nangle - cfa institute · derivatives outstanding 1999 – 2009 deleveraging option #2: default...

Toby Nangle

Baring Asset

Management Limited

155 Bishopsgate, London EC2M 3XY

Tel +44 (0)20 7628 6000Fax +44 (0)20 7638 7928

www.barings.com

Authorised and regulated by theFinancial Services Authority

Investing in **flationary times

Toby NangleDirector – Multi-Asset & Fixed Income

November 2010

Overview

� The Challenge of Sovereign Debt

� Deleveraging Options

1

� Deleveraging Options

� Which Road?

� Scenario Planning in an Uncertain Environment

The Challenge of Sovereign Debt

Sovereign Debt to GDP for G7 Nations 1950–2009

80

100

120

Deb

t/ G

DP

(%

)

2Source: Fathom and OECD, as of June 2010

0

20

40

60

1950 1960 1970 1980 1990 2000 2010

Deb

t/ G

DP

(%

)

Sovereign Debt to GDP in the G7

Deleveraging Options

� Deleveraging options, and investment implications:

� #1 Fiscal Austerity

3

� #2 Default

� #3 Inflation

Are these credible? Are they discounted?

Deleveraging Option #1:Fiscal Austerity

Real Real Ten-Year Government Bond Yields June 2007–Oct 2010

1.5

2.0

2.5

3.0

Yie

ld to

Mat

urity

(%)

4

Source: Bloomberg as at 30th October 2010

Real Real Ten-Year Government Bond yields show the ten-year inflation-linked yield minus the price of insuring against default in the CDS market

-1.0

-0.5

0.0

0.5

1.0

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun -11

Yie

ld to

Mat

urity

(%)

Italy 10yr UK 10yr US 10yr France 10yr

U.S. Banks have already been rebuilding Capital Ratios…

… By retaining earnings and shrinking the lending book


5Source: Goldman Sachs, August 18 2010

Regulatory reform has accentuated negative growth pressures

Government Primary Balances 1970–2009 (%GDP)

Govt Primary Balances to Stabilise Debt/GDP by 2020


5

10

15

5

10

15

6

Source: OECD and Barings, as at June 2010. Primary surplus targets to stabilize government debt/ GDP ratios assume Barings trend real growth rates of 1% in Japan, 2.3% in US, 2.2% in UK, and 1.5% in Germany. It is assumed that real interest rates are 1%. The projections take IMF assessments of current government debt. Net debt has been used for Japan, gross debt for others.

-15

-10

-5

0

1970 1980 1990 2000 2010 2020

UK US Japan Germany

15yr Av to ‘07

2010 60% Target

80% Target

-15

-10

-5

0

UK US Japan Germany

GDP Growth vs. Previous Trend Real Growth by Deleveraging Strategy


90

95

100

105

GD

P G

row

th (

%)

2

3

4

5

6

7

7Source: McKinsey & Matt King - Citigroup, Arresting the Sovereign Avalanche?, as at June 2010

70

75

80

85

90

t=0 t+2 t+4 t+6 t+8 t+10 t+12 t+14

Belt tightening Inflation Default Belt tightening Inflation Default

GD

P G

row

th (

%)

-4

-3

-2

-1

-

1

10yr pre 1-2 yrs 2-3 yrs 4-5 yrs Trend

+10yr

5-yr Credit Default Swap Spreads – Eurozone & US States

Deleveraging Option #2: Default

300

350

400

450

500

5yr

CD

S S

prea

d 600

700

800

900

1,000

Gre

ek 5

yr C

DS

Spr

ead

300

350

400

450

500

5yr

CD

S S

prea

d

8Source: Bloomberg, as at 21st October 2010

0

50

100

150

200

250

Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

5yr

CD

S S

prea

d

-

100

200

300

400

500

Gre

ek 5

yr C

DS

Spr

ead

Ireland Portugal Spain Italy

Belgium Austria Netherlands Switzerland

Finland Greece (LHS)

0

50

100

150

200

250

Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

5yr

CD

S S

prea

d

Illinois Florida California Michigan New Jersey New York Nevada Massachusetts Ohio Connecticut Pennsylvania Wisconsin Texas

5-yr Credit Default Swap Spreads – G5

Deleveraging Option #2:Default

5 ye

ar C

DS

Spr

ead

(bps

)

120

140

160

180

9Source: Bloomberg, as at 21st October 2010

5 ye

ar C

DS

Spr

ead

(bps

)

0

20

40

60

80

100

Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10

Japan US UK Germany France

Gross Notional Over-the-Counter Derivatives Outstanding 1999–2009


400,000

500,000

600,000

700,000

US

$ B

illio

n

10Source: Bank of International Settlements & Barings, 30th June 2010

0

100,000

200,000

300,000

Jun 98 Jun 00 Jun 02 Jun 04 Jun 06 Jun 08

US

$ B

illio

n

Credit Default Swaps Options Forwards and Swaps

Interest Rate Contracts Foreign Exchange Contracts

Commodity Contracts

Equity-Linked Contracts

Market Value of Over-the-Counter Derivatives Outstanding 1999 – 2009


20,000

25,000

30,000

35,000

US

$ B

illio

n

11Source: Bank of International Settlements & Barings, as at 30th June 2010

Jun 98 Jun 00 Jun 02 Jun 04 Jun 06 Jun 08

0

5,000

10,000

15,000

20,000

US

$ B

illio

n

Credit Default Swaps Commodity Contracts Equity-Linked Contracts

Interest Rate ContractsForeign Exchange Contracts

Breakeven Inflation Rates, 30 June 2007–30 October 2010

Deleveraging Option #3:Inflation

2.5

3.0

3.5

4.0

4.5

Bre

akev

en In

flatio

n R

ate

(%)

-1.5

-1.0

-0.5

0.0

0.5

Japa

nese

Bre

akev

en In

flatio

n R

ate

(%)

12Source: Bloomberg and Barings, as at 30th October 2010

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

Bre

akev

en In

flatio

n R

ate

(%)

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

Japa

nese

Bre

akev

en In

flatio

n R

ate

(%)

US 10yr Breakeven Inflation UK 10yr Breakeven Inflation

Italian 10yr Breakeven Inflation Japan 8yr Breakeven Inflation (RHS)


25

20

APF

Phase IILehman

Federal Reserve

Euro System

Bank of England (a)

Central Bank Total Liabilities as % of Annual Nominal GDP

13

Source: Bank of England, http://www.bankofengland.co.uk/publications/speeches/2009/speech413.pdf , 2nd December 2009. (a) Excludes loans and associated deposits in course of settlement.

15

10

5

0

20072006 20092008

Jun Oct Feb Jun Oct Feb Jun Oct Feb Jun Oct

Global Inflation rate distribution2009

40

50

60

Num

ber o

f Cou

ntrie

s % 40

50

60

% o

f Glo

bal U

S$

GD

P

30

40

50

60

Num

ber o

f Cou

ntrie

s %

30

40

50

60

% o

f Glo

bal U

S$

GD

P


Global Inflation rate distribution1990

14Source: IMF, Barings, as of June 2010

We live in Homogenous times!

Annual Inflation Rate (%)

# of countries (LHS) GDP Weight (RHS)

0

10

20

30

-20 0 15 40

Num

ber o

f Cou

ntrie

s %

-

10

20

30

% o

f Glo

bal U

S$

GD

P

# of countries (LHS) GDP Weight (RHS)

0

10

20

30

-20 0 15 40Annual Inflation Rate (%)

Num

ber o

f Cou

ntrie

s %

-

10

20

30

% o

f Glo

bal U

S$

GD

P

Which road?

My view as of Summer 2010

� Every G7 sovereign will pursue Fiscal Austerity

Every G7 sovereign will Default

15

� Every G7 sovereign will Default

� Every G7 sovereign will Inflate

Taxation, Inflation and Confiscation (as well as

Regulation)

Which road?Example 1: UK

� Taxation:

� Emergency Budget of June 2010 brought up taxes; Comprehensive Spending Review of October 2010 cut spending by Government Departments by 19%, and slashed welfare.

� Confiscation:

16

Confiscation:

� Default on non-tradable contractual obligations:

- Public sector pension defaults: RPI to CPI link cost public sector workers c.14% GDP; Stable defined benefit at an increased cost, etc.

- Accelerated increase in retirement age.

But evidence for inflationary intent?

UK Treasury Issuance Skews vs. 10-yr Breakeven Inflation Rate, 15yrs Forward 2002 – 2010

Which road?Example: UK

UK

10y

r B

E In

fl R

ate,

15y

r F

wd

min

us 3

%

% F

low

of I

/L B

onds

1

2

3

15

20

25

Long-term Inflation expectations below

upper MPC limit: DMO shrinks I/L

17Source: Bank of England, Debt Management Office, and Baring as at 30th June 2010

UK

10y

r B

E In

fl R

ate,

15y

r F

wd

min

us 3

%

% S

tock

of I

/L B

onds

-%

Flo

w o

f I/L

Bon

ds

-5

-4

-3

-2

-1

0

Dec 02 Dec 04 Dec 06 Dec 08 Dec 10

-15

-10

-5

-

5

10

Long-term Inflation expectations above

upper MPC limit: DMO still shrinks I/L

Which road?

My view as of Winter 2010

� Every G7 sovereign will pursue Fiscal Austerity

Every G7 sovereign will Default

18

� Every G7 sovereign will Default

� Every G5 sovereign will Inflate

(Still) Taxation, Inflation and Confiscation (as well as

Regulation)

Which road?Example 2: Europe

� Taxation:

� Fiscal tightening across Europe announced and being implemented.

� Confiscation:

� Default on non-tradable contractual obligations: Public sector pension defaults; public sector contract renegotiations; increase in

19

pension ages.

� Default on tradable obligations in some Eurozone countries.

� Inflation:

� The ECB is aiming for 2% overall inflation, but the disinflationary pressures of fiscal austerity, default and unemployment in the periphery will be balanced by higher levels of inflation in the core.

Evidence?

Fiscal Tightening (%GDP, Cum. 2010-13)

Which road?Example: Europe

2.5

3.0

3.5

4.0

Fis

cal T

ight

enin

g (%

GD

P, C

um. 2

010-

13)

20Source: Capital Economics & Eurostat, 30th October 2010

0.0

0.5

1.0

1.5

2.0

Germ

any

Italy

Belgi

um

Austria

Nether

lands

Franc

e

Portu

gal

Spain

Ireland

Greec

e

Fis

cal T

ight

enin

g (%

GD

P, C

um. 2

010-

13)

French, German, Irish Inflation yoy, 2006-2010

Which road?Example: Europe

Real Effective Exchange Rates (2000 = 100)

120

130

140

150

Rea

l Effe

ctiv

e E

xcha

nge

Rat

es (2

000

= 10

0)

1

2

3

4

5

Har

mon

ised

Inde

x of

Con

sum

er P

rices

(yo

y %

)

21Source: Bloomberg, 30th October 2010

80

90

100

110

120

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Rea

l Effe

ctiv

e E

xcha

nge

Rat

es (2

000

= 10

0)

Italy Spain Ireland Greece Germany

-4

-3

-2

-1

0

1

Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10H

arm

onis

ed In

dex

of C

onsu

mer

Pric

es (

yoy

%)

France Ireland Germany

Inflation in core, disinflation in the periphery,

unless or until the system breaks

Summary and Conclusions

� There is no easy way to deleverage

� Although markets are busy deciding which will be the route of choice, governments will commit all three sovereign sins:

� Taxation

Inflation

22

� Inflation

� Confiscation

� By themselves, they have quite different portfolio implications.

� Market will likely swing from one extreme to the other as evidence emerges supporting each route.

� The endgame is a sustained decline in the relative standard of living of the West.

References I

� Abbas, S.M. Ali, Nazim Belhocine, Asmaa El-Ganainy and Mark Horton (2010) "A Historical Public Debt Database", IMF Working Paper WP/10/245, Washington, DC. http://www.imf.org/external/pubs/ft/wp/2010/wp10245.pdf, and see http://www.imf.org/external/ns/cs.aspx?id=262 for the data itself.

� Ang, A. & G. Bekaert, 2003. The Term Structure of Real Rates and

23

� Ang, A. & G. Bekaert, 2003. The Term Structure of Real Rates and Expected Inflation. Columbia University and NBER Paper (26 September). http://www.dmo.gov.uk/documentview.aspx?docname=research/inflation/ang-bekaert-2003.pdf&page=Research/inflation_research

� Bliss, C. 1999. The real rate of interest: a theoretical analysis, Oxford Review of Economic Policy, Vol 15, No.2. http://www3.hi.is/~ajonsson/kennsla2005/bliss.pdf

References II

� Deutsche Bundesbank (DB), 2001. Real Interest Rates: Movements and Determinants, Monthly Report (July). http://www.bundesbank.de/download/volkswirtschaft/mba/2001/200107mba_art02_interestrates.pdf

� Ferguson, R. 2004. Equilibrium Real Interest Rate: Theory and Application. Federal Reserve (October 29).

24

Application. Federal Reserve (October 29). http://www.federalreserve.gov/boarddocs/speeches/2004/20041029/default.htm

� Fergusson, A, 2010. When Money Dies: The Nightmare of the Weimar Hyper-Inflation.

References III

� Nangle, T, Washington and Wall Street: The Interplay of Financial Influences on the Course of Debt and Currency Crises in Argentina, Brazil, and Uruguay, 1998-2002 (May 30, 2005). Available at SSRN: http://ssrn.com/abstract=1633112

� Reinhart, C M. & K Roggoff. 2009. This Time Is Different: Eight Centuries of Financial Folly.

25

Centuries of Financial Folly.

� Reinhart, C M., This Time is Different Chartbook: Country Histories on Debt, Default, and Financial Crises (March 2010). NBER Working Paper Series, Vol. w15815, pp. -, 2010. Available at SSRN: http://ssrn.com/abstract=1569233

References IV

� Reinhart, C M. & K Roggoff. 2010. Growth in a Time of Debt. www.nber.org/papers/w15639.pdf

� Seppala, J. 2000. The Term Structure of Real Interest Rates: Theory and Evidence from UK Index-Linked Bonds, University of Illinois at Urbana−Champaign. http://www.business.illinois.edu/Working_Papers/papers/00-0120.pdf

26

http://www.business.illinois.edu/Working_Papers/papers/00-0120.pdf

� Willetts, D, 2010. The Pinch: How the Baby Boomers Took Their Children's Future - And How They Can Give it Back.

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