Small is beautiful

It is generally thought that in most developed markets it is the small and mid-sized businesses that provide the backbone of a prosperous economy. They are usually more flexible and more innovative than their larger counterparts. Additionally, they do not have significant market power and as a result, competition is fierce. On the other side, large businesses profit more from economies of scale and scope. However, as an industry gets increasingly dominated by a smaller number of larger firms, market power increases and with that the risk of a reduction in competitivity for example via on average higher prices or less investment in R&D. Large firms tend to engage increasingly into rent-seeking behaviour. Overall, an economy dominated by a relatively small group of big businesses will deviate increasingly from the ideal of perfect atomistic competition, resulting in lower trend growth amid an increasingly sclerotic economy and a society where economic and political power is concentrated in the hands of a few. The only beneficiaries of such a process will be the owners of these increasingly large companies.
Unfortunately, there are strong signs that the US has been taking a step in this direction (this is not to say that they are close, just that they are moving closer). I have already previously written about the state of small businesses in the US (Small business job creation, personal income & consumption: weak dated Oct 7). Small firms (defined as having less than 50 employees) were responsible for approx. a third of all jobs created in the period of Q392-Q42000 and Q303-Q307 and only accounted for 9% of the job losses in between Q101-Q203. However, in between Q407-Q408 they accounted for 45% of all job losses! The reason for this shift in job creation can be found in the dependency on the domestic economy and the restrictive financing environment. Small firms tend to be more domestically focused than large companies. If the data here are anything to go by, then small businesses - this time defined as those with less than 500 employees - were responsible for half of nonfarm private GDP but only roughly for a quarter of exports. Given the subdued outlook for the domestic economy, their creditworthiness has deteriorated substantially. Furthermore, while large businesses can access the capital markets directly and were able to profit from the bond issuance boom of this year, small firms are depending on the banking sector to get access to credit. Important sources for the smallest US businesses have been home equity loans and credit card loans. But home equity values have been declining sharply while the lines for credit cards have been cut back significantly and lending standards tightened as banks remain unwilling and unable to lend.
In turn, this combination of a poor outlook for the domestic economy (amid an overindebted and undersaving consumer in an economy overly dependent on consumption) and a lack of financing creates an extremely challenging environment for small businesses and job creation does not promise to stage a rebound soon.
A result is that the trend growth rate of the US economy (or any economy with a similar dynamic) should decline - in line with my multi-year view - as in aggregate small businesses lose market share in favour of large businesses. Large businesses in turn should fare relatively better than their smaller counterparts, be it in terms of market share as well as in terms of profitability. I think that the banking sector provides a case in point given that the largest banks have been showing significant profits again for the past quarter whereas below the surface, the bankruptcy of smaller and medium-sized banks is continuing. The chart below shows the number of bank failures per week as reported by the FDIC. Last week marked a new record in the current crisis with 9 bank failures (that is excluding CIT), bringing the total to 115 this year.Finally, if this is indeed the case then the numbers being reported by the quoted company sector do paint too rosy a picture with respect to the state of the (US) economy.

Rates Strategy: Upgrading the tactical view back to bullish

On Thursday in Last day of Fed Treasury purchases: Do as the Fed does?, I argued once again that nominal growth will be at historically low levels for several years to come given subdued real growth in a stop-and-go economy and amid the lack of inflation pressures. In turn, nominal bond yields should trade at historically low levels as well and I suggested to stick to the strategic long duration positions I started to propose back in June. From a tactical perspective I last downgraded the outlook to neutral from bullish on Oct 12 (see Rates Strategy: Back to neutral). I think that by now, the combination of weaker risky assets, a government bond friendlier macro-view as the V-shaped recovery hopes take a hit and a more supportive positioning environment by non-commercial investors should open the doors for further price gains.

While growth in the US has rebounded sharply from -0.7% in Q2 to +3.5% in Q3, the outlook for Q4 does not look as bright. First in Q3 the impetus on growth by the fiscal stimulus was very significant. However, this does not promise to be repeated in Q4. Remember that for the fiscal stimulus to continue to exert a significant positive impact on growth, it needs to get larger. However, the additional fiscal stimulus in Q4 vs. Q3 does not promise to have that significant an impact on growth. Additionally and as written previously, the summer months were likely to have profited from seasonal adjustments (as argued in more detail here). 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. As a result, Q4 growth is likely to surprise negatively vs. consensus and put a dampener on the hopes for a V-shaped recovery.
The latest drop in equity and commodity prices as well helps to ease the upward pressures on bond yields which was apparent during October. Whether especially the weakness in equity markets will be sustained or proves to be just another shallow and temporary setback on the way to new highs remains open. I remain cautious given my fundamental macro-economic view.
Finally, non-commercial investors in US bond futures - which moved to neutral by early October - have scaled back into short-duration exposure over the past three weeks.

In turn, I think that fundamentals as well as positioning open the door for further price gains in government bonds over the next weeks and I move back to a tactical bullish outlook for government bonds.

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.