With a new administration installed in the US and a $1.9trln relief package approved, attention has now turned to how this fiscal largesse will be paid for. I thought this article from September 2020 might add to the debate.
Macro Letter – No 137
A Review of Stock Market Valuations – Part 2
- As global stock markets continue to rise, commentators talk of a bubble
- Shorter-term indicators suggest the markets have run ahead of fundamentals
- Expectations about the speed of economic recovery from the pandemic remain key
- Even a slight moderation of fiscal and monetary expansion could precipitate a crash
Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.
Charles Mackay – Extraordinary Popular Delusions and the Madness of Crowds (1841)
Money is a public good; as such, it lends itself to private exploitation.
Contributing to euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
JK Galbraith – A short history of financial euphoria (1990)
This is the second of a two part letter reviewing the current valuation of stocks. The focus is US-centric and looks at both long-run valuation (Part 1) and shorter term factors which may be warning signs of irrational exuberance (Part 2).
During the last year we have seen stock markets around the world, decline rapidly and then rebound. Technically the longest bull-market in history ended in March of 2020, but the recovery was so swift that many commentators are calling it merely a sharp correction, simply an aberration. Since March the US stock market, fuelled by aggressive monetary and fiscal easing, has shot to new all-time highs. 2020 ended with the approval of the first Covid-19 vaccines, sending markets higher still.
Equity markets are forward-looking, the economic woes of today are discounted, expectations of recovery, backed by further fiscal support, make the prospects for future earnings appear relatively rosy. In this, the second part of my letter, I want to examine some shorter-term indicators which may or may not be cause for concern that current valuations are a triumph of hope of reality.
I once gave a speech entitled The Trouble with Alpha the gist of which contained my observation that Alpha – that portion of an investment managers returns which are not the result of the performance of the underlying assets was, was simply timing. To arrive at this conclusion I looked at 24 definitions of Alpha, finding that – once I had accounted for factors such as leverage, the ability to be long or short and (of particular importance) the choice of the index which was supposed to represent Beta – all that remained was timing.Suffice to say the speech was not received with acclaim by the audience – who were primarily investment managers. I mention this because, for the majority of investors, the investment time-horizon is finite. It is all very well for me to write about the Long Run and for Warren Buffet to describe his favourite investment horizon being forever, but for most investors, volatility, liquidity and mortality are key.
The economic historian Charles Kindleberger published Manias, Panics and Crashes: A History of Financial Crises in 1978, in which he observed patterns of fear and greed stretching back centuries, however, personally, I think Jesse Livermore sums-up the behaviour of financial markets best in the opening pages of Reminiscences of a Stock Operator, published in 1923: –
There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.
In trading especially, but in investment too, timing is (almost) everything.
Show me the signs
There are times when making money from the stock market is hard, and times when it is easy, the latter periods are few and far between, but one of the tell-tale signs that a market has become excessively speculative is when retail investors pile in.
Stock market folk-lore tells of how Joseph Kennedy (although others attribute it to James Pierpont Morgan) decided to sell his stock portfolio ahead of the market crash of 1929. Kennedy figured that when he found himself in receipt of stock tips from his shoeshine boy, the market bubble was very well advanced. The table below shows the uptick in retail stock broker accounts between Q1 2019 and Q1 2020: –
Source: Factset, CNBC
Robinhood is not on the list above, but more on that topic later.
In a recent post – A Visit from the Doom Squad – 10th Man, Jared Dillian quotes research from South Korea on the behaviour of retail stock traders in the aftermath of a bursting stock bubble: –
The researchers observed the behavior of a few thousand of them. After six months, 90% of them had given up. After a year, the 1% who were left barely had enough money to cover their daily expenses.
Dillian believes the biggest risk is of the Federal Reserve becoming more hawkish as the pandemic is brought to heel by the process of mass-vaccination. He concludes: –
That is a real risk. In fact, it is really the only risk, because people correctly point out that the economy will recover strongly in the second half, once most of the vaccines have been distributed.
Aside from the proliferation of retail stock-trading accounts, there are several indicators of excessive speculative activity in the US stock market. Firstly, record OTC/Pink Sheet trading volume – these are stocks not listed on the main exchanges: –
Source: Finra, Bloomberg
Another bubble warning sign is the record high levels of equity margin trading. The chart below shows the evolution of margin balances and the direction of the S&P 500 index up to December 2020: –
Source: Advisor Perspectives
A further worrying sign of excess is the rise of the SPAC – Special Purpose Acquisition Company. This is a blank cheque shell corporation designed to take a company public without going through the traditional IPO process. SPACs allow retail investors to gain access to private equity type opportunities, particularly leveraged buyouts. A slightly tongue-in-cheek description of the difference between a SPAC and a traditional IPO is that, an IPO is a company in search of capital, whilst a SPAC is capital in search of an investment.
This chart of the ballooning of US money supply growth may help to explain the allure of the SPAC, along with many other signs of speculation: –
In 2020, SPACs accounted for most of the growth in the US IPO market, raising $80bln from 237 listings. This surpassed the previous record of $13.6 billion raised from 59 IPOs in 2019. The trend has entered a new phase with $38bln raised from 128 listings in the first six weeks of 2021.
Another outcome of the rapid expansion in money supply can be observed in corporate capital raising. Last December The Economist – A year of raising furiously – noted that corporations globally raised more capital in 2020 than ever before: –
According to Refinitiv, a data provider, this year the world’s non-financial firms have raised an eye-popping $3.6trn in capital from public investors Issuance of both investment-grade and riskier junk bonds set records, of $2.4trn and $426bn, respectively. So did the $538bn in secondary stock sales by listed stalwarts, which leapt by 70% from last year, reversing a recent trend to buy back shares rather than issue new ones.
Here is a chart from the first part of this Macro Letter showing the composition of global corporate capital raising in 2020: –
Source: The Economist
This brings us to the story of GameStop (GME) a video gaming retailer with dismal earnings expectations that was trading at less than $5/share in August of 2020 and peaked at $347/share during a frenzy of hedge fund short covering last month. An excellent description of the time-line and the players involved in the saga can be found in – How Main Street stormed the Financial Capital – the GameStop Story – Vijar Kohli. The GameStop effect spilt over into many small-cap names and pushed the Russell 2000 index to new highs.
The GameStop tale is intertwined with the fortunes of a retail stockbroker with the beguiling name, Robinhood Financial , and an even more beguiling mobile app. This CNBC article from October 2020 – How Robinhood and Covid opened the floodgates for 13 million amateur stock traders– sheds light on this new phenomenon: –
Robinhood has been the fintech darling of Silicon Valley, founded by Vladimir Tenev and Baiju Bhatt in 2013. The app has amassed 13 million user accounts and led the way for zero-commission fee trading. In no time, it has created brand awareness and popularity unlike that of the legacy brokerages such as Charles Schwab and Fidelity, or its app-first competitors like Webull and Dough.
Despite Robinhood being forced to suspend customer purchases of GameStop, together with some other securities – precipitating an SEC investigation and string of Class Action law suits – the company has continued to take on new clients. According to Rainmaker Securities, the latest private bids for Robinhood shares puts the company’s valuation around $40bln. This February 2021 article from Yahoo Finance – Robinhood is still the app of choice for retail investors: new data– provides more colour. Here is a chart showing the downloads of the Robinhood App last month: –
Source: SimilarWeb, Gavekal
For a more robust economic analysis of the implications of the GameStop saga, Weimin Chen, The Austrian Economic Center – Gamestop Market Mayhem and the Sickness of the Economy is illuminating:. The author concludes: –
There will likely be future limitations placed by brokerage platforms, greater calls for government regulation of the markets, more instances of hysteric market actions, and a general scramble for the next Gamestop style speculation. Federal Reserve Chairman Jerome Powell was quick to deflect blame for this week’s market volatility, but this could be just the beginning of more upcoming economic turbulence.
Another feature of the Robinhood Effect has been the dramatic increase in call option trading on single stocks: –
Source: FT, Sundial Capital Research
A common claim is that 90% of options expire worthless, but this is based on the fact that only 10% of option contracts are exercised. According to the CBOE, between 55% and 60% of options contracts are closed out prior to expiration. A more reasonable estimate is therefore that 30-35% of contracts that actually expire worthless. Nonetheless, retail investors have still paid option market-makers a vastly increased amount of option premium during the past year.
The traded options market is also an important indicator of risk. When the stock market falls, price volatility tends to rise, but option prices can anticipate changes in risk appetite. Without delving too deeply into the dark arts of option trading, in stable market conditions, call options tend to have lower prices (and therefore lower implied volatility) than put options, since investors tend to sell call options against their underlying portfolios but purchase put options to protect themselves from sudden market declines. There is a lot more to option pricing and trading than we can discuss here, suffice to say the Chicago Board Options Exchange (CBOE) calculate a SKEW Index – the difference between the relative price of different call and put options. SKEW values generally range between 100 and 150 – the higher the value, the higher the perceived tail risk. A reading of 100 should represent its lower bound (low tail-risk). For a further explanation I defer to David Kotok of Cumberland Advisors – GameStop And SKEW: –
Source: CBOE, Cumberland Advisors
When you examine the SKEW methodology closely, you realize that a 79.25 price is practically impossible. It would mean that the stock market is paying you to take a tail-risk. In other words, such a price means that a trade can be constructed in which the investor cannot lose significantly. This is never supposed to happen. But we see that there is evidence that such a trade may have occurred on the same day as the wild swings of short covering and GameStop trading. That price suggests a market distortion that was quickly multiplied by many times.
Markets are complex systems, the price action in GameStop – and other small cap securities – feeds through to the option market, which in turn impacts other markets. The hedge fund Melvin Capital survived the brutal GameStop short-squeeze to fight another day but the episode is reminiscent, in a more contained way, of the LTCM debacle of 1998 – here is the report of the President’s Working Group on Financial Markets from April 1999 – Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.
The Robinhood Effect – a lethal mixture of work from home, stay at home and getting a government relief cheque – has been mirrored among other online brokers: –
Source: Horizon Fintex
A similar rise in first-time retail customers is evident in the Cryptocurrency and Foreign Exchange markets.
Another sign of assets being in bubble territory is the performance of the housing market. Now, it goes without saying, all property is local, but looking at the US, where the fiscal and monetary response has been the largest, we find yet another asset market at an all-time high: –
Source: Federal Reserve
The rise in house prices has been fuelled by cheap money: –
Source: III Capital Management, Bloomberg, JP Morgan
Combined with a shortage of supply: –
Source: III Capital Management, Goldman Sachs, NAR
Finally, fiscal and monetary expansion is akin to fiat currencies have debasement, it is scant surprise, therefore, to see Cryptocurrencies resurgent. The chart below shows the combined market capitalisation of all the listed digital currencies: –
Of course the principal focus of the media has been on Bitcoin (BTC) access to which was made available to Paypal customers from October 2020. This month’s big stories include Telsa (TSLA) purchasing $1.5bln of BTC during January and Mastercard indicating that they intend to accept BTC as a form of payment later this year. The next chart shows the rising dominance of BTC (61%) compared to the previous peak in 2017: –
Ethereum (ETH) is second with a mere 12.7%. Putting digital assets in perspective, however, the market capitalisation of BTC, which just topped $1trln last week, is still less than 10% of the total market capitalisation of gold.
Whether or not one regards digital assets as an alternative store of value, soon to displace what Keynes dubbed the barbarous relic (gold), it is incontrovertible that the digital asset industry is in its infancy whilst the underlying technologies – DL, Blockchain and DeFi – have the potential to disrupt the entire financial system – who needs banks or other financial intermediaries in this brave new decentralised world? Coinbase, which has been described as the Robinhood of the Crypto world, is planning an IPO for later this year. The current indication is that it will achieve a capitalisation of $77bln.
What is of concern is that the Crypto charts above wreak of euphoria. Traders and investors with no prior experience, have jumped on the trend and now command cult-like status among the ingénue. Some of their followers will be lucky, but these price patterns are the tell-tale traits of a greater fool’s marketplace.
Even in the liquid, large-cap names, echoes of the DotCom bubble are apparent. Apple (AAPL) and Tesla (TSLA) stock rose more than 50% in the days after they announced stock splits. Apple created more value for shareholders by announcing a stock split in 2020 than through its new product launches, Tesla, which declared the first profit in its 18 year existence in 2020 ($721mln) has made more from its purchase of Bitcoin than it has made in its lifetime.
In a recent post, on what many have dubbed the everything bubble, – Is This The Biggest Financial Bubble Ever? Hell Yes It Is – John Rubino concludes: –
Meanwhile, the actions necessary to fix some of these bubbles are mutually exclusive. A stock market or housing bust requires much lower interest rates and bigger government deficits, while a currency crisis brought on by rising inflation requires higher interest rates and government spending cuts. Let everything blow up at once and there will be literally no fixing it. And the “everything bubble” will become the “everything bust.”
John’s website is called Dollar Collapse, of the two end-games he outlines above, letting the US$ slide is the least painful short-term solution, no wonder the US administration keep labelling other countries currency manipulators.
The Stock Market’s Nemesis
Having lain dormant for so long, its return to prominence may come as a shock to newer participants in the stock market: I am of course referring to the US Treasury Bond market. The chart below shows the 10yr yield over the last quarter century: –
Source: Trading Economics
10yr yields hit their all-time low at 32bp last March, today (24th February) they have risen to 1.39%. The table below shows a selection of forecasts for year-end yields: –
Source: III Capital Management
Central Bankers are holding short-term rates near to zero but the longer end of the yield-curve is being permitted to express concerns about the inflationary consequences of excessively accommodative fiscal and monetary policy. Meanwhile, central bank buying of corporate bonds has insured that credit spreads have shown a muted response to the recent increase in yields. At some point there will be an inflection point and credit will reprice violently. For those adventuring in the stock market, these words attributed to James Carville – a political adviser to President Clinton – remain worthy of careful reflection: –
I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.
Unless, as I expect, the world’s leading central banks intervene to fix the price of government bonds, the bond market, left to its own devices, will bring the stock market back to reality with a crash.
Conclusion and Investment Opportunities
Having written more than 6,000 words in this two part Macro Letter I still feel as if I have merely scratched the surface of the conflicting and contrasting factors which support the bull and bear case. Taking a step back, I encourage you to read Five Lessons From History By Morgan Housel, The Collaborative Funda short-ish article which presents five lessons which can be applied to investing and to life in general. In the interests of brevity: –
Lesson #1: People suffering from sudden, unexpected hardship are likely to adopt views they previously thought unthinkable.
Lesson #2: Reversion to the mean occurs because people persuasive enough to make something grow don’t have the kind of personalities that allow them to stop before pushing too far.
Lesson #3: Unsustainable things can last longer than you anticipate.
Lesson #4: Progress happens too slowly for people to notice; setbacks happen too fast for people to ignore.
Lesson #5: Wounds heal, scars last.
Reflecting on the current great viral crisis (GVC) and its aftermath, I see many signs of irrational exuberance but remain cognisant of the low likelihood of any sudden policy reversals by developed nation governments or their central banks, this is primarily due to the fragility of the current global economy. The scars of Covid will take many years to heal, unsustainable things may last longer than anticipated and, as JM Keynes famously observed: –
The markets can remain irrational longer than you can remain solvent.
The cult of the personality, personified by the likes of Elon Musk, remains ascendant, so reversion to mean may be postponed a while. There is widespread evidence of what the French philosopher Rene Girard dubbed mimetic desire; the idea that, because people imitate one another’s desires, they tend to desire the same things; in the process this desire creates rivalry and increases the fear of missing out. In the classic evolution of a bubble mimetic desire leads from the momentum or awareness phase to the hallowed halls of mania and euphoria: –
Source: Dr Jean-Paul Rodrigue – Holstra University
Now is not the time to be rushing headlong into the stock market, but the upward trend remains firmly in tact. Alan Greenspan observed irrational exuberance in 1996, it took the market another four years to reach its high, mimetic desire makes it hard for investors to risk taking profit for fear of missing an exponential rise. There are several risk reduction strategies, but these statements, attributed to two of the most successful investors of all time are always worth keeping in mind: –
Be fearful when others are greedy. Be greedy when others are fearful.
The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.
Sir John Templeton
Macro Letter – No 136 – 19-02-2021
A Review of Stock Market Valuations – Part 1
- As global stock markets continue to rise, commentators talk of a bubble
- Longer-term indicators present mixed signals about valuation
- Expectations about the speed of economic recovery from the pandemic are key
- A recovery in productivity growth relies on saving and investment in innovation
This is the first of a two part letter reviewing the current valuation of stocks. The focus is US-centric and will investigate both long-run valuation (Part 1) and shorter term factors which may be warning signs of irrational exuberance (Part 2).
During the last 12 months we have seen stock markets around the world, decline rapidly and then rebound. Technically the longest bull-market in history ended in March of 2020 but the recovery was so swift that many commentators are calling it merely a sharp correction, simply an aberration. Since March the US stock market, fuelled by aggressive monetary and fiscal easing, has shot to new all-time highs. Q4 of 2020 witnessed the approval of the first Covid-19 vaccines, sending markets higher still.
Equity markets are forward-looking, the economic woes of today are discounted, expectations of recovery, backed by further fiscal support, make the prospects for future earnings appear relatively rosy. In this, the first part of my, letter I want to examine the arguments for a continued rise in equity prices together with the counter-claim that a repeat of the performance of the past decade is simply inconceivable.
Every stock index is different but, for the purposes of this research, I will focus on the US rather than the rest of the world, since it is the US market which has tended, historically, to set the global tone. The chart below looks at the forward PE ratio of the US (in red) and the MSCI World – Ex-US (in blue): –
Looking at the evolution of earnings per share and incorporating the recent forecasts for 2020 and 2021, we get a picture of a market which might just have got a little ahead of itself: –
Source: Crestmont Research
Part of the explanation for the substantial outperformance of the US has been the scale of the fiscal and monetary response of the US administration and its notionally independent central bank, yet, as the infographic below reveals, the US response whilst substantive is relatively less dramatic than that of some other countries: –
Many commentators are concerned that the stock market (especially in the US) is over-valued, however a more nuanced view is provided by veteran equity market practitioner, Gregory van Kipnis. Writing at the beginning of last month in AIER, he makes a number of important observations in his article – Angst Over High Price-Earnings Levels Likely Misplaced. Stating from the outset that his purpose is not to provide valuation advice but a perspective on approaches to earnings valuation, the author looks at a variety of alternative valuation methodologies before reaching his conclusion: –
Market pundits who focus on PE, PE[-12], PE[+12] have come to the conclusion that the US stock market, as measured by the S&P 500, is overvalued and due for correction. Some believe we are in a bubble and there will be a sharp correction. Others opine that from current levels we are headed for a low rate of market performance for the next 10 years. These views may turn out to be correct.
However, a more formal analysis of classic valuation theory that relates the current price level to the present value of the future stream of expected income suggests otherwise; that is, the market is more fairly valued and in keeping with its historical norms. From a statistical point of view, there is uncertainty around such a conclusion. Market returns routinely fluctuate. Two thirds of the time total returns realized in the market fluctuate by plus or minus 4.4%. Nonetheless, there is analytical support for the conclusion that from both a market efficiency point of view and from the perspective of long-term valuation theory, the market is roughly aligned with long-term norms.
The chart below shows the S&P500 cumulative compounded total return at constant rate. The blue dotted line shows theoretical ‘fair-value’ derived from the author’s Total Return Model.
Van Kipnis continues: –
At the risk of seeming repetitive, it should be stressed that the market trades within a range around its long-term fair value norms. For sure prices have trended for long periods below and above the historical norm. But it cannot be dismissed lightly that those historical norms are real and give every appearance of remaining intact for the foreseeable future.
Value amid the Growth
I have written on a number of occasions about the return of the Value investor, however, we are in a different environment from the 1980’s, where small cap stocks outperformed. The evolution is best explained by Robert Zuccaro, CIO of Target QR Strategies, who made the following observation in his January investor letter: –
Major differences are apparent between the economies of 1980 and 2020. Most companies in 1980 were industrial in nature and domestic in scope. In acknowledgement of the heavy influence of industrial companies in economic activity, the S&P 400 in this era was comprised solely by industrial stocks. Globalization has dramatically altered both the economy and the stock market. Whereas business activities were principally domestic in scope in the past, globalization offers an opportunity that is five times greater than the domestic market. Secondly, tech companies possess the capability to ramp up sales and profits faster than ever before. For example, it took Apple 31 years to reach a market cap of $100 billion. DoorDash which just came public did this in just 7 years. Forty years ago, some small companies starting from a small sales base were able to generate sales and profits growth up to 30-40% each year. Today, large cap tech companies with global reach can generate growth rates of 100%.
Vitaliy Katsenelson discusses the Growth versus Value debate in greater detail in – Value & Growth Demagogues – the author begins: –
I have a problem with both growth and value demagogues.
Growth demagogues will argue that valuation is irrelevant for high-growth companies because the price you pay for growth doesn’t matter. They usually say this after a very extended move in growth stocks, where these investors look like gods that walk on water. They call value investors “accountants.”
Katsenelson goes on to explain that he analyses corporate earnings looking four years ahead in order to capture the value in high growth stocks, nonetheless he believes many growth stocks as insanely overvalued.
On February 4th, Goldman Sachs, chief global equity strategist, Peter Oppenheimer expressed a more sanguine opinion on growth: –
We believe that we are still in the early stages of a new bull market, transitioning from the ‘hope’ phase (which typically starts during a recession, led by rising valuations) to a longer ‘growth’ phase as strong profit growth emerges.
The client note went on to discuss six areas which could benefit from capital inflows if investors start to price in higher inflation expectations: –
- Equities relative to bonds
- Value relative to growth
- Cyclicals relative to defensive
- Banks relative to staples
- High volatility relative to low volatility
To date, roughly 70% of US companies have reported Q4 results, of these, around 85% have beaten expectations. Before you rush to buy remember the stock market is much happy travelling than arriving, the good earnings news is largely contained in the current price.
The Overvaluation Argument
Notwithstanding the analysis of van Kipnis and the forecasts of Goldman Sachs, the arguments for irrational exuberance are compelling. The catastrophic damage caused by the pandemic has yet to be fully revealed and a long-term secular stagnation remains a clear and present danger.
In his Forecast 2021: The Stock Market – John Mauldin takes a less rosy approach to current valuation: –
We all know the stock market was up significantly last year, and even more so around year-end, but you may not know how historically wild this is.
Citi Research has a “Euphoria/Panic” index that combines a bunch of market mood indicators. Since 1987, the market has typically topped out when this index approached the Euphoria line. The two exceptions were in the turn-of-the-century technology boom, when it spent about three years in the euphoric zone, and right now.
Source: Peter Boockvar, Pinnacle Data, Haver Analytics, Citi
Another measure of overvaluation is the ratio of Equity Market Capitalisation to GDP, often referred to as the Buffett Ratio, since it is favoured by the Sage of Omaha: –
Source: Advisor Perspectives
I have a couple of issues with this ratio; firstly, as interest rates fall, so the attractiveness of debt relative to equity capital increases, and secondly, as a result of this fall in the cost of borrowing, less equity is issued and more equity is retired through mergers, de-listings and share buy-backs.
In the aftermath of the pandemic a number of governments prohibited share buybacks by key institutions, in the September 2020 quarterly review from the BIS – Mind the buybacks, beware of the leverage the authors concluded: –
…share buybacks affect firms’ performance and financial resilience mostly through leverage… There is, however, clear evidence that companies make extensive use of share repurchases to meet leverage targets. The initial phase of the pandemic fallout in March 2020 put the spotlight on leverage: irrespective of past buyback activity, firms with high leverage saw considerably lower returns than their low-leverage peers. Thus, investors and policymakers should be mindful of buybacks as a leverage management tool, but they should particularly beware of leverage, as it ultimately matters for economic activity and financial stability.
The recent pick-up in the number and size of equity financings, despite historically low interest rates may be the beginning of a reversal of the 25 year decline of listed market breadth.
This chart shows how the number of listed US equities has waxed and waned since interest rates peaked in the early 1980’s: –
Source: FT, World Bank
This shrinking pool of listed securities is somewhat deceptive, the number of securities that trade on OTC Markets, colloquially referred to as the Pink Sheets (although it includes more than 4,000 names listed on Nasdaq’s OTCBB) currently stands at 11,943, more than double the total of 2010.
This is not simply to do with the onerous nature of listing requirements for the major exchanges, the preference for private over public also shows up in the value of IPOs versus Venture Funds: –
Source: The Economist
There is also a rising preference for debt financing, rather than equity issuance, a more direct effect of the financial repression of artificially low interest rates, which is evident, not just in the US but, at a global level: –
Source: The Economist, Refinitive
A number of other equity valuation metrics are in the top percentile of their historic ranges: –
Source: Crescat Capital, Doug Kass, Bloomberg, Yale, John Hussman
The Felder Report – What Were You Thinking? Goes further, observing the percentage of companies with a multiple of sales valuation exceeding 10: –
Source: The Felder Report
For the author, this is redolent of the Dotcom bubble of 1999. As for the title of his recent blog?
“What were you thinking?” That is the rhetorical question Scott McNealy, CEO of SunMicrosystems, asked of investors paying a “ridiculous” ten times revenues for his stock at the height of the Dotcom Mania. The incredulity in his voice is amplified by the benefit of hindsight as McNealy gave the interview this quote was taken from in the wake of the Dotcom Bust, after his stock price had lost over 90% of its value.
The Yield Dilemma
Another way to look at the valuation of stocks is to chart the earnings yield: –
Source: Meanwhile in the Markets, MLTPL
However, to get a more realistic picture you need to compare the earnings yield of stocks against the yield of US Treasuries, after all, investors need to put their money somewhere: –
Source: Meanwhile in the Markets, Yale
Writing in Forbes – Dan Runkevicius – The Stock Market Is The Most Attractive Since 1980, Nobel-Winning Economist Says – the author concludes: –
By this measure, the S&P is the most attractive against bonds since 2014. Nobel-prize winning economist Robert Shiller—who came up with the CAPE ratio—wrote in a recent paper:
“With rates so low, the excess CAPE yield across all regions is almost at all-time highs, indicating that relative to bonds, equities appear highly attractive.”
If the Federal Reserve are toying with the idea of introducing yield-curve control – a policy currently adopted by the Bank of Japan – then stocks become the onlyliquid game in town. If you think the idea of the Fed following the Japanese model is anathema, this Federal Reserve article – How the Fed Managed the Treasury Yield Curve in the 1940s – might give you pause for thought: –
By mid-1942 the Treasury yield curve was fixed for the duration of the war, anchored at the front end with a ⅜ percent bill rate and at the long end with a 2½ percent long-bond rate. Intermediate yields included ⅞ percent on 1-year issues, 2 percent on 10-year issues, and 2¼ percent on 16-year issues…
In late November 1950, facing the prospect of another major war, the Fed, for the first time, sought to free itself from its commitment to keep long-term Treasury yields below 2½ percent. At the same time, Secretary of the Treasury John Snyder and President Truman sought a reaffirmation of the Fed’s commitment to the 2½ percent ceiling.
The impasse continued until mid-February 1951, when Snyder went into the hospital and left Assistant Secretary William McChesney Martin to negotiate what has become known as the “Treasury-Federal Reserve Accord.” Alan Meltzer has observed that the Accord “ended ten years of inflexible [interest] rates” and was “a major achievement for the country.”
Given that the Covid-19 pandemic has had a war-like impact on the global economy, it is not unreasonable to anticipate a decade of near-zero US interest rates. Perhaps the Fed Hawks will prevail, but here is what US inflation did between 1941 and 1951: –
After the inflationary experience of the 1970’s and 1980’s, the Federal Reserve may not have quite the tolerance for inflation that they had in the 1940’s, but when the least painful solution to the current debt crisis is inflation, the Fed may turn out to be far more tolerant of a rising price level than the markets are thinking at present.
A final factor when considering the performance of the US stock market is the amount of cash available for investment. When we look at the Mutual Fund market there is cause for concern, but the record low levels of cash available to mutual fund managers is itself a function of the poor return available on cash. This post from Lance Roberts – Why There Is Literally No “Cash On The Sidelines” – elaborates on the topic, but the chart below suggests that this trend is by no means new: –
Source: Real Investment Advice, Sentiment Trader
The other side of the cash debate concerns the rapid increase in the US personal savings rate which has accompanied the lockdown restrictions. This post fromthe Federal Reserve Bank of Kansas City – Why Are Americans Saving So Much of Their Income? – looks at the topic in more detail, however,the chart below supports my supposition that, as savings have risen, so too has the percentage of windfall payments which are invested rather than saved or consumed: –
Source: BEA, Haver Analytics, KC Fed
The author, A. Lee Smith is, of course, concerned with direction of consumption spending, concluding: –
As fiscal support lapses and forbearances expire, the strength of U.S. consumption is likely to be tested in the coming months. Recent increases in the personal savings rate have stirred hope that consumption will remain resilient. However, I find that such optimism may be misplaced, as past increases in the savings rate have failed to predict future consumption behavior.
An important caveat to this conclusion is that the unprecedented nature of this crisis could lead to departures from historical patterns. The sheer size and scope of recent government transfers, for example, could support spending once the pandemic recedes. However, the scarring nature of the crisis and previously unimaginable income risk could just as easily have given consumers a lasting desire to increase their liquidity buffers and guard against future income losses. After the Great Recession, for instance, Gallup surveys show a persistent increase in the share of consumers who prefer to save rather than spend (Saad 2019).
The uneven imprint of this crisis across the economy, which my aggregate analysis overlooks, could also lead to a departure from historical savings and consumption patterns. While many consumers may now have the desire to save more, only those that remain employed have the ability to actually save more. This distinction between desired and actual savings is important, as a pullback in consumption by employed households could amplify income losses for unemployed households in hard-hit sectors. This sectoral dynamic leaves little reason to be optimistic about future spending based on the elevated savings rate. In particular, if employed households are forgoing vacations and travel, forgone consumption today is unlikely to be made up in the future, creating a lasting income loss for many households.
If the author is correct, the likelihood of Federal Reserve tapering is very low indeed.
To arrive at a conclusion about current the value and near-term future prospects for equities, we also need to look at a range of shorter-term factors. This will be the focus of the second part of this letter.
Podcast with Max Gottlich – 22-01-2021
A 30 minute podcast interview covering stocks, crypto assets and thoughts about monetary and fiscal policy for the year ahead.
With another $1.9trln of US fiscal relief set to be voted through, attention is likely to switch back to Europe. This article from August 2020 seems relevant to the debate.
Macro Letter – No 135 – 31-12-2020
US Stocks in 2020 and the prospects for 2021
- 2020 has been a torrid year for stock markets globally
- Fiscal and monetary stimulus rescued investors from a brutal bear-market
- Digital transformation has accelerated and fortunes of the technology sector with it
- With mass-vaccination still some way off, 2021 will see many trends continue
The US stock market is making all-time highs (as at 29th December). It has been a torrid year. The 35% shakeout in the S&P 500, seen in March, turned out to be the best buying opportunity in several years. The market recovered, despite the human tragedy of the pandemic, fuelled by a cocktail of monetary and fiscal stimulus. When news of the rollout of a vaccine finally arrived in November, apart from a renewed rise in the broad market, there was an abrupt rotation from Growth to Value stocks. Value ETFs saw $8bln of inflows during November, there was also a weakening of the US$ and resurgence of European stocks. This was not necessarily the sea-change anticipated by many commentators, by the start of December technology stocks had resumed their upward march.
November marked some market records. It was the strongest month for the Dow since 1987 and the best November since 1928. European stocks rose 14%, their best monthly gain since April 2009 – that headline grabbing performance needs to be qualified, European indices remain lower than they began the year. For Japan’s Nikkei 255, the 15% rise marked its most positive monthly performance since January 1994, whilst for Global Equities, which returned 12.7%, it was the best month since January 1975.
Other financial and commodity markets also reacted to the vaccine news. OPEC agreed supply reductions helping oil prices higher, although Brent Crude remains around 22% lower than it started the year. The larger issue for stock markets is the logistical challenge of delivering the vaccination, this will test the healthcare systems of every country on the planet. The OPEC deal may fray at the edges, demand for oil could arrive later than anticipated. Nonetheless, risk assets have generally benefitted whilst both gold and silver have remained range-bound. After their strong rally in the summer, precious metals seem to have had their time in the sun. Interestingly, Bitcoin appears to be dancing to a different tune. Over the past two months it has risen more than 120%, breaking the previous highs of December 2017 to breach $28,000.
Looking ahead, Covid sensitive stocks should continue to recover, this chart shows the relative performance by industry sector over the last year (to 29th December): –
Source: Barchart.com, S&P
Energy, November’s top performing sector, remains more than 38% down over the last 12 months, whilst Information Technology is up almost 41% over the same period.
Prospects for 2021
Central bank monetary policy and developed nation fiscal policy will be key to deciding the direction of stocks next year. This infographic from McKinsey shows the gargantuan scale of the fiscal response compared to the Great Financial Crisis of 2008: –
Source: McKinsey, IMF
The degree of largesse needs to be qualified, more than half of government support has been in the form of guarantees, designed to help companies avoid insolvency. Added to which, other stimulus measures have been announced, but that capital has yet to be been committed. The eventual bill for the pandemic might not be quite the strain on collective international government finances the McKinsey infographic portends. This chart from the IMF shows the composition of fiscal support as at mid-May: –
A more important factor for global stocks is the enormous injection of liquidity which has been pumped into the world economy: –
This global picture disguises the variance between countries: –
Source: Federal Reserve, National Central Banks, Haver Analytics, Globalization Institute
With the exception of the US, money supply growth has been relatively muted thus far, although it has been broadly comparable to the expansion undertaken in the aftermath of the sub-prime crisis of 2008. The vast expansion of the US monetary base is unprecedented by comparison with its developed nation peers, but even more so when seen in the context of US policy since WWII: –
Money supply growth cannot be ignored when seeking a reason for the rise in US stocks. North American asset markets, such as stocks and real estate, will continue to benefit even if some of that liquidity seeps away to international investment opportunities. The Cantillon Effect, named after 18th century Irish economist, Richard Cantillon, remains very much alive and well. In Cantillon’s – Essai sur la Nature du Commerce en General – which was published posthumously in 1755 – he observed that those who were closest to the minting of money benefitted most.
Today, with unemployment sharply higher and lockdown restrictions curtailing consumption, the US savings rate has risen sharply. Even after hitting a peak in April it remains well above the levels seen since the 1970’s. The chart below does not account for the effect of the recent relief package which will release a further $900bln, including cheques to many individuals of $600 each: –
Source: Federal Reserve Bank of St Louis
Whilst the unemployment rate remains elevated, that excess liquidity will either be hoarded or flow into the stock market, in these uncertain times it is unlikely to fuel a consumption boom. This chart shows how unemployment rates have increased across the US, EU and OECD countries in aggregate: –
Aside from a short-lived boom in the grocery sector at the start of the crisis, US consumer spending remained muted running into the summer: –
The situation improved in Q3 as the inforgraphic below reveals: –
Source: Deloitte, BEA, Haver Analytics
Real personal consumer expenditure grew by 8.9% in Q3 compared to Q2. The nature of consumer spending has also changed as a result of the pandemic, with many consumers buying relatively more goods than services. Without reliable data it is difficult to assess the picture for Q4, but the second wave of Corona cases appears to be a worldwide phenomenon, a repeat of the April/May lockdown may yet defer the much anticipated recovery in consumption.
Investment Opportunities for 2021
Looking ahead, the first important test of US political sentiment will be the runoff Senate race in Georgia on January 5th. Nonetheless, for the coming year, with government bond yields still miserably low, excess liquidity will continue to flow into stocks. The recent weakening of the US$ may lend additional support to international markets, especially if Europe stops its squabbling and embraces fiscal expansion. Dollar bulls might just be rescued by the US bond market, 10yr yields reached 99bps at the beginning of December, the highest since the pandemic struck in March, yields have remained elevated with a fresh stimulus package to finance, but an economic recovery remains some way off, a real bond bear-market needs a significant inflation catalyst.
As Milton Friedman famously observed, ‘Inflation is always and everywhere a monetary phenomenon.’ Even allowing for a strong rebound in demand for goods and services in 2021, the consumer will remain cautious until mass-vaccination has proved to be effective. Meanwhile, that excess liquidity will have to go somewhere, all other things equal, asset markets will rise with liquid, listed equities in the vanguard.
Macro Letter – No 134 – 27-11-2020
Relax, Rotate, Reflate
- With US elections over and a vaccine in sight, financial market uncertainty has declined
- Rotation has seen a resurgence in those stocks battered by the onset of the pandemic
- Monetary and fiscal spending will continue until inflation returns
November has been an interesting month for financial markets around the world. The US Presidential election came and went and with its passing financial market uncertainty diminished. This change of administration is undeniably important, but its effect was overshadowed by the arrival of three vaccines for Covid-19. As I write (Thursday 26th) the S&P 500 Index is within 30 points of its all-time high, amid a chemical haze of pharmaceutical hope, whilst the VIX Index has tested its lowest level since February (20.8%). The Nasdaq Composite is also near to its peak and the Russell 2000 Index (an index of smaller capitalisation stocks) burst through its highs from February 2020 taking out its previous record set in September 2018. The chart below shows the one year performance of the Russell 2000 versus the S&P500 Index: –
Source: Yahoo Finance, S&P, Russell
It is worth remembering that over the very long term Small Caps have outperformed Large Caps, however, during the last decade the rapid growth of index tracking investments such as ETFs has undermined this dynamic, investment flows are a powerful force. I wrote about this topic in June in – A Brave New World for Value Investing – in which I concluded: –
Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.
The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.
To date, evidence of a return to Value Investing seems premature, Growth still dominates and the structural acceleration of technology trends seems set to continue – one might say, ‘there is Value in that.’
The vaccine news led to a rotation out of technology stocks but this was more to do with profit taking, new ‘Tech’ buyers quickly emerged. The rotation into Small Caps was also echoed among a number of out of favour sectors such as Airlines and Energy. It was enough to prompt the creation of a new acronym – BEACHs – Booking, Entertainment, Airlines, Cruises and Hotels.
Source: Barchart.com, S&P
Above is the one year performance of the 11 S&P 500 industry sectors. Information Technology remains the leader (+38%) with Energy bringing up the rear (-32%) however the level of dispersion of returns is unusually which has presented an abundance of trading opportunities. The table below shows the one, three and six month performance for an expanded selection of these sectors: –
Beyond the US, news of the vaccines encouraged both European and emerging markets, but the latter (EEM), helped by the strong performance of Chinese stocks, have tracked the US quite closely throughout the year, it is Europe (IEUR) which has staged the stronger recovery of late, although it has yet to retest its February highs: –
Source: Yahoo Finance, S&P, MSCI
In the aftermath of the US election, US bond yields have inched higher. From an all-time low of 32bp in March, 10yr yields tripled, testing 97bp in the wake of the Democrat win. Putting this in perspective, the pre-Covid low was seen at 1.32% in July 2016. The current concern is partly about the ‘socialist’ credentials of President-elect, Biden, but the vaccine announcement, together with the prospect of a return to some semblance of normality, has also raised the spectre of a less accommodative stance from the Fed. There was initial fear they might ‘take away the punch-bowl’ before the global economy gets back on its knees, let alone its feet. Governor Powell, quickly dispelled bond market fears and yields have since stabilised.
Longer-term, these bond market concerns may be justified, as this infographic from the McKinsey Institute reveals, combined central bank and government fiscal stimulus in 2020 has utterly eclipsed the largesse witnessed in the wake of the 2008 crisis: –
Bond watchers can probably rest easy, however, should the global economy stage the much vaunted ‘V’ shaped recovery economists predicted back in the spring, only a fraction of the fiscal stimulus will actually materialise. Nonetheless, prospects for mass-vaccination, even in developed countries, remains some months away, both monetary and fiscal spigots will continue to spew for the present.
On the topic of monetary policy it is worth noting that the Federal Reserve previously employed ‘yield curve control,’ though it was not called by that name, back in April 1942, five months after the attack on Pearl Harbor. Under this arrangement the Fed committed to peg T-Bills at 3/8th and implicitly cap long-dated T-Bonds at 2.5%. The aim was to stabilize the securities market and allow the government to engage in cheaper debt financing during the course of WWII. This arrangement only ended with the Treasury – Fed Accord of 1951 in response to a sharp peace-time resurgence in inflation. This chart shows the period from 1941 (when the US entered WWII) up to the middle of the Korean War: –
Source: US BLS
I believe we will need to see several years of above target inflation before the Fed to feel confident in raising rates aggressively. The experience of Japan, where deflation has been lurking in the wings for decades, will inform Fed decision making for the foreseeable future.
Returning to the present environment; away from the stock and bond markets, oil prices also basked in the reflected light shining from the end of the pandemic tunnel. West Texas Intermediate, which tested $33.64/bbl on 2nd, reached $46.26/bbl on 25th. The energy sector remains cautious, nonetheless, even the recent resurgence leaves oil prices more than $15/bbl lower than they were at the start of the year.
Looking ahead, the stock market may take a breather over the next few weeks. A vaccine is coming, but not immediately. US politics also remains in the spotlight, the Republicans currently hold 50 Senate seats to the Democrats 48. If Democrats secure the two seats in Georgia, in the runoff election on 5th January, VP Elect, Harris, will be able to use her ‘tie-break’ vote to carry motions, lending the Biden Presidency teeth and hastening the expansion of US fiscal policy.
The stock market has yet to make up its mind about whether Biden’s ‘New New Dealers’ are a positive or a negative. Unemployment and under-employment numbers remain elevated as a result of the pandemic: and, whilst bankruptcies are lower than at this time last year, the ending of the myriad schemes to prolong the existence of businesses will inevitably see those numbers rise sharply. Does the stock market benefit more from the fiscal spigot than the tax increase? This is a question which will be mulled, chewed and worried until long after Biden’s inauguration on January 20th.
Meanwhile the trend accelerations in technology which I discussed in – The prospects for Emerging and Frontier Markets in the post-Covid environment – earlier this month, continue. The chart below shows how information industries have been transforming the makeup of global trade ever since the great financial crisis: –
Source: ECIPE, OECD, TiVA, van der Marel
Manufacturing trade is in retreat, trade in digital services is accelerating. The chart above stops at 2015, when we have the data to incorporate the period of the current pandemic, I expect the pace of growth in information industries to have gain even greater momentum.
Back in 1987, MIT economist and Nobel Laureate, Robert Solow, observed that the computer age was everywhere except for the productivity statistics. During the 1990’s technology productivity growth was finally observed, but the past decade has seen a string of disappointing productivity growth statistics, yet they have coincided with digitisation transforming vast swathes of the global economy, perhaps the next decade will see the fruit of these labours. I believe we can look forward to significant productivity improvements in the coming years. Stock prices, however, are forward looking, their valuations may seem extended but this may be entirely justified if technology ushers in a new golden age.
Back in June I wrote about the prospects for inflation in the wake of global money supply growth. The deflationary forces of the pandemic and demographic aging still maintain the upper hand for now, but there’s a tug of war which governments need to win if debt is to be inflated away.
Macro Letter – No 133 – 06-11-2020
The prospects for Emerging and Frontier Markets in the post-Covid environment
- The Covid pandemic has accelerated several economic trends
- Technology industries will benefit
- Less developed countries will suffer
- This crisis could see ‘The African Century’ postponed
During the past six months the global economy has been assailed by a multitude of vicissitudes. But on closer inspection, the pandemic has served to accelerate a number of economic and political trends which were in train long before the outbreak in Q1 of this year.
Back in February, when the crisis was largely confined on China and financial markets were still in denial, I wrote in – When the facts change: –
Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs.
Then came the panic of March. Stocks collapsed, developed market government bonds rallied, the VIX Index quadrupled: and central banks and government Treasuries intervened to an unprecedented degree in order to right the ship. Our leaders triumphed, stock markets recovered, bond yields moderated, short-term interest rates in several emerging market economies were slashed and the policy of quantitative easing spread, from the ‘developed’ core, to countries which could barely have contemplated such asset purchases during previous global crisies. Here are few of the actions taken by EM central banks: –
Source: VoxEU CEPR, Hartley and Rebucci
To some degree, masked by the gyrations of the stock market, certain longer-term economic trends have simply accelerated. Technology companies have taken centre-stage, with digital transformation changing the working practices of, perhaps, half the global labour-force. In the US it is estimated that the percentage of people now able to work remotely has risen from 41% to 59%, but whereas prior to the pandemic, remote work amounted to the occasional day, here or there, remote working has now become the new normal.
There has been a seismic shift in the real-estate market. Demand for commercial office space has declined, demand for larger residential units and for houses (with outdoor space) rather than apartments. This is an entirely predictable response to these changes in the nature of work.
Other technological trends have also accelerated. The robotics revolution is replacing humans in a wide array of industries in the way it transformed the car assembly line some decades ago. Add in advances in the digitisation of logistics and the era of ‘just in time production’ can much more effectively offset the higher cost of domestic manufacture. Global supply chains have been shortening since the great financial crisis. Since the spring these trends have gained additional momentum.
In March, in an article for AIER I asked – Is this the End of Globalization?Among the topics I discussed was the impact these supply chain trends may have on Emerging and Frontier markets: –
In his July 2019 essay for Project Syndicate, In Praise of Demographic Decline, Adair Turner observes:
Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. That’s good news for most of the world, but not for Africa.
The author goes on to suggest that for countries in demographic decline, automation of manufacturing processes is an economic boon, whereas for countries with rising fertility it is an impediment to improvements in their per capita standard of living.
As with many trends among developed countries, Japan, where deaths outnumber births by an average of 1,000 people per day, is in the vanguard in embracing technology to counter the demographic deficit. The shortening of GVC’s will simply hasten their innovation in automation.
I went on to look at the rising use of robots: –
Source: IMF, International Federation of Robotics
The infographic above comes from a June 2018 IMF publication entitled, Land of the Rising Robotsin which the authors’ conclude: –
…the wave of change is clearly coming and will affect virtually all professions in one way or another. Japan is a relatively unique case. Given the population and labor force dynamics, the net benefits from increased automation have been high and could be even higher, and such technology may offer a partial solution to the challenge of supporting long-term productivity and economic growth.
Last year, the McKinsey Global Institute looked at the job security of different occupations in the face of automation in the US. Countries with lower average earnings will be slower to adopt automation but their comparative advantage is likely to be eroded, especially if the worlds’ trade policies grow more protectionist: –
Source: Mckinsey Global Institute
In labour-force terms, most of the roles which can be automated are unskilled. As long as EM and Frontier countries can maintain a comparative advantage in labour input costs, their unemployment rates will remain low. The threat of developed nation automation, however, imposes a ceiling on wages in all countries and developing nations will feel the effect most directly.
Returning to Lord Turner’s article for Project Syndicate – In Praise of Demographic Decline– the author quotes from the UN 2019 population projection which indicates that Asia, Europe and the Americas have almost achieved population stability. The problem of automation on employment prospects is therefore lower in these countries. It is poorer countries whose populations are young and still growing which are most at risk . This is especially true of Africa where the UN projects the population will soar from 1.34bln to 4.28bln by the end of the century.
Turner tentatively suggests there may be a universal rule of human behaviour; that rich, successful societies choose to adopt fertility rates which lead to gradual population decline. He also challenges the concept of the ‘working age’ population (15 to 64 years) questioning why, if longevity is increasing, that upper bound should still apply, going on to surmise: –
…in a world of rapidly expanding automation potential, demographic shrinkage is largely a boon, not a threat. Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. Conversely, automation makes it impossible to achieve full employment in countries still facing rapid population growth.
The author compares India, where the population continues to expand, with China, which has been aggressively embracing automation as its population ages and the effect of its ‘one child’ policies has caused its population to plateau – growing old before they grow rich.
If the greatest demographic challenges face countries with rapid population growth, then Africa may find its route to middle income status impeded, especially if developed nation manufacturing can be almost entirely automated.
As Turner concludes: –
Automation has turned conventional economic wisdom on its head: there is greater prosperity in fewer numbers.
The Covid-19 pandemic has caused other weaknesses of emerging economies to be laid bare. The IMF – How COVID-19 Will Increase Inequality in Emerging Markets and Developing Economies – published earlier this month, observes that, several years prior to the crisis, EM income inequality had begun to rise, along with worryingly high levels youth inactivity. They also note increasing educational inequality and an absence of economic opportunities for woman. All these trends have accelerated during the past nine months, to such an extent that the improvements of the last decade have been swept aside: –
In their 2nd May briefing on EM bonds, The Economist took up this theme asking – Which emerging markets are in most in peril?The authors listed several EM bond issuers who had defaulted even before the current crisis had begun: –
Argentina has missed a $500m payment on its foreign bonds. If it cannot persuade creditors to swap their securities for less generous ones by May 22nd, it will be in default for the ninth time in its history… Ecuador, which has postponed $800m of bond payments for four months to help it cope with the pandemic; Lebanon, which defaulted on a $1.2bn bond in March; and Venezuela, which owes barrelfuls of cash (and crude oil) to its bondholders, bankers and geopolitical benefactors in China and Russia… Zambia, which is seeking to hire advisers for a “liability-management exercise”, an agreement to pay creditors somewhat less, somewhat later than it promised.
Anticipating trouble ahead they also produced this most informative table: –
Source: The Economist
The Economist notes that the 66 countries listed need to find $4trln to service their existing debt this year – which drops to $2.9trln once China is excluded. With luck this refinancing will be manageable. Global capital markets have matured and deepened greatly since the Asian crisis of 1997. The table below shows the percentage of local currency bonds issued by various EM borrowers today: –
Source: Institute of International Finance
On average 79% of these issuers tapped their local currency markets, rendering them relatively immune to speculative abuse on the foreign exchanges. By contrast, those countries which were obliged to tap the international market, raising capital primarily in US$, were forced to pay a substantial credit premium for the privilege.
The IMF, concerned by the rapidity of the capital flight from EM bond markets at the start of the pandemic, focussed their research on the risks of a sudden stop in credit markets and the policy actions which should be undertaken to avert disaster. The next chart shows the initial divergence and subsequent re-convergence of global government bond markets since Q1: –
Surprisingly, international investor exposure to EM bonds has remained fairly static over the last five years, as the chart below reveals: –
Source: Institute of International Finance
As developed nation central banks have lowered interest rates and increased QE so the quest for yield has risen. Given the attractive yields offered by EM issuers one might have expected a significant increase in international exposure. It seems the risks of EM sovereign default has leant investors some degree of sobriety.
Of course the BIS has been keen to observe the synchronicity between this years’ EM bond rebound and the advent of EM central bank QE. Perhaps this new approach will strengthen the resolve of yield hungry investors: –
Source: EPFR, JP Morgan, BIS
Conclusions and Investment Opportunities
As a watcher (and trader) of the European government bond markets over more than three decades, I have observed the convergence and divergence of yield spreads between the periphery and the core. When looking beyond the Eurozone, one has to account for currency, as well as interest rate and duration risk. In the past EM bonds lacked of local currency liquidity which meant the credit risk could be taken through a spread between the US$ sovereign issuer and US Treasuries. Today the EM capital markets have matured, nonetheless, local currency bonds need to be hedged against adverse currency movement. Meanwhile, those issuers, forced to raise capital in the US$ markets are likely to be less liquid and, in many cases, less credit worthy.
The new paradigm for EM bond traders is the introduction of EM central bank QE. This is a ‘whatever it takes’ moment for many emerging nations. If they can successfully defend their currencies and their bond markets from speculative capital flight they will foster increased liquidity and with it increased capital raising capacity for the governments. We stand upon the threshold of a brave new world where an EM country, with a flexible exchange rate regime and well-anchored inflation expectations, can suspend disbelief and print its way out of a credit crisis. A recent BIS paper – Inflation at risk in advanced and emerging market economies– found that EM countries success in taming inflation, together with their adoption of inflation targeting frameworks, has greatly reduced upside inflation risks.
For the developed nation central banks, for whom the Bank of Japan has been the leader of innovation, for almost two decades, the efforts of EM central banks to wield QE, will be watched with bated breath. It still remains unclear how far a central bank can expand its balance sheet before the currency market calls it to task. Given that the Bank of Japan has yet to do so, it falls to an EM country will discover those limits. Until then, the widening of EM credit spreads will (selectively) provide an excellent buying opportunity.
In the longer term the demographic dividend of a young population may no longer be the panacea it once was hoped. Technology, and especially the automation of manufacturing means that countries which might have adopted a mercantilist, export driven approach to raise themselves out of poverty will find the road is longer and less rapid. Emerging economies will bifurcate into those that can afford to automate and those that need to support their unskilled youth. This will determine their economic growth trajectory, their government finances and the success of their domestic businesses. For emerging, and particularly Frontier economies, their youth, without education, is no longer unalloyed stuff of economic prosperity.