Fairy Tales of the US Bond Market (Tale I)
Jul 27, 2006
Joachim Fels (London) and Manoj Pradhan (London)
Note: This is the first instalment of a three-part Forum comment. Our full report including charts and a technical Appendix is available on Morgan Stanley’s Client Link.
The great humiliator Kenneth Fisher, a money manager and columnist for Forbes, once nicknamed the stock market ‘the great humiliator’ for its uncanny tendency to regularly wrong-foot even the greatest experts. The same could be said of the bond market, especially since the middle of 2004 when the Fed started to raise the funds rate. Back then, most bond practitioners and analysts expected yields on medium and long-maturity bonds to rise along with short rates. But the opposite happened, with 10-year Treasury yields easing during the second half of 2004 and then hovering sideways throughout 2005 at levels significantly below those prevailing around the time the Fed began to tighten. Standard explanations unconvincing. Egg-on-face, the experts almost fell over each other during 2005 to present seemingly plausible explanations for this phenomenon, which Alan Greenspan had famously dubbed the interest rate conundrum in the meantime. The most popular explanations were pension funds’ or Asian central banks’ forced buying of Treasuries, a global savings glut (proposed by Ben Bernanke), higher Fed transparency and/or credibility, and lower macroeconomic volatility. However, just when it had become conventional wisdom that some or all of these factors had severed the traditional link between short-term and long-term interest rates and would probably keep long rates low for longer, these finally started to rise. Since the beginning of 2006, 10-year yields have climbed by almost 100bp (from 4.28% to 5.25% a few weeks ago), even though most of the factors that allegedly depressed long-term bond yields have remained in place. The great humiliator strikes again! Excess liquidity argument works, so far… As explained in previous reports, our own tentative account of why bond yields stayed so low in 2005 was that global excess liquidity became even more abundant during 2005, as the ECB and the Bank of Japan kept short rates at rock-bottom levels and the fed funds rate remained below the natural, or neutral, rate despite the Fed’s hikes. Conversely, when the Fed finally raised the funds rate above our estimate of the natural rate in early 2006, and the ECB started to tighten, global excess liquidity began to contract and pushed bond yields higher. Admittedly, this is a very broad-brush, tentative, and merely qualitative explanation for the bond gyrations over the last two years, which the great humiliator may still decide to debunk at some stage, too. Introducing MS FAYRE The ongoing, unresolved debate about the possible reasons for the interest rate conundrum (if there ever was one) serves to highlight the need for a more rigorous quantitative analysis of the links between bond yields and economic fundamentals. In this note we address this need by introducing MS FAYRE, an acronym for the Morgan Stanley FAir Yield Regression Estimate. MS FAYRE, our proprietary estimate of the fundamental fair value for the US 10-year Treasury bond yield, is derived from an econometric model that links economic fundamentals to bond yields. MS FAYRE helps to answer questions that are highly relevant for bond investors: - Which fundamental factors are the main drivers for US bond yields, and what is their relative importance for yield determination?
- Once these fundamental drivers and their relative strength have been established, are bonds currently overvalued or undervalued relative to these fundamentals? And if so, by how much?
- What does the model tell us about the latest holy grail of the bond market cognoscenti: the ‘term premium’ or ‘risk premium’ in long-term interest rates?
In what follows, we address each of these questions in turn. Readers interested in the theory behind and the econometric details of the model may also want to refer to Manoj Pradhan’s Appendix in the full report, available on Morgan Stanley’s Client Link. MS FAYRE links bond yields to fundamentals Put simply, to produce MS FAYRE — our estimate of the fundamental fair value for 10-year Treasury yields — we first try to explain as much of the past swings in bond yields as possible with a small number of economic and policy variables that are generally thought to influence bonds yields. An alternative approach would be to apply the so-called expectations theory of bond yields, which says that the yield of a long-term bond can be expressed as the average of short-term interest rates over the lifetime of the bond (assuming that the investor rolls over short-term deposits or bills as an alternative) plus a term premium that investors demand for committing money for the entire lifetime of bond. While this approach is theoretically intuitive, we find the empirical attempts to separate true short rate expectations from the risk premium unconvincing as yet. By contrast, we model 10-year bond yields as being driven by three factors: (1) The real fed funds rate. This can be thought of either as an indicator of the monetary stance or, if you are wedded to the expectations theory, as a glimpse into the expected average level of real short rates over the lifetime of the bond. Specifically, we deduct the year-over-year increase of the core PCE deflator, the Fed’s preferred inflation gauge, from the fed funds target to calculate the real fed funds rate. (2) Inflation expectations. Investors in long-term bonds expect to be compensated for a deterioration in the purchasing power of their invested funds. Theoretically, what should matter for the determination of 10-year bond yields are 10-year ahead inflation expectations. A long time series starting in the early 1980s for these expectations is available from the Survey of Professional Forecasters (SPF), conducted each quarter by the Federal Reserve Bank of Philadelphia. But as this measure of inflation expectations has been rock-steady at 2.5% for the past several years, which lends the series undesirable statistical properties, we instead use the four-quarter ahead inflation expectations from the same survey, which are more volatile than, but closely correlated with, 10-year inflation expectations. (3) Inflation volatility. Uncertainty about future inflation induces investors to demand a risk (or term) premium for holding a long-dated security, over and above the expected inflation rate. The more uncertain the future level of inflation, the more compensation investors will demand. Specifically, we capture inflation uncertainty by using the standard deviation of a rolling 5-year window of actual core PCE inflation. Inflation volatility was high in the early 1980s when bond yields were also high, and then declined over the 1980s and 1990s, before stabilising at a low level in the last several years. Tomorrow, we address the question whether bonds are still overvalued according to MS FAYRE. We also show that last year’s conundrum was not atypical in historical comparison.
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German Restructuring in a G3 Context
Jul 27, 2006
Elga Bartsch (London)
This is the second instalment of a two-part analysis of the German restructuring story. Today we assess how the German restructuring compares to that seen in the US and Japan. We find that the German share of profits in national income has risen more than the US share, but less than the Japanese share. In addition, Germany has deregulated more than the US or Japan. It still remains more regulated than the US or the UK though. Morgan Stanley’s proprietary ModelWare metrics show that German RoE has improved only slightly in recent years. RoE differentials can be traced back to US companies benefiting from higher operating margins, Japanese companies from faster asset turnover and German companies from higher leverage. The proposed taxation of interest payments under the yet-to-be-finalised corporate tax reform could have negative RoE repercussions by making higher leverage less attractive. Future RoE gains in Germany would thus have to come from margin expansion. The full report including a list of companies, which recently announced major restructuring initiatives, is available on Client Link. Comparing the German restructuring progress to the US and the Japanese experience, we find that the profit share in Germany has risen to an all-time high, with the gain over the last six years sharper than those ever recorded in the US, but still less pronounced than the one recorded in Japan over the same time span or in the early 1980s. Likewise, the compression in the wage share (i.e., the share of the compensation of employees in gross national income) has been on a par with the one witnessed in Japan since the late 1990s. Matching macro data and ModelWare estimates Morgan Stanley’s proprietary ModelWare database offers a new way to compare macro economic national accounts data against aggregated company data (see T. Harris and G. Weyns, ModelWare (ver. 1.0): A Roadmap for Investors, August 2, 2004). Based on detailed internationally comparable company data going back to the mid-1990s, we have built country aggregates for the G3 (the US, Japan and Germany) as well as Europe. This allows us to calculate various metrics of profitability and compare them across countries. We use the standard Dupont Analysis to break the return on equity (RoE) down into net operating margins, asset turnover and financial leverage, which provide an indication of each countries’ corporate sector efficiency in operating, in using its assets and in choosing its financial structure (see also H. McVey, Thinking about the Three Pillars of RoE, June 30, 2005). ModelWare estimates show that Return on Equity (RoE) of non-financial companies between the G3 countries differs less than you would have expected*. The notable exception is Japan though. Compared to the macroeconomic profit share, which has improved sharply, the rise in net operating margins has been more subdued. The relatively similar RoE estimates across both sides of the Atlantic, however, mask interesting differences. Using the Dupont scheme to break the RoE up into its components, we find that - US companies benefit from having higher net operating margins,
- Japanese — and to some extent German — companies benefit from achieving a faster turnover of their assets, and
- German companies benefit from being more leveraged than their counterparts.
The latter makes the planned corporate tax reform, which proposes to tax part of the interest paid on debt in exchange for a marked reduction in the corporate tax rate, somewhat worrisome. For the corporate tax reform, if implemented, would likely lead to lower leverage of German companies over the longer run (for an analysis of the planned corporate tax reform, see Cutting Corporate Taxes, July 14, 2006). At the same time, however, lower corporate taxes should help to improve net operating profit margins. Different policy setting adds to structural reform pressures In gauging the restructuring progress, we have put Germany’s experience into a global perspective and compare it to the US and Japan. The US and Japan have gone through major structural reforms since the 1980s, well documented in the writings of my colleagues Steve Roach, Morgan Stanley’s Global Chief Economist, and Robert Feldman, our Japanese Chief Economist (for an overview, see Steve Roach’s special economic study, Global Restructuring: Lessons, Myth, and Challenges, June 12, 1998). Overall, I would view German restructuring to be broadly on a par with that seen in the US or Japan based on the improvement in macroeconomic profit margins and the deregulation undertaken. However, the conditions under which the restructuring takes place in Germany could not be more different: - For starters, Germany gave up its monetary autonomy to the European Central Bank in 1998. Thereby, the country has lost interest rate and exchanges rate policy as additional country-specific policy parameters.
- In addition, the Stability and Growth Pact (SGP) limits the ability to complement structural reforms with a fiscal boost.
Being deprived of most macroeconomic demand management tools, Germany has no choice but to reform ‘the hard way’. This doesn’t need to be a bad thing, for the absence of effective demand management makes it more difficult to gloss over structural difficulties. In isolation, this should reduce the likelihood of having false starts, of which we have seen plenty in Japan, for instance, according to my colleague Robert Feldman (see What Europe Must Learn from Japan, May 23, 2006). That said, the limitations to active demand management might make it more difficult to achieve a political consensus on a certain reform programme. In the absence of a macro booster accompanying structural reforms, the adjustment costs in terms of job losses are also likely to be higher. This makes labour market reforms even more pressing in order to ensure that unemployment doesn’t ratchet in at the higher level. - By being part of a currency union, Germany’s reform progress won’t translate into the same currency response as it would — everything else equal — in Japan or in the US where a stronger currency tends to offset the positive effects of restructuring on earnings.
- At the same time, within a currency union, any loss of competitiveness or profitability has to be regained by below-average wage and above-average productivity gains. To put it more technically, a depreciation of a fictional German currency versus the euro can only be brought about by relative price or cost movements. It can’t come through exchange rate realignments anymore.
- The pronounced wage moderation in Germany since the mid-1990s has caused concerns about a downward spiral of competitive wage restraint within the euro area. In my mind, these concerns are somewhat misdirected. There is no mistaking the downward pressure on wages due to globalisation. It is not a surprise that, as a high wage country, Germany feels the pressure more than others.
- Germany is much more open than the US or Japan — in terms of cross-border trade and in terms of international capital flows. Hence, Germany is more exposed to the competitive pressures arising from globalisation. Within Western Europe, Germany is also at the forefront of economic integration with Central and Eastern Europe.
- The intended free movement of goods, services, capital and people in the enlarged European Union further adds to these pressures, and Brussels has added an extra layer of pro-market reform impetus, notwithstanding various attempts to stall the completion of the Single Market programme (see, for instance, Not in Service, April 22, 2005).
Germany has deregulated more than the US and Japan Yet, Germany remains more regulated than the US and the UK today. This holds for labour market regulations and for product market regulations. There is, however, no notable difference between Germany and Japan in terms of today’s level of regulation. Contrary to labour market legislation, product market deregulation has advanced considerably in Germany over the last 30 years. While still being more regulated than the US or the UK, it is the most liberal of the larger European economies. In addition, the deregulation in Germany in the last three decades is more pronounced than in the US and Japan, according to the OECD regulation indices. But in Germany, deregulation started a decade later than in the US and about half a decade later than in Japan. Hence, some of the positive effects of deregulation might still be in play in Germany. In addition, existing bilateral agreements between companies and trade unions reached as part of their regular wage negotiation often contain clauses on employment protection, voluntary benefits or working hours that go way beyond what the law in Germany stipulates. Take, for instance, the high level of non-wage labour costs: about half of the non-wage labour costs in Germany are due to additional benefits companies have agreed to offer in those negotiations or even on a unilateral basis. This is why, in my view, micro restructuring at the corporate level is so important in Germany. To reap the full benefits of these reforms, it is vital, however, that macro reforms don’t fall too far behind the corporate reality. *With a coverage of 80% compared to MSCI market capitalisation in Germany, 85% in Europe, 73% in the US and 58% in Japan, the underlying dataset should give a reasonably representative picture. Cross-country comparisons are sometimes difficult to interpret due to the different sector composition of the stock market indices. We used median values rather than weighted averages to discount the different sector weightings. For an overview, see Naoki Kamiyama’s note, International Comparisons of RoE and P/E, July 13, 2006. ModelWare also allows a RoE analysis in the context of a profitability tree. However, such granularity isn’t needed for this macro analysis conducted here.
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Myth, Reality and National Wealth - Just How Much Stuff Does the UK Have?
Jul 27, 2006
David Miles (London)
We all know that people in the UK obsess over house values and channel their resources into buying them and embellishing them. We all know that the UK transport infrastructure is decaying and frayed from years of underinvestment and that companies have not done much investment in recent years despite healthy profitability and a low cost of borrowing. We all know that because of this the UK stock of tangible assets — the stuff we can put our hands on and which helps create GDP — has been skewed towards residential property and away from capital assets that produce goods that can be traded. Well actually, a cold and calculated assessment of the stock of capital of the UK reveals that most of these things we ‘know’ turn out to be pretty far off the mark. And this matters for how you see the economy growing and for how monetary policy evolves. Nearly all that what we do know about the overall tangible wealth of the UK comes from the Office for National Statistics (ONS), which has just released its latest assessment of the stock of national ‘stuff’ — more properly called the net capital stock. It makes fascinating reading. Consider first what has actually been happening to the replacement value of the stock of dwellings in the UK. This is the value of the constructed stock of houses and flats. Since land is not constructed, that is excluded. So what this measures is the assessed value of replacing the housing structures in the UK; that is a measure of how much real value is embedded in the millions of homes built in the UK over past decades. One might imagine that this value has increase sharply in recent years — after all house prices have more than doubled since 2000 while consumer prices are only up by about 20%, so it looks like the value of houses should be about 80% higher in real terms. But since 2000, the real value of the stock of residential dwellings in the UK has risen by…just under 6%. So what is going on here? The answer is, very largely, that the rise in the real market value of homes almost entirely reflects a rise in the price of land (a non-produced asset). That has two implications: first that we should be very sceptical about the idea that there has been a really big increase in the overall real wealth of UK households since 2000. Second, the idea that we have been pouring too much into housing — with its implication that we have done so at the expense of investing enough in other forms of tangible wealth — is thoroughly wrong-headed. Just how wrong is illustrated by the latest ONS figures. While the value of the capital stock in the form of houses has increased by under 6% since 2000, the value of all other forms of capital (plant, machinery, commercial buildings, transport equipment, structures) has risen by about 17% — almost three times as fast. If we go back a little further — to the rather arbitrary starting point of 1997 when the Labour party returned to power under Tony Blair — the picture is rather similar. The table below shows how things stack up over that period from the end of 1997 to the end of 2005: Change in UK capital stock and output since 1997 (to end 2005): Increase in the real net capital stock in dwellings (excluding land) 8.6% Increase in real stock of all capital excluding dwellings 32.7% Increase in real GDP 24.7% Implications The real capital stock in the form of houses and apartments — a reflection of the real resources put into building homes — has increased by only about a third as much as GDP since 1997. The real stock of other capital goods — machines, plant, offices, factories, roads and so on — has again increased by a third as much as GDP. The growth in non-housing productive assets has been running at a rate close to three times the growth in the real value of houses. The apparent huge increase in real housing wealth is largely due to the rise in the value of land — which uses no resources and is dubious as a source of national wealth. What should we make of this? There is some good news here. It is this. Over a period when GDP growth in the UK has been steady and has averaged about 2.8% — significantly above the long-term rate of about 2.4% — the value of the capital stock most directly devoted to production has increased even faster. So, despite a low rate of national saving and worries about anaemic growth in corporate investment, the stock of capital has more than matched the rise in output — at least if we ignore the slowest-growing component of overall tangible assets, namely houses. In terms of the sustainability of the rate of growth in output, this is reassuring. It adds some weight to the judgment on monetary policy implicit in the Bank of England Inflation report that growth at a rate of between 2.5% and 3% need not in itself mean that interest rates will need to rise sharply to head off domestic inflationary pressures. But we should take no comfort from trends in the domestic capital stock about the ability of the UK to absorb any further inflationary shocks coming from overseas.
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