UK CPI: one swallow doesn't make a summer

UK CPI (February YoY) came in ahead of expectations at +3.2% versus consensus of +2.6%. The 10 year Gilt yield rose to 3.37%, up 24 basis points. Mervyn King commented this morning on the higher than expected inflation number in an open letter to the Chancellor:

"Since last summer, world commodity prices have fallen sharply and that has helped drive a fall in overall CPI inflation from 5.2% in September to 3.2% in February. But the effect on UK consumer prices of decreases in world prices has been dampened by the depreciation of sterling. Since my December letter, the sterling effective exchange rate has depreciated by about 5%, bringing the total depreciation to 28% since the summer of 2007. February's inflation out turn is somewhat higher than expected. That could reflect pass-through of the exchange rate depreciation to consumer prices since much of the strength in the out turn appears to be concentrated in components where a large share of goods is imported."

Later, when questioned by the Treasury Committee about the implications about the implications for the Bank's QE programme, Mervyn King commented:

"We might need to do less on QE than £75 billion if it works... the target is to complete something in the order of £75 billion in QE over the next three months"

However, one swallow doesn't make a summer and it is still premature to say whether monetary policy is working or if it is stoking inflation. Indeed, Mervyn King noted in a statement to the Treasury Committee this morning that inflation is likely to fall in the medium term:

"Inflation in the UK is currently still above target. CPI data released this morning show that inflation was 3.2% in February, triggering another open letter from me to the Chancellor. At its next meeting, the Committee will want to consider further the implications of this inflation out turn. But the sharp slowdown in spending is likely to generate a significant margin of spare capacity in the economy, which, in turn, will bear down on inflation in the medium term. So the key question for the MPC is how to ensure nominal demand returns to a level that is consistent with meeting the inflation target."

Back to basics: 7 investment principles for successful investing

The application of all of the following seven principles should result in successful long term investment. However, achieving success requires diligence, patience and discipline to adhere to one approach. It cannot be achieved overnight with a series of short term 'punts' which, at best, can work in your favour 50% of the time and, at worst, could cumulatively destroy capital rather than growing it.

1. Accept that you can never be 100% sure what will happen or what will be the best performing asset class, so diversify.
2. Even if you are 100% certain, it is impossible to time the market consistently, so be patient and deploy capital gradually.
3. Construct and manage a portfolio, not a series of independent asset classes. Be aware of the risk exposures contained within each asset class and maximise portfolio diversification by avoiding the unintended duplication of risk exposures that arises from allocating according to asset class.
4. Diversification done one the basis of capital allocation alone can be misleading. Given that diversification is about reducing risk, it makes sense to allocate according to, or at lease be aware of, the portfolio's risk allocation.
5. Despite their infrequent occurrences, high impact low probability events can have a severe effect on portfolio returns, often eliminating years of previous positive performance. So, hedge against tail risk.
6. Demand a large risk premium on every investment since the level at which an investment is entered into is a key determinant of the subsequent return.
7. The past is never a guide to the future.

The week that was

• Fed announces $300 billion of QE in 2-10 year Treasuries, US curve flattens, long yields fall 50bps, pushing 10 year sub 3%
• USD safe have status evaporates on QE (DXY -4.5% on week), investors look to NOK as new haven (+7% vs. USD on week), backed by oil revenues and robust finances.
• UN preparing recommendation to member countries to diversify away from USD reserves & to adopt a currency basket. Likely impact unclear as UN doesn't have the financial muscle of the IMF or G7.
• USD weakness pushes gold (+3%) & oil (+10%) higher as well as broad commodity indices - it's H1 2008 all over again.
• Equity rally peters out (MXWO +6% on the week)
• IMF forecasts global economic activity to contract by 0.5% to 1% in 2009 on an annual average basis—the first such fall in 60 years before growing 1.5-2.5% in 2010. The US is expected to contract by 2.6%, the Euro area by 3.2% and Japan by 5.8% with advanced economies as a whole contracting by as much as 3.5% and emerging and developing economies likely to grow only 1.5-2.5%. The contraction in the U.S. is expected to push the output gap to levels not seen since the early 1980s.
• UK jobless claims worst since 1971 but BoE chief economist, Spencer Dale, thinks "a substantial amount of the total contraction we’re going to see has come through”, saying the economy would begin growing again by the end of the year and expand at normal rates throughout 2010
• UBS CDS tightens 75bps on improved Tier 1 ratio driven by buyback of Tier 2 debt

Anything you can do...

Anything you can do,
I can do better.
I can do anything
Better than you.

No, you can't.
Yes, I can. No, you can't.
Yes, I can. No, you can't.
Yes, I can,
Yes, I can!

Following the Bank of England's recent announcement that it intends to purchase £75 billion of Gilts, the Fed announced today it will purchase up to $300 billion of long dated Treasuries over the next six months. Beat that Mervyn!

Despite being a drop in the ocean (c. 2.7%) relative to the $11 trillion of outstanding public debt, $300 billion was enough to push yields down significantly. Longer dated Treasuries surged on the news, with 10 year yields falling 47 basis points to 2.54% and 30 year yields fell 37 basis points to 3.46%. The 10/2's spread flattened 37 basis points 1.62%.

However, the move stoked fears of inflation and currency debasement, pushing gold 6% higher. Bloomberg reported that:

The dollar fell the most against the euro since September 2000 as the Federal Reserve said it will purchase $300 billion of longer-term Treasuries, spurring speculation the central bank is debasing the currency. The dollar depreciated as much as 3.3 percent to $1.3493 per euro before trading at $1.3468 at 3:20 p.m. in New York. The dollar lost 2.5 percent to 96.17 yen from 98.60. The yen dropped 1.1 percent to 129.44 per euro from 128.35. The Dollar Index, which the ICE uses to track the greenback’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, dropped 2.7 percent to 84.595. The gauge fell 5.6 percent since reaching 89.624 on March 4, the highest level since April 2006.

Quantitative easing is now de rigueur amongst the world's major central banks. The Bank of England is buying government bonds and corporate debt, the Bank of Japan is snapping up government notes and making subordinated loans to banks, and the Swiss National Bank is intervening to weaken the franc. Naturally, anything the rest of the world can do, America can do it bigger and better...

Bear or bull market rally, you decide

The debate on whether this is a bear market rally or the foundations of a bull market goes on but I thought it would be interesting to consider some of the facts given that, relative to the change in fundamentals, the market recovery appears somewhat excessive.

Last week's economic numbers were in general appalling and the rate of change continued to decline. The chart below shows year-on-year industrial production numbers for Jan & Feb. I have focussed on industrial production numbers because all of the major countries released figures in the last 7 days so they are a good basis for comparison.

This compares to equity market performance over the last 6 trading days shown below...

QE gets under way

UBS Investment Bank reports:

"The Bank of England embarks on its quantitative easinig effort today with a £2 billion gilt purchase. This will the first of a bi-weekly event that will continue for the next 3 months until the Bank has acquired around £75 billion of gilts and corporate bonds."

Purchases will be made via a reverse auction, in which sellers determine the price that the BoE pays. The Bank will hold only one auction this week, but there will be two per week from next week on Mondays and Wednesdays. The central bank will take non-competitive offers until 12:00 p.m. on auction days, announcing the amount it will allot to such offers at 1:00 p.m.. It will then also publish the size open to competitive offers, and will take bids for that operation between 2:15 p.m. and 2:45 p.m. British time. It will announce the results of that operation soon thereafter.

In today's auction the BoE has specified it wants to buy £2 billion of Gilts maturing from 2014 to 2018. M&G's bond team note, via their blog, Bond Vigilantes:

"The Bank is not buying back sub 5 year paper as part of this programme, as that is where overseas Central Banks (big financers of the UK budget deficit) own gilts, and it could lead to a big reduction in the gilt market's investor base and a possible knock on impact on the £ if overeas investors sold their gilts back to the authorities. Nor is the Bank buying gilts over 25 years in maturity, which would exacerbate the illiquidity in ultra long dated gilts, and possibly cause further problems for pension funds."

Auction results
The reverse auction was 5.25 times subscribed as the BoE receioved offers of £10.5 billion and bought £2 billion. Bull flattening is under way, with the UK 10-2 spread having tightened by 50 bps since the BoE first announced QE on Thursday.

A portfolio for all seasons

"[Thomas] More is a man of an angel's wit and singular learning. I know not his fellow. For where is the man of that gentleness, lowliness and affability? And, as time requireth, a man of marvelous mirth and pastimes, and sometime of as sad gravity. A man for all seasons."

Robert Whittington, 1520

Attempting to construct a portfolio at the moment is at best difficult due to the uncertainty surrounding the state of the global economy. On the one hand, a protracted period of synchronised recession and deflation suggest that taking risk will not be rewarded and that investors should park their cash in safe haven assets until the economic storm has passed. On the other hand, a lot of bad news is already in the price and the size of the stimulus matches the severity of the problem, suggesting that opportunities abound and potential returns are more than commensurate with the risks.

On whichever side of the fence you sit, there is a common factor that make the risks of being wrong very painful: volatility. Investor behaviour has become bipolar, split between fear and greed. So, the bears who invest in fear assets, such as US Treasuries and gold, do so at high prices which can quickly reverse when the risk barometer turns back to greed.

The challenge is therefore to create a portfolio for all seasons. Such a portfolio should be split between fear investments that profit from a bearish outcome, and greed investments that profit from a bullish outcome.

Fear investments

Long dated conventional Gilts are the instrument of choice to play the risk of deflation and depression. Indeed, the BoE believes so too, since they are prepared to buy £100m of them in order to stave off deflation and stimulate the economy. As discussed previously in QE in the UK, this implies a bullish flattening of the Gilt curve. Therefore, given the BoE's plans to acquire 24% of eligible medium and long Gilts in the first £75 billion tranche of QE, extending duration across the 7 to 25 year maturities is likely to best capture any fall in yields.

As for equities, if Nouriel Roubini is to be believed then:

"If a near depression were to take hold globally a 40% to 50% further fall in U.S. and global equities from current levels could not be ruled out... Earnings per share (EPS)of S&P 500 firms will be in the $50 to 60 range, but they could fall to $40. The price earnings (P/E) ratio may fall in the 10 to 12 range in a U-shaped recession. If earnings are closer to 50 or the P/E ratio falls to 10 then the S&P could fall to 600 (12 x 50 or 10 x 60) or even to 500 (10 x 50)."

Buying out of the money puts on the S&P 500 or FTSE 100 is therefore a cheap method of insuring against possible Armageddon.

For investors looking for a save haven, the US dollar remains the favoured currency. However, this notion of safety is an illusion, based on the relative attractiveness of the Dollar (see The relative illusion of USD safety). Fundamentally, the Dollar is no better off than its counterparts, however its strength lies in investor appetite for US Treasuries and forced buyers of the currency who are unable to refinance their debt. However, once the financial system shows signs of stabilising, the Dollar is likely to collapse under the weight of huge deficits, inflation and overvaluation, possibly challenging the long established Dollar hegemony. Thus, in the longer term, gold is likely to be a better store of value and in the short to medium term the Dollar is likely to continue to appreciate versus another previous safe haven currency, the Japanese Yen.

Greed investments

What if the talk of depression is overdone and if risk aversion turns to risk seeking? Fear investments will be a 'busted flush'. Admittedly, this seems unlikely, although if there is one thing that the last 18 months have taught us, it is to expect the unexpected.

Equities are the most effective and liquid way to increase risk. The freeze in credit markets is unlikely to thaw overnight, leaving corporate bonds illiquid outside of the primary market. Notwithstanding a further 10-20% cut in earnings, many markets are trading on single digit P/E ratios (e.g. FTSE 100 trading on 9.2x forward earnings & €Stoxx 50 trading on 7.9x forward earnings, which would increase to 9.8x if earnings were cut a further 20%). Moreover, many other metrics of value suggest that equities are oversold.

However, with high volatility the risk of investing too early or all out depression means that being wrong can result in significant losses. Options are therefore an effective way of playing any potential rally in stock prices, since they allow the investor to participate in the upside with leverage and the downside is limited to the loss of one's premium.

Given that risk aversion is now a consensus trade, any bad news would have to get even worse in order to affect the price of safe haven assets. If the situation improves or, at least does not deteriorate further, a mass exodus from safe haven assets is possible. This has clear implications for the US dollar and US Treasuries, the biggest recipients of safe haven flows, both of which could see a sharp unwind if risk appetite returns. Indeed, at his annual press conference, China’s Premier Wen noted:

"We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries."

The risk reward trade-off for shorting the Dollar and US Treasuries have therefore improved and any collapse in the Dollar will more than likely support the gold price.

A combination of short Dollar, short US Treasuries and long gold also happens to be an effective hedge against a wildcard, inflation. The further interest rates fall in the shorter term, the greater the risk of inflation in the medium to longer term. Thus, at some point, assuming the stimulus has the desired effect of reflating the economy, inflation will rise again. Moreover, given that the stimulus has been funded by record amounts of government borrowing, yields are likely to respond in kind to both rising inflation and issuance as investors demand a higher risk premium. Indeed, it is possible that governments and central banks may want to induce a period of above target inflation in order to reduce the public and private debt burden. For now, the market is concerned about possible deflation and breakeven inflation rates have fallen to levels that make insuring against inflation attractive.

Conclusion

A portfolio for all seasons is therefore characterised by fearful greed, where asymmetrical payoffs are expressed in the main via out of the money options whose downside is limited to the loss of premium and upside is unlimited. Given the high levels of asset price volatility and leverage built into options, risk management is essential. Setting a risk budget, using a VaR limit, ensures that portfolio risk is kept within acceptable levels.

Finally, the ideas expressed in this note have been expressed in an illustrative £1 million portfolio, which began 1st March. Performance will be monitored on a monthly basis, net of a total expense ratio of 2%. Capital and risk allocation are divided between four 'buckets': interest rates, FX, equity & cash (see current capital allocation below). The portfolio is already performing well, up 11.8% with most of the P&L coming from 5-15 year Gilts, FTSE 100 puts and FTSE/ Xinhua 25 calls.

QE in the UK

A new era of monetary policy was ushered in yesterday as the Bank of England embarked on quantitative easing (QE). In the press release that accompanied yesterday's 50 basis point rate cut, the Bank of England confirmed the size and implementation of its quantitative easing programme.

Having received approval from the Chancellor to begin quantitative easing, the MPC voted to begin a programme of asset purchases of £75 billion over three months via the Asset Purchase Facility. This represents the first tranche of an overall £150 billion sanctioned by the Treasury for purchasing of £50 billion of private sector assets (CP & corporate bonds) and up to £100 billion of Gilts, as requested by Mervyn King in recent letter to Chancellor:

"In order to facilitate an expansion of the monetary base through the Asset Purchase Facility, the MPC proposes that gilt-edged securities be added to the list of eligible assets set out in your letter of 29 January. I suggest that the MPC be authorised to use the facility to purchase eligible assets financed by central bank money up to a maximum of £150 billion but that, in line with the current arrangements and in recognition of the importance of supporting the flow of corporate credit, up to, £50 billion of that should be used to purchase private sector assets… If the facility were to be used for monetary policy purposes, I envisage that the Committee would vote each month on a resolution concerning the asset purchases it deemed necessary to meet the inflation target."

What are the implications for the Gilt market? More specifically, which part of the Gilt curve will be impacted most and how does the size of the programme compare to the value of outstanding Gilts?

In their press release, the Bank of England indicated that the majority of the first £75 billion will used to buy Gilts. Purchases will target medium (7-15 year maturities) and long (15+ year maturities) conventional Gilts, as defined by the Debt Management Office (DMO).

The nominal value of all outstanding conventional Gilts is £543.9 billion. The market is segmented between £233.7 billion (43%) in short Gilts, £107 billion (20%) and £203.2 billion (37%) in long Gilts. The first tranche of £75 billion therefore represents 24% of the universe of eligible Gilts of £310.2 billion. The full £100 billion sanctioned for Gilt purchases represents 32% of medium & long Gilts and 18% of the overall Gilt market.

The size of the initial tranche of £75 billion is also substantial in relation to forthcoming net Gilt issuance, representing 58% of the £130 billion expected in the current financial year. Furthermore, the chancellor confirmed that current debt management policy remains in place and there are no plans to change it in light of quantitative easing.

The size of Bank's quantitative easing programme is therefore significant and will have a sizeable impact on the Gilt market. Indeed, the initial 40 basis point rally in 7 to 30 year Gilts following the announcement reinforces this. Going forward, it is likely therefore that the Bank of England's operations will result in a bull flattening of the Gilt curve, as long yields converge on shorter yields. Bull flattening is not only consistent with the Japanese experience of QE in the 1990's, but it has become the consensus forecast for the Gilt curve, as the chart below demonstrates.

Caught between a rock and a hard place

Shareholders are caught between between dividend cuts and rights issues in what is effectively a liquidity squeeze. As if reduced cash flows from dividends wasn't bad enough, investors are also being asked to cough up more cash by companies issuing new shares.

In the UK alone, Threadneedle forecast £50 billion of equity issuance by UK companies 2009, more than double the £23 billion issued in 2008.

The outlook for dividends is equally bleak. Standard & Poor’s forecasts the worst year for dividend cuts since 1938 for US investors. S&P forecast dividend pay-outs for 2009 to drop at least 22.6%, since cash flow is crucial for companies and their need to conserve cash will outweigh their desire to pay dividends.

Moreover, having principally affected financials, who were responsible for £16.9 billion of the total £23 billion raised from rights issues in the UK in 2008, the list of sectors issuing new shares and slashing dividends has grown considerably in 2009. Indeed, BP, whose dividends accounted for over 11% of the total dividends paid by FTSE All Share companies, is expected to freeze its dividend this year for the first time since 1999.

Investor appetite for forthcoming rights issues is likely to be severely tested. Indeed, following another new low in equity prices, investors will be wondering whether they should throw yet more good money after bad. Indeed, the investment banks who are underwriting the rights issues are charging 50% more in fees to compensate them for the risk of being left with a large rump in volatile markets.

Banking on dividend cuts

Following the recent dividend cuts from financials such as HSBC and JP Morgan, who have cut their dividends by more than 80%, the forward looking yield on major equity indices is likely to be reduced significantly due to the large weighting of financials within these indices. For example, financials make up 30% of the €Stoxx 50 index and they contribute circa 50% and 30% of the index's historic and projected yield. Whilst this suggests that the market has already factored in dividend cuts, any further cuts, of say 50%, could reduce the index's dividend yield by 1%, from 6.5% to 5.5%.