Britain’s gas system is under unprecedented pressure after cold weather pushed demand to a new record today.

Gas consumption hit an all-time high of 465.8m cubic metres today as people opted to work from home instead of braving the icy roads to the office, and turned the heating up a notch or two, according to initial estimates by National Grid, the network operator.

The increased gas consumption will add about £10 to the average household’s energy bill this week. Each one-degree drop below the typical temperature for the time of year adds 29p a day in extra heating costs, according to the National Energy Action charity.

The jump in demand also pushed the wholesale price of gas to its highest level for over two years, which could potentially feed through into higher costs per unit for some consumers if the freeze persists.

Anticipating the surge in gas use, National Grid issued a “gas balancing alert” – warning of pending shortages – yesterday. This is the sixth such alert since the code was introduced in 2005 and the first to be issued as early in the winter as December.

The continuation of unseasonably high demand for gas is testing Britain’s supply network, which relies on imports for about half of the gas consumed – a far cry from just 10 years ago when the North Sea satisfied the UK’s entire demand.

The loss of gas independence has made the UK far more susceptible to global fluctuations in demand and left the nation competing with emerging markets such as China for some supplies.

Britain is Europe’s largest consumer of gas, getting through about 100bn cubic metres a year – a third of the country’s total energy consumption. Residential uses such as heating and cooking account for about half, with power generation accounting for much of the rest.

“Our system hasn’t been tested in this way since we’ve become much more dependent on imports. The supply of the gas market has changed a lot in the past two years, but we will get the gas in,” said Edward Cox, of the London-based energy information and consultant ICIS Heren.

“It is very early to get this high level of demand for gas – we’ve never had a December where demand for gas has been this high,” Cox added. He said he did not expect Britain to run out of gas, before adding: “There is always scope for something unplanned, like a big issue at a terminal and if you are already a bit pushed, there is less scope for things to go wrong.”

Far more likely, Cox said, is that the sustained cold weather could eventually see us “paying significantly more” for gas.

In the past two years the UK’s use of liquefied natural gas (LNG) – which is brought into the country by ship, heated up and pumped into the grid – has gone from virtually nothing to account for about a fifth of total gas consumption.

In contrast to supplies from Norway, Belgium and the Netherlands, which are delivered through an interconnector linking Britain to mainland Europe, the UK must compete globally for supplies of LNG. Countries such as China, Japan, Taiwan, the US, Brazil and Argentina are using increasing quantities of LNG, leaving it open to potentially significant price rises if other sources of gas fail to satisfy demand, analysts said.

The so-called spot price of gas hit 71.5 pence per therm today, the highest level in at least two years and nearly double the level of 38p it was at this time last year.

National Grid today insisted that Britain was well prepared for the continuing cold snap.

Chris Train, National Grid’s network operations director, said: “Increased demand for energy is an inevitable consequence of the cold weather as Britain shivers. However, we remain well supplied with gas and electricity.

Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisers and is former President of the National Bureau for Economic Research.

Copyright: Project Syndicate, 2011.
www.project-syndicate.org

European Union: All in it together

It remains a tragedy that we are led by governments who insist that British interests are served by distance and disengagement in Europe

• Editorial
• The Guardian, Tuesday 21 December 2010

At times yesterday it was hard to credit that the David Cameron who reported to MPs on last week’s Brussels EU summit was the same David Cameron who had emerged from that summit claiming a victory for his efforts to put a seven-year cap on the Eu’s £129bn budget that was not even on the agenda in Brussels. Whatever the merits of that budget campaign, his emphasis on it was chiefly a public relations smokescreen, aimed at Britain’s anti-European media and his own backbenches. The much more pressing issue facing Europe today is the eurozone crisis, on which Mr Cameron was right to stress to MPs that Britain’s interests are engaged in support of stability. It is a pity that he does not make this his primary message more often.

Mr Cameron would be uncharacteristically naive if he thought his budgetary real-terms freeze campaign is either in the bag or that it may not bite back at him in the future. It is not in the bag because there are no signatures on the deal yet, just promises. Europe’s net budget receivers still have time to mobilise against net contributors like the UK. And it may bite back because Mr Cameron’s anti-European backbenchers are not the kind of people to accept any sort of increase in the EU budget, including a freeze in real terms. They want the EU budget to be cut, not frozen, and they want it cut big. They will not buy assurances from a man who has compromised on the EU to seal the coalition deal with pro-European Lib Dems.

The real business last week was the effort, led by Germany, to nail down a permanent bail-out system for debt-laden eurozone members. The agreement creates German-influenced “strict conditionality” rules for rescues from 2013 to replace the ad hoc ones adopted after the Greek crisis. Non-eurozone states, like the UK, can participate (or, more likely, not) on a case-by-case basis. Tight conditions (details to come) will be put on private bondholders. In the meantime, there is an effective pledge not to let Spain, which got a fragile report from the OECD yesterday, go to the wall. Suggestions that the eurozone would issue its own bonds – which would have put fresh pressures on states such as Germany, with sounder finances – have been dropped.

It is a very delicate package, one which risks a deflationary effect across Europe, though one which Mr Cameron, already set on such policies at home, can certainly sign up for. But it is a huge gamble. The truth, as Mr Cameron knows but does not say often enough, is that UK economic interests are fully bound up in the short and long-term success of the bailout package. It remains, as ever, a tragedy that we are led by governments who insist that British interests are served by distance and disengagement in Europe – when in reality the reverse is true.

Government alarm at citizens’ revolt as tent protests spread

Anger over rising prices is fuelling ‘Israeli Summer’ and generating widespread support for action

A tent camp in Tel Aviv: the protests over high rents and house prices have the support of 87% of the population, according to a poll. Photograph: Uriel Sinai/Getty Images Israel’s tent city protests over housing are growing by the day, and the mood of civil activism is spreading to other issues. The voices saying this is a serious crisis for Binyamin Netanyahu and his government are getting louder. I visited a protesters in Jerusalem a week ago, and two days later I was in Rothschild Boulevard in Tel Aviv, where the protests began and which is the biggest of the tent cities which have now spread to at least 25 towns. It was an impressive sight – literally hundreds of pop-up tents stretching the length of the city’s most affluent street, populated by mostly young people. There are debating areas, kitchens for creating huge communal meals, musical performances, poetry readings, TV screens – and genuine anger over the price of housing. Last night, the popular revolt against the cost of living focussed on a new issue: the price of bringing up a child in Israel. Thousands of parents marched with young children in pushchairs, demanding lower prices and tax breaks on baby equipments and childcare. Less than a week ago, tens of thousands of people rallied in Tel Aviv in support of the housing protest. Dozens of key roads and junctions have been blocked by protesters, and the entrance to the Knesset (Israeli parliament) has been blockaded. The Histradut, Israel’s trade union federation, has threatened to join the action next week. It will “use all the measures at its disposal,” said leader Ofer Eini. Doctors are on strike over pay and conditions. A Facebook campaign has called on Israeli citizens to “boycott” their jobs on Monday in an unofficial, social media-organised general strike. Demonstrations have been called in six Israeli cities for this Saturday evening – Tel Aviv, Jerusalem, Haifa, Ashdod, Beer Sheva and Nazareth. The last is an Israeli-Arab town; tent protest villages have appeared in Arab areas of the country in the past few days. Although the main focus is on the cost of housing – Tel Aviv rents are generally reckoned to absorb about 50% of income – there is also anger about the price of food, electricity and fuel as well as baby goods. A consumer boycott of cottage cheese in protest at dairy prices won widespread support. Inevitably connections have been made between the Arab Spring and this Israeli Summer. There are of course important differences: the protesters are mostly middle-class; the focus is on the cost of living rather than fundamental rights of freedom and democracy. And the protests are tolerated rather than repressed by the authorities. But there is a palpable hostility in Israel towards the government for its failures to feel the pain of its citizens and to do anything about it. And a poll showed 87% support for the protest. The government has been seriously rattled. Netanyahu’s emergency housing measures, announced this week, were immediately rebuffed by protesters. Even student leaders, who acknowledged that the concessions offered to them were unprecedented, said they would not give up their protest until the needs of other sectors of society had also been addressed. The protests have been given enormous – and sympathetic – media coverage here, adding to Netanyahu’s anxieties. An analysis which leads the front page of today’s Haaretz (English edition) begins: A wartime mood prevailed in the prime minister’s office yesterday. The other shoe dropped. This is a serious, unprecedented, powerful phenomenon. The middle-class rebellion, spreading like wildfire throughout the country, is undoubtedly the most acute crisis the second Netanyahu government has had to deal with. An editorial in the same (liberal) paper on Thursday said: Even those who don’t entirely agree with the messages coming out of the protests, marches, hunger strikes and demonstrations blocking traffic can’t ignore the protest’s vigour, in contrast to the apathy and even impassiveness that characeterised the Israeli people in recent years. In the surprising reversal of a process in which sectors of society turned inward, splintering the country and weakening it, the protest has swept up a broad public that has displayed a kind of solidarity and involvement that seemed gone forever. In Yedioth Ahranoth, Israel’s biggest-selling daily, the respected veteran commentator Nahum Barnea wrote: The Rothschild Boulevard rebellion is a fascinating phenomenon. It is difficult for me to assess its seriousness, its depth, its life expectancy. It is measured by standards with which I am not familiar, and is part of a different discourse, a different culture, different from the one that characterized previous waves of protest. We are accustomed to gauging waves of protest according to the demands they raise and according to the achievements they win at their end. The residents of the encampment on Rothschild do not have an orderly list of demands and predetermined exit points. They have nothing, save the authentic feeling that their situation, as young middle class Israelis, is terrible, unfair, crying out for change. Just as they loathe Netanyahu or Steinitz, they loathe the residents of the luxury towers further down the street. This is a non-political, anti-political loathing. The question is still open whether at a certain point it will become a political lever that will turn things around in the state. And in Ma’ariv, Ben Caspit made a connection between the protests and Netanyahu’s other big headache, the looming Palestinian bid for statehood at the UN in September: For months he has been preparing for September, been afraid of September, been repressing September and been preparing himself for the worst of all in September. But suddenly, Binyamin Netanyahu has now found himself waiting eagerly for September… If only it were September already, the prime minister says to himself, how wonderful it will be in September with the Palestinians and the Arabs and the UN General Assembly and with the entire world against us, and finally we’ll be able to mark for ourselves a common enemy. How wonderful, because better to have the entire world against us than to have the middle class against me. In September he won’t have to embrace everyone all the time and utter artificial words of reconciliation; he won’t have to grit his teeth and praise the protest movement; he won’t have to recognize publicly the justice of the position of the people demonstrating against him; he won’t have to hold press conferences and shoot programs from the hip and invent new supertankers. In September everything will be clear. Them and us, Arabs and Jews, the stuff that I already know and can handle excellently. I can hardly wait for September. Indeed, some have said the protesters themselves need to make a few connections, such as whether the funds that successive Israeli governments have poured into subsidising housing in the West Bank settlements could have been better spent on addressing their concerns. Whether the momentum of these protests continue to grow, and develop into something that can seriously threaten the current government, or whether it will dissipate in the torpor of August, is hard to tell at the moment. But right now this seems, on a smaller scale, to be yet another example of this year’s ripples of revolt across the region. • Comments on this article are set to remain open for 12 hours after publication but may close overnight.

Posted by Harriet Sherwood Friday 29 July 2011 08.29 BST guardian.co.uk

European Perspectives  2011

Plan B

• Markets are concerned that Europe’s policy response to date decisively addresses neither the very real solvency concerns nor the path to regaining competitiveness in a fixed exchange rate environment.
• The challenges facing Europe were aggravated by the global financial crisis but are rooted in the framework of the Economic and Monetary Union (EMU).
• We think Europe will muster the political will to keep the monetary union intact, but there remains a residual probability that some societies may prefer to exit the union rather than face years of economic hardship.

“Before I draw nearer to that stone to which you point, answer me one question. Are these the shadows of the things that Will be, or are they shadows of things that May be, only?”
– Ebenezer Scrooge
In Charles Dickens’ novel A Christmas Carol, the third spirit, the Ghost of Christmas Yet to Come, harrows Ebenezer Scrooge with dire visions of the future if he does not learn and act upon what he has witnessed. Scrooge’s own neglected and untended grave is revealed, prompting him to change his ways in the hope of changing the shadows of what may be. Europe is experiencing a similar moment.

Government bond yields in Europe’s fiscally challenged countries continue to rise. Instead of being reassured by budget cuts and official loans provided to Greece and Ireland, capital flight continues, market measures of credit risk remain elevated and the European Central Bank’s (ECB) holdings of Greek, Irish and Portuguese government bonds remain on an upward trend. In the process, markets are questioning how countries that have built up large debt overhangs, that have become internationally uncompetitive and that share a common monetary policy but limited cross-border labor movement and fiscal transfers can regain competitiveness in a fixed exchange rate regime?

The challenges facing Europe were aggravated by the 2008–2009 global financial crisis. Yet their roots lie in the framework and governance structure of the Economic and Monetary Union (EMU). Given this framework, there is high uncertainty about the future debt dynamics of EMU’s fiscally challenged countries and their ability to sustain significant austerity programs while transitioning to higher growth.

It is not clear yet how this important chapter in Europe’s history will play out. There are a range of possibilities: It is possible that the peripheral European economies will deliver on their ambitious fiscal adjustments and, in the process, regain the path of high growth and financial stability. It is also possible that adjustment fatigue will set in, growth will not materialize as expected, and the risk of some countries defaulting and possibly exiting EMU goes up.

Europe’s policy response to date has been to provide liquidity support to Greece and Ireland in return for very ambitious fiscal austerity measures. The objective is to buy time for these countries to grow into more sustainable debt dynamics and for banks with exposures to them to build capital reserves.

Markets are concerned that this response decisively addresses neither the very real solvency concerns nor the path to regaining competitiveness in a fixed exchange rate environment. Liquidity by itself – be it through a larger European Financial Stability Facility (EFSF), more purchases by the ECB, common Eurobonds or lower interest rates on official loans – is not sufficient to solve these long-term structural problems.

There’s also the risk that simply applying a liquidity solution to an insolvency problem may contaminate the balance sheets of otherwise financially strong countries. Moreover, constraints on EMU’s fledgling political integration and fixed exchange rates make for difficult policy choices that increase the risk of contagion.

On the one hand, the danger of addressing insolvency issues now is depleting even more capital from Europe’s banking system, which is still recovering from the U.S. subprime debacle. On the other hand, if growth does not turn out as expected and addressing insolvency problems is postponed, the risk is that contagion will spread to Spain, Italy and Belgium, making the problem bigger. As investors, we need to factor in this possibility and consider alternative strategies.

Regaining Competitiveness

Underlying EMU’s sovereign crisis is a combination of uncompetitiveness and a debt overhang. Since the inception of the euro in 1999, prices in Spain, Greece and Portugal have risen relative to their trading partners, reducing their competitiveness and coinciding with large current account deficits (Chart 1). Add on the debt overhang – in Greece in the public sector; in Ireland and Spain the private sector and in Portugal a bit of both – and you have the ingredients for today’s problem. To complicate matters, Europe’s banking system intermediated the current account deficits assuming no exchange rate risk and little credit risk but without considering how these countries will regain competitiveness.

Regaining competitiveness is hard through only “internal devaluations” associated with tight fiscal policy. Moreover, the regional economic environment is not enabling, as all countries in Europe are trying to reduce their budget deficits at the same time. It’s hard to grow when both you and your trading partners are cutting consumption too. Fiscal austerity, while necessary, can also undermine the economic growth needed to stabilize these countries’ debt burdens.

Generally, a sovereign insolvency can be averted via sufficiently large transfers or currency depreciation when debt is denominated in local currency. Historically, European countries that successfully completed large fiscal adjustments fulfilled the latter conditions. Most of them experienced exchange rate depreciation and most of their debt was denominated in local currency. Prior to EMU, as the top half of Chart 2 shows, European countries completed fiscal adjustments that averaged 10% of GDP, took eight years to complete and were associated with 13% exchange rate depreciations and 22% increases in nominal GDP over the first three years of the adjustment.

There is little historical evidence of countries successfully regaining competitiveness and working off debt overhangs without experiencing exchange rate depreciation. In Europe prior to EMU, only Germany (1979–1989) and Switzerland (1993–2000) completed large fiscal adjustments without exchange rate depreciation. Latvia, which pegs the lat to the euro, successfully began a large adjustment worth almost 9% of GDP in late 2008, but so far at the price of nominal GDP falling 27% from peak to trough. Outside Europe, Argentina tried but defaulted in 2001.

Without access to fiscal transfers or exchange rate flexibility and local currency debt, those European Union (EU) countries in the lower half of Chart 2 face a policy credibility and flexibility issue. We are witnessing a real-time experiment in fiscal adjustment frameworks between Iceland, which is outside the EU, pursuing a policy of defaults, capital controls and external devaluation, and EU countries that are opting for internal devaluation. Only time will tell which framework works best. We remain skeptical that Europe’s fiscally challenged countries will muster the social cohesion necessary to regain competitiveness and reduce their debt overhangs via internal devaluation without further concessionary assistance.

Default becomes an especially high risk event when a debt overhang exists and the debt is denominated in external currency, but it provides little help to regain competitiveness. As Desmond Lachman suggests in a December paper delivered to the Legatum Institute, some countries could have to ultimately exit EMU in order to regain competitiveness because their primary deficits are so large, and there are limits to how much labor productivity can be increased or how much people are willing to let living standards fall in order to devalue internally. We think Europe will muster the political will to keep EMU intact. But in light of the ongoing protests against fiscal austerity and the apparent inequity of making the broad population suffer while private sector creditors receive their bonds paid back in full, there remains a residual probability that some societies may prefer to exit EMU rather than face years of economic hardship.

What are the pros and cons of exiting the euro anyway? The main advantage would be the opportunity to regain competitiveness. The harmonized competitiveness indicators in Chart 1 offer a clue: Assuming a 2% inflation difference, Ireland, Portugal and Italy could catch up to the average competitiveness level of Germany, Austria, Finland and France in six to seven years. But Greece and Spain would need 10 to 11 years to bridge their competitiveness gap with the core. Although practically that means zero inflation in the periphery given 2% in the core, it will take a long time, depress nominal GDP in the process and risk destabilizing the debt dynamics. Therein lays the risk of a social backlash against the euro and accompanying policy fatigue. The main disadvantage of exiting the euro would be the likelihood for an abrupt wave of public and private sector defaults due to the soaring value of euro debt obligations in local currency, not to mention the enormous social and operational costs of reintroducing a local currency. Exiting the euro should therefore only be seen as an ultima ratio option when really nothing else, including unconditional transfers, works.

A host of solutions have been proposed to solve the crisis, including Eurobonds, large scale asset purchases by the ECB, a larger EFSF, lower rates on official loans and a stand-by loan for Spain. In one way or another, they aim to provide more liquidity at concessional rates. While the liquidity would buy more time, it would not solve a country’s competitiveness problem. Eurobonds with joint and several liabilities would provide fiscally challenged countries liquidity at concessional rates but without giving surplus countries any tool to ensure budget compliance in the former group. Eurobonds could also raise EMU’s AAA-rated countries’ borrowing costs by between €2 billion and €5 billion per annum. That surplus countries will have to pay more is unavoidable. The question is how to sell it to their voters.

Proposals led by Germany to create the European Stability Mechanism (ESM) in 2013 when the current EFSF expires go in the right direction. Rather than being criticized for aggravating the crisis, Germany should be commended for its initiative to introduce a sovereign debt restructuring mechanism inside the ESM, including private sector burden sharing. Germany has demonstrated it understands the difference between liquidity and solvency solutions. We think the ESM should be activated sooner: Given the low probability of peripheral countries’ achieving sufficient economic growth to stabilize their debt (due to lack of policy flexibility), uncertainty about the future value of these countries’ bonds could potentially prevent interest rates in Spain, Italy and Belgium from falling. Credible fiscal policies alone will not stabilize debt; interest rates also need to fall. Italy is the world’s third largest government bond market and Europe cannot afford to allow these latter countries to lose market access.

Plan B

At PIMCO’s quarterly economic forums, where we discuss our outlook for the global economy and financial markets in order to formulate our top-down investment strategy, we are often advised to “separate what you think will happen from what should happen”. What we think will happen is that the European sovereign crisis will end when the hidden losses of unsustainable debt burdens, whether real or perceived, are either crystallized, socialized or earned away via higher growth.

Fiscal austerity and lack of exchange rate flexibility preclude higher growth. The EU’s budget and governance structures are too young to allow socialization of losses. That leaves realizing losses, which is a real risk for investors. Without addressing the insolvency issues in Greece, Ireland and Portugal in a timely fashion, contagion could spread to Spain, Italy and Belgium. This could prompt a bigger, albeit reactive policy response, including the ECB or EFSF buying more peripheral bonds and a larger EFSF. But that will not end the crisis.

For the euro to endure, a more comprehensive plan is needed. What we think should happen is for the ESM to be activated sooner. A thorough debt sustainability analysis, which the ESM is mandated to conduct from 2013 onward, will likely show what markets are discounting today. Haircuts sufficient to restore debt sustainability may be needed. Banks exposed to sovereigns whose debt sustainability is at risk should speed up raising capital. Old bonds of those countries conducting haircuts could be exchanged for new bonds guaranteed by EMU’s AAA-rated countries. Banks and their shareholders and creditors may not like that, but bailing in the private sector would give politicians in the surplus countries that have to foot the bill credibility with their electorates who resent bailing out banks, Greece and Ireland.

Ultimately, the decision-making power over distribution of the EU’s budget needs to change if Europe moves toward unconditional transfers, which a fiscal union implies. Larger value added tax (VAT) contributions to the common budget, reallocation of appropriations away from agricultural subsidies directly to countries’ central government budgets and reorganization of voting rights in the European Council to better reflect countries’ populations and contributions to the budget would strengthen the euro area’s longevity.

A Bird in the Hand is Worth Two in the Bush

Rome was not built in one day. While our wish list for the euro area is nothing more than that – a wish list – and may require decades to be realized, if at all, some things can be executed in a timely fashion. Waiting for the perfect conditions to implement the ESM in 2013 may be too late. Consequently, our European investment strategy remains similar to the strategy we pursued in 2010.

We continue to underweight European peripheral sovereign and credit risk given possible restructuring and contagion issues. We are cautious on German duration and the euro, given the potential for the peripheral countries to contaminate the German balance sheet, other core countries and the ECB.

We remain underweight European senior bank debt, reflecting concerns that the peripheral crisis could lead to more contagion in the banking sector. We believe that U.S. senior financials offer better risk/reward characteristics and valuations relative to their European counterparts.

As with other PIMCO portfolios, a key part of our strategy across European portfolios is to target “safe spread” investment opportunities: Securities we believe are able to earn a spread relative to sovereign debt across a range of possible economic scenarios. Our focus is skewed toward investment grade credit and select high yield opportunities, covered bonds and asset-backed securities. Given the contrast in fundamentals and growth opportunities, we will continue to favor emerging market securities and currencies.

At the end of A Christmas Carol, Scrooge awakens Christmas morning with joy and love in his heart, and he spends the day with his nephew’s family after anonymously sending them a prize turkey for Christmas dinner. Scrooge becomes a different man overnight, treating his fellow citizens with kindness, generosity and compassion. If the euro is to endure, Europe will have to undergo a similar transformation.

April 2011

Where to Invest in Emerging Markets

• ​ With central banks in developed nations generally continuing to hold rates low, investors may wish to reconsider how they invest in bonds.
• Emerging market investments have been, and remain at the forefront of a push at PIMCO to find attractive spread opportunities.
• As the asset class expands it provides portfolios with potential opportunities to diversify currency holdings, cushion against developed world rising rates, and hedge downside risks.

In a world where developed economy central banks are using low interest rates to heal damaged balance sheets, investors in government bonds face what Bill Gross recently described as a “Devil’s Bargain” – holding bonds that provide a fixed interest but whose value is being confiscated through either inflation, currency debasement or both. What to do?

Investors seeking to maximize total returns in this environment should break away from investing in bonds in the traditional way, since that provides an inadequate hedge against inflationary risks, and instead move toward “safe spread.” By this we mean sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios, given the range of risks.

Emerging market (EM) investments have been, and remain, at the forefront of this push at PIMCO. As the asset class expands it provides portfolios with a wide range of instruments to diversify currency holdings, cushion against developed world rising rates through attractive spread opportunities, and hedge against downside risks through stronger balance sheets.

Not all emerging markets provide these attractive spread attributes. Indeed, different markets and different instruments within individual countries also vary greatly in their prospects to deliver compelling risk/reward profiles in the current investing environment. The strength of the asset class as a whole, however, resides in the ability of the active manager to navigate the underlying risks and move between countries and markets in an effort to protect investors from developed market headwinds while simultaneously seeking to take advantage of still-compelling emerging market tailwinds.

So, where do we see opportunities?

Asian Currencies
The best opportunities in Asia are in currencies. Several Asian currencies are supported by strong fundamentals, including balance of payments attributes that suggest appreciation pressure coming from both the current and capital accounts. Valuations are also compelling as many Asian currencies look attractive vs. long-run metrics such as purchasing power parity and deviations from real effective exchange rates. We can see that Asian currencies have lagged the strengthening trend of currencies in other regions following the crisis of 2008 to 2009 (Figure 1). Policymakers have stepped up reserve accumulation to “lean against the wind” in the face of these appreciation pressures, but evidence suggests that policymakers are acquiescing to more currency strength, either as a part of their tool kit to fight a strong inflationary impulse or as reserve accumulation fatigue sets in.

While Asian currency exposure has many of the attributes we look for in identifying “safe spread” opportunities, Asian local duration exposure warrants different considerations. Indeed, with real rates in Asia sharply negative and nominal rates among the lowest in the world, little compensation is given to fixed income investors for burgeoning inflation risks. Policymakers in the region have a history of running growth-oriented policies even in the face of strong pricing pressures. Relatively modest interest rate hikes to this point suggest that many Asian central banks currently risk falling behind the curve. So why take rates risk in Asia when one can simply choose to take duration exposure in other markets where the compensation for inflation is much greater?

Brazil Local Rates
The value contrast in local duration exposure between much of Latin America and the rest of the world is significant, particularly in the case of Brazil. As opposed to the majority of the G-3, much of Asia and much of emerging Europe, where real rates are sharply negative, Brazil has among the highest nominal and real rates in the world (Figure 2). Put differently, Brazil local markets currently compensate an investor substantially more for inflation and currency risk than do traditional G-3 fixed income markets. Put still another way, investors may be able to get a higher level of nominal compensation to lend money (buy bonds) to investment grade Brazil in reais (BRL) than they currently do to lend money to the bulk of the credit-impaired eurozone.

Brazil, a BBB- investment grade rated credit, has an exceptionally strong balance sheet highlighted by its strong international investment position and comfortably high reserve coverage. Its responsive central bank has earned a high degree of credibility and shown a firm commitment to inflation targeting. Yet despite these strengths, Brazil is forced to pay investors a higher rate of interest for three main reasons. First, the government has massively increased the level of subsidized lending channeled to its development bank BNDES (Figure 3). This low cost of funding allows BNDES to lend money not at the benchmark overnight rate set by the nation’s central bank (currently 11.75%), but at its own much lower non-market rate of interest of 6%. The more credit that flows into the economy at these subsidized rates, the higher the clearing rate that the central bank must set for interest rates on the rest of the economy to contain price pressures. In other words, with BNDES pricing credit at an artificially low rate, the market clearing level for Brazilian rates moves to an artificially higher level.

The second main reason rates are so high in Brazil relates to concerns of fiscal slippage and a pro-growth policy that heightens inflationary pressures and puts an increased burden on the central bank to aggressively tighten monetary policy to contain inflation. On this issue, the newly inaugurated Rousseff administration has responded to early tests in the fiscal program in an encouraging fashion, announcing a headline fiscal reduction plan of 50 billion BRL, and capping minimum wage gains at a reasonable level. These trends suggest that runaway fiscal profligacy will not be a hallmark of the coming years in Brazil.

Third, investors have to contend with heterodox policy and the threat of increased taxes from the finance ministry. The finance ministry has tried to slow gains in the BRL by implementing (and then tripling) the IOF tax to a whopping 6%! This high level may seem daunting in many ways, but looking at it differently serves to crystallize the extent that Brazilian rates are mispriced vs. the rest of the world. The IOF toll charge to enter Brazilian local markets means, for example, that a foreign investor purchasing a 10-year BRL bond in Brazil that yielded a pre-tax of 12.8% would have accepted an after-tax yield-to-maturity of 11.6%. This is still more attractive than most other markets (again Figure 2). (The IOF, Imposto sobre Operações Financeiras, is a tax on financial transactions paid up front by a foreign investor in Brazil, currently levied at 6% for fixed income securities.)

The most damaging aspect of the IOF tax is  the impact it has had on Brazil itself, namely 1) increasing the cost of its financing in BRL as investors simply back-up the market clearing rates to compensate for the taxes, 2) stunting the development of an important financing source for Brazil, namely the long duration onshore market, as the depth and liquidity of that market gets impaired by these restrictions and further pushes yields to higher levels than they otherwise would clear in a frictionless exchange, and 3) removing this market as a viable and cost-efficient source of financing for the large and growing corporate sector, pushing them increasingly to USD-based financing (original sin) or back to BNDES, exacerbating these same dynamics.

Russian Oil and Gas Sector Debt
Investing in emerging markets sovereign debt was for many years characterized by the willingness to underwrite greater political, economic and financial market volatility in less developed countries in exchange for wider spreads and relatively clean balance sheets. For the most part, the large mispricing that existed in sovereign risk for many years between developed and developing markets has now disappeared. Underrated EM sovereign credits like Mexico, Brazil and Russia now trade through many substantially overrated credits in the eurozone, while Korea and Japan trade at the same spread level of sovereign risk, and China trades well through both. So while the fundamentals of many emerging market sovereigns are superior to their developed world counterparts, this trend is now reflected in many markets.

Investors looking to capture excess premium for emerging markets investments might want to consider focusing on opportunities in the corporate sector, particularly in Russian oil and gas. In this area, PIMCO has invested in a basket of companies whose strong credit fundamentals suggest high single A ratings, based on PIMCO analysis, but whose spreads in the markets are closer to low BBB.

Consider as an example the large spread pickup seen in the BBB rated oil and gas sub-index of the JPMorgan Russian Bond Index (RUBI), which trades at spreads of roughly 250 basis points (bps) over U.S. Treasuries.  This is almost 100 bps higher than traditional BBB rated energy indexes like the energy sub-index of the Merrill Lynch Commodity Index (ML CIEN). At the same time, the RUBI oil and gas subindex’s largest constituents have proven reserves larger than many of the developed world oil majors (Figure 4).

Bottom Line
The developed world is still suffering from large headwinds to growth from the balance sheet damage inflicted by the crisis of 2008. In addition, risks to investing are rising from geopolitical uncertainty in the Middle East, natural disasters in Japan and the threat of rising inflationary pressures. At the same time, monetary policy in the developed world and Asia is still loose. Investors should continue to refine how they look at spread opportunities to focus investments in areas that may provide larger cushions to absorb these potential shocks. In currencies, that likely means looking to undervalued Asian currencies whose appreciation may help combat rising inflationary impulses in the region and help rebalance global growth. Among global interest rate markets, it means recognizing that developed world sovereign debt carries large risk – both on the credit side as debt trends worsen and on the inflation side as central banks latently apply confiscatory monetary policy to fixed interest debt securities. We believe better alternatives exist in select EM markets, where balance sheets are cleaner and real interest rates are high – Brazil stands out as a prime example. In credit, understand and be willing to underwrite a similar value proposition in EM corporates that was proven attractive in EM sovereigns. That is, focus on obtaining more spread for less leverage but consider accepting higher volatility and less liquidity while the markets secularly reprice EM corporate risk to that of developed markets. Russian oil and gas stand out as an example of a sector attractively positioned to potentially benefit from high commodity prices and able to deliver a steady supply of energy as other sources may look less viable.

Importantly, these conclusions are not just for the dedicated emerging markets investor but should increasingly be pondered by the global investor. With EM economies accounting for roughly 35% (and more on purchasing power parity measures) of global GDP but just roughly 10% of its fixed income markets, investors that recognize and move early a larger allocation of their assets into EM may stand best positioned to capture attractive spread opportunities in the period ahead.
Michael Gomez
Executive Vice President