Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

  • The US stock market is close to being in a corrective phase -10% off its highs
  • Global debt has passed $63trln – well above the levels on 2007
  • Interest rates are still historically low, especially given the point in the economic cycle
  • Predictions of a bear-market may be premature, but the headwinds are building

The recent decline in the US stock market, after the longest bull-market in history, has prompted many commentators to focus on the negative factors which could sow the seeds of the next recession. Among the main concerns is the inexorable rise in debt since the great financial recession (GFR) of 2008. According to May 2018 data from the IMF, global debt now stands at $63trln, with emerging economy debt expansion, over the last decade, more than offsetting the marking time among developed nations. The IMF – Global Debt Database: Methodology and Sources WP/18/111 – looks at the topic in more detail.

The title of this week’s Macro letter comes from the poet Stevie Smith: –

I was much further out than you thought

And not waving but drowning.

It seems an appropriate metaphor for valuation and leverage in asset markets. In 2013 Thomas Pickety published ‘Capital in the 21st Century’ in which he observed that income inequality was rising due to the higher return on unearned income relative to labour. He and his co-authors gathering together one of the longest historical data-set on interest rates and wages – an incredible achievement. Their conclusion was that the average return on capital had been roughly 5% over the very long run.

This is not the place to argue about the pros and cons of Pickety’s conclusions, suffice to say that, during the last 50 years, inflation indices have tended to understate what most of us regard as our own personal inflation rate, whilst the yield offered by government bonds has been insufficient to match the increase in our cost of living. The real rate of return on capital has diminished in the inflationary, modern era. Looked at from another perspective, our current fiat money and taxation system encourages borrowing rather than lending, both by households, corporates, for whom repayment is still an objective: and governments, for whom it is not.

Financial innovation and deregulation has helped to oil the wheels of industry, making it easier to service or reschedule debt today than in the past. The depth of secondary capital markets has made it easier to raise debt (and indeed equity) capital than at any time in history. These financial markets are underpinned by central banks which control interest rates. Since the GFR interest rates have been held at exceptionally low levels, helping to stimulate credit growth, however, that which is not seen, as Bastiat might have put it, is the effect that this credit expansion has had on the global economy. It has led to a vast misallocation of capital. Companies which would, in an unencumbered interest rate environment, have been forced into liquidation, are still able to borrow and continue operating; their inferior products flood the market place crowding out the market for new innovative products. New companies are confronted by unfair competition from incumbent firms. Where there should be a gap in the market, it simply does not exist. At a national and international level, productivity slows and the trend rate of GDP growth declines.

We are too far out at sea and have been for decades. Markets are never permitted to clear, during economic downturns, because the short-term pain of recessions is alleviated by the rapid lowering of official interest rates, prolonging the misallocation of capital and encouraging new borrowing via debt – often simply to retire equity capital and increase leverage. The price of money should be a determinant of the value of an investment, but when interest rates are held at an artificially low rate for a protracted period, the outcome is massively sub-optimal. Equity is replaced by debt, leverage increases, zombie companies limp on and, notwithstanding the number of technology start-ups seen during the past decade, innovation is crushed before it has even begun.

In an unencumbered market with near price stability, as was the case prior to the recent inflationary, fiat currency era, I suspect, the rate of return on capital would be approximately 5%. On that point, Pickety and I are in general agreement. Today, markets are as far from unencumbered as they have been at any time since the breakdown of the Bretton Woods agreement in 1971.

Wither the stock market?

With US 10yr bond yields now above 3%, stocks are becoming less attractive, but until real-yields on bonds reach at least 3% they still offer little value – US CPI was at 2.9% as recently as August. Meanwhile higher oil prices, import tariffs and wage inflation all bode ill for US inflation. Nonetheless, demand for US Treasuries remains robust while real-yields, even using the 2.3% CPI data for September, are still exceptionally low by historic standards. See the chart below which traces the US CPI (LHS) and US 10yr yields (RHS) since 1971. Equities remain a better bet from a total return perspective: –

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

What could change sentiment, among other factors, is a dramatic rise in the US$, an escalation in the trade-war with China, or a further increase in the price of oil. From a technical perspective the recent weakness in stocks looks likely to continue. A test of the February lows may be seen before the year has run its course. Already around ¾ of the stocks in the S&P 500 have suffered a 10% plus correction – this decline is broad-based.

Many international markets have already moved into bear territory (declining more than 20% from their highs) but the expression, ‘when the US sneezes the world catches a cold,’ implies that these markets may fall less steeply, in a US stock downturn, but they will be hard-pressed to ignore the direction of the US equity market.

Conclusions and investment opportunities

Rumours abound of another US tax cut. Federal Reserve Chairman, Powell, has been openly criticised by President Trump; whilst this may not cause the FOMC to reverse their tightening, they will want to avoid going down in history as the committee that precipitated an end to Federal Reserve independence.

There is a greater than 50% chance that the S&P 500 will decline further. Wednesday’s low was 2652. The largest one month correction this year is still that which occurred in February (303 points). We are not far away, however, a move below 2637 will fuel fears. I believe it is a breakdown through the February low, of 2533, which will prompt a more aggressive global move out of risk assets. The narrower Dow Jones Industrials has actually broken to new lows for the year and the NASDAQ suffered its largest one day decline in seven years this week.

A close below 2352 for the S&P 500 would constitute a 20% correction – a technical bear-market. If the market retraces to the 2016 low (1810) the correction will be 38% – did someone say, ‘Fibonacci’ – if we reach that point the US Treasury yield curve will probably be close to an inversion: and from a very low level of absolute rates. Last week the FRBSF – The Slope of the Yield Curve and the Near-Term Outlook – analysed the recession predicting power of the shape of the yield curve, they appear unconcerned at present, but then the current slope is more than 80bp positive.

If the stock correction reaches the 2016 lows, a rapid reversal of Federal Reserve policy will be required to avoid accusations that the Fed deliberately engineered the disaster. I envisage the Fed calling upon other central banks to render assistance via another concert party of quantitative, perhaps backed up by qualitative, easing.

At this point, I believe the US stock market is consolidating, an immanent crash is not on the horizon. The GFR is still too fresh in our collective minds for history to repeat. Longer term, however, the situation looks dire – history may not repeat but it tends to rhyme. Among the principal problems back in 2008 was an excess of debt, today the level of indebtedness is even greater…

We are much further out than we thought,

And not waving but drowning.

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Divergent – the breakdown of stock market correlations, temp or perm?

Divergent – the breakdown of stock market correlations, temp or perm?

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Macro Letter – No 101 – 31-08-2018

Divergent – the breakdown of stock market correlations, temp or perm?

  • Emerging market stocks have stabilised, helped by the strength of US equities
  • Rising emerging market bond yields are beginning to attract investor attention
  • US tariffs and domestic tax cuts support US economic growth
  • US$ strength is dampening US inflation, doing the work of the Federal Reserve

To begin delving into the recent out-performance of the US stock market relative to its international peers, we need to reflect on the global fiscal and monetary response to the last crisis. After the great financial recession of 2008/2009, the main driver of stock market performance was the combined reduction of interest rates by the world’s largest central banks. When rate cuts failed to stimulate sufficient economic growth – and conscious of the failure of monetary largesse to stimulate the Japanese economy – the Federal Reserve embarked on successive rounds of ‘experimental’ quantitative easing. The US government also played its part, introducing the Troubled Asset Relief Program – TARP. Despite these substantial interventions, the velocity of circulation of money supply plummeted: and, although it had met elements of its dual-mandate (stable prices and full employment), the Fed remained concerned that whilst unemployment declined, average earnings stubbornly refused to rise.

Eventually the US economy began to grow and, after almost a decade, the Federal Reserve, cautiously attempted to reverse the temporary, emergency measures it had been forced to adopt. It was helped by the election of a new president who, during his election campaign, had pledged to cut taxes and impose tariffs on imported goods which he believed were being dumped on the US market.

Europe and Japan, meanwhile, struggled to gain economic traction, the overhang of debt more than offsetting the even lower level of interest rates in these markets. Emerging markets, which had recovered from the crisis of 1998 but adopted fiscal rectitude in the process, now resorted to debt in order to maintain growth. They had room to manoeuvre, having deleveraged for more than a decade, but the spectre of a trade war with the US has made them vulnerable to any strengthening of the reserve currency. They need to raise interest rates, by more than is required to control domestic inflation, in order to defend against capital flight.

In light of these developments, the recent divergence between developed and emerging markets – and especially the outperformance of US stocks – is understandable. US rates are rising, elsewhere in developed markets they are generally not; added to which, US tariffs are biting, especially in mercantilist economies which have relied, for so many years, on exporting to the ‘buyer of last resort’ – namely the US. Nonetheless, the chart below shows that divergence has occurred quite frequently over the past 15 years, this phenomenon is likely to be temporary: –

MSCI Developed vs MSCI EM 24-8-2018 Yardeni Research

Source: MSCI, Yardeni Research

Another factor is at work, which benefits US stocks, the outperformance of the technology sector. As finance costs have fallen, to levels never witnessed in recorded history, it has become easier for zombie companies to survive, crowding out more favourable investment opportunities, but it has also allowed, technology companies, with no expectation of near-term positive earnings, to continue raising capital and servicing their debts for far longer than during the tech-bubble of the 1990’s; added to which, the most successful technology companies, which evolved in the aftermath of the bursting of the tech bubble, have come to dominate their niches, often, globally. Cheap capital has helped prolong their market dominance.

Finally, capital flows have played a significant part. As emerging market stocks came under pressure, international asset managers were quick to redeem. These assets, repatriated most often to the US, need to be reallocated: US stocks have been an obvious destination, supported by a business-friendly administration, tax cuts and tariff barriers to international competition. These factors may be short-term but so is the stock holding period of the average investment manager.

Among the most important questions to consider looking ahead over the next five years are these: –

  1. Will US tariffs start to have a negative impact on US inflation, economic growth and employment?
  2. Will the US$ continue to rise? And, if so, will commodity prices suffer, forcing the Federal Reserve to reverse its tightening as import price inflation collapses?
  3. Will the collapse in the value of the Turkish Lira and the Argentine Peso prompt further competitive devaluation of other emerging market currencies?

In answer to the first question, I believe it will take a considerable amount of time for employment and economic growth to be affected, provided that consumer and business confidence remains strong. Inflation will rise unless the US$ rises faster.

Which brings us to the second question. With higher interest rates and broad-based economic growth, primed by a tax cut and tariffs barriers, I expect the US$ to be well supported. Unemployment maybe at a record low, but the quality of employment remains poor. The Gig economy offers workers flexibility, but at the cost of earning potential. Inflation in raw materials will continued to be tempered by a lack of purchasing power among the vastly expanded ranks of the temporarily and cheaply employed.

Switching to the question of contagion. I believe the ramifications of the recent collapse in the value of the Turkish Lira will spread, but only to vulnerable countries; trade deficit countries will be the beneficiaries as import prices fall (see the table at the end of this letter for a recent snapshot of the impact since mid-July).

At a recent symposium hosted by Aberdeen Standard Asset Management – Emerging Markets: increasing or decreasing risks? they polled delegates about the prospects for emerging markets, these were their findings: –

83% believe risks in EMs are increasing; 17% believe they are decreasing

46% consider rising U.S. interest rates/rising U.S. dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat

50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latin America to have the greatest potential

64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.

The increase in EM bond yields may be encouraging investors back into fixed income, but as I wrote recently in Macro Letter – No 99 – 22-06-2018 – Where in the world? Hunting for value in the bond market there are a limited number of markets where the 10yr yield offers more than 2% above the base rate and the real-yield is greater than 1.5%. That Turkey has now joined there ranks, with a base rate of 17.75%, inflation at 15.85% and a 10yr government bond yield of 21.03%, should not be regarded as a recommendation to invest. Here is a table looking at the way yields have evolved over the past two months, for a selection of emerging markets, sorted by largest increase in real-yield (for the purposes of this table I’ve ignored the shape of the yield curve): –

EM Real Yield change June to August 2018

Source: Investing.com

Turkish bonds may begin to look good value from a real-yield perspective, but their new government’s approach to the imposition of US tariffs has not been constructive for financial markets: now, sanctions have ensued. With more than half of all Turkish borrowing denominated in foreign currencies, the fortunes of the Lira are unlikely to rebound, bond yields may well rise further too, but Argentina, with inflation at 31% and 10yr (actually it’s a 9yr benchmark bond) yielding 18% there may be cause for hope.

Emerging market currencies have been mixed since July. The Turkish Lira is down another 28%, the Argentinian Peso by 12%, Brazilian Real shed 6.3% and the South African Rand is 5.7% weaker, however the Indonesian Rupiah has declined by just 1.6%. The table below is updated from Macro Letter 100 – 13-07-2018 – Canary in the coal-mine – Emerging market contagion. It shows the performance of currencies and stocks in the period January to mid-July and from mid-July to the 28th August, the countries are arranged by size of economy, largest to smallest: –

EM FX and stocks Jan-Jul and Jul-Aug 2018

Source: Investing.com

It is not unusual to see an emerging stock market rise in response to a collapse in its domestic currency, especially where the country runs a trade surplus with developed countries, but, as the US closes its doors to imports and growth in Europe and Japan stalls, fear could spread. Capital flight may hasten a ‘sudden stop’ sending some of the most vulnerable emerging markets into a sharp and painful recession.

Conclusions and Investment Opportunities

My prediction of six weeks ago was that Turkey would be the market to watch. Contagion has been evident in the wake of the decline of the Lira and the rise in bond yields, but it has not been widespread. Those countries with twin deficits remain vulnerable. In terms of stock markets Indonesia looks remarkably expensive by many measures, India is not far behind. Russia – and to a lesser extent Turkey – continues to appear cheap… ‘The markets can remain irrational longer than I can remain solvent,’ as Keynes once said.

Emerging market bonds may recover if the Federal Reserve tightening cycle is truncated. This will only occur if the pace of US economic growth slows in 2019 and 2020. Another possibility is that the Trump administration manage to achieve their goal, of fairer trading arrangements with China, Europe and beyond, then the impact of tariffs on emerging market economies may be relatively short-lived. The price action in global stock markets have been divergent recently, but the worst of the contagion may be past. Mexico and the US have made progress on replacing NAFTA. Other countries may acquiesce to the new Trumpian compact.

The bull market in US stocks is now the longest ever recorded, it would be incautious to recommend stocks except for the very long-run at this stage in the cycle. In the near-term emerging market volatility should diminish and over-sold markets are likely to rebound. Medium-term, those countries hardest hit by the recent crisis will languish until the inflationary effects of currency depreciations have fed through. In the Long Run, a number of emerging markets, Turkey included, offer value: they have demographics on their side.

Where in the world? Hunting for value in the bond market

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Macro Letter – No 99 – 22-06-2018

Where in the world? Hunting for value in the bond market

  • Few government bond markets offer a positive real return
  • Those that do tend to have high associated currency risk
  • Active management of fixed income portfolios is the only real solution
  • Italy is the only G7 country offering a real-yield greater than 1.5%

In my last Macro Letter – Italy and the repricing of European government debt – I said: –

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets.

Suffice to say, I received a barrage of advice from some of my good friends who have worked in the fixed income markets for the majority of their careers. I felt I had perhaps been flippant in dismissing an entire asset class without so much as a qualm. In this letter I distil an analysis of more than one hundred markets around the world into a short list of markets which may be worthy of further analysis.

To begin with I organised countries by their most recent inflation rate, then I added their short term interest rate and finally, where I was able to find reliable information, a 10 year yield for the government bond of each country. I then calculated the real interest rate, real yield and shape of the yield curve.

At this point I applied three criteria, firstly that the real yield should be greater than 1.5%, second, that the real interest rate should also exceed that level: and finally, that the yield curve should be more than 2% positive. These measures are not entirely arbitrary. A real return of 1.5% is below the long-run average (1.7%) for fixed income securities in the US since 1900, though not by much. For an analysis of the data, this article from Observations and Notes is informative – U.S. 10-Year Treasury Note Real Return History: –

As you might have expected, the real returns earned were consistently below the initial coupon rate. The only exceptions occur around the time of the Great Depression. During this period, because of deflation, the value of some or all of the yearly interest payments was often higher than the original coupon rate, increasing the yield. (For more on this important period see The 1929 Stock Market Crash Revisited)

While the average coupon rate/nominal return was 4.9%, the average real return was only1.7%. Not surprisingly, the 3.2% difference between the two is the average inflation experienced for the century.

As an investor I require a positive expected real return with the minimum of risk, therefore if short term interest rates offer a real return of more than 1.5% I will incline to favour a floating rate rather than a fixed rate investment. Students of von Mises and Rothbard may beg to differ perhaps; for those of you who are unfamiliar with the Austrian view of the shape of the yield curve in an unhampered market, this article by Frank Shostak – How to Interpret the Shape of the Yield Curve provides an excellent primer. Markets are not unhampered and Central Banks, at the behest of their respective governments, have, since the dawn of the modern state, had an incentive to artificially lower short-term interest rates: and, latterly, rates across the entire maturity spectrum. For more on this subject (6,000 words) I refer you to my essay for the Cobden Centre – A History of Fractional Reserve Banking – the link will take you to part one, click here for part two.

Back to this week’s analysis. I am only interested in buying 10yr government bonds of credit worthy countries, where I can obtain a real yield on 10yr maturity which exceeds 1.5%, but I also require a positive yield curve of 2%. As you may observe in the table below, my original list of 100 countries diminishes rapidly: –

Real Bond yields 1.5 and 2 percent curve

Source: Investing.com, Trading Economics, WorldBondMarkets.com

Five members of this list have negative real interest rates – Italy (the only G7 country) included. Despite the recent prolonged period of negative rates, this situation is not normal. Once rates eventually normalise, either the yield curve will flatten or 10yr yields will rise. Setting aside geopolitical risks, as a non-domicile investor, do I really want to hold the obligations of nations whose short-term real interest rates are less than 1.5%? Probably not.

Thus, I arrive at my final cut. Those markets where short-term real interest rates exceed 1.5% and the yield curve is 2% positive. Only nine countries make it onto the table and, perhaps a testament to their governments ability to raise finance, not a single developed economy makes the grade: –

REal Bond yields 1.5 and 2 pecent curve and 1.5 real IR

Source: Investing.com, Trading Economics, WorldBondMarkets.com

There are a couple of caveats. The Ukrainian 10yr yield is derived, I therefore doubt its accuracy. 3yr Ukrainian bonds yield 16.83% and the yield curve is mildly inverted relative to official short-term rates. Brazilian bonds might look tempting, but it is important to remember that its currency, the Real, has declined by 14% against the US$ since January. The Indonesian Rupiah has been more stable, losing less than 3% this year, but, seen in the context of the move since 2012, during which time the currency has lost 35% of its purchasing power, Indonesian bonds cannot but considered ‘risk-free’. I could go on – each of these markets has lesser or greater currency risk.

I recant. For the long term investor there are bond markets which are worth consideration, but, setting aside access, liquidity and the uncertainty of exchange controls, they all require active currency management, which will inevitably reduce the expected return, due to factors such as the negative carry entailed in hedging.

Conclusions and investment opportunities

Investing in bond markets should be approached from a fundamental or technical perspective using strategies such as value or momentum. Since February 2012 Greek 10yr yields have fallen from a high of 41.77% to a low of 3.63%, although from the July 2014 low of 5.47% they rose to 19.44% in July 2015, before falling to recent lows in January of this year. For a trend following strategy, this move has presented abundant opportunity – it increases further if the strategy allows the investor to be short as well as long. Compare Greek bonds with Japanese 10yr JGBs which, over the same period, have fallen in yield from 1.02 in January 2012 to a low of -0.29% in July 2016. That is still a clear trend, although the current BoJ policy of yield curve control have created a roughly 10bp straight-jacket beyond which the central bank is committed to intervene. The value investor can still buy at zero and sell at 10bp – if you trust the resolve of the BoJ – it is likely to be profitable.

The idea of buying bonds and holding them to maturity may be profitable on occasion, but active management is the only logical approach in the current global environment, especially if one hopes to achieve acceptable real returns.