many data releases scheduled for this week. In turn, we might consolidate first before taking another leg higher. However, I would regard this as a very short-term risk and would not expect a meaningful retracement in bond prices. In light of all this, it should not come as a surprise that I stick with my long duration positions on a tactical as well as strategic time scale. Furthermore, I still look for the long-end to be the driver of the market and therefore, the short-end to lag in terms of performance.

Autumn growth weakness is finally becoming evident

Given the latest data-set with some negative surprises (for example Chicago PMI, ISM, notoriously high jobless claims and also today's employment report), it is time to reconsider the short-term outlook for growth. On July 20 I stated in Q3 growth likely to surprise positively but not final sales that I was looking for a fairly upbeat Q3 growth number but that this would not be mirrored by the development of final sales. Furthermore, I expected that given seasonsal adjustments, growth going into summer would be overstated. Finally, once summer would be ending and seasonal factors assume a strenghtening of the economy, seasonally adjusted data should show a reversal of the earlier strength. So far, I see myself confirmed in this picture and expect a weakening growth momentum in the near term.

To recap: Growth has been improving going into Q3 helped by the abating of the inventory correction, the reduction in negative growth contributions especially from residential construction as well as from auto manufacturing and increasing effects from the enacted fiscal stimulus. So, GDP growth has rebounded largely because of a reduction in the drags on growth. In addition, as most economic data is seasonally adjusted, technical factors should have amplified the Q3 growth rebound. As an example, the auto industry has lost one third of its jobs between December 2007 and June 2009. In turn, the usual seasonal drop in auto employment during the summer months was a lot less pronounced. This point was also made by the Atlanta Fed on July 17 (see here): "On an unadjusted basis, the initial claims data showed a fairly large increase last week—up 86,000 workers. But claims for unemployment compensation typically rise in early July as auto plants shut down to retool for the new model year. The jump in claims this July hasn't been as large as in years past since many of the auto plants were waylaid earlier in the year. So on a 'seasonally adjusted' basis, the data showed a drop in claims of 47,000 workers."
Therefore, given the previous job and output losses, the typical seasonal weakness going into summer was less pronounced resulting in stronger than expected seasonally adjusted data. However, now that summer has ended, the typical seasonal strength should also be less than usual. In short, the people who would normally have been let go for the summer period will not be hired for the autumn rebound as these jobs have been lost irrespective of the seasonal pattern, i.e. on a more medium-term to permanent basis. Therefore, parts of what we perceived to have been good news at the start of the summer was only a technical aberration which is being corrected now as the summer ended. I hope the chart below helps to understand the situation. In blue is the normal course of action. Actual economic activity usually slumps into summer (blue dotted line). However, what we get in terms of data releases are the sesaonally adjusted data correct for this pattern and therefore do not show such a slump (the blue solid line). However, this year we started from a lower base in some of the most affected industries and hence the slump was less pronounced than usual (the red dotted line). The solid dotted line shows the seasonally adjusted path: an apparent upturn into summer, followed by a downturn into autumn.

Less pronounced seasonal weakness into summer followed by weaker-than-usual rebound

Source: ResearchAhead

This would go a long way in explaining the behaviour of weekly jobless claims which dropped sharply during June but have remained stubbornly high since. Furthermore, it would also at least partially explain the behaviour of the ISM (which is also seasonally adjusted) which has fallen again in September.
So far, the recent economic data releases do support the picture of a less-pronounced-than-usual economic rebound into autum and I believe we should look for further negative surprises from September and October seasonally adjusted economic data. This should dampen the optimisit growth outlook which has become consensus over the past months. However, while the late spring/early summer number painted too bright a picture, the September/October data might paint a too negative picture about the underlying economic dynamic.

A look at credit yields and spreads

What is the outlook for credit-related yields? I think there are two main forces at work. For one, the underlying fundamentals remain difficult as rating downgrades are far from over while default rates do not seem to have hit their peaks yet. Furthermore, growth is far from self-sustainable and continues to depend on the life support provided by central banks and governments. On the other side, the environment of ultra-low short-end yields forces investors out the curve and out the rating scale in order to earn carry income. This is important for end investors as well as for pension funds but also increasingly for banks. Banks need to restructure and recapitalise their balance sheets. And here a steep yield curve as well as pronounced credit spreads help over time. Banks can fund themselves at almost 0% and can invest the money into either long-term government bonds or into credit-related paper (if they are usable as collateral with the central bank). In turn, demand for carry should remain strong as long as short-end yields are low. Furthermore, even though spreads have tightened sharply over recent months, they are still substantial as a percentage of the underlying risk free rate. Just as an example, a spread of 100bp does not appear that big in an environment where 10y government bonds are trading around 5-6%. However, if 10y govies are yielding only around 3%, such a spread would be equal to a return enhancement of 33%! In turn, the lower the yield level, the more attractive a given spread will become.

In order to derive some investment conclusions, I will take a brief look at history of the 1930s US.

The effects of the banking crisis in the 1930s on the bond markets

Source: St. Louis Federal Reserve

For the corporate bond yields I used the Moody's seasoned indexes which try to include bonds with remaining maturities as close as possible to 30 years. During the banking crisis in the early 1930s - and similar to what we saw last year - government bond yields were moving sideways to lower whereas credit-related yields were shooting higher, aggravating the banking crisis. Credit yields peaked in mid 1932 before entering a multi-year downward trend. Credit spreads showed the same behaviour as the chart below shows. This is remarkable as the recession lasted from August 1929 until March 1933. In between, the spread between Baa and long-term government bond yields had fallen from a peak of almost 800bp in May 1932 to a low of 420bp in autumn 1932 before rewidening temporarily. However, in 1932 real GDP collapsed by roughly 13% and fell by another 1.3% in 1933. Furthermore, even though growth rose to 10.9% in 1934 and 8.9% in 1935, credit yields continued to trend lower.

Corporate bond spreads entered multi-year downward trend following the banking crisis

Source: St. Louis Federal Reserve, ResearchAhead

However, what the above charts also shows is the huge volatility in the Baa yields and spreads vs. relatively stable AAA yields and spreads. Furthermore, there is a significant discrepancy between the AAA and Baa yields going into the next recession which started in 1937. AAA yields briefly moved a bit higher ahead of the recession but soon moved back on the path to lower yields.

Multi-year downward trend only briefly interrupted by onset of next recession for AAA bonds

Source: St. Louis Federal Reserve

On the other side, Baa yields once again moved significantly higher also starting a bit ahead of the recession but moved higher during almost the entire recession!

More pronounced and longer-lasting rise in yields for Baa bonds

Source: St. Louis Federal Reserve

I think that this diverging behaviour between high-grade bonds and their lower rated counterparts is likely to play out as well over the medium term amid the diverging forces between ongoing difficult fundamentals (and the risk of a double-dip) on the one side and the hunt for carry on the other. First the obvious: High-rated bonds will show a much lower volatility (no surprise) than low-rated ones, i.e. if one underperforms, the underperformance will be less. However, more importantly history during the 1930s suggests that the probability to underperform is also significantly lower in the case of higher-rated bonds. In turn, given the significant spread tightening since spring, I would not overweight high-yield bonds from a strategic asset allocation perspective. Rather, I would continue to overweight high-rated bonds vs. both, government bonds as well as high-yield.

Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Italy, Austria and Belgium and be neutral on Spain (amid the poor fundamentals) as well as Germany and France (amid the lack of yield pick-up). On the other side I would be underweight in Ireland, Greece and Portugal amid poor fundamentals and a lack of liquidity despite the yield pick-up. Finally, I would continue to overweight covered bonds in general as well.