484-595-0100
Inflation expectations yet to decouple from ECB target

Inflation expectations yet to decouple from ECB target

Used with Permission from atradiuscollections.com

Despite rising inflation in the eurozone, we argue it has not yet sprung loose from the ECB target in the medium term

  • Inflation in the eurozone is high and well above the 2% target set by the European Central Bank.
  • The current high inflation rate is to a large extent driven by pandemic-related factors and energy price increases related to the Russia-Ukraine war. We also observe that inflation expectations have not yet decoupled from the ECB’s official target rate. This makes us to believe that inflation will come down in the short term. A simple calculation exercise confirms this picture.
  • We conclude that inflation projections in the medium term have not yet sprung loose from the official ECB target and the current moderate intervention policy appears justified.

ECB ends wait-and-see

 

High inflation is the current hot economic topic. In June, inflation was running at over 11% in the Netherlands; for the eurozone it was nearly 9%, which is surely a record. It is also sure that the inflationary bite is being felt, particularly in the purchasing power of lower income groups. The question is, how long will this high inflation last? In recent months, energy prices have gone through the roof (see figure 1), with geopolitical developments playing a major role. If the pressure on these prices abates, inflation will also ease off. In principle, the monetary authorities should then not need to intervene much, if at all

But the ECB has decided not to wait any longer. In its press conference of 9 June, it announced its intention to raise its policy rates by 0.25% in July, and to end its bond purchasing programme. Moreover, it indicated a further interest rate increase in September, this time of 0.5%. But that will depend on how inflation pans out.

In this article we will look at inflation in the eurozone. Using simple calculations, we will explain how, in our view, the current high level of inflation in the eurozone will not be sustained. The main reason for this view is that a recurrence of the energy price explosion is unlikely. In addition, eurozone unemployment, which is far from negligible (over 7%) is weighing on wage rises, thus limiting second round effects of inflation. In this respect, the ECB acts as a lock on the door. Yes, inflation expectations are rising, but have not yet de-anchored from the official target of 2%.

 

Energy price in HICP index 2015-2022

Major impact of energy price rise

 

Energy prices have played a major role in the high inflation of recent months (figure 2). Yet this accounts for a relatively limited share (11%) of the total price index. However, on a year-on-year basis, the energy component has shot up by as much as 42% in June, which had a very sizeable effect on the total price index. Thus nearly half of HICP inflation in June this year – 4.0% points – can be attributed to higher energy prices. Food (including alcohol and tobacco) accounted for 1.9% points, and core inflation stood at 2.6% points.

Inflation Eurozone (year-on-year change in the monthly index

Instead of looking at the contributions of the components energy, food and core, if we focus on the rise of these individual categories, the numbers are even more spectacular: besides the 42% for energy (year-on-year), we see 8.9% for food and 3.7% for core inflation. Clearly, inflation is not only happening in energy prices, food prices have also risen and even core inflation is currently running well above 2%.

Rising energy and food prices may be regarded as temporary. However, when core inflation goes up, this is a sign that inflation is filtering through to the rest of the economy. Moreover, core inflation has already been above the target rate of 2% since October 2021. This will also have played a part in the ECB’s decision to adjust its inflation expectations upwards for 2022 and 2023. That said, there is still an expectation that inflation will subside, a consideration that is reflected in the moderate extent of ECB’s intervention.

Reasoning for declining inflation

 

Although the ECB has factored in a decline in inflation, it did not give specific reasons for this in its press release. But of course, it has its reasons. We will first look at the arguments in favour of this view. We then present our calculations, based our core argument: a recurrence of the energy price rise is unlikely.

First, underlying factors which have kept inflation moderate in recent decades have not disappeared. At most, they have been somewhat weakened by the pandemic. These factors include (i) globalisation, which weighs on prices thanks to competition from more suppliers; (ii) digitalisation, which makes pricing more transparent; (iii) weak wage growth: from low labour participation, a decline in trade union membership and competition from foreign workers, partly through migration; and (iv) population ageing, which leads to lower aggregate demand as consumer spending declines with age. While globalisation (and migration) may have cooled a little from the pressure of the pandemic and geopolitical tensions, a reversal of globalisation would appear to be out of the question.

Second, the rise in inflation from the second half of 2021 was initially triggered mainly by the recovery of economic activity after the pandemic. During the pandemic, aggregate demand was propped up mainly by support from governments. But because services such as hospitality, events and travel were mostly closed, demand shifted to goods such as electronics, household appliances and (outdoor) sports goods. This increased the pressure on the international supply chain, which was reflected in long delivery delays and price increases. There were logjams in transport, particularly in container transport, which also pushed up prices. Now that the pandemic has become more endemic in nature, and most sectors have re-opened, the demand for services will increase. Relative demand for goods will lessen, as will the pressure on international supply and transport chains. Thus one source of inflation will lose its strength. This process will be further reinforced by a decline in demand on the back of reduced purchasing power – itself a direct result of inflation. Early signs of this process are already visible in the easing of supply chain pressure (figure 3).

Eurozone global supply chain pressure index, standard deviation from the average

Third, for future inflation development, it is important that current inflation is sufficiently absorbed by the economic agents to prevent new imbalances in the economy. In this respect, wage development is crucial. It is important that companies are not saddled entirely or largely with the burden of inflation, because they would then set in motion a spiral of price and wage rises. So far, this is not the case in the eurozone. Wage rises remain limited at around 3% (figure 4).

negotiated wages, % year-on-year
This falls well short of the 8% inflation rate and will act as a brake on any tendency of European companies to shore up prices.  In the wage bargaining process, important considerations are the above issues such as unchanged inflationary pressure from underlying factors and easing pressure in the supply chains. The role of the ECB as guardian of the euro also plays a part: do the economic players expect that the ECB will ultimately be able to guarantee price stability through adequate policy response? These elements coalesce in the inflation expectations. Although these have gone up, they do not currently give reason for undue concern (figure 5).
Inflation expectations eurozone
The picture generated by this reasoning is one of inflation that is not sustainable at the current high level. We now substantiate this further with our calculations which are based on a temporary rise in the energy and food indices.

Calculations confirm the picture

 

We calculate the expected inflation from June 2022 to end 2023 in a simple manner. This involves looking at the year-on-year percentage changes in the monthly index – for example the difference between June 2022 and June 2021. We took the following approach.

For the period concerned, we calculated the price index of the components energy, food (including alcohol and tobacco) and core. The basic premise for the development of the indices of energy and food from June 2022, is the average of the rise in the sub-index for the period 2015-2019. Thus our conclusion is that the current state of energy and food price development cannot last. We will explain why.

With regard to the energy prices, we base our view on the underlying reason for the recent price rise: the war in Ukraine, and in particular the ensuing sanctions. These have pushed oil and gas prices to unprecedented heights. However, any further rise would require a second shock, such as major disruption to the Russian oil and gas supply. This could conceivably be an effective boycott of Russian oil or Russia turning off the gas supply to Europe. However, we don’t see this happening yet. True, with its sixth package of sanctions, the EU has aligned with the G7’s oil boycott, but the EU boycott will not take effect for another six months. Moreover, the G7 is working towards limiting the effect of the sanctions on oil prices. Yes, it appears Russia is reducing gas deliveries. But it is highly questionable whether gas deliveries will be fully stopped; it is certainly not in Russia’s interest to lose this easy source of money – especially at current high prices – to fund its war. Russia’s actions in this regard may prolong turbulence on the energy markets. However, we concur with the expectations of the World Bank and the OECD that energy prices will gradually stabilise. The same is true for food prices, with the pressure on supply from the production and delivery problems in Ukraine being absorbed by ramped-up production in other countries, such as the US, Argentina and Brazil.

Expected inflation Eurozone (% m-o-m change index)
Figure 6 shows the result of the calculations: eurozone inflation will have peaked in July this year and the rate will slide gradually until the end of the year, followed by an acceleration of the downward trend from early 2023. This will culminate in inflation of just over 2% by the end of 2023.

Just to give an idea of the effect of the calculation: In June, the energy index stood at 156 and we estimate it to reach 160 by the end of 2023. Food inflation will go from 121 to 124. These numbers represent increases of 2.5% and 2.4% respectively. Our estimates for core inflation are based on a shorter and more recent period, i.e. the average rise of the sub-index from July 2020 to June 2022. We factor in a second round effect of current inflation as well as the underlying (downward) pressure on inflation that we have explained above. For the forecast period until end 2023, the core inflation index will rise from 111 to 114, which represents an increase of 3.3%. To calculate the HICP, we used the weights of the sub-indices from June 2022.

The figure clearly shows that the energy component has an over-sized role in current inflation. This effect is evident from the (expected) energy sub-index, which, according to our calculations will reach 157 in December 2022 – a rise of 26% on the December 2021 index. However, if we look at the index for March 2023 and compare it with March 2022 when it stood at 154, we see a rise, i.e. inflation, of just over 2%. In other words, the inflationary spike of 2022 is matched by its mirror image in a drop in 2023. This is a simple, but powerful mathematical conclusion which does not require any further assumptions. The current high inflation is not here to stay.

Our calculations result in an average HICP of 7.9% in 2022 and 3.5% in 2023, with core inflation running at 3.6% and 2.9% respectively. This compares with the ECB’s reckoning for HICP of 6.8% and 3.5% respectively for 2022 and 2023 and average core inflation of 3.3% and 2.8%. Thus inflation expectations have not yet sprung loose from the official target rate, and the ECB’s current moderate policy appears justified.

John Lorie, Chief Economist
john.lorie@atradius.com
+31 20 553 3079

Theo Smid, Senior Economist
theo.smid@atradius.com
+31 20 553 2169

Dana Bodnar, Economist
dana.bodnar@atradius.com
+31 20 553 3165

You can read the original article on Atradius’ website at https://atradiuscollections.com/global/reports/economic-research-inflation-expectations-yet-to-decouple-from-ecb-target.html

About Securitas

Since 2004, Securitas Global Risk Solutions (“Securitas”) has helped clients worldwide develop credit and political risk transfer solutions that provides value on numerous levels.  As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring complete understanding of policy wording and delivering excellent responsive service.

Recommended News

Let’s Get in Touch

Office

900 West Valley Road Suite 701, Wayne, PA 19087

Call Us

484-595-0100

Liquidity matters: Corporates may need half a trillion of additional working capital requirement financing in 2021

Liquidity matters: Corporates may need half a trillion of additional working capital requirement financing in 2021

Used with Permission from eulerhermes.com

Summary

      • In 2020, Working Capital Requirements in the West increased (+5 days in North America and +1 day across Western Europe) while it dropped in regions such as Latin America (-3 days), Eastern Europe (-2 days) and APAC (-1 day). Inventory management and government support explain most of this divide. In the US and EU, severe lockdowns pushed companies into a “forced” stockpiling mode, which was fortunately tempered by the “invisible bank”, i.e. the very accommodating management of payment terms between customers and suppliers, , partly financed by liquidity support measures. 2020 saw a surge in WCR across industrial sectors: +13 days for metals to 95 days, +9 days to 117 days for machinery, +4 days to 84 days for paper and +3 days to 87 days for automotive.
      • Looking ahead, we estimate that large companies will face a record increase of EUR453bn in WCR  in 2021, equivalent to +4 days of turnover, up to EUR8.4trn. This comes in a context of the strong demand rebound triggered by the grand reopening, alongside severe shortages in inputs, labor and final goods. The surge in WCR already observed in most developed economies will ramp up in 2021, while WCR would remain well under control in a few emerging countries, notably in China (-6 days). In both the US and the Eurozone, we expect WCR to rise by +4 days.
      • While all sectors will see a rise in WCR, consumer goods sectors could see the biggest jump. Last year was a year of divergence. We expect many global sector WCR levels to resynchronize on the upside in 2021, with retail (+9 days up to 52 days) and agrifood (+8 days up to 81 days) seeing the largest rises, followed by industrial sectors such as metals (+7 days up to 103 days), transport equipment (+5 days) and machinery (+4 days).
      • Stocks matter: Along with the “just in case” model of inventory management, and the end of “just in time” for most sectors, rebuilding stocks in an environment of supply shortages will be the key driver of the increase in global WCR, notably across Western European countries. In 2020, Days Inventory Outstanding surged by +5 days in North America and by +1 day in Western countries, while the drop in inventories across Emerging Markets made up for the stockpiling in developed economies. In 2021, we expect pent-up demand and the massive restocking policies of Western companies in the midst of global supply-chain disruptions to weigh notably on their WCR levels. However, in 2022, reduced supply bottlenecks should mitigate the soaring inventory fallout on developed countries’ WCR.
      • State support matters, too: The additional WCR needs represent less than 20% of non-financial corporates’ net cash positions in the Eurozone. However, total deposits of non-financial corporates cover at best 30% of total debt, with France the most vulnerable. Our estimations for the Eurozone show that NFCs’ net cash positions (deposits – new loans up to EUR1mn) increased by EUR547bn in 2020, almost three times more compared to 2019. This compares to EUR102bn of expected additional WCR needed to be financed in 2021, i.e. 17% of 2020 net cash positions. Since the end of 2020, net cash positions have continued to increase in the Eurozone (EUR38bn as of May 2021), with Germany (+EUR18bn) and Italy (+EUR7bn) on top of the list, while in France net cash positions fell by -EUR9bn. However, if the grace periods on state-guaranteed loans are not extended beyond 2021, cash buffers will decrease as total deposits on non-financial corporates cover 30% of total debts at best, with only 23% in France, one of the lowest ratios.

A glance at the change in Working Capital Requirements in 2020 for 36 countries reveals a divide between Advanced Economies and Emerging Markets for the very first time. The WCR level in the West increased (+5 days in North America and +1 day across Western Europe) while it dropped in regions such as Latin America (-3 days), Eastern Europe (-2 days) and APAC (-1 day). Inventory management explains most of this diverging trend (see Appendix).

In EMs, total inventory levels were minimally impacted as demand for goods picked up and has remained strong since the summer of 2020. In contrast, the more severe lockdowns in the US and EU pushed companies into a “forced” stockpiling mode. France, Denmark and Spain, for example, saw their inventory outstanding level surge by +5 days, +7 days and +10 days, respectively, last year. The very accommodating management of payment terms between customers and suppliers fortunately tempered these increases in inventories in some Eurozone countries. France, for example, succeeded in seeing its WCR drop by -2 days over the year, thanks to longer payment terms to suppliers (+6 days) in relation to shorter payments from customers (-1 day).

Massive stockpiling always weighs on WCR levels and cash balances accordingly. However, it is not always a bad thing: it can pay off if it arises from companies’ expectations about future demand growth, to be sure of being able to cater to clients’ orders on time after the crisis period. Conversely, if stockpiling results from an inability to deplete current inventories fast enough, it usually brings on cash shortages for the company, which could end up going bust in the worst case. The different levels of change in WCR from one sector to the other also depend on where they are located in the global supply chain scale in regards to the final consumer. The more a sector is capital-intensive, the more it undergoes a significant WCR rise as any supply disruptions are more expensive when a plant has to temporarily stop production due to a lack of inputs.

2020 saw a surge in WCR across industrial sectors (see Figure 1): +13 days for metals to 95 days, +9 days to 117 days for machinery, +4 days to 84 days for paper and +3 days to 87 days for automotive. These sectors were forced into stockpiling during lockdowns instead of shutting down their plants because of how high closure costs usually are for capital-intensive activities. Overall, metals and machinery were the two losers in regards to last year’s changes in WCR: The Covid-19 crisis has highlighted how inflexible their manufacturing tools are in case of a sudden change in the economic cycle, especially from the inventory point of view. Conversely, the sectors most exposed to the boom of remote work saw their WCR level massively benefit from resilient demand and destocking. This includes electronics ranging from semiconductors to computers (-13 days down to 94 days) as the sector saw skyrocketing demand in 2020. Household equipment saw a fall in WCR of -5 days (down to 92 days), thanks to better-than-expected sales during lockdowns while construction also registered a fall in WCR (-4 days down to 76 days) as the sector cashed in on the shutdowns of new building programs to sell off all inventories left.

The two special cases are pharmaceuticals and automotive, which both saw their respective WCR rise by +3 days, pushing them up to a ten-year record high: 106 days of turnover for the former and 87 days of turnover for the latter. In spite of selling its medicines through drug stores, the pharmaceuticals sector unfortunately bears a very high level of WCR because drug makers usually deal with public hospitals and social security programs with very long payment terms. Conversely, pharmaceuticals has always generated a high level of cash flow so that it can easily support longer payment terms. The high WCR in the automotive sector has more to do with car dealers closely linked to carmakers by the fact that they share the same brand and usually support the funding of the largest part of car inventories.

WCR, just like Days Sales Outstanding (DSOs), tend to increase both in recession and recovery times. In Figure 2, we try to graph the effect that unprecedented liquidity support measures by governments have had – and continue to have – on compressing WCR variations. Initially designed to avoid hysteresis effects (bankruptcies and unemployment), and unlike the 2008-09 crisis, the Covid-19 crisis response has been very much focused on avoiding liquidity gaps and preserving B2B flows and credit. Using IMF data on liquidity support measures (state-guaranteed loans, moratoria on debt, subsidies) and our own WCR calculations (2021 forecasts explained hereafter), we see the lifeline from governments to help suppliers (the invisible bank) continue to finance their clients. In Europe, for instance, the WCR change has been quite limited, alongside very generous liquidity bridges. Also note that initial conditions (WCR levels, structure of the economy), as well as varying intensities of the crisis or recovery, certainly explain specific country developments (Spain and China for e.g.) In large Emerging Markets, we see that liquidity gaps may have been only partially bridged and that corporates will be faced with binding financing constraints as they return to pre-crisis activity.

Figure 1: Global sector WCR in 2020, in number of days (worldwide average)
Figure 1: Global sector WCR in 2020, in number of days (worldwide average)
Sources: Bloomberg, Euler Hermes, Allianz Research

 

Figure 3 summarizes the results of our WCR forecasts in 2021 for a few Western countries. France clearly appears to be the weak link in our sample as the country whose cash needs are likely to be the highest in order to finance the additional WCR of EUR31bn. Germany and Spain follow, with EUR17bn of additional WCR each, albeit a difference in level (EUR383bn for Germany and EUR109bn for Spain). The Netherlands’ additional WCR of EUR15bn expected in 2021 has to be monitored because this country was previously known for keeping its WCR low. Positioned as a big European platform country for international trade, it is no doubt paying more attention to enough restocking to avoid any fallout of supply-chain disruptions on its WCR. With its additional WCR of EUR153bn expected for the ongoing year, the US accounts for a third of the global additional WCR of EUR453bn needed to be funded in 2021, for a total of more than EUR2600bn.

Figure 3: Breakdown and 2021 forecasts of WCR amounts (EUR bn)

In 2021, nearly every country will see an increase in WCR levels, but the rise will be more significant across the northern hemisphere, given the dynamism of demand in the Eurozone and its massive restocking policies against very low levels of inventories (see Figure 4). Hence, we expect an increase of +4 days on average in WCR across Europe in 2021, ranging from +6 days in France and +7 days in Switzerland to +10 days in Austria and a more worrisome +15 days in the Netherlands. For the US, we expect a rise of +4 days in 2021.

Similarly, when looking at sectors, the rise of WCR is likely to affect all 18 that we monitor, in line with the return to growth prompted by the grand reopening and massive vaccination campaigns, which will improve demand prospects. Hence, we expect WCR to resynchronize on the upside in 2021 at a global level, with the largest increases seen in sectors linked to final consumer goods or closely related to them. Yet, sectors considered as strongly industrial should also see their WCR rise in 2021, such as metals, pharmaceuticals, transport equipment and machinery due to surging commodity prices, which will raise their production costs.

Figure 4 Inventories by sector
2021 WCR forecasts by sector (number of days)
Global demand by sector (new orders + backlogs of work)

Which sectors are the ones to watch? Agrifood (+8 days up to 81 days), retail (+9 days up to 52 days), transport (+ 4 days up to 32 days) and household equipment (+5 days to 97 days). We also expect large rises in WCR for metals (+7 days up to 103 days), pharmaceuticals (+5 days), transport equipment (+5 days) and machinery (+4 days). Last year, the transport equipment (aeronautics) sector benefited from the large destocking of Boeing’s 737 Max planes since these were allowed to fly again from the last quarter of 2020.

The WCR levels for electronics (+1 day), energy O&G (+2 days) and telecom (+0 days) are expected to remain around their long-term historical levels. Their WCR are better suited to withstand any upward pressures despite the acceleration of the recovery around the world. Now more than ever they have become instrumental to the new industrial background taking shape through global digitalization, which puts them in a strong position to set payment terms for both customers and suppliers.

Our WCR forecasts highlight a ten-year high level in 2021 for some sectors, notably agrifood (at 81 days), retail (52 days), pharmaceuticals (111 days), automotive (92 days) and machinery (121 days). These record levels could put companies at risk if they are denied additional credit lines from banks when they need to finance their operating cycle on a rise.

Furthermore, agrifood and retail are two specific sectors strongly destabilized by the booming remote work and e-commerce models, respectively. Not only has e-commerce prevailed over brick-and-mortar retail throughout the world, but also it is faster than before the Covid-19 crisis. Yet, meeting customers’ demands online usually requires e-commerce players to bear a higher level of stocks than retail outlets. It is all the more required now that consumption patterns have shifted towards durable goods, and government income support strengthened demand, while transportation services were limited. The conjunction of booming demand for consumer durables from Asia and supply-side bottlenecks created by sanitary restrictions in ports and terminals have kept shipping costs elevated for several months and made it all the more important to keep high inventories in the West.

However, stockpiling can also result from an inability to deplete current inventories fast enough. As a result, it can usually bring on cash shortages that could even push a company to go bust in the worst case. If replenishing current inventories, particularly in the northern hemisphere, is fueling the rise in WCR globally, changes in payment terms granted to clients should add to this upswing over 2021. This is because a relaxation in payment terms is usually an easy way of getting back market shares that could have been definitively lost by the supply disruptions that occurred last year due to the pandemic.

 

In the Eurozone, companies’ available cash surpluses generated by massive state support policies (notably direct liquidity support and state-guaranteed loans) appear to be significantly higher than the looming additional amounts of WCR.

Our estimations for the Eurozone show that the net cash positions (deposits – new loans up to EUR1mn) of non-financial corporates increased by EUR547bn in 2020, almost three times more compared to 2019. This compares to EUR102bn of expected additional WCR needed to be financed in 2021, i.e. 17% of the 2020 net cash positions. Since the end of 2020, net cash positions have continued to increase in the Eurozone (EUR38bn as of May 2021), with Germany (+EUR18bn) and Italy (+EUR7bn), on top of the list, while in France net cash positions fell by –EUR9bn, which suggests non-financial corporates have started to use their deposits in addition to new loans for operating activities (see Figure 6). German companies benefit from half of the French amount of cash surpluses stemming from public support policies back in 2020 (EUR93bn against EUR197bn in France). The positive point is that the first five months of 2021 show a further rise in cash generation of EUR18bn, which will fully cover the additional WCR expected in 2021. This stems from either additional public support programs or German companies’ profitability generating positive cash flows again since the beginning of the year alongside recovering export flows.

Figure 7 Available cash positions in 2020

While reassuring, it is important to bear in mind that these excess net cash positions are also needed for the repayment of all other debts. Therefore, this cash cushion might evaporate much quicker than expected, notably if the grace periods on state-guaranteed loans are not prolonged beyond the end of 2021 and companies need to start reimbursing their debt. Looking at the share of total coverage of the stock of loans & debt securities by total non-financial corporates’ deposits, France and Belgium appear to be most vulnerable despite the high levels of available cash. Indeed, total deposits cover 23% of total stock of total debt against around 30% in Germany and Italy (see Figure 8).

Fig 8 Share of coverage of total stock of loans and debt securities

About Securitas

Since 2004, Securitas Global Risk Solutions (“Securitas”) has helped clients worldwide develop credit and political risk transfer solutions that provides value on numerous levels.  As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring complete understanding of policy wording and delivering excellent responsive service.

Recommended News

Let’s Get in Touch

Office

900 West Valley Road Suite 701, Wayne, PA 19087

Call Us

484-595-0100

The Looming Corporate Debt Bubble

The Looming Corporate Debt Bubble

As we exit the COVID-19 pandemic, the economy appears to be aggressively recovering, fueled by pent-up consumer demand, low interest rates and cash from government stimulus programs. First quarter GDP grew at 6.4%. The Biden Administration just announced a $6 trillion budget, and currently negotiating with Congress for an infrastructure bill which will add another $1 – $2 trillion into the economy over the next several years. While largely positive, this combination has raised concerns about inflation as the prices of commodities, residential real estate, and basic food staples, transportation and travel are increasing. The Consumer Price Index rose 4.2% in April, the largest increase in twelve years.

Due to historically low interest rates, investors seeking higher yields are pouring cash into equities, real estate and alternative investments, such as cryptocurrencies, raising asset bubble concerns. The S&P 500 trailing twelve months (TTM) PE ratio is 31.36 vs. the thirty year average – 23.32. The median existing home price in April was $314,600, 19% year over year increase. Even with recent correction the crypto-currency market is now roughly $1.5 trillion, up nearly 600% from a year ago.

Less widely discussed however is the increased debt levels that corporations have taken on over the last ten years.

According to the Federal Reserve and Securities Industry and Financial Markets Association, large U.S. companies now face the highest levels of debt on record – more than $10.5 trillion. This figure doesn’t include small and middle market company debt estimated to be an additional $5 trillion.

Nonfinancial Corporate Business; Debt Securities

Source:  Federal Reserve Economic Data| FRED| Federal Reserve Bank of St. Louis 

While the coronavirus pandemic contributed to increased borrowing levels (nonfinancial corporate debt outstanding has grown by $1 trillion in two years), because of historically low interest rates, companies have been increasingly accessing cash through the debt markets since 2008 economic crisis.

 

Ten-year treasury yield:

10 Year Treasury Bond Yield

Source: Federal Reserve of the United States

Low interest rates have encouraged companies to borrow, but instead of funding business investment, in many cases the money was used for share buybacks to bolster share prices. According to JPMorgan Chase (Harvard Business Review, Why Stock Buybacks Are Dangerous for the Economy, Jan 2020) roughly 30% of stock buybacks in 2016 & 2017 were funded by corporate bonds. The International Monetary Funds’s Global Financial Stability Report, issued in October 2019 highlights “debt-funded payouts” as a form of financial risk-taking by U.S companies that “can considerably weaken a firm’s credit quality”. The authors conclude that “when companies do these buybacks, they deprive themselves of the liquidity that might help them cope when sales and profits decline in an economic downturn.”

This has left many companies with less flexibility to weather interest rate increases, or an economic contraction.

Non-financial corporate debt now stands at 40% of GDP:

Corporate Debt as % of GDPSource: Informa Financial Intelligence

 

Non-Financial Companies with Long-Term debt:

Nonfinancial Companies' Long-Term Debt

Source: “HowMuch.net, a financial literacy website”

The economic growth forecast for the second quarter and remainder of 2021 are positive. For federal budgeting purposes, the Congressional Budget Office forecasts 2021 real GDP growth rate at 5.6%. The highest since 1984 when the GDP annual growth was 7.24%.

Given the increased liquidity and consumer demand, the Federal Reserve will have the difficult task of managing interest rates to reign in inflationary pressures. Higher interest rates could have the dual impact of increased debt service levels and slowing the economy, both of which would negatively impact a highly leverage business.

As the saying goes “Everything thing is fine, until it’s not”. Companies will have to continue to diligently monitor credit even as the economy improves. Trade credit insurance and “Put” option contracts are two tools to assist financial executives evaluate credit risk and protect their balance sheet.

Credit Insurance

Trade credit insurance can be an integral part of a comprehensive credit evaluation and risk management strategy. Credit insurance protects the seller from buyer nonpayment due to insolvency or slow-pay. Credit insurers maintain extensive credit databases and actively capture, update and monitor debtor credit information. They often provide early notification if a debtor’s credit quality deteriorates, or financial performance declines. This information helps credit management professionals determine if, or how much, credit can safely be extended to a buyer.

“Put” Option contract

If a debtor is uninsurable (debt is rated CCC+ or lower), a Put option contract might be available. Put option contracts are non-cancelable and protect the seller if the debtor files for bankruptcy during the contract term. The contract terms are generally based on debtor credit quality, tenor and amount. Put option contracts have been limited to debtors with publicly traded debt. However, with recent changes in the Put option market, they can now be written on private debtors as well if financials are available.

Since 2004, Securitas Global Risk Solutions has helped clients develop credit and political risk solutions. As independent trade credit and political risk specialists, we are focused on developing comprehensive solutions that meet the needs of our clients. Please feel free to call us with any questions, or if we can be of any assistance.

Notes:

William Lazonick, Mustafa Erdem Sakinc, and Matt Hopkins. “Why Stock Buybacks Are Dangerous for the Economy.” Harvard Business Review, Jan 7, 2020, pages 2-3

HowMuch.net. a financial literacy website

Federal Reserve Bank of St. Louis

Congressional Budget Office, Nonpartisan Analysis for the U.S. Congress

Let’s Get in Touch:

Telephone: 484-595-0100

Fax: 484-582-0111

Recommended News

Let’s Get in Touch

Office

900 West Valley Road Suite 701, Wayne, PA 19087

Call Us

484-595-0100

Securitas Global Risk Solutions, LLC. Launches Securitas India

Securitas Global Risk Solutions, LLC. Launches Securitas India

New Venture to Address Growing Demand in India for Specialized Real Property Title Solutions 

July 8, 2021 – Securitas Global Risk Solutions, LLC, (“Securitas”) a specialty credit and political risk insurance brokerage based in Wayne, Pennsylvania announces the launch of Securitas Global, LLC (“Securitas India”), a new corporate initiative to offer land title solutions, cross border investment protection, and land portfolio management specifically for the Indian market. Expanding on Securitas’ long-standing record of helping clients manage their credit and political risk needs locally and internationally, Securitas India furthers the mission by providing title and political risk solutions for a range of Indian and international clients including: 

    • International and local developers 
    • Mortgage lenders in India 
    • Insurers and international re-insurers 
    • Private equity funds and foreign direct investment 
    • Development Finance Institutions (DFI) and Export Credit Agencies (ECA)

Why Securitas India?  With nearly 10 million people in India migrating to cities each year, India’s current land titling system does not support the surging growth.  This is an impediment to new investment, and lacks consistency, transparency and security. India’s backlog of land disputes has put many major infrastructure projects on hold and stifled the country’s economic potential.  A recent article in Bloomberg notes that the Indian government is working to reform the land titling system through a model bill that will guarantee the accuracy of land titles, require states to computerize land records, and establish tribunals to resolve the backlog of land disputes within three years.  Land titling reform carries the potential for an investment boom and considerable job growth.   

“India’s real estate market is set to grow by nearly $800 billion this decade. There is a clear need for the quality risk and titling services Securitas India can provide to facilitate investment and business certainty in India.”

-Shekar Narasimhan, Co-Founder 

Securitas India

As land transactions increase in the coming years, Securitas India will provide solutions to support the dynamic real estate sector via tailored insurance products, project monitoring and transaction management. Our expertise and client specific solutions will increase investor confidence and de-risk all aspects of the real estate finance and development continuum. Our team of professionals in the United States and India, brings over 100 years of experience in title surety, risk cover and real estate transaction monitoring and management.

Securitas India will be assisted in its efforts by Trimble Inc., a leading technology solutions provider of global positioning, modeling, connectivity, data analytics and land solutions.   

Securitas India and Trimble Partner

 For more information or to set up a consultation, contact Securitas at 484.595.0100 or at https://www.securitasglobal.com/contact-us/ 

About Securitas 

Since 2004, Securitas Global Risk Solutions (“Securitas”) has helped clients worldwide develop credit and political risk transfer solutions that provides value on numerous levels.  As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring complete understanding of policy wording and delivering excellent responsive service. 

About Trimble 

Trimble is transforming the way the world works by delivering products and services that connect the physical and digital worlds. Core technologies in positioning, modeling, connectivity and data analytics enable customers to improve productivity, quality, safety and sustainability. From purpose-built products to enterprise lifecycle solutions, Trimble software, hardware and services are transforming industries such as agriculture, automotive, construction, geospatial and transportation. For more information about Trimble (NASDAQ: TRMB), visit:  www.trimble.com. 

About Trimble Land Administration 

Trimble’s Land Administration solutions automate and integrate land registries, cadastral mapping, and the permitting and licensing of land for surveyors, governments, and businesses worldwide. Through the integration of a broad portfolio of technologies with workflow management tools, and consulting services, Trimble provides a fully configurable, scalable solution to help drive the efficient administration of land and its associated transactions, rights, and agreements. 

    Recommended News

    Let’s Get in Touch

    Office

    900 West Valley Road Suite 701, Wayne, PA 19087

    Call Us

    484-595-0100

    Lithium Market Set to Boom – A Risk Focus on the Lithium Triangle

    Lithium Market Set to Boom – A Risk Focus on the Lithium Triangle

    As the global economy continues to put the Covid-19 slump behind it, the market for electronic devices and an anticipated surge in electric vehicle demand has re-sparked interest in lithium, a highly reactive and conductive metal vital to the global economy. Found in only a handful of countries, with a small number of companies dominating its production, demand and prices have the potential to boom. In such a scenario, the potentially conflicting demands of consumers, mining companies, and lithium-rich countries warrants a look at political risk, particularly in South America’s Lithium Triangle, the home of 58% of the world’s lithium reserves.

    Why Lithium is in Demand

    The critical component of lithium-ion batteries, lithium’s demand corresponds to global demand for manufacturing electronics such as smartphones and electric cars, which are expected to have a 70% increase in demand in 2021 and throughout the decade, driven by consumer interest and by growing efforts in many countries to phase out internal combustion engine vehicles. In Europe, lithium-ion battery production is projected to increase from 28 GWh (gigawatt hours) in 2020 to 368 GWh in 2025. United States’ production capacity of the batteries is projected to more than double from 42 GWh in 2020 to 91 GWh in 2025 according to S&P global market intelligence, though it also projects the U.S. share of the market to decrease from 9% in 2020 to 6% in 2025. According to Seeking Alpha, lithium demand will increase by 600% by 2040.

    Low Prices and a Potential Boom

    An oversupplied market in early 2020 saw a decline in lithium demand, mainly due to Covid-19. According to data from Trading Economics, (shown below), lithium prices declined 45% between July 2019 and July 2020.

    Trading economics lithium Prices graph

    Yet the chart above shows a recent spike in prices. Lithium prices jumped up 41% in the Chinese market in January 2021, causing a significant rebound in global price. Simon Moores, Managing Director of Benchmark Minerals (@sdmoores) noted the jump in early February.

    Who is Buying Lithium?

    China is by far the world’s biggest owner and buyer of lithium. China has gained a dominant position (called a “stranglehold” by one mining trade source) of the main precious metals in the electric vehicle supply chain: lithium, cobalt, and nickel. Additionally, China manufactures most electric vehicles made in the world. As countries move to transition away from internal combustion vehicles, a range of countries appear poised to increase domestic production of lithium-ion batteries and electric vehicles, with accompanying demand for lithium resources.

    Simon Moores' tweet on global lithium prices

    Where is Lithium Being Produced?

    Lithium deposits and production are highly concentrated in a few countries, most notably Australia—the world’s largest producer of lithium—and the Lithium Triangle—Argentina, Bolivia, and Chile.  The Lithium Triangle has 58% of the world’s identified lithium resources, according to the January 2021 U.S. Geological Survey. S&P Global also projects a 199% in South American lithium supply as new lithium brines (saline groundwater enriched in dissolved lithium) begin production and existing salars (a lithium brine reservoir) increase production. Between 2008 and 2018, Australian lithium production jumped from 24.7% of the global lithium supply to 60%.[12] This is largely due to its ability to export lithium to China. According to a 2018 survey by Bacanora lithium, four companies produce 73% of the world’s lithium:

    (Tianqi Lithium owns an additional 24% of SQM.)

    Political Risk in the Lithium Triangle

    The anticipated surge in lithium demand and prices has renewed focus on South America’s Lithium Triangle.

    Bolivia

    Bolivia, owing to its large reserves and a recent political history, garners the most attention regarding political risk.  The left-wing populism of former President Evo Morales has promoted state regulation of key resources for well over a decade. The Morales government nationalized the oil and gas sector in 2006 and power companies beginning in 2010.

    Argentina

    A painful economic recession in 2019 led to the electoral victory of current President Alberto Fernandez and Vice-President Christina Kirchner, a former president whose previous administration was noted for taking on heavy debt and state intervention into key sectors.  Under her administration in 2012, Argentina nationalized YPF, an oil company.  Just last year, the Fernandez administration expropriated its leading grain exporter, Vicentin, after it declared bankruptcy.  While Fernandez is enjoying a bump in popularity, with 56% of Argentinians expressing confidence in the overall direction of the government in 2020, (up from 24% 2019), the country’s economic struggles remain.  As with Bolivia, Argentina’s recent history of using expropriation and nationalization in economic policymaking makes it a political risk concern regarding how it plans to utilize its lithium reserves as demand grows. 

    The Lithium Triangle

     

    Argentina

    • Lithium resources: 19.3 million tons
    • 2020 mine production: 6200 metric tons
    • Largest deposit: Sal de Vida, 1.1 million metric tons
    • Estimated percentage of GDP from mining: 5.3%

     

    Bolivia

    • Lithium resources: 21 million tons
    • Annual mine production: about 400 metric tons
    • Largest deposit: Salar de Uyuni, 5.5million metric tons
    • Estimated percentage of GDP from mining:
    • 13.5% (2015)

     

    Chile

    • Lithium resources: 9.6 million tons
    • 2020 Mine production: 18,000 metric tons
    • Largest deposit: Salar de Atacama 7.5 million tons
    • Estimated percentage of GDP from mining: 10%, mostly from copper.

     

    Sources: US Geological Survey, Mineral Commodity Summaries 2020;  Statista.com, Major countries in worldwide lithium mine production from 2010 to 2020; TradingEconomics.com

    Chile

    Chile has been a major source of lithium in recent years, but has disappointed investors as other countries have outpaced its mining growth.

    While Chile has generally rejected expropriation of lithium investment and has historically allowed private investment in the mining sector, the role of the state in taxing and regulating mining is tied up in current debates in Chile about constitutional change, environmental protection, and community rights.  Chile’s legislature has re-opened a charged debate over mining royalities, while Chile’s President Sebastian Piñera vowed to facilitate private and state partnership to double the country’s output of Lithium carbonate to 230,000 metric tons.

    Analysis

    Despite the recent slump, lithium’s long-term profit potential remains strong owing its importance to the global economy.  In many resource-rich countries, such as those in the Lithium Triangle, lithium mining’s economic potential will draw foreign investors who will face powerful political demands to see tangible community benefits from mining. This political mix raises risk concerns not just of increased taxation or regulation, but of expropriation and nationalization in countries with a history of state-intervention in key sectors such as mining.

    For international investors, political risk insurance helps safeguard investments in the event of nationalization, expropriation, confiscation, currency inconvertibility, civil unrest and property damage.

    Pie chart of world lithium resources

    Since 2004, Securitas Global Risk Solutions (“Securitas”) has helped clients worldwide develop credit and political risk transfer solutions that provides value on numerous levels.  As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring complete understanding of policy wording and delivering excellent responsive service.

    Recommended News

    Let’s Get in Touch

    Office

    900 West Valley Road Suite 701, Wayne, PA 19087

    Call Us

    484-595-0100