17/06/2011: Who's Confidence is it, folks?

Here are few charts to illustrate the fact that some 3 years into the 'Restoring Confidence' strategy of the successive Irish Governments... and things are not exactly working out.

First straight up, the markets 'voting' on Irish banks:
Looks like investors are not really in tune with Irish Government plans for 'repairing' our banking system despite unprecedented guarantees from the Sovereign which have:

• Explicitly underwritten virtually all deposits and most of the bonds held or issued by the IRL6;
• Implicitly underwritten virtually any extent of losses in the IRL6;
• Explicitly purchased some of the worst 'assets' held by the IRL6; and
• Explicitly underwritten all of the IRL6 funding through ECB and CBofI lending facilities

And what about the entire system of domestic financial institutions? Well, the story is pretty much the same:Recall, thus that at the present (and the picture remains stable in this context since around late 2008):

• Financial investors have no confidence in IRL6 (as these charts illustrate)
  
• Fellow peer banks around the world have no confidence in IRL6 (as clearly indicated by the fact that other banks are not willing to lend to IRL6)
• Bond markets have no confidence in IRL6 (since none of IRL6 can issue any debt paper)
• The ECB has no confidence in IRL6 as it desperately tries to shed their borrowings off its balance sheet (including by shifting it onto CBofI balancesheet)
• Private sector have no confidence in IRL6 as they have taken out some €24 billion worth of funds from IRL6 (per April 2011 data from CBofI) or 23% relative to peak
  

So the only ones still showing confidence in IRL6 is... Irish Government itself, with the Sovereing - itself severely strapped for cash - putting some €18.566 billion worth of taxpayers money into Irish banks deposits since April 2010. That's a whooping ca 8-fold increase in Confidence, then.

15/06/2011: Few points of the future of FS

This is the presentation I gave at the Roundtable (thanks to all 150+ academic & industry practitioners who came and engaged) on the Future of Financial Services at the Infinity 2011 Conference on International Finance. Slides and few points:
Since I was chairing the event, I had to limit severely my presentation and the core of the event was based on 3 presentations by industry experts and the discussion with the audience - less Q&A, more open discussion.
Consistent with my view, the global financial crisis continues to threaten macroeconomic stability of the global financial and economic systems.

• The core component of the crisis - the crisis across global financial markets has abated due to the efforts of the Central Banks and Governments around the world. But it has not gone away. The system overall remains fragile on the side of liquidity (with quantitative easing rounds now being scaled back and no liquidity traps remaining, holding liquidity already supplied in the system locked away from the process of real lending).
• The crisis continues largely unabated in the sub-geographies of advanced economies and in particular within the banking sector in Europe, Japan and to a much lesser extent - the US. In the US, where balancesheet repairs on the capital side took stronger forms, the crisis in now manifested on the demand side for lending as well as in continued stagnation in the core household asset markets (property in particular).
• The main focus of the crisis has shifted onto debt - with deleveraging of balance sheets being secondary to the need to continue deleveraging households - something that continues to evade the focus of the policymakers.
• A number of large economies are now also experiencing a full-blown or forthcoming sovereign debt crises.

Overall, the duration, the breadth and the depth of the current crisis are so profound that in my view they signal a structural nature of the crisis, leading to a permanent (or long run) shift in:

• Regulatory environments (tightening of regulatory and supervisory systems, higher demand for capital, higher demand for quality capital, etc) all of which, unfortunately, so far, represent no qualitative departure from the already failed model of regulation that led to the current crisis in the first place. In other words, there's 'more of the same' type of a response on the regulatory side that is emerging so far, which does not hold any real promise of change, but suggest dramatic increases in the cost of capital provision, especially via debt instruments.
• The process of re-banking advanced economies - yet to start - will be taking Europe, North America and other advanced economies to a New Normal which will require cardinal rebalancing of the markets for financial services provision. This, in my opinion, will see consolidation of global banking institutions and a decline in their combined market shares, and the emergence of highly competitive and innovative specialization-driven service providers. The latter will be drawing increasingly greater shares of the markets for FS globally and will be largely free from the legacy of the crisis. In this context, the legacy of the crisis that will remain with the sector is the legacy of massive destruction of wealth inflicted onto the clients by the minimal compliance (prudential or suitability tests-based standards) ethos of the pre-crisis investment and wealth management services providers. In their place, the new providers will be adopting (driven by market demand, not regulatory systems) a fiduciary principle-based services ethos, which will put client needs as the main driver of revenues for the sector. Up-selling complexity and risk is out as a business strategy for margins support. Client relationship-building and product-backed client support will emerge as the core replacement strategy.
  
• In terms of re-equilibrating demand and supply of credit, the problem of shrinking pool of savings (due to fiscal austerity-driven tax increases, and demographic aging in the West contrasted with consumption expansion in the New Advanced Economies - NAE) will have to alleviated through new instruments. Debt will remain constrained as long-term process of deleveraging unfolds, equity will be the king, but hybrid instruments (on corporate finance side, less so onr etail side) and some new instruments for investment will have to emerge.
  
• Lastly, the New Normal will be characterized by a drastic scaling back of real off-balancesheet public liabilities (pensions, health and social welfare nets). The age of reduced local (within advanced economies) savings, falling debt levels and tighter global supply of savings (consumption effects in the emerging and NAE economies) will result in reduced ability to finance sustained deficits. This will precipitate emergence of new financing mechanisms (more closely aligned pay and benefits) for public investment, further reducing private investment supply.

The New Normal is already emerging via the divergence of financial services environments across two geographies: the Advance Economies (the "North") and the NAE economies (the "South").
In addition to regulatory pressures of 'Do More of the Same' approach in the advanced economies, and on top of a persistent gap in growth between the advanced economies and NAEs regions, there are emerging gaps in Investment volumes heavily skewed in favor of NAEs, a margin gap and a capital gap (both in terms of quantity and quality of capital, with many NAE banking systems explicitly or implicitly underwritten by solvent and liquid SWFs).

This geographic bifurcation of the FS models will fully emerge, in my view, around 2015-2020 and by 2020-2025 we are likely to see the drive toward convergence of FS across two geographies:
This convergence will be driven, in addition to the above factors, by the rising pressure of competition with 'North' service providers pushing into NAEs to capture higher margins and new markets, and with 'South' service providers pushing aggressively into the advanced economies markets to capture know-how, exercise competitive advantage of relatively cheaper capital available in the 'South' and retaliate against 'North's' competitive drive into their own markets. The end result will be globally lower Returns to Equity (ROE) squeezed on both sides by higher capital requirements and compliance and risk management costs (E-up) and lower margins (R-down) due to lower availability of savings, regulatory costs increases outside capital costs alone and a long-term shift of demand away from high risk high margin products (the shift toward fiduciary standards). Overall risk (sigma) will abate, as global economy settles on a lower structural growth level, further reducing risk premia-driven margin and ability to upsell risk.

In this process of transition to the New Normal, it is, IMO, of interest to have expanded academic and practitioner debate and research relating to the following questions:

11/06/2011: Irish Competitiveness: latest data

Q4 2010 data for Euro area-wide competitiveness indicators is now out and it's worth updating my old charts and crunching through some numbers.

Remember - Irish and some European policymakers are quick to point to improving competitiveness as a core strength of Irish economy. I am slightly in a more skeptical camp on this. Improving competitiveness is good, but it matters where these improvements come from and whether our competitiveness is improving not in absolute terms, but relative to the rest of Euro zone. Let's take a look at what data tells us:

• Euro area Harmonized Competitiveness Indicator (unit labour cost-based) deteriorated in Q4 2010 to 97.9 from 96.3 in Q3 2010 (higher values reflect lower competitiveness). This means that qoq HCI for Euro area (the average benchmark to compare ourselves against) has deteriorated 1.66%, while yoy it is still showing improvement of 9.69%. For the 6mo from July through December 2010 Euro area competitiveness improved 9.55% on same period in 2009.
• Irish HCI has moved from 110.8 in Q3 2010 to 113.8 in Q4 2010 - a deterioration in competitiveness of 2.71% - much deeper drop than for the Euro area average. However, year on year we are still outpacing Euro area gains in competitiveness, with our competitiveness improving 10.60% on Q4 2009, against Euro area improvement of 9.69%. For the 6 mo through December 2010, Irish competitiveness improved 10.62% yoy again outpacing improvements in the Euro area at 9.55%.
• So the speed at which our competitiveness indicators are improving is about 16-17% faster compared to Euro area for the Q3-4 2010, but in Q4 our competitiveness has deteriorated about 10% faster than that of the Euro area.

Charts to illustrate:

This means that we have to think not only in terms of the rates of change, but in terms of actual levels of competitiveness. And here we are not exactly a shining example of a competitive economy:

• In Q3 2010, Ireland was the third least competitive economy in the Euro area, scoring 110.8 HCI reading against 111.7 for Luxembourg and 171.3 for Slovakia. In Q4 2010 we slipped down to the second least competitive economy ranking with 113.8 for Ireland, against 113 for Luxembourg. Not exactly where we would like to be, nor the direction we would like to be heading in. Especially since wages are not growing and unemployment is not improving, while overall employment is declining - in Ireland, while the opposite is true for many of our competitors. Which suggests that the value added of our output is declining to drive our HCIs readings up.
• More significantly, since Slovakia and Lux are not exactly our immediate comparators, as chart below shows, our performance remains extremely poor compared to other core Euro area economies.

So let's use the FF slogan from the past: "Lots done, more to do" to describe our situation. At the peak of our 'non-competitiveness', Irish HCI's exceeded Euro area reading by 25.9 points (Q1 2008). In Q4 2010, we exceeded Euro area benchmark by 15.9. Less than half of the gap in competitiveness has been erased by Ireland Inc. To get ourselves down to the level of our direct competitors (other Small Open Economies, SOE) we would need (assuming they stay put at Q4 2010 levels and excluding Slovakia and Ireland) to shave off roughly speaking another 8 points from our HCIs. In other words, you can think of this in the following terms - for all the pain we've experienced, we've traveled so far just under 56% of the road to becoming as competitive as the average other similar SOE. "Lots done, folks. Yet much left to do, still."

10/06/2011: Capital Assets Acquisition in Industry - Q4 2010 data

Another data update for Ireland - Capital Investment in Industry, based on the CSO data for Capital Acquisitions.

Updating to Q4 2010:

• Total volume of new capital acquisitions in the industry in Ireland reached €911mln in Q4 2011, up32.5% yoy.
• New investment in capital acquisitions in Ireland for 2010 reached €2.333bn, down 25.4% on 2009 and less than half the level recorded in 2008 (€5.033bn). This was the lowest amount of capital acquisitions over the years 2006-2010.
• Combined investments into capital acquisition in Pharmaceutical, Computer and Machinery sectors reached €261mln in Q4 2010 up 43.4% yoy. Total annual level of new investment in capital acquisition in these sub-sectors stood at €592mln in 2010, down 42.7% on €1.034bn n 2009 and down on annual levels in 2008 (€1.695bn), 2007 (€1.603bn) and 2006 €1.054bn)

Chart to illustrate:

10/06/2011: Industrial turnover and production - April 2011

Industrial Production and Turnover data was released today for April, indicating the overall activity in the manufacturing sector and the broadly defined sources of this activity.

In line with this, I went back and linked - re-based - 2006 and 2007 CSO data to current base to show some comparatives to pre-crisis dynamics.

Here are the highlights:

• Manufacturing activity was up 4.09% on annual basis, compared to April 2010. Monthly increase was 2.24%. However, Manufacturing activity was down 1.44% on 3 months ago and 4.16% on April 2007 (pre-crisis). The seasonally adjusted volume of industrial production for Manufacturing Industries for the 3mo period to April 2011 was 1.8% lower than in the preceding 3mo period
• All industries activity was up 1.32% mom and 2.67% yoy, but down 2.095% on 3 months ago and down 5.33% on April 2007.
• Modern Sectors posted a volume increase of 2.52% yoy and 1.41% increase mom. The activity in Modern Sectors is up 4.79% on April 2007, but is down 2.4% on 3mo ago.
• Traditional Sectors activity was up 1.39% yoy and 1.15% mom, but down 0.57% on 3mo ago and a whooping 18.05% on April 2007.
• It is interesting to note that Modern Sectors are positively correlated with Manufacturing output to the tune of 0.772 for the full sample (January 2006-present), but this correlation grew to 0.863 for the sub-sample covering the crisis (since January 2008) and continues to grow today - up to 0.926 for the sub-sample since January 2010.
  
• In terms of Modern Sectors influence on All Industries volumes, the same relationship holds, with full sample correlation of 0.713 rising to 0.812 for the crisis period and to 0.887 for the period since January 2010.
• The predominant role of Modern Sectors in driving Irish Industrial production is contrasted by a very modest role played by Traditional Sectors, where correlation with All Industries has declined from 0.416 in the full sample since January 2006, to 0.290 in the sub-sample covering the crisis since January 2008, to 0.142 for the sub-sample since January 2010.
  

Chart to illustrate:
Of course, the driving factors discussed above imply that:

• The collapse of construction and real estate investment exposed the extreme degree of indigenous industries dependence on these areas of economic activity;
• MNCs-dominated modern sectors, free of constraints of domestic demand, have been experiencing strong recovery. Manufacturing has regained pre-crisis peak of 109 (attained in 2007) back last year (reaching index reading of 110.1 for the year), which also pushed All Industries index a notch above pre-crisis peak. Modern Sectors have shot to new historic highs in 2010, reaching 124.7 index reading, compared to pre-crisis peak of 111.2 attained in 2007. It is worth noting that Modern Sectors have recovered from the recession back in 2009, having posted volume of production index reading of 112.7 - above the pre-crisis peak.
• These trends continued in April 2011, as CSO notes, since "the most significant changes [in Volume of Production Indices] were in the following sectors: Basic Pharmaceutical products and Preparations (+11.3%) and Beverages (9.9%)... The “Modern” Sector, comprising a number of high-technology and chemical sectors, showed an annual increase in production for April 2011 of 2.6% and a increase of 1.4% was recorded in the “Traditional” Sector.

Next, consider turnover indices:

• Turnover in Manufacturing sector in April registered index activity at 95.9, which is 3.01% above March activity and 3.45% above April 2010 activity. However, turnover is 4.29% below that recorded 3 mo ago and 14.40% below April 2007. The turnover in April was also lower than the turnover in any of the months from May 2010 through February 2011
  
• Turnover in Transportable Goods Industries posted index reading of 95.4, which was up 2.69% mom and 3.02% above April 2010 reading. The index was down 4.6% on 3 mo prior to April 2011 and 15.22% below April 2007 reading.
• This suggest that output sales conditions have improved mom (monthly changes in turnover exceed change in volumes), but are still down yoy.

Chart to illustrate:
Lastly, the above chart also shows new orders activity which has risen from 90.7 in March to 95.9 in April for all sectors. However, new orders activity remains slowest for any month since the end of April 2010 through February 2011. New orders index is therefore up 5.73% mom (good news) and 3.79% yoy (also good news), but it is still down 4.39% from 3 mo ago and is down 15.52% on April 2007.

09/06/2011: CPI data for May

Consumer Price Inflation data for May is out today. Recall that a month ago, higher mortgage costs and oil prices pushed inflation to a 30-month high, with prices in April up 0.4% mom and 3.2% yoy. This was the second highest rate of annual inflation since 2008. This time around, the catalyst for inflationary pressures was supposed to be mortgages costs, as ECB hike of 25bps in April was expected to feed through to retail rates. CSO is very careful about this aspect of inflation, having issued in the latest release an explanatory note (see below). Market expectation, consistent with my view expressed in December-January issue of Business & Finance magazine, is for inflation to average around 2.8-3.1% in 2011.

Now, on to today's data:

• May CPI rose 0.1% mom - below the markets expectations and below 0.6% mom rise in May 2010. Yoy inflation was at 2.7% in May 2011, again below expectations in the market.
• HICP - omitting, among others, cost of mortgages, car and home insurance, car taxes etc (see CSO note on this in the main release) - posted 0% change mom against 0.3% increase mom in May 2010. Annual HICP rose 1.2% relative to May 2010.

Charts to illustrate - first CPI, then two indices of prices:
In annual terms, largest increases were posted in

• Housing, Water, Electricity, Gas & Other Fuels - up 8.5% after posting 11.8% rise in April and 12.5% in March. Within the category, Rents posted a 1.0% decline yoy and 0.1% increase mom, while mortgages interest costs posted a 0.6% mom rise and 20.1% increase yoy. Electricity, gas & other fuels sub-category posted a 1.0% decline mom and 6.6% rise yoy with Liquid fuels falling 3.8% mom and rising 17.9% yoy.
• Miscellaneous Goods & Services posted a 8.4% increase yoy primarily driven by Insurance (+15.9% yoy) of which Health Insurance (+21.6% yoy, but -0.6% mom) was the biggest culprit. Motor car insurance was up 7.6% yoy and 0.7% mom.
• Communications were up 4.1% yoy - driven solely by 4.3% rise yoy in Telephone & communication services.
• Health was up 4.0% yoy - hospital services up 11.4% yoy (no change mom) followed by Pharmaceutical products (+2.5% yoy and 0% change mom)
  

Deflation was recorded in

• Furnishings, Household Equipment & Routine Household Maintenance (-1.9% yoy and -0.1% mom) with strong deflationary momentum in Furniture & furnishings (-5.7%), and Major household appliances (-4.0%)
  
• Education - down -1.3%- driven by 1,8% yoy decline in Other education and training and -1.4% drop in Third level education. On the opposite side of the spectrum, Primary education costs rose 1.3% yoy and Second level education costs were up 0.8% yoy.
  

Charts to illustrate these trends:

As usual - an imperfect measure of state v private sector controlled prices - first straight forward state-controlled or dominated or influenced sectors:

Next - an index of prices in two broadly defined sectors:
One point worth making - the above chart clearly shows that inflation has moderated in state-controlled sectors. It remains to be seen if this welcome change mom will translate into a longer term trend.

Finally, a point, as promised above, on the issue of mortgages costs. CSO provides a handy explanation of their terminology on page 10 of the main release, from which I quote here:

"... current approach to measuring mortgage interest in the CPI reflects the situation in the base reference period December 2006 when the standard variable rate was dominant. Subsequently, tracker mortgages have become more popular. This did not give rise to any difficulties while the standard variable and tracker mortgage interest rates moved broadly in line with one another, which would be the normal expectation. However, the decoupling that has taken place since August 2009 has resulted in dramatically different trends emerging. For example, between September 2009 and September 2010 the standard variable rate increased from 2.93% to 3.66% whereas the tracker rate did not change. The Mortgage Interest component of the CPI, which is largely determined by the trend in the standard variable rate, increased by 25.1% as a result and contributed +1.25% to the overall change in the All Items index. It is crudely estimated that the latter impact would have been reduced by between 0.2% and 0.5% had the Mortgage Interest component been calculated on a current weighting basis."

So what CSO are saying is that current mortgages costs metric overstates the overall impact of mortgages costs increases on CPI because more mortgages, since 2006, were issued in the form of tracker mortgages. That's fine, but there is also a sticky problem of the weights assigned to all spending categories, which are all based on December 2006. If since December 2006 the following changes took place:

1. Overall costs of mortgages rose relative to other costs,
2. Home ownership proportion in population rose (which could have been due to emigration out of the country selecting predominantly non-homeowners, for example),
3. There have been significant exits from tracker mortgages and fixed-rate mortgages since 2006 (perhaps due to either selection bias in defaults or due to bias in favor of fixed rate mortgages in maturing mortgages, for example)
   

Then the weights used for this sub-category of spending might be below their current levels, off-setting the above effects of tracker mortgages.